Business Finance 12th Ed.

BUSINESS
FINANCE
PEIRSO N
12e BROW N
EASTON
HOW ARD
PINDER
BUSINESS
FINANCE
Monash University
L
University of Melbourne
University of Newcastle
Monash University
—
Graw
Hill
Education
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National Library o f Australia Cataloguing-in-Publication Data

Author: Peirson, Graham, author.
Title: Business finance / Graham Peirson, Rob Brown, Steve Easton,
Sean Pinder, Peter Howard.
Edition: 12th edition
ISBN: 9781743078976 (paperback)
Notes: Includes index.
Subjects: Business enterprises-Finance.
Cash management.
Corporations-Finance.
Other Authors/Contributors: Brown, Rob, author.
Easton, Stephen Andrew, author.
Pinder, Sean, author.
Howard, Peter, author.
Dewey Number: 658.15
Published in Australia by
McGraw-Hill Education (Australia) Pty Ltd
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PUBLISHER'S FOREW ORD
When this endeavour began 44 years ago, few could have foreseen the success of this publication, and few
could have imagined how proud we would be to have published a resource that has guided well over 2 0 0 0 0 0
undergraduate students through their introduction to business finance. This title has become one of McGraw-Hill
Education Australia's longest-standing and most successful textbooks. It is with the greatest pleasure that McGraw-
Hill Australia now presents the twelfth edition of Business Finance by Graham Peirson, Rob Brown, Steve Easton,
Peter Howard and Sean Pinder.
This text is an original work—not an adaptation of US material. The founding authors, Graham Peirson and Ron
Bird, embarked on an ambitious undertaking: to write a meaningful introduction to the fascinating field of business
finance, specifically for students in Australia and New Zealand. They succeeded, and the first edition was published
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Quality content is clearly the key. The twelfth edition author team has worked hard, in consultation with instructors
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up-to-date thinking in an accessible format that will engage students and instructors alike. This twelfth edition has
done just that, demonstrating the authors, commitment to refining their text and ensuring that Business Finance not
only retains a reputation for currency, but emerges once again as the standard setter.
Our focus at McGraw-Hill is wholly on providing superior content. W ith Business Finance twelfth edition we are
confident we offer you the best there is.
M c G ra w -H ill Education A u stra lia , 2 0 1 4
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BRIEF C O N TEN TS
CHAPTER 1 Introduction 1
CHAPTER 2 Consumption, investment and the capital market 10
CHAPTER 3 The time value o f money: on introduction to financial mathematics 28
CHAPTER 4 A pplying the time value o f money to security valuation 74
CHAPTER 5 Project evaluation: principles and methods 103
CHAPTER 6 The application o f project evaluation methods 129
CHAPTER 7 Risk and return 772
CHAPTER 8 The capital market 210
CHAPTER 9 Sources o f finance: equity 232
CHAPTER 10 Sources o f finance: debt 275
CHAPTER 11 Payout policy 315
CHAPTER 12 Principles o f capital structure 3 56
CHAPTER 13 C apital structure decisions 3 93
CHAPTER 14 The cost o f capital 417
CHAPTER 15 Leasing and other equipment finance 450
CHAPTER 16 C apital market efficiency 477
CHAPTER 17 Futures contracts and swops 507
CHAPTER 18 Options and contingent claims 5 63
CHAPTER 19 Analysis o f takeovers 605
CHAPTER 2 0 Managem ent o f short-term assets: inventory 646
CHAPTER 21 Managem ent o f short-term assets: liqu id assets and accounts receivable 666
C O N TEN TS
Publisher's foreword V Digital resources xxx i

Preface X X V // Highlights o f this edition xxx ii
About the authors x x v iii How to use this book xxxiv
Acknowledgments XXX
Chapter 1 Introduction
Learning objectives
ID FINANCE AS AN AREA OF STUDY 2

IB FINANCIAL DECISIONS 2
IB BUSINESS STRUCTURES 3
1.3.1 Sole proprietorship 3
1.3.2 Partnership 3
1.3.3 Company 4
IQ THE COMPANY'S FINANCIAL OBJECTIVE 5
IB FUNDAMENTAL CONCEPTS IN FINANCE 5

1.5.1 Value 5
1.5.2 The time value of money 5
1.5.3 Risk aversion 6
1.5.4 Nominal and real amounts 6
1.5.5 Market e仟iciency and asset pricing 6
1.5.6 Derivative securities 7
1.5.7 Arbitrage 7
1.5.8 Agency relationships 7
ID OUTLINE OF THE BOOK 8

Summary 8
Key terms 8
Questions 9
Chapter 2 Consumption, investment and the capital market 10

Learning objectives JO
m INTRODUCTION 11
^ FISHERY SEPARATION THEOREM: A SIMPLIFIED EXAMPLE 11

2.2.1 Introduction to the example 11
2.2.2 Assumptions 11
2.2.3 The shareholders7 consumption opportunities and preferences 12
2.2.4 Solution: introduce a capital market 12
2.2.5 An analysis using rates of return 13
2.2.6 A solution requiring borrowing 13
C ontents
2.2.7 Fisher's Separation Theorem and net present value 13

2.2.8 Fisher’s Separation Theorem: summary 14
Q | FISHERS SEPARATION THEOREM: A FORMAL APPROACH 14

2.3.2 The company 15
2.3.3 The shareholders 15
2.3.4 The company’s decision 16
2.3.5 Solution: introduce a capital market 16
2.3.6 Proving there is an optimal policy 19
2.3.7 Identifying the optimal policy 21
2.3.8 Implications for financial decision making 22
B | INVESTORS'REACTIONS TO MANAGERS' DECISIONS 24

2.4.1 Certainty 25
2.4.2 The introduction of uncertainty 25
Summary 26
Key terms 26
Questions 26
Problems 26
References 27
The time value of money: an introduction to

financial mathematics 28
Learning objectives 28
m INTRODUCTION 29
|B FUNDAMENTAL CONCEPTS OF FINANCIAL MATHEMATICS 29

3.2.1 Cashflows 29
3.2.2 Rate of return 29
3.2.3 Interest rate 30
3.2.4 Time value of money 30
IQ SIMPLE INTEREST 31
3.3.1 The basic idea of simple interest 31
3.3.2 Formula development: future sum 31
3.3.3 Formula development: present value 32
3.3.4 Applications of simple interest 32
COMPOUND INTEREST 33
3.4.1 The basic idea of compound interest 33
3.4.2 Formula development: future sum and present value 34
3.4.3 Nominal and effective interest rates 37
3.4.4 Compound interest: two special cases and a generalisation 40
IB VALUATION OF CONTRACTS WITH MULTIPLE CASH FLOWS 46

3.5.1 Introduction 46
3.5.2 Value additivity 46
ix
C ontents
3.5.3 Formula development: valuation as at any date 48

3.5.4 Measuring the rate of return 49
|Q ANNUITIES 50
3.6.1 Definition and types of annuity 50
3.6.2 Formula development: present value of an ordinary annuity 51
3.6.3 Formula development: present values of annuities-due, deferred annuities and
ordinary perpetuities 52
3.6.4 Future value of annuities 56
IB PRINCIPAL-AND-INTEREST LOAN CONTRACTS 58

3.7.1 Basic features of the contract 58
3.7.2 Principal and interest components 59
3.7.3 Balance owing at any given date 60
3.7.4 Loan term required 61
3.7.5 Changing the interest rate 62
|Q GENERAL ANNUITIES 63
Summary 66
Key terms 66
Self-test problems 66
Questions 67
Problems 67
References 73
Applying the time value of money to security valuation 74

ED INTRODUCTION 75
IQ FINANCIAL ASSET VALUATION UNDER CERTAINTY 75
m VALUATION OF SHARES 76
4.3.1 Valuation of shares assuming certainly 76
4.3.2 Valuation of shares under uncertainty 77
4.3.3 Share valuation and the price-earnings ratio 79
|Q VALUATION OF DEBT SECURITIES 80
EB INTEREST RATE RISK 81
ED THE TERM STRUCTURE OF INTEREST RATES 82

4.6.1 W hat is the term structure? 82
4.6.2 Using the term structure to price a bond 83
4.6.3 Term structure theories: expectations and liquidity (risk) premium 85
4.6.4 Empirical evidence 88
4.6.5 Inflation and the term structure 89
EB THE DEFAULT-RISK STRUCTURE OF INTEREST RATES 89

C ontents
W
ED OTHER FACTORS AFFECTING INTEREST RATE STRUCTURES 91
Summary 92
Key terms 92
Questions 93
Problems 93
References 96
APPENDIX 4.1 DURATION AND IMMUNISATION 97

Introduction 97
Bond duration 97
Duration and interest elasticity 99
Duration and bond price changes 100
Duration and immunisation 100
I Project evaluation: principles and methods 103

m INTRODUCTION 104
Q THE CAPITAL-EXPENDITURE PROCESS 104
E 9 METHODS OF PROJECT EVALUATION 104

5.3.1 Discounted cash flow methods 107
0 3 THE DISCOUNTED CASH FLOW METHODS COMPARED 108

5.4.1 Net present value 108
5.4.2 Internal rate of return 109
5.4.3 Choosing between the discounted cash flow methods 112
5.4.4 Benefit-cost ratio (profitability index) 1 17
Q OTHER METHODS OF PROJECT EVALUATION 118

5.5.1 Accounting rate of return 1 18
5.5.2 Payback period 120
5.5.3 Economic value added (EVA) 121
Q PROJECT EVALUATION AND REAL OPTIONS ANALYSIS 123

5.6.1 Real options analysis 123
5.6.2 W ho uses real options analysis? 124
Summary 125
Key terms 125
Questions 125
Problems 126
References 128
xi
C ontents
Chapter 6 The application of project evaluation methods 129

INTRODUCTION 130
APPLICATION 〇 F THE NET PRESENT VAUJE METHOD 130

6.2.1 Estimation of cash flows in projectevaluation 130
6.2.2 Illustration of cash-flow information in project evaluation 133
TAX ISSUES IN PROJECT EVALUATION 134

6.3.1 Effect of taxes on net cash flows 134
6.3.2 Illustration of cash-flow information inproject evaluation with taxes 137
COMPARING MUTUALLY EXCLUSIVE PROJECTS THAT HAVE DIFFERENT LIVES 139
DECIDING WHEN TO RETIRE (ABANDON) OR REPLACE A PROJECT 146

6.5.1 Retirement decisions 146
6.5.2 Replacement decisions 147
ANALYSING PROJECT RISK 149

6.6.1 Sensitivity analysis 149
6.6.2 Break-even analysis 151
6.6.3 Simulation 152
DECISION-TREE ANALYSIS 153
QUALITATIVE FACTORS AND THE SELECTION OF PROJECTS 156
PROJECT SELECTION WITH RESOURCE CONSTRAINTS 157

Summary 159
Key terms 159
Questions 160
Problems 161
References 171
Chapter 7 Risk and return 172

INTRODUCTION 173
RETURN AND RISK 173
THE INVESTORS UTILITY FUNCTION 176
THE RISK OF ASSETS 179
PORTFOLIO THEORY AND DIVERSIFICATION 179

7.5.1 Gains from diversification 180
7.5.2 Diversification with multiple assets 184
7.5.3 Systematic and unsystematic risk 186
7.5.4 The risk of an individual asset 187
7.5.5 The efficient frontier 189
C ontents
m THE PRICING OF RISKY ASSETS 190

7.6.1 The capital market line 191
7.6.2 The Capital Asset Pricing Model (CAPM) and the security market line 192
7.6.3 Implementation of the CAPM 195
7.6.4 Risk, return and the CAPM 197
■ ADDITIONAL FACTORS THAT EXPLAIN RETURNS 197
Q PORTFOLIO PERFORMANCE APPRAISAL 198

7.8.1 Alternative measures of portfolio performance 199
Summary 203
Key terms 204
Questions 204
Problems 205
References 208
The capital market 210
INTRODUCTION 211
8.1.1 The flow of funds 21 1
8.1.2 The capital market 211
8.1.3 Types of financial market 212
8.1.4 Developments in Australia's financial markets 212
8.1.5 Business funding 214
■ FINANCIAL AGENCY INSTITUTIONS 215

8.2.1 Brokers and the stock exchange 216
8.2.2 Investment banks 217
HI FINANCIAL INTERMEDIARIES 220

8.3.1 Banks 220
8.3.2 Money market corporations 223
8.3.3 Finance companies 223
8.3.4 Securitisation 223
IQ INVESTING INSTITUTIONS 224

8.4.1 Insurance companies and superannuation funds 225
8.4.2 Unit trusts and investment companies 228
8.4.3 Overseas sources and markets 229
Summary 230
Key terms 230
Questions 230
References 231
C ontents
I Sources of finance: equity 232

BD INTRODUCTION 233
Q THE CHARACTERISTICS OF ORDINARY SHARES 234

9.2.1 Fully paid and partly paid shares 234
9.2.2 Limited liability 234
9.2.3 No liability companies 234
9.2.4 The rights of shareholders 235
9.2.5 Advantages and disadvantages of equity as a source of finance 235
PRIVATE EQUITY 236

9.3.1 W hat is private equity? 236
9.3.2 Information problems and new ventures 237
9.3.3 Sources of finance for new ventures 237
9.3.4 Finance from business angels 238
9.3.5 Finance from private equity funds 238
d INFORMATION DISCLOSURE 240

9.4.1 Offers of unlisted securities 240
9.4.2 Offers of listed securities 241
9.4.3 Offers that do not need disclosure 241
Q FLOATING A PUBLIC COMPANY 242

9.5.1 Public versus private ownership 242
9.5.2 Initial public offering of ordinary shares 243
9.5.3 Pricing a new issue 243
9.5.4 Underwriting and managing a newissue 244
9.5.5 Selling a new issue 246
9.5.6 The costs of floating a company 246
9.5.7 Long-term performance of IPOs 250
SUBSEQUENT ISSUES OF ORDINARY SHARES 252

9.6.1 Rights issues 253
9.6.2 Placements (private issues) 260
9.6.3 Contributing shares and instalment receipts 262
9.6.4 Share purchase plans 262
9.6.5 Company-issued share options 262
9.6.6 Choosing between equity-raising methods 263
m EMPLOYEE SHARE PLANS 265
B 3 INTERNAL FUNDS 266

9.8.1 Dividend reinvestment plans 267
® MANAGING A COMPANY'S EQUITY STRUCTURE 268

9.9.1 Bonus issues and share splits 268
9.9.2 Share consolidations 269
C ontents
Summary 270
Key terms 270
Questions 271
Problems 272
References 273
Chapter 10 Sources of finance: debt 275

BT8B1 INTRODUCTION 276
1BH GENERAL CHARACTERISTICS OF DEBT 277
10.2.1 The interest cost of debt 278
10.2.2 Effect of debt on risk 279
10.2.3 Effect of debt on control 279
10.2.4 Security for debt 280
10 3 ■ SHORT-TERM BORROWING FROM BANKS AND OTHER FINANCIAL INSTITUTIONS 282

10.3.1 Bank overdraft 282
10.3.2 Debtor finance 283
10.3.3 Inventory loans 284
10.3.4 Bridging finance 284
10 4 ■ LONG-TERM BORROWING FROM BANKS AND OTHER FINANCIAL INSTITUTIONS 285

10.4.1 Long-term loan choices available to borrowers 285
10.4.2 Variable-rate term loans 286
10.4.3 Fixed-rate term loans 287
10.4.4 Other features of term loans 287
10.4.5 W hy do borrowers use term loans instead of security issues? 288
10 5 ■ DEBT SECURITIES 289

10.5.1 Debt securities: the general principles 289
10.5.2 Commercial paper 290
10.5.3 Bills of exchange 292
10.5.4 Debentures 295
10.5.5 Unsecured notes 297
10.5.6 Corporate bonds 297
10 6 ■ PROJECT FINANCE 301

10.6.1 The main features of project finance 301
10.6.2 When is project finance attractive? 302
10 7 ■ HYBRIDS OF DEBT AND EQUITY 302

10.7.1 Convertible notes and convertible bonds 303
10.7.2 Preference shares 305
Summary 309
Key terms 309
C ontents

Questions 310
Problems 311
References 313
Chapter 1 1 Payout policy 315

Learning objectives 3 75
INTRODUCTION 316
11.1.1 Dividend declaration procedures 316
11.1.2 Types of dividend 317
11.1.3 Legal and tax considerations 317
11.1.4 Repurchasing shares 318
IS PAYOUT POLICY IMPORTANT TO SHAREHOLDERS? 319

11.2.1 Alternative payout policies 319
1 1.2.2 Managers and payout decisions 320
11.2.3 The irrelevance of payout policy 321
1 1.2.4 The importance of full payout 323
11.2.5 Payout policy in practice 324
TRANSACTION COSTS AND FLOTATION COSTS 324

1 1.3.1 Transaction costs 324
1 1.3.2 Flotation costs 325
|
DIVIDENDS AND TAXES 325

1 1.4.1 Dividends and the imputation tax system 325
1 1.4.2 Imputation and capital gains tax 327
1 1.4.3 Dividend policy with imputation and capital gains tax 328
gl
1 1.4.4 The market value of franking credits 329
INFORMATION EFFECTS AND SIGNA山 NG TO INVESTORS 332
DD AGENCY COSTS AND CORPORATE GOVERNANCE
BEHAVIOURAL FACTORS AND CATERING THEORY

335
339
SHARE BUYBACKS 339
DD 11.8.1 W hy do companies repurchase shares?

1 1.8.2 Share repurchases in Australia
340
343
I
DD DIVIDEND REINVESTMENT PLANS AND DIVIDEND ELECTION SCHEMES 346
PAYOUT POLICY AND COMPANY LIFE CYCLE 347

Summary 349
Key terms 349
Questions 350
Problems 351
References 353
C ontents
Chapter 12 Principles of capital structure 356

|B | INTRODUCTION 357
12.2 THE EFFECTS OF FINANCIAL LEVERAGE 357
12.3 THE MODIGLIANI AND MILLER ANALYSIS (NO TAX CASE) 361
12.3.1 Modigliani and Miller's Proposition 1 361
12.3.4 W hy is the M M analysis important? 369
12.4 THE EFFECTS OF TAXES ON CAPITAL STRUCTURE UNDER A CLASSICAL TAX SYSTEM 369
12.4.1 Company income tax 369
12.4.2 Company tax and personal tax 371
12.4.3 Miller's analysis 373
12.4.4 The scope of Miller's analysis 374
12.5 THE EFFECTS OF TAXES ON CAPITAL STRUCTURE UNDER AN IMPUTATION TAX SYSTEM 374
12.5.1 W hat is an imputation tax system? 374
12.5.2 The effects of tax on capital structure decisions under an imputation tax system 376
12.6 THE COSTS OF FINANCIAL DISTRESS 377

12.6.1 Bankruptcy costs 377
12.6.2 Indirect costs of financial distress 378
12.7 AGENCY COSTS 379

12.7.1 Conflicts of interest between lenders and shareholders 379
12.7.2 Conflicts of interest between shareholders and company managers 380
12.8 OPTIAAAL CAPITAL STRUCTURE: THE STATIC TRADE-OFF THEORY 381

12.9 CAPITAL STRUCTURE WITH INFORMATION ASYMMETRY 382
12.9.1 Pecking order theory 382
12.9.2 Information asymmetry and the undervaluation of a company's assets 383
12.9.3 Information asymmetry and the overvaluation of a company's assets 385
12.9.4 Implications of information asymmetry for financing policy 386
Summary 387
Key terms 387
Questions 388
Problems 389
References 392
Capital structure decisions 393

13.1 INTRODUCTION 394
13.1.1 Company financing: some initial facts 394
XVII
C ontents
13.2 EVIDENCE ON CAPITAL STRUCTURE 395

13.2.1 Evidence on taxes 395
13.2.2 Evidence on the costs of financial distress 397
13.2.3 Evidence on agency costs 399
13.2.4 Evidence on information costs and the pecking order theory 401
13.2.5 Evidence from dual issues and spin-offs 403
13.2.6 Evidence on the choice of maturity and priority of debt 404
13.2.7 Evidence from surveys 405
13.3 ASSESSING THE THEORIES OF CAPITAL STRUCTURE 406

13.3.1 How useful is the static trade-off theory? 406
13.3.2 How useful is the pecking order theory? 407
13.4 FINANCING AS A MARKETING PROBLEM 408

13.5 DETERMINING A FINANCING STRATEGY 409
13.5.1 Business risk 409
13.5.2 Asset characteristics 410
13.5.3 Tax position 410
13.5.4 Maintaining reserve borrowing capacity ('financial slack') 411
13.5.5 Other factors 411
Summary 412
Key terms 412
Questions 413
References 414
The cost of ca pital 417

|Q | INTRODUCTION 418
B 〇 RISK, RETURN AND THE COST OF CAPITAL 418

14.2.1 Risk independence 419
14.3 TAXES AND THE COST OF CAPITAL 419
14.4 ALTERNATIVE APPROACHES TO ESTIMATION OF THE COST OF CAPITAL 421
14.4.1 Direct use of the CAPM 421
14.4.2 The weighted average cost of capital (WACC) 422
14.5 ESTIMATION OF THE COST OF CAPITAL: AN EXTENDED EXAMPLE 423

14.5.1 The cost of debt 424
14.5.2 The cost of preference shares 427
14.5.3 The cost of ordinary shares 427
14.5.4 The company's cost of capital 429
14.5.5 Issue costs and the cost of capital 430
14.6 PROJECT AND COMPANY COST OF CAPITAL 431
14.6.1 Calculating the cost of capital for divisions using the 'pure play7 approach 432
14.6.2 Calculating the cost of capital for divisions using the direct estimation approach 434
x v iii
EVALUATION TECHNIQUES 436
[ED USING CERTAINTY EQUIVALENTS TO ALLOW FOR RISK 437

Summary 440
Key terms 440
Questions 441
Problems 442
References 446
APPENDIX 14.1 THE COST OF CAPITAL UNDER ALTERNATIVE TAX SYSTEMS 447
Introduction 447
Deriving cost of capital formulae 447
Summary 449
Chapter 15 Leasing and other equipment finance 450

[Q l INTRODUCTION 451
451
15.2.1 Finance leases 452
15.2.2 Operating leases 453
15.2.3 Sale and lease-back agreements 453
15.2.4 Leveraged leasing 454
15.2.5 Cross-border leasing 455
[ Q | ACCOUNTING AND TAXATION TREATMENT OF LEASES 455

15.3.1 Accounting for leases 455
15.3.2 Taxation treatment of leases 456
15.4 SETTING LEASE RENTALS 456

15.5 EVALUATION OF FINANCE LEASES 458
15.5.1 Leasing decisions and investment decisions 460
15.5.2 The value of leasing in competitive capital markets 461
15.5.3 Establishing an advantage for leasing 462
15.5.4 Taxes and the size of leasing gains 463
15.5.5 Leasing and the imputation tax system 464
15.6 EVALUATION OF OPERATING LEASES 465

15.7 ADVANTAGES AND DISADVANTAGES OF LEASING 466
15.7.1 Possible advantages of leasing 466
15.7.2 Leasing policy 469
15.8 CHATTEL MORTGAGES AND HIRE-PURCHASE 471

15.8.1 Equipment finance and the goods and services tax 471
C ontents
Summary 472
Key terms 472
Questions 473
Problems 474
References 475
Chapter 16 Capital market efficiency 477

16.2 THE EFFICIENT AAARKET HYPOTHESIS 478
16.2.1 A non-instantaneous price reaction 479
16.2.2 A biased price reaction 479
16.2.3 Categories of capital market efficiency 480
16.2.4 Market efficiency and the joint test problem 480
16.3 TESTS 〇 F RETURN PREDICTABILITY 481

16.3.1 The relationship between past and future returns 481
16.3.2 The presence of seasonal effects in returns 482
16.3.3 Predicting future returns on the basis of other forecast variables 483
16.4 EVENT STUDIES 487

16.4.1 The methodology of event studies 487
16.4.2 Evidence: profit and dividend announcements in Australia 491
16.4.3 Other events 493
TESTS FOR PRIVATE INFORMATION 493

16.6 MARKET EFFICIENCY AT THE MACRO LEVEL 495
16.7 BEHAVIOURAL FINANCE AND MARKET EFFICIENCY 495
16.8 IMPLICATIONS OF THE EVIDENCE WITH RESPECT TO MARKET EFFICIENCY 497
16.8.1 Implications for investors in securities 497
16.8.2 Implications for financial managers 499
Summary 501
Key terms 501
Questions 501
References 503
Chapter 17 Futures contracts and swaps 507

17.2 WHAT IS A FUTURES CONTRACT? 509
17.2.1 Forward contracts and futures contracts 509
17.2.2 How a futures market is organised 509
C ontents
17.2.3 Deposits, margins and the mark-to-market rule 51 1

17.2.4 The present value of a futures contract 512
17.3 THE AUSTRALIAN SECURITIES EXCHANGE 512
17.4 DETERMINANTS OF FUTURES PRICES 513
17.5 FUTURES MARKET STRATEGIES: SPECULATING AND HEDGING 515

17.5.1 Introduction 515
17.5.2 Speculating 516
17.5.3 Hedging 517
17.5.4 Some reasons why hedging with futures is imperfect 518
17.5.5 Hedging and regretting 521
17.5.6 Selecting the number of futures contracts 522
17.6 FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 90-DAY

BANK-ACCEPTED BILL FUTURES CONTRACT 525
17.6.1 A brief review of bank bills 525
17.6.1 Specification of the bank-accepted bill futures contract 526
17.6.2 Uses of the bank bill futures contract 527
17.7 FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 10-YEAR

TREASURY BOND FUTURES CONTRACT 532
17.7.1 A brief review of bond pricing 532
17.7.2 Specification of the 10-year bond futures contract 533
17.7.3 Uses of the 10-year bond futures contract 533
17.8 FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE 30-DAY

INTERBANK CASH RATE FUTURES CONTRACT 535
17.9 FINANCIAL FUTURES ON THE AUSTRALIAN SECURITIES EXCHANGE: THE SHARE

PRICE INDEX S&P/ASX 200 (SPI 200) FUTURES CONTRACT 536
17.9.1 A brief review of Australian Securities Exchange indices 536
17.9.2 Specification of the S&P/ASX 200 futures contract 537
17.9.3 Uses of the S&P/ASX 200 futures contract 537
17.10 VALUATION OF FINANCIAL FUTURES CONTRACTS 540

17.10.1 Valuation of bank bill futures contracts 540
17.10.2 Valuation of share price index futures contracts 541
FORWARD-RATE AGREEMENTS 542
SWAPS 544
17.12.1 W hat is a swap? 544
17.1 2.2 Interest rate swaps 544
CURRENCY SWAPS 551

Summary 556
Key terms 557
Questions 557
Problems 558
References 562
C ontents
Chapter 18 Options and contingent claims 563

(E D INTRODUCTION 564
564
18.2.1 W hat is an option? 564
1 8.2.2 How options are created and traded 565
1 8.2.3 Option contracts and futures contracts 566
1 8.2.4 Payoff structures for calls and puts 566
1 8.2.5 Factors affecting call option prices 567
1 8.2.6 Some basic features of put option pricing 571
18.2.7 Put-call parity 573
1 8.2.8 The minimum value of calls and puts 576
B H BINOMIAL OPTION PRICING 577

1 8.3.1 The basic idea: pricing a single-period calloption using the binomial approach 577
1 8.3.2 Risk neutrality as a solution method 579
1 8.3.3 Binomial option pricing with many time periods 579
1 8.3.4 Applying the binomial approach to other option problems 582
^ 1 THE BLACK-SCHOLES MODEL OF CALL OPTION PRICING 582

1 8.4.2 The Black-Scholes equation 583
1 8.4.3 A brief assessment of the Black-Scholes model 587
OPTIONS ON FOREIGN CURRENCY 588

18.5.1 W hat is an option on foreign currency? 589
1 8.5.2 Combinations of options on foreign currency 590
18.6 OPTIONS, FORWARDS AND FUTURES 591

18.7 OPTIONS ON FUTURES 593
1 8.7.1 W hat is an option on a futures contract? 593
1 8.7.2 Uses of options on futures 593
18.7.3 Pricing options on futures 594
18.7.4 Specification of the SPI 200 futures options contract 594
18.8 CONTINGENT CLAIMS 595

18.8.1 W hat is a contingent claim? 595
18.8.2 Rights issues 595
18.8.3 Convertible bonds 596
1 8.8.4 Valuation of levered shares and risky zero-coupon debt 596
1 8.8.5 Valuation of levered shares and risky coupon-paying debt 596
1 8.8.6 Project evaluation and Veal’ options 597
Summary 599
Key terms 599
C ontents
Questions 600
Problems 601
References 604
.；
, 1 Analysis of takeovers 605
INTRODUCTION 606
19.1.1 Fluctuations in takeover activity 606
19.1.2 Types of takeover 607
19.2 I REASONS FOR TAKEOVERS 608

19.2.1 Evaluation of the reasons for takeovers 609
19.2.2 Survey evidence of the motives for takeovers 613
19.2.3 The roles of takeovers 613
19 3 ■ECONOMIC EVALUATION OF TAKEOVERS 614

19.3.1 Comments on estimation of takeover gains 615
19.3.2 Comparing gains and costs 616
19.3.3 Estimating cost for a share-exchange takeover 617
19 4 ■ALTERNATIVE VALUATION APPROACHES 618

19.4.1 Valuation based on earnings 618
19.4.2 Valuation based on assets 619
19 5 ■REGULATION AND TAX EFFECTS OF TAKEOVERS 619

19.5.1 Off-market bids 620
19.5.2 Market bids 621
19.5.3 Disclosure requirements 621
19.5.4 Creeping takeover 622
19.5.5 Partial takeovers 622
19.5.6 Schemes of arrangement 622
19.5.7 Other controls on takeovers 623
19.5.8 Tax effects of takeovers 623
19.5.9 Break fees, takeovers and corporate governance 624
1 1 9 . 6 1 TAKEOVER DEFENCES 625

19.6.1 Poison pills 625
19.6.2 Acquisition by friendly parties 625
19.6.3 Disclosure of favourable information 625
19.6.4 Claims and appeals 626
19.6.5 The effects of takeover defences 626
W 7 | CORPORATE RESTRUCTURING 627

19.7.1 Divestitures 627
19.7.2 Spin-offs 627
19.7.3 Buyouts 628
XXIII
C ontents
EMPIRICAL EVIDENCE ON TAKEOVERS 630

19.8.1 The target company 631
19.8.2 The acquiring company 631
19.8.3 Are takeovers poor investments? 633
19.8.4 Distinguishing between good and bad takeovers 636
19.8.5 The net effects of takeovers 636
19.8.6 The sources of gains from takeovers 637
Summary 639
Key terms 639
Questions 640
Problems 642
References 643
Chapter 20 Management of short-term assets: inventory 646

B Q INTRODUCTION 647
THE IMPORTANCE OF SHORT-TERM FINANCIAL DECISIONS 647
TYPES OF SHORT-TERM ASSET 648

20.3.1 Inventory 648
20.3.2 Liquid assets (cash and short-term investments) 648
20.3.3 Accounts receivable (debtors) 648
B Q THE NEED FOR SHORT-TERM ASSET MANAGEMENT 648
Q fl SHORT-TERM ASSETS AND SHORT-TERM LIABILITIES 649
E H OVERVIEW OF INVENTORY MANAGEMENT 650
INVENTORY COSTS: RETAILING AND WHOLESALING 650

20.7.1 Acquisition costs 650
20.7.2 Carrying costs 651
20.7.3 Stockout costs 651
B Q INVENTORY COSTS: MANUFACTURING 651

20.8.1 Inventories of raw materials 651
20.8.2 Inventories of finished goods 652
E 0 in v e n t o r y MANAGEMENT UNDER CERTAINTY 652

20.9.1 The economic order quantity (EOQ) model 652
20.9.2 Cost estimation 655
20.9.3 The EOQ model with positive lead time 656
20.9.4 The EOQ model with quantity discounts 657
E S S INVENTORY MANAGEMENT UNDER UNCERTAINTY 658

20.10.1 Specifying an acceptable probability of stockout 660
20.10.2 Specifying an acceptable expected customer service level 660
20.11 INVENTORY MANAGEMENT AND THE 'JUST-IN-TIME' SYSTEM 661
Summary 662
Key terms 663
Questions 663
Problems 664
References 665
Chapter 21 Management of short-term assets:丨

iquid assets and
accounts receivable 666
O H INTRODUCTION 667
w xn OVERVIEW OF LIQUIDITY MANAGEMENT 667
21.2.1 W hat are liq u id ' assets? 667
21.2.2 Liquidity management and treasury management 667
21.2.3 Centralisation of liquidity management 668
21.2.4 Motives for holding liquid assets 669
21.2.5 Major issues in liquidity management 669
Q Q CASH BUDGETING 670

21.3.1 Forecasting cash receipts 670
21.3.2 Forecasting cash payments 671
THE CHOICE OF SHORT-TERM SECURITIES 673

Q Q TYPES OF SHORT-TERM INVESTMENT 674
21.5.1 Deposits of funds with financial institutions 674
21.5.2 Discounting of commercial bills 674
21 6 | THE CORPORATE TREASURER AND LIQUIDITY MANAGEMENT 675

Q Q OVERVIEW OF ACCOUNTS RECEIVABLE MANAGEMENT 675
21.7.1 What are accounts receivable? 675
CREDIT POLICY 677

21.8.1 The decision to offer credit 677
21.8.2 Selection of credit-worthy customers 677
21.8.3 Limit of credit extended 680
21.8.4 Credit terms 680
Q Q COLLECTION POLICY 681
EVALUATION OF ALTERNATIVE CREDIT AND COLLECTION POLICIES 682

Summary 686
Key terms 687
Questions 687
C ontents
Problems 688
References 689
APPENDIX 21.1 FINANCIAL STATEMENT ANALYSIS 690

Introduction 690
Measurement and interpretation of several financial ratios 690
Usefulness of financial ratio analysis 695
Financial ratios and short-term asset management 696
Appendix A Numerical tables 698

Appendix B Solutions to self-test problems 709
Glossary 725
Index 736
xxvi
PREFACE
W
This book is designed primarily for use in a first subject in the principles and practice of finance. Our main objectives
are to introduce readers to finance theory and to the tools of financial decision making in the context of the
Australian institutional environment. Nevertheless, it is also suitable for students who have completed an introductory
subject on capital markets and financial institutions. It also contains sufficient material for two subjects in finance.
Readers who are familiar with previous editions of the book will notice changes that go well beyond the updating
that might be expected from a new edition. New finance theories and new empirical evidence are presented with
each edition. For example, in this edition both new theoretical material and related empirical evidence have been
incorporated on the determinants of payout policy (Chapter 1 1), the capital structure decision (Chapter 13) and the
analysis of takeovers (Chapter 19). Some of this new material provides more detailed coverage, compared with
previous editions, of the expanding area of behavioural finance—an area where investor psychology is incorporated
into research design. Theories and evidence with respect to market efficiency (Chapter 16) are also updated.
Since the eleventh edition, Eugene Fama and Robert Shiller have each been awarded the Nobel Memorial Prize in
Economic Sciences for their work examining market efficiency. Both have made a fundamental contribution to our
understanding of market efficiency yet they have different views as to the extent that markets are efficient. Like the
Nobel Prize Committee, the approach we take is to highlight the range of evidence in this area.
Practice in finance also necessitates updates. For example, since the last edition there have been on-going
developments in financial markets, including in Australia, and changes in the functions of banks. M any of these
developments result from the Global Financial Crisis and are incorporated in Chapter 8.
Rather than distort the coherent flow of the book by altering its structure to reflect these changes in principles and
practice, new material is embedded into the existing structure. Indeed, the major structural change in this edition is
the omission of international finance as a separate chapter and instead embedding material where appropriate into
relevant chapters; in particular into Chapter 17, which now incorporates a detailed discussion of swaps.
Finally, we wish to express our special thanks to Graham Peirson and Peter Howard who have both retired
from active authorship but have made a substantial contribution to the foundations of the book. Graham deserves
particular mention. Having been central to the book from the first edition, he continues to make a great contribution
to each new edition by providing valuable comments on the draft of each chapter. Graham brings not only a deep
knowledge but also an uncanny ability to detect flaws in logic and in writing style. His thoroughness has again
prevented many such flaws from appearing in print.
ROB BROWN ♦ STEVE EASTON ♦ SEAN PINDER August 2014
x x v ii
ABO U T THE AUTHORS
G rah am Peirson
Graham Peirson is Emeritus Professor of Accounting and Finance at Monash
University. He has published widely in academic and professional journals and
is also coauthor of Issues in Financial Accounting; Accounting: An Introduction;
Financial Accounting: An Introduction; and Financial Accounting Theory.
Graham is a graduate of Adelaide University, and has taught at Adelaide
University, the University of California (Berkeley), the University of Illinois, the
University of Florida and the University of Washington. He has also taught short
courses for a range of clients, including the Australian Competition and
Consumer Commission and the National Australia Bank.
Rob Brown
Rob Brown is Emeritus Professor of Finance at the University of Melbourne. He
has published many research papers in international journals, including
Economica, the Journal o f Banking and Finance, the Journal o f Multinational
Financial Monogementand \he Journal o f Fixed Income. He is a former associate
editor (finance) of Accounting and Finance, the research journal of the
Accounting and Finance Association of Australia and New Zealand. Rob has
taught at the University of Sydney, Lancaster University and Monash University,
and been a visiting scholar at the University of British Columbia (Canada) and
the University of Manchester (UK). His current research interests are analysts'
investment recommendations.
Steve Easton
Steve Easton is Professor of Finance at the University of Newcastle, where he
previously served as Head of the Department of Accounting and Finance and
Dean of the Faculty of Economics and Commerce. His research work has been
accepted for publication in a wide range of journals, including the Journal o f
Futures Markets, Economico and the Journal o f Banking and Finance. Steve has
taught at Adelaide University, Lancaster University and Monash University. He
has also provided short courses for a range of private and public sector
organisations, including Australia Post, Macquarie Generation, State Forests of
New South Wales and the Tasmanian Chamber of Commerce and Industry. His
current research interests are in asset pricing, portfolio management and
corporate governance.
XXVIII
Peter H o w a rd
Peter Howard taught finance at Monash University for more than 25 years.
Before this he worked for eight years as an engineer in the petrochemical and
mining industries. He has extensive experience in project evaluation and has
taught on short courses for a range of clients, including BHP Billiton and the
National Australia Bank. Peter has published in academic and professional
journals on lease evaluation and the effects of imputation on payout and
financing decisions. He has extensive teaching experience at both postgraduate
and undergraduate levels. Since retiring from Monash University he has
maintained a strong interest in the finance literature and the operation of
Australian financial markets.
Sean Pinder
Sean Pinder is an Associate Professor in the Department of Finance at the
University of Melbourne. Prior to this he held positions at Monash University and
the University of Newcastle and taught at the postgraduate level at Lancaster
University in England and the Melbourne Business School. He has undertaken a
range of consulting activities for international firms and has developed and
delivered professional short courses on treasury risk management, derivatives
and capital budgeting issues for major Australian and international companies.
Sean has an extensive research profile, with his work appearing in leading
Australian and international journals. He has received a number of prizes for
his research and teaching.
A C K N O W LE D G M E N T S
We have received valuable assistance from a number of people, including Philip G. Brown, Chris Deeley, Paul
Docherty, Stefan Petry and Michael Seamer.
We would like to join McGraw-Hill in thanking academic colleagues who provided their valuable time and
expertise in aligning the learning resources with this edition of our book. They include:
♦ Mariya Yesseleva-Pionka, Monash University

♦ Neil Hartnett, University of Newcastle
♦ Damian Bridge, Macquarie University
♦ Md Akhtaruzzaman, University of Newcastle
We also owe a debt of thanks to the following reviewers of earlier editions who have helped us shape the text
you hold today: John Ablett (University of Western Sydney), David Allen (Edith Cowan University), Vicki Baard
(Macquarie University), Robert Bianchi (Griffith University), Barry Burgan (University of Adelaide), Nicholas Carline
(Lancaster University, UK), Meena Chavan (Macquarie University), Andrew Child (Monash University), Scott Dobbs
(University of Wollongong), Samson Ekanayake (Deakin University), Don Geyer (Charles Sturt University), Abeyratna
Gunasekarage (Monash University), Neil Hartnett (University of Newcastle), Darren Henry (La Trobe University),
Ben Jacobsen (James Cook University), Sian Owen (University of New South Wales), Judy Paterson (University of
Canberra), Alex Proimos (Macquarie University), Boyd Scheuber (University of Southern Queensland), Chander
Shekhar (University of Melbourne), Jing Shi (Australian National University), Yew Lee Tan (Victoria University),
Madhu Veeraraghavan (Monash University) and David W oodliff (University of Western Australia).
In addition, we thank publisher Jillian Gibbs and senior product developer Jane Roy.
Thanks also to Kate Easton for her suggestions for the cover design of this book.
Finally, and most importantly, we thank our wives—Chris, Rayna, Diane, Dawn and Debra—for their support
during this project.
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HIGHLIGHTS OF THIS EDITION
CHAPTER 1 CHAPTER 8
► Delivers a simple, concise overview of the essential ► Update on developments in Australian financial
concepts of corporate finance. markets.
► Expanded discussion of the functions of banks.
CHAPTER 2
CHAPTER 9
► Provides detailed coverage of Fisher’s Separation
Theorem and the company’s objective to maximise ► Provides greater detail on the various accelerated
current value. rights issue structures that have developed in the
Australian market and recent evidence on the
CHAPTER 3 popularity of, and costs associated with, the main
► Introduces simple interest, compound interest and methods of raising equity capital.
the time value of money in one logically structured CHAPTER 10
chapter.
► Features a new Finance in action piece on the
CHAPTER 4 failure of the Banksia Financial Group.
► Updating of discussion of debtor finance.
► Greater emphasis on zero-coupon rates and the
► Expanded overview of the growth of the debenture
zero-rate curve.
and corporate debt markets in Australia.
► New section on pricing off the zero curve.
► Includes estimates of the Australian
zero-rate curve. BRIEF CONTENTS
► Updates Australian corporate and government
CHAPTER 1 Introduction ...................................... 1
ratings. CHAPTER 2 Consumption, investment and the
► Expanded explanation of liquidity (risk) premium capital market ................................ 10
approach to the term structure. CHAPTER 3 The time value of money: an
introduction to financial
CHAPTER 5 mathematics....................................28
► Provides international survey evidence of capital CHAPTER 4 Applying the time value of money
budgeting practices. to security valuation ...................... 74
► Features an in-depth discussion of the application CHAPTER 5 Project evaluation: principles and
of real options analysis as well as evidence of the methods ......................................103
extent of usage of the technique. CHAPTER 6 The application of project
evaluation methods.................... 129
CHAPTER 6 CHAPTER 7 Risk and return ........................... 172
CHAPTER 8 The capital market .......................210
► Is dedicated specifically to applying methods of
CHAPTER 9 Sources of finance: e q u ity ...........232
project evaluation.
CHAPTER 10 Sources of finance: debt ............. 275
► Includes a new section dealing specifically with CHAPTER 11 Payout policy ...............................315
how taxes should be incorporated into project CHAPTER 12 Principles of capital structure ...... 356
evaluation techniques. CHAPTER 13 Capital structure decisions ..........393
CHAPTER 14 The cost of capital ...................... 417
CHAPTER 7 CHAPTER 15 Leasing and other equipment
► Updates estimates of the systematic risk of finance ..........................................450
Australian firms. CHAPTER 16 Capital market efficiency ............477
► Updates empirical evidence concerning the market CHAPTER 17 Futures contracts and swaps........ 507
risk premium in an international and domestic CHAPTER 18 Options and contingent claims ..563
context. CHAPTER 19 Analysis of takeovers ..................605
CHAPTER 20 Management of short-term assets:
► Includes a detailed discussion of models that
inventory .....................................646
incorporate factors other than systematic risk in
CHAPTER 21 Management of short-term assets:
explaining expected returns.
liquid assets and accounts
► Addresses alternative methods of appraising the
receivable..................................... 666
performance of an investment portfolio.
H ighlights of this edition
^ Expanded discussion of convertible securities and ► Features a new Finance in action piece illustrating
why they are issued. the impact of expectations in share market reaction
► Restructure of the discussion of preference shares. to announcements.
CHAPTER 1 1 CHAPTER 17
► Includes changes in the legal requirements for ► Includes updated exchange contracts values and
payment of dividends. exchange indices throughout.
► Emphasises the importance of a 'full payout' policy ► The chapter now includes a detailed discussion
and de-emphasises the dividend irrelevance theorem. of swaps, including a comprehensively revised
► Highlights recent evidence on the market value of discussion of interest rate swaps which emphasises
franking credits. the different uses of swaps.
► Discusses recent research on the growing
CHAPTER 1 8
importance of share buybacks and the substitution
► Includes updated examples illustrating the
of buybacks for dividends.
relationship between an option's market price
於 Includes an explanation of behavioural factors that
and characteristics such as its term-to-expiry and
may affect payout policy.
exercise price.
► Features a new Finance in action piece on ANZ
► Features a Finance in action piece describing how
Bank’s dividend announcement.
options written on a share price index are used to
CHAPTER 12 create a Volatility Index (VIX), which then provides
► Updates of examples. useful information to investors about the level of
uncertainty in the market.
CHAPTER 13
► Features a new Finance in action piece on the CHAPTER 19
benefits of the no-debt decision of a company that ► Updates empirical evidence on the fluctuations in
had previously experienced a financial collapse. takeover activity over time.
► Includes recent Australian evidence on surveys of ► Includes a new section providing survey evidence
chief financial officers. of the motives of acquiring managers for takeover
► Includes recent empirical evidence on the costs of activity.
financial distress. ► Updates the discussion of the regulation of takeover
► Includes recent empirical evidence with respect to activity.
agency costs. ► Extensively updates the empirical evidence
presented on the wealth effects of alternative forms
CHAPTER 14
of takeovers and corporate restructuring including
► Updates empirical evidence on the value of the role of investor psychology in determining what
imputation tax credits in Australia. an appropriate bid price may need to be in order
► A streamlined discussion of the impact of taxes on to ensure success of a bid.
the process of project evaluation.
► Features a new Finance in action piece dealing with CHAPTER 2 0
the new approach taken by the Australian Energy ► Provides concise but thorough coverage of short
Regulator to estimate an appropriate weighted term assets, focusing on inventory, for the curious
average cost of capital for energy distributors. or advanced student.
► A new Finance in action piece on inventory
CHAPTER 15
management problems at Treasury W ine Estates.
► Updated evidence on the use of lease finance by
Australian companies. CHAPTER 21
► Includes a discussion of the proposed changes to the ► Provides concise but thorough coverage of short
accounting standards relating to leases as put forward term assets, focusing on liquid assets and accounts
by the International Accounting Standards Board receivable, for the curious or advanced student.
► Provides, in the appendix, a completely updated
CHAPTER 16
comprehensive example demonstrating the
► Incorporates a range of new evidence with respect application of financial statement analysis
to the extent to which markets are efficient. techniques in practice.
XXXIII
H O W TO USE THIS B O O K
L e arn in g objectives list the information you will learn by studying the chapter. They are restated in the margins
in appropriate locations and so become useful revision tools.
LEARNING OBJECTIVES
After studying this chapter you should be able to:
1 understand how assets are valued under conditions of certainty
m
2 use the tools of financial mathematics to value equity securities
3 explain the main differences between the valuation of ordinary shares based on dividends and on LEARNING
earnings OBJECTIVE 1
4 use the tools of financial mathematics to value debt securities Understand how
assets are valued
5 explain the nature of interest rate risk
under conditions of
6 understand the theories that are used to explain the term structure of interest rates certainty
7 understand the effect of default risk on interest rates
8 apply the concept of duration to immunise a bond investment.
C h ap fe r introductions give you an overview of the chapter's most important points and contextualise the topics
to the wide area of business finance.
Introduction
I n C h a p t e r 1 w e d is c u s s e d b r ie f ly t h e im p o r t a n t c o n c e p t o f t h e t im e v a lu e o f m o n e y . I n C h a p te r 3 w e
p r e s e n te d s o m e m a t h e m a t ic a l to o ls u s e f u l i n a n a ly s in g p ro b le m s in v o lv in g t h e t im e v a lu e o f m o n e y .
I n p a r t i c u la r , w e s h o w e d h o w p ro m is e d s tre a m s o f f u t u r e ca sh flo w s c a n b e v a lu e d , p r o v id e d t h a t th e
r e q u ir e d r a te o f r e t u r n is k n o w n .
I n t h i s c h a p te r w e a p p ly th e s e to o ls t o t h e v a lu a t io n o f d e b t a n d e q u it y s e c u r itie s . I n i t i a l l y w e
a s s u m e t h a t t h e s e c u r it y s f u t u r e c a s h flo w s a re k n o w n w i t h c e r ta in ty . L a t e r in t h e c h a p te r w e in tr o d u c e
u n c e r t a in t y , b u t o n ly i n a lim it e d w a y . A m o re f o r m a l a n d d e ta ile d t r e a t m e n t o f u n c e r t a in t y is g iv e n in
C h a p te r 6 .
K e y term s are defined in the margins beside the term's first appearance in the text. These terms are then listed in
the glossary at the end of the book.
T h e le a s t c o m p lic a te d m e a s u re o f t h e t e r m s tr u c tu r e o f in t e r e s t ra te s is t h e m a r k e t y ie ld o n a
g o v e r n m e n t b o n d t h a t p a y s n o in t e r e s t d u r in g it s lif e , b u t p a y s a fix e d s u m a t m a t u r it y . S u c h a b o n d is
ZERO-COUPON BONDS k n o w n as a z e r o - c o u p o n b o n d ( o f te n a b b r e v ia te d ju s t t o a z e r o ) .
(ze r o s )
T h e p ric e o f a z e ro w i t h a fa c e v a lu e o f F d o lla r s a n d a t e r m o f n y e a rs is s im p ly :
bonds that pay only
one cash flow, the
payment at maturity P〇 = (l+z„)n
E x a m p le s are provided
Example 4.
throughout the text to illustrate
Rankine Ltd is currently paying a dividend of 90 cents per share. If investors expect this dividend
to be maintained and require a rate of return of 15 per cent on the investment, what is the value of the practical application of
Rankine’s shares?
the theory and working
SOLUTION
The value of Rankine's shares is calculated as follows: providing guidance for
歷0 .1 5 students.
0
= $ 6.00
xxxiv
How TO USE THIS BOOK
Finance in action
F,NANCE ON GUARD AGAINST A BOND FALL is a feature containing
IN ACTION ----------------------------- ------------ ------- ---- ----------------- ---------------------- ------------------- ------------
In an artide published in 2013, financial journalist Christopher Joye reminds readers of interest
rate risk, which flows from the connection between interest rates and bond prices. interesting items from the
Bond traders have been making out like bandits since the global financial crisis. A portfolio of business media that relate
Australian government bonds with maturities longer than 10 years has delivered annual total
returns of over 12 per cent since December 2007. the theory to real-world
Yet the preconditions for the mother-of-all bond market reckonings are sliding into place.
This contingency, which AM P^ Shane O liver believes is a 'significant risk', could result in practice.
wiping more than $60 billion off Aussie bond values, with steep capital losses.
To properly understand these risks, one needs to appreciate how extraordinary current
circumstances are. W hen doing so, it helps to keep in mind a key principle: bonds that pay
fixed, a$ opposed to variable, rates hove prices that are inversely related to external interest
rates.
If you invested in a bond paying an annual fixed coupon of, say, 3 per cent, and market
interest rates surge to 5 per cent, that bond would be worth substantially less than when you
bought it. The converse is also true: if market rates decline ... it would be worth more.
This is why Australian government bond prices have soared since 2007: market yields
have fallen sharply as global central banks have floored policy rates close to zero and printed
unprecedented amounts of money to fund public and private debt.
Source: 'O n guard against a bond fall', Christopher Joye, Australian Financial Review, 5 January 2013, p. 39.
S u m m a rie s give students

SUMMARY
a checklist of the topics
• Financial assets such as bonds and shares can be and a price-earnings ratio. The value of this ratio
covered in the chapter and valued by discounting their future cash flows to depends mainly on risk and expected growth in
present values and summing these present values. earnings.
serve as a useful revision The discount rate used is the required rate of return • Debt securities (bonds) are priced by discounting
or opportunity cost of capital. their future coupon interest payments and face
tool when preparing for • If the future cash flows from an asset are certain, value. For any company, the interest rate required by
the required rate of return will reflect only the lenders will be less than the required rate of return
exams. effect of time on the value of money. on the company's ordinary shares. The price of a
• If the future cash flows are uncertain, investors debf security is inversely related to the interest rate
will also require compensation for risk and the required by investors.
rate will be increased by the inclusion o f a risk • Interest rates at any given time will usually be different
premium. for different terms to maturity. This pattern is known
Self-test p ro b le m s
f jt SELF-TEST PROBLEMS
at the end of selected
chapters cover all the
1 Richards Ltd pays annual dividends on its ordinary shares. The latest dividend was 75 cents per share
and was paid yesterday. Dividends are expected to grow at 8 per cent per annum for the next 2 years, topics within the chapter
after which a growth rate of 4 per cent per annum will be maintained indefinitely. Estimate the value of
one share if the required rate of return is 14 per cent per annum. for thorough exam
2 A government bond with a face value of $100 and a coupon interest rate of 11 per cent per annum
matures in 3 years, time. Inferest payments occur twice each year and a payment has just been made. preparation.
If the current market yield on the bond is 13 per cent per annum, what is the current price of the bond?
3 The current interest rates (yields) on zero-coupon government bxinds are as follows:
1 13.90
2 11.70
3 10.50
Assume that the term structure can be explained purely by expectations of future interest rates, and
therefore there is no liquidity (or risk) premium. Calculate the expected 1-year rates for the next 2 years.
Solutions to self-test p r o b lem s a r e a v a ila b le in A p p e n d ix B.
Additional e n d -of-ch ap te r
q u e stio n s a n d p ro b le m s cA PROBLEMS
provide further practice and 1 Valuation under certainly [LO 1]
A promise to pay $10000 in 4 years, time is certain to be kept. If the risk-free rate for a 4-year term is 5.5 per
develop deeper understanding cent per annum, what is the value of this promise today? Do we know what the value will be in a year's time?
Why or why not?
of the topics covered. They 2 Valuation of shares [LO 2]
are linked back to the learning Assume that today is the last day of 2014. Rednip Ltd is expected to pay annual dividends of 64 cents in
2015 (Year 1). Assume that this dividend is expected to grow at an annual rate of 10 per cent and investors
objectives for each chapter. require a rate of return of 20 per cent per annum,
a) Estimate Rednip Ltd's share price today.
XXXV
CHAPTER CONTENTS
m Finance as an area of study 2 m The company's financial objective
m Financial decisions 2 KB Fundamental concepts in finance
KQ Busi门
ess structures 3 IB Outline of the book
LEARNING OBJECTIVES
1 describe the structure of finance as an area of study
2 identify the major decisions made by financial managers and investors
3 identify the major types of business entities
4 specify the objective of the company
5 identify and explain the fundamental concepts in finance.
B usiness finance
Finance as an area of study

This book introduces the reader to the area o f study know n as finance. Although financial issues have
LEARNING been studied fo r centuries, i t is only relatively recently— in the last 50 years or so— th a t finance has
OBJECTIVE 1
Describe the structure emerged as an area o f study in its own rig ht, w ith a well-established body o f theory and evidence. In the
of finance as an area chapters th a t follow, we w ill introduce you to the m ajor issues in finance.
of study Finance can be described as having tw o m ain components, which are:1
• corporate finance
• investments.
Corporate finance takes the view point o f the company. The m ain issues involved are the choice o f
assets, the financing decision and the dividend decision. Imagine th a t a group o f investors has set up a
new company. The investors are the shareholders (that is, the owners) o f the company. The company must
decide2 w hat assets i t w ill buy and how i t w ill fund the purchase o f these assets. The company may use its
own m oney— th a t is, the money contributed by the shareholders— to fund the purchase, or i t may borrow
the money. O r it may use b oth shareholders* funds and borrowed funds. When the company has been
operating fo r a tim e, it may have made a p ro fit. I f so, it may decide to d istribute some or all o f the p ro fit to
the shareholders. Such a d istrib u tio n is called a dividend. I f the dividend paid is less than the p ro fit, then
some o f the p ro fit is retained w ith in the company, and w ill be used to fu nd asset acquisitions and/or debt
repayment. Corporate finance is also concerned w ith corporate governance issues. For example, should
the Board o f Directors include some outsiders*? Should senior managers be granted shares to encourage
them to make decisions th a t are in the best interests o f the shareholders?
Investments takes the view point o f the investor rather than the company. Investors are concerned
about the re tu rn they w ill earn on an investm ent — the more the better. But unless investors are w illin g
to take a risk, they cannot expect to earn a high return. A ll investors dream o f fin d in g an investm ent
th a t produces high returns at low risk— b u t m ost w ill never fin d one. So, investors m ust make a trade
o ff between retu rn and risk. In investm ents, this balancing o f risk and re tu rn is a m ajor issue. A large
p art o f the solution is fo r investors to choose a diversified set o f assets in w hich to invest. Investments
is also about the pricing o f securities such as shares and bonds. These securities are traded in financial
markets, many o f which are very active, w ith transactions ru n n in g in to the m illions o f dollars every day.
How does the risk o f a security affect the price at which i t w ill trade in these financial markets? W hat
factors, other than risk, m ig ht also be im portant? And how m ig h t the price be expected to change in
the future?
Financial decisions
In this book we focus on financial decisions made by companies and investors. Some o f these decisions are:
LEARNING
OBJECTIVE 2 Corporate (or company) decisions:
Identify fhe major
decisions made by Asset management: W hat new assets should the company acquire? How much should i t pay fo r
financial managers these assets?
and investors W orking capital management: How much cash should the company hold? How much inventory?
Capital structure: How much should the company borrow?
Payout policy: How much should the company pay out to its shareholders?
Mergers and acquisitions: Should the company take over another company?
1 A third component, financial markets and institutions, overlaps to some extent with corporate finance and investments. The
focus o f this component is on the markets for various securities and the design of financial instruments. It also considers the
financial issues faced by banks and other financial institutions.
2 Strictly speaking, a company is just a legal structure, and hence cannot have any personal qualities, such as the ability to make
decisions. Company decisions are in fact made by people such as the company s directors. However, for ease of exposition, we
attribute personal qualities to companies.
C hapter o ne Introduction
Investor decisions:
• Portfolio theory: How can an investor achieve a better trade-off between risk and return?
• Asset pricing: How much is a particular security w orth? W hat is the relationship between long-term
interest rates and short-term interest rates?
Busi门ess structures
When a business is being established, one o f the firs t decisions th a t has to be made concerns the type o f
business structure th a t is to be used. In Australia, although many small businesses are sole proprietorships LEARNING
OBJECTIVE 3
or partnerships, nearly all large businesses, and many thousands o f small businesses, are companies.
Identify the major
Hence, in this book, our focus is on companies. But to place the corporate (company) form in context, we types of business
firs t discuss the advantages and disadvantages o f sole proprietorships and partnerships. entities
1.3.1 I Sole proprietorship

A sole proprietorship is a business owned by one person. M any small service businesses, retail stores SOLE PROPRIETORSHIP
and professional practices are operated as sole proprietorships. business owned by

one person
Advantages
The advantages o f a sole proprietorship structure include:
• Control o f the business rests w ith the owner, so it is relatively easy to make decisions and there is no
scope fo r disagreements between owners.
• I t is easy and inexpensive to form , and to dissolve.
• It is n o t treated as a separate e n tity fo r tax purposes. Therefore, any business p rofits belong to the
owner and are taxed only once as p art o f the owner s assessable income.
Disadvantages
The disadvantages o f a sole proprietorship structure include:
• It is n o t a separate legal e n tity and therefore the owner has unlim ite d lia b ility fo r debts incurred by
the business. In other words, all obligations o f the business are personal obligations o f the owner.
• The size o f the business is lim ite d by the wealth o f the owner and by the am ount th a t can be
borrowed. I t can be d ifficu lt to raise funds fo r expansion because lenders are usually reluctant to
lend large amounts to individuals.
• Ownership o f a sole proprietorship can be transferred only by selling the business to a new owner. I f
a sole proprietorship is n o t sold, then i t w ill cease to exist when the owner retires or dies.
1 .3.2! Partnership
A partn ersh ip is a business owned by tw o or more people acting as partners. M any small service PARTNERSHIP
businesses, retail stores and professional practices are operated as partnerships. business owned by
two or more people
acting as partners
Advantages
The advantages o f a partnership structure include:
• I t is easy and inexpensive to fo rm because there are no legal requirements th a t need to be met. A ll
th a t is necessary is an agreement, preferably in w ritin g to avoid future disagreements, by those
form ing the partnership.
• A partnership can combine the wealth and talents o f several individuals, and employees can be
offered the prospect o f becoming partners (owners) in the future.
B usiness finance
Disadvantages
There are also im p o rta n t disadvantages o f a partnership structure, including:
• Partnerships are n o t separate legal entities and the partners are therefore personally liable for
obligations (including debts) entered in to by the partnership.
• It can be d ifficu lt fo r partners to w ithdraw th e ir investm ent because the partnership w ill term inate
i f a p artne rs interest in the partnership is sold or a partner dies. In either case, a new partnership
w ill have to be formed.
• Disputes between partners or form er partners can be very damaging.
.3 .3 1Company
COMPANY A com pany is a separate legal e n tity form ed under the Corporations A ct 2001. The owners o f a company
separate legal entity are called shareholders because th e ir ownership interests are represented by shares in the company s
formed under the
capital. Companies vary greatly in size. They range from large companies listed on a stock exchange w ith
Corporations Act
2001; shareholders many thousands o f shareholders to small fam ily companies carrying on a relatively small-scale business.
are the owners of a In a large company, the shareholders and the managers are usually separate groups. The shareholders
company elect the Board o f Directors, which appoints managers to run the company on behalf o f the shareholders.
Advantages
Companies have several advantages, including:
• A company is a legal e n tity d istin ct from the owners, which enables it to conduct its operations in
its own name. A company can buy, own and sell property; it can sue or be sued in its own name; and
LIMITED LIABILITY i t can enter into contracts w ith other entities. The shareholders o f m ost companies have lim ited
legal concept that liability. This means th a t i f the company fails and i t is unable to pay its debts, the owners o f fu lly
protects shareholders
paid shares are n o t obliged to contribute fu rth e r funds to meet the company s debts. However, if
whose liability to meet
a company’s debts is shares are p a rtly paid, then shareholders can be obliged to contribute any unpaid amount.
limited to any amount • A company has an indefinite life, which means that, unlike a sole proprietorship or partnership, its
unpaid on the shares existence and operations are unaffected by the death or retirem ent o f its owners.
they hold • The Corporations Act 2001 distinguishes between public companies, which may in vite members
o f the public to invest in them, and proprietary companies, which have no such power. Public
companies may be listed on a stock exchange, which facilitates trading in the company s shares.
Ownership o f shares in a listed public company can be transferred very easily w ith o u t any effect on
the company s operations, which are conducted by employees. Stock exchange lis tin g also makes
it relatively easy fo r public companies to raise capital by issuing additional shares th a t are sold to
existing shareholders or to new investors.
Disadvantages
The corporate form o f ownership also has some disadvantages, which include:
• A company is more expensive to establish than a sole proprietorship or a partnership.

• A company is subject to more onerous regulation. For example, there are extensive reporting
requirements, p articularly fo r listed public companies. Capital raising by companies is also highly
regulated. For example, shares and other securities can be issued only i f investors are provided w ith
info rm a tio n to make inform ed decisions about whether to invest in those securities.
• It can be d ifficu lt to m otivate managers and staff who are employees o f a company. In comparison,
sole proprietorships and partnerships are managed by people who are also owners o f the business
and who w ill see a direct lin k between th e ir efforts and the rewards they receive.
• Because a company is owned by one group (the shareholders) b ut may be run by a d ifferent group
(the managers), there can be conflicts o f interest between those who own the company and those
who make decisions on th e ir behalf. These conflicts result in agency costs1which are discussed
fu rth e r in Section 1.5.8.
• The taxation treatm ent o f companies can be a disadvantage. Company profits are subject to
income tax and shareholders may also be taxed when they receive dividends paid o ut o f the profits.
Therefore, the use o f a company structure can involve double taxation. However, the extent o f this
problem depends on the type o f taxation system imposed by the government. Under Australian tax
law, many shareholders are n ot subject to double taxation.
Much o f this book concerns listed public companies. However, m ost o f the concepts in this book
are also relevant to other form s o f business entity. There w ill, o f course, be differences in the details,
depending on the e n tity s size and the nature o f its business. In addition, many o f the ideas considered in
this book can be applied to n o t-fo r-p ro fit entities, including public sector entities.
Rational solutions to investm ent and financing problems can only be achieved i f the company s objective
is clearly specified. The objective assumed in m ost o f this book is th a t management seeks to maximise LEARNING
OBJECTIVE 4
the m arket value o f the company s ordinary shares. Because an alternative term fo r shares is equityt this
Specify the objective
objective is often expressed as the m axim isation o f the m arket value o f shareholdersJequity. I t is consistent of the company
w ith the economists assumption th a t companies seek to maximise economic p ro fit. I f the m arket value
o f a company s ordinary shares is maximised, then the opportunities open to the shareholders are also
maximised— greater wealth implies more choices. For example, i f a shareholder wishes to sell his or her
shares in order to finance greater consumption, the higher the share price, the greater are his or her
consumption opportunities.
LEARNING
OBJECTIVE 5
Identify and explain
In Section 1.4 we stated th a t we assume th a t management seeks to maximise the m arket value o f the fundamental
concepts in finance
shareholders’ equity. To achieve this objective, the financial manager m ust understand how financial
markets work. To finance a company s investments, securities, such as shares and debt securities, w ill
need to be issued— th a t is, these securities w ill need to be sold to investors. Subsequently, investors may
choose to sell th e ir securities to other investors in financial markets. The actions o f buyers and sellers
in financial markets w ill determ ine the prices o f the securities and therefore the m arket value o f the
company. The m arket value, V, o f a company may be expressed as:
V= D+ E
where D = the m arket value o f the company s debt

E = the m arket value o f the company s equity (shares)
The value th a t the financial markets place on a company s debt and equity securities w ill depend on the
risk and expected return on investments in those securities. In tu rn , the risk and retu rn o f the securities
w ill depend on the risk and return th a t the company achieves on the investments it makes in its assets. In
finance, the success o f an investm ent is judged by its a b ility to generate more cash than originally outlaid
on the investment. This w ill enable the company to make interest payments to lenders and repay the
amount borrowed, and to make payouts, such as dividends, to shareholders.
The tim e value o f money principle is based on the proposition th a t an individual w ill always prefer to TIME VALUE OF M ONEY
receive a dollar today rather than receive a dollar at any later date. Even i f the individual does n ot want principle that a dollar
is worth more (less),
to spend the dollar today, he or she would rather receive the dollar today and then invest it, rather than
the sooner (later) it
receive the dollar at a later date. Therefore, a dollar is w o rth more Qess), the sooner (later) i t is to be is to be received, all
received, all other things being equal.This principle is discussed and applied in Chapter 3. Some fu rth e r other things being
applications are considered in Chapter 4. equal
B usiness finance
1 .5 .3 1 Risk aversion
In finance, i t is usually assumed th a t investors display risk aversion, which means th a t they do not like
risk. Given a choice between tw o investments th a t have the same expected return, b u t one has lower risk,
RISK-AVERSE INVESTOR a risk-averse investor w ill choose the one w ith the lower risk. Risk aversion does n o t im ply that an
an investor who investor w ill reject all risky investments. Rather, it implies th a t an investor w ill choose a risky investment
dislikes risk and who
only i f the expected retu rn on the investm ent is high enough to compensate the investor fo r bearing the
will only choose a
risky investment if the risk. Because investors are risk averse, we expect th a t in the long term , the average re tu rn on high-risk
expected return is high investments w ill exceed the average retu rn on low -risk investm ents— i f this were n o t so, no-one would
enough to compensate invest in the high-risk investments. For example, in the long term , shares produce higher returns than
for bearing the risk bank deposits because shares are riskier than bank deposits. The relationship between ris k and expected
return is discussed in Chapter 7.
The purchasing power o f money changes as a result o f price increases (inflation) and price decreases
(deflation). D uring a period o f in fla tio n there is an increase in the general level o f prices, w ith a consequent
decrease in the purchasing power o f money. In contrast, during a period o f deflation there is a decrease in
the general level o f prices, w ith a consequent increase in the purchasing power o f money. I t is necessary,
therefore, to distinguish between the nominal or face value o f money and the real or inflation-adjusted
value o f money. For example, i f the annual rate o f in fla tio n is 3 per cent, the real value o f a dollar is
decreasing annually by 3 per cent— th a t is, relative to the purchasing power o f a dollar today, a dollar next
year w ill be w orth only 97 cents in real term s.3
Returns on investments may be measured in either nom inal or real terms. In m ost financial markets,
trading is conducted in nom inal terms. Similarly, m ost financial contracts are w ritte n in nom inal terms.
For example, the interest rate agreed to in a loan m ust be paid whatever the future in fla tio n rate turns out
to be. Such an interest rate is called a nominal interest rate. An interest rate may also be expressed in real
terms, w hich is equal to the nom inal interest rate after taking out the effect o f infla tion . I f the nom inal
rate o f retu rn on an investm ent exceeds the in fla tio n rate, then the real rate o f return is positive— th a t is,
the investm ent w ill increase the investors purchasing power.
An efficient financial market is one composed o f numerous w ell-inform ed individuals whose trading
activities cause prices to adjust instantaneously and w ith o u t bias in response to new inform ation. Price
changes are therefore caused by new inform a tion becoming available. The concept o f m arket efficiency
means th a t we should expect securities and other assets to be fa irly priced, given th e ir risk and expected
return.
In Section 1.5.3 we explained that, because investors are risk averse, higher-risk investments w ill
need to offer investors higher expected returns— th a t is, in the long term , risk and expected return w ill
be positively related. But w hat are the details o f this relationship? The capital asset pricing model (CAPM)
provides one answer to this question. According to the CAPM, risk can be a ttributed to tw o sources:
a market-wide factors, such as changes in interest rates and foreign exchange rates— this is called
systematic risk (also referred to as non-diversiftable or market risk)
b factors th a t are specific to a p articular company, such as the possible discovery o f a new m ineral
deposit by a m ining company— this is called unsystematic risk (also referred to as diversifiable or
unique risk).
W hile unsystematic risk can be largely elim inated by the investor holding a well-diversified portfolio,
systematic risk cannot be eliminated.
A nother model th a t has been developed to measure the riskiness o f an investm ent and to establish
the trade-off between risk and expected retu rn is the Fama-French model. According to the CAPM and
3 This result is an approximation. With a rate of inflation of 3 per cent per annum, $1 today is equivalent to $1.03 next year and
it follows that a dollar next year is worth $1/1.03 = $0.970874 today. This issue is discussed further in Chapter 3.
C hapter one Introduction
the Fama-French model, risk-averse investors can diversify th e ir investments to elim inate unsystematic
risk. Consequently, the m arket w ill only reward investors by offering a higher expected retu rn fo r bearing
systematic or m arket risk. Both models are discussed in Chapter 7. M arket efficiency is considered in
detail in Chapter 16.
Derivative securities include forward contracts, futures contracts, options and swaps. In each case, the
value o f the derivative security depends on the value o f some underlying security. For example, the value
o f an option to buy a share in Wesfarmers Ltd depends heavily on the m arket value o f a Wesfarmers
share. In this case, the option is the derivative, while the Wesfarmers share is the prim ary security, or
underlying asset. Real assets, like a coal m ine or an idea fo r a new product, may also have features that
resemble derivatives. For example, the owner o f a coal m ine has the option to close the m ine and reopen
it later. Derivative securities are considered in Chapters 17 and 18.
Arbitrage plays a central role in finance. I f two identical assets were to trade in the same market at different ARBITRAGE
prices, and i f there were no transaction costs, then an arbitrage opp ortu nity would exist. A risk-free p ro fit simultaneous
transactions in
could be made by traders simultaneously purchasing at the lower price and selling at the higher price.
different markets that
This situation could n ot persist because competition among traders would force up the price o f the lower- result in an immediate
priced asset and/or force down the price o f the higher-priced asset u n til the prices o f the two assets were risk-free profit
the same. Arbitrage therefore precludes perfect substitutes from selling at different prices in the same
market. I t follows th a t the financial prices we observe m ust be set by the financial markets in such a way
th a t arbitrage is n ot possible. This idea is simple yet remarkably powerful. It has applications throughout
finance in such diverse areas as the capital structure decision (how much should a company borrow?),
payout policy, interna tion al finance, option pricing and the term structure o f interest rates.
In Section 1.3.3 we m entioned th a t one o f the disadvantages o f the corporate structure is the p ossibility
th a t managers may pursue th e ir own objectives rather than the interests o f the shareholders. For example,
a company th a t operates in a mature ind ustry where there are few grow th opportunities may have surplus
cash th a t cannot be invested p rofitably in its usual fields o f operation. The company s shareholders would
benefit i f the surplus were paid to them as a dividend or used to buy back shares. But the managers may
decide instead to use the cash to acquire another company th a t operates in a different industry. This
investm ent may benefit managers by giving them greater opportunities fo r prom otion and higher pay
justified by the increase in company size. However, the acquisition may n o t increase shareholders* wealth.
There can therefore be a conflict o f interest between shareholders and managers.
M aking an unprofitable takeover is only one way in which managers may pursue th e ir own interests at
the expense o f the shareholders. O ther examples include managers w orking less energetically than they
could and managers directly diverting the company s resources to th e ir own benefit, such as by acquiring
expensive company cars, taking unnecessary business trips to exotic locations, and so on.
The relationship between shareholders and managers is an example o f an agency relationship. In an
agency relationship, one party, the principal, delegates decision-making a u th o rity to another party, the
agent. In a company run by managers, the managers are the agents and the shareholders are the principals.
Shareholders are aware o f the possibility th a t managers may pursue th e ir own objectives and w ill try
to lim it this behaviour by monitoring the behaviour o f managers and by in s titu tin g contracts designed
to align the interests o f managers and shareholders. For example, a Board o f Directors th a t includes
a significant number o f non-executive directors can be effective in m on itoring managers on behalf o f
shareholders. In addition, many companies employ management remuneration schemes designed to give
managers an incentive to maximise shareholders* wealth. For example, these schemes often provide
senior executives, particularly the chief executive, w ith options to purchase shares in the company at
an attractive price. Finally, i f agency costs are high, the company w ill probably be poorly run and, in
B usiness finance
consequence, its share price w ill be low and it may become a target fo r takeover. Existing managers
generally fare badly when such a change o f control occurs, so the desire to avoid being taken over can also
lim it the self-interested behaviour o f managers.
Agency theory has been used to examine various corporate financial decisions including capital
structure, dividend and share repurchase decisions, and leasing decisions. The application o f agency
theory to these decisions is discussed in Chapters 1 1 ,1 2 ,1 3 and 15.
O utline of the book

The ideas introduced in this chapter are developed in the remainder o f the book.
• In Chapters 2 to 7, fundam ental concepts underlying finance theory are developed.

• Chapters 8, 9 and 10 consider sources o f finance fo r companies, and the in s titu tio n a l framework in
which financing decisions are made.
• In Chapters 1 1,12 and 13, payout decisions and financing decisions are discussed.
• Chapter 14 then considers the measurement o f the cost o f capital to be used in project evaluation,
while Chapter 15 provides an analysis o f leases.
• Chapter 16 reviews the literature on m arket efficiency, while Chapters 17 and 18 consider futures
contracts and options respectively.
• Chapter 19 reviews the theory and evidence on takeovers.
• In Chapters 20 and 21 the principles outlined earlier in the book are applied to short-term asset
management, including inventory, cash and accounts receivable.
SUMMARY
M3IA3W 3M〇
In this chapter, we have introduced the key themes to The objective assumed in most of this book is that
be addressed in the book. management seeks to maximise the market value
• The two main components of finance are corporate of the company's ordinary shares (shareholders'
finance and investments. This book focuses on equity). To do this, the financial manager must
financial decisions made by companies (corporate understand how financial markets work. The
decisions), w hich include asset and w orking fundamental concepts in finance include value, the
capital management decisions, capital structure time value of money, risk aversion, nominal versus real
and borrow ing decisions, payout policy and values, market efficiency and asset pricing, derivative
awldvHu
merger and acquisition decisions; and financial securities, arbitrage and agency relationships. The
decisions made by investors (investor decisions), market value (V) of a company can be expressed as
including portfolio and risk decisions and asset the market value of the company's debt (D) plus the
pricing decisions. market value of the company's equity (£).
KEY TERMS
arbitrage 7 risk-averse investor 6
company 4 sole proprietorship 3
limited liability 4 time value of money 5
partnership 3
8
itu
CHAPTER O N E REVIEW
QUESTIONS
1 [LO 2】Distinguish between investment decisions and financing decisions.
2 [LO 3] Explain the following:
a) a sole proprietorship
b) a partnership
c) a company.
3 [LO 3] Outline the advantages and disadvantages of a sole proprietorship.
4 [LO 3] Outline the advantages and disadvantages of a partnership.
5 [LO 3] W hat advantages does a company have over a sole proprietorship and a partnership?
6 [LO 3] W hich types o f investors have limited liability? Explain your answer.
7 [LO 5] W h y do people usually prefer to receive $1 today instead of in a year's time?
8 [LO 5 】 Comment on this statement: A company should borrow during times o f high inflation because it con
repay the loan in cheaper dollars.
9 [LO 5] W h a t is the relationship between diversifiable and non-diversifiable risk? How does this distinction
affect the reward that investors receive for bearing risk?
10 [L0 5] W h a t is meant by the term 'efficient market'? How does competition between traders promote
efficiency?
11 [LO 5] W h a t is meant by the term 'arbitrage7?
12 [L0 5] W h a t is meant by the term 'agency relationships'?
9
CHAPTER TWO
Consumption,
investment and the
capital market
CHAPTER CONTENTS
HI Introduction 11 BS Fisher's Separation Theorem: a form al
a pproach 14
Fisher’s Separation Theorem: a sim plified
exam ple ii m Investors' reactions to m anagers' decisions 24
LEARNING OBJECTIVES
1 explain how a com pany's m anagers can, in principle, make financial decisions that w ill be
supported by all shareholders
2 explain how the existence o f a capital m arket makes it possible for the com pany to make
decisions acceptable to all shareholders
3 identify a com pany's optim al investm ent/dividend p olicy under conditions o f certainty.
命
C hapter t w o C o n s u m p t io n , investment a n d the capital market
^ ^ J ~ ln t r o d u c t io n
In this chapter we present a theoretical fram ework, know n as ‘Fisher’s Separation Theorem’，th a t shows
im p orta nt relationships between companies, th e ir shareholders and the capital m arket. We use this
fram ework to make some observations on investm ent decisions, financing decisions and dividend policy.
Although the fram ework we present is simple and rather abstract, it provides im p o rta n t insights into
some fundam ental issues in finance. To introduce the framework, we present in Section 2.2 a sim plified
numerical example th a t captures many o f the m ain lessons o f the theorem. Readers who do n o t wish to
develop a detailed technical understanding o f the theorem may wish to read only Section 2.2.
LEARNING
OBJECTIVE 1
Explain how a
company's managers
Fishers Separation Theorem can be traced to the w ork o f Irv in g Fisher1 2 and is widely regarded as laying a can, in principle,
foundation fo r many fundam ental results o f finance theory. The theorem considers the follow ing situation. make financial
decisions that will
Suppose th a t a company has to decide how much it should pay to its shareholders in dividends and how
be supported by all
much it should retain fo r investm ent in the company. The more the company pays out in dividends, the shareholders
less there is available fo r investm ent; the more the company invests, the less there is available to pay
out as dividends. M ig h t some shareholders want high dividends (and therefore low investment), while
other shareholders w ant ju s t the opposite? I f so, w ill the company be forced to make a decision that w ill
disappoint some o f its shareholders? Fishers answers are, yes, there may be this type o f disagreement
among the shareholders b ut, no, i f there is a capital m arket then there is a way to please all shareholders.
In this section, we outline a sim plified example o f Fishers Separation Theorem th a t preserves much o f its
flavour b u t is based on in tu itio n rather than a rigorous, technical approach.
Assume th a t a company is operating under conditions o f certainty, th a t there are tw o tim e dates (‘now,
and ‘later’）and th a t there are tw o equal shareholders (‘A ’ and ‘B’). The company m ust decide3 how
much o f its current resources i t should invest and how much it should pay out as a current dividend.
An investm ent now generates a retu rn later, and the company then pays out all its resources as a final
dividend. Shareholders can use th e ir dividends to finance consumption. In itially, there is no capital
m arket b ut at a later stage in the analysis i t is assumed th a t transactions in a capital m arket are possible.
The existence o f the capital m arket enables individuals (including the shareholders A and B) to borrow
and lend fo r one period at a fixed interest rate.
It is fu rth e r assumed th a t the company has $8000 in resources and has identified tw o possible
investm ent projects called ‘Project Small’ and ‘Project Upgrade’.
• Project Small requires an in itia l outlay o f $5000 now and w ill produce a cash inflow o f $5700 later.
• Project Upgrade requires a further outlay o f $2000 now and w ill produce a further cash inflo w o f
$2200 later.
I t is also assumed th a t it is impossible to invest only in Project Upgrade. Together, projects Small and
Upgrade constitute P roject Large*. Clearly, Project Large requires an outlay o f $5000 + $2000 = $7000
now and w ill produce a cash inflo w o f $5700 + $2200 = $7900 later. I f the company invests only in Project
1 This section is drawn from Brown (1996).

2 Fisher (1930). See also Hirshleifer (1970).
3 In fact, decisions are made by managers rather than by an inanimate company* but for ease of expression we frequently refer
to a company making a decision. We have assumed that managers will seek to maximise the interests of the shareholders.
B usiness finance
Small, it can pay a dividend o f $8000 - $5000 = $3000 now b u t i f it invests in Project Large, i t can pay a
dividend o f only $8000 - $7000 = $1000 now.
This situation is summarised in Table 2.1.
TABLE 2.1 Investment/dividend opportunities facing the company

Project Investment outlay Dividend now (equals Dividend later ($)
now ($) $8000 minus outlay) ($)
Small 5000 3000 5700
Upgrade 2000 n.a.(a) 2200
Large 7000 1000 7900
Not applicable because Project Upgrade is not a stand-alone project.
2 .2 .3 1 The shareholders' consumption opportunities and

preferences
Recalling th a t Shareholders A and B hold equal shares, the consumption opportunities each faces are equal
to h a lf the to ta l dividends paid by the company as shown in Table 2.1. For sim plicity, i t is also assumed
th a t a dividend paid now cannot be stored in order to finance consumption later.4 The consumption
o pportunities facing each shareholder are shown in Table 2.2.
TABLE 2.2 Consumption opportunities facing each shareholder

Project selected by the company Consumption per shareholder Consumption per shareholder
now ($) later ($)
Small 1500 2850
Large 500 3950
Suppose th a t Shareholder A wishes to consume $1500 now, w hile Shareholder B wishes to consume
only $500 now. Thus, Shareholder A wants a relatively high dividend now and therefore wants the
company to invest in Project Small. Shareholder B, o f course, is in the opposite position. Desiring only
a low level o f consumption now, Shareholder B wants the company to adopt a high level o f investm ent
and thus wants the company to invest in Project Large. Clearly, the company cannot make a decision that
w ill satisfy b oth shareholders simultaneously and therefore i t is n o t possible to say which investm ent is
optim al. The company w ill be forced to make a decision th a t w ill be opposed by one o f its tw o shareholders.
2 .2 .4 1 Solution: introduce a capital market

A solution can be found i f there is a capital m arket in which the shareholders can borrow and lend on
th e ir personal accounts. In this example, it is assumed th a t the interest rate in the capital m arket is
LEARNING 12 per cent per period. I t is now possible to state th a t there is an optim al decision th a t w ill be supported
OBJECTIVE 2
by b oth shareholders. This decision is th a t the company should invest in Project Small and should reject
Explain how the
the o pp o rtu n ity to invest in the upgrade th a t w ill convert Project Small to Project Large. In other words,
existence of a capital
market makes it allowing Shareholder B access to the capital m arket has caused B to change his or her support from
possible for the w anting the company to invest in Project Large to w anting the company to invest in Project Small.
company to make
decisions acceptable 4 This assumption simplifies the analysis but is not necessary. It is a simple matter to permit resources to be carried from one
to all shareholders period to the next. In the absence of a capital market, resources can be carried forward in time at an interest rate of zero.
However, any consumption opportunities opened up by allowing resources to be carried forward at an interest rate of zero
will be more restricted than the opportunities that become available when a capital market is introduced and interest rates
are positive.
命
How do we know Shareholder B w ill react in this way? The answer is th a t the capital m arket allows
Shareholder B to make financial arrangements that, from Bs view point, provide an even better outcome
than is possible i f the company invests in Project Large. This result can be proved as follows. When the
company invests in Project Small, Shareholder B w ill receive a current dividend o f $1500. This w ill finance
Bs desired current consum ption o f $500, w ith $1000 le ft over. This sum o f $1000 can be le n t in the
capital m arket fo r one period at an interest rate o f 12 per cent, thus producing a later cash in flo w to B o f
$1000 x 1.12 = $1120. This sum can then be added to the future dividend o f $2850. Therefore, on the later
date, Shareholder B can consume resources to the value o f $1120 + $2850 = $3970. If, instead, Project
Large were undertaken, Shareholder B could consume only $3950 on the later date (see Table 2.2).
Therefore, provided there is a capital market, the shareholders w ill be unanimous and the company can
make investm ent and dividend decisions confident th a t these decisions are optim al from the view point
o f all shareholders.
2 .2 .5 1 An analysis using rates of return

The analysis can be recast in terms o f rates o f return. The rates o f retu rn on the projects are:
$5700-5000
Project Small: 14%
$5000
$2 2 0 0 -2 0 0 0
Project Upgrade: = 10%
$2000
Comparing these rates o f retu rn w ith the interest rate o f 12 per cent, the optim al decision is to accept
Project Small (because 14 per cent exceeds 12 per cent) and to reject Project Upgrade (because 10 per cent
is less than 12 per cent). In effect, the cost o f investing is the o pp o rtu n ity cost o f forgoing the capital
m arket return o f 12 per cent. For Project Small, the benefit (14 per cent) exceeds the o pp o rtu n ity cost
(12 per cent), while fo r Project Upgrade the benefit (10 per cent) is lower than the o pp o rtu n ity cost
(12 per cent).
Note also th a t while the apparent rate o f retu rn on Project Large is ($7900 - $7000)/$7000 = 12.86
per cent, this rate o f retu rn is in fact a weighted average o f the rates o f retu rn on the component projects
Small and Upgrade. I t is not valid to suggest th a t the company should invest in Project Large merely
because 12.86 per cent exceeds 12 per cent.
2.2.61 A solution requiring borrowing

In Section 2.2.4, the interest rate (12 per cent) fell between the rates o f retu rn on Project Small (14 per
cent) and Project Upgrade (10 per cent). Therefore, Project Small was accepted and, in tu rn , this decision
required Shareholder B to lend in the capital m arket. I f the interest rate had been lower than the rate o f
return on both projects— say i t had been 9 per cent— then the optim al decision would have been to invest
in both projects. In other words, Project Large would have been accepted. Therefore, the current dividend
would have been only $500 per shareholder. W hile this decision would clearly have won the support o f
Shareholder B, who wishes to consume only $500 now, a current dividend o f $500 per shareholder w ill be
insufficient fo r Shareholder A to finance his or her desired current consumption o f $1500.
In this case, Shareholder A m ust borrow $1000 from the capital m arket. A t an interest rate o f 9 per
cent per period, the required repayment later is $1000 x 1.09 = $1090. This am ount is paid out o f the later
dividend o f $3950, thus leaving Shareholder A w ith $3950 - $1090 = $2860 to finance later consumption.
This level exceeds the $2850 o f later consum ption th a t would have been available to Shareholder A i f the
company had invested in only Project Small. Therefore, Shareholder A w ill also support the decision to
invest in Project Large and there is again a unanimous decision.
LEARNING
2 .2 .7 1 Fisher's Separation Theorem and net present value OBJECTIVE 3
Identify a company's
The problem facing the company s manager can also be solved by calculating a measure know n as a optimal investment/
projects *net present value* (NPV). This measure is extremely im p o rta n t and is referred to in a num ber o f dividend policy under
later chapters. It is discussed in detail in Chapter 5. A t this p o in t we provide only a very b rie f introduction. conditions of certainty
B usiness finance
To calculate a projects net present value, we firs t use the projects required rate o f retu rn to convert
future cash flows to th e ir equivalent values today. We then subtract the in itia l outlay required. I f the result
is a positive number, then the project is an acceptable investm ent; i f the result is a negative number, then
the project is n o t acceptable. In the in itia l example o f Project Small and Project Upgrade presented in
Section 2.2.4, the interest rate in the capital m arket is 12 per cent. In this example, it is also the required
rate o f retu rn on the project. The net present value calculations are:
iV W o f Project Small = ---------- $5000 = $89.29 > 0

1.12
N P V o f Project Upgrade = - $2000 = -$35.71 < 0
1.12
Project Small is an acceptable investm ent because its NPV is positive, while Project Upgrade is not
an acceptable investm ent because its NPV is negative. Thus, use o f the NPV rule has led to the same
investm ent decision as we discussed earlier in Section 2.2.4. N ot only does an optim al decision exist, it
can also be found by applying the NPV rule.
2 .2 .8 | Fisher’s Separation Theorem: summary

In the absence o f a capital market, the shareholders disagreed on what decisions the company should
LEARNING
make on th e ir behalf. This problem could be solved* only by imposing a solution to the detrim ent o f
OBJECTIVE 1 one o f the shareholders. But i f there is a capital m arket, the shareholders are sure to reach a unanimous
Explain how a decision. Thus, there is an optim al investm ent/dividend decision.
company’s managers This resolution is possible because the existence o f the capital m arket enables one o f the shareholders
can, in principle,
to achieve a result th a t fo r h im or her was indisputably b etter than the result th a t the company alone
make financial
could provide, given the investm ent o pportunities available. An o ptim al decision exists, and can be
decisions that will
be supported by all identified by the company s managers i f they use the net present value (NPV) rule to analyse investm ent
shareholders proposals.
2.3 Fisher’s Separation Theorem:

a formal approach
The conclusions th a t we reached largely by in tu itio n in Section 2.2 are reached in a more rigorous fashion
in this section.
2.3.1 | Assumptions
The assumed objective o f a company is to maximise the m arket value o f its ordinary shares. A company s
managers, therefore, have to make investment, financing and dividend decisions consistent w ith that
objective. The managers* job would be easier i f there were a consistent set o f decision rules th a t could be
employed in m aking investm ent, financing and dividend decisions. The w ork o f Irv in g Fisher provides
a fram ework in which such rules can be developed. In itia lly these decision rules are developed in a very
sim plified setting. However, the decision rules are applicable even when more realistic assumptions are
made.
The assumptions in Fishers analysis are:
a There are only two points in tim e: the present (Time 1) and a later tim e (Time 2).
b There is no uncertainty, and hence the outcome o f all decisions is know n now to everybody.
C There are no imperfections in the capital market,
d A ll decision makers are rational.
e The company s managers wish to use the company s resources according to the wishes o f the
shareholders.
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2 .3 .2 |T h e company
The company is endowed w ith a fixed am ount o f resources at Time 1 and the managers have to decide how
much o f these resources should be invested and how much should be paid out as dividends. Any resources
not paid out at Time 1 are invested, and the level o f this investm ent determines the resources available
to pay dividends at Time 2.
The opportunities available to the company are summarised in a production p o ssib ilities curve PRODUCTION
POSSIBILITIES CURVE
(PPC) as illustrated in Figure 2.1.
curve that displays
the investment
opportunities and
Figure 2.1 Production possibilities curve outcomes available
to the company;
its shape therefore
determines the
combinations of
current dividends,
investments and future
dividends that a
company can achieve
l^l
s8Jno
(N
0sEJ
9J
l—
The horizontal axis measures resources available to the company at Time 1. Assume th a t the company
has 200 units o f resources available to it. It could pay this am ount as a dividend at Time 1. In this case,
investm ent would be zero and dividends at Time 2 w ould also be zero. The p oint (200, 0) represents this
extreme decision. A t the other extreme, the company could pay no dividend at Time 1 and invest the
whole o f the company s resources. This decision would result in 250 units being available fo r d is trib u tio n
as a dividend at Time 2 and is represented by the p o in t (0, 250). Point Q is an interm ediate case in which a
dividend o f 150 units is paid at Time 1, leaving 50 units to be invested. The PPC shows th a t an investm ent
o f 50 units at Time 1 can be transform ed in to 160 units o f resources at Time 2. Therefore the dividend at
Time 2 is 160 units.
INDIFFERENCE CURVE
curve showing a set
2 .3 .3 |T h e shareholders of combinations such
that an individual
derives equal utility
Shareholders forgo current consumption by investing in the company at Time 1 in order to receive a retu rn
from (and thus is
th a t then increases th e ir consum ption o pportunities at Time 2. A persons preference fo r consumption at indifferent between)
Time 1 (Cj) or at Time 2 (C2) is represented by indifference curves as depicted in Figure 2.2. The term any combinations in
indifference indicates th a t the person derives equal u tility from the bundles o f C and C2 represented the set
A B usiness finance
by all points on a single curve; fo r example, equal u tility is derived from points X and Y in Figure 2.2.
However, any p o in t on a higher indifference curve is preferred to all points on lower curves; fo r example,
Z is preferred to X and Y.
The slope o f an indifference curve at any p o in t shows the consumer s willingness to trade o ff Cx fo r C2.
I t can be seen from Figure 2.2 th a t the indifference curves are convex; they approach the horizontal
as the level o f C1 increases and approach the vertical as the level o f C2 increases. The im plication is th a t a
consumers desire to increase consumption fu rth e r at a given tim e decreases as the level o f consumption
at th a t tim e increases.
:igure 2.2 Indifference curves of a representative shareholder
2 .3 .4 1 The company’s decision

We now b ring together the company and the shareholders in an attem pt to id e n tify the decision the
company should make. We assume th a t there are two shareholders, and (B\
In Figure 2.3, indifference curves fo r Shareholder A are labelled A v A 2 and A 3 and indifference
curves fo r Shareholder B are labelled Bv B2 and B3. I f the company chooses p o in t A — th a t is, a current
dividend o f 90 and investm ent o f 110, yielding a dividend o f 228 at Time 2— then shareholder As u tility
is maximised. However, Shareholder Bs u tility is n o t maximised at this point; i t is maximised only i f
the company chooses p o in t B. This requires a current dividend o f 160 and investm ent o f 40, yielding a
dividend o f 144 at Time 2.
In short, the company is unable to reach a decision th a t w ill lead simultaneously to m axim um u tility
fo r both shareholders. This situation poses a severe dilemma fo r the company because i t means th a t the
company m ust consider the preferences o f each o f its shareholders when m aking investm ent decisions.
In other words, there is no simple decision rule th a t w ill satisfy all shareholders. Such a rule does exist,
however, i f there is a capital market.
LEARNING
OBJECTIVE 2
Explain how the 2.3^5| Soluti on: introduce a capital market
existence of a capital
market makes it
In this simple model, the capital m arket can be thought o f as a place where current resources may be
possible for the
company to make transform ed into future resources and vice versa. The rate at which these transform ations may be made
decisions acceptable is in effect an interest rate. We assume th a t the capital m arket is frictionless, and therefore the interest
to all shareholders rate fo r borrowers is equal to the interest rate fo r lenders. For example, i f the interest rate is 10 per cent
命
90 160 200*2
0
5
Time 1 resources ( q i
per period, and 100 u nits o f current resources are placed w ith the capital m arket fo r one period, then
100 x 1.1 = 110 units o f resources become available at Time 2. In effect, this is lending to the capital
market. Similarly, i f a person has a claim to receive 110 units o f resources at Time 2, the capital m arket
may be used to transform this claim in to 110/1.1 = 100 units o f resources at Time 1. This transaction
corresponds to a person borrow ing 100 units at Time 1 and repaying the loan w ith a payment o f
110 u nits at Time 2.
Suppose th a t a person has claims on resources in both periods. For example, a person may have an
income o f 100 units at Time 1 and an income o f 165 units at Time 2. W hat consumption opportunities
are available i f the interest rate is 10 per cent per period? A t one extreme, the person may choose to
consume only at Time 2. In this case, consumption at Time 1 is zero and consumption at Time 2 is
165 + 100 x 1.1 = 275 units. A t the other extreme, the person may choose to consume only at Time 1.
In this case, consum ption at Time 2 is zero and consum ption at Time 1 is (165/1.1) + 100 = 250 units.
Therefore, this persons claim on current resources is 250 units. In short, this persons wealth at Time 1 is
250 units. Figure 2.4 illustrates this case.
The line join in g these tw o extreme positions is shown in Figure 2.4 and may be called a m arket MARKET
opportunity line as i t defines all combinations o f consumption possibilities at the tw o Times, consistent OPPORTUNITY LINE
w ith an in itia l wealth level o f 250 units. I f a person can reach any one p o in t on this line, then by borrow ing line that shows the
combinations of
or lending, all other points on the line are also available to the person. For example, i f a person can reach
current and future
point A (100 units at Time 1 and 165 units at Time 2), then the person can also reach p o in t (140 units consumption that an
at Time 1 and 121 units at Time 2), by borrow ing 40 units today and repaying 44 units at Time 2. individual can achieve
The equation o f a m arket o pp o rtu n ity line can be derived as follows. I f a persons income at Time 1 is from a given wealth
Cx and at Time 2 is C2, and the interest rate is i per period, then the persons wealth W1 at Time 1 is: level, using capital
market transactions
… ^ C2
B usiness finance
Figure 2.4 Market opportunity line
Equivalently, this equation can be w ritte n as:
W \(l + /) = C“ 1 + /) + C2
or
C2 = - ( l + i)C 1 + Wl ( l + i)
This is a linear equation w ith slope -(1 + 〇 and intercept ^ ( 1 + i). W ith a current wealth level o f 250
and an interest rate o f 10 per cent per period the equation is:
C2 = - ( 1 + 0.1)C1 + 250(1.1)
and therefore
C2 = - l . l C 1 + 275
To illustrate fu rth e r the interpretatio n o f m arket o pp o rtu n ity lines, suppose th a t the person is offered
a choice o f two income streams, A or B. Stream A consists o f 100 units at Time 1 and 165 units at Time 2,
w hile Stream B consists o f 120 units at Time 1 and 55 units at Time 2. I t has already been shown that
i f the interest rate is 10 per cent, Stream A corresponds to a wealth level o f 250 units at Time 1 and the
equation o f the m arket o pp o rtu n ity line is C2 = -1.1C 1 + 275. The wealth level corresponding to Stream
B is 120 + 55/1.1 = 170 units. The equation o f the m arket o pp o rtu n ity line fo r Stream B is C2 = -1.1C1 +
187. These lines, together w ith the persons indifference curves, are shown in Figure 2.5.
Figure 2.5 shows th a t this person w ill maximise u tility by accepting income Stream A and then use
a capital m arket transaction to convert Stream A to Stream A \ As we have seen, Stream A provides an
income o f 100 units at Time 1 and 165 units at Time 2, and a wealth level o f 250 units. The person then
enters the capital m arket and borrows 40 units at Time 1, achieving a consumption level o f 140 units
at Time 1. In return, the persons claim on Time 2 resources is reduced by 44 units (fro m 165 units to
121 units). The loan repayment required at Time 2 is, o f course, 44 units (since 40 x 1.1 = 44).
命
C hapter t w o C o n s u m p tio n , investment a n d the capital market
Figure 2.5 Consumption opportunities offered by two wealth levels
Had Stream B been accepted, the optim al p o in t would have been B \ which could have been achieved by
lending 120 - 80 = 40 units at Time 1 and consuming 55 + (40)(1.1) = 99 units at Time 2. However, p o in t
is on a lower indifference curve than p o in t A / and therefore yields lower u tility . To summarise: Stream
A should be chosen because i t corresponds to a higher wealth level, which, in tu rn , ensures th a t higher
u tility can be achieved, given access to a capital market.
2 .3 .6 1 Proving there is an optimal policy

Fishers Separation Theorem provides the optim al solution and involves all three elements: the company,
the shareholders and the capital market.
Suppose th a t the company has E units o f resources and is considering three investm ent/dividend
policies, shown in Figure 2.6 as points Pv P2 and P.
A m arket o pp ortu nity line w ith slope -(1 + z) has been drawn through each o f the three points. The line
through P1 shows th a t i f policy P1 were adopted, the shareholders* wealth would increase from E to Wv
Similarly, i f policy P2 were adopted, the shareholders* wealth would increase to W2i and i f policy P were
adopted, the shareholders’ wealth would be PV. Because the u tility o f shareholders depends directly on
th eir wealth, they w ill unanim ously prefer policy P because the resulting wealth level W is the maximum
achievable. Relative to policy P, i t is clear th a t represents too little investm ent by the company, whereas
P2 represents too much investm ent by the company. Policy P, which occurs at the p o in t o f tangency
between the PPC and the m arket o p p o rtu n ity line, is the optim al policy fo r the company and w ill receive
the support o f all shareholders. This result may be shown more form ally by superimposing representative
indifference curves fo r shareholders A and B on Figure 2.6. This is shown in Figure 2.7.
The company chooses policy P; th a t is, i t invests (E - C p and pays dividends o f C* at Time 1 and C*2
at Time 2. Shareholder A enters the capital m arket and lends resources so th a t this shareholders personal
optim al p oint PA is reached. Shareholder B borrows from the capital m arket in order to reach PB, which
B usiness finance
Figure 2.6 Effect of company policy on shareholder wealth
Figure 2.7 Fisher’s Separation Theorem: two shareholders with access to a

capital market
is Bs personal optim al p oint. A ny policy other than P w ill result in lower u tility fo r both shareholders. For
example, i f the company were to choose policy Pv then Shareholder As m axim um u tility would occur at
p o in t P^, which is on a lower indifference curve than p o in t PA, w hile Shareholder Bs m axim um u tility
would occur at p o in t P^, which is on a lower indifference curve than p o in t PB. The same conclusion holds
i f the company were to choose policy P2.
There is, therefore, just one policy P th a t w ill maximise the u tility o f all shareholders simultaneously.
Regardless o f differences in th e ir u tility functions (preferences), all shareholders w ill support the
company s decision to choose policy P. In this sense, the company and its shareholders are separate. The
company does not need to consult each shareholder before it makes its decision because it knows in
C hapter t w o C o n s u m p tio n , investment
advance th a t all shareholders, regardless o f differences in th e ir personal preferences, w ill support the
choice o f policy P. Since policy P does n o t require knowledge o f any shareholders u tility function, it
follows th a t P m ig ht be identifiable using data directly available to the company. That this is in fact the
case is proved in the follow ing section.
2 .3 .7 | Identifying the optimal policy

Suppose th a t a company is endowed w ith E units o f current resources and is considering a num ber o f
small investm ent projects, each requiring an outlay o f A units o f resources. I t has compiled a lis t o f these
projects, ranked from the highest rate o f return to the lowest. The project w ith the highest rate o f retu rn
w ill return C2 units at Tim e 2. The company proposes the follow ing decision rule: accept the project i f and
only if:
R e tu m a tT im e 2 _ A > 〇
This is illustrated in Figure 2.8.
Figure 2.8
I t is clear from Figure 2.8 th a t C; > △ (1 + f) and therefore:
Under the proposed rule, the project is accepted. Fishers Separation Theorem also recommends
acceptance since policy P has n ot yet been achieved. Now consider the second project, w hich also requires
an outlay o f A and which returns Cf，2 at Time 2. Reading from Figure 2.8, it is found that:
C2 + C2 〉 C*2 + △(!■ + /)
and therefore
Both Fishers Separation Theorem and the decision rule recommend acceptance o f this second project.
Projects w ill continue to be accepted u n til policy P is reached. Beyond th a t point, both the theorem and
the rule recommend rejection o f all fu rth e r projects on the list. This is shown in Figure 2.9.
B usiness finance
Reading from Figure 2.9 it is found that:
C2 " + A(1 + i) > C2 " + C2 "
and therefore
-△ < 0
Therefore, both the proposed rule and the theorem recommend rejection o f this project.
The proposed rule and the theorem are completely consistent. A ll projects th a t are acceptable according
to the theorem are also acceptable according to the rule. A ll projects rejected by the theorem are also
rejected by the rule. Therefore, a company th a t always applies this rule to its investm ent decisions w ill be
able to locate the optim al investm ent/dividend policy and w ill maximise the wealth o f its shareholders.
In tu rn , the shareholders can use the capital m arket to achieve th e ir preferred consum ption patterns and
thereby maximise u tility.
The name given to this rule is the net present value rule. The retu rn next period is divided by the
factor (1 + z) to convert the future retu rn in to a present value. The investm ent outlay is then subtracted
from the present value to give the net present value (iVPV). I f the iVPVis positive, the project w ill increase
the wealth o f the shareholders and should therefore be accepted. I f the NPV is negative, the project w ill
decrease the wealth o f the shareholders and should therefore be rejected. The NPV rule is frequently used
in practice and is considered fu rth e r in Chapter 5.
2 .3 .8 1 Implications for financial decision making

A num ber o f im plications fo r investm ent, financing and dividend decisions can be drawn from Fishers
analysis. These im plications w ill hold where there are perfect markets fo r both capital and inform ation.
However, Fishers analysis is unaffected by the intro du ction o f uncertainty, provided it is assumed that
all participants have the same expectations.5 Further, although the presentation o f Fishers analysis has
5 Fama and Miller (1972, pp. 301-4).

been confined to a case involving only tw o periods, its im plications are unaffected by extension to the
m ultiperiod case.6
The investment decision

Fishers Separation Theorem means th a t a company can make investm ent decisions in the interests o f
every shareholder，regardless o f differences between shareholders’ preferences— th a t is, a company can
make an investm ent decision w ith which every shareholder w ill agree. Moreover, there is a rule th a t
w ill ide ntify th a t decision: a company should invest up to the p o in t where the net present value o f the
marginal u n it o f investm ent is zero. In this simple model, an equivalent rule is to invest up to the p o in t
where the rate o f retu rn on the m arginal u n it o f investm ent equals the m arket interest rate. These tw o
rules and other commonly implem ented investm ent evaluation techniques are considered in Chapter 5 in
the context o f certainty. This discussion is extended in Chapter 6 to investm ent evaluation where there
is uncertainty.
The financing decision

In Fishers analysis there is a single m arket interest rate. In effect, there is no d istinction between debt and
equity securities, and the cost to the company o f acquiring funds is independent o f the type o f security
issued. I t follows th a t the value o f the company and the wealth o f its shareholders are independent o f
the company’s capital structure. As a result, the financing decision can be described as ‘irrelevant’. When
the financing decision is discussed in Chapter 12 this result is confirm ed in a less restrictive framework.
The dividend decision

In Fishers analysis, all resources n ot invested at Time 1 are distributed to shareholders as dividends,
and all returns at Time 2 are also distributed as dividends_ th a t is, it is assumed th a t the company does
not borrow or lend in the capital market, although its shareholders may do so. Suppose, however, that
the company is perm itted to borrow o r lend in the capital market. In th a t case, the company has greater
choice in its dividend policy, while m aintaining the same level o f investm ent. For example, the company
could pay a higher dividend at Time 1 and borrow the resources needed to m aintain investm ent at the
optim al level given by the p o in t o f tangency between the PPC and the m arket o p p o rtu n ity line. This is
illustrated in Figure 2.10.
ure 2.10
6 ibid” pp. 64-7.

B usiness finance
Compared w ith the basic Fisher analysis (Fig. 2.7), the company in Figure 2.10 pays a larger dividend
at Time 1 (C**> C^) and a smaller dividend at Time 2 (C^* < C*2). To m aintain the company s investment
level at E - C*, the company borrows C** - C\ from the capital m arket. A t Time 2 the company s gross
retu rn is b u t the loan repayment reduces the net retu rn at Time 2 to C^. In short, the company、
investm ent decision is unchanged b ut its dividend decision is different. The im p o rta n t p o in t to note
is th a t the new policy Pr lies on the same m arket o pp o rtu n ity line as the original *Fisher policy* P and
therefore the wealth o f shareholders is unchanged. The ability o f shareholders to maximise th e ir u tility is
also unchanged. As explained previously, i f any one p o in t on a m arket o p p o rtu n ity line is attainable, then,
by borrow ing or lending, all other points on the line are also attainable. From the shareholders’ p o in t o f
view, therefore, p o in t Pr is no b etter or worse than p o in t P.
In summary, provided th a t the company does n o t alter its investm ent decision, the dividend decision
does n o t affect shareholders* wealth. In this sense dividend policy is irrelevant. This proposition is
discussed fu rth e r in Chapter 11.
2.4 Investors' reactions to managers/

decisions
The lin k between decisions made by a company s managers and the resultant actions by investors is
Figure 2.11
supplies funds to transact in
A company s managers may, on behalf o f the company, make an investm ent decision, a financing
decision o r a dividend decision. In fo rm atio n about this decision is transm itted to investors. On the basis
o f this inform ation, investors may adjust th e ir expectations o f future returns from an investm ent in the
company, and revise th e ir valuation o f the company s shares. Investors w ill then compare the current
m arket price o f the company s shares w ith th e ir revised valuation and either buy or sell shares in the
company. Investors* actions in the share m arket w ill determ ine the new m arket price o f the company s
shares.
令
Pursuing a goal o f m axim ising the m arket value o f a company s shares is easy when there are no m arket
imperfections and no uncertainty. Managers know w ith certainty an investm ents cash flows and its net
present value. Therefore, they w ill know whether acceptance o f the investm ent w ill increase the m arket
value o f the company s shares. As all investors also know the investm ents net present value, there w ill
be an immediate increase in the price o f the company s shares to reflect the resulting increase in the
wealth o f the company. Further, managers and investors know th a t financing and dividend decisions are
irrelevant and therefore these decisions w ill have no effect on the m arket value o f the comp any s shares.
In practice there is uncertainty. W hat effect w ill the acceptance o f an investm ent proposal have on the
m arket value o f a company s shares? As is illustrated in Figure 2.11, any change in the company s share
price w ill depend on the reaction o f investors to the decisions made by the managers. Obviously there can
be no reaction unless investors obtain inform a tion about th a t decision. When there is uncertainty, the
effect on the share price o f decisions made by managers is no longer perfectly predictable. A sim plification
is to assume that everyone agrees about the probability d istrib u tio n o f the outcomes o f all decisions. This
means th a t although there is uncertainty, the exact nature o f th a t uncertainty is agreed on by all. In this
case, when investors obtain inform ation, the share price w ill adjust im m ediately to reflect the new best
estimate o f the ‘tru e ’ value o f the company.
Sufficient conditions fo r this to arise are: *... a m arket in which (i) there are no transaction costs in
trading securities, (ii) all available inform a tion is costlessly available to all m arket participants and (iii) all
agree on the im plications o f current inform a tion fo r the current price and d istrib u tio n o f future prices
o f each security’.7
As these conditions are n o t satisfied in existing capital markets, it is fortunate th a t they are sufficient
b ut not necessary conditions.8 For example, managers* decisions may s till have an impact on share prices
even though there are transaction costs and/or there are only a lim ite d number o f investors who have
access to inform a tion about these decisions.
I t is true th a t departures from the sufficient conditions give rise to the problem th a t managers are
unable to predict w ith certainty the impact th a t a particular decision w ill have on a company s share price.
Fortunately there is a great deal o f empirical evidence on the reaction o f share prices to the release o f
inform ation. This evidence is reviewed in Chapter 16. A t this p o in t we sim ply note th a t there is evidence
in well-developed capital markets (such as the Australian capital market) th a t there are investors who
react quickly to the receipt o f new inform ation, w ith the result th a t this in fo rm a tio n w ill be reflected
in security prices. In general, therefore, managers should n o t depart from a course th a t they expect w ill
increase the value o f the company’s shares.
7 Fama (1970, p. 387).

8 ibid” pp. 387-8.
B usiness finance
SUMMARY
• A company's shareholders are likely to be a diverse interest rate in the capital market. Therefore, the
group, with different preferences regarding current optimal decisions can be identified using net present
and future consumption. Therefore, it might be value (NPV) analysis. These decisions will maximise
thought that when making decisions on investments the wealth of the shareholders. In this sense, the
and dividends, a company’s managers would find company and its shareholders are 'separate7; the
it impossible to meet the wishes of all shareholders. company's managers can make optimal decisions
• Fisher showed that, provided there is a capital without having to discover the preferences of
market through which shareholders can borrow and individual shareholders.
lend, a company can make decisions that w ill be • Although the w orld of business is considerably more
supported by all shareholders. complicated than Fisher's simple model, the central
• The company should invest up to the point where messages of his theorem remain a useful guide for
the return on the marginal investment equals the company managers.
KEY TERMS
indifference curve 15 production possibilities curve 15
market opportunity line 17
tu1
QUESTIONS
[LO 2] Outline the roles played by companies, shareholders and the capital market in Fisher's analysis.
2 [LO 3] Fisher's Separation Theorem ties together many o f the basic notions that underlie much o f modern
finance theory: wealth maximisation, utility maximisation and net present value. Discuss.
3 [LO 3] W h a t is Fisher's Separation Theorem? W h a t are its major implications for financial decision making?
4 [LO 3] Financial decision making is a trivial task in a w orld o f certainty. Discuss.
5 [LO 3 】W hat are the implications for financial decision making when the interest rate on borrowing is
greater than the interest rate on lending?
PROBLEMS
1 Calculating consumption possibilities with and without a capital market [LO 2]
Assume a three-date model in which a rational person has an endowment of $ 2 0 0 0 now, $ 1 0 0 0 in Year 1
and $50 0 in Year 2. If the person wishes to consume $40 0 now and $ 12 00 in Year 2, what could she
consume in Year 1 if:
a) there is no capital market
b) there is a capital market in which the interest rate is 5 per cent per year?
2 Investment decisions: applying Fisher's Separation Theorem [LO 3]
A company faces a similar situation to the one described in Section 2.2. It has two equal shareholders
(A and B)x is operating under conditions of certainty in a two-period framework ('now7 and later') and is
considering an investment in Project Small, which can be upgraded to Project Large. Project Small requires
an outlay of $1 1 0 0 0 0 today and will return $121 0 0 0 later. Project Upgrade requires an outlay of $ 6 0 0 0 0
today and will return $ 6 5 0 0 0 later. The company has $ 2 0 0 0 0 0 in resources. There is a capital market in
which the interest rate for both borrowing and lending is 5 per cent per period.
a) Using the net present value rule, show that the company should invest in Project Large (that is, it should
invest in both Project Small and Project Upgrade).
26
CHAPTER T w o REVIEW
b) How much will the company pay each shareholder in dividends today, and how much will it pay each
shareholder in dividends later?
c) Suppose that Shareholder A wishes to consume $ 4 0 0 0 0 today. What does she do? How much will she be
able to consume later? Show that this outcome is better for Shareholder A than if the company had invested
only in Project Small.
d) Suppose instead that Shareholder A wishes to consume equal amounts now and later, and the company
invests in Project Large. What does she do? Show that this action will deliver the desired outcome for
Shareholder A.
Investment decisions: applying FisheKs Separation Theorem [LO 3]
Consider exactly the same situation as in Problem 2, except that the interest rate is 9 per cent per period.
a) Using the net present value rule, show that the company should invest only in Project Small.
b) How much will the company pay each shareholder in dividends today, and how much will it pay each
shareholder in dividends later?
c) Suppose that Shareholder A wishes to consume $ 4 0 0 0 0 today. What does she do? How much will she be
able to consume later?
d) Compare Shareholder A's consumption in Problem 2(c) with her consumption in Problem 3(c).
Investment planning [LO 3]
Consider the following situation:
• A company starts with $12 million in cash.
• The interest rate is 15 per cent.
• The optimal policy for the company is to invest $6 million in assets.
• The net present value of this investment is $2 million.
Answer the following questions:
a) In 1 year’s time, how much will the company receive from the investment?
b) Draw, to scale, the Fisher diagram that represents this case.
c) What are the marginal and average rates of return on the investment?
d) What is the total wealth of the company's shareholders immediately after the investment plan is announced?
Effect of an interest rate decrease [LO 3]
Redraw your diagram for Problem 4 to show the effect of an interest rate decrease on the company's
investment plan. Show the net present value of the revised investment plan. Would all investors be made better
off by the decrease in interest rates and the consequential revision in the investment plan? Give reasons for
youranswer.
Effect of higher investment [LO 3]
Return to the diagram you have drawn for Problem 4. Suppose that the company decides to invest
$7.5 million— that is, $1.5 million more than before. Redraw the market opportunity line consistent with
this new level of investment. What effect has the increased level of investment had on the company's
shareholders?
REFERENCES
Brown, R.L., 'Fisher’s Separation Theorem: an alternative Fama, E. & Miller, M .; The Theory of Finance, Holt, Rinehart &
approach^ Accounting Research Journal, 1996, vol. 9, Winston, N ew York, 1972.
no. 1, pp. 7 8 -8 1 . Fisher, I., The Theory of Interest, M acm illan Company,
Fama, E., 'Efficient capital markets: a review o f theory and N e w York, 1930.
empirical w ork', Journal of Finance, M a y 1970, Hirshleifer, J.; Investment, Interest a n d Capital, Prentice-Hall,
pp. 3 8 3 -4 1 7 . Englewood Cliffs, N e w Jersey, 1970.
27
CHAPTER CONTENTS
ED Introduction 29 H3 Valuation of contracts with multiple
cash flows 46
HH Fundamental concepts of financial
mathematics 29 Annuities 50
HH Simple interest 31 田 Principal-and-interest loan contracts 58
m Compound interest 33 BH General annuities 63
LEARNING OBJECTIVES Z
1 understand and solve problems involving simple interest and compound interest, including accumulating,
discounting and making comparisons using the effective interest rate
2 value, as at any date, contracts involving multiple cash flows
3 distinguish between different types of annuity and calculate their present value and future value
4 apply your knowledge of annuities to solve a range of problems, including problems involving
principal-and-interest loan contracts
5 distinguish between simple and general annuities and make basic calculations involving general annuities.
C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL /sAATHEMATICS
Financial mathematics provides the finance specialist w ith some extremely useful tools w ith which to
solve financial problems. In this chapter, we present the m ajor tools o f financial mathematics and indicate
some o f th e ir im p o rta n t applications. You w ill fin d th a t a thorough understanding o f these tools, and
how they may be used, w ill be very valuable when you study later chapters. Although you w ill fin d a
large number o f formulae in this chapter, you w ill n ot master financial mathematics i f you sim ply try
to memorise the formulae. I f you fu lly understand the approach and the logic th a t are embodied in the
formulae, you w ill n o t need to memorise them.
3.2 Fundamental concepts of financial

mathematics
In this section, we explain four fundam ental concepts used in financial mathematics: cash flows, rate o f
return, interest rate and tim e value o f money.
3 .2 .1 1 Cash flows
Financial mathematics concerns the analysis o f cash flows between parties to a financial con tract.1 CASH FLOW
For example, when money is borrowed there is an in itia l flow o f cash from the lender to the borrower, payment (cash
outflow) or receipt
and subsequently one (or more) cash (re)payment(s) from the borrower to the lender. In financial
(cash inflow) of money
mathematics, as in finance generally, we are concerned w ith the cash flow consequences o f a decision or
a contract. How much cash w ill flow between the parties? When w ill these cash flows occur? These are FINAN C IAL CONTRACT
the basic questions th a t m ust firs t be answered when analysing a financial contract using the tools o f arrangement,
financial mathematics. We are n o t concerned w ith the possible non-cash consequences o f a contract, such agreement or
investment that
as effects on reported p ro fit; nor are we concerned w ith effects on parties outside the contract.
produces cash flows
3 .2 .2 ! Rate of return
Financial decision makers usually fin d it convenient to relate the cash inflows th a t result from a contract
to the cash outflows th a t the contract requires. Typically, this inform a tion is presented as a rate of RATE OF RETURN
return. Where there are only tw o cash flows in a financial contract— one at the sta rt o f the contract and calculation that
expresses the ratio
another at the end— the rate o f retu rn is usually measured by:2
of net cash inflows to
Ci - C 〇 cash outflows
C〇
where C1 = cash in flo w at Time 1
C〇= cash outflow at Time 0
r = rate o f retu rn per period
The value o f C1 - C〇measures the dollar return to the investor. D ividing the dollar return by C〇 , which
is the investm ent outlay, measures the rate o f return. Example 3.1 illustrates the calculation o f a rate o f
return.
Note th a t a rate o f retu rn is always measured over a tim e period. In Example 3.1 the tim e period is
1 year. It is meaningless to state th a t an investm ent has returned, say, 20 per cent w ith o u t also specifying
the tim e period involved.
1 We use the term contract* broadly. For example, we include depositing money in a bank as an act carried out as part of the
contract between the depositor and the bank.
2 There are other measures. For example, under some circumstances it is convenient to measure the rate of return by EnCCj/Cg)
[natural logarithm]. This measure is discussed further in Section 3.4.4.
B usiness finance
Example 3.1
bB On 1 January 2014, Paul buys an antique clock for $ 2 00 00. On 1 January 2015, the clock is sold
for $2 4 0 0 0 . What rate of return has been achieved?
SOLUTION
Using Equation 3.1, the rate of return is:
r= Ci ~ C 〇
C〇
_ $24 0 0 0 -$ 2 0 0 0 0
$20000
$4000
_ $20000
4
= 20% per annum
3 2 3 | Interest rate
INTEREST RATE The term in te r e st ra te 1 is an im p o rta n t special case o f the more general term 4rate o f return* and is
rate of return on debt used when the financial contract is in the fo rm o f debt. A lthough a precise defin itio n o f debt is difficult,
the general principle involved is th a t one party (the borrower) provides a specific promise regarding the
DEBT
financial contract in future cash flow(s) payable to the other party (the lender). Debt may be contrasted w ith agreements
which the receiver of where no particular promise is made regarding the future cash flows. For example, when Paul purchased
the initial cash (the the antique clock in Example 3.1 he was n ot promised any particular future cash inflow. Similarly, where
borrower) promises a an investm ent is made in ordinary shares, the shareholder is n o t promised any p articular cash inflow(s)
particular cash flow,
from the investment.
usually calculated
using an interest rate,
to the provider of
funds (the lender) 3 .2 .4 |T im e value of money
TIME VALUE OF MONEY One o f the m ost im p o rta n t principles o f finance is th a t money has a tim e value. This principle means
principle that a dollar th a t a given sum o f money (say, a cash flow o f $100) should be valued differently, depending on when the
is worth more (less),
cash flow is to occur.
the sooner (later) it
is to be received, all Suppose you have the choice o f receiving $100 either today or in 1 years tim e. As a rational person you
other things being w ill choose to take the money today. Even i f you do n ot plan to spend the money u n til 1 year later, you w ill
equal s till choose to take the money today rather than in 1 years tim e because you w ill be able to earn interest
on the money during the coming year. Because o f the interest you w ill earn, you w ill have more than $100
in 1 year’s tim e. Obviously, from your p o in t o f view this is better than receiving only $100 in 1 year’s time.
By choosing to take the $100 today, rather than $100 in 1 years tim e, you are in effect saying th a t $100
received today is more valuable to you than the promise o f $100 to be received in 1 years tim e. To p ut this
another way, you have im plied th a t $100 to be received in 1 years tim e is w o rth less than $100 today. You
have recognised th a t money has a tim e value.3
An im p o rta n t consequence o f the fact th a t money has a tim e value is th a t we cannot validly add cash
flows th a t w ill occur on different dates. Suppose you are offered $100 today and a fu rth e r $100 in 1 years
time. How much is this offer w o rth to you? A t this stage we cannot answer this question, except to say
th a t the value today is less than $200. The value today o f the cash flow o f $100 in 1 years tim e is less than
3 Other reasons for taking the money today, rather than later, are risk (you are not certain that the future cash flow will be paid)
and e x p ected in flation (you fear that in a years time the purchasing power of $100 will be lower than it is today). While these
reasons are valid, note that money has a time value, even in the absence of these reasons—that is, even if the risk is zero
(you are certain that the future cash flow will be paid) and you expect that the inflation rate next year will be zero or negative
(purchasing power either will not change or will increase), you will s till take the $100 today, in preference to $100 later,
simply because interest rates are positive.
C hapter three T he time value of m o n e y : a n introduction t o financial mathematics
$100, so the to ta l value today o f the tw o cash flows m ust be less than $200. In financial mathematics it is
extremely im p o rta n t never to attem pt to add cash flows th a t w ill occur on different dates.
3.3 Simple interest

LEARNING
3.3.1 | The basic idea of simple interest OBJECTIVE 1
Understand and solve
Many financial contracts specify the interest rate to be paid, rather than specifying explicitly the cash problems involving
simple interest
payment(s) required. Suppose, fo r example, th a t you borrow $1000, and agree to repay the loan by making
and compound
a lum p sum payment in 1 years tim e at an interest rate o f 12 per cent per annum. Then: interest, including
accumulating,
Interest owed = 0.12 x $1000 = $120
discounting and
Lump sum payment = $1000 + $120 = $1120 making comparisons
using the effective
This example is, o f course, very straightforw ard. O nly one tim e period is involved— in this case it
interest rate
happens to be 1 year— and the interest rate is quoted on a m atching (annual) basis. There is little scope
fo r confusion in this case. But suppose the contract had specified a lum p sum repayment after 2 years, but
the interest rate was quoted as 12 per cent per annum. How do we apply an annual rate to a period that is
n ot equal to 1 year?
To answer this question we need a rule or convention to enable us to apply an annual interest rate to
a period o f 2 years. There are several ways in which this can be done, one o f which is sim ple in terest. SIMPLE INTEREST
A distinguishing feature o f simple interest is that, during the entire term o f the loan, interest is computed method of calculating
interest in which,
on the original sum borrowed. For example, suppose th a t a loan o f $100 m ust be repaid in a lum p sum
during the entire term
after 2 years. Simple interest is to be charged at the rate o f 12 per cent per annum. Because simple interest of the loan, interest
is being used, interest in both years is charged on the sum o f $100. The interest in each year is thus $12, so is computed on the
the lum p sum repayment is $124. Therefore, the interest rate payable at the m a tu rity (term ination) o f the original sum borrowed
loan w ill in fact be 2 x 12 per cent = 24 per cent. Similarly, i f payment was instead due after h a lf a year, a
simple interest rate o f 12 per cent per annum means that, in fact, interest w ill be paid at the rate o f V2 x
12 per cent = 6 per cent per half-year. Example 3.2 illustrates simple interest.
Example 3.2
Molly's Bakeries Ltd borrows $ 1 0 0 0 0 and agrees to repay the loan by a lump sum payment in
6
6 months7 time. The interest rate is 8 per cent per annum (simple). Calculate the lump sum payment.
SOLUTION
Interest rate per half-year = - x 8%

2
=4%
Interest payable = $10000 x 0.04
=$400
Lump sum payable = $ 1 0 0 0 0 + $400
= $10400
3 .3 .2 | Formula development: future sum

Suppose an am ount P— also know n as the principal — is borrowed and w ill be repaid in a lum p sum. The PRINCIPAL
interest rate is r per period (for example, per annum) and repayment is required after t periods. Using amount borrowed at
the outset of a loan
simple interest, the interest payable is based on the original principal, so the interest owing after one
B usiness finance
FUTURE SUM period is P x r. A fte r t periods the interest payable is sim ply P x r x t. Therefore, the required future sum
amount to which a 5, th a t w ill repay the am ount borrowed, is given by:
present sum, such as
a principal, will grow S = principal and interest
(accumulate) at a = P + P rt I
future date, through
S = P (l + rt) 3.2
the operation of
interest Example 3.3 illustrates the use o f Equation 3.2 to calculate a future sum using simple interest.
Example 3.3
a) Use Equation 3.2 to calculate Molly’s repayment of a loan of $ 1 0 0 0 0 after 6 months if simple
interest is used and the interest rate is 8 per cent per annum.
b) W hat would be the repayment if the lump sum repayment were instead required after 15 months?
SOLUTION
a) S = P(1 + rt)
6 、
= $10000 1+0.08
,T2,
$10000 X 1.04
$10400
b) S = P(1 + rt)
=$10000
'1 5 、
= $10000 1+0.08
.T2,
$ 10000x 1.10
$11000
3 .3 .3 1 Formula development: present value

In many practical cases, we know the future repayment S, the interest rate r and the tim e period t, and
PRESENT VALUE our problem is to fin d the principal P (or presen t value) th a t is implied. In this case we simply rearrange
amount that Equation 3.2 to find:
corresponds to today's
value of a promised
future sum 1 + rr 3.3
The present value P is the sum o f money th a t corresponds to today s value o f the future sum promised.
The fact th a t P is n ot equal to S follows from the fact th a t money has a tim e value. Im portantly, P in
Equation 3.3 can also be thought o f as a price. I f a prospective borrower promises to pay a sum S in t years*
time, then given the interest rate r, we can calculate the price (value) o f the borrowers promised future
payment o f S. In other words, i f we view the loan from the lenders perspective, the principal represents
the price (or present value) paid by the lender, to secure from the borrower, the promise to pay the future
cash flow required by the contract. Looked at from the borrow ers view point, the promised future cash
flow has been sold by the borrower to the lender fo r its present value, which is the loan principal.
3.3.4 | Applications of simple interest

There are many commercial applications o f simple interest. For example, simple interest is used for
Treasury notes, bills o f exchange and many bank deposits. Because large sums o f money are often
involved, there m ust be clear rules or conventions used in applying simple interest. These conventions
can differ between countries. Using bills o f exchange as an example, the Australian conventions are:
a Interest rates are quoted on an annual basis.

b The tim e period t is calculated as the exact num ber o f days divided by 365.
C In a leap year, 29 February is included in the num ber o f days, b ut the year is s till assumed to consist
o f 365 days.
d Calculations are made to the nearest cent.
Bills o f exchange are discussed in detail in Section 10.5.3. The conventions used in Australia are
illustrated in Examples 3.4 and 3.5.
Example 3.4
Stars Ltd borrows $ 1 0 0 0 0 0 on 20 January 201 2, to be repaid in a lump sum on 2 March 2012. The
interest rate is 8.75 per cent per annum. Calculate the lump sum repayment.
SOLUTION
The time period involved is 42 days, consisting of 1 1 days in January, 29 days in February and 2 days
in March; note that we do not count both 20 January and 2 March but we d o count 29 February
because 2012 is a leap year.
Using Equation 3.2 and the conventions explained in this section the lump sum repayment is:
S = P(1 +rf)
=$10 00 0 0 1 + (0 .0 8 7 5 )( 盖 )
=$10 00 0 0 x 1.010068493
$101 006.85
Example 3.5
Moon Ltd promises to pay $ 5 0 0 0 0 0 in 6 0 days’ time. For a company with M oon’s credit standing the
market interest rate for a loan period of 6 0 days is 14.4 per cent per annum. How much can Moon
borrow?
SOLUTION
Using Equation 3.3 and the conventions explained in this section, Moon can borrow the sum of:
P=丄
1 + rt
$500000
= 1 + ( 0 .144)(盛）
$500000
_ 1.023 671 232
=$488 438.07
3.4 Com pound interest

COM PO U N D INTEREST
interest calculated
each period on the
3 .4 .1 1 The basic idea of compound interest principal amount and
on any interest earned
When interest is received by a lender, the interest can then be le n t to another borrower and, in due on the investment up
course, w ill earn fu rth e r interest. The basic idea o f com p ou n d in te r e st is th a t interest is periodically to that point
B usiness finance
added to the principal. Thus interest generates fu rth e r interest, which then generates s till more interest,
and so on. This process is illustrated in Example 3.6.
Example 3.6
i s On 31 December 2013, Kee Saw deposited $ 1 0 0 0 0 0 in a bank account that paid interest at the rate
of 5 per cent per annum. How much was in the account after 4 years?
SOLUTION
The history of Kee Saw ’s account is as follows:
Balance
31 December 2013 Account opened $100000.00
31 December 2014 Interest

0.05 x $100000.00 = $5000.00 $105000.00

0.05 x $105000.00 = $5250.00 $110250.00

0.05 x $110250.00 = $5512.50 $115762.50

0.05 x $115762.50 = $5788.13 $121550.63
As the growth in Kee Saw 's account balance makes clear, with compound interest, the
amount of interest each year increases. For example, in the first year the interest received was
$ 5 0 0 0 .0 0 but in the fourth year the interest received was $5788.13. After 4 years, Kee Saw ’s
account balance is $ 1 2 1 5 5 0 .6 3 but had the account been paid interest at the fixed amount
of $ 5 0 0 0 per annum — that is, if Kee Saw had not been able to reinvest interest to earn further
interest— the balance would have been only $ 1 2 0 0 0 0 . Therefore, in 4 years, Kee Saw earned
$1 55 0 .6 3 of 'interest on interest'.
3 .4 .2 1 Formula development: future sum and present value

Assume th a t a principal o f P dollars is deposited— th a t is, lent to a bank o r o ther financial in s titu tio n —
fo r a term o f n periods, w ith interest paid at the rate i per period at the end o f each period. O ur task is to
ACCUMULATION develop a form ula fo r the future sum 5 th a t w ill be accum ulated after m periods, allowing fo r compound
process by which, interest.
through the operation A fte r one period the interest earned is iP, so the account balance at the end o f the firs t period is
of interest, a present
P + iP = P(1 + 〇. In fact the balance (or accumulated sum) at the end o f any given period is simply the
sum becomes a
greater sum in balance a t the sta rt o f th a t period m ultiplie d by (1 + 〇. D uring the second period interest w ill be earned
the future on the am ount P(1 + 〇.
So:
Balance at end o f Period 2 = (balance at start o f Period 2) x (1 + /)

= (balance at end o f Period 1) x (1 + /)
= P(1 4- i) x (1 + i)
= P(1 + 〇2
命
CHAPTER THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
Similarly:
Balance at end o f Period 3 = (balance at start o f Period 3) x (1 -h /)

= (balance at end o f Period 2) x (1 + /)
= P(1 + i)2 x (1 + i)
= P(1 + 〇3
Generalising from this discussion, the sum accumulated after n periods is given by P(1 + i)nf so the
form ula fo r the future sum S is:
S = P ( l + i) n 3.4
The corresponding form ula to find the present value P o f a future sum S is:
^ S
3.5
where 5 = future sum a fter n periods
P = principal (or price or present value)
i = interest rate per period
n = num ber o f periods
To illustrate Equation 3.4 we use the inform a tion in Example 3.6. The value o f Kee Saws deposit after
selected terms is shown in Table 3.1.
TABLE 3.1 Accumulated value (future sum) of $100000 at 5 per cent per annum
Date Number of years completed Calculation Accumulated value ($)
31 December 2014 1 $100000 (1.05) 105000.00
31 December 2015 2 $100000(1.05)2 110250.00
31 December 2016 3 $100000 (1.05)3 115 762.50
31 December 2017 4 $100000(1.05)4 121550.63
31 December 2018 5 $100000 (1.05)5 127628.16
31 December 2023 10 $100000 (1.05)10 162889.46
31 December 2033 20 $100000 (1.05)20 265 329.77
31 December 2063 50 $100000 (1.05)50 1146739.98
The effect o f compound interest becomes more pronounced as the number o f periods becomes large.
For example, after 50 years, the value o f Kee Saws account is nearly $1.15 m illion, or more than 10 times
the amount w ith which he opened the account.
Finance
£ 6000 DEBT GREW TO £116 000_____________________________ in ACTION
If you don't repay a loan, and a lot of time passes, the debt can grow to unmanageable
proportions, as happened to an unfortunate borrower in Manchester in the United Kingdom.
A grandmother has been forced to put her house up for sale after she ended up owing a
massive £1 16 0 0 0 — on a £ 6 0 0 0 loan. Esther 〇sei, 57, borrowed the money in 1 9 8 8 to pay
for her father's funeral and to buy a new cooker for her Clayton home.
continued
B usiness finance
continued
But she could not meet the cost of the loan and 1 8 years later, the amount she owed had
grown to £1 16 0 0 0 . .. Esther said: 1 borrowed the money when I was grieving for my father.
I just signed the papers/
W h en the lender applied to take possession of her home, Esther sought help by going
to the North Manchester Law Centre. Lawyers negotiated a deal at Manchester County
Court . . . A law centre spokesperson said Esther should never have entered into the loan
agreement. 'It was a very high rate of interest/
/ 5 、 l/n
Autnors7 note: Equation 3.4 can be rearranged to: /= f - J - 1. Substituting S = £1 16 000,
P = £ 6 0 0 0 and n = 1 8 years into this equation, gives / = 17.89 per cent per annum.
However, this may not have been the contract interest rate because the final debt may
have included unpaid fees.
Source: '£ 6 0 0 0 debt grew to £116 0 0 0 7, Jo Rostron, Manchester M etro News, 21 July 2006.
To illustrate Equation 3.5, which gives the present value o f a future sum promised, suppose th a t an
individual is offered the sum o f $100 000 to be received after 5 years. I f the relevant interest rate is 5 per
cent per annum, compounded annually, the present value o f this promised sum is:
(1 + /广
_ $100 000
一（1.05)5
$100 000
_ 1.276281563
=$78352.62
That is, looking ahead 5 years to the receipt o f this promised sum o f $100000, it is w orth, in todays
terms, only $78 352.62. The logic underlying this result is th a t i f one wished to set aside money today to
accumulate a sum o f $100000 in 5 years* tim e, the am ount needed to be set aside today is $78352.62.
A fte r 5 years, this sum w ill accumulate to $78 352.62 x (1.05)5 = $100 000. Clearly, all o ther things being
equal, the longer the w aiting period— th a t is, the later the promised sum is to be received— the lower is
the value today.
DISCOUNTING The process by which a future sum is converted to its equivalent present value is called discounting.
process by which, This process is illustrated in Table 3.2, which shows the present value o f $100 000 to be received at selected
through the operation
future dates, discounted using an interest rate o f 5 per cent per annum.
of interest, a future
sum is converted to Again, the effect o f compound interest becomes more pronounced when the num ber o f periods is
its equivalent present large. A promise to be paid $100000 in 50 years* tim e is w o rth only $8720.37 in todays terms i f the
value discount rate is 5 per cent per annum.
TABLE 3.2 Present value of $100000 at 5 per cent per annum

Number of years to wait Calculation Present value ($)
1 $100000/1.05 95 238.10
2 $100000/(1.05)2 90702.95
3 $100000/(1.05)3 86383.76
4 $100000/(1.05)4 82270.25
C hapter three T he time value of m o n e y : a n introduction to financial mathematics
Table 3.2 continued
Number of years to wait Calculation Present value ($)
5 $100000/(1.05)5 78352.62
10 $100000/(1.05)10 61391.33
20 $100000/(1.05)2° 37688.95
50 $100000/(1.05)so 8720.37
3 .4 .3 1 Nominal and effective interest rates

Many financial contracts specify th a t a loan shall be repaid by a series o f payments made on various future
dates, rather than by a lum p sum at the end o f a single tim e period. For example, a so-called interest- INTEREST-ONLY LOAN
only loan requires payments o f interest at regular intervals followed by the repayment o f the principal in loan in which the
borrower is required
a lum p sum on the loan’s m a tu rity date.
to make regular
In m ost loans, the interest rate specified is a nom inal in terest rate, which is an interest rate where payments to cover
interest is charged more frequently than the tim e period specified in the interest rate. To sim plify interest accrued but is
matters, we assume th a t interest is charged (and therefore compounded) on the same dates as payments not required to make
are required.4 Examples o f nom inal interest rates are: 15 per cent per annum w ith quarterly payments, payments to reduce
the principal. On the
and 1.5 per cent per quarter w ith m on thly payments.
maturity date of the
Where a nom inal interest rate is used in a loan contract, a convention is needed to decide how an loan, the principal is
interest rate quoted fo r one tim e period w ill be applied to a different tim e period. The convention adopted repaid in a lump sum
is to take a simple ratio. So, fo r example, *15 per cent per annum payable quarterly* means th a t interest
N O M IN A L INTEREST
w ill be charged each quarter at the rate o f 3.75 per cent per quarter— th a t is, the annual rate o f 15 per RATE
cent is simply scaled down to one-quarter o f this rate because there are fo ur quarters in a year. Similarly, quoted interest
*1.5 per cent per quarter payable m o n th ly * means th a t interest w ill be charged each m on th at 0.5 per cent rate where interest
per m onth because a m on th is one-third o f a quarter and one-third o f 1.5 is 0.5. is charged more
frequently than the
Conversely, an effective in terest rate is one where the frequency o f charging (payment) does match
basis on which
the tim e period specified by the interest rate. Examples o f effective interest rates are: 15 per cent per the interest rate is
annum w ith annual payments and 0.5 per cent per m onth w ith m on thly payments. W hile few financial quoted. The interest
contracts specify an effective interest rate, i t is an im p o rta n t concept because it provides a consistent rate actually used to
basis on which to compare interest rates. This use is illustrated later in Example 3.8. calculate the interest
charge is taken as
From the lender s view point i t is preferable to have interest paid more frequently, all other things
a proportion of the
being equal. To illustrate th is fact, suppose th a t a bank is w illin g to lend $100 000 fo r 1 year at 15 per cent quoted nominal
per annum on an in te re s t only, basis b u t has the choice o f receiving either annual or quarterly interest rate. Note: The term
payments. Thus, the bank faces a choice between the cash inflows shown in Table 3.3. 'nominal interest rate7
also has another
meaning (see Section
3.4.4)
TABLE 3.3 Cash inflows at 15 per cent per annum EFFECTIVE INTEREST
RATE
Cash inflow at Hme t interest rate where
At f = 1 quarter A t t = 2 quarters A " = 3 quarters At f = 4 quarters interest is charged at
the same frequency
Annual interest $0 $0 $0 $115000 as the interest rate is
quoted
Quarterly interest $3750 $3750 $3750 $103750
4 This assumption is relaxed in Section 3.8.

I f we sim ply add up the two streams o f cash flows shown in Table 3.3 we would, o f course, find that
both to ta l $115000 but, as we explained earlier, this procedure is n o t valid because i t involves adding
cash flows th a t occur on different dates. Because earlier cash inflows are preferred to later cash inflows,
the quarterly interest stream is w o rth more to the bank. I t is w o rth more because the early* cash inflows
o f $3750 can be re-lent to earn fu rth e r interest later in the year.
Exactly how much more valuable the quarterly stream w ill prove to be w ill depend on the level o f
interest rates during the year, b u t because interest rates are always positive, the bank cannot lose by
accepting the quarterly payments rather than the annual payment.
An im p o rta n t special case can be developed by assuming th a t during the coming year the bank can
continue to lend money at 3.75 per cent per quarter. Thus the firs t quarterly inflow o f $3750 can be
re-lent fo r the rem aining three quarters, generating fu rth e r quarterly interest payments o f 0.0375 x
$3750 = $140.63, together w ith the repayment o f $3750 at the end o f the fo u rth quarter. A quarter-
by-quarter analysis is shown in Figure 3.1.
As shown in Figure 3.1, taking in to account the future opportunities fo r re-lending, the bank can
secure a to ta l cash inflow, at the end o f the fo u rth quarter, o f $115 865.06, which fo r the bank is clearly
preferable to a cash in flo w (on the same date) o f only $115 000. In effect, w ith interest paid quarterly, the
bank has earned at an annual rate o f retu rn given by:
$115 865.06 - $100 000
$100 000
» 15.865%
Cash flows re-lent at 3.75 per cent per quarter

0 1 2 3 4 Quarters
$3 750.00 $3 750.00 $3 750.00 $103 750.00
1— ,► $ 140.63 $ 140.63 $ 3 890.63

$3 890.63
1----------- ► $ 145.90 $ 4 036.53

$4 036.53
$ 4 187.90
$115 865.06
W ith only an annual interest payment, the bank would have had to specify an interest rate o f 15.865
per cent per annum to equal this rate o f return. Therefore, this example has established that there is a
sense in which the nom inal interest rate o f 15 per cent per annum, which is payable quarterly, is equivalent
to an effective interest rate o f 15.865 per cent per annum, payable annually.
But the sum o f $115865 is simply the future sum that would result from lending $100000 to earn
compound interest at the rate o f 3.75 per cent per quarter for four quarters. This is easily seen by noting that:
$100000 x (1.0375)4 = $100000 x 1.158 65 = $115865

Generalising from this example, i f a lender advances a principal o f P and specifies a nom inal interest
rate o f; per period, w ith interest payments required every subperiod, and there are m subperiods in every
period, then the future sum at the end o f one period is given by:
The effective interest rate i per period is:

. S -P
i = ------
P
p { x+ i ) ~p
P
C hapter THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
therefore
Equation 3.6 is the form ula fo r calculating the effective interest rate zper period fo r a nom inal interest
rate;, compounding m times per period. The use o f this form ula is illustrated in Examples 3.7 and 3.8.
Example 3.7
Calculate the effective annual interest rates corresponding to 12 per cent per annum, compounding:
6
a) semi-annually
b) quarterly
c) monthly
d) daily.
SOLUTION
Using Equation 3.6, the calculations are shown in Table 3.4.
TABLE 3.4
Compounding frequency Calculation Effective annual interest rate (%)
(a) Semi-annually (1.06)2- 1 12.3600
(b) Quarterly (1.03)4 - 1 12.5509
(c) M onthly ( l. 〇l ) 12- l 12.6825
(d) Daily (1.000 328 767)365- l 12.7475
These calculations illustrate the fact that, all other things being equal, more frequent compounding
produces a higher effective interest rate.
Example 3.8
Lake Developments Ltd wishes to borrow money and is offered its choice of the following nominal
6
interest rates:
a) 15.00 per cent per annum, payable annually
b) 14.50 per cent per annum, payable semi-annually
c) 14.00 per cent per annum, payable quarterly
d) 13.92 per cent per annum, payable monthly.
Which of these nominal interest rates provides the lowest cost of finance in terms of the corresponding
effective annual interest rate?
SOLUTION
Using Equation 3.6, the effective annual interest rates are:
a) /= 15 per cent per annum
b) / = (1.0725)2 - 1 = 1 5 . 0 2 6 per cent per annum
c) / = (1.035)4 - 1 = 14.752 per cent per annum
d) / = (1.01 16)12 - 1 = 14.843 per cent per annum.
Thus option (c), which is a nominal interest rate of 14.00 per cent per annum with quarterly
compounding, provides the lowest effective annual interest rate.
In some problems it is necessary to fin d out w hat nom inal interest r a te ,m u s t be charged in order to
achieve a target effective interest rate, z. Answering a problem o f this type requires th a t Equation 3.6 be
rearranged so th a t; appears on the left-hand side o f the equation. This is shown below. Equation 3.6 is:
1 + 丄
m
Adding 1 to b oth sides, and raising to the power 1/m:
( l + /)1/m = l + 丄
m
Subtracting 1 from b oth sides, and m u ltip lyin g by m:
7 = /7?[(l + /)1/m- l ] 3.7

The use o f this form ula is illustrated in Example 3.9.
Example 3.9
A financial institution raises funds from several different types of deposits but all its loans to borrowers
6
require monthly repayments. The effective annual interest rate that it pays depositors is 7.5 per cent
per annum. To cover its other costs and make a profit, the institution adds a margin of 3 per cent per
annum. Therefore, its target effective interest rate is 10.5 per cent per annum. W hat nominal annual
interest rate must it charge borrowers?
SOLUTION
Using Equation 3.7, the nominal annual interest rate is:
/ = m[(l + i)]^m- 1]
= 12W.10511/ 12- 1]
= 1 2 x 0.008355155
= 1 0% per annum
The financial institution would need to charge a nominal annual interest rate of 10 per cent on the
loans it makes.
3.4.41 Compound interest: two special cases and

a generalisation
In this section we discuss real interest rates, continuous interest rates and geometric rates o f return. To
understand the remainder o f the chapter, knowledge o f these issues is not required, so some readers may
wish to o m it this section.
Special case no. 1: the real interest rate

REAL INTEREST RATE A real in te re st rate is an interest rate after taking out the effects o f infla tion . Hence, the word Veal1
interest rate after
in this context is used in the same sense as i t is used in phrases such as ‘real GDP’ and ‘real wages’. An
taking out the effects
of inflation interest rate before taking out the effects o f in fla tio n is usually referred to as a nom inal in terest rate.
N O M IN A L INTEREST
The phrase ‘nom inal interest rate’ in this context should n o t be confused w ith its use in Section 3.4.3.
RATE In th a t section, the phrase N om inal interest rate* referred to an interest rate where the frequency o f
interest rate before payment o r compounding did n ot match the basis on which the interest rate was quoted.
taking out the effects Suppose th a t a representative basket o f goods th a t a consumer m ig ht buy costs $500 today. I f the
of inflation. Note: the
in fla tio n rate in the coming year is expected to be 20 per cent per annum, the price o f the basket at the end
term 'nominal interest
rate' also has another
o f the year is expected to be $500 x 1.2 = $600. Suppose also th a t a lender currently has $2000 th a t w ill
meaning (see Section be lent at a nom inal interest rate fo r 1 year. By lending this sum the lender forgoes the consumption now
3.4.3) o f four representative baskets o f goods. I f a real interest rate o f 5 per cent per annum is to be achieved,
C hapter three T he time value of m o n e y : a n introduction to financial mathematics
then the lender requires th a t at the end o f the year the sum generated w ill be sufficient to purchase
4 x 1.05 = 4.2 baskets o f goods— th a t is, the sum required in 1 year is:
4.2 baskets x $600 per basket = $2520
Therefore, the nom inal annual interest rate required is:

$2520 - $2000
$2000
=26%
Generalising from this example, let:
B = the price today o f a representative basket o f goods

P = principal
p = expected in fla tio n rate
z* = required real interest rate
z = nom inal interest rate ^ ^
Thus the lender forgoes consumption o f — baskets today, to be able to consume ~ ^ + baskets in
a years tim e. The expected price o f one basket in a years tim e is B(1 + p ). Therefore, the sum required in
p
1 years tim e is —(1 + i*) x B(1 + p). Therefore, the nom inal interest rate required is:
i = ^ -------------------------------
P
On sim plifying, this gives:
/ = (1 + i*) (1 + / ? ) - l
3.8
Equation 3.8 shows the lin k w ith the idea o f compounding: the nom inal interest rate i is n o t sim ply
the sum o f the real interest rate i* and the expected in fla tio n rate p t b u t rather is in the form o f the real
interest rate compounded, by the expected in fla tio n rate. Rearranging Equation 3.8 gives:
l + P
3.9
Equation 3.9 gives the real interest rate corresponding to a nom inal interest rate z i f the expected
infla tion rate is p. Expansion o f Equation 3.9 gives the result:
•氺 . •幸
i = i- p - p i
士 i- v
That is, the real interest rate i* is not simply the difference between the nom inal interest rate i and the
expected infla tion rate p. However, where the rates are ^m a ir, pi* w ill also be small and the approximation
i* ^ i - p w ill be close. The calculation o f a real interest rate is illustrated in Example 3.10.
E xample 3.10
If the inflation rate is expected to be 2 0 per cent per annum and the nominal interest rate is 30 per
6
cent per annum, calculate the corresponding real interest rate.
SOLUTION
Using Equation 3.9:
r = 上^ - 1
1 +P
1.30 .
= ---------l
1.20
=8.33% per annum
Special case no. 2: continuous interest rates
As we showed in Section 3.4.3, the more frequently compounding occurs, the higher is the effective
interest rate, other things being equal. In the lim itin g case, compounding becomes so frequent th a t the
CONTINUOUS INTEREST tim e period between each interest charge approaches zero. This is know n as continuous in terest and it
method of calculating can be shown th a t continuous interest is an example o f exponential growth. Using continuous interest,
interest in which
the fu tu re sum S is
interest is charged so
frequently that the time S = P eJn 3.10
period between each
charge approaches where S = future sum
zero P = principal
j = continuously compounding interest rate per period
n = number o f periods
e = 2.71828182846
The calculation o f a future sum using continuous interest is illustrated in Example 3.11.
E xample 3.11
If the interest rate is 12 per cent per annum, compounding continuously, how much will a principal of
$ 1 0 0 0 0 0 be worth after 1 year? After 2 years?
SOLUTION
Using Equation 3.10, the future sum after 1 year is:
S = Pein
=$100000 x e (012) ( 1)
=$100000 X 1.127496852
=$112 749.69
Again using Equation 3.10, the future sum after 2 years is:
S = Pein
=$100000 x e (012)( 2)
=$100000 x e 0-24
=$127124.92
The effective interest rate th a t results from continuous compounding is found by setting n equal to 1
period and solving:
. S -P
i = ------
P
_ Pef - P
— P
i h Kill
where i = effective interest rate per period
j = continuously compounding interest rate per period
e = 2.71828182846
The calculation o f an effective annual interest rate th a t is equivalent to a continuously compounding
interest rate is illustrated in Example 3.12.
命
C hapter three T he time value of m o n e y : a n introduction to finan c ial mathematics
E xample 3.1!
W hat is the effective annual interest rate corresponding to a nominal interest rate of 12 per cent per
annum, compounding continuously?
SOLUTION
Using Equation 3.11, the effective annual interest rate / is given by:
/= - 1
= e°-,2 - l
= 1 2 .7 4 9 6 9 % per annum
Of course, this is the interest rate implicit in Example 3.1 1.
Although continuous compounding is rarely used in loan contracts, i t is frequently used in other
contexts. In particular, academic studies o f security prices often assume th a t returns compound
continuously between the dates on which the prices are observed. Consider the security prices P〇, Px and
P2 observed on dates 0 ,1 and 2 respectively. These dates are assumed to be equally spaced. For example,
the prices may be observed at weekly intervals. Assuming th a t returns accrue continuously through time,
we can apply Equation 3.10 to assert th a t in the firs t week:
P i = P〇eri
and in the second week:
P2 = P\eri
where r1 is the continuously compounding weekly rate o f retu rn in the firs t week and r2 is the continuously
compounding weekly rate o f retu rn in the second week.
Solving fo r r1 and r2 gives:
n = in (P i/P 〇 )
and
r2 = in {P2/P l )
where in means logarithm to the base e (usually referred to as the natural logarithm ). More generally, we
can w rite th a t the rate o f retu rn in period t is:
rt = £n {P t/P t-i)
An expression o f the fo rm £n (P t/P t-i) is called a lo g p ric e re la tiv e and, when calculated this way, r t LOG PRICE RELATIVE
is called a logarithm ic rate o f retu rn or a continuous rate o f return. natural logarithm of

the ratio of successive
There are two reasons fo r choosing to measure rates o f retu rn in this way. First, the correct way to
security prices.
compound logarithm ic rates o f return is sim ply to add them. Thus, fo r example: Implicitly, it is assumed
P2 = P\er2 that prices have
grown (or decayed)
But in a continuous
fashion between
P\ = P〇 eri
the two dates on
Substituting, we find: which the prices are
observed. Also known
P2 = P〇 en er2
as a logarithmic
That is: rate of return and a
continuous rate of
P2 = P0eri+r2 return
The last equation shows that, using logarithm ic rates o f return, the to ta l rate o f retu rn over the
two tim e periods is sim ply the sum o f the rates o f retu rn in each o f the tw o constituent periods. Thus
calculations such as finding an average rate o f retu rn are simpler when using logarithm ic rates o f return.
命
B usiness finance
As discussed in Section 3.4.5, i t is not valid to add rates o f retu rn i f they are measured using the simple
a rith m e tic1d efin itio n that:
The second reason fo r using logarithm ic rates o f retu rn is a statistical one. The greatest loss an investor
can suffer is when the security price falls to zero. Using the simple arithm etic definition, the rate o f return
associated w ith this event is - 1 — th a t is, the rate o f retu rn is -1 0 0 per cent. Using logarithm ic rates o f
return, the same event w ill register as a rate o f retu rn o f - 〇〇. Given th a t there is no upper lim it to the
rate o f retu rn th a t m ight be achieved, i t follows th a t while arithm etic rates o f retu rn fa ll in the range
-1 to +〇〇, logarithm ic rates o f retu rn fa ll in the range - 〇〇to +〇〇. Thus, w hile the statistical d istribution
th a t describes logarithm ic rates o f retu rn might have the convenient property o f symmetry, and thus
might fo llo w the norm al d istribution, arithm etic rates o f retu rn w ill not be sym metric and thus cannot be
norm ally distributed.
A generalisation: geometric rates of return

GEOMETRIC RATE OF Compound interest is a special case o f a geom etric rate o f return. In the case o f compound interest, the
RETURN interest rate is the same in each period. In the more general case o f geometric rates o f return, the rate o f
average of a sequence
retu rn can be different in each period. W hile the sum invested is s till subject to the compounding process,
of arithmetic rates of
return, found by a
the rate at which compounding occurs w ill differ from period to period.
process that resembles Suppose th a t $1000 is invested fo r 4 years and each year the investm ent earns a different rate o f
compounding return, as follows:
• In Year 1: 10 per cent per annum

• In Year 4 :1 5 per cent per annum.
The value o f this investm ent therefore grows as follows:
1 A t the end o f Year 1: $1000.00 x 1.10 = $1100.00

4 A t the end o f Year 4: $1247.40 x 1.15 = $1434.51.
O f course, this result could have been found more quickly and conveniently by calculating, in one step:
$1000 x 1.10 x 1.05 x 1.08 x 1.15 = $1434.51

W ritin g the calculation in this way emphasises the sim ilarity between compound interest and the
more general case o f geometric rates o f return.
I t is natural to ask: w hat annual compound interest rate would have produced the same result? In
other words, w hat single rate o f retu rn zper year would need to be earned in each o f the 4 years, to produce
the same future sum? To answer this question we need to solve:
$1000 x 1.10 x 1.05 x 1.08 x 1.15 = $1000(1 + 〇 4

th a t is,
i = [(1.10)(1.05)(1.08)(1.15)]1/4_ i
=(1.434 S l) 1^ - !
=9.440% per annum
In fact, i in this calculation is the mean (or average) geometric rate o f return. I t is the rate o f return
which, i f earned in every period, and allowing fo r the effects o f compounding, would produce the same
outcome as th a t actually observed. In the general case, the mean geometric rate o f retu rn is:
i = [ ( l + r i ) ( l + r2) . . . ( l + 〇 ] V " - l K1H

where rk = the rate o f retu rn in period k
/c = 1, 2, n
n = the num ber o f completed periods
命
I f the rate o f retu rn is calculated each period from security prices P〇, Pl t then:
Pk ~ Pk-\
Pk-l
Pk
Pk-l
Substituting in Equation 3.13 gives:
3.14
It is im p o rta n t to understand th a t the mean rate o f retu rn is not (rx + r2 + ... + rn)/ri— th a t is, i t is not
correct simply to sum the rates o f retu rn and divide by the number o f periods. This fact is illustrated in
Example 3.13.
E xample 3.1
An investment of $ 1 0 0 0 0 0 produces rates of return as follows:
In Year 1: a gain of 10 per cent
In Year 2: a loss of 5 per cent
In Year 3: a loss of 8 per cent
In Year 4: a gain of 3 per cent
Calculate the value of the investment at the end of the fourth year and calculate the mean annual
rate of return.
SOLUTION
The value of the investment at the end of the fourth year is:
$ 1 0 0 0 0 0 x 1.10 x 0.95 x 0.92 x 1.03 = $ 9 9 0 2 4 .2 0
Using Equation 3.14, the mean annual rate of return is:
_ /$ 9 9 0 2 4 .2 0 \1/4 1
—V $100000 ) 一
= -0.002 448
= -0.2 448%
This small negative mean rate of return is consistent with the outcome that the final value ($99024.20)
is less than the sum invested ($ 1 0 0 0 0 0 )— that is, the investment has produced a loss after 4 years.
Note that the incorrect calculation of the mean as:
10% - 5 % - 8 % + 3 %
4
=0%
clearly gives a nonsensical answer because in this example the mean rate of return must be negative.5
5 Note that we are discussing here the correct measurement of p a s t returns. We are not discussing the forecasting of fu tu re
returns.
B usiness finance
3.5 Valuation of contracts with multiple

cash flows
LEARNING
OBJECTIVE 2
Value, as at any date, 3.5.1 | Introduction
contracts involving
multiple cash flows Many loan contracts stipulate th a t more than one cash flow is required to repay the loan. For example, a
housing loan may require m on thly repayments over a period o f 20 years— a to ta l o f 240 repayments. In
this section we consider the valuation o f contracts th a t involve m ultiple cash flows. We do n o t assume
th a t the am ount or tim in g o f the cash flows follows any particular pattern. Some im p o rta n t special cases
involving equal amounts at equally spaced tim e intervals are considered in Section 3.6.
3.5_2| Value additivity

W hile i t is not valid to add cash flows th a t occur at different times, i t is valid to add cash flows th a t occur at
the same tim e. Therefore, i f a contract requires cash payments to be made on, say, 1 A p ril and 1 May, we
should n o t sim ply add these cash flows.
However, i f we firs t value the 1 A p ril cash flow as i f i t were to occur on 1 May, we could then add the
two cash flows, since one is actually a May cash flow and the other has, so to speak, been converted to the
equivalent o f a May cash flow. Alternatively, we could firs t value the 1 May cash flow as i f it were to occur
on 1 A p ril; sum m ation o f these tw o cash flows then provides the to ta l value o f the tw o cash flows as at 1
A pril. For th a t m atter we could choose any date at all, value the two cash flows as i f they were to occur on
that date, and thus produce a valuation as at th a t date.
To im plem ent this approach we need to decide how we can value, as at any given date, a cash flow that
occurs on some earlier or later date. For example, we need to decide how a 1 A p ril cash flow can be valued
as at 1 May. The answer is provided by the interest rate. Using our knowledge o f compound interest we
can use Equation 3.4 to carry forw ard in tim e (‘accumulate’）the value o f any cash flow, provided we know
the interest rate to use. Similarly, we can use Equation 3.5 to carry backward in tim e (‘discount’) the
value o f any cash flow i f we know the interest rate to use. The process o f valuation as at any given date is
illustrated in Example 3.14.
Example 3.14
On 1 February 2 0 1 4 you sign a contract that entitles you to receive two future cash flows, as follows:
On 1 February 2016: $ 1 0 0 0 0
On 1 August 2017: $6 00 0
Assuming that the relevant interest rate is 5 per cent per annum (effective), value this contract as at:
a) 1 February 2 0 14
b) 1 February 2 0 16 and
c) 1 August 2017.
The following time line shows the timing of the cash flows in this problem.
t= 0 years t= 2 years t= 3.5 years

I I I
1 1 1
1 February 2014 1 February 2016 1 August 2017
$10000 $6000
SOLUTION
a) Valuation as at 1 February 2 0 14
Both cash flows must be discounted to 1 February 2014. This requires that the $ 1 0 0 0 0 to be
received on 1 February 2016 be discounted for 2 years and the $6 0 0 0 to be received on 1 August
20 1 7 be discounted for 3.5 years. The equation we need to use in each case is Equation 3.5. The
valuation as at 1 February 2 0 1 4 is:
$10000 $6000
° (1.05)2 + (1.05)3.5
= $9070.2948+ $5058.1151
= $ 1 4 128.41
Because this valuation is made as at the start of the contract, Va is called the present value of the PRESENT VALUE OF A
contract. CONTRACT
the value today
b) Valuation as at 1 February 20 1 6 that is equivalent to
The cash flow of $ 6 0 0 0 on 1 August 2 0 1 7 must be discounted for 1.5 years to calculate an the stream of cash
equivalent amount as at 1 February 2016. Therefore, the valuation as at 1 February 2 0 1 6 is: flows promised in a
financial contract
$6000
Vb = $10000 +
(1 .0 5 )15
= $ 1 0 0 0 0 + $5576.57
$15 576.57
c) Valuation as at 1 August 2 0 1 7
The cash flow of $ 1 0 0 0 0 on 1 February 2 0 16 must be accumulated for 1.5 years to calculate an
equivalent amount as at 1 August 2017. The equation we need to use is Equation 3.4. Therefore, the
TERMINAL VALUE OF A
valuation as at 1 August 2 0 1 7 is:
CONTRACT
^ = $1 〇〇〇〇(1.〇5)15 + $6000 the value, as at the

date of the final cash
=$10759.30 +$6000 flow promised in a
= $16759.30 financial contract, that
is equivalent to the
Because 1 August 2 0 1 7 is the date of the final cash flow of the contract, Vc is called the terminal stream of promised
value of the contract. cash flows
In Example 3.14, the three valuations VQf Vb and Vc are all valuations o f the same financial contract.
They d iffer because the date o f valuation differs. There should, therefore, be logical connections between
the three valuations. For example, the contracts present value (Vai the valuation as at 1 February 2014)
should be the same as taking the contracts term inal value (Vct the valuation as at 1 August 2017) and
discounting fo r 3.5 years. In fact, the mathematics underlying the valuation process guarantees this
result, as the follow ing calculation confirms:
Vc
(1.05)3*5
$16759.30
(1.05)3*5
=$14128.41
=Va
In effect, the valuation process consists o f using compound interest to discount and accumulate cash
flows to calculate value equivalents at a common date. The valuation as at th a t date is then found sim ply
by adding the value equivalents fo r th a t date.
3 .5 .3 1 Formula development: valuation as at any date
Where a cash flow o f C dollars occurs on a date t, the value o f th a t cash flow as at a valuation date t* is
given by:
V r = Ct( l +
I f date t* occurs after date t, then t* is greater than t and, in Equation 3.15, the power (t* - t) is
positive, and the equation correctly indicates th a t an accumulation o f Ct is required. Conversely, i f date
t* occurs before date t, then t* is less than t and, in Equation 3.15, the power (t* - t) is negative, and the
equation correctly indicates th a t a discounting o f Ct is required.
Where there is more than one cash flow to be valued, the to ta l value o f the contract is the sum o f
the values o f each cash flow. The calculation o f a contracts value at various dates is illustrated in
Example 3.15.
E xample 3.15
Confirm that Equation 3.15 is correct by using it to recalculate the valuations made in Example 3.14.
In each case, / = 5 per cent per annum, C 2 = $ 1 0 0 0 0 and C3 5 = $6000. The valuation date t * ,
however, differs in each case.
SOLUTION
a) Valuation as at 1 February 20 1 4
In this case, t* = 0. Using Equation 3.15:
V〇= $ 10 0 0 0 (1,05)°-2 + $ 6 0 0 0 (1.05)°-3-5

= $ 10 0 0 0 11.05 厂2 + $ 6 0 0 0 (1 _05 广3 5
= $10000 $6000
(1.05)2 (1.05)3"5
= $ 9 0 7 0 . 2 9 4 8 + $5058.1151
= $ 1 4 1 2 8 .4 1
= Va as calculated in Worked example 3.14
b) Valuation as at 1 February 2016
In this case, t* = 2. Using Equation 3.15:
V2 = $ 10 0 0 0 (1.05)2-2 + $6 0 0 0 (1,05)2-3-5
= $ 10 0 0 0 (1.05)0 + $ 6 0 0 0 (1.05 广1 5
= $10000+ ^ 〇
(1.05)1-5
= $ 1 0 0 0 0 + $5 576.57
= $ 1 5 576.57
= as calculated in Worked example 3.14
c) Valuation as at 1 August 2 0 17
In this case, t* = 3.5. Using Equation 3.15:
V3 5 = $10 0 0 0 (1,05)3-5- 2 + $ 6 0 0 0 (1.05)3-5- 3-5

= $ 10 0 0 0 (1.05)1 5 + $6 0 0 0 (1.05)°
= ($ 10 0 0 0 x 1.075 92 9 83) + $6 00 0
= $ 1 6 7 5 9 .3 0
= Vc as calculated in Worked example 3.14
3 .5 .4 1 Measuring the rate of return

When there are m ultiple cash flows in an investm ent, there are also m ultiple tim e periods. Inevitably
the question arises: For a given set o f cash flows extending over tw o or more tim e periods, how can we
measure the rate o f retu rn per period? There are a num ber o f d ifferent answers to this question, b ut the
answer most frequently offered is to employ a measure know n as the internal rate o f return. In this
section we outline this method. I t is discussed in greater detail in Section 5.4.2.
First, however, we review the measurement o f the rate o f retu rn over a single period. Consider a one-
period investm ent th a t costs $1000 and promises a cash inflo w o f $1120 a year later. Such an investm ent
would usually be described sim ply as a 1-year loan o f $1000 at an interest rate o f 12 per cent per annum.
We would infer th a t the interest rate is 12 per cent per annum by observing th a t the interest component
o f the cash flow after 1 year is $120, so the interest rate is $120/$1000 = 12 per cent. This is, o f course,
the result given by the simple defin itio n o f *rate o f return* in Equation 3.1. Equally, we could have said
that the rate o f return is the value o f r th a t solves the follow ing equation:
$1120
-$1000 = 0
The calculation $1120/(1 + r) is the present value o f $1120 using a discount rate o f r. On solving this
equation we would, o f course, fin d th a t r = 0.12, or 12 per cent.
The advantage o f th in kin g about the rate o f retu rn in this way is th a t we can readily see how to extend
this approach to the case o f many cash flows and tim e periods. Consider the follow ing investm ent. An
in itia l investm ent o f $1000 is made and, as before, a cash flow o f $1120 is to be received after 1 year but,
in addition, a fu rth e r cash flow o f $25 is to be received 2 years after making the in itia l investm ent. In
tabular form , the cash flows o f this investm ent are shown in Table 3.5.
TABLE 3.5
Year Cash flow ($)
0 -1 0 0 0
1 + 1120
2 + 25
Obviously this investm ent promises a rate o f retu rn o f more than 12 per cent per annum, since the
firs t cash inflo w alone is sufficient to produce a rate o f retu rn o f 12 per cent per annum. As an investor,
however, we would prefer the $25 inflo w to have been promised fo r Year 1 rather than Year 2. Had this
occurred, the cash inflow after 1 year would be $1145, representing a rate o f retu rn o f 14.5 per cent per
annum. P utting these observations together, the investm ent s annual rate o f retu rn m ust be more than
12 per cent, b u t less than 14.5 per cent.
The internal rate o f return measure proposes th a t the rate o f retu rn in this case is the value o f r th a t
satisfies the follow ing equation:
$1120 $25
-$1000 = 0
1+ r (1 + r)2
The term $25/(1 + r)2 can be thought o f as the present value o f $25, discounted fo r 2 years at the rate r
per annum. Solving this equation, we find r = 14.19 per cent per annum.6 We can confirm this result by
noting that:
$1120 $25
-$1000
1.1419 (1.1419)2
= $980.821438 + $19.172 725 - $1000
= -$ 0 .0 0 5 8 3 6
«$0
6 In this particular case, r can be found by solving the resulting quadratic equation. In more general cases, numerical methods
are usually required.
B usiness finance
The figure o f 14.19 per cent falls w ith in the range o f 12 per cent to 14.5 per cent, as suggested earlier
by our in tu itiv e reasoning.
Where there are n cash inflow s Ct (where t = 1, n), follow ing an in itia l cash outflow o f C〇, the
internal rate o f return is th a t value (or values) o f r th a t solves the equation:7
c. , c2
r\ I ••• l Cn
1+ r (1 + r)2 (1 + r)1
or
X： Ct t Co = 0
3.16
3.6 A n n u itie s
LEARNING
OBJECTIVE 3 3.6.1 I Definition and types of annuity
Distinguish between
different types of
In Section 3.5 we explained how to analyse contracts th a t require more than one cash flow to be paid.
a 门nuity and calculate
their present value and
We considered a general case th a t can be used to deal w ith a wide range o f contracts. There is, however, a
future value special case th a t is found in a large num ber o f financial contracts and hence requires fu rth e r discussion.
This is the case o f the annuity.
AN N U ITY An annuity is a series o f cash flows, usually o f equal amount, equally spaced in tim e. Thus, fo r example,
series of cash flows, $500 paid each m onth fo r a year is an annuity. Similarly, $600 per week fo r 12 weeks is an annuity; so is
usually of equal
$20 000 per annum fo r 10 years. Annuities are involved in many personal loans and commercial loans,
amount, equally
spaced in time and in certain kinds o f financial instrum ents such as bonds.
In itia lly we consider fo ur types o f annuity: ordinary annuity, annuity-due, deferred annuity and
ordinary perpetuity.
The o rd in a ry annuity
ORDINARY ANNUITY Like many annuities, the cash flow pattern o f the ordinary annuity consists o f equal amounts, equally
annuity in which the spaced in tim e. The distinguishing characteristic o f the ordinary annuity is that the tim e period fro m the
time period from the
date o f valuation to the date o f the firs t cash flow is equal to the tim e period between each subsequent
date of valuation to
cash flow.
the date of the first
cash flow is equal Diagrammatically, the cash flow pattern o f the ordinary annuity, using six cash flows as an example, is:
to the time period
between each 0 1 2 3 4 5 6
subsequent cash flow $C $C $C $C $C $C
AN NUITY-DUE
annuity in which the The annuity-due
first cash flow is to
occur 'immediately' The distinguishing feature o f the annuity-due is th a t the firs t cash flow occurs on the valuation
(i.e. on the valuation date 一 th a t is, immediately.
date)
Diagrammatically, the cash flow pattern o f the annuity-due, using six cash flows as an example, is:
DEFERRED AN N U ITY 0 1 2 3 4 5
annuity in which
the first cash flow
$C $C $C $C $C $C
is to occur after a
time period that The deferred annuity
exceeds the time
period between each The distinguishing feature o f the deferred annuity is th a t the firs t cash flow is to occur after a tim e
subsequent cash flow period th a t exceeds the tim e period between each subsequent cash flow.
7 If the cash flows are produced by a bond, it is conventional to call the internal rate of return the bonds y ie ld -to -m a tu rity (or
'yield1for short). For further discussion, see Sections 4.4 and 4.7. The Microsoft Excel* function IRR uses numerical methods
to calculate the internal rate of return for a given initial outlay and set of cash flows.
Diagrammatically, the cash flow pattern o f the deferred annuity, using as an example six cash flows,
the firs t to occur after three tim e periods, is:
0 1 2 3 4 5 6 7 8
$C $C $C $C $C $C
The ordinary perpetuity

The ordinary perpetu ity is an ordinary annuity w ith the special feature th a t the cash flows are to ORDINARY PERPETUITY
continue forever.8 ordinary annuity with

the special feature that
Diagrammatically, the cash flow pattern o f the ordinary perpetuity is:
the cash flows are to
0 1 2 3 4_____________ continue forever
$C $C $C $C ----------------- >
where the arrows indicate continuing forever.
3 .6 .2 1 Formula development: present value of an ordinary annuity

The form ula fo r the present value o f an ordinary annuity is one th a t we w ill use frequently. This form ula
can then be adapted to apply to the other types o f annuity.
The cash flow pattern o f an ordinary a nnuity o f n cash flows o f C dollars each is shown below:
0 1 2 3 n -1 n
$C $C $C $C $C
The present value P o f this stream o f cash flows is given by the sum o f the present values o f the
individual cash flows:
C C C C C
P-
+ i ( i + iy ( i + iy ( l + i) " - 1 ( l + i) n K IH
where z = the interest rate per period.
M u ltip lyin g both sides o f Equation 3.17 by (1 + 〇 gives:
n/1 .x ^ C C C C
P(1 + z) = C +
+ / ( l + i)2 ( l + 〇n_2 ( l + i) n~l B f lU
Subtracting Equation 3.17 from Equation 3.18, we fin d th a t all terms on the right-hand side cancel
out, except the last term o f Equation 3.17 and the firs t term o f Equation 3.18, giving:
C
P (l + / ) - P = C -
(1 + 0 "
C
Pi = C-
(1 + i)n
which, on rearrangement gives:
C 1
P.
(1 + ^
I t is often convenient to consider an annuity o f $1 per period— th a t is, we set C = 1 and Equation 3.19
becomes:
P = A(n, i)
(i + 0n
Equation 3.20 is the form ula fo r the present value o f an ordinary a nnuity consisting o f n cash
flows, each o f $1 per period. The functional notation A{ny i) is sim ply a shorthand way o f referring to
8 We could, of course, also consider the categories p e rp e tu ity -d u e and d eferred p e rp e tu ity but have not done so because the
purpose at this stage is simply to introduce the idea of a perpetuity, as distinct from an annuity of finite life.
this equation.9 Values o f A(n, 〇 fo r different values o f n and i are provided in Table 4 o f Appendix A.
The valuation o f ordinary annuities is illustrated in Example 3.16.
Example 3.
Find the present value of an ordinary annuity of $ 5 0 0 0 per annum for 4 years if the interest rate is
8 per cent per annum by:
a) using a calculator to discount each individual cash flow
b) using a calculator to evaluate the formula given in Equation 3.19
c) using the Microsoft Excel® function PV (rate, nper, pmt)
d) using Table 4 of Appendix A to evaluate the formula given in Equation 3.20.
SOLUTION
a) Discounting each individual cash flow:
P= — + C + C + C
i + ； (i +/)2 (i +/]3 (i +/)4
=$5000 $5000 $5000 $5000
1.08 (1.08)2 (1.08)3 (1.08)4
=$4629.6296 + $4286.6941 + $3969.1612 + $3675.1493
= $16560.63
b) Using Equation 3.19:
$5000
0.08 (1.08)4
$ 5 0 0 0 x3 .3 1 2 122 684
$16560.63
c) Using the Microsoft Excel® function PV (rate, nper, pmt):
The Microsoft Excel® function PV returns -1 x the present value of an ordinary annuity. The
required inputs are the interest rate (as a decimal), the number of periods and the amount of each
cash flow. Using a Microsoft Excel® spreadsheet, we find that-PV(0.08, A, 5000) = $16560.63.
d) Using Table 4 of Appendix A:
P= CA[n, i)
=$5000 x 3.3121
=$16560.50
Except for the relatively small rounding error when using Table 4 of Appendix A, the four answers
are identical.
3.6.31 Formula development: present values of annuities-due,

deferred annuities and o rdinary perpetuities
Present value of an annuity-due

The cash flow pattern o f an annuity-due w ith n cash flows o f C dollars each is shown below:
0 1 2 3 n -2 n -1
$C $C $C $C $C $C
9 The notation sometimes read as 'A angle n at rate i \ is also used to indicate this equation. There is no special significance
in this notation: it is simply a different convention. Mathematically, the functional notation A {n ,i) serves equally well.
C hapter three T he time value of m o n e y : a n introduction to
It is im p o rta n t to be aware th a t in an annuity-due consisting o f n cash flows, there are only {n - 1)

tim e periods involved.10
Inspecting the annuity-due diagram, i t is clear th a t an annuity-due o f n cash flows is sim ply an
immediate cash flow plus an ordinary a nnuity o f (n - 1) cash flows. The present value o f an annuity-due
is therefore:
P = C + -4 ^
i 1 ( l + £•广 1 13.21
or
P = C[1 + y 4 ( n - l, 〇l 13.22
where P = present value
C = cash flow per period
z = interest rate per period
n = num ber o f cash flows
The valuation o f annuities-due is illustrated in Example 3.17.
E xample 3.17
Kathy's rich uncle promises her an allowance of $ 1 0 0 0 0 per month, starting today, with a final
payment to be made 6 months from today. If the interest rate is 0.5 per cent per month, what is the
present value of the promised allowance?
SOLUTION
Kathy has been promised seven payments of $ 1 0 0 0 0 with the first being due immediately. Thus,
she has been promised $ 1 0 0 0 0 today, plus an o rd in a ry annuity of six payments. This is the logic
embodied in Equation 3.21. Using this equation with n set equal to 7, gives:
p= c + ^ [ i - - L _ ]
= $10000+ i M ° ° [ l
0.005 (1.005)7-1
= $ 1 0 0 0 0 + $ 10000 1
0.005 (1.005)6
= $ 1 0 0 0 0 + $58 963.84
=$ 68 963.84
Present value of a deferred annuity

The cash flow pattern o f a deferred annuity is as follows:
0 1 2 k -1 k k+1 k + n -2 k + n -1
$C $C $C $C
In this case, there are n cash flows and the firs t cash flow occurs on date k. To find the present value o f
this series o f cash flows, imagine th a t the valuation was to be made as at date (k - 1) instead o f date zero.
Looking ahead from date ( k - 1 ) , the cash flow pattern is th a t o f an ordinary a nnuity o f n cash flows. Thus,
at date (/c - 1), the present value is given by the present value o f an ordinary annuity:
10 This is frequently a source of confusion. For an ordinary annuity, it makes no difference whether n is defined as the number
of cash flows or the number of time periods, since these are equal. For an annuity-due, we must choose whether to use
n to represent the number of cash flows or the number of time periods. We have chosen to develop the formula with n
representing the number of cash flows.
c 1
Pk-l
(1 + i) n 3.23
where _ 丄= the present value at date (/c - 1)
To s h ift the valuation date back from date (k - 1) to date zero, we sim ply discount the value given by
Equation 3.23 fo r (k - 1) periods. Thus the required form ula is:
」 ____C
P=
(1 + 〇fc_1 i (1 + i) n 3.24
or
C
P= A{n, i)
(1 + 〇fc_1 3.25
where C = cash flow per period
z = interest rate per period
n = num ber o f cash flows
k = num ber o f tim e periods u n til the firs t cash flow
Alternatively, the present value o f a deferred a nnuity can be found by firs t im agining th a t cash flows
are to occur on all (k + n - 1 ) dates. The present value o f such a stream is, o f course, given by the present
value o f an ordinary annuity consisting o i (k + n - 1) cash flows. The effect o f the deferral period is
accounted fo r by subtracting the present value o f the firs t (k - 1) h is s in g 1cash flows, because these cash
flows w ill n o t occur. That is:
present value o f an present value o f an
p = ordinary annuity of less ordinary annuity o f
(k-\- n - l ) cash flows (A: - 1) cash flows
That is:
C !_ 1 c 1 1
i ( l + i) k+n- \ i
= C[A(k+ n - l J ) - A ( k - l , i ) ] 3.26
The valuation o f deferred annuities is illustrated in Example 3.18.
Example 3.
Jason will be starting a 6-month live-in training course in 4 months, time. His father, Sam, has promised
him a living allowance of $ 2 0 0 0 per month to help support him during this time. If the simple interest
rate is 9 per cent per annum, payable monthly, how much money will Sam need to set aside today to
finance Jason's allowance?
SOLUTION
Sam needs to set aside the present value of the promised allowance. The allowance is an annuity of
six payments, the first payment to be made 4 months from today.
Diagrammatically, the cash flows are:
0 1 2 3 4 5 6 7 8 9
$2000 $2000 $2000 $2000 $2000 $2000

Using the logic developed in this section, we can approach this problem in two stages. First, w hen
v ie w e d from the s ta n d p o in t o f d ate 3, the cash flows form an ordinary annuity of six payments. W e
therefore value this stream, as at date 3, using Equation 3.19, which gives the present value of an
ordinary annuity. Second, we find the value as at date zero by discounting for three periods. The
calculations are shown below. Note that the interest rate is 0.09/1 2 = 0.75 per cent per month.
G h APTER THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
As at date 3 the value is:
$2000
0.0075 (1.0075)°
$11 691.195 260
As at date zero, the value is thus:
p _ $11 691.195 260
(1.0075)3
=$11 432.04
This is, of course, the logic embodied in Equation 3.24, as we now show. In this case, n = 6,
k = 4 and /' = 0.09/1 2 = 0.75 per cent per month. Using Equation 3.24:
n 1 C
k-]
(1+/) (1
1 $2000
(1.0075) r 0.0075 (1.0075)°.
1
x $ 2 0 0 0 x5 .8 4 5 59763
1.022 669172
=$11 691.195260
~ 1.022 669172
= $11432.04
Alternatively, using Equation 3.26, and again using n = 6 , k = 4 and / = 0.75 per cent per month,
the required sum is:
c ! 1 C , 1
i L ( i+ ^ ' J i
$2000 i i $2000 , 1
0.0075 L (1.0075)9 J 0.0075 L ( i. 〇〇75)3 J
=($2000 x 8.671 5 76 42 3)-($ 20 00 x 2.955 556 237)
= $ 17343.1 5 2 9 -$ 5 9 1 1 .1125
= $11432.04
Present value of an ord ina ry perpetuity

The cash flow pattern o f an ordinary perpetuity o f C dollars per period is shown below:
0 1 2 3 4 5
---------------------------------------------------------------►
$C $C $C $C $ C --------------------►
The ordinary p erpe tu ity is an ordinary annuity where the num ber o f cash flows n becomes in d e fin ite ly
large. Therefore, to fin d its present value, we need to consider the form ula fo r the present value o f an
ordinary annuity and allow n to become indefinitely large. Thus the problem is to value:
P = lim —
(1 + i) n
Because the interest rate z is positive, (1 + i)n becomes ind efin itely large as n becomes ind efin itely
1
large. This means th a t (丄 + becomes very small because the denom inator o f this fraction becomes
very large. In the lim it, the value o f this fraction approaches zero and thus the present value o f an ordinary
p erpetuity is:11
C
3.27
where C = cash flow per period
i = interest rate per period
The valuation o f ordinary perpetuities is illustrated in Example 3.19.
E xample 3.19
A government security promises to pay $3 per annum forever. If the interest rate is 8 per cent per
annum and a payment of $3 has just been made, how much is the security worth?
SOLUTION
Using Equation 3.27:
$3
0.08
=$37.50
The value of the security is $37.50.
3 .6 .4 ! Future value of annuities

I t is frequently necessary to calculate the value o f an annuity as at the date o f the final cash flow. Such a
calculation is required if, fo r example, regular savings are being made towards a target fu tu re sum.
To derive the form ula fo r the future value o f an ordinary annuity, we use a two-stage process. First,
the present value o f the annuity is calculated. Second, the future value is calculated by accumulating the
present value fo r the n periods from the valuation date to the date o f the final cash flow. In effect we
use the compound interest form ula S = P(1 + i)n where, in this case, P is given by the present value o f an
ordinary annuity. That is:
1
(1 + i) n
(1 + i) n
= f [ ( i + On - i ] 3.28
I f C = $1, Equation 3.28 may be w ritte n as:12
S(n, i) = (1 + 〇 n-1
i 3.29
Values o f S(«, z) fo r different values o f n and i are given in Table 3 o f Appendix A. Alternatively, the
M icrosoft Excel4 fu nctio n - FV(rate, nper, pm t) m aybe used. The FV fu nctio n returns the value o f- 1 x the
future value o f an ordinary annuity, where 'rate* means the interest rate as a decimal, 'nper* means the
number o f periods and pint* means the am ount o f each periodic cash flow. The calculation o f the future
value o f an annuity is illustrated in Example 3.20.
• _ . . . c
11 Similarly, it is a simple matter to show that the present value of a perpetuity-due is C + —, and the present value of a deferred
1 C i
perpetuity, where the first cash flow occurs after k periods, i s ------- -- x
12 The notation can also be used. (1 + i)K
Example 3.20
Starting with his next monthly salary payment, Harold intends to save $ 2 00 each month. If the interest
6
rate is 8.4 per cent per annum, payable monthly, how much will Harold have saved after 2 years?
SOLUTION
The monthly interest rate is 8.4/12 = 0.7 per cent. Using Equation 3.28, Harold's savings will
amount to:
s = y [ii+ - r - i]
= ^ ° ° f(1.007)24- l l
0.007 L' J
= $ 2 0 0 x2 6 .0 3 4 9 2 5 07
=$5206.99
Alternatively, using Microsoft Excel®, we find that - FV(0.007, 24, 200) = $5206.99.
We could use this two-stage approach to derive formulae fo r the future values o f annuities-due and
deferred annuities. In practice, however, i t is usually ju s t as easy to apply this approach using the numbers
o f the particular problem. As we said at the sta rt o f this chapter, rather than learning a lis t o f formulae, i t is
preferable to learn the approach and then apply th is approach to the particular problem. This is illustrated
in Example 3.21.
Example 3.21
Harold's sister Janice can also save $ 2 0 0 per month, but whereas Harold takes 1 month to save his
first $200, Janice will start by setting aside $ 2 0 0 immediately. With an interest rate of 0.7 per cent
per month, how much will she have in 2 years' time? Reconcile this amount with the savings achieved
by Harold in the previous example.
SOLUTION
This problem requires the future value of an annuity-due. W e first calculate the present value, then
accumulate this amount for 24 months:
Step 1
n ^ C 1
(1 + /)
$200
$200.
0.007 (1.007)24
$4604.321 714
Step 2
S=P(1 +/)n
=$4604.321 714(1.007)24
=$5443.43
Janice is thus able to save $5443.43 after 2 years, compared with Harold's savings of $5206.99.
That is, Janice will save $236.44 more than Harold. Logically, this amount should equal the future
value of the initial $ 2 0 0 Janice set aside at the start, accumulated for 24 months at 0.7 per cent per
month. This is in fact the case, because $ 2 00 x (1.007)24 = $236.44.
B usiness finance
3.7 Principal-and-interest loan contracts

LEARNING
OBJECTIVE 4 Basic features of the contract
Apply your knowledge
of annuities to solve An im p o rta n t application o f annuities is to loan contracts, where the principal is gradually reduced by a
a range of problems,
series o f equal repayments. This type o f loan is often called a prin cipal-an d-in terest loan or a credit
including problems
involving principal- foncier loan. M any commercial loans, consumer loans and housing loans are in this category. The promised
and-interest loan repayments form an annuity and the present value o f the repayments is equal to the loan principal.
contracts Therefore, i f the promised future repayments are made on tim e the debt should reduce gradually during
the loan term , so th a t when the final promised repayment is made the debt should be extinguished. This
pattern is illustrated in Example 3.22.
Example 3.22
On 31 December 2014, Pennant Ltd borrows $ 1 0 0 0 0 0 from Z N A Bank. Annual repayments are
required over 5 years at a fixed interest rate of 11.5 per cent per annum. How much is each annual
repayment? Show the year-by-year record of the loan account for the 5 years ended 31 December
2019.
SOLUTION
PRIN CIPAL-AND -
INTEREST LOAN The annual repayments of C dollars form an ordinary annuity with a present value of $ 100000. Using
loan repaid by a Equation 3.19:
sequence of equal
cash flows, each of C
$100000 =
which is sufficient 0.115 (1.115 广
to cover the interest
C x 3.649 877 84
accrued since the
previous payment and So
to reduce the current
balance owing.
c= $100000
Therefore, the debt _ 3.649 877 847
is extinguished when =$27398.18
the sequence of cash
flows is completed. The annual repayment required is $27398.1 8.
Also known as a credit Alternatively, we could use the Microsoft Excel® function PMTjrate, nper, pv). Using the spreadsheet,
fonder loan we find that -PM T(0.115,5, 100000) returns $27398.1 8.
The year-by-year record o f the loan account is shown in Table 3.6.
TABLE 3.6
Date Entry Balance owing
31 December 2014 Principal borrowed $100000.00
31 December 2015 interest 0.115 x $100000.00 = $11500.00 $111500.00
Less repayment $27398.18 $84101.82
31 December 2016 Arfrf interest 0.115 x $84101.82 = $9671.71 $93 773.53
Less repayment $27398.18 $66375.35
31 December 2017 AcW interest 0.115 x $66375.35 = $7633.17 $74008.52
Less repayment $27398.18 $46610.34

Table 3.6 continued
Date Entry Balance owing
31 December 2018 interest 0.115 x $46610.34 = $5360.19 $51970.53
Less repayment $27398.18 $24572.35
31 December 2019 ^ i n t e r e s t 0.115 x $24572.35 = $2825.83 $27398.18
Less repayment $27398.18 $0.00
The year-by-year record shows th a t annual repayments o f $27398.18 are just sufficient to repay the
loan over the 5-year term .
3 .7 .2 1 Principal and interest components

As shown by the loan account in Example 3.22, the required repayments are ju s t sufficient to extinguish
the debt at the required date. This is achieved by a series o f repayments, each o f which is sufficient to cover
interest accrued since the previous repayment and to reduce the principal. As the principal decreases, so
also does the interest accruing and thus, as tim e passes, a larger p roportion o f each repayment goes to
reducing the principal. The principal and interest components o f the repayments in Example 3.22 are
shown in Table 3.7.
TABLE 3.7
Year ended 31 December Interest component ($) Principal component ($) Repayment ($)
2015 11500.00 15898.18 27398.18
2016 9671.71 17726.47 27398.18
2017 7633.17 19765.01 27398.18
2018 5 360.19 22037.99 27398.18
2019 2825.83 24572.35 27398.18
This pattern is more marked where the num ber o f repayments to be made is large. This is shown in
Example 3.23.
Example 3.23
Phantom Ltd borrows $1 0 0 0 0 0 at an interest rate of 1 1.5 per cent per annum, repayable by equal
monthly instalments over 2 0 years. Calculate the principal and interest components of the first and
last repayments.
SOLUTION
In this example, the monthly interest rate is 0 .1 1 5 /1 2 = 0 .0 0 9 5 8 3 3 3 3 and the loan term is
20 x 12 = 2 40 months. W e use Equation 3 .19 to calculate the monthly repayment:
________ 1________
$ 1 0 0 0 0 0 = --------- ---------- 1-
0.009583 333 (1.009583 333)240
= C x 93.77084022
continued
continued
So
c= $100000
~ 93.770 840 22
= $1066.43
The interest accrued during the first month of the loan is 0 .0 0 9 5 8 3 333 x $ 1 0 0 0 0 0 = $958.33.
Therefore, when the first monthly repayment of $ 1066.43 is made, $958.33 (or nearly 90 per cent of
the repayment) is required to meet the interest accrued during the first month and only $108.10 (just
over 10 per cent of the repayment) is available to reduce the principal. At the end of the loan term
this pattern is reversed. Only a small amount of interest will accrue during the last month, so almost
the whole of the final monthly repayment will be available to reduce the principal. The component
of principal in the final repayment is $ 1 0 6 6 .4 3 / 1 .0 0 9 5 8 3 333 = $1056.31; therefore, the interest
component is only $10.1 2. One aspect of this pattern is that the balance owing decreases slowly in
the early stages of repayment, but decreases rapidly as the maturity date is approached. This pattern
is considered in more detail in the next section.
3 .7 .3 ] Balance owing at any given date

The balance owing at any given date is the present value o f the then rem aining repayments. We explained
earlier how the principal is the present value o f all promised repayments. O f course, the principal is
sim ply the balance owing at the tim e the loan is made. Similarly, the balance owing at any given date is
the present value o f the repayments s till to be made as at th a t date. The calculation o f the balance owing
on a loan is illustrated in Example 3.24.
E xample 3.24
Consider again Phantom Ltd's loan of $ 1 0 0 0 0 0 at an interest rate of 1 1.5 per cent per annum,
repayable by equal monthly instalments over 20 years. As shown in Example 3.23, the required
monthly repayment is $1066.43. W hat is the balance owing when:
a) one-third of the loan term has expired?
b) two-thirds of the loan term has expired?
SOLUTION
a) The loan term is 2 4 0 months. Therefore, when one-third (or 80 months) of this term has expired,
160 monthly repayments are still to be made. The balance owing at the end of month 80 is the
present value of the then remaining 16 0 repayments:
$1066.43
0.009583 333 (1.009583 333)*160.
= $87087.85
b) When two-thirds (or 160 months) of the loan term has expired, 80 monthly repayments still have
to be made. Therefore, the balance owing at the end of month 160 is:
$1066.43 ________1________ ■
0.009583 333 (1.009583 333)80.
=$59394.64
In the previous section we explained that, in these types of loans, the balance owing reduces
slowly at first and more rapidly towards the end of the loan term. This pattern is clearly evident in this
example. When one-third of the loan term has expired, the balance owing is still more than $ 8 7 0 0 0
out of an original loan of $ 1 0 0 0 0 0 . That is, the passing of one-third of the loan term has seen the
principal fall by less than 13 per cent. When two-thirds of the loan term has expired, only about
4 0 per cent of the debt has been repaid. A more detailed presentation of this pattern is provided in
Figure 3.2.
Figure 3.2 Balance owing as a loan is repaid

0
9
8
7
6
o
5
4
3
o
o
oo
o
oo
o o o - $ lM O
cr)
.E
9UUDID
CQ
10
220 200 180 160 140 120 100 80 60 40 20

Months remaining
3 .7 .4 1 Loan term required

In some applications it is necessary to solve fo r the required loan term n given the principal, interest rate
and periodic repayment. For example, in order to plan future expenditure, a borrow er may wish to know
when an existing loan w ill be repaid. Solving fo r the loan term requires us to rearrange Equation 3.19 so
th a t n appears on the left-hand side:
C
(i + 0"
(1 + i) n c
c
( i + O77
C -P i
and therefore:
n = log[C/(C-P/)] _ _
i 〇g (i + 〇 E E 3
Logarithms to any base (such as base 10 or base e) w ill give the correct answer. The calculation o f a
required loan term is illustrated in Example 3.25.
A B usiness finance
E xample 3.25
One year ago, Canberra Fruit Ltd borrowed $ 7 5 0 0 0 0 at an interest rate of 12 per cent per annum.
The loan is being repaid by monthly instalments of $ 1 6 6 8 3 .3 4 over 5 years. As a result of making
the promised repayments over the past year, the balance owing is now $ 6 33 532 .48 . The company
can now afford repayments of $ 2 0 0 0 0 per month and the company manager wishes to know when
the loan will be repaid if repayments are increased to that level. The manager also wishes to know
the amount of the final repayment.
SOLUTION
Using Equation 3.30:
n _ log [C /(C -P i]
lo g (l + /)
_ log { $ 2 0 0 0 0 / [ $ 2 0 0 0 0 - ($633 5 3 2.481(0.011]}
= log(l.Ol)
_ lo g ( $ 2 0 0 0 0 / $ l3 6 6 4 .6 7 5 2 )
= l〇g(i. 〇 i)
_ log (1 .4 6 3 6 2 7 9 1 )
= log(l.Ol)
Using 'common' logarithms (logarithms to the base 10):13
= 0 .1 6 5 4 3 0 6 8 2
0 .0 0 4 321 373
= 3 8 .2 8 2 months
The loan will be repaid after a further 39 months; for the first 38 months the repayment will be
$ 2 0 0 0 0 per month, while the last (39th) repayment will be a smaller amount. The amount of the last
repayment must be such that the present value of all 39 repayments equals the balance owing of
$633 532.48. Using R to represent the amount of the last repayment, we therefore require that:
$20000 R
$ 6 3 3 5 3 2 .4 8 =
0.01 (1.01)38 (1.01)39
= $ 6 2 9 69 3 .2 6 6 1 + —
(1.01)39
R
$ 3 8 3 9 .2 1 3 9 =
(1.01)39
which gives R = $5659.47.

The amount of the last (39th) repayment is $5659.47.
3 .7 .5 1 Changing the interest rate

VARIABLE INTEREST In some loan contracts, usually called variable in terest rate loans, the interest rate can be changed at any
RATE LOAN tim e by the lender, although, in practice, changes are norm ally made only when there has been a change in
loan where the
the general level o f interest rates in the economy. Such a change may be signalled or caused by the Reserve
lender can change
the interest rate Bank o f Australia changing the cash rate. In Australia, many housing loans, and many commercial loans,
charged, usually in are in this category. Typically, the parties to the contract w ill at the outset agree on a notio na l loan term —
line with movements say, 15 years fo r a housing loan— and the lender w ill then require a regular repayment th a t is calculated as
in the general level i f the current interest rate is fixed fo r 15 years. If, as is always the case, the general level o f interest rates
of interest rates in the
subsequently changes, the interest rate charged on the loan w ill then be changed. The lender w ill then set
economy
the new required repayment, which w ill be calculated as i f the new interest rate is fixed fo r the remaining
13 Use of natural logarithms (logarithms to the base e) must give the same answer. In this case the calculation is
n = 0.380918223/0.00995033 = 38.282.
令
C hapter THREE T he TIME VALUE OF MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
loan term. Alternatively, the lender may allow the borrower to continue m aking the same repayment and,
instead, alter the loan term to reflect the new interest rate.14 O f course, a com bination o f b oth responses
is also a possibility. These choices are illustrated in Example 3.26.
E xample 3.26
Three years ago Andrew and Jane borrowed $ 8 0 0 0 0 , repayable by equal monthly instalments over
15 years. At the time they borrowed the money, the interest rate was 9.6 per cent per annum calculated
monthly. Following standard procedures, the lender correctly calculated the required monthly payment
to be $840.21. Andrew and Jane have made all repayments on time and the balance owing is now
$71 685.05. The general level of interest rates has been rising and the lender has now decided
to increase the interest rate to 10.8 per cent per annum calculated monthly. What will be the new
monthly repayment if the loan term is to remain unchanged? If, instead, the monthly repayment is left
at $840.21, by how many months will the loan term increase?
SOLUTION
The new monthly repayment C must be set so that the present value, calculated using the ne w interest
rate, of the remaining 144 repayments equals the balance outstanding of $71 685.05. The new
interest rate is 10.8 per cent per annum or 0.9 per cent per month. Therefore, using Equation 3.19:
$ 7 1 6 8 5 .0 5 = — ^ 1 --------- — -
0.009 L (1.009)144.
= 80.531 669 39 C
C = $890.15
The new repayment is $890.15 per month.
Alternatively, if the loan term is extended, and the monthly repayment is left at $840.21, the new
loan term may be found using Equation 3.30:
n log [C /(C -P f)]
log(l + /)
log {$8 40.21/[$840.21 -($71 685.05)(0.009)]}
log( 1.009)
_ log(4.307785 068)
= log( 1.009) LEARNING
=162.998 months OBJECTIVE 5
Distinguish between
w 163 months simple and general
The remaining loan term is now 163 months, which is 19 months longer than the 144 'expected7 annuities and make
basic calculations
at the time of the interest rate increase.
involving general
annuities
SIMPLE A N N U IT Y
annuity in which the
3.8 G eneral annuities frequency of charging

interest matches the
frequency of payment
In our discussion o f annuities, the frequency o f compounding has coincided w ith the frequency o f the GENERAL A N N U IT Y
cash flows. An a nnuity w ith this feature is called a sim ple annuity. For example, we have considered annuity in which the
cases where interest is calculated and charged annually, and the borrow er is required to make annual frequency of charging
repayments. In practice, however, this is n ot always the case. Situations arise where loan repayments are interest does not
match the frequency
required more frequently, o r less frequently, than interest is charged (compounded). An a nnuity w ith this
of payment; thus,
feature is called a general annuity. repayments may be
made either more
14 Note, however, that if the interest rate is increased to a level where the monthly repayment is less than the monthly interest frequently or less
accruing (that is, C < P i), then the loan term becomes infinite. In these circumstances lenders will usually require a higher frequently than interest
monthly repayment. is charged
In a general annuity, the frequency o f compounding does n o t match the frequency o f repayment.
There are thus two cases to consider:
a The frequency o f compounding is greater than the frequency o f repayment. For example, a loan contract
may specify an interest rate o f 8 per cent per annum, compounding quarterly, b u t repayments are
made annually.
b The frequency o f compounding is less than the frequency o f repayment. For example, a loan contract may
specify an interest rate o f 8 per cent per annum, compounding quarterly, b u t repayments are made
m onthly.
In b oth cases, to solve the problem we need firs t to adjust the specified interest rate to an interest rate
where the compounding frequency matches the repayment frequency.15 This adjustm ent is made using
the concept o f the effective interest rate th a t we discussed in Section 3.4.3. This concept was summarised
in Equation 3.6, which we reproduce below:
/ . \ m
/=(1 +m) _1
where i = the effective interest rate per period
j = the nom inal interest rate, compounding m times per period
Note th a t in this equation the tim e dimension o f z is fo r a longer period than the tim e dimension o f
j/m . For example, z m ig ht be an interest rate per annum while m ight be an interest rate per quarter.
I t is convenient to restate Equation 3.6 in terms o f an interest rate zs, fo r the shorter tim e period, and an
interest rate zL, fo r the longer tim e period. That is, Equation 3.6 is rew ritten as:
3.31
where m = the num ber o f ‘short’ periods in one ‘long’ period.
The use o f Equation 3.31 is illustrated in Examples 3.27 and 3.28.
E xample 3.27
Use Equation 3.31 to express 8 per cent per annum, compounding quarterly, as:
a) an effective annual interest rate
b) an effective monthly interest rate.
SOLUTION
a) In this case, interest is compounding quarterly and we wish to calculate an equivalent interest rate
in which compounding occurs annually. Thus we are required to calculate iL,
where is = 0.08/4 = 0.02, and m = 4. Using Equation 3.31:
彳=(1 + 'S )m _ 1
= (1.02)4 -1
= 0 .0 8 2 4 3 2 16
« 8 .2 4 3 % perannum
b) In this case, interest is compounding quarterly and we wish to calculate an equivalent interest rate
in which compounding occurs monthly. Thus we are required to calculate is,
where iL = 0.08/4 = 0.02 and m = 3. Using Equation 3.31:
0.02 = (1 + /s)3 - l
/s = (1 .0 2 )1/ 3 _ l
= 0 .0 0 6 6 2 2 71
« 0 .6 6 2 % per month
15 Alternatively, an adjustment can be made to the repayment amount. However, when using a calculator it is generally easier to
adjust the interest rate.
Example 3.28
A loan is currently being repaid by repayments of $ 5 5 0 0 0 at the end of each quarter. The interest
rate is 8 per cent per annum. The borrower wishes to change to a monthly repayment schedule that
will pay oft the loan by the same maturity date. Calculate the amount of each monthly repayment.
SOLUTION
The repayment schedule for a typical quarter is shown in Figure 3.3.
:igure 3.3 Monthly and quarterly repayments
i :l 3 me)nths
$55 000
$c $C $C
As shown in Figure 3.3, it is proposed to replace each end-of-quarter cash flow of $ 5 5 0 0 0 with
three end-of-month cash flows of C dollars each. Interest is charged quarterly at a nominal rate of
8 per cent per annum— that is, the effective qfuarter/y interest rate is 2 per cent per quarter. As shown
in Example 3.27 (b), the equivalent effective m onthly interest rate is 0.662 271 per cent per month.
Equating the present values of the quarterly and monthly cash-flow streams gives:
$55 000 = C
1.02 1.006622 71 (1.006622 71 )3
Note, however, that although we have included the calculation of (1.006622 71 )3 in this
expression, this calculation should by definition equal 1.02 (see the calculation in Example 3.27 (b)
for clarification). Therefore, we need to solve:
$55 000 = C L _ 1 '
1.02 0.006622 71 L 1.02.
which gives C = $ 1 8 2 1 2 .4 5
Therefore, monthly repayments of $1 8 2 1 2 .4 5 will pay the loan off at the same maturity date as
quarterly repayments of $ 5 5 0 0 0 . Note that 3 x $18 212.45 = $5 46 37.3 5, which is slightly less
than the quarterly repayment of $5 5 0 0 0 . This difference reflects the present-value effect of making
monthly repayments earlier than the quarterly repayments they replace.
B usiness finance
SUMMARY
• Financial managers frequently make decisions that for dealing with several related problems. Annuity
involve the time value of money. This chapter covered applications, including interest-only loans and
the major tools of financial mathematics needed principal-and-interest loans, were also discussed.
to support these decisions. These tools include • A wider class of problems, in which interest is
calculating rates of return, present values and future charged either more frequently or less frequently
values, and defining and applying interest rates, than cash flows occur, was also discussed.
including simple interest and compound interest. • Throughout the chapter, emphasis was placed on
• The definition and valuation of various streams of developing a sound understanding to support the
cash flows were considered in detail, with the present use of the various formulae that were derived.
value of an ordinary annuity being used as the basis
KEY TERMS
accumulation 34 log price relative 43
annuity 50 nominal interest rate 3 7 , 40
annuity-due 50 ordinary annuity 50
cash flow 29 ordinary perpetuity 51
compound interest 33 present value 32
continuous interest 42 present value of a contract 47
debt 30 principal 31
deferred annuity 50 principal-and-interest loan 58
discounting 36 rate of return 29
effective interest rate 37 real interest rate 40
financial contract 29 simple annuity 63
future sum 32 simple interest 31
general annuity 63 terminal value of a contract 47
geometric rate of return 44 time value of money 30
interes卜 only loan 37 variable interest rate loan 62
interest rate 30
SELF-TEST PROBLEMS
1 Andrew borrowed $ 6 0 0 0 and repaid the loan 60 days later by a single payment of $6250. What is the
implied annual simple interest rate?
2 Angela deposits $ 5 0 0 0 today in a bank account that pays interest annually at the rate of 8 per cent. She
then makes 10 more deposits of $ 1 0 0 0 each at annual intervals.
a) How much does she have when she has made the last deposit?
b) If Angela wished to accumulate the same sum by making a single deposit now, what amount would she
need to deposit?
3 Geoff and Gail wish to borrow $ 7 5 0 0 0 to be repaid by equal monthly instalments over 25 years. The
nominal annual interest rate is 9.9 per cent.
a) What is the effective annual interest rate?
b) What is the amount of the monthly repayment?
Solutions to self-test problem s ore a v a ila b le in A p p e n d ix B.
INTERNATIONAL ARTICLES
International articles related to this topic are available on the Online Learning Centre at www.mhhe.com /
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66
CHAPTER THUEE REVIEW

QUESTIONS
1 [LO 1] Explain the difference(s) between an interest rate and a rate of return.
2 [LO 1] Distinguish between simple interest and compound interest.
3 [LO 1] In financial mathematics, the symbol P can stand for 'present value', 'price' or 'prin cipa l’，but all
three terms really hove the some meaning. Discuss.
4 [ L O llT h e term 'nominal interest rate' has two different meanings. Explain these two meanings,
distinguishing carefully between them.
5 [LO 1] Rotes o f return should be multiplied, not added. Is this true? Why, or why not?
6 [LO 2] Given a required rote o f return, a set o f cash inflows can be valued os at any date, and the later is
the valuation date the higher the value. Is this true? Why, or why not?
7 [LO 3] Distinguish between an annuity-due and a deferred annuity.
8 [LO 4] In any variable interest rote loon, it is possible that the interest rate con be increased to a level where
the loan term becomes infinite unless the periodic repayment is increased. Explain how this can occur, and
relate your answer to the characteristics of Equation 3.30.
9 [LO 5] Distinguish between a simple annuity and a general annuity.
PROBLEMS
1 Simple interest earned [LO 1]
Nicholas deposits $2 0 0 0 in a bank fixed deposit for 6 months at an interest rate of 13.25 per cent per
annum. How much interest will he earn?
2 Simple interest earned [LO 1]
If Nicholas reinvests the $2000, plus the interest earned (see Problem 1), for a further 6 months, again at
13.25 per cent per annum, how much interest will he earn in this second 6-month period?
3 Implied simple interest rate [LO 1]
Jane borrowed $ 1 0 0 0 0 and repaid the loan 30 days later by a single payment of $10400. What is the
implied annual simple interest rate?
4 Calculating the loan term [LO 1]
Mary borrowed $7250 at an annual simple interest rate of 15.50 per cent. She repaid the loan by paying a
lump sum of $7394.70. What was the loan term?
5 Calculating the lump sum repayment [LO 1]
On 2 April 2014, Paradise Pencils Ltd borrows $2 00 000 , repaying in a lump sum on 16 M ay 2014. The
interest rate is 9.55 per cent per annum. How much is the lump sum repayment?
6 Simple interest earned (harder) [LO 1]
On 5 February 2014, Financial Solutions Ltd deposits $ 3 0 0 0 0 0 with Second Street Bank at a simple interest
rate of 4.4 per cent per annum. The maturity date of the deposit is 5 M ay 2014. Calculate the amount of
interest the deposit will earn.
7 Present value [LO 1]
Jupiter Mining Ltd promises to pay $ 5 0 0 0 0 0 in 90 days' time. Taking into account the company’s credit
standing, the market interest rate for a loan period of 90 days is 10.65 per cent per annum. How much can
Jupiter Mining borrow?
8 Simple and compound interest [LO 1]
a) What will be the accumulated value, at the end of 10 years, of $1000 invested in a savings account that
pays 8 per cent per annum? Assume that no withdrawals are made from the savings account until the end
of the tenth year. What is the interest component of the accumulated value?
b) Assume that interest is withdrawn every year. What will be the total interest earnings at the end of the tenth
year? W hy does this amount differ from the interest earned in Problem 8 (a)?
67
Compound interest earned [LO 1]
If you invest $ 6 5 0 0 0 for 3 years at 14.7 per cent per annum (interest payable annually), how much will you
have at the end of the 3 years?
Compound interest earned [LO 1]
If you invest $ 8 7 0 0 0 at 7.35 per cent per annum (interest paid annually), how much will you have:
a) at the end of 3 years?
b) at the end of 6 years?
Compound interest earned (harder) [LO 1]
Frank has invested $ 1 0 0 0 0 for 10 years at 12.4 per cent per annum. He has to pay tax on the interest
income each year.
a) Calculate the value of the investment at the end of the tenth year if his tax rate is:
i) 45 per cent per annum
ii) 30 per cent per annum
iii) 15 per cent per annum
iv) zero per annum.
b) Rework your answer to (a)(i) if, instead of having to pay tax each year, Frank must pay in tax 45 per cent
of the accumulated interest at the end of the tenth year. Which tax system is better for him? W h y?
Compound interest earned [LO 1】
Philip invests $ 1 7 2 0 0 at an interest rate of 2.5 per cent per quarter. How much is the investment worth after
2 years?
Compound interest earned [LO 1】
Rhiannyn invests $ 2 5 0 0 0 at an interest rate of 0.6 per cent per month. How much is the investment worth after
3 years?
Present value [LO 1]
Calculate the following present values:
a) $1 00 0 payable in 5 years if the interest rate is 12 per cent per annum
b) $ 1000 payable in 10 years if the interest rate is 12 per cent per annum
c) $1000 payable in 5 years if the interest rate is 6 per cent per annum
d) $ 1 6 2 0 5 payable in 1 year if the interest rate is 1.5 per cent per month
e) $1 million payable in 4 0 years if the interest rate is 15 per cent per annum
f) $1 million payable in 100 years if the interest rate is 15 per cent per annum.
Compound interest [LO 1]
Neeta Stoves Ltd borrows $8 00 0 repayable in a lump sum after 1 year. The interest rate agreed to is
described as ' 15.0 per cent per annum, calculated monthly’. How much is the repayment?
Implied compound interest rate [LO 1]
What is the annual interest rate (compound) implied by each of the following future values (FV), present values
(PV) and terms (/):
a) FV = $9 20 00; PV = $8 20 00; f = 2 years
b) FV = $1 6 0 4 6 0 0 ; PV = $1 50 0 0 0 0 ; f= 4 years
c) FV = $ 2 0 0 0 0 0 0 ; PV = $ 1 3 0 7 6 0 0 ; t = 3 years
d) FV = $ 1 0 0 0 0 0 0 0 ; PV = $ 6 0 0 0 0 0 0 ; t = 6 years
e) FV = $ 1 0 0 0 0 0 0 0 ; PV = $ 6 0 0 0 0 0 0 ; f = 5.5 years?
Effective annual interest rate [LO 1]
What is the effective annual interest rate corresponding to each of the following nominal interest rates:
a) 18 per cent per annum, payable half-yearly
b) 18 per cent per annum, payable monthly
c) 18 per cent per annum, payable fortnightly
d) 1 8 per cent per annum, payable daily
e) 18 per cent per annum, payable continuously?
C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
CHAPTER THUEE REVIEW

18 Effective annual interest rate [LO 1]
What is the effective annual interest rate corresponding to each of the following nominal interest rates:
a) 7.5 per cent per annum, payable half-yearly
b) 7.5 per cent per annum, payable monthly
c) 7.5 per cent per annum, payable fortnightly
d) 7.5 per cent per annum, payable daily
e) 7.5 per cent per annum, payable continuously?
19 Effective annual interest rate [LO 1]
Jerm Ltd buys a bank bill for $91 107 and sells it 5 4 days later for $93 323. What annual effective interest
rate did Jerm Ltd earn?
20 Simple interest and effective annual interest rate [LO 1]
Liana Ltd bought a bank bill on 7 January 2012 for $976 751 and sold it on 3 March 2012 for $98761 8.
a) What simple interest rate did Liana Ltd earn?
b) What annual effective interest rate did Liana Ltd earn?
21 Calculating the effective annual interest rate [LO 1]
On 16 January 201 2, an investor lent a sum of money to be repaid, with interest, on 1 1 March 2012. The
interest rate was 6.15 per cent and was quoted on a simple interest basis. What effective annual interest rate
did the investor earn?
22 Effective annual interest rate (harder) [LO 1]
Rock Solid Ltd sells, on credit, goods to the value of $8465.95 to University Garden Supplies Ltd. Rock Solid
offers a discount of half of 1 per cent for payment within 7 days; otherwise, payment must be made on or
before the thirtieth day. What is the effective annual interest rate implicit in the discount being offered? State
any assumptions you make.
23 Effective annual interest rate (harder) [LO 1]
Since 1 August 201 2, W ing Yin's investment policy has been to lodge fixed (term) deposits at her local bank.
The bank pays interest on the maturity date of a deposit and the interest rate is expressed as an annual simple
interest rate. When a deposit matures, W ing Yin's policy is to re-lodge the whole sum (principal and interest)
immediately for a further period. She chooses the term of each deposit according to her assessment of the
interest rates available at that time. W ing Yin's decisions to date are as follows:
Date Decision
1 August 2012 8-month deposit at 9.15 per cent per annum
1 April 2013 6-month deposit at 8.45 per cent per annum
1 October 2013 10-month deposit at 8.16 per cent per annum
Calculate, as at 1 August 2014, the effective annual interest rate W ing Yin has earned since she began this
policy. (Assume that all months are of equal length.) Briefly explain each step.
24 Nominal interest rate [LO 1]
A retail chain operates its own credit provision system for customers. Company policy is to set a nominal
annual interest rate, and to charge interest monthly. To cover its costs and make a return on capital, the
company has a target effective interest rate of 19.5 per cent per annum. What nominal annual interest rate
should it set?
25 Nominal interest rate [LO 1]
If the real interest rate is 10 per cent per annum, and the expected inflation rate is 25 per cent per annum,
what should be the nominal interest rate?
26 Nominal interest rate (harder) [LO 1]
George is intending to lend money to his nephew to help him set up a new business. The loan will be
made now, and is to be repaid in a lump sum after 3 years. George wishes to earn a real interest rate of
3.5 per cent per annum. He expects the inflation rate in the coming year to be 10 per cent but believes that it
will fall steadily thereafter to 6 per cent in the following year and to 4 per cent in the third year. What annual
interest rate should George set on the loan?
69
27 Nominal interest rate (harder) [LO 1]
Grose Paterson Bank Ltd is intending to lend money to a client. The loan is to be repaid in a lump sum after 7
years. The bank's required real rate of return is 3 per cent per annum. The bank expects the inflation rate in
the coming year to be 8 per cent per annum, falling to 5 per cent per annum the following year and 4 per cent
per annum thereafter. What annual interest rate should the bank set?
28 Real annual rate of return [LO 1]
In Xanadu, the consumer price index (CPI) stood at 147.6 on 1 January 2010. O n that date, SBF Ltd invested
$ 5 0 0 0 0 for 4 years at an interest rate of 11.4 per cent per annum (compound). On 1 January 2 0 14 the CPI
stood at 193.8. What real annual rate of return has SBF earned?
29 Log price relative [LO 1]
An investor purchases 1000 shares at $5.50 per share on 31 M ay 2014. Over the next 6 months the investor
notes down the price of the share at the end of each month. The result is shown below:
End o f June $5.85
End of July $6.12
End o f August $5.75
End o f September $5.75
End o f October $6.44
End of November $6.60
There were no dividends paid in this period. Calculate, for each month, the log price relative, using
natural (base e) logarithms. What does the sum of the log price relatives represent? Compare this sum to
^n($6.60/$5.50). Explain.
30 Average annual rate of return [LO 1]
Matthew bought an apartment for $3 64 000 . After 4 years he estimates that its value has changed as follows:
In Year 1: an increase of 7 per cent
In Year 2: an increase of 2 7 per cent
In Year 3: a decrease of 5 per cent
In Year 4: an increase of 1 1 per cent.
How much is it worth now? What is the average annual rate of return?
31 Present value [LO 1]
What is the present value (at 7 per cent per annum) of a contract that provides for the following three
payments to be made:
After 6 months: $7601
After 2.5 years: $9900
After 7 years: $1 8 5 2 2 ?
32 Present and future values [LO 1]
A company is entitled to receive a cash inflow of $8 00 0 in 2 years7 time and a further cash inflow of $ 1 4 0 0 0
in 5 years' time. If the interest rate is 8.5 per cent per annum, how much is this stream of cash inflows worth:
a) today
b) in 5 years7 time.
33 Internal rate of return [LO 1]
An investment costs $ 5 0 0 0 0 and generates cash inflows of $ 4 0 0 0 0 after 1 year and $ 3 0 0 0 0 after 2 years.
Show that the internal rate of return on this investment is approximately 27.2 per cent per annum.
34 Valuation of cash flows at any date [LO 2]
A contract will produce cash inflows on 4 different dates. These cash inflows are: $1 0 0 0 after 1 year, $8000
after 3 years, $ 1 2 0 0 0 after 7 years and $ 1 0 0 0 0 after 10 years. The required rate of return is 8.5 per cent
per annum.
a) Calculate the present value.
b) Calculate the value as at the start of Year 1.
CHAPTER THREE REVIEW

c) Calculate the value as at the start of Year 3.
d) Calculate the value as at the start of Year 7.
e) Calculate the terminal value.
f) What is the relationship between these successive valuations?
35 Valuing different types of annuity [LO 3]
Consider an annuity of 6 cash flows of $5 00 0 payable annually. If the interest rate is 7 per cent per annum,
what is the value of this annuity today if the first cash flow is to be paid:
a) immediately
b) in 1 year’s time
c) in 4 years' time?
36 Annuities [LO 3]
Today is Stanley's 55th birthday. He plans to retire on his 65th birthday and wants to put aside the same sum
of money every birthday (starting today) up to and including his 65th birthday. He then wants to be able to
withdraw $ 1 0 0 0 0 every birthday (starting with his 66th) up to and including his 85th birthday. He believes
that an interest rate of 10 per cent per annum is a reasonable estimate. How much does he need to put aside
each birthday?
37 O rdinary perpetuities [LO 3]
How much money would be needed to establish a permanent scholarship paying $1 00 0 at the end of each
year, if money can be invested at 8 per cent per annum?
38 O rdinary perpetuities (harder) [LO 3]
Kevin Oldfellow attended Unicorn High School in the 1960s. After leaving school, Kevin established an
advertising agency that proved to be highly successful. Kevin is now very wealthy and wishes to establish a
fund that will provide a perpetual scholarship scheme to support students at Unicorn High. At the initiation
of the scheme Kevin will award six scholarships— one each to students currently in Years 7 to 12 inclusive.
These students keep these scholarships until they leave the school. In subsequent years, one scholarship will be
awarded every year to a student entering the school at Year 7 and that student keeps the scholarship through
to Year 12. Kevin has sought advice from the school and has been told that it costs about $6 00 0 to keep a
student at Unicorn High for 1 year.
The current long-term nominal interest rate is 6 per cent per annum. The long-term real interest rate is
estimated to be 2.5 per cent per annum. Kevin has been advised that it will cost him $ 6 3 6 0 0 0 to set up the
scheme. However, Kevin is not convinced, arguing that, 'The current inflation rate is about 3.5 per cent per
annum. If this continues then it won't be long before the real value of a scholarship will not be enough to keep
a student at the school for a year. Surely this has to be factored into the calculation somehow'. Kevin has
approached you for advice.
a) What is the logic behind the advice that a fund of $ 6 3 6 0 0 0 would be sufficient? Show your calculations.
b) Suppose that for the next 5 years the annual inflation rate continues to be 3.5 per cent and the annual
interest rate continues to be 6 per cent. What will be the real value of an annual scholarship payment after
5 years?
c) What amount would you advise Kevin to put into the scholarship fund? Explain.
d) Assuming that the forecasts in (b) are correct, show how the amount in the fund and the amount of each
scholarship would evolve over the first 2 years.
39 Deferred perpetuities [LO 3]
A pine plantation returns nothing to its owner in the first 2 years. In the following 2 years, the returns are
$ 1 0 0 0 0 0 and $1 50 000 , respectively, and after that the return is $ 2 0 0 0 0 0 per year in perpetuity. All returns
are in cash and occur at year end.
a) What is the present value of the constant return stream at the beginning of the fifth year if the returns can be
invested at 8 per cent per annum?
b) What is the current present value of the whole return stream at the same required rate of return?
40 Deferred perpetuities [LO 3]
What is the present value of a perpetual cash inflow of $1 00 0 received at the end of each year, the first inflow
occurring 2 years from now, if the interest rate is 5 per cent per annum? This cash flow can be produced by
investing $ 1 0 0 0 0 in a business this year and $6 00 0 next year. What is the present value of the investment?
Is it profitable?
71
B usiness finance
41 Calculating principal and interest repayments [LO 4]

Luke borrows $ 8 0 0 0 0 0 from a bank to set up a medical practice. He agrees to pay a fixed interest rate of
10.2 per cent per annum (calculated monthly) and to repay by equal monthly instalments over 10 years.
Calculate the monthly repayment. By how much does Luke's first repayment reduce the principal? If the loan is
paid off as planned, by how much will the lost repayment reduce the principal?
42 Calculating principal outstanding [LO 4]
After making 21 monthly repayments, Luke (see Problem 41) inherits a large sum of money and decides to
repay the (remaining) loan. When the twenty-second repayment is due he asks for the payout figure. How
much should it be?
43 Calculating the loan term [LO 4]
John decides that he desperately needs a new Italian suit priced at $1999. He borrows the money and agrees
to pay $71.07 each month at an interest rate of 16.8 per cent per annum, payable monthly. For how long will
he be making repayments?
44 Annual rate of return [LO 4]
What is the approximate annual rate of return on an investment with an initial cash outlay of $ 1 0 0 0 0 and net
cash inflows of $2 77 0 per year for 5 years?
45 Nom inal interest rate and effective interest rate [LO 4 】
Warren Cameron buys a boat for $30000, paying $5 00 0 deposit. The remainder is borrowed from the
Goodfriend Loan Co. to be repaid by 15 monthly payments of $2027.50 each. What is the monthly interest
rate being charged? What is the nominal annual interest rate? What is the effective annual interest rate?
46 Calculating the loan term [LO 4 】
Anne Hopewell has just borrowed $ 7 0 0 0 0 to be repaid by monthly repayments over 20 years at an interest
rate of 18 per cent per annum. Based on this information, the monthly repayment is approximately $1 08 0 but
Anne intends to make higher monthly repayments. She asks you how long it will take to repay the loan if the
amount she pays per month is:
a) $1100
b) $1200
c) $1500.
47 Annuities [LO 4]
Layla borrows $5 00 00, repayable in monthly instalments over 10 years. The nominal interest rate is
12 per cent per annum. What is the monthly repayment? After 3 years have passed, the lender increases
the interest rate to 13.5 per cent per annum and Layla is given the choice of either increasing the monthly
repayment or extending the term of the loan. What would be the new monthly repayment? What would be
the new loan term?
48 Annuities [LO 4]
Exactly a year ago, Stephen and Lan Kuan borrowed $ 1 5 0 0 0 0 from a bank, to be repaid in equal monthly
instalments over 25 years at an interest rate of 7.8 per cent per annum. Today, the bank told them that it was
introducing a monthly fee of $10 but they could continue to repay the loan by making their current monthly
payments. However, Stephen and Lan Kuan are worried because if they do this, the loan will take longer to
repay. They have asked you to calculate how much longer it will take to repay the loan.
49 Effective annual interest rate, repayments and loan terms [LO 4 】
Don and Jenny wish to borrow $180000, to be repaid over a period of 20 years by monthly instalments.
The interest rate (nominal) is 7.8 per cent per annum. The first payment is due at the end of the first month.
a) Calculate the effective annual interest rate.
b) Calculate the amount of the monthly repayment if the same amount is to be repaid every month for the
period of the loan.
c) Suppose, instead, that the lender agrees that Don and Jenny will repay $1 10 0 per month for the first 12
months, then $ 1 2 5 0 per month for 出e 12 months after that, then $X per month thereafter. Assuming that
the term is to stay at 20 years, how much is $X?
d) Alternatively, suppose that Don and Jenny decide to repay $2 50 0 per month from the time the money is
borrowed until it is repaid. How long would it take to repay the loan? What would be the amount of the
final payment?
72
C hapter THREE T he TIME VALUE 〇F MONEY: AN INTRODUCTION TO FINANCIAL MATHEMATICS
CHAPTER THREE REVIEW

50 Repayments and loan terms [LO 4 】
Peter borrowed $ 8 0 0 0 0 0 to refit his fishing trawler. The loan requires monthly repayments over 15 years.
When he borrowed the money the interest rate was 13.5 per cent per annum, but 18 months later the bank
increased the interest rate to 15.0 per cent per annum, in line with market rates. The bank tells Peter he can
increase his monthly repayment (so as to pay off the loan by the originally agreed date) or he can extend the
term of the loan (and keep making the same monthly repayment). Calculate:
a) the new monthly repayment if Peter accepts the first option
b) the extra period added to the loan term if Peter accepts the second option.
51 Calculating repayments [LO 4]
Wahroonga Furniture Ltd (WFL) is planning a large sale of its stock of lounge suites and dining tables. As part
of its marketing, WFL will offer customers loans of up to $1 00 00, with no repayment required during the first
6 months. The customer then makes equal monthly repayments. The total loan term (including the first 6 months)
is 2 years. The effective interest rate that WFL requires on the loans is 12 per cent per annum. What monthly
repayment must WFL charge on a loan of $ 1 0 0 0 0 ?
52 Simple and general annuities [LO 5]
A simple annuity of $ 3 00 per quarter is to be replaced by annual payments (the payments to be made at the
end of each year). What will be the annual payments if the nominal interest rate is 6 per cent per annum?
REFERENCES
Crapp, H. & Marshall, J., Money Market Maths, Allen & M artin, P. & Burrow, M ., Applied Financial Mathematics,
Unwin, Sydney, 1986. Prentice-Hall, Sydney, 1991.
Knox, DM., Zima, P. & Brown, R.L., Mathematics of Finance,
2nd edn, M cG raw-H ill, Sydney, 1999.
73
CHAPTER FOUR
Applying the time
value of money
. to security .
valuation
CHAPTER CONTENTS
ED Introduction 75 The term structure of interest rates 82
m Financial asset valuation under certainty 75 EB The default-risk structure of interest rates 89
m Valuation of shares 76 BE1 Other factors affecting interest rate structures 91

HH Valuation of debt securities 80 Appendix 4.1 Duration and immunisation 97
BH Interest rate risk 81
LEARNING OBJECTIVES
1 understand how assets are valued under conditions of certainty
2 use the tools of financial mathematics to value equity securities
3 explain the main differences between the valuation of ordinary shares based on dividends and on
Gamings
4 use the tools of financial mathematics to value debt securities
5 explain the nature of interest rate risk
6 understand the theories that are used to explain the term structure of interest rates
7 understand the effect of default risk on interest rates
8 apply the concept of duration to immunise a bond investment.
命
C hapter four A pplying the time value of m o n e y to security valuation
In Chapter 1 we discussed b riefly the im p o rta n t concept o f the tim e value o f money. In Chapter 3 we
presented some mathematical tools useful in analysing problems involving the tim e value o f money.
In particular, we showed how promised streams o f future cash flows can be valued, provided th a t the
required rate o f retu rn is known.
In this chapter we apply these tools to the valuation o f debt and equity securities. In itia lly we
assume th a t the security s fu tu re cash flows are know n w ith certainty. Later in the chapter we introduce
uncertainty, b ut only in a lim ite d way. A more form al and detailed treatm ent o f u ncertainty is given in
Chapter 6.
4.2 Financial asset valuation under certainty 1

The benefits o f owning an asset are the present and future consumption opportunities attributable to
it. For a financial asset, these benefits are in the form o f cash. For example, an investor who holds a LEARNING
OBJECTIVE 1
government bond u n til m a tu rity receives cash in the form o f interest payments during the bonds life
Understand how
and, at m aturity, in the fo rm o f the payment o f the face value. In the case o f shares, the investor receives assets are valued
cash in the form o f dividends and, on sale o f the shares, in the form o f the price obtained fo r the shares. under conditions of
A decision to buy an asset implies a simultaneous decision to forgo current consumption. It is assumed certainty
that, at any time, investors prefer more consumption to less consumption, other things being equal.
Application o f this principle between tw o points in tim e implies that, other things being equal, earlier
cash inflows are preferred to later cash inflows. As explained in Chapter 3, these observations may be
summarised by the phrase ‘money has a tim e value’.
To review this principle, suppose th a t a person is given the choice o f receiving $100 now or $100 in
1 years time. A rational person w ill always choose to receive the cash immediately, even i f there is no
desire to consume immediately. The reason, o f course, is th a t the earlier cash flow can be invested. This
w ill enable even greater consum ption later. I f the interest rate is 12 per cent per annum, the investor
(consumer) in this example can invest fo r 1 year the immediate cash flow o f $100, and at the end o f
the year have $112 available fo r consumption. Clearly $112 o f consum ption is preferable to $100 o f
consumption. In this example the cash flows were, in effect, a g ift. Suppose, however, th a t the investor
is offered the chance to buy the rig h t to receive $100 in 1 years tim e. W hat is the m axim um price the
investor should offer fo r th is right? We have just seen th a t $100 is ‘w o rth ’ $100 x 1.12 = $112 in 1 year’s
time. The rig h t to receive $100 in 1 years tim e is therefore w o rth at present:
$100
=
1.12
$89.29
The am ount $89.29 is referred to as the present value o f $100 to be received in 1 years tim e i f the
discount rate is 12 per cent per annum. Therefore, the interest rate has tw o functions: it is the rate at
which present sums can be converted to equivalent future sums, and i t is also the rate at which promised
future sums can be converted to equivalent present values. Therefore the value o f a financial asset is
not simply the sum o f the cash th a t it generates in future periods. For example, a financial asset that
generates returns o f $100 at the end o f each o f the next 5 years is n o t w o rth $500 today. I t is n o t valid
to add together cash flows th a t occur at different times. However, adding together present values is valid
because each value relates to the same tim e, the present.
Where there are many cash flows from the same asset, the present value o f the asset is the sum o f the
present values o f every future cash flow. The present value o f the asset is calculated using the relevant
interest rate. I f the cash flows are certain to occur, as we assume here, then the relevant interest rate is
the risk-free interest rate, Tr. Thus:
P〇 =
1+ 7 + —(l +^ rf—2)2 + . . . + — ^
(1 + rf)n
1 In this section we review some of the results explained in Chapter 3. Readers familiar with this material may safely omit this
section.
令
A B usiness finance
or
p〇 = t ^ y ED
where P〇 = present value o f the asset
Ct = dollar return (cash flow) at tim e t
n = term o f the investm ent
= risk-free interest rate per tim e period
t = 1, 2, n
Suppose th a t an asset returns $100 per annum fo r 5 years and th a t an investor requires an annual
interest rate o f 3.6 per cent as compensation fo r forgoing current consumption. Substituting in
Equation 4.1 we find that:
n $100 $100 $100 $100 $100

1 + 0.036 (1 + 0 .0 3 6 ) 2 (1 + 0.036” （1 + 0 .0 36)4 (1 -f 0 .0 3 6 )5
= $ 9 6 ,5 2 5 + $93,171 + $89,933 + $86,808 + $83,792
= $ 4 5 0 ,2 2 9
Therefore, this investor would be prepared to pay $450.23 fo r the asset. In summary, a financial asset
is valued in a w orld o f certainty by discounting the known future cash flows at the risk-free interest rate,
thus compensating investors fo r th e ir preference fo r current consumption.
4.3 Valuation of shares

LEARNING
OBJECTIVE 2 4.3.1 [V aluation of shares assuming certainty
Use the tools of
financial mathematics I f future cash flows are known w ith certainty, Equation 4.1 can be used to value shares.2 The periodic
to value equity
cash flows from an investm ent in shares are called dividends. Unless liqu id atio n o f the company is
securities
contemplated, the dividends are assumed to continue indefinitely. Therefore, Equation 4.1 may be
rew ritten as:
DIVIDENDS
D,
periodic distributions, p 〇 = J2
usually in cash, by (1 + rf Y 4.2
a company to its
shareholders where D t = dividend per share in period t
The appropriate discount rate remains the risk-free interest rate, because under conditions o f certainty
investors require the same rate o f return on all assets.
I t m ig h t appear th a t Equation 4.2 ignores a second potential source o f retu rn from an investm ent in
shares— th a t is, the capital gain from selling the shares at a price greater than the price at which they were
purchased. This impression is incorrect. Suppose th a t an individual purchases shares w ith the inte n tio n
o f selling them in 5 years* time. Equation 4.2 may be expanded as follows:
Dt Ps
p〇 = E
r=l (1 + rf )[ (1 + r /)5 4.3
where P5 = share price at the end o f the fifth year
The capital gain (or loss) is the difference between P5 and P〇
. The price o f the shares when they are sold
is the discounted value o f all future dividends from Year 6:
〇〇
Dt
作 = Z
t=6 (1 + r/ 广 5 4.4
2 The discussion that follows is directed towards the valuation of ordinary shares. Preference shares are another form of
equity capital. The valuation of preference shares is discussed in Chapter 14 and the distinction between ordinary shares and
preference shares is discussed in detail in Section 10.7.2.
令
Substituting Equation 4.4 in to Equation 4.3:
x
E
5 3E D/
+
(
-f/
-
I
5
W
I
-
+/
which is Equation 4.2.

Therefore, where a company is assumed to have an in fin ite life, the current m arket price o f its shares
can be expressed as the present value o f an in fin ite stream o f dividends. Even in a m arket where investors
are seeking capital gains, the valuation form ula remains the same.
4 .3 .2 1 Valuation of shares under uncertainty

Valuing a security under uncertainty is d iffic u lt and, in general, few ( if any) people can consistently expect
to reach a better valuation than that given by the current m arket price. This statement is discussed fu lly
in Chapter 16. However, the statement is unhelpful i f the company is n ot traded on a stock exchange,
because there is then no current m arket price to observe. Moreover, to say th a t the best estimate o f a
shares ^true* value is its current m arket price provides no insight in to the factors th a t give a share its
value. In this section, some o f the fundam ental factors determ ining a share s value are considered.
Where there is uncertainty, investors require compensation in the form o f a higher promised rate of
return. Equation 4.2 becomes:
g (D ')
p 〇= H
(i +
where E(Dt ) = expected dividend per share in period t

ke = required rate o f return on the shares
The appropriate value o f ke is determ ined using the concept o f the o p p o rtu n ity cost o f capital.
The ‘true ’ or economic cost o f investing in a particular security is the retu rn forgone on the next best
alternative. For a risky security, this return is greater than the return on the risk-free security (r^). In
short, ke > r,. The am ount by which ke exceeds rîs often referred to as the security s risk premium.
Further, the riskier the security being considered, the higher the risk premium w ill be and the higher
ke w ill be. D eterm ination o f exactly how much higher ke should be requires a measurement o f risk* and a
theory lin kin g th a t measure to required rates o f return. These theories are developed in Chapter 7.
A t this p o in t we assume th a t all investors reach the same assessment o f risk, and therefore apply the
same o p p ortu nity cost o f capital (discount rate) to the same expected dividend stream, therefore a rriving
at the same price fo r the company s shares. It may seem unrealistic to assume th a t everyone has the same
expectations. However, at the tim e o f making a financial decision, it may be reasonable fo r the company s
management to assume th a t its assessment o f the likely impact o f th a t decision on the company s share
price w ill prove to be correct. I f this is so, then management should act as i f it is realistic to assume that
everyone has the same expectations.
The simplest assumption to make when estim ating a share s value is th a t the company w ill m aintain
in perpetuity the current dividend per share, D 〇 . In this case the estimate is:3
A)
P〇
ke
The use o f Equation 4.6 is shown in Example 4.1.
3 This formula treats the dividends as an ordinary perpetuity. For further details, see Section 3.6.
♦
B usiness finance
Example 4.1
Rankine Ltd is currently paying a dividend of 90 cents per share. If investors expect this dividend
to be maintained and require a rate of return of 15 per cent on the investment, what is the value of
Rankine's shares?
SOLUTION
The value of Rankine's shares is calculated as follows:
$0.90
0.15
$ 6.00
G rowth in dividends
I t is usually more realistic to assume th a t a company s dividend per share w ill change. For example, it may
be assumed th a t the dividend per share w ill grow at a constant rate. In this case, the estimated value is:
Q〇( l + g ) f
p 〇 = J2 (1 + ke)1
where g = expected grow th rate in dividend per share

Where k e is greater thang and the grow th in dividends is assumed to continue indefinitely, Equation 4.7
can be w ritte n as:4
A ) ( l+ g )
P〇
k e -g
One approach to estim ating g is to calculate the past grow th rate in dividend per share and use this as
the estimate o f the expected grow th rate. This is shown in Example 4.2.
Example 4 .：
Assume that for the past 10 years the growth rate in Rankine Ltd's dividend per share has been 10 per cent
per annum. Assume further that this growth rate is expected to be maintained indefinitely. The latest
dividend per share was 90 cents and was paid yesterday. What is the value of Rankine's shares?
SOLUTION
Using Equation 4.8, the value of Rankine’s shares is:
D〇
(l+ g )
P〇 -
k e -g
$0.90 x 1.1
0 .1 5 -0 .1 0
$19.80
4 The terms in Equation 4.7 form an infinite geometric series, with a common factor (or ratio) between each term of,
-8 . Provided that - 1 < + 8
• there will be a limiting sum equal to the first term of the series, divided by
1 ke \ ke
(1 - the common ratio). That is:
P 〇 \ ke 、 1 K}
D〇(l + g ) k e-g
1 + kt> ■+ ke
A)(l +g)
ke-g
If ke < g , the model breaks down. Under these circumstances: - > 1 and there is no limiting sum (P0 ).
〇〇
■ke
命
A second approach to estim ating g is to assume th a t the grow th in dividend per share is related to
the company s retained earnings and to the rate o f retu rn on those earnings. I f the company retains a
constant p roportion b o f its earnings each year and reinvests those earnings at a constant rate r, then
g = hr, and Equation 4.8 can be rew ritten:
If Rankine Ltd retains 4 0 per cent of its earnings each year (jb = 0.4), and these earnings are reinvested
to earn a 25 per cent rate of return (r = 0.25), what is the value of Rankine's shares?
SOLUTION
The value of Rankine’s shares, using Equation 4.9, is as follows:
p _ $0.90 x [1 + (0.4 x 0.25)]
0 一 ^ 0 . 1 5 - ( 0 . 4 x 0.25)^
=$19.80
The assumption th a t the past grow th rate is expected to be m aintained indefinitely is unlikely to be
realistic, particularly where the company has been experiencing a relatively high growth rate. We m ight
therefore assume th a t the current grow th rate w ill be m aintained fo r several years before falling to a level
expected to be sustained indefinitely. This is shown in Example 4.4.
Example 4.4
Assume that the growth rate will remain at its current level of 10 per cent per annum (gf^ for only
a further 3 years, and is then expected to fall to 6 per cent per annum (g) and remain at that level
indefinitely. W hat is the share price today?
SOLUTION
This complication is easily handled by first using Equation 4.8 to estimate the value of the shares as at
the end of the third year. The value of the shares today is given by the present value of this estimate,
plus the present value of the dividends to be paid in the first 3 years. The value of Rankine's shares is
calculated as follows:
p D〇
l i + g ,) , P〇
(i ^ g ') 2 , Poll + g ,)3 , 1 _ :: P 〇
( i + g 'l 3(i+ g l
0 (i + M (i + M 2 (l + M 3 (l + M 3 (b-gl
_ $ 0 .9 0 X 1.10 $ 0 .9 0 X (1.10)2 $ 0 .9 0 x (1.10 )3 1 $ 0 .9 0 x (1.10)3 x (1.06)
1.15 + (1.15)2 + (1.15 )3 + (1.15)3 X (0 .1 5 -0 .0 6 )
= $ 1 1 .7 5
Comparing the previous tw o examples, the reduction in the expected dividend grow th rate after Year 3
has resulted in a reduction in the value o f the shares from $19.80 to $11.75. This highlights the sensitivity
o f the share value to estimates o f the future grow th rate in dividend per share.
The formulae used to estimate a share value may also be used to estimate the required rate o f retu rn on
a company s shares, given th e ir current m arket price. This application is discussed fu rth e r in Chapter 14.
m
LEARNING
OBJECTIVE 3
Explain the main
differences between
4 .3 .3 | Share valuation and the price-earnings ratio the valuation of
ordinary shares based
The ratio o f a company s share price to its earnings per share— th a t is, its price-earnings ratio _ is often on dividends and on
used by security analysts to estimate the value o f the company s shares.5 To illustrate this m ethod o f earnings
5 A discussion of the use of the price-earnings ratio to value shares is contained in most texts on investments. See, for example,
Brailsford, Heaney and Bilson (2011, pp. 386-93) and Bodie, Kane and Marcus (2011, pp. 601-9).
命
B usiness finance
valuation, we again use the example o f Rankine Ltd, and assume th a t Rankines current earnings per
share is $2.25. Assume also th a t an analyst estimates th a t the appropriate price-earnings ratio fo r the
company is 9.0. Therefore, the value o f each share is estimated at $20.25— th a t is, $2.25 x 9.0. This
estimate would then be compared w ith the current market price to determine whether the shares are
overvalued or undervalued.
However, this leaves unanswered the question: How does an analyst estimate the appropriate price-
earnings ratio? In m ost cases where analysts use this m ethod o f valuation, the appropriate price-earnings
ratio is determ ined in a way th a t can best be described as judgm ental— th a t is, no form al model is used
b ut the analyst tries to take into account the factors considered to be relevant.
Two im p o rta n t factors are risk and grow th opportunities. The riskier the analyst believes the
investm ent to be, the lower the appropriate price-earnings ratio. To see this, imagine th a t an analyst is
try in g to value two companies th a t are equivalent in all respects, including th e ir current and expected
earnings, except th a t one company is riskier than the other. Because investors dislike risk, other things
being equal, the company th a t is riskier w ill be less attractive to investors and w ill thus have a lower value.
Since both companies have the same earnings, the ratio o f price to earnings w ill be lower fo r the riskier
company.
The other im p o rta n t factor is grow th opportunities. I f an analyst believes a company has substantial
opportunities fo r growth, a high price-earnings ratio w ill be assigned. In this case the current earnings
level is likely to be surpassed in the future, thereby ju stifyin g a price today th a t appears ‘h igh’ relative to
current earnings. O ther factors likely to be considered include the price-earnings ratios o f companies in
the same industry, and prospects fo r the ind ustry and the economy as a whole.
4.4 Valuation of debt securities

As we saw in Section 4.3, the returns on an investm ent in shares are dividends and capital gains. In the
LEARNING case o f an investm ent in debt securities (frequently called bonds or debentures), the returns are usually
OBJECTIVE 4
in the fo rm o f interest payments and the repayment o f the face value or principal on the m a tu rity date.
Use the tools of
financial mathematics As has been explained fo r shares, i f all securities offer certain returns, each security s o p p o rtu n ity cost o f
to value debt securities capital is the risk-free interest rate (or yield) r^. Therefore, i f future cash flows are know n w ith certainty,
rf \s the appropriate discount rate to apply. Equation 4.1 is rew ritten fo r bonds as follows:
n
deben tu res)
Q F
d e b t s e c u ritie s issued P〇 == E
w ith a m e d iu m o r lo n g t=\ (1 + rf y (1 + rf )n
te rm to m a tu rity
where interest payment (often called coupon payment or just coupon) at tim e i
F = face value (principal repayment) at m aturity, which is date n
COUPONS
fix e d in te re s t p a y m e n ts
n = num ber o f periods to m a tu rity
m ade on bonds a nd rf =
risk-free interest rate (yield)
d e b e n tu re s The use o
Example 4.5
Suppose that Rankine Ltd borrows by issuing 3-year bonds with a face value of $100, and a coupon
interest rate of 10 per cent. The cash flows to a bond holder will be interest (/coupon,) payments of
$ 1 0 per year for 3 years, followed by payment of $ 1 0 0 at the end of the third year. If the required
rate of return is also 10 per cent per year, what is the value of Rankine’s bonds?
SOLUTION
The value of the bonds is given by Equation 4.10:
D $10 $10 $10 $100

0 1.1 ( l. l) 2 ( l. l) 3 ( l. l) 3
=$9.091 +$8.26 4+ $7.513+ $75.131
= $ 100.00
Once a bond has been issued— th a t is, sold by the borrower to the lender— its promised future cash
flows are fixed. Ownership o f the bond entitles the owner to receive from the issuer a fixed schedule
o f future cash flows. I f the m arket interest rate changes, it w ill affect the attractiveness o f the bond to
potential investors. I f m arket interest rates decrease, the bond w ill become more attractive; i f m arket
interest rates increase, the bond w ill become less attractive. O f course, this w ill cause bond prices to
change. A decrease (increase) in m arket interest rates w ill cause an increase (decrease) in the prices of
existing bonds. This is illustrated in Example 4.6.
Example 4.6
Suppose that immediately after Rankine's debt contract is agreed, conditions in the debt market
change and the required rate of return falls to 8 per cent per annum. Rankine must still make interest
payments of $1 0 each year, but investors now require a return of 8 per cent per annum. W hat is the
value of Rankine’s bonds now?
SOLUTION
Again applying Equation 4.10, the security is now valued more highly, as follows:6
$10 ^ $10 $10 ( $100

0 = h O S + (1.08 )2 + (1 .0 8 )3 + (1.08)3
= $ 1 0 5 ,1 5 4
Similarly, if the required rate of return had risen from 10 per cent to 12 per cent, the price would
have fallen as follows:
$10 $10 $10 $100

TTTi + (i.i2)2 + (1.12)3 + (i.i2)3
$ 9 5 .1 9 6
4.5 Interest rate risk

Example 4.6 shows th a t when interest rates change, so do bond prices. The possibility o f unforeseen price
changes means th a t a bond is risky— its future value is uncertain. Thus, even i f a bond is risk-free in the
m
LEARNING
OBJECTIVE 5
sense th a t the borrower is certain to make the promised cash payments, it is risky in the sense th a t the
Explain the nature of
bond holder (lender) can suffer unforeseen losses i f interest rates increase. interest rate risk
When interest rates increase, bond prices fall. For the investor in bonds this is a capital loss, and
therefore in this respect the increase in interest rates is undesirable. A benefit m ust be set against that
loss: the interest receipts can be reinvested at the new, higher rate o f interest. The opposite occurs when
interest rates fall. Investors make capital gains b ut interest receipts can be reinvested only at the new
lower rate. These effects are know n as the price effect and the reinvestment effect and are always o f opposite
sign fo r a given change in m arket interest rate. The price effect and the reinvestm ent effect are both
sources o f interest rate risk. The net effect fo r the investor depends on the size o f the interest rate change
and on the period fo r which the bond is held. Appendix 4.1 outlines a m ethod th a t an investor may use to
obtain some protection against interest rate risk.
A t any given tim e, the m arket-determ ined interest rate (or yield) on a bond w ill depend on the features
o f that bond. Two features th a t are usually particularly im p o rta n t to m arket participants are the term o f
the security and the risk o f the borrower defaulting on the promised payments. The connection between
By convention, bonds in Australia are assumed to have a face value of $100, but in practice bond face values are much
higher—often in the millions o f dollars. Therefore, bond prices per $100 of face value are usually taken to more than two
decimal places. We follow the Australian convention and use three decimal places.
B usiness finance
Finance
O N GUARD AGAINST A BOND FALL__________________________
in ACTION
In an article published in 2013, financial journalist Christopher Joye reminds readers of interest
rate risk, which flows from the connection between interest rates and bond prices.
Bond traders have been making out like bandits since the global financial crisis. A portfolio of
Australian government bonds with maturities longer than 10 years has delivered annual total
returns of over 12 per cent since December 20 07 .
Yet the preconditions for the mother-of-all bond market reckonings are sliding into place.
This contingency, which A M P ’s Shane Oliver believes is a 'significant risk’， could result in
wiping more than $ 6 0 billion off Aussie bond values, with steep capital losses.
To properly understand these risks, one needs to appreciate how extraordinary current
circumstances are. W hen doing so, it helps to keep in mind a key principle: bonds that pay
fixed, as opposed to variable, rates have prices that are inversely related to external interest
rates.
If you invested in a bond paying an annual fixed coupon of, say, 3 per cent, and market
interest rates surge to 5 per cent, that bond would be worth substantially less than when you
TERM STRUCTURE OF
bought it. The converse is also true: if market rates decline ... it would be worth more.
INTEREST RATES This is why Australian government bond prices have soared since 20 07 : market yields
relationship between have fallen sharply as global central banks have floored policy rates close to zero and printed
interest rates and term unprecedented amounts of money to fund public and private debt.
to maturity for debt
securities in the same Source: 7On guard against a bond fall', Christopher Joye, The Australian Financial Review, 5 January 2013, p. 39.
risk class
DEFAULT-RISK
STRUCTURE OF
INTEREST RATES
relationship between term and interest rates is called the term stru ctu re o f in te re st rates, while the connection between
default risk and default risk and interest rates is called the d efau lt-risk stru ctu re of in te re st rates. These are now
interest rates considered.
4.6 The term structure of interest rates

LEARNING
OBJECTIVE 6 4.6.1 | W h a t is the term structure?
Understand the
theories that are used To consider the effect o f a bonds term on its interest rate, all other factors need to be held constant.
to explain the term
Thus, to elim inate the effect o f differences in default risk, the term structure o f interest rates is usually
structure of interest
rates studied by focusing on government bonds since all such bonds have the same risk o f default (assumed to
be zero).
The least complicated measure o f the term structure o f interest rates is the m arket yield on a
government bond th a t pays no interest during its life, b ut pays a fixed sum at m aturity. Such a bond is
ZERO-COUPON BONDS known as a zero-coupon bond (often abbreviated just to a zero).
(zero s)
The price o f a zero w ith a face value o f F dollars and a term o f n years is simply:
bonds that pay only
one cash flow, the
payment at maturity
P〇= ( T ^ f
where zn is the yield on the zero, often known as the zero rate fo r a term o f n. The term structure o f
interest rates is the set o f zero rates zv z2, ... zn. In practice, except fo r terms o f 6 m onths or less, zero-
coupon bonds are relatively rare. However, there are coupon-paying bonds and it is possible to estimate
the underlying zero rates from the prices o f coupon-paying bonds. The Reserve Bank o f Australia has
made such estimates fo r the Australian m arket. Four examples are shown in Figure 4.1.
As shown in Figure 4.1, the shape and level o f the term structure can vary w idely over tim e. For
example, i t may be steeply upward sloping, as i t was on 27 June 1994, or almost flat, as i t was on 19 July
2006, or gently downward sloping, as i t was on 27 November 2007.
G h APTER FOUR A pplying THE TIME VAUJE OF MONEY TO SECURITY VALUATION
ure 4.1 The term structure Australia: various dates
12 . 00 %
— — 27-Jun-94
10. 00 %
--------- 19-Jul-06
d
8 .00 %
d
a> 一广 ——— 27-Nov-07

oJ
OJOZ
6 .00 % ...... 7-Jan-09

P 0 !
4.00%
D
如SE
LU
2 .00 %
0.00%
0.00 2.00 4.00 6.00 8.00 10.00 12.00
Term to maturity (years)
Source: Based on estimates available from the Reserve Bank of Australia website.
4 .6 .2 1 Using the term structure to price a bond

I f we know — or have estimated— the current term structure o f zero rates, in principle it is easy to calculate
the price o f any coupon-paying bond. This process is illustrated in Example 4.7. When we have the prices,
we can then calculate the corresponding yields. These calculations are shown in Example 4.8.
Example 4.7
Suppose that the face value of every bond is $ 100 and the current zero rates for terms of 1 ,2 and 3
years are 7 .0 , 8.0 and 8.5 per cent per annum respectively. W hat are the prices of: a 1-year bond
paying annual coupons of 5 per cent, a 2-year bond paying annual coupons of 9 per cent and a
3-year bond paying annual coupons of 7.5 per cent per annum?
SOLUTION
In a year's time, the 1-year bond will make a single payment of $105, consisting of $ 1 0 0 face value
and $5 of coupon interest. The required rate of return on a 1-year investment is 7.0 per cent per
annum. The price of the bond is therefore
D $105
r = -------
1.07
=$98.131
The 2-year bond will pay $9 after 1 year and $1 09 after 2 years. In effect, this coupon-paying
bond can be decomposed into two zero-coupon bonds. The first is a 1-year zero which pays $9 and
the second is a 2-year zero that pays $109. Because we know the 1-year and 2-year zero rates, we
know how to price these constituent zero-coupon bonds. The price of the 2-year bond is the sum of
the two constituents.
D $9 $109
p = ------- +
1.07 (1.0812 *
=$101.861
Extending the same logic to the 3-year bond, its price is
$ 7 .5 0 $7.5 〇 + $ 1 〇7.5 〇
_______
P:
1.07 + (1.08)2 (1.085)J
$97.602
B usiness finance
Given the price o f a coupon-paying bond, its in te rn a l rate o f return, know n as the bonds yield, can be
calculated. For fu rth e r details, see Sections 3.5.4 and 5.4.2.
Example 4.8
What are the yields on the three bonds described in Example 4.7?
SOLUTION
For the 1-year bond, the yield is the value of r which solves the following equation:
$98,131 = $ 1 0 5 0 0
1+r
We know from the previous example that the solution to this equation is r = 7.0 per cent per annum.
For the 2-year bond, yield is the value of r which solves the following equation:
$101,861 l^ + $10900
n + r|2
This equation is solved when r is approximately 7.957 per cent per annum.
For the 3-year bond, yield is the value of r which solves the following equation:
$ 7 .5 0 $ 7 .5 0 $ 1 0 7 .5 0
$ 9 7 ,6 0 2
1 + r + (1 + r ) 2 + (1 + r)3
This equation is solved when r is approximately 8.438 per cent per annum.
Note that the 2-year and 3-year yields are close to, but not equal to, the corresponding zero rates.
YIELD CURVE The pattern o f yield against term is called the yield curve. Data fo r the Australian yield curve at 10
graph of yield to different dates are given in Table 4.1.
maturity against bond
term at a given point
in time
TABLE 4.1 Australian yield curve data
Term to maturity
Date of yield curve 3 months 6 months 2 years 5 years 10 years
June 1998 4.93 4.98 5.18 5.38 5.58
June 2000 5.87 5.96 5.89 6.05 6.16
June 2002 5.21 5.32 5.44 5.78 5.99
June 2004 5.61 5.65 5.34 5.67 5.87
June 2006 6.09 6.16 5.78 5.78 5.79
June 2008 7.81 8.04 6.97 6.69 6.59
June 2009 3.25 3.30 3.90 5.10 5.56
June 2010 4.89 5.01 4.57 4.97 5.33
June 2011 4.99 5.10 4.75 4.89 5.16
June 2012 3.49 3.41 2.40 2.49 3.00
Source: Compiled from Reserve Bank of Australia data (www.rba.gov.au). See tables Interest Rates and Yields— Money
Market and Capital Market Yields— Government Bonds. For 1998 and 2000 yields for 3(6) months are issue yields for
13-(26)-week Treasury notes. From 2002 to 201 2 these yields are yields for 90-(l 80)-day bank accepted bills. Yields for 2,
5 and 10 years are bond yields.
Like the closely related concept o f the term structure, yield curves can have a wide range o f shapes.
For example, the yield curve in Australia was upward sloping in June 2002 and June 2009 b ut m ostly
downward sloping in June 2012. Typical yield curve shapes are illustrated in Figure 4.2.
Figure 4.2 Alternative yield curves
4 .6 .3 1 Term structure theories: expectations and liquidity (risk)

premium
Obviously the term structure at any given tim e is no accident. Presumably, participants in the debt
markets do n ot set the interest rate for, say, a term o f 2 years7 w ith o u t in some way considering the
1-year and 3-year interest rates. In other words, the interest rate fo r a particular term w ill be determ ined
by the m arket in the context o f interest rates fo r other terms. The exact id e n tity o f the factors th a t explain
the term structure is controversial, w ith different theories proposing different mechanisms. There is,
however, broad agreement th a t expectations o f the future course o f interest rates are central to explaining
the term structure.
The core o f the e x p e c ta tio n s th e o ry o f the term structure is th a t interest rates are set such that EXPECTATIONS THEORY
investors can expect, on average, to achieve the same retu rn over any future period, regardless o f the term of the term structure is
that interest rates are
o f the zero-coupon bond in which they invest. For example, suppose th a t in the current term structure
set such that investors
the interest rate fo r a 2-year term to m a tu rity is 8 per cent per annum, while the interest rate fo r a 3-year in bonds or other
term to m a tu rity is 9 per cent per annum. Suppose, fu rthe r, th a t $1000 is invested fo r 3 years. A fte r 3 debt securities can
years, the investor w ill have $1000 x (1.09)3 = $1295.03. Alternatively, suppose the same investor invests expect, on average,
$1000 fo r 2 years. A fte r 2 years, the investor w ill have $1000 x (1.08)2 = $1166.40. I f the investor can to achieve the same
return over any future
re-lend this sum fo r the th ird year at an interest rate o f 11.028 per cent per annum, then at the end o f the
period, regardless of
th ird year the investor w ill have $1166.40 x 1.11028 = $1295.03, which is the same as the retu rn from the security in which
the 3-year investm ent. This is shown in Figure 4.3. they invest
Figure 4.3 Return from the 3-year investment
0 1 2 3 years
<<--------------------------------------------- 9% p . a . --------------------------------------------- >
< --------------8% p.a. -----------------------------1.028% p .a .----------------------------->
As shown in Figure 4.3, the current term structure is 8 per cent per annum fo r a term o f 2 years and
9 per cent per annum fo r a term o f 3 years. According to expectations theory, the factor th a t explains the
7 For ease of exposition, in this section we use the term interest rate for a term of n years* to mean the yield per annum on a
zero-coupon bond with a term o f n years.
B usiness finance
current term structure is the m arkets expectation th a t the 1-year interest rate on the day 2 years from
now w ill be 11.028 per cent per annum. In th a t case investors w ill earn 9 per cent per annum over the
coming three years, regardless o f whether they invest fo r three years, by:
a buying the 3-year bond today; or

b buying the 2-year bond today and buying a 1-year bond in 2 years* time.
Therefore, the expectation o f the future interest rate determines today s term structure.
This process is extended in Figure 4.4. Suppose th a t today s 1-year interest rate is 6.5 per cent per
annum. Then the m arket m ust expect next years 1-year interest rate to be 9.521 per cent per annum,
because (1.08)2 = 1.065 x 1.095 21 = 1.1664. The economic interpretatio n is th a t the same return is
expected over the next 2 years, regardless o f whether an investor:
a buys a 1-year bond today and buys a fu rth e r 1-year bond in 1 years tim e; or
b buys the 2-year bond today.
Figure 4.4 Return from the 3-year investment (extended)
years
- 9% p.a.
8% p.a. -11.028% p.a.
-6.5% p .a .- -> < r 9.521% p.a.- -11.028% p.a.
As a final illu stratio n o f the expectations mechanism, consider again the in fo rm a tio n shown in
Figure 4.4 and imagine th a t there is an investor who intends to lend $1000 fo r a 2-year period. Consider
the follow ing three ways in which such an investm ent could be made:
a Buy the 2-year bond now and hold i t u n til i t matures. A t the end o f the 2-year period, this
investm ent w ill have accumulated to $1000 x (1.08)2 = $1166.40.
b Buy a 1-year bond now and, after 1 year, reinvest in a fu rth e r 1-year bond, which is then held u n til
m aturity. A t the end o f the 2-year period, this investm ent is expected to have accumulated to
$1000 x 1.065 x 1.095 21 = $1166.40.
c Buy the 3-year bond now and sell i t after 2 years. A t the end o f the 2-year period, th is investm ent is
expected to be w o rth $1000 x (1.09)3/1 .1 10 28 = $1166.40.
As these calculations show, the expected outcome is the same, regardless o f the investm ent strategy.
The m arket has set today s term structure in such a way th a t it reflects the m arkets expectations o f the
future course o f interest rates.
To formalise our discussion o f expectations theory, we w ill use the notation zt t+k to mean the interest
rate per annum fo r a period beginning on date t and ending on date t + k. For example, z3 4 means the
interest rate fo r the year starting 3 years from now and ending 4 years from now. We make the follow ing
assumptions:
a fu tu re 1-year interest rates (zx 2, z2 3, and so on) are known w ith certainty8
b there are no transaction costs.
Given these assumptions, com petition in the bond m arket w ill result in a term structure th a t ensures
th a t the sum to which a dollar accumulates over n years i f invested at today s long-term interest rate z 〇n
m ust equal the sum to which it accumulates over n years when invested in the sequence o f present and
future 1-year interest rates z12, z2 3, . . . , zn_^ n. As a consequence, an investor who wants to invest for, say,
10 years is indifferent between investing in a 10-year bond and investing in a sequence o f 1-year bonds
over the next 10 years. Hence, today s 2-year interest rate, z〇2, is determ ined from today s 1-year interest
rate and the 1-year interest rate in a years time. That is,
(1 + z 〇 ,2)2 = (1 + 2〇 .i)(l +<2l ，2)
8 Alternatively, we could assume that investors are risk neutral. The concept of risk neutrality is explained in Section 7.3.
命
Similarly, today s 3-year interest rate, z 〇3, is determ ined from today s 1-year interest rate, the 1-year
interest rate in a years tim e and the 1-year interest rate in the year after that. That is,
(1 + 2 〇,3)3 = (1 + z 〇，i ) ( l + 2 1?2)(1 + 之 2,3)
Generalising, fo r any given term o f t years, today s t-year interest rate z〇t is set by the m arket such that:
(1 + 20，f ) ’ = (1 + 20，1)(1 + 21，2)(1 + Q j ) . . . (1 + 2 f- l ，f )

Rearranging this equation, today’s t-year interest rate z 〇t is given by:
z〇 ,t = [(1 + 2〇a ) x (1 + z i, 2) x (1 + z 2,3) x ... x (1 + z M .f) ]1/r- l E U I
Thus, in our earlier discussion, using Equation 4.11 gives the 2-year interest rate as:
z 〇,2 = (1.065 x 1.095 21)1/2- 1

= 8% oer annum
and the 3-year interest rate is:
z〇,3 = (1.065 x 1.095 21 x 1.11028)1/3 - 1

= 9% per annum
The essence o f expectations theory is th a t the term structure is determ ined by investors’ expectations
o f short-term rates w ith in the m a tu rity o f the competing long-term security.9 Expectations theory can
help to reconcile the existence o f the differing shapes o f the term structures shown in Figure 4.1 and the
yield curves shown in Figure 4.2.
In general, an upward-sloping term structure implies th a t investors expect future short-term interest
rates to increase.10 In th a t case, investors are n ot prepared to invest in long-term securities unless the
yield is greater than th a t on short-term securities, because otherwise the investors would be better o ff
investing in short-term securities and reinvesting the proceeds at m aturity.
In general, a downward-sloping term structure implies th a t investors expect future short-term
interest rates to decrease— th a t is, investors are prepared to purchase long-term securities yielding less
than short-term securities because they expect th e ir retu rn to be no larger i f they adopted an investm ent
LIQUIDITY PREMIUM
strategy requiring continual reinvestm ent in short-term securities. In short, i f expectations about the ( r is k p r e m i u m )
level o f future short-term rates change, then actual long-term yields on existing securities w ill tend to THEORY
adjust in the same direction. of the term structure

A fla t term structure means th a t investors expect future short-term interest rates to be the same as is that although
future interest rates
the current short-term rate. Consequently, the long-term rates w ill equal the short-term rates.11
are determined
Commentators on the expectations theory o f the term structure have suggested th a t interest rates are by investors'
not formed solely on the basis o f expectations. For example, the liquidity prem ium (risk prem ium ) expectations, investors
theory suggests th a t although expectations are a foundation fo r the term structure, there is in addition require some reward
a premium due to uncertainty about the future level o f interest rates. Suppose, fo r example, th a t an (liquidity premium) to
bear the increased risk
investor has an investm ent target o f $10000 to be achieved in 2 years* tim e — th a t is, the investm ent
of investing long term
horizon is 2 years. The easiest and safest way to achieve this target is to invest today the present value o f
$10000, where the present value is calculated using todays 2-year zero rate. Alternatively, the investor INVESTMENT HORIZO N
the particular future
could invest the same sum today fo r 1 year at today s 1-year interest rate and, when this investm ent
date on which an
matures in 1 years tim e, reinvest the proceeds fo r a fu rth e r year. O f course, this reinvestm ent is made at investor intends to
next years 1-year interest rate, which today is n ot known. Hence, the outcome o f this alternative is risky, liquidate (sell) their
whereas the previous approach is risk-free.12 This fact is illustrated in Example 4.9. investment
9 It is convenient to think of short-term rates as determining long-term rates, but in fact the market determines all rates
simultaneously.
10 That this is not always the case may be seen from the following example. If the current term structure is: 1 year: 6 per cent;
2 years: 10 per cent; and 3 years: 11 per cent, then the 1-year interest rate, 1 year hence, is expected to b e :--------- 1 = 14.15%
( l. ll) 3 l 〇6
while the 1-year interest rate, 2 years hence, is expected to be: —------ - 1 = 13.03%.
(I.IO)2
11 This result holds even if there is a large difference in the number of bonds outstanding with different maturities. One of the
implications of the expectations theory is that interest rates are independent of the relative supply of bonds across the range
of maturities.
12 A third possibility would be to buy today a 3-year bond and sell it after 2 years, at which time it has become a 1-year bond. The
price obtained at the end of 2 years will depend on the 1-year interest rate at the time of the sale. Because this interest rate is
not known today, the price that will be achieved is also unknown today—that is, the investment is risky.
令
Example 4 .9
Freya wishes to have $ 1 0 0 0 0 in 2 years7 time. The current interest rate on a 2-year zero-coupon
bond is 7.5 per cent per annum and Freya decides to invest in this bond.
a) How much should Freya invest today? How much will she have after 2 years have passed?
b) The current interest rate on a 1-year zero-coupon bond is 6.5 per cent per annum. It turns out that
during the coming year interest rates fall steeply and at the end of the year the interest rate on a
1-year zero-coupon bond is only 4.2 per cent per annum. If Freya had chosen to invest the same
amount in 2 sequential 1-year investments, how much would she have after 2 years have passed?
c) The current interest rate on a 3-year zero-coupon bond is 8 per cent per annum. It turns out that
the 1-year interest rate at the end of 2 years is 9.5 per cent per annum. If Freya had chosen to
invest the same amount in a 3-year bond and then sell that bond after 2 years, how much would
she have after 2 years have passed?
SOLUTION
a) Freya should invest today the present value of $ 1 0 0 0 0 at today's 2-year interest rate. The amount
to invest is therefore $ 1 0 0 0 0 / (1 .075)2, which equals $8653.33.
• That is, Freya will today pay $8653.33 for a 2-year zero-coupon bond with a face value of
$10000.
• This investment is guaranteed to produce $ 1 0 0 0 0 after 2 years because on the bond's maturity
in 2 years7 time, the face value of $ 1 0 0 0 0 will be paid to Freya.
b) After 1 year, Freya will have $8653.33 x 1.065, which is equal to $9215.80. Reinvesting this
amount for a further year at 4.2 per cent per annum produces a final amount of $9 215.80 x
1.042, which is equal to $9602.86. Freya therefore does not achieve her target of $1 00 00.
c) The face value of the 3-year zero-coupon bond must be $8653.33 x (1.08)3, which is equal to
$1 09 00.7 0. At the end of the second year, the bond has become a 1-year bond and the interest
rate at that time is 9.5 per cent per annum. Therefore, the price of the bond when it is sold is
$1 0900.70/1.095, which equals $9954.98. Freya therefore does not achieve her target of
$10000.
As Example 4.9(a) illustrates, an investor who buys a zero-coupon bond w ith a term to m a tu rity that
matches the investm ent horizon is guaranteed to achieve th e ir target. As Examples 4.9(b) and 4.9(c)
illustrate, a different choice may lead to the target n ot being achieved. In other cases, the target could
be exceeded. For example, in p a rt (c), i f the 1-year interest rate at the end o f the second year had been
anything lower than 9.007 per cent Freya would have ended up w ith more than $10 000 at the end o f the
th ird year.13 In other words, any choice other than investing in the m aturity-m atching bond involves risk:
the target m ig ht be exceeded or i t m ight n o t be achieved. To induce an investor to depart from investing
in the m aturity-m atching bond w ill require a higher interest rate— th a t is, a risk prem ium . In Freyas
case, she w ould require a higher interest rate on either the 1-year or the 3-year bonds. However, proponents
o f the liq u id ity (risk) prem ium theory believe that, in general, the investm ent horizons o f bond investors
(lenders) are shorter than the investm ent horizons o f bond issuers (borrowers).14 Therefore, on balance,
the prem ium tends to be higher, the longer the term o f the bond, causing an upward bias in the term
structure. Such a bias w ill tend to cause yield curves to be upward sloping.
This means th a t compared w ith the yield curves th a t would be observed i f only expectations mattered,
an upward-sloping yield curve w ill become steeper, a downward-sloping yield curve w ill become less steep
(or perhaps even fla t o r upward-sloping) and a fia t yield curve w ill become upward sloping.15
4 .6 .4 | Empirical evidence
The empirical evidence on the theories we have discussed presents a rather complex picture. In the
US, Fama (1984), McCulloch (1987) and Richardson, Richardson and Sm ith (1992) found evidence
13 Because $10 900.70/1.09007 is equal to $10 000.

14 Proponents could, for example, point to the fact that investors rarely lodge fixed deposits at a bank with a term exceeding
5 years. But banks often offer mortgage loans with terms of 20 or 30 years.
15 In June 2009 the yield curve was steeply upward sloping. This yield curve is consistent with short-term interest rates having
been reduced by central banks to stimulate growth in response to the global financial crisis. Higher yields for longer term
securities are consistent with expectations of increasing future short-term interest rates and an increase in the risk premium.
supporting the existence o f a premium. But Longstaff (2000) found no evidence o f a prem ium at the
very short end o f the yield curve. The evidence in Australia is also mixed. In a test at the short end o f
the term structure (90-day interest rates, compared w ith 180-day interest rates), Tease (1988) found
that the data quite strongly supported the expectations theory in various forms. Similarly, studies by
Robinson (1998), and Young and Fowler (1990) found support fo r the expectations theory using 90-day
and 10-year interest rates. However, studies by Alles (1995) and Heaney (1994), in both cases using more
thorough statistical analyses, found little support fo r the expectations theory. In a study o f 14 countries,
Beechey, Hjalmarsson and Osterholm (2009) found that, consistent w ith the expectations hypothesis,
in 10 countries (including Australia) the m arket appeared to set short-term interest rates and long-term
interest rates simultaneously. However, fo r all 10 o f these countries there appeared to be risk premiums,
suggesting th a t expectations alone do n o t determine the term structure.
4 .6 .5 1 Inflation and the term structure

One issue yet to be considered is the relationship between the in fla tio n rate and the term structure o f
interest rates. In general, we w ould expect lenders to require the nom inal interest rate to compensate
them fo r expected in fla tio n .16 Therefore, the higher the expected in fla tio n rate, the higher w ill be the
observed nom inal interest rate. As a consequence, i f the in fla tio n rate is expected to increase over
tim e, the nom inal interest rate on sh ort-term bonds w ill also be expected to increase over tim e.
According to the expectations th eo ry we w ill therefore see an upward-sloping yield curve. In addition,
unexpected changes in the in fla tio n rate are also like ly to have an im pact on the term structure. Such
unexpected changes w ill cause a change in the level o f interest rates. As explained earlier, the p ossibility
o f such changes gives rise to interest rate risk, and the liq u id ity prem ium th eo ry suggests th a t this in
tu rn w ill give rise to the tendency fo r interest rates on long-term bonds to be higher than those on
short-term bonds.
4.7 The default-risk structure of interest rates

As explained in Section 4.3.2, the presence o f uncertainty causes the o p p o rtu n ity cost o f capital to exceed
the risk-free interest rate. For debt o f a given term , the higher the m arkets assessment o f the p robability LEARNING
OBJECTIVE 7
o f default, the higher w ill be kdi the required rate o f return (or expected yield) on the debt. However,
Understand the effect
because debtholders rank ahead o f shareholders, it is expected th a t the required rate o f retu rn on a of default risk on
company s debt w ill be less than the required rate o f return on its shares. In short, fo r any given company, interest rates
rf <kd <ke.
Similarly, fo r debt o f a given term and fo r a given company, the required rate o f return, kd, w ill be less
than the yield to m aturity, r, where yield to m a tu rity is the rate o f retu rn earned by an investor i f the
company does n o t default. This relationship is shown in Example 4.10.
Services have existed fo r many years th a t supply ratings on the Quality* o f debt securities issued by
both public and private sector borrowers. There is evidence to suggest th a t there is a high correlation
between these ratings and the p robability o f default and i t is n o t surprising, therefore, th a t the yields are
related to the quality rating.
In Australia, ratings are supplied by Fitch Ratings (www.fitchratings.com .au), M oody s Investors
Service (www.moodys.com.au) and by Standard & Poors (w w w .standardandpoors.com .au). Issuers |www j
o f long-term debt are rated by M oody s on a 21-point scale, ranging from Aaa (of the highest quality,
w ith m inim al credit risk) down to C (typically in default, w ith little prospect fo r recovery o f principal or
interest).17 The inform a tion in Table 4.2 is indicative o f the ratings supplied by M oody s.
16 See Equation 3.7 and the discussion in Section 3.4.4.

17 Standard & Poors rates issuers o f long-term debt on a 23-point scale ranging from AAA (extremely strong capacity to pay
interest and repay principal) to D (the borrower is expected to fail to pay all or substantially all of its obligations as they come
due). Fitch uses a 21-point scale, ranging from AAA (exceptionally strong capacity for payment of financial commitments)
to D (has entered into bankruptcy filings, administration, receivership, liquidation or other formal winding-up procedure, or
which has otherwise ceased business). All three companies also rate short-term debt. Both Fitch and Standard & Poors use an
8-point scale, while Moody’s uses a 4-point scale.
Example 4 . 1 0
Bonds issued by the Red Vines Company mature in 1 year's time with a maturity value of $110.
There is no cash flow during the year. Investors believe that there is a 90 per cent chance that the full
payment of $ 1 10 will be made and a 10 per cent chance that no payment will be made. Calculate:
a) the price of Red Vines' bonds
b) the yield to maturity of the bonds.
SOLUTION
a) The expected payment at the end of the year is 0.90 x $ 1 1 0 + 0 . 1 0 x $ 0 = $99. Assuming that the
market requires an expected rate of return, kd, of 10 per cent on these bonds, they will have a price of:
=$90
b) The yield, r, is therefore found by solving:
$ 9 0 = ili 〇
1+ r
Therefore, the yield to maturity is:
$110 ,
r = ----------1
$90
= 22 . 22 %
That is, an investor who purchases the bonds for $9 0 and holds them to maturity will earn a rate
of return of 22.22 per cent per annum if Red Vines does not default.
TABLE 4.2 Moody's ratings for long-term <obligations of selected Australian

companies and government entities
Aaa Of the highest quality; minimal credit risk
Government o f Australia New South Wales Treasury Corporation
Treasury Corporation o f Victoria Western Australian Treasury Corporation
Aa High quality; subject to very low credit risk
Aal Queensland Treasury Corporation South Australian Government Financing Authority
Tasmanian Public Finance Corporation
Aa2 Australia and New Zealand Banking Group Ltd Australian Rail Track Corporation Ltd
Commonwealth Bank of Australia Macquarie University
Rabobank Australia Ltd National Australia Bank Ltd
University o f Newcastle (Australia) Westpac Banking Corporation
Aa3 Toyota Finance Australia Ltd
A Upper-premium grade; subject to low credit risk
A1 BHP Billiton Ltd HSBC Bank Australia Ltd
SPI Electricity Pty Ltd Suncorp-Metway Ltd
A2 AMP Group Finance Services Ltd Bendigo and Adelaide Bank Ltd
Macquarie Bank Ltd Telstra Corporation Ltd
Westfield Group
A3 Coca-Cola Am atil Ltd Heritage Bank Ltd
Jemena Ltd Members Equity Bank Pty Ltd
Rio Tinto Ltd Volkswagen Financial Services Australia Ltd
Wesfarmers Ltd Woolworths Ltd
Baa Subject to moderate credit risk; medium grade; may possess certain speculative characteristics
Baal Bank of Queensland Ltd Brambles Ltd
Table 4.2 continued

Dexus Property Group Transurban Finance Company Pty Ltd
Victoria Teachers Mutual Bank Woodside Petroleum Ltd
Baa2 Alcoa of Australia Ltd Amcor Ltd
Brisbane A irport Corporation Pty Ltd Envestra Ltd
Goodman Group Leighton Holdings Ltd
Origin Energy Ltd Sydney A irport Finance Company Pty Ltd
Baa3 Ansell Ltd Boral Ltd
Lend Lease Group Newcrest M ining Ltd
Premier Finance Trust Australia Qantas Airways Ltd
Ba Speculative elements; subject to substantial credit risk
Bal Investec Bank (Australia) Ltd
Ba2 Aus drill Ltd Nufarm Ltd
Ba3 Fortescue Metals Group Ltd Genesee & Wyoming Australia Pty Ltd
B Speculative; subject to high credit risk
B1 Barminco Holdings Pty Ltd
B2 Atlas Iron Ltd
B3 Cristal Mining Australia Ltd
Caa Of poor standing; subject to very high credit risk
Caal
Caa2
Caa3
Ca Highly speculative; in or very near default; some prospect of recovery of principal and interest
C Typically in default; little prospect for recovery of principal or interest
Source: www.moodys.com, accessed 9 September 2013.
4.8 O ther factors affecting interest rate

structures
Yield differentials on securities may also result from differences in m arketability— th a t is, the investors
ability to convert the securities in to cash w ith o u t a price penalty. O ther things being equal, an investor w ill
buy a security o f low m arketability only i f the yield is greater than th a t on a security o f high m arketability.
For example, a life insurance company would usually require a higher interest rate to lend mortgage funds
to a company than to lend the same am ount by purchasing the company s debt securities th a t are traded
in an active m arket. Similarly, it is conceivable th a t tax effects w ill give rise to differences in yields on
bonds.
Finally, we refer briefly to the relationship between the yield on bonds and the required rate o f retu rn
on ordinary shares. In Section 4.3, we suggested th a t the required rate o f return on ordinary shares may
be expressed as the rate o f discount th a t equates the present value o f the expected future dividends w ith
the current m arket price o f the shares. Clearly, i f dividends are expected to grow over tim e, the required
rate o f return on an investm ent in ordinary shares w ill be greater than the current dividend yield (D 〇/P 〇).
Therefore, it is n ot valid to directly compare the yields on debt securities w ith the dividend yields on
ordinary shares. N ot surprisingly, the evidence suggests th a t the required returns on ordinary shares
exceed those on debt securities.18 This evidence is consistent w ith the idea th a t investors require a higher
expected rate o f return to invest in ordinary shares than to invest in, say, debentures because ordinary
shareholders are exposed to greater risk. Their risk exposure is greater because ordinary shareholders
are the residual claimants on the cash flows o f the company. Therefore, th e ir returns are the firs t to be
affected by a dow nturn in the company s prospects and, in the event o f the company being wound up,
ordinary shareholders have the last claim on its assets.
18 For international evidence, see Dimson, Marsh and Staunton (2003) and for Australian evidence, see Brailsford, Handley and
Maheswaran (2008) and Brailsford, Handley and Maheswaran (2012).
命
B usiness finance
SUMMARY
• Financial assets such as bonds and shares can be and a price-earnings ratio. The value of this ratio
valued by discounting their future cash flows to depends mainly on risk and expected growth in
present values and summing these present values. namings.
The discount rate used is the required rate of return • Debt securities (bonds) are priced by discounting
or opportunity cost of capital. their future coupon interest payments and face
• If the future cash flows from an asset are certain, value. For any company, the interest rate required by
the required rate of return will reflect only the lenders will be less than the required rate of return
effect of time on the value of money. on the company’s ordinary shares. The price of a
• If the future cash flows are uncertain, investors debt security is inversely related to the interest rate
will also require compensation for risk and the required by investors.
rate will be increased by the inclusion of a risk • Interest rates at any given time will usually be different
premium. for different terms to maturity. This pattern is known
• The value of an ordinary share is the present value as the term structure of interest rates. Expectations
of a dividend stream that can, in principle, continue of future interest rates, together with a risk premium
forever. The calculation of a share’s value can be have been suggested as explanations of the shape
simplified by assuming that dividends are constant of the term structure.
or grow at a constant rate over time. Shares can • The interest rate or yield on debt also depends on
also be valued using the company’s current earnings the probability that the borrower will default.
KEY TERMS
bonds (or debentures) 80 immunisation 97
coupons 80 investment horizon 87
default-risk structure of interest rates 82 liquidity premium (risk premium) theory 87
dividends 76 term structure of interest rates 82
duration 98 yield curve 84
expectations theory 85 zero-coupon bonds 82
SELF-TEST PROBLEMS
1 Richards Ltd pays annual dividends on its ordinary shares. The latest dividend was 75 cents per share
and was paid yesterday. Dividends are expected to grow at 8 per cent per annum for the next 2 years,
after which a growth rate of 4 per cent per annum will be maintained indefinitely. Estimate the value of
one share if the required rate of return is 14 per cent per annum.
2 A government bond with a face value of $ 1 00 and a coupon interest rate of 1 1 per cent per annum
matures in 3 years7 time. Interest payments occur twice each year and a payment has just been made.
If the current market yield on the bond is 13 per cent per annum, what is the current price of the bond?
3 The current interest rates (yields) on zero-coupon government bonds are as follows:
Interest rate [%
13.90
11.70
10.50
Assume that the term structure can be explained purely by expectations of future interest rates, and
therefore there is no liquidity (or risk) premium. Calculate the expected 1-year rates for the next 2 years.
Solutions to self-test problems are available in Appendix B.
92
CHAPTER F O U R REVIEW
QUESTIONS
1 [LO 1] Assuming certainty, the rates o f return on a ll financial assets w ill be identical. Outline why this
statement is correct and indicate the factors on which this market rate of return depends.
2 [LO 2] The valuation o f a share using the dividend growth model is very sensitive to the forecast o f the
dividend growth rate. This feature is a serious limitation on its usefulness to a share analyst. Discuss.
3 [LO 3] A company's share price reflects the discounted value o f either its future dividends or its future
earnings. Discuss.
4 [LO 4] W h y are bond prices and yields inversely related? Doesn't a higher yield make a bond more
attractive to investors and hence make it worth more, not less?
5 [LO 5] Government bonds are not riskless. Do you agree with this statement? W h y?
6 [LO 6] Differences between the current yields on different bonds con be explained by their relative riskiness
and different terms to maturity. Discuss.
7 [LO 6] What is the term structure of interest rates? Discuss the various theories that try to explain the term
structure of interest rates.
8 [LO 6 】Given an upward-sloping term structure, it is preferable for a company to raise debt by issuing short-
term debt securities. Discuss.
9 [LO 6 】 If the term structure is downward sloping, does this mean that liquidity preferences are not having
any influence on interest rates?
10 [L0 7] How can both the Government of Australia and the Treasury Corporation of Victoria have a credit
rating of A a a? Wouldn't the Treasury Corporation of Victoria have a higher credit risk than the Australian
government?
11 [LO 8] What is 'immunisation7? (See Appendix 4.1, Introduction.) How may duration matching help? What
are the problems of duration matching?
cA
1
PROBLEMS
Valuation under certainty [LO 1]
A promise to pay $ 1 0 0 0 0 in 4 years' time is certain to be kept. If the risk-free rate for a 4-year term is 5 .5 per
cent per annum, what is the value of this promise today? Do we know what the value will be in a year's time?
W hy or why not?
2 Valuation of shares [LO 2]
Assume that today is the last day of 2014. Rednip Ltd is expected to pay annual dividends of 64 cents in
2015 (Year 1). Assume that this dividend is expected to grow at an annual rate of 10 per cent and investors
require a rate of return of 20 per cent per annum.
a) Estimate Rednip Ltd's share price today.
b) What is Rednip Ltd's share price expected to be at the end of 2 0 1 5 ?
3 Valuation of shares [LO 2]
The required rate of return on the shares in the companies identified in (a) to (c) below is 15 per cent per
annum. Calculate the current share price in each case.
a) The current earnings per share of Zero Ltd are $1.50. The company does not reinvest any of its earnings,
which are expected to remain constant.
b) Speedy Ltd's current dividend per share is 80 cents. This dividend is expected to grow at 5 per cent per
annum.
c) Reduction Ltd's current dividend per share is 60 cents. The dividend of the company has been grow
ing at 12 per cent per annum in recent years, a rate expected to be maintained for a further 3 years.
It is envisaged that the growth rate will then decline to 5 per cent per annum and remain at that level
indefinitely.
4 Required rate of return on a bond [LO 4]
A 10 per cent $ 1 00 government bond that pays interest annually, and currently is 5 years from maturity, is
selling for $103.29. What is the required rate of return (yield) on this bond? What is the implied real interest
rate if the expected inflation rate is 5 per cent per annum?
5 Valuation of bonds [LO 4]
A 12 per cent $ 1 00 government bond pays coupon interest twice yearly and matures in 5 years7 time. The
current market yield on the bond is 10 per cent per annum. If a coupon payment has just been made, what is
the current price of the bond?
6 Bond prices and interest rate changes [LO 5]
Consider two 1 2 per cent $100 government bonds that differ only in that one matures in 2 years7 time and the
other in 5 years7 time. Both bonds are currently selling for $1 00 and pay coupon interest annually.
a) What will be the price of each bond, given an immediate fall in the required yield to 10 per cent per
annum?
b) What will be the price of each bond, given an immediate increase in the required yield to 14 per cent per
annum?
c) Explain the relative price movements in response to interest rate changes as evidenced by parts (a) and (b).
7 Bond prices and interest rate changes [LO 5]
Welshpool Investments Ltd has a portfolio of 5 bonds (A, B, C, D and E). Their terms to maturity are 2, 3, 5,
10 and 25 years respectively. Each of the bonds has a coupon interest rate of 8 per cent per annum and a
yield of 6 per cent per annum and each has just made a coupon payment. All 5 bonds pay annual coupons.
a) Calculate the price of each bond.
b) Re-calculate the price of each bond if the required yield on each bond increases to 7 per cent per annum.
c) Comparing your answers to (a) and (b), what patterns are evident? Explain.
8 Using the term structure to price a bond [LO 6]
The government currently has on issue zero-coupon bonds with terms of 1, 2 and 3 years. Their yields are,
respectively, 6, 9 and 10 per cent per annum. The government proposes to issue a 3-year bond paying
annual coupons and wishes to issue the bond at a price close to its face value of $100. To two decimal
places, what coupon interest rate should the government choose?
9 Expectations theory of the term structure [LO 6]
The current risk-free zero-coupon interest rates are as follows:
1 6.00
2 6.50
3 6.90
4 7.20
5 7.40
a) Assume that the term structure can be explained purely by expectations of future interest rates, and there
fore there is no liquidity or risk premium. Calculate the expected 1-year interest rates for the next 4 years.
b) Explain why it is not possible in this market for the 6-year zero-coupon interest rate to be 6 per cent per
annum.
10 Liquidity premium theory of the term structure [LO 6 】
The current zero-coupon interest rates for terms of 4 and 5 years are 8.4 and 8.5 per cent per annum
respectively. Jane Chan wishes to invest today and has an investment horizon of 4 years. Specifically, her
target is to have $ 1 0 0 0 0 0 in 4 years' time. She is considering two investment strategies: (i) buying the 4-year
bond and (ii) investing the amount calculated for the first strategy but instead buying the 5-year bond and
selling the bond after 4 years have passed.
CHAPTER FOUR APPLYING THE TIME VALUE 〇F MONEY TO SECURITY VALUATION
C H A P T EF
a) How much will Jane need to invest today if she implements strategy (i)?
b) Suppose Jane decides to implement strategy (ii). What 1-year interest rate on the horizon date will see Jane
exceed her target?
c) How would proponents of the expectations hypothesis interpret this result? How would proponents of the
liquidity premium hypothesis interpret this result?
11 Pricing with default risk [LO 7]
R oan HEVIE
Waverton Foundry Ltd has just issued a 1-year zero-coupon bond with a face value of $ 1 0 0 0 0 0 0 0 . It is
known that there is a 3 per cent chance that the company will default on this payment and that, if it does,
investors in the bond will receive nothing. The market requires an expected rate of return of 8.6 per cent per
annum.
a) How much is the bond issue worth today? What is the implied promised yield?
b) Suppose instead that, in the event of default, there is a 2 per cent chance that investors would receive
$ 7 0 0 0 0 0 0 and a 1 per cent chance that they would receive nothing. How much is the bond issue worth
today? What is the implied promised yield? Compare this with your answer to (a) and comment.
12 Duration and interest rate elasticity [LO 8]
芝
Consider the following four bonds:
Bond Term to maturity (years) Coupon rate [% p.a.)
A 2 10
B 3 12
C 3 10
D 3 8
Each bond has a face value of $100 and the current yield is 9 per cent per annum. All bonds pay annual
coupons.
a) Calculate the current price of each bond.
b) Calculate the duration of each bond. (See Appendix 4.1.)
c) Calculate what the price of each bond would be if the market interest rate increased to 11 per cent per
annum.
d) What would be the percentage capital loss on each bond?
13 Duration and immunisation [LO 8]
An investor is considering the purchase of a 10-year bond that pays a single annual interest payment at the
rate of 10 per cent. The bond's face value is $1 00 0 and its current price is $1 134.19. Determine whether the
investor can ensure a particular rate of return over a 7-year time horizon. (See Appendix 4.1
14 Duration and immunisation [LO 8]
If you wish to 'lock in’ the current yield of 8.5 per cent per annum for 3 years, which of the following bonds
should you invest in?
Bond Term to maturity (years) Coupon rate (% p.a.) 1
A 2.0 10
B 3.0 10
C 3.5 10
D 4.0 10
E 4.0 18
Each bond has a face value of $100. Assume that coupon payments are made at the end of each year.
95
B usiness finance
REFERENCES
Alles, L, 'Time varying risk premium and the predictive Fama, E.F., 'Term premiums in bond returns', Journal of
power of the Australian term structure of interest rates ’， Financial Economics, December 1984, pp. 5 2 9 -4 6 .
/Accounf/ng one/ F/'nance, November 1995, pp. 7 7 —96. Heaney, R., 'Predictive power of the term structure in
Beechey, M w Hjalmarsson, E. & Osterholm, P., Testing Australia in the late 1980s: a note', Accounting and Finance,
the expectations hypothesis when interest rates are near M a y 1994, pp. 3 7 -4 6 .
integrated', Journal of Banking and Finance, M ay 2009, Longstaff, F.A., The term structure of very short-term rates:
pp. 9 3 4 -4 3 . new evidence for the expectations hypothesis', Journal of
Bodie, Z., Kane, A. & Marcus, A.J., Investments, 9th edn; Financial Economics, December 20 00 ,
M cG raw-H ill, N ew York, 20 1 1 . pp. 3 9 7 -4 1 5 .
Brailsford, Tw Heaney, R. & Bilson, C., Investments, 4th edn, Macaulay, Fw Some Theoretical Problems Suggested by the
Cengage, M elbourne, 20 11 . Movements of Interest Rates, Bond Yields and Stock Prices in
Brailsford, T., Handley, J.C. & Maheswaran, K., the US Since 1856, N ational Bureau o f Economic Research,
'Re-examination of the historical equity risk premium N ew York, 1938.
in Australia7, Accounting and Finance, M arch 20 08 , McCulloch, J., 'The monotonicity o f the term structure: a
pp. 7 3 -9 7 . closer look', Journal of Financial Economics, M arch 1987,
Brailsford, T.; Handley, J.C. & Maheswaran, K., 'The pp. 1 8 5 -9 2 .
historical equity risk premium in Australia: post-GFC and Richardson, M ., Richardson, P. & Smith, T., 'The monotonicity
128 years o f da ta', Accounting and Finance, M arch 20 12 , of the term structure: another look', Journal of Financial
pp. 2 3 7 -4 7 . Economics, M arch 1992, pp. 9 7 -1 0 5 .
Cox, J.C., Ingersoll, J.E. & Ross, S.A., 'Duration and the Robinson, E.S., 'The term structure of Australian interest rates:
measurement o f basis risk', Journal of Business, January tests of the expectations hypothesis', Applied Economics
1979, pp. 5 1 -6 1 . Letters, July 1998, pp. 4 6 3 -6 7 .
Dimson, E., Marsh, P.R. & Staunton, M ., 'G loba l evidence Tease, W.J., The expectations theory of the term structure of
on the equity risk premium', Journal of Applied Corporate interest rates in Australia7, The Economic Record, June 1988,
Finance, Fall 2 0 0 3 , pp. 2 7 -3 8 . pp. 1 2 0 -7 .
Elton, EJ. & Gruber, M J ., Modern Portfolio Theory and Young, I. & Fowler, D., 'Some evidence on the term structure
Investment Analysis, 5th edn, John W ile y and Sons, of interest rates: how to find a black cat when it's not there',
N ew York, 1995. Accounf/’ng one/ F/nance, M a y 1990, pp. 2 1 -6 .
96
A ppendix 4 .1 D uration a n d im m u n isatio n
A p p e n d ix
命
Duration and immunisation
Introduction
In S ection 4.5 it w as sh ow n that h old ers o f b o n d s are su bject to in terest rate risk. A change in th e level
o f interest rates affects b o th the m arket price o f an existing b o n d an d th e in terest rate at w hich in terest
receipts can be reinvested. For exam ple, an increase in in terest rates m eans an im m ed ia te capital loss to
LEARNING
holders o f b o n d s becau se th e price o f th eir secu rities w ill fall. H ow ever, th ere is th en th e o p p o r tu n ity to
OBJECTIVE 8
reinvest in terest receipts at th e h igh er in terest rate. The reverse applies i f in terest rates fall. Apply the concept of
The possib ility o f ch a n g in g in terest rates p resen ts difficulties fo r in vestors. Su ppose, fo r exam ple, duration to immunise a
that an in vestor w ishes to h ave a target su m o f m o n e y in 3 years* tim e. The challenge is to c h o o s e a b o n d bond investment
in vestm en t that w ill achieve th is target, regardless o f in terest rate changes du ring the 3 years. A strategy
to achieve such an ob jectiv e is called im m unisation. If p ossib le, the in vestor sh ou ld bu y a 3-year b o n d IM M U N IS A TIO N
that m akes n o in terest p a ym en ts (k n ow n as c o u p o n s) du ring its life. Such secu rities are usually called strategy designed
to achieve a target
z e r o -co u p o n b o n d s .19 The in v e s to r k n ow s w ith certain ty the price o f the b o n d at th e en d o f th e 3 years
sum of money at a
because th e b o n d w ill th en b e w o rth exactly its face value, as it m atu res at th at tim e. Since there are n o future point in time,
cou p on in terest paym en ts, th e in vestor also has n o d ou b ts arising fr o m u n certain ty a b ou t the in terest rate regardless of interest
that w ill b e earn ed o n rein vested cou p on s. Th erefore, the in vestor k n ow s p recisely w hat th e in vestm en t rate changes
w ill b e w orth at the en d o f th e 3 years, an d thus ach ievem en t o f the target is guaranteed. The p rob lem
is that alth ough z e r o -c o u p o n b o n d s exist, c o u p o n b o n d s are m u ch m ore co m m o n . Im m u n isation u sing
cou p on -p a y in g b o n d s is m ore difficu lt to achieve.
A tech n iqu e certain to im m u n ise an in v estm en t in c ou p on -p a y in g b o n d s against all p ossib le changes
in in terest rates has n ever b e e n achieved. H ow ever, there is a tech n iq u e th at w ill im m u n ise a b o n d
in vestm ent in a relatively sim ple en v iro n m e n t in w hich the yield curve is fiat, b u t m a y m ake a single
parallel sh ift up o r d o w n .20 This tech n iq u e is b a sed o n th e co n c e p t o f b o n d d u ra tion an d its origin s can be
traced to research u n derta k en b y M acaulay (1 9 3 8 ).
Bond duration
M acaulay realised th at a b o n d payin g a lo w c o u p o n rate is in a sen se a lon ger* in v estm en t th an a h igh er
c o u p o n b o n d w ith the sam e term to m aturity. For exam ple, con sid er tw o 5-y ear b o n d s , b o th o f w h ich
have a face value o f $ 1 0 0 0 , pay in terest annually an d are cu rren tly p riced to yield 10 p er cen t p er annum .
They differ, h ow ever, in that o n e has a c o u p o n rate o f 5 p e r cen t per an n u m and the o th e r a c o u p o n rate
o f 15 p er cen t p er annum .
The cash flow s and th eir p resen t values are sh ow n in Table A 4.1.
Table A 4 .1
Year 5% coupon cash flow Present value 15% coupon cash flow Present value
($) t$) ($) ($)
1 50 45.45 150 136.36
2 50 41.32 150 123.97
3 50 37.57 150 112.70
50 34.15 150 102.45

4
5 50 31.05 150 93.14
5 1000 620.92 1000 620.92
Total 8 1 0 .4 6 1189.54
19 With zero-coupon bonds, an investor receives no regular interest payments during the bonds life. A zero-coupon bond is
purchased at a discount from its face value and it is either held to maturity, when the investor receives the face value, or sold
before maturity at a price determined in the market.
20 For a discussion of techniques appropriate to several, more complex, environments, see Elton and Gruber (1995).
令
T h erefore, th e price o f the 5 per cen t c o u p o n b o n d is $ 8 1 0 .4 6 and th e price o f th e 15 p er cen t cou p on
b o n d is $ 1 1 8 9 .5 4 . For th e lo w -c o u p o n b o n d , th e face value p a ym en t ($ 1 0 0 0 ) represents a b ou t 77 per cent
o f its p rice (becau se $ 6 2 0 .9 2 /$ 8 1 0 .4 6 = 0 .7 7 ). For the h ig h -c o u p o n b o n d , th e face value represents
on ly a b o u t 52 p er cen t o f its p rice ($ 6 2 0 .9 2 / $ l 1 8 9 .5 4 ~ 0 .5 2 ). Conversely, the first in terest paym en t
con trib u tes on ly a b ou t 5.6 p er cen t to the value o f th e lo w -c o u p o n b o n d ($ 4 5 .4 5 /$ 8 1 0 .4 6 = 0 .0 5 6 ) bu t
c on trib u tes nearly 11 .5 p er cen t to the value o f th e h ig h -c o u p o n b o n d ($ 1 3 6 .3 6 /$ 1 1 8 9 .5 4 = 0 .1 1 5 ). It is
clear th a t the lo w -c o u p o n b o n d brin gs returns to th e in vestor later in its life, relative to the h ig h -co u p o n
b on d . In this sense, the lo w -c o u p o n b o n d is longer*.
DURATION M acaulay p r o p o s e d that this tim in g feature cou ld be in co rp o ra te d in to a d u r a t io n m easure by
measure of the w eigh tin g th e n u m ber o f p eriod s that w ill elapse b e fo r e a cash flo w is received b y th e fraction o f the
time period of an
b o n d s p rice th at the p resen t value o f th at cash flo w represents. In this w ay th e tim e p e r io d is w eigh ted by
investment in a bond
th e ‘relative im p o rta n ce ’ o f the cash flo w that w ill occu r at th at tim e.
or debenture that
incorporates cash Table A 4 .2 sh ow s th e calculation o f d u ra tion fo r the tw o b o n d s discu ssed above.
flows that are made
prior to maturity
T able A 4 . 2
鲁 ~ 'f
Time 5% coupon weight Weight x time 15% coupon weight Weight x time
1 4 5 .4 5 /8 1 0 .4 6 = 0 .0 5 6 0 8 0.056 08 1 3 6 .3 6 /1 1 8 9 .5 4 = 0 .1 1 4 6 3 0.1 14 63
2 4 1 .3 2 /8 1 0 .4 6 = 0 .0 5 0 9 8 0.101 96 1 2 3 .9 7 /1 1 8 9 .5 4 = 0 .1 0 4 2 2 0.208 44
3 3 7 .5 7 /8 1 0 .4 6 = 0 .0 4 6 3 6 0.139 08 1 1 2 .7 0 /1 1 8 9 .5 4 = 0 .0 9 4 7 4 0.2 84 22
4 3 4 .1 5 /8 1 0 .4 6 = 0 .0 4 2 1 4 0.168 56 1 0 2 .4 5 /1 1 8 9 .5 4 = 0 .0 8 6 1 3 0.344 52
5 3 1 .0 5 /8 1 0 .4 6 = 0 .0 3 8 3 1 0.191 55 9 3 .1 4 /1 1 8 9 .5 4 = 0 .0 7 8 3 0 0.391 50
5 6 2 0 .9 2 /8 1 0 .4 6 = 0 .7 6 6 1 3 3.830 65 6 2 0 .9 2 /1 1 8 9 .5 4 = 0 .5 2 1 9 8 2.609 90
T otal = d u ra tion 4 .4 8 7 88 3.9 5 3 21
As su ggested earlier, the du ration o f the lo w -c o u p o n b o n d (4 .4 8 8 years) is lon g er th an the du ration

o f th e h ig h -c o u p o n b o n d (3 .9 5 3 years). D u ration an d term to m a tu rity are equal on ly fo r a z e r o -co u p o n
b on d . The du ration o f a co u p o n -p a y in g b o n d is always less th an its term to m aturity.
The steps u sed to calculate d u ra tion D are su m m arised in th e form u la:
D = f rm 〇) if
台卜。J A4.1
w here Ct = cash flo w (c o u p o n in terest o r p rin cip al) at tim e t
PV(Ct) = p resen t value o f Ct
Q
~ (i + 0 f
N ow
P 〇 = price o f the b o n d
_ y - Q , Pn
" t t (i + 0 f (1 +
w here Ct = c o u p o n in terest at tim e t

Pn = face value pa ym en t at m atu rity
z = required yield p er p e rio d
n = n u m ber o f p eriod s to m atu rity
E qu ation A 4 .1 can be rew ritten in its m ore usual form :
y ' Ct x t
f t i (1 + 〇r
D：
f Q
r t i (1 + iY A4.2
A ppendix 4 .1 D uration a n d im m unisation
Example A4.2 includes a duration calculation th a t follows Equation A4.2. First, however, we provide
a b rie f mathematical analysis to h ig hligh t the importance o f the duration measure. Readers who are n ot
interested in this analysis can o m it this section.
Duration and interest elasticity

As explained in Section 4.4, i f interest rates increase (decrease), then bond prices decrease (increase).
When there is a change in interest rates, all bond prices respond in the opposite direction, b u t they do
not all respond to the same extent. In other words, different bonds have different interest elasticities. It
is im p orta nt fo r a bond investor to know the interest elasticity o f the bond because this w ill be a good
indicator o f the interest rate risk being borne.
The n otio n o f elasticity is prom inent in economics. Perhaps the best known example is the price
elasticity o f demand fo r a particular good. This is expressed as follows:
QdP
where rj = price elasticity o f demand
P = price o f the good
Q = q uantity o f the good demanded
^ = derivative o f q ua ntity demanded w ith respect to price
Price elasticity indicates the response o f the q ua ntity demanded to a change in price.
W hat m atters fo r a bond investor is the interest elasticity o f the bond price; in other words, what
matters is the response o f the bond price to a change in the interest rate. The elasticity E is given by:
i dP〇
E:
P〇 d i A4.3
The form ula fo r bond price is:
Ci C2 Cn Pn
P〇
(i + v (1 + i) n (1 + /广
and therefore:
dP〇 Q 2C2 nCn nPn

di ~ (1 + 0 2 (1 + i f (l + i) ^ 1 (l + O^ 1
(-1 ' f C\ 2 〇2 nCn . nPn
\\-\- i ) \ l + i (1 + 〇2 (1 + i) n ( l + i) n
Substituting in to Equation A4.3:
^ i \ f l \ f C{ 2C2 nCn nPn

E ：
P〇 I \ l + i ) \ l + i (1 + i y (1 -f i) n (1 + i) n
D A4.4
.1 + /
where duration, D, is as defined in Equation A4.2.

Equation A4.4 shows th a t the interest elasticity o f a bonds price is proportional to its duration. The
longer the duration, the greater (in the sense o f being more negative) is the interest elasticity. For example,
i f the interest rate is 10 per cent per annum and the duration is 4.5 years, the interest elasticity is:
3.10
(4.5)
( 1r 10
, . ,
：-0.409
I f the duration is 9 years, the interest elasticity is:
/0.10、
E ⑼
V I . 10,
- 0 .8 1 8
Duration and bond price changes

Given th a t duration is related to interest elasticity, it follows th a t i t is possible to use duration to work
out the approximate percentage price change th a t w ill occur fo r a given change in interest rate. Using
Equations A4.3 and A4.4:
i dP〇 = _ f
D
P〇 d i ~ VI
I t follows that:
dP〇 _ f \
Ddi
P〇" ~ ~ V l T /
Therefore, fo r 'small* discrete changes in interest rates and bond prices we have the follow ing
approxim ation:
AP〇
DAi
(it A4.5
An application o f Equation A4.5 is shown in Example A4.1.
Example A 4 .1
Consider the 5-year 15 per cent coupon bond priced to yield 10 per cent per annum. As shown in
Tables A4.1 and A4.2, the price of this bond is $1 189.54 (per $1 0 0 0 face value) and its duration
is 3.953 years. What is the percentage price change if the interest rate falls to 9.5 per cent per
annum?
SOLUTION
In this case the interest rate change is -0.5 per cent = -0.005. Equation A4.5 gives the approximate
answer as:
1
(3.953)(-0.005)
V I . 10
0.01797
In other words, the result will be a capital gain of approximately 1.797 per cent. (The exact answer
is close to 1.819 per cent.)
Duration and immunisation

Suppose th a t the yield curve is flat, b ut i t may make a parallel s h ift up or down. If, at the tim e o f a
parallel sh ift, an investor is holding a bond whose duration matches the rem aining investm ent period, the
investm ent is im m unised against the s h ift— th a t is, the investm ent w ill achieve at least the target yield,
notw ithstanding the yield shift. This can be seen in Example A4.2.
Managing risk by matching Macaulay s duration to the investm ent horizon is an im p o rta n t idea but
the procedure we have described has a num ber o f lim ita tion s. In particular, it is im p o rta n t to investigate
w hat happens i f there is more than one yield s h ift during the investm ent period. Consider again
Example A4.2 and suppose th a t the yield had shifted down to 8 per cent imm ediately after date 0.0, but
then shifted up to 12 per cent just before date 3.0 (the end o f the investm ent period). In th a t case, the
investor w ill hold 1.229 37 bonds after 3 years have passed, b ut the price w ill be only $1022.578 per bond,
which gives a value o f 1.229 37 x $1022.578 = $1257.127. This falls short o f the target o f having at least
$1275.312.
A ppendix 4 .1 D uration a n d im m unisation
Example A4.2
Suppose that there is a flat yield curve at an interest rate of 10 per cent per annum. An investor wishes
to lock in7 this yield for a 3-year investment period. Bond A has a term of 3.4 years, a face value of
$1000, a coupon rate of 7 per cent and pays interest annually. Table A4.3 shows the calculation of
Bond A 7s duration using Equation A4.2.
n $2877.402
Duration = —---------------
$958,161
=3.003 years
Table A4.3 Bond A

Time (years) Cash flow ($) Present value of cash flow ($) Time x present value ($)
0.4 70 67.382 26.953
1.4 70 61.256 85.758
2.4 70 55.687 133.649
3.4 1070 773.836 2631.042
Total 958.161 2877.402
According to the immunisation strategy, Bond A should provide an immunised investment because
its duration matches the investment period— that is, an investment of $958,161 in Bond A will be
worth at least $958,161 x ( l. l) 3 = $127 5.31 2 in 3 years7 time, regardless of an interest rate shift.
To demonstrate this, it is assumed that:
a) immediately after buying Bond A, the yield curve makes a parallel shift from 10 per cent to 8 per
cent, and remains at that level for the next 3 years
b) as each coupon interest payment is received, the investor reinvests in— that is, buys more of— the
same bond
c) bonds and dollars are infinitely divisible, thereby allowing the investor to purchase or sell any
fraction of Bond A.
After 0.4 years have passed, the investor receives a coupon payment of $70. The bond is now a
3-year bond. The yield curve has shifted down to 8 per cent, so the price of one bond is then:
$70 $70 $1070

hOS + (1.08)2 + (1.08)3
=$974,229
Therefore, the investor can purchase the fraction 70.00 /97 4.2 29 of one bond. This fraction is
0.071 852, so the investor now holds 1.071 852 bonds. After 1.4 years, the investor receives a further
coupon payment of $70 per bond; therefore the cash received is $70 x 1.071 852 = $75.0296. The
bond is now a 2-year bond and its price is:
$70 $1070
L08 + (1.08)2
=$982,167
The investor can now purchase a further 75 .02 9 6 / 9 8 2 .1 6 7 = 0 .0 7 6 3 9 of a bond. This type of
cycle is repeated after 2.4 years and the investment in bonds is then sold after 3 years. Table A4.4
summarises the progress of the investment.
continued
continued
Table A4.4
Date = investment period expired (years)
Item
0.0 0.4 M 2.4 3.0
Bond term remaining (years) 3.40000 3.00000 2.00000 1.00000 0.40000
Coupon interest received ($) N il 70.00000 75.02960 80.37700 Nil
Price o f one bond ($)(fl) 958.16100 974.22900 982.16700 990.74100 1037.56300
Bonds purchased (no.) 1.00000 0.07185 0.07639 0.08113 N il
No. of bonds held 1.00000 1.07185 1.14824 1.229 37 1.22937
Value o f bonds held ($) 958.16100 1044.22700 1127.76400 1217.98700 1275.54900
(°) Present value of remaining cash flows per $ 1000 face value. Yield used is 10 per cent per annum for the price at date
zero. Yield used is 8 per cent per annum for prices calculated after date zero.
As can be seen in the bottom right-hand corner of the table, the sum received from the sale after
3 years is $1275.549. This amount exceeds the target sum after 3 years of $ 1 27 5.31 2 and the
investment has therefore achieved the target rate of return of at least 10 per cent per annum.
What if the interest rate had risen to 12 per cent (instead of falling to 8 per cent)? In that case, the
progress of the investment would be as shown in Table A4.5.
Table A4.5
Date = investment period expired (years)
Item
0.0 0.4 1.4 2.4 3.0
Bond term remaining (years) 3.40000 3.00000 2.000 00 1.00000 0.40000
Coupon interest received ($) Nil 70.00000 75.56880 81.34680 N il
Price o f one bond ($)(a) 958.16100 879.90800 915.49700 955.35700 1022.57800
Bonds purchased (no.) 1.00000 0.07955 0.08255 0.08515 N il
No. of bonds held 1.00000 1.07955 1.16210 1.24725 1.24725
Value o f bonds held ($) 958.16100 949.905 00 1063.89700 1191.56500 1275.40600
Present value of remaining cash flows per $ 1000 face value. Yield used is 10 per cent per annum for the price at date
zero. Yield used is 12 per cent per annum for prices calculated after date zero.
Again, therefore, the investment has achieved the target yield of 10 per cent per annum,
notwithstanding the shift in yield after the investment was made.
In principle, this problem can be solved easily. W hen the yield changes, so too does the duration o f
the bond held. W hen the yield shifts on the firs t occasion, the investor should change the bond holding
so that, once again, duration matches the investm ent period. The investor is then imm unised against
the next yield shift. This is simple in principle b ut in practice there are difficulties because it implies that
a rebalancing o f the investm ent— buying and selling bonds— is needed every tim e the duration o f the
investm ent changes. Because duration is a function o f the current yield and future coupon payments, this
means th a t a bond transaction is needed every tim e the yield shifts, and every tim e a coupon payment is
received. This can be costly and cumbersome.
Only a fla t yield curve subject to parallel shifts has been considered. It may be shown th a t i f a sloped
yield curve shifts in parallel fashion the investor s till matches duration and investm ent period, b ut the
duration form ula is slightly more complex. I f a sloped yield curve shifts in some non-parallel way then the
im m unisation strategy w ill depend on the type o f non-parallel s h ift assumed to occur. For an example,
see the article by Cox, Ingersoll and Ross (1979).
▼
CHAPTER CONTENTS
ED Introduction 104 m The discounted cash flow methods compared 108
m The capital-expenditure process 104 EB Other methods of project evaluation 118

BH Methods of project evaluation 104 Project evaluation and real options analysis 123
LEARNING OBJECTIVES
1 explain the importance of each of the steps in the capital-expenditure process
2 outline the decision rules for each of the main methods of project evaluation
3 explain the advantages and disadvantages of the main project evaluation methods
4 explain why the net present value method is preferred to all other methods
5 understand the relationship between economic value added (EVA) and net present value (NPV)
6 understand the relationship between real options, managerial flexibility and firm value.
B usiness finance
Introduction
In Chapter 1 we described the p rim ary financial functions o f a financial manager as raising funds and
allocating them to investm ent projects so as to maximise shareholders’ wealth. In this chapter, we
consider how such projects should be selected to ensure the m axim isation o f shareholders’ wealth.
The term investment project is interpreted very broadly to include any proposal to outlay cash in the
expectation th a t future cash inflow s w ill result. There is, therefore, a wide range o f such projects. These
include proposals fo r the replacement o f plant and equipment, a new advertising campaign, research and
development activities, and proposals to take over competing firm s.
In th is book, investm ent and financing decisions are discussed in the order in which they are usually
considered in practice. In general, management w ill firs t examine the alternative investm ent projects
available to it. A fte r the acceptability o f these projects has been determined, management w ill, i f
necessary, set about raising the funds to im plem ent them. It is logical, therefore, to discuss the evaluation
and selection o f proposed investm ent projects before discussing the methods o f financing them. In this
chapter, we examine the principles and methods o f project evaluation. In Chapter 6, the application o f
these principles and methods is discussed.
The evaluation and selection o f investm ent projects is only one element o f the capital-expenditure
process. Before discussing the methods o f project evaluation, therefore, we outline the capital-expenditure
process.
5.2 The capital-expenditure process

Capital-expenditure management involves the planning and control o f expenditures incurred in the
LEARNING expectation o f deriving future economic benefits in the fo rm o f cash inflows. Consider the follow ing
OBJECTIVE 1
possible proposals: a m anufacturer is considering b uilding a new plant; an airline is considering the
Explain the importance
of each of the steps in replacement o f several o f its aircraft; a pharmaceutical company is considering a new research and
the capital-expenditure development program. Each proposal involves m aking current outlays in the expectation o f future cash
process inflows and, therefore, each can be analysed as a capital-expenditure proposal. This is the case even though,
fo r example, the costs o f research and development are usually recognised fo r accounting purposes as
expenses in the period in which they are incurred.
Capital expenditures are very im p o rta n t fo r a company because freq ue n tly the am ounts o f m oney
involved are large and th e ir effects extend w ell in to the fu tu re . A fte r capital expenditures have
been made, i t is lik e ly th a t th e ir effects w ill continue fo r some tim e as m any projects are n o t easily
m odified. I f there is e ithe r no second-hand m arket or, at best, o nly a <th in , m arket fo r capital assets,
management may have to abandon a project i f i t proves to be unprofitable. Because o f the longevity
and frequent irre v e rs ib ility o f many investm ents, they are lik e ly to com m it a company to a p articula r
technology and to have a considerable influence on the p a tte rn o f its fu tu re operating cash flows.
The im portance o f these decisions, therefore, can extend w ell beyond the period in w hich the in itia l
capital outlay is made.
The tasks involved in the capital expenditure process, as well as the associated outcomes from their
im plem entation, are outlined in Table 5.1.
*
LEARNING
5.3 Methods of project evaluation
OBJECTIVE 2
In th is section we consider the evaluation and selection o f investm ent projects. F irst, we consider
Outline the decision
rules for each of the the net present value and the in te rn a l rate o f re tu rn m ethods, w hich were explained in a one-period
main methods of se ttin g in Chapters 2 and 3. We then consider o the r m ethods th a t have been employed in project
project evaluation evaluation.
^0^
C hapter five Project evaluation : principles a n d methods
TABLE 5.1 Tasks and outcomes of the capital expenditure process

|
Tasks Outcomes
Stage 1 Systematic processes are established to Investment proposals are forwarded

Generation of ensure members of the organisation may to management
investment contribute ideas to enhance firm value - employees dealing in production
proposals Incentives may be provided to reward processes w ill typically
employees who contribute ideas contribute ideas relating
to eliminating operating
inefficiencies
- proposals by upper-level
managers w ill mostly relate to
wider issues such as product
development or expansionary
opportunities
Stage 2 Data about each investment proposal are • A list o f recommended projects
Evaluation collected. Data include: is prepared by responsible
and selection 一 a description of the proposal management
of investment - the reasons for its adoption
proposals - estimates of amount and tim ing of cash
inflows and outflows
- an estimate o f the time u ntil the proposal
w ill come into operation and the economic
life o f the proposal once it is adopted
All proposals are then evaluated using
standard uniform procedures to ensure that
assessments are conducted objectively
The economic evaluation of the projects
is conducted using a variety o f techniques
(discussed in Section 5.3) that take into
account the risk of the net cash flows that are
expected to be delivered by the project
Stage 3 A capital expenditure budget is prepared that • Systematic processes are

Approval details the estimated capital expenditure established that enable the firm to
and control requirements on new and existing projects effectively manage and m onitor the
of capital over the next few years: implementation o f new projects
expenditures - a short-term budget is prepared that
relates to a period ranging from, say,
6 months to 2 years
- a longer-term budget is also prepared that
provides forecasts of cash requirements
over the next 2 to 5 years
Processes are established to ensure that the
project is properly managed and monitored.
These processes typically include:
- the appointment of a project manager
responsible for the implementation of
the project and the preparation of regular
progress reports
一 the establishment of a realistic timetable
for implementation of the project
- the establishment of a separate
account for each project to ensure that
expenditures are readily observed
continued
B usiness finance
Table 5.1 continued
Tasks Outcomes
Stage 4 • Projects are regularly re-evaluated via a post- • In itial investment decisions may be
Post completion audit to ensure that each project is improved as those responsible for
completion meeting the expectations o f the firm investment proposals are aware that
audit of • The audit w ill identify where cash flows are they w ill be audited
investment significantly different from budget forecasts • Improvements in the operating
projects and possible reasons for such differences perform 芑nee of projects
facilitated as new inform ation is
regularly provided to managers
Unsuccessful projects are identified
at the earliest possible time—
leading to their abandonment and
subsequent savings to the firm
M any methods are used to evaluate and compare investm ent projects. The methods outlined in this
section are those th a t surveys o f business practice suggest are used most frequently. They are o f two basic
types:
a the discounted cash flow methods, such as the internal rate o f return and net present value
methods, which discount a projects estimated cash flows to allow fo r the magnitude and tim in g o f
the cash flows
b the non-discounted cash flow methods, such as the accounting rate o f retu rn and payback period
methods.
Figure 5.1 shows some results from different surveys o f chief financial officers in the US, Australia and
Canada. In all three countries, net present value and internal rate o f retu rn are easily the m ost popular,
followed by payback period.
Figure 5.1 Selected project evaluation methods used by surveyed chief financial
officers!0)
80.00%
70.00%
<
、
- ui 60.00%
!/> 50.00%
40.00%
30.00%
f i 20 .00 %
s<
^0 o 10.00 %
0.00%
Internal rate Net present Payback Accounting rate Real options
of return value period of return analysis
(a) The aggregated percentage exceeds 100 per cent because most respondents use more than one method of project evaluation
Sources: Graham, J.R. & Harvey, C.R., 'The theory and practice of corporate finance: Evidence from the field7, Journal
of Financial Economics, May 2001, pp. 187-243; Coleman, L., Maheswaran, K. & Pinder, S.; 'Narratives in managers'
corporate finance decisions', Accounting & Finance, September 2010, pp. 6 0 5 -3 3 ; Baker, H., Dutta, S. & Saadi, S.,
'Management views on real options in capital budgeting', Journal of Applied Finance, February 2011, pp. 18-29.
In this chapter i t is assumed in itia lly th a t investm ent projects are independent. Two projects are said
to be independent i f the acceptance o f one project does n o t preclude the acceptance o f the other project. INDEPENDENT PROJECT
Two conditions are necessary fo r two or more projects to be classified as independent: a project that may be
accepted or rejected
• It m ust be technically feasible to undertake one o f the projects, irrespective o f the decision made without affecting
about the other project(s). the acceptability of
another project
• The net cash flows from each project m ust be unaffected by the acceptance or rejection o f the other
project(s).
An example o f independent investm ent projects is where an e n tity is considering whether to

purchase new machinery fo r its factory and whether to commission a new advertising campaign. As
these investments are independent, management can make an accept/reject decision on each investm ent
w itho ut considering its relationship to other investments. Problems caused by the existence o f projects
that are n ot independent are considered in Section 5.4.3. DISCOUNTED CASH
FLOW (DCF) METHODS
methods which
involve the process of
5.3.1 I Discounted cash flow methods discounting a series of
future net cash flows to
their present values
It can be seen from Figure 5.1 th a t the two m ost frequently employed discounted cash flow (DCF)
m ethods are the net present value and internal rate o f retu rn methods.The net presen t value (NPV) NET PRESENT VALUE
o f a project is equal to the difference between the present value o f its net cash flows and its in itia l cash (N P V )
the difference between
outlay.1 Assuming a cash outlay at the beginning o f the projects life, and a series o f net cash flows in the
the present value of
following periods, the net present value o f the project is calculated as follows: the net cash flows
from an investment
discounted at the
required rate of
return, and the initial
which can be w ritte n more conveniently as: cash outlay on the
investment
npv = y c, ?- c 〇
^ (1 + k)( 5.2
where C〇= the in itia l cash outlay on the project
Ct = net cash flow generated by the project at tim e t
n = the life o f the project
k = required rate o f retu rn
The in tern al rate of retu rn (IRR) o f a project is the rate o f return th a t equates the present value o f INTERNAL RATE OF
its net cash flows w ith its in itia l cash outlay.2 Assuming a cash outlay at the beginning o f the projects life RETURN (IRR)
the discount rate
and a series o f net cash flows in the follow ing periods, the internal rate o f retu rn is found by solving fo r
that equates the
r in the follow ing equation: present value of an
investment’s net cash
C〇 = - ^ - + — ^ + + flows with its initial
(1 + r) (1 + r)2 (1 + r)n 5.3
cash outlay; it is the
discount rate at which
This can be w ritte n more conveniently as: the net present value is
n equal to zero
Ct
Q = E 5.4
t=\ (1 + r )'
where C〇= the in itia l cash outlay on the project

Ct = net cash flow generated by the project at tim e t
n = the life o f the project
r - the internal rate o f return
1 The cash flows could be discounted and/or compounded to equivalent values at any point in time. It is usual to discount
the cash flows to the present; hence the use of the term n e t p r e se n t value. An alternative would be to calculate a n et terminal
value. This is equal to the difference between the accumulated value of the net cash flows generated by a project, and the
accumulated value of the initial cash outlay. Use of the net terminal value method gives the same decision as for the net
present value method.
2 Other terms used to describe the same concept include ‘the DCF return on investment’，‘yield’ and ‘the marginal efficiency of
capital’.
5.4 The discounted cash flo w methods
com pared
The assumed objective o f a company is to maximise shareholders* wealth. Consistent w ith this objective,
projects should be accepted only i f they are expected to result in an increase in shareholders’ wealth.
Therefore, the m ethod o f project evaluation m ust be consistent w ith m axim ising shareholders* wealth.
O ther things being equal, this w ill occur where a project generates more cash, rather than less cash, and
generates cash sooner, rather than later. The ability o f the net present value and interna l rate o f return
methods to result in decisions th a t are consistent w ith this objective is considered in the follow ing
sections.
5.4.1 | Net present value

The net present value o f a project is found by discounting the projects future net cash flows at the
required rate o f return and deducting from the resulting present value the in itia l cash outlay on the
project. Therefore:
n
Ct
npv =J2 -C o
t= l (1 + 吖 5.5
Where the investment outlays occur over more than one period, C〇in Equation 5.5 refers only to the
in itia l cash outlay. A ll subsequent outlays are included in the calculation o f the net cash flows o f future
periods. O f course, this may result in subsequent negative net cash flows in addition to the in itia l cash outiay.
Management should select projects w ith a positive net present value and reject projects w ith a negative
net present value. The am ount o f any positive net present value represents the imm ediate increase in
the company s wealth th a t w ill result from accepting the project— th a t is, a positive net present value
means th a t the projects benefits are greater than its cost, w ith the result th a t its im plem entation w ill
increase shareholders1wealth. Conversely, projects th a t have a negative net present value would reduce
shareholders’ wealth.
The m agnitude o f a projects net present value depends on the projects cash flows and the rate used to
discount those cash flows. I t follows th a t the estim ation o f a projects future cash flows is an im p o rta n t
step in project evaluation. This involves deciding w hat cash flow data are relevant fo r project evaluation
and then estim ating those data. W hile both aspects are im p orta nt, the mechanics o f estim ation, which is
the job o f engineers, m arket research analysts and others, is beyond the scope o f this book. We focus on
the firs t aspect— th a t is, the principles involved in defining and measuring project cash flows.
There are essentially tw o approaches to measuring a projects net cash flows. The most popular
m ethod is to forecast the expected net p ro fit from the project and adjust i t fo r non-cash flow items, such
as depreciation. The second method, and the approach used in this book, is to estimate net cash flows
directly. The cash inflow s w ill comprise receipts from the sale o f goods and services, receipts from the sale
o f physical assets, and other cash flows. Cash outflows include expenditures on materials, labour, indirect
expenses fo r m anufacturing, selling and adm inistration, inventory and taxes. W hile the measurement o f
a projects net cash flows may seem to be straightforw ard, there are some aspects th a t w arrant fu rth e r
consideration. These are discussed in Chapter 6.
In addition to estim ating a projects future cash flows, i t is also necessary to estimate the life o f the
project and determine the required rate o f retu rn to be used in discounting the cash flows. The correct
discount rate to apply is the o p p o rtu n ity cost o f capital.3 This is the rate o f retu rn required on the next
3 Estimation of the required rate of return, or discount rate, is discussed in Chapter 14. It is sufficient at this stage to point out
that the required rate of return is simply the rate of return that a project must generate in order to justify raising funds to
undertake it. Where there is perfect certainty about the outcome of an investment, the risk-free rate, such as the current yield
on government securities of the same maturity as the investment, is the appropriate discount rate. However, where there
is uncertainty about the outcome of the investment, a risk-adjusted required rate of return must be used. Throughout the
remainder of the book we will use the term req u ired rate o f retu rn to indicate the discount rate used in discounted cash flow
calculations.
best— th a t is, forgone— alternative investment. I f the net cash flows have been estimated on an after-tax
basis, then, to be consistent, the appropriate required rate o f retu rn is the after-tax rate. The measurement
o f the required rate o f retu rn is considered in Chapter 14.
Example 5.1 illustrates the application o f the net present value method.
Example 5.1
Bruce Barry is considering an investment of $ 9 0 0 0 0 0 in a project that will return net cash flows
of $5 09 000 , $ 4 5 0 0 0 0 and $ 4 0 0 0 0 0 at the end of Years 1, 2 and 3, respectively. Assuming a
required rate of return of 10 per cent per annum, what is the net present value of the project?
SOLUTION
The net present value may be calculated as shown in Table 5.2.
TABLE 5.2 Calculating a project’s net present value (NPV)

Year Net cash flows ($ ) ! Discount factor at 10% Present value ($)
0 (900 000 )⑷ (900000)
1 509000 0.909 09 462 727 (扮
2 450000 0.826 45 371901^)
3 400000 0.751 31 300 526 (幻
NPV ($) 235154
^T h e amount in brackets represents the initial cash outlay.

^T he sum of $ 4 6 2 7 2 7 + $371 901 + $ 3 0 0 5 2 6 = $1 135 154 is the maximum amount the company
would be prepared to pay for the project if the required rate of return is 10 per cent per annum.
A t a discount rate o f 10 per cent per annum, the project has a positive NPV o f $235154 and is
therefore acceptable.
This m ethod is consistent w ith the company’s objective o f m axim ising shareholders’ wealth. I f a
company implements a project th a t has a positive net present value, the company w ill be more valuable
than before it undertook the project, and therefore, other things being equal, the to ta l m arket value o f
the company s shares should increase im m ediately by the same am ount as the net present value o f the
new project. In other words, the company is undertaking a project th a t has a net present value in excess
o f th a t necessary to leave its share price unchanged. This was shown form ally in Chapter 2 using Fishers
Separation Theorem.
In summary, the decision rule fo r the net present value m ethod is as follows:
Accept a project i f its net presen t value is positive when the p ro je cts net cash flows are discounted a t
the required rate o f return.
5 .4 .2 1 Internal rate of return

The internal rate o f return fo r a project is the rate o f return th a t equates the present value o f the projects
net cash flows w ith its in itia l cash outlay. This means th a t Equation 5.4 can be rew ritten as follows:
Ct
c〇 = 0
From Equation 5.6, the internal rate o f retu rn is the discount rate th a t results in a zero net present
value. However, the interna l rate o f retu rn is n o t only the discount rate th a t causes the net present value
o f the projects cash flows to be zero. It also represents:
... the highest rate o f interest an investor could afford to pay, w ithout losing money, i f a ll the funds to
finance the investm ent were borrowed, an d the loan (principal an d accrued in terest) w as repaid by using
the cash proceeds from the investm ent a s they were earn ed.4
Even i f the investm ent outlays occur in more than one period, C〇in Equation 5.6 refers only to the
in itia l cash outlay. Any subsequent investm ent outlays are subtracted from the cash flows o f future
periods, which suggests th a t some o f the net cash flows in Equation 5.6 m aybe negative. The effect on the
interna l rate o f retu rn o f negative net cash flows in subsequent periods is discussed later in this section.
If, as is usual in practice, the projects net cash flows in each period are n o t equal, the internal rate o f
retu rn can be found only by tria l and error— th a t is, by varying the discount rate u n til the present value
o f the cash flows is equal to the investm ent outlay. I f this process shows th a t the present value o f the net
cash flows is greater than the in itia l cash outlay, then some higher discount rate should make them equal,
and vice versa.
A fte r the interna l rate o f return has been measured, the acceptability o f an investm ent project is
determ ined by comparing the internal rate o f return r w ith the required rate o f retu rn k. Any project w ith
r > k should be accepted and any project w ith r < k should be rejected.
Example 5.2 illustrates the application o f the internal rate o f retu rn method.
Example 5.2
If we take the cash flows of Example 5.1, the project's internal rate of return may be calculated using
Equation 5.3 as follows:
Cn = C l + C2 + C3
〇 _ d - ) d + r )2 ( l + r )3
Thus:
$900 0 0 0 - $509000 + $450000 + $_400000
By trial and error, r = 25 per cent.5 If the required rate of return is, say, 15 per cent, the project’s
internal rate of return of 25 per cent exceeds the required rate of return and the project is acceptable.
The use o f this method, therefore, appears to be consistent w ith the company s objective o f m aximising
shareholders* wealth. I f the required rate o f retu rn is the m inim um return th a t investors demand on
investments then, other things being equal, accepting a project w ith an internal rate o f return greater
than the required rate should result in an increase in the price o f the company s shares.
M ultiple and indeterminate internal rates of return

In Example 5.2 the investm ents cash flows consisted o f an in itia l cash outlay, followed by a series o f
positive net cash flows. In such cases a unique positive internal rate o f retu rn w ill usually exist.
In certain circumstances, however, it is possible fo r the present value o f the future net cash flows to be
equal to the in itia l cash outlay at more than one discount rate— th a t is, a project may have more than one
internal rate o f return. A necessary condition fo r m ultiple internal rates o f retu rn is th a t one or more o f
the net cash flows in the later years o f a projects life m ust be negative. The presence o f negative net cash
flows in the later years o f a projects life is n o t a sufficient condition fo r m ultiple interna l rates o f return.
In many cases, negative cash flows in the later years o f a projects life are consistent w ith there being only
one internal rate o f re tu rn .6
4 See Bierman and Smidt (1993).

5 In practice, a financial calculator may be used to calculate the internal rate of return and eliminate the time-consuming
computations involved in the trial-and-error process. Alternatively, the ^RR1function in Microsoft Excel® might also be used.
6 Descartes* rule of signs states that there can be as many positive roots for 1 + r as there are changes in the sign of the cash
flows. Therefore, if, after the initial cash outlay, the net cash flows are always positive, there will be at most one positive root
for l + r, and consequendy only one for r itself. However, two sign changes in the cash flow can result in two positive values
for 1 + r, so there may also be two positive values for r. For example, if the two positive values for 1 + r are +1.1 and +1.3,
there will be two positive values for r: 10 per cent and 30 per cent. In the remainder of this section we use the term in tern al
rate o f retu rn to mean p o sitiv e in te rn al r a te o f retu rn .
While, in practice, there is little likelihood o f the occurrence o f m ultiple internal rates o f return, i t is
im p orta nt to recognise th a t there are circumstances where m ultiple internal rates do occur. Such a set o f
circumstances is illustrated in Example 5.3.
E xample 5.3
Consider an investment project with the cash flows shown in Table 5.3. 6 ^
TABLE 5.3 Project cash flows
Year Cash flow
0 -14545 620
1 34182 000
2 -20000 000
An example of where such a cash flow pattern may occur is where a mining company is obliged,
after completion of its mining operations, to restore the mine site to its original condition. If we solve
for the internal rate of return of this project, then we find that its net present value is zero at both
10 per cent and 25 per cent— that is, the project has two internal rates of return. The project's net
present value profile, which plots the project's net present value as a function of the required rate of
return, is shown in Figure 5.2.
Figure 5.2 Net present value profile showing two internal rates of return
The number o f internal rates o f retu rn is lim ite d to the number o f sign reversals in the cash flow
stream. In this case there are tw o sign reversals, which is a necessary, b u t n o t sufficient, condition fo r two
internal rates o f return. Three sign reversals is a necessary condition fo r three rates, and so on. Hence, the
number o f cash flow sign reversals corresponds to the maximum, b ut n ot necessarily the actual, number
o f internal rates o f return.
It may be argued th a t m ultiple rates are not a problem because the project may be abandoned at the
beginning o f the second year, thereby avoiding the subsequent negative cash flow, and also the m ultiple
internal rate o f return problem. I f the project is term inable and has a positive residual value, a unique
internal rate o f return may be calculated. However, in some cases, abandonment o f the project may n ot
be feasible because it may involve substantial abandonment costs in the early years o f operation, or there
may be a legal obligation to continue the project fo r a num ber o f years.
In addition to the problem o f m ultiple internal rates o f return, it is possible fo r an investm ent project
to have no internal rate o f return. For example, a project w ith the follow ing pattern o f cash flows:
-$80 000, +$100 000, -$5 0 000, has no internal rate o f return.
B usiness finance
Projects w ith a cash flow stream th a t results in either m ultiple internal rates o f return, or no internal
rate o f return, are likely to be rare in practice, b ut the possibility o f such occurrences does exist. In what
follows, it is assumed th a t a projects cash flow pattern results in a unique internal rate o f return.
In summary, the decision rule fo r the internal rate o f retu rn m ethod is:
Accept a project i f it h as a unique in ternal rate o f return th at is g reater than the required rate o f return.
5 .4 .3 1 Choosing between the discounted cash flow methods
Independent investments
LEARNING
OBJECTIVE 3 For independent investments, both the IRR and NPV methods o f investm ent evaluation lead to the same
Explain the accept/reject decision, except fo r those investments where the cash flow patterns result in either m ultiple
advantages and interna l rates o f retu rn or no internal rate o f return. In other words, i f a project has an internal rate o f
disadvantages of retu rn greater than the required rate o f return, the project w ill also have a positive net present value
the main project
when its cash flows are discounted at the required rate o f retu rn — th a t is, NPV > 0 when r > k, NPV < 0
evaluation methods
when r < k, and NPV = 0 when r = k. This is always true, provided th a t the projects cash flows consist o f
one or more periods o f cash outlay followed only by positive net cash flows. Such a project is referred to
as a conventional project and the net present value profile o f such a project is illustrated in Figure 5.3.
Figure 5.3 shows th a t the higher the discount rate, the lower is the net present value. The intercept o f the
net present value profile w ith the horizontal axis occurs at the p o in t where k = r, which is the interna l rate
o f return because i t is the discount rate at which the net present value is zero.
Figure 5.3 Net present value profile for a conventional project
Figure 5.3 shows th a t at a required rate o f retu rn o f k1} the net present value is positive and r >
k1} while at a required rate o f retu rn o f k2 the net present value is negative and r < /c2. I f management
has to decide whether to accept or reject an independent investm ent project, then b o th the internal
rate o f retu rn m ethod and the net present value m ethod w ill give results consistent w ith m axim ising
shareholders’ wealth.
M utually exclusive investments

So far it has been assumed th a t investm ent projects are independent, which means th a t management
can make an accept/reject decision about each project w ith o u t considering its relationship w ith other
projects. In this section, we allow fo r the fact th a t investm ent projects may be interdependent. In this
case, the expected benefits fro m one project are affected by a decision to accept or reject another project.
In the extreme case, where the expected cash flows from a project w ill completely disappear i f another
project is accepted, or i t is technically impossible to undertake the proposed project i f another project is
accepted, the projects are said to be m utually exclusive. For example, i f a company owns land on which MUTUALLY EXCLUSIVE
it can build either a factory o r a warehouse, then these tw o projects are m utually exclusive. I f a decision PROJECTS
is made to b uild the factory, the company is unable to build the warehouse. A nother example o f m utually alternative investment
projects, only one
exclusive projects is i f different types o f equipment can be used to manufacture the same product. The of which can be
choice o f one type o f equipm ent autom atically leads to the rejection o f the other.In the remainder o f accepted
this section the discounted cash flow methods w ill be evaluated, assuming th a t investm ent projects are
m utually exclusive. Where management has to select from m utually exclusive projects it is necessary to
rank the projects in order o f acceptability. This means th a t i t is necessary to determ ine w hether it makes
any difference to project selection i f projects are ranked according to th e ir internal rates o f retu rn or th eir
net present values.
First, we consider in Example 5.4 whether the interna l rate o f retu rn or net present value methods
should be used to evaluate m utually exclusive investments.
E xample 5.4
Consider the mutually exclusive investments, A and B, in Table 5.4.
TABLE 5.4
Net cash flow 1 year after the year
Project 1 Cash outlay ($) of outlay ($) IRR (%) N P V @ 10%($)
A -1 +10 900 8.09
B -100000 +200000 100 81818.18
The internal rate o f retu rn m ethod ranks a 900 per cent retu rn on $1 ahead o f a 100 per cent return
on $100000. A t a required rate o f retu rn o f 10 per cent, both investments are w o rth undertaking, but
if a choice has to be made between the tw o investments, then investm ent B w ith the larger net present
value is to be preferred. This is because B adds more to the company s value than A. The net present value
method w ill ensure th a t the value o f the company is maximised, whereas the use o f the internal rate
o f return m ethod w ill n o t ensure th a t result. I t is apparent, therefore, th a t the internal rate o f return
and net present value methods can rank m utually exclusive investm ent projects differently. This is now
explained.
Ranking mutually exclusive investments

Although both projects in Example 5.4 had the same life, the in itia l cash outlays were different. However,
even if the in itia l cash outlays and the projects* lives had been the same, i t is s till possible th a t the internal
rate o f return and net present value methods would rank m utually exclusive investments differently. This
is illustrated by Example 5.5.
In Example 5.5, the difference in ranking is caused by differences in the magnitude o f the net cash
flows. In addition to differences in ranking caused by differences in the cash flow streams, the interna l
rate o f retu rn and net present value methods may give a different ranking where the investm ent projects
have unequal lives.
It may be concluded, therefore, that:
… any difference in the m agnitude or tim ing o f the cash flows m ay cause a difference in the ranking o f
investm ent projects using the internal rate o f return an d net presen t value methods.
Example 5.5
Two projects, C and D, have the same initial cash outlays and the same lives but different net cash
flows, as shown in Table 5.5.
What are the internal rates of return and net present values for projects C and D?
SOLUTION
Table 5.6 shows the internal rates of return and the net present values at a required rate of return of
10 per cent for projects C and D.
TABLE 5 .6
Project Internal rate of return (%) Net present value ($)
C 40 119008
D 50 105 785
Both projects have a positive net present value and an internal rate of return greater than the
required rate of return and are therefore acceptable in their own right. In other words, if the projects
are independent, both should be implemented. However, if the projects are mutually exclusive and
therefore must be ranked, the two methods give different rankings. In this case using the net present
value method, C is preferred to D, while using the internal rate of return method, D is preferred to C.
This is illustrated in Figure 5.4, which shows the net present value profiles fo r tw o projects, E and
F. Assume, as in Example 5.5, th a t the tw o projects have the same cash outlay and lives, and that the
pattern o f net cash flows results in the net present value profiles shown in Figure 5.4. In this case, the
net present value profiles o f the two projects intersect. A t a discount rate o f rv or at any other discount
rate less than r2, the net present value o f E is greater than the net present value o f F, w hile at a discount
rate o f r3, or at any other discount rate greater than r2, the net present value o f F is greater than the net
present value o f E.7
On the other hand, it has already been shown th a t the interna l rate o f retu rn is found where the net
present value is zero and, using this rule, Project F is ranked ahead o f Project E because its internal rate o f
return, r5, is greater than r4, which is the internal rate o f retu rn o f E.8 In this case, the tw o methods can
provide management w ith different rankings o f projects E and F.
7 For projects such as those in Table 5.5 with the same initial cash outlay, r2 is found by equating the present values of projects
E and F as follows:
Ce, c,：t
PVe = Y 7. (1 + r2) f
-E ；
,= 1 (1 + 厂2 )
In this instance, r2 = 18.89 per cent. This means that if the required rate of return is less than 18.89 per cent, the internal rate
of return and net present value methods result in conflicting rankings.
8 Remember that discounting of the net cash flows at the internal rate of return will result in a net present value of zero.
Therefore:
n
Q -C 〇
〇= E ( l + r)f
Figure 5.4 Net present value profiles for projects E and F
Like Example 5.5, Figure 5.4 shows th a t even where tw o m utually exclusive projects have the same
in itia l outlays and the same lives, a difference in the projects* rankings may s till occur as a result o f the
projects’ different tim e patterns o f net cash flows. Therefore, fo r m utually exclusive investm ent projects,
the net present value m ethod is superior to the internal rate o f retu rn method, because it always gives a
wealth-maximising decision.
Figure 5.5 Net present value profiles for projects G and
Even where the projects are m utually exclusive, the tw o methods could 5deld consistent rankings i f
the patterns o f the projects* net cash flows result in net present value profiles th a t do n o t intersect. This
is illustrated in Figure 5.5. In this case, the net present value o f Project G at a discount rate o f is greater
than the n et present value o f Project H. This is consistent w ith the internal rate o f retu rn m ethod as r3,
the interna l rate o f retu rn o f Project G, is greater than r2, the internal rate o f retu rn o f Project H.
However, because o f the possibility th a t the internal rate o f retu rn m ethod may give an incorrect
ranking o f m utually exclusive investm ent projects, the net present value m ethod is preferred.
The incremental internal rate of return approach to ranking

mutually exclusive investments
The internal rate o f return m ethod can be adapted so th a t i t provides a correct ranking o f m utually
exclusive projects. This is shown in Example 5.6.
Example 5.6
The cash flows for two projects, I and J, are shown in Table 5.7. Are projects I and J acceptable?
TABLE 5.7
"
Cash flows ($)
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
I -45 000 13 500 13500 13500 13500 13 500
J -30000 9150 9150 9150 9150 9150
SOLUTION
If the required rate of return is 8 per cent per annum, both projects are acceptable using either the net
present value or the internal rate of return method, as shown in Table 5.8.
TABLE 5.8
Project Internal rate of return (%) Net present value ($)
I 15.2 8902
J 15.9 6533
If the two projects are mutually exclusive, then, using the net present value method, Project I is
preferred to Project J, while using the internal rate of return method, Project J is preferred to Project I.
The incremental cash flows from choosing Project I (the project with the lower internal rate of return)
rather than Project J (the project with the higher internal rate of return) are presented in Table 5.9.
These cash flows may be assigned to the notional project 1 minus J’.
TABLE 5.9 Cash flows for notional project

Year 1 minus } ' ($)
0 -15000
1 4350
2 4350
3 4350
4 4350
5 4350
The internal rate of return of this notional project is 13.8 per cent. As this internal rate of return
is greater than the required rate of return of 8 per cent, the notional project should be accepted.
Accepting the notional project 7I minus J7 is equivalent to accepting Project I in preference to Project J.
This is the ranking given by the net present value method.
The possibility o f conflict between the interna l rate o f retu rn and net present value methods may
therefore be avoided by the use o f this ‘increm ental internal rate o f retu rn ’ approach. It results in a
ranking o f m utually exclusive projects th a t is consistent w ith the net present value method. However,
the net present value m ethod is simpler and is more obviously consistent w ith the objective o f wealth m
maximisation, which is expressed in absolute dollar term s rather than in percentage terms.
LEARNING
OBJECTIVE 4
Explain why the net
5 .4 .4 1 Benefit-cost ratio (profitability index) present value method
is preferred to all other
Research shows th a t some chief financial officers use the p ro fita b ility index m ethod o f project methods
evaluation. In this m ethod, instead o f showing the net present value as an absolute am ount, the
present value o f the n et cash flows is divided by the in itia l cash outlay to give a b e n e fit-c o st ra tio or BENEFIT-COST RATIO
p ro fita b ility index.A b e n e fit-co st ratio fo r the project in Table 5.2 is calculated as follows: index calculated by
dividing the present
present value o f net cash flows value of the future
Benefit-cost ratio = 5.7
initia l cash outlay net cash flows by the
initial cash outlay
_ $1 135154 (also known as a
$900 000 profitability index)
= 1 .2 6
Using the benefit-cost ratio, the decision rule is to accept projects w ith a benefit-cost ratio greater than
1, and to reject projects w ith a benefit-cost ratio less than 1. Clearly, projects w ith benefit-cost ratios
greater than 1 w ill have positive net present values, and those w ith benefit-cost ratios less than 1 w ill have
negative net present values. In the above example, the net present value is $235154 and the benefit-cost
ratio is 1.26. Both methods therefore indicate th a t the project is acceptable and, in general, b oth methods
LEARNING
w ill give the same accept/reject decision fo r independent projects. OBJECTIVE 2
However, the benefit-cost ratio provides no info rm a tio n additional to th a t already provided by the Outline the decision
NPV method. Thus, there is little p o in t in using this method. In addition, the benefit-cost ratio can result rules for each of the
in a ranking o f m utually exclusive projects th a t differs from the ranking th a t would result from using the main methods of
project evaluation
NPV method. This is shown in Example 5.7.
Example 5.7
Consider the mutually exclusive investments projects in Table 5.10.
TABLE 5.10 Ranking projects using the benefit-cost ratio

Project K Project L
Present value of net cash flows ($) 260000 100000
Initial cash outlay ($) 180000 50000
Net present value 80000 50000
Benefit-cost ratio = 260 000 100 000

180 000 50 000
1.44 2.00
In this case, although the net present value of Project L is less than the net present value of Project K,
the benefit-cost ratio of L is greater than that of K.
命
B usiness finance
Therefore, i f the b e n e fit-co st ra tio is used i t may result in management p re fe rrin g projects
w ith low er net present values. The b e n e fit-co st ra tio m ust therefore be rejected as a ranking
technique because i t can provide incorrect rankings o f m u tu a lly exclusive projects. Research
indicates th a t the p o p u la rity o f the p ro fita b ility index to managers relative to o the r p roject evaluation
techniques is low. Further, survey evidence9 suggests th a t the technique tends to be used by managers
who face a shortage o f funds available to invest in w ealth-enhancing projects. Faced w ith such
constraints, managers have to decide on the m ix o f acceptable projects th a t should be funded in order
to m axim ise the w ealth created fo r the firm . This process, know n as capital rationing, is discussed in
Section 6.8.
5.5 O ther methods of project evaluation

In Figure 5.1, there were two m ajor non-discounted cash flow methods employed by the companies
surveyed. They are the accounting rate o f retu rn and the payback methods. These methods are frequently
employed in conjunction w ith the discounted cash flow methods o f project evaluation.
The accounting rate of return

ACCOUNTING RATE OF There are many ways to calculate the accounting rate o f return or retu rn on investm ent. The most
RETURN popular methods are those th a t express a projects average annual earnings as a percentage o f either the
earnings from an in itia l investm ent or the average investm ent in the project. That is:
investment expressed
as a percentage of the average annual earnings 100
Va = ------------------------------------------------------------ X ------- %
investment outlay 5.8
■
initia l investment in a project 1
average annual earnings 100

ra = --------------------------------------------------- x ----- % 5.9
average investment in a project 1
PAYBACK PERIOD
the time it takes
for the progressive Payback period
accumulated net cash
flows generated by an The payback period is the tim e it takes fo r an e n tity to recover a projects in itia l cash outlay. For example,
investment to equal the the payback period o f a machine th a t costs $300000 and has net cash flows o f $100000 per annum
initial cash outlay is 3 years. Sections 5.5.1 and 5.5.2 show th a t the accounting rate o f retu rn and payback methods are
in fe rio r to the net present value method.
5.5.1 | Accounting rate of return

LEARNING Essentially, the accounting rate o f retu rn is the earnings from a project, usually after deducting both
OBJECTIVE 2 depreciation and income tax, expressed as a percentage o f the investm ent outlay. I t is compared w ith a
Outline the decision
required rate o f retu rn or cut-off rate to determine the project s acceptability. I f the accounting rate o f
rules for each of the
main methods of return is greater than the required rate o f return, the project is acceptable; i f i t is less than the required
project evaluation rate o f return, the project is unacceptable.
The accounting rate o f retu rn has many variants. We w ill calculate only three o f these. To calculate
these variants o f the accounting rate o f return, management m ust firs t estimate:
a the average annual earnings to be generated by a project. This is calculated by d ivid in g the to ta l
net p ro fit from the project by the num ber o f years d urin g w hich the p ro fit is expected to be
received.
b the investm ent outlay on the project. This is equal to either its in itia l investm ent outlay, including
additional and permanent w orking capital requirements, or the average capital employed in the
9 For surveys of capital budgeting practices, see Burns and Walker (2009).
project. The average capital employed on a project is calculated either as the average book value
o f the investment, or more frequently as the average o f the capital invested in the project at the
beginning and the end o f its life.
The methods o f calculating the accounting rate o f retu rn are illustrated in Example 5.8.
E xample 5.8
Assume that a company is considering an investment project that costs $ 1 0 0 0 0 0 0 0 and generates
6
returns in Years 1 ,2 and 3 as shown in Table 5.11.
TABLE 5.11 Data for calculating the accounting rate of return

Item___________ I Year 1_____ Year 2 Year 3 | Average
Earnings (after depreciation 2000000 3000000 4000000 3000000

and income tax) ($)
Book value ($)(a)
1 January 10000000 7000000 4900000
31 December 7000000 4900000 3430000
Average 8500000 5 950000 4165 000 6205 000
Âssuming that depreciation is calculated at 30 per cent on the reducing balance.
Using these data, the following accounting rates of return may be calculated:
a) Accounting rate of return based on the initial investment is:
$3000000 =3〇%
$10000000
b) Accounting rate of return based on the average book value is:
$3 000000 = 48%
$6205000
c) Accounting rate of return based on average investment as measured by the average of the capital
invested at the beginning and the end of the project's life is:
$3 000000
=44.68%
$ 10 000000+ $3 430000
Each variant yields a different rate of return. For example, if the rate of return is calculated by
dividing average annual earnings by the a verage investment outlay, then the project's rate of return
would be much higher than if it had been calculated by dividing average annual earnings by the
in itia l investment outlay.
There are two fundam ental problems w ith using the accounting rate o f return, irrespective o f the way LEARNING
it is defined. First, it is arbitrary. This is because i t is based on accounting earnings rather than cash flows. OBJECTIVE 3
Explain the
As a result, factors such as the depreciation m ethod employed and the m ethod o f valuing inventories
advantages and
w ill have a substantial bearing on the measurement o f earnings and therefore on the accounting rate o f disadvantages of
return. Second, i t ignores the tim in g o f the earnings stream. Equal weight is given to the earnings in each the main project
year o f the projects life. This problem is illustrated in Example 5.9. evaluation methods
E xample 5.9
A company is considering two projects, M and N. Both projects cost $ 1 000 00 at the beginning of
the first year and have a life of 5 years. The residual value of each project at the end of the fifth year
is zero. The earnings for each project are shown in Table 5.12.
TABLE 5.12
Annual earnings ($)
Project Outlay ($1 Year 1 Year 2 Year 3 Year 4 Year 5 Total
M 100000 2500 5000 10000 15000 17500 50000
N 100000 17500 15000 10000 5000 2500 50000
The average rate of return for each project is:

$50 00 0/5 $10000 100% 0^ 0/
$ 10 00 00 /2 $50000 1
Project M has increasing earnings while Project N has decreasing earnings. However, both result
in the same total earnings, and therefore the same average annual earnings. Consequently, both
projects are regarded as equally acceptable if the accounting rate of return method is used. However,
the two projects are not equally acceptable because the earnings from Project N are received earlier
than the earnings from Project M. Intuition would suggest, therefore, that Project N is preferable to
Project M.
The accounting rate o f retu rn fails to reflect the advantages th a t earlier returns have over later returns.
As a result, this m ethod ranks projects w ith the same in itia l outlay, life and to ta l earnings equally, even
though the projects1patterns o f earnings may be different. In addition, i f projects w ith the same in itia l
outlay and to ta l earnings have different lives, the accounting rate o f retu rn m ethod w ill automatically
favour projects w ith short lives. However, there is no reason w hy such projects should necessarily prove
to be the m ost profitable projects.
Because o f its significant shortcomings, the accounting rate o f retu rn m ethod should n o t be used to
evaluate investm ent projects. However, as we observed earlier, in practice the accounting rate o f return is
often used in conjunction w ith the discounted cash flow methods. Because external financial analysts use
earnings (profit) to assess a company s performance, management may wish to ensure th a t projects are
acceptable according to both accounting and discounted cash flow criteria.
5 .5 .2 1 Payback period
The payback period is the tim e it takes fo r the in itia l cash outlay on a project to be recovered from the
projects net cash flows. I t is calculated by summing the net cash flows from a project in successive years
u n til the to ta l is equal to the in itia l cash outlay. This is illustrated in Table 5.13.
TABLE 5.13 Calculation of payback period

Project Q Project R
Year Initial cash outlay ($) Net cash flow ($) Initial cash outlay ($) Net cash flow ($)
0 100000 100000
1 20000 20000
2 30000 40000
Table 5.1 3 continued
Project Q Project R
Year Initial cash outlay ($) Net cash flow ($) Initial cash outlay ($) Net cash flow ($)
3 30000 40000
4 20000 10000
5 70000 10000
Total 170000 120000
Payback 4 years 3 years

period
To decide whether a project is acceptable, its payback period is compared w ith some maximum
acceptable payback period. A project w ith a payback period less than the m axim um w ill be accepted, while
a project w ith a payback period greater than the m axim um w ill be rejected.
An im p o rta n t question is: W hat length o f tim e represents the correct, payback period as a standard
against which to measure the acceptability o f a particular project? In practice a m axim um payback period
LEARNING
is set, which is inevitably arbitrary, and may be from , say, 2 to 5 years. A ll projects w ith a payback period OBJECTIVE 2
greater than this m axim um are rejected. Outline the decision
Calculation o f the payback period takes in to account only the net cash flows up to the p o in t where they rules for each of the
equal the investm ent outlay. The calculation o f the payback period ignores any net cash flows after that main methods of
project evaluation
point. As a result, the payback m ethod o f evaluation discriminates against projects w ith long gestation
periods and large cash flows late in th e ir lives.
The payback period is n o t a measure o f a project s pro fitab ility. I f the m ost profitable projects were
always those th a t recovered the investm ent outlay in the shortest period o f tim e, then current assets
such as inventory and accounts receivable would yield higher returns than non-current assets, and non-
current assets w ith short lives would yield higher returns than non-current assets w ith long lives. Mere
recovery o f the outlay on a project yields no p ro fit at all. I f there is a p ro fit on the project i t m ust be due
to additional cash flows after the investm ent outlay has been recovered. Therefore, the m ajor weakness
o f the payback m ethod is its failure to take account o f the magnitude and tim in g o f all o f a projects cash
inflows and outflows.
Why then is payback popular as a m ethod o f investm ent evaluation? As was shown in Figure 5.1,
many companies around the w orld use payback in conjunction w ith other methods. One reason fo r its
popularity is th a t i t provides in fo rm a tio n on how long funds are likely to be com m itted to a project.
Managers who prefer projects w ith short payback periods are interested in how soon the funds invested in
a project w ill be recouped and hence this m ethod provides managers w ith inform a tion th a t w ill facilitate
th eir preparation o f cash flow budgets, thereby enabling them to better manage the liq u id ity o f the firm .
Another reason is th a t the near-term cash flows considered in calculating the payback period are regarded
as more certain than later cash flows. As a result, insistence on a short payback period is a simple b u t
imprecise way o f controlling fo r risk.
5 .5 .3 1 Economic value added (EVA)

In Section 5.5.1, i t was noted th a t the accounting rate o f retu rn m ethod is often used in addition to
the discounted cash flow methods because financial analysts generally use accounting inform a tion to
assess performance year by year. To overcome the problems o f measuring the accounting rate o f return
m
LEARNING
OBJECTIVE 5
discussed in Section 5.5.1, the economic value added (EVA) approach to measuring performance was Understand the
introduced by consulting firm s in the US.10 relationship between
economic value added
(EVA) and net present
10 Economic value added (EVA) is the term used by the US consulting firm Stern-Stewart. This firm has been instrumental in value (NPV)
popularising this measure of performance.
B usiness finance
Accounting p ro fit is calculated as the difference between revenues and expenses fo r a reporting
period. One o f the costs incurred by a company th a t is n o t deducted in calculating p ro fit is the company s
required rate o f return. To calculate the EVA o f an investm ent, i t is sim ply a m atter o f deducting from
accounting earnings the p ro fit required from the investm ent, calculated as the required rate o f return
m ultiplie d by the capital invested in the project. Thus, using Example 5.9, i f the required rate o f return is
10 per cent, then the returns generated in Years 1, 2 and 3 would be as shown in Table 5.14.
TABLE 5.14
Year 1 Year 2 Year 3
Earnings (after depreciation and income tax) ($) 2000 3000 4000
Capital charge:
Am ount invested x 10% ($) 1000(fl) 700 490
Economic value added (EVA) $1000 $2300 $3510
In Year 1, the amount invested in the project is $10000, therefore the capital charge is $10000 x 10% = $1000.
The EVA in Table 5.14 shows the addition to the company s wealth created by the investment. If
the accounting rate o f retu rn were equal to the required rate o f return, then EVA would be zero. EVA,
therefore, provides management w ith a simple rule: invest only i f the increase in earnings is sufficient to
cover the required rate o f return.
EVA makes the required rate o f retu rn an im p o rta n t element in measuring the performance o f an
investm ent. The manager o f a plant can improve EVA either by increasing earnings or by reducing the
capital employed. Therefore, there is an incentive fo r managers to id e n tify underperform ing assets and
dispose o f them.
Note th a t this approach to measuring EVA does n ot measure present value. However, it can be shown
th a t the present value o f a stream o f future EVAs fo r an investm ent is equal to the net present value of
the investm ent. The EVA in each period is equal to the net cash flow plus or m inus the change in the value
o f the investm ent less the required rate o f return. Thus:
E V A ^ C ^ il-I^ -k l^ 5.10
where Ct = net cash flow in Year t
I t = value o f the investm ent at the end o f Year t
= value o f the investm ent at the end o f Yeart
k = required rate o f return
However, there are tw o special cases:
a In Year 0, EVA0 = C〇+ J〇because there is no capital charge u n til Year 1.

b A t the end o f the project, the investm ent in the project (Jt) is zero because the investm ent is
liquidated and therefore EVAt = Ct - (1 + k) 1 ^ .
Therefore, the present value o f a stream o f EVAs is:

EVAi EVA2 EVAT. y EVAt
EVA〇
1+ k (1 + k ) 2 { l + k )T~l ( l + k )T BB1
where EVA0 = C〇+ J〇
EVA1 = C1 + I 1 - ( l + k) I 0
EVA2 = C2 + 12 - (1 + /c)
£ \^ 4 了_1 = C t_i + 1"了_1 (1 + /c) 1了_2
EVAj = CT - (1 + /c) I T-1
W hen these values are substituted in to Equation 5.11, we fin d th a t all the I terms cancel out, leaving:
C〇 ^ - g j - + — ^ + .,,+ £ r-i _C t
1 + fc (1 + k f (l + k f - 1 (1 + k ) T
= NPV
That is, the discounted stream o f EVAs is the same as the NPV o f the investment.
5.6 Project evaluation and real options

analysis
LEARNING
OBJECTIVE 6
A key message o f this chapter has been th a t discounted cash flow techniques, such as NPV and IRR,
Understand the
provide the m ost accurate, and m ost popular, approach to project evaluation. However, we know th a t relationship between
these techniques are answering a very specific question about the lin k between a project and wealth real options,
creation th a t may n o t be the question we should be m ost interested in. For example, NPV analysis managerial flexibility
provides us w ith an estimate o f the wealth created fo r the firm now zfthe firm were to imm ediately invest and firm value
in the project. That is, the approach treats projects as now-or-never prospects— whereas we know th a t in
reality managers often have significant fle xib ility in how they manage a project (including when to begin
it). In addition, NPV is lim ite d to a yes-or-no analysis; fo r example, i t im p lic itly gives no recognition to
the fact that, after a project has begun, managers may intervene in the project as circumstances develop.
Obviously, this significantly understates the role o f managers.
These lim ita tion s o f NPV analysis can, in principle, be dealt w ith using an approach known as
real options analysis. The follow ing section explains how real options analysis differs from standard REAL OPTIONS
discounted cash flow techniques and describes some o f the evidence th a t suggests that, despite its ANALYSIS
method of evaluating
apparent usefulness, it is used by relatively few financial managers.11
an investment
opportunity that
accounts for the
5 .6 .1 1 Real options analysis value associated with
managers having
Consider the follow ing scenario: substantial o il reserves have just been discovered in Sydney Harbour flexibility in their
and the government has called fo r bids fo r the rig h t to extract the oil. Comprehensive geological reports decisions about when
estimate th a t there are 40 m illio n barrels o f o il th a t could be extracted. Owing to the unique environm ent to invest, how to
manage the investment
in which the o il is located, and the need to ensure that any disturbance to the environm ent fro m the
and when to divest
invasive extraction process is remedied, the present value o f the expected cost o f extraction is relatively themselves of the
high, at $80 per barrel. The long-run expected sales price o f the o il is estimated to be $70 per barrel in investment asset
present value terms. How much would an investor bid fo r the rig h t to extract oil? Standard NPV analysis
would suggest that no rational investor would bid a positive amount fo r the extraction rig h t as the project
has a negative NPV w ith each barrel o f o il extracted decreasing wealth by $10.
W hat is wrong w ith this analysis? I t ignores the fact th a t the successful bidder fo r the project obtains
the right, b u t n o t the obligation, to commence operations. That is, the successful bidder has the option to
extract the oil. Based upon current expectations o f available technology, cost structures and revenues i t is
at present unprofitable to extract the o il and the option would n o t be imm ediately taken up. However, it
is n ot d ifficu lt to th in k o f circumstances th a t may result in the project having a positive NPV. For example,
new technology may be developed to substantially reduce the cost o f extraction or the long-run expected
sales price o f o il m ig ht increase. Either way, the successful bidder has purchased the rig h t to exploit any
advantageous change in circumstances.
Throughout this chapter it has been im p lic itly assumed th a t the problem facing management is
lim ited to accepting or rejecting a project fo r immediate im plem entation. In reality o f course, th is is
rarely the case. Managers can often choose when to im plem ent a project and can influence the way an
ongoing project is managed. These choices* faced by management are often referred to as real option s REAL OPTIONS
and problems may arise when the value o f options created (or destroyed) by management decisions is not the flexibility that
a manager has in
accounted fo r during the project evaluation stage.
choosing whether to
Some common examples o f real options include: undertake or abandon
a project or change
• O ption to delay investm ent— this option is linked to the a b ility o f the firm to ‘w ait and see’ and
the way a project is
collect more inform a tion about the project th a t may alter the final decision. This option is especially managed
valuable to a firm where the level o f uncertainty surrounding a project is high. W hen a firm finally
commits to a project, it is giving up the o pp o rtu n ity to collect more info rm a tio n about the project,
and hence, it is often argued, the NPV o f a project m ust n o t only be positive, b ut be great enough to
compensate the firm fo r the value o f the fle xib ility i t is giving up.
11 For an excellent and accessible discussion of the importance of incorporating real options into project evaluation see Dixit
and Pindyck (1995).
B usiness finance
• O ption to expand operations— when a firm firs t enters a m arket i t quite often does so on
unprofitable terms. That is, firm s w ill quite w illin g ly enter in to a project th a t has a negative NPV.
One explanation fo r this seemingly irra tion al behaviour is th a t by gaining a presence in the market,
the firm is able to acquire valuable expansion options th a t would otherwise be unavailable. An
example o f this type o f behaviour was the intro du ction o f V irg in Blue Airlines to the Australian
m arket. In itia lly the airline provided only seven daily Brisbane-Sydney return flights. However,
follow ing the collapse o f Ansett Airlines (the second largest domestic carrier in Australia at the
tim e), V irg in Blue found itse lf in a position where it could rapidly expand to fill the void le ft by
Ansett.
• O ption to abandon operations— once a firm makes the decision to proceed w ith a project, it
generally retains the rig h t to abandon operations and sell o ff the assets dedicated to the project at
th e ir salvage value. A t the outset, o f course, the firm does n o t expect to make use o f (or exercise)
this option, b u t i t is im p orta nt th a t it has the a bility to do so i f m arket conditions were to move
significantly against the project. This does not, however, im p ly th a t the firm w ill abandon operations
as soon as a project becomes unprofitable, since by doing so the firm gives up the a bility to remain in
the m arket were conditions to change back in the project’s favour.
• Once we accept the notion th a t managerial fle x ib ility is valuable, ide ntifyin g real options is relatively
straightforw ard. The d ifficult p art is to tr y to then value them. A discussion o f the general principles
underlying option pricing, as well as a more detailed discussion o f real options analysis, is provided
in Chapter 18.
W hile finance academics have been very enthusiastic about the possible im plications o f real options
analysis fo r financial managers, the international evidence in Figure 5.1 suggests th a t the actual usage of
the technique has been relatively low over an extended tim e interval beginning at the tu rn o f the century.
So who is using real options analysis and why are they doing so? In a survey o f the capital budgeting
practices o f Fortune 1000 companies in the US, Block (2007) reports th a t users o f the technique tended
to be concentrated in industries such as technology, energy and u tilitie s, where sophisticated analysis*
was a standard part o f running the business. In a sim ilar survey o f Canadian firm s, Baker, D utta and
Saadi (2011) report th a t the most popular reasons cited fo r using real options analysis were that the
approach assists management in form ing th e ir strategic vision, fo r the firm while allowing fo r the impact
o f managerial fle x ib ility in the analysis. Also o f interest are the factors th a t impede the im plem entation o f
real options analysis. Block (2007) finds th a t the m ost frequently cited reason fo r avoiding the technique
is *[a] lack o f top management support*. Baker, D utta and Saadi (2011) provide a helpful glimpse at the
reason behind th a t lack o f support: th e ir respondent sample nominates a 'lack o f expertise or knowledge*
as the m ost significant reason fo r not using the approach.
C H A P T E R FIVE R E V I E W
SUMMARY
Of the two discounted cash flow methods of investment • If the projects are independent, accept a project
evaluation, we recommend the net present value if its net present value is greater than zero, and
method because it is consistent with the objective of reject it if its net present value is less than zero.
maximising shareholders' wealth. It is also simple to • If the projects are mutually exclusive, accept
use and gives rise to fewer problems than the internal the project with the highest net present value,
rate of return method. W e have shown that where provided that it is greater than zero.
mutually exclusive projects are being considered, the • In practice, companies often use one method of
internal rate of return method may result in rankings project evaluation in conjunction with other methods.
that conflict with those provided by the net present For example, one of the discounted cash flow methods
value method. In addition, we have shown that even may be used to measure a project's profitability, but
if investment projects are independent, it is possible the payback period may also be used, either as a
that a project's pattern of cash flows may give rise to check on liquidity effects or as a means of monitoring
multiple internal rates of return, or to no internal rate the project's cash flows against expectations.
of return at all. • Whereas the evaluation methods considered
If the net present value method is adopted, the throughout the chapter tend to treat projects as
rules for making correct investment decisions are 'now-or-never7 prospects, and ignore the ability of
straightforward: management to intervene in an ongoing project,
• Calculate each project's net present value, using real options analysis considers the value associated
the required rate of return as the discount rate. with managerial flexibility.
KEY TERMS
accounting rate of return 1 18 mutually exclusive projects 113
benefit-cost ratio 117 net present value (NPV) 107
discounted cash flow (DCF) methods 107 payback period 118
independent project 107 real options 123
internal rate of return (IRR) 107 real options analysis 123
SELF-TEST PROBLEMS
The management of a company is considering an investment of $1 8 0 0 0 0 in a project that will generate
net cash flows of $101 80 0 at the end of the first year, $ 9 0 0 0 0 at the end of the second year and
$ 8 0 0 0 0 at the end of the third year. Assuming a required rate of return of 10 per cent per annum,
calculate the project's net present value.
Calculate the internal rate of return for the investment in Question 1.
Calculate the benefit-cost ratio for the investment in Question 1.
QUESTIONS
1 [LO 1 ] Outline the four steps in the capital-expenditure process.
2 [LO 2 】What factors does the required rate of return of a project reflect?
3 [LO 2] Compare the internal rate of return and net present value methods of project evaluation. Do these
methods always lead to comparable recommendations? If not, why not?
4 [LO 2] Distinguish between independent and mutually exclusive investment projects.
5 [LO 3] Evidence suggests that financial managers use more than one method to evaluate investment projects.
Comment on this statement.
B usiness finance
6 [ L 0 3 ] The internal rate o f return m ethod o f p ro je c t evaluation is easier to use because it avoids the need to
calculate a re q u ire d rate o f return. C o m m e n t o n th is s ta te m e n t.
7 [L O 3 ] W h a t p ro b le m s a r e a s s o c ia te d w ith th e use o f th e a c c o u n tin g r a te o f re tu rn m e th o d f o r th e
e v a lu a tio n o f in v e s tm e n t p ro p o s a ls ? W h y m ig h t m a n a g e rs b e a ttr a c te d to its use?
8 [L O 4 ] Even w here projects are independent, the uncritical use o f the internal rate o f return m ethod can
seriously m islead management. D iscuss.
9 [L O 4 】D e m o n s tra te , fo r in d e p e n d e n t in v e s tm e n t p ro je c ts , th a t th e in te rn a l ra te o f re tu rn a n d n e t p re s e n t
v a lu e m e th o d s o f e v a lu a tio n y ie ld id e n tic a l d e c is io n s . S p e c ify a n y a s s u m p tio n s y o u m a k e .
10 [LO 4 ] U s in g th e N P V p r o file te c h n iq u e , e x p la in w h y th e IRR a n d N P V ru le s w ill a lw a y s re s u lt in th e s a m e

a c c e p t o r r e je c t d e c is io n f o r in d e p e n d e n t p ro je c ts .
11 [LO 4 The p a y b a c k p e rio d m ethod o f p ro je c t evaluation is b ia se d a g a in st projects w ith lo n g e r

developm ental lives, even w here they ultim ately generate g re a t value fo r the firm. Discuss.
12 [L 0 5 ] A s th e p re s e n t v a lu e o f a stre a m o f EVAs f o r a n in v e s tm e n t is th e s a m e a s its n e t p re s e n t v a lu e , w h y
d o a n a ly s ts use EVA?
13 [L O 6 ] T h e re is s o m e e v id e n c e th a t w h e n m a n a g e rs e v a lu a te p ro je c ts , th e y s y s te m a tic a lly e m p lo y d is c o u n t
ra te s th a t e x c e e d th e ris k -a d ju s te d r e q u ire d ra te o f re tu rn . H o w is th is o b s e r v a tio n c o n s is te n t w ith th e n o tio n
th a t re a l o p tio n s a r e im p o r ta n t in p r o je c t e v a lu a tio n ?
14 [L O 6 ] Real options analysis prom ises to be a ve ry p o w e rfu l to o l fo r fin a n c ia l m anagers. D e s c rib e th e

e v id e n c e c o n c e r n in g th e p o p u la r ity o f th e a p p r o a c h — re la tiv e to d is c o u n te d c a s h f lo w t e c h n iq u e s — a n d
s u g g e s t p o s s ib le re a s o n s f o r th e se resu lts.
cA
1
PROBLEMS
Discount rates, IRR and N P V analysis [LO 2]
A s s u m e th a t y o u a re a s k e d to a n a ly s e th e fo llo w in g th re e p ro je c ts :
A -2 0 0 0 0 0 20000 20000 20000 20000 220000
B -2 0 0 0 0 0 52760 52760 52760 52 760 52760
C -2 0 0 0 0 0 一一一一 322100
C o n s tru c t a s p re a d s h e e t, a n d a s s o c ia te d g ra p h s , th a t w ill e n a b le y o u to a n a ly s e th e im p a c t o f d iffe re n t d is c o u n t

ra te s o n th e N P V o f a p r o je c t as w e ll a s c a lc u la te th e IRR fo r a p r o je c t (a n e x a m p le is p r o v id e d in F ig u re 5 .2 ).
a) R a nk th e th re e p ro je c ts a s s u m in g th e a p p r o p r ia te d is c o u n t ra te is:
i) 6 p e r c e n t p e r a n n u m
ii) 10 per cent per annum
iii) 15 p e r ce n t p e r a n nu m .
b) C a lc u la te th e IRR fo r e a c h o f th e p ro je c ts , th e n ra n k th e m .
2 IRR and N P V analysis for independent projects [LO 2]

T he fo llo w in g in v e s tm e n t p ro p o s a ls a re in d e p e n d e n t. A s s u m in g a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t, a n d
u s in g b o th th e in te rn a l ra te o f re tu rn a n d n e t p re s e n t v a lu e m e th o d s , w h ic h o f th e p ro p o s a ls a r e a c c e p ta b le ?
C a s h f lo w ($ )
P ro p o s a l Year 0 Year 1 Year 2
A -4 0 0 0 0 8000 48000
B -4 0 0 0 0 42000
C -4 0 0 0 0 48000
126
C H A P T E R FIVE R E V I E W
A c c o u n tin g ra te o f r e tu r n , p a y b a c k p e r io d , IRR a n d N P V [L O 2 ]
U s in g th e fo llo w in g d a ta , c a lc u la te th e :
a) a c c o u n tin g ra te o f re tu rn
b) p a y b a c k p e rio d
c) in te rn a l ra te o f re tu rn
d) n e t p re s e n t v a lu e .
P ro je c t co st: $100000
E stim a te d life : 5 y e a rs
E s tim a te d re s id u a l v a lu e : $20000
A n n u a l n e t c a sh f lo w : $30000
R e q u ire d ra te o f re tu rn : 10%
U se th e s tra ig h t-lin e m e th o d o f d e p r e c ia tio n in y o u r c a lc u la tio n s .
H o w w o u ld y o u r a n s w e rs d iff e r if th e n e t c a s h flo w s w e r e a s fo llo w s ?
Y e a r 1: $30000
Year 2: $40000
Year 3: $60000
Year 4 : $20000
Year 5: $50000
A c c o u n tin g r a te o f re tu r n a n d p a y b a c k p e r io d [L O 3 ]
U s in g th e f o llo w in g d a ta , c a lc u la te :
a) th e a c c o u n tin g ra te o f re tu rn
b) th e p a y b a c k p e r io d .
P ro je c t co st: $40000
E stim a te d p r o je c t life : 5 y e a rs
E stim a te d re s id u a l v a lu e : $8000
A n n u a l a c c o u n tin g p r o fit
(e q u a l to a n n u a l n e t c a s h in flo w ): $ 12000
Use th e s tra ig h t-lin e m e th o d o f d e p r e c ia tio n in y o u r c a lc u la tio n s .
H o w w o u ld y o u r a n s w e rs to (a) a n d (b) d iffe r if th e e s tim a te d d o lla r re tu rn s w e r e a s fo llo w s ?
Year 1 $12000
Year 2 $16000
Year 3 $24000
Year 4 $20000
Year 5 $8000
IRR a n d N P V a n a ly s is [L O 4 ]
E ach o f th e fo llo w in g m u tu a lly e x c lu s iv e in v e s tm e n t p ro je c ts in v o lv e s a n in itia l c a sh o u tla y o f $ 2 4 0 0 0 0 . T he
e s tim a te d n e t c a s h flo w s fo r th e p ro je c ts a re a s fo llo w s :
C a s h f lo w ($)
P ro je ct
1 140000 20000
2 80000 40000
3 60000 60000
4 20000 100000
5 20000 180000
127
B usiness finance
T he c o m p a n y 's re q u ire d ra te o f re tu rn is 1 1 p e r ce n t.
C o n s tru c t a s p re a d s h e e t, a n d a s s o c ia te d g ra p h s , th a t w ill e n a b le y o u to a n a ly s e th e im p a c t o f d iffe re n t

d is c o u n t rates o n th e N P V o f a p r o je c t as w e ll as c a lc u la te th e IRR fo r a p ro je c t. W h a t is th e N P V a n d IRR fo r
b o th p ro je c ts ? W h ic h p r o je c t s h o u ld b e c h o s e n ? W h y ?
6 N P V and IRR analysis for mutually exclusive projects [LO 4 】

A c o m p a n y w is h e s to e v a lu a te th e fo llo w in g m u tu a lly e x c lu s iv e in v e s tm e n t p ro p o s a ls :
P ro p o s a l
A -97400 34000 34000 34000 34000 34000
B -63200 24000 24000 24000 24000 24000
a) C a lc u la te e a c h p r o p o s a l’s n e t p re s e n t v a lu e a n d in te rn a l ra te o f re tu rn . A s s u m e th e re q u ire d ra te o f re tu rn is
8 p e r ce n t.
b) H o w w o u ld y o u e x p la in th e d iffe re n t ra n k in g s g iv e n b y th e n e t p re s e n t v a lu e a n d in te rn a l ra te o f re tu rn
m e th o d s?
7 N P V a n d IRR a n a ly s is [L O 4 】
You h a v e b e e n a s k e d to e v a lu a te th e f o llo w in g in v e s tm e n t p ro p o s a ls :
C a s h f lo w ($ )
P ro p o s a l Year 0 Year 1 Year 2
A 100000 -140000 60000
B -12000 24000 -20000
C a lc u la te th e n e t p re s e n t v a lu e (a s s u m in g a re q u ire d ra te o f re tu rn o f 1 2 p e r cen t) a n d th e in te rn a l ra te o f
re tu rn fo r e a c h p ro je c t. E x p la in y o u r results.
REFERENCES
Baker, H., Dutta, S. & Saadi, S., 'M anagem ent views on real Dixit, A.K. & Pindyck, R.S., 'The options approach to capital
options in capital budgeting', Journal of A pplied Finance, investment7, Harvard Business Review, M ay-June 1995,
February 2 0 1 1 , pp. 1 8 -2 9 . pp. 1 0 5 -1 5 .
Bierman, H. Jr & Smidt, S., The Capital Budgeting Decision: Graham, J.R. & Harvey, C.R., 'The theory and practice of
Economic Analysis of Investment Projects, 8th edn, M acmillan corporate finance: evidence from the field', Journal of
Company, N ew York, 1993. Financial Economics, May-June 2 0 0 1 , pp. 1 8 7 -2 4 3 .
Block, S., 'Are "real options” actually used in the real world?' W alker, E.D., Introducing project management concepts
The Engineering Economist, 2 0 0 7 , pp. 2 5 5 -6 7 . using a jewelry store robbery7, Decision Sciences Journal of
Burns, R.M. & W a lk e r,」•，'C apital budgeting surveys: The Innovative Education, Spring 2 0 0 4 , pp. 6 5 -9 .
future is now ', jo u m a / o f >App//ec/ 尸 /nance, 2 0 0 9 , pp. 7 8 -9 0
Coleman, L , Maheswaran, K. & Pinder, S., 'N arratives in
managers7 corporate finance decisions', Accounting and
Finance, September 2 0 1 0 ; pp. 6 0 5 -3 3 .
128
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CHAPTER CONTENTS
m I n t r o d u c tio n 130 A n a ly s in g p r o je c t ris k 149
A p p lic a t io n o f th e n e t p r e s e n t v a lu e m e th o d 130 D e c is io n - tr e e a n a ly s is 153
T a x is s u e s in p r o je c t e v a lu a t io n 134 QQj Q u a lit a t iv e f a c t o r s a n d th e s e le c tio n

o f p r o je c ts 156
H H C o m p a r in g m u tu a lly e x c lu s iv e p r o je c ts t h a t
h a v e d if f e r e n t liv e s 139 H H P r o je c t s e le c tio n w it h r e s o u r c e c o n s tr a in ts 157
D e c id in g w h e n to r e t ir e ( a b a n d o n ) o r
r e p la c e a p r o je c t 146
LEARNING OBJECTIVES
A f te r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to :
1 e x p la in th e p r in c ip le s u s e d in e s t im a tin g p r o je c t c a s h f lo w s
2 e x p la in th e e ffe c ts o f t a x e s o n p r o je c t c a s h flo w s
3 c o m p a r e m u t u a lly e x c lu s iv e p r o je c ts t h a t h a v e d if f e r e n t liv e s
4 d e t e r m in e w h e n to r e t ir e ( a b a n d o n ) o r r e p la c e a s s e ts
5 e x p la in h o w s e n s itiv ity a n a ly s is , b r e a k - e v e n a n a ly s is a n d s im u la t io n a s s is t in a n a ly s in g p r o je c t r is k
6 u s e d e c is io n - tr e e a n a ly s is to a n a ly s e s e q u e n tia l d e c is io n s
7 e x p la in th e r o le o f q u a lit a t iv e f a c t o r s in p r o je c t s e le c tio n
8 e x p la in th e e ffe c ts o f r e s o u r c e c o n s t r a in ts o n p r o je c t s e le c tio n .
B usiness finance
Introduction
In C h a p te r 5, m e th o d s o f p ro je c t e v a lu a tio n w e re discussed a n d th e reasons f o r u s in g th e n e t p re s e n t
va lu e m e th o d o f p ro je c t e v a lu a tio n w e re o u tlin e d . H o w e ve r, in C h a p te r 5 i t was a ssu m ed t h a t a p ro je c ts
cash flo w s a n d th e d is c o u n t ra te a p p lic a b le to th o s e cash flo w s w e re b o th k n o w n . In p ra c tic e , a p ro je c t s
cash flo w s a n d re q u ire d ra te o f r e tu r n are n o t k n o w n w it h c e rta in ty b u t m u s t be e s tim a te d . In o th e r
w o rd s, p ra c tic a l p ro je c t e v a lu a tio n in v o lv e s im p o r t a n t issues c o n c e rn in g th e e s tim a tio n o f cash flo w s an d
ris k . These a n d o th e r issues are th e s u b je c t o f th is c h a p te r. In p a rtic u la r, th e m a tte rs c o n s id e re d in th is
c h a p te r in c lu d e :
• th e a p p lic a tio n o f th e n e t p re s e n t v a lu e m e th o d , in c lu d in g th e e s tim a tio n o f cash flo w s
• u s in g th e n e t p re s e n t v a lu e m e th o d to solve p ro b le m s , such as c o m p a rin g p ro je c ts w it h d iffe re n t
liv e s a n d a sse t-re p la ce m e n t de cisio ns
• th e a p p lic a tio n o f te c h n iq u e s t h a t a llo w m an ag ers to analyse th e r is k o f p ro je c ts
• th e in flu e n c e o f q u a lita tiv e fa c to rs o n th e s e le c tio n o f in v e s tm e n t p ro je c ts
• th e p ro b le m s associated w it h u s in g th e n e t p re s e n t v a lu e m e th o d w h e re co m p a n ie s are assu m ed to
have o n ly lim ite d access to reso urce s.1
6.2 A pp lica tio n of the net present value

method
LEARNING
OBJECTIVE 1
A n y a p p lic a tio n o f th e n e t p re s e n t va lu e m e th o d re q u ire s e s tim a te s o f p ro je c t cash flo w s . This s e c tio n
Explain the principles
used in estimating discusses issues t h a t are im p o r t a n t in d e fin in g th e re le v a n t cash flo w s.
project cash flows
6.2.1 | Estimation of cash flows in project evaluation

Issues t h a t a rise in d e fin in g th e re le v a n t cash flo w s in c lu d e th e :
• tre a tm e n t o f fin a n c in g charges

• in c lu s io n o f in c re m e n ta l cash flo w s
• im p o rta n c e o f e x c lu d in g s u n k costs
• tre a tm e n t o f a llo c a te d costs
• tre a tm e n t o f a p ro je c ts re s id u a l value
• t im in g o f th e cash flo w s
• tr e a tm e n t o f in fla tio n .
These issues are discussed in tu r n .
Financing charges
C o m pa nie s s h o u ld use th e re q u ire d ra te o f r e tu r n to d is c o u n t a p ro je c ts n e t cash flo w s . The re q u ire d rate
o f r e tu r n is th e r e tu r n t h a t is s u ffic ie n t to co m p e n sa te s h a re h o ld e rs a n d d e b th o ld e rs f o r th e resources
c o m m itte d to th e p ro je c t. I t in clu d e s b o th in te re s t p a id to d e b th o ld e rs a n d re tu rn s to sha reh old ers.
T h ere fore, fin a n c in g charges such as in te re s t a n d d iv id e n d s s h o u ld n o t be in c lu d e d in th e c a lc u la tio n o f a
p ro je c ts n e t cash flo w s . The in c lu s io n o f fin a n c in g charges in a p ro je c t s n e t cash flo w s a n d in th e d is c o u n t
ra te w o u ld re s u lt in d o u b le c o u n tin g .
Incremental cash flows

In c a lc u la tin g a p ro je c t s n e t cash flo w s , i t is th e in c re m e n ta l n e t cash flo w s t h a t are im p o r ta n t. A n a n a ly s t
s h o u ld in c lu d e all cash flo w s t h a t change i f th e p ro je c t is u n d e rta k e n . W h e n d e c id in g w h e th e r a p a rtic u la r
ite m s h o u ld be in c lu d e d , th e a n a ly s t is in te re s te d in th e an sw e rs to tw o q u e s tio n s :
1 The effects of taxes on discount rates are discussed in Chapter 14.

C hapter six T he application of project evaluation methods
a Is i t a cash ite m ?
b W ill th e a m o u n t o f th e ite m change i f th e p ro je c t is u n d e rta k e n ?
I f th e an sw e r to b o th q u e s tio n s is ‘yes’，th e n th e ite m is an in c re m e n ta l cash flo w . I f th e a n sw e r to

e ith e r q u e s tio n is ‘n o ’，th e n th e ite m is irre le v a n t to th e an alysis. F o r e xa m p le , assum e t h a t a c o m p a n y
is re c e iv in g $ 4 0 0 0 0 p e r yea r fr o m r e n tin g a p o r tio n o f its fa c to ry , a n d t h a t i t is c o n s id e rin g u s in g th a t
space to m a n u fa c tu re a p ro d u c t t h a t w i ll r e tu r n n e t cash flo w s o f $ 1 0 0 0 0 0 p e r year. In t h is case, $ 1 0 0 000
o ve rsta tes th e n e t cash flo w s f r o m th e p ro d u c t b y an a m o u n t o f $ 4 0 0 0 0 ; th e cash in flo w fo rg o n e because
a p o r tio n o f th e fa c to ry w ill n o t be re n te d . The in c re m e n ta l n e t cash flo w in th is case is $ 6 0 0 0 0 p e r
year. The p rin c ip le o f in c lu d in g o n ly in c re m e n ta l cash flo w s m a y seem sim p le , b u t i t s o m e tim e s in v o lv e s
d iffic u ltie s such as id e n tify in g s u n k costs a n d a llo c a te d costs.
Sunk costs
Suppose t h a t th e S p ilt O il C o m p a n y has s p e n t $ 2 0 m illio n e x p lo rin g a p a r tic u la r area w ith o u t success.
H a rv e y M ills , th e g e o lo g is t w h o o r ig in a lly id e n tifie d th a t area as p o te n tia lly va lu a b le , argues t h a t th e
co m p a n y s h o u ld spe nd a n o th e r $5 m illio n to d r ill an a d d itio n a l w e ll because: ‘I f w e d o n ’t, th e $ 2 0 m illio n
th a t we have a lre a d y s p e n t w i ll be lost*. M r M ills s a rg u m e n t is in c o rre c t because th e $ 2 0 m illio n is a sunk SUNK COST
cost. S u n k costs are p a s t o u tla y s a n d s h o u ld be ig n o re d in m a k in g de cisio n s a b o u t w h e th e r to c o n tin u e a cost that has already
been incurred and
p ro je c t o r to te rm in a te it . In t h is case, th e $ 2 0 m illio n has a lre a d y b e en s p e n t. T his fig u re w i ll n o t change
is irrelevant to future
i f th e p ro je c t is c o n tin u e d o r a b a n d o n e d . A llo w in g s u n k costs to in flu e n c e d e cisio n s can lead to t h r o w in g
decision making
good m o n e y a fte r b a d 1. R egardless o f w h e th e r $2 o r $2 0 m illio n has a lre a d y be en s p e n t, d e cisio n s o n
w h e th e r to c o n tin u e a p ro je c t s h o u ld be based o n ly o n e xp ected future costs a n d b e n e fits .
Allocated costs
C om panies o fte n a llo ca te costs such as re n t, p o w e r, w a te r, research a n d d e v e lo p m e n t, he ad o ffic e costs,
tra v e l an d o th e r ove rh e a d costs to t h e ir d iv is io n s . T h ere fore, w h e n th e p r o fita b ilit y o f a p ro je c t is
e stim a te d , th e costs a ttr ib u te d to th e p ro je c t m a y in c lu d e a share o f th e se a llo c a te d costs. The a n a ly s t
s h o u ld re m e m b e r t h a t w h e n a p ro je c t is b e in g eva lu ated , o n ly in c re m e n ta l cash flo w s s h o u ld be in c lu d e d .
In som e cases, im p le m e n tin g an a d d itio n a l p ro je c t m a y re s u lt in s ig n ific a n tly h ig h e r o v e rh e a d costs, b u t
in o th e r cases a n y increase m a y be n e g lig ib le . W h e n e s tim a tin g p ro je c t cash flo w s , a n y a llo c a te d costs
s h o u ld be e x a m in e d c a re fu lly to d e te rm in e w h e th e r th e y w o u ld change i f th e p ro je c t w e re to go ahead. I f
th e y w o u ld n o t change th e y s h o u ld be exclud ed.
Residual value
W h e n a p ro je c t is te rm in a te d , i t is lik e ly t h a t a p o r tio n o f th e in it ia l c a p ita l o u tla y w ill be recovered. This
is o fte n te rm e d th e p ro je c ts residual value. A p ro je c ts re s id u a l va lu e w ill be th e d isp o sa l va lu e o f th e RESIDUAL VALUE
p ro je c ts assets, less a n y d is m a n tlin g a n d re m o v a l costs associated w it h th e te r m in a tio n o f th e p ro je c t. disposal value of

a project's assets
less any dismantling
Timing of the cash flows and removal costs
associated with the
In som e cases, fin a n c ia l c a lc u la tio n s are based o n th e precise t im in g o f th e re le v a n t cash flo w s . F o r project's termination
exam ple, such p re c is io n is s ta n d a rd p ra c tic e w h e n c a lc u la tin g th e va lu e o f m a rk e ta b le d e b t s e c u ritie s
such as b o n d s a n d b a n k b ills . In the se cases, b o th th e a m o u n t a n d th e t im in g o f th e cash flo w s are k n o w n .
H o w eve r, w h e n an in v e s tm e n t p ro je c t is e va lu a te d , th e m a g n itu d e o f th e cash flo w s is ra re ly k n o w n b u t
m u s t be e s tim a te d , u s u a lly w it h som e degree o f e rro r. S im ila rly , th e t im in g o f cash flo w s can ra re ly be
e s tim a te d p re c is e ly a n d th e s im p lify in g a s s u m p tio n t h a t n e t cash flo w s are rece ive d a t th e e n d o f a p e rio d
is u s u a lly a d o p te d . T his a s s u m p tio n reduces th e c o m p le x ity o f th e n e t p re s e n t v a lu e c a lc u la tio n s w ith o u t
causing a m a rk e d decrease in th e ir re lia b ility , a n d i t is th e a s s u m p tio n a d o p te d in th e re m a in d e r o f th is
cha pter.
Inflation and project evaluation

The A u s tra lia n e co n o m y has a t tim e s e xp e rie n ce d p ro lo n g e d p e rio d s o f in fla tio n . D u rin g a p e rio d
o f in fla tio n th e re is an in crea se in th e g e n e ra l le v e l o f p rice s a n d hence a fa ll in th e p u rc h a s in g p o w e r
o f m oney. There are tw o a p pro ache s to in c o rp o ra tin g th e e ffe cts o f in fla t io n in to p ro je c t e v a lu a tio n .
B o th ap pro ache s, a p p lie d c o n s is te n tly , w ill g ive th e sam e n e t p re s e n t value . B o th re q u ire th e a n a ly s t to
e s tim a te th e f u tu r e ra te o f in fla tio n .
O ne a p p ro a ch in v o lv e s m a k in g e s tim a te s o f cash flo w s t h a t are based o n a n tic ip a te d p rice s d u rin g
each y e a r o f a p ro je c ts life , a n d d is c o u n tin g th o s e cash flo w s a t th e n o m in a l re q u ire d ra te o f r e tu rn . In
th is case, th e e s tim a te d n e t cash flo w s fr o m a p ro je c t in , say, its f o u r t h y e a r o f o p e ra tio n are based on
th e p ric e s e xp ected in t h a t f o u r t h year. The presence o f in fla t io n th e re fo re m akes th e jo b o f e s tim a tin g
n e t cash flo w s m o re d iffic u lt, esp e cia lly i f p rice s are e xp e cte d to increase a t a ra p id ra te . The use o f th e
nominal re q u ire d ra te o f r e tu r n m ea ns t h a t th e d is c o u n t ra te re fle c ts th e m a rk e ts e x p e c ta tio n s a b o u t th e
ra te o f in fla tio n . I f i t is e xp e cte d t h a t th e ra te o f in fla t io n w ill increase in th e fu tu re , th e n m a rk e t pressure
s h o u ld le a d to an increase in th e n o m in a l re q u ire d ra te o f r e t u r n o n an in v e s tm e n t. T h e re fo re , o b serve d
n o m in a l ra te s o f r e tu r n have b u ilt in to th e m e xp ected f u tu r e in fla t io n rates. T his a p p ro a ch is c o n s is te n t,
in t h a t n e t cash flo w s based o n a n tic ip a te d f u tu r e p ric e le vels are d is c o u n te d a t th e n o m in a l re q u ire d rate
o f r e tu r n , w h ic h also has b u ilt in to i t e xp ected in fla t io n rates.
The o th e r a p p ro a ch in v o lv e s e s tim a tin g th e n e t cash flo w s w ith o u t a d ju s tin g th e m f o r a n tic ip a te d
changes in p rice s, a n d d is c o u n tin g th o se cash flo w s a t th e real re q u ire d ra te o f re tu rn . In o th e r w o rd s, th e
n e t cash flo w s are e s tim a te d u s in g e x is tin g (c o n s ta n t) prices. To be c o n s is te n t i t is n e cessa ry to d is c o u n t
the se n e t cash flo w s a t th e real re q u ire d ra te o f re tu rn , w h ic h excludes e xp e cte d in fla tio n .
E xa m p le 6.1 illu s tra te s t h a t th e tw o approaches, a p p lie d c o n s is te n tly , g ive th e sam e re s u lt.
Example 6.1
A s s u m e th a t a n in v e s tm e n t o f $ 1 0 0 0 is e x p e c te d to g e n e r a te c a s h flo w s o f $ 5 0 0 , a t c o n s ta n t p ric e s ,
a t th e e n d o f e a c h o f 3 y e a rs . A s s u m e a ls o th a t p ric e s a r e e x p e c te d to in c re a s e a t th e ra te o f 1 0 p e r
c e n t p e r a n n u m a n d th a t th e n o m in a l r e q u ire d ra te o f re tu rn is 1 5 p e r c e n t p e r a n n u m . W h a t is th e
p r o je c t's n e t p re s e n t v a lu e ?
SOLUTION
U s in g th e firs t a p p r o a c h , th e n e t p re s e n t v a lu e o f th e in v e s tm e n t is a s fo llo w s :
$]〇〇〇| $500 (1.10 ) f $ 5 0 0 (1 .10)2 ( $ 5 0 0 (1 .10)3

1.15 (1.15)2 (1.15 )3
= $ 1 0 0 0 = $550 + ^ +
1.15 1.3225 1 .5 209
= $ 3 73
U s in g th e s e c o n d a p p r o a c h , th e n e t c a s h f lo w o f $ 5 0 0 p e r a n n u m a t c o n s ta n t p ric e s is d is c o u n te d
a t th e re a l r e q u ire d ra te o f re tu rn . A s d is c u s s e d in S e c tio n s 1 . 5 . 4 a n d 3 . 4 . 4 , th e re a l ra te m a y b e
e x p re s s e d in te rm s o f th e n o m in a l ra te a s fo llo w s :
1+p
w h e re i* = th e re a l ra te o f re tu rn p e r a n n u m
/ = th e n o m in a l ra te o f re tu rn p e r a n n u m
p = th e a n t ic ip a t e d ra te o f in fla tio n p e r a n n u m
T h e re fo re :
1.10
= 4 .5 5 %
T he n e t p re s e n t v a lu e is th e n c a lc u la te d a s fo llo w s :
$500 $500 $500

1 .0 455 (1.0455)2 (1 .0 4 5 5 )3
-$ 1 0 0 0 + J 5 0 ^ + J 5 0 ^ + J 5 0 ^
1.0455 1.0931 1.1428
= $373
In su b se q u e n t exam ples, th e f ir s t a p p ro a ch to in c o rp o ra tin g th e e ffe c t o f in fla t io n in to p ro je c t

e v a lu a tio n is g e n e ra lly a d o p te d . U n lik e th e second ap p ro a ch , i t can be re a d ily a p p lie d w h e re th e a n a ly s t
w ishes to in c o rp o ra te d iffe re n t rates o f change in p rice s f o r d iffe re n t c o m p o n e n ts o f a p ro je c ts cash flo w s.
F o r exam ple, th e ra te o f change in wage rates m a y be fo re c a s t to be d iffe re n t fr o m th e ra te o f change
in ra w m a te ria ls prices. In a d d itio n , th e seco nd a p p ro a ch re q u ire s re lia b le e s tim a te s o f th e a n tic ip a te d
ra te o f in fla tio n , w h ic h m a y be d iff ic u lt to o b ta in . T h e re fo re , th e f ir s t a p p ro a ch is easier to h a n d le in
practice.
6 .2 .2 1 Illustration of cash-flow information in project evaluation

The cash flo w in fo r m a tio n t h a t s h o u ld be c o m p ile d f o r p ro je c t e v a lu a tio n is illu s tra te d in E xa m p le 6.2.
Example 6.2
T he F ra n k S to n e C o m p a n y is c o n s id e r in g th e in tr o d u c tio n o f a n e w p ro d u c t. G e n e r a lly , th e c o m p a n y 's
p ro d u c ts h a v e a life o f a b o u t 5 y e a rs , a fte r w h ic h th e y a r e d e le te d fro m th e r a n g e o f p ro d u c ts th a t
th e c o m p a n y sells. T he n e w p r o d u c t re q u ire s th e p u rc h a s e o f n e w e q u ip m e n t c o s tin g $ 4 0 0 0 0 0 0 ,
in c lu d in g f r e ig h t a n d in s ta lla tio n c h a rg e s . T h e u se fu l life o f th e e q u ip m e n t is 5 y e a rs , w ith a n e s tim a te d
re s id u a l v a lu e o f $1 5 7 5 0 0 0 a t th e e n d o f th a t p e r io d .
T he n e w p r o d u c t w ill b e m a n u fa c tu re d in a f a c t o r y a lr e a d y o w n e d b y th e c o m p a n y . T h e fa c to r y
o r ig in a lly c o s t $1 5 0 0 0 0 0 to b u ild a n d h a s a c u r r e n t re s a le v a lu e o f $ 3 5 0 0 0 0 0 , w h ic h s h o u ld
re m a in f a ir ly s ta b le o v e r th e n e x t 5 y e a rs . T h is f a c t o r y is c u r r e n tly b e in g re n te d to a n o th e r c o m p a n y
u n d e r a le a s e a g r e e m e n t th a t h a s 5 y e a rs to ru n a n d p r o v id e s f o r a n a n n u a l re n ta l o f $ 1 5 0 0 0 0 .
U n d e r th e le a s e a g re e m e n t, th e F ra n k S to n e C o m p a n y c a n c a n c e l th e le a s e b y im m e d ia te ly p a y in g
th e le ssee c o m p e n s a tio n e q u a l to 1 y e a r 's re n ta l p a y m e n t.
It is e x p e c te d th a t th e p r o d u c t w i ll in v o lv e th e c o m p a n y in s a le s p r o m o tio n e x p e n d itu re s th a t w ill
a m o u n t to $ 5 0 0 0 0 0 d u r in g th e firs t y e a r th e p r o d u c t is o n th e m a rk e t. A d d it io n s to c u r r e n t a sse ts w ill
re q u ire $ 2 2 5 0 0 0 a t th e c o m m e n c e m e n t o f th e p r o je c t a n d a r e a s s u m e d to b e fu lly r e c o v e r a b le a t th e
e n d o f th e fifth y e a r.
T h e n e w p r o d u c t is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s a s fo llo w s :
Y e a r 1: $ 2 0 0 0 0 0 0
Year 2 : $ 2 5 0 0 0 0 0
Year 3: $3 2 5 0 0 0 0
Year 4 : $ 3 0 0 0 0 0 0
Year 5 : $ 1 5 0 0 0 0 0
It is a s s u m e d th a t a ll c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r a n d th e r e q u ire d ra te o f re tu rn
is 1 0 p e r c e n t p e r a n n u m . W h a t is th e n e t p re s e n t v a lu e o f a d d in g th e n e w p ro d u c t?
SOLUTION
T he s o lu tio n to th is e x a m p le is se t o u t in T a b le 6 . 1 .
TABLE 6.1 Cash flow information for adding the new product
C ash flows ($，_
Item Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. I n it ia l o u tla y (4000)
2. Sale o f e q u ip m e n t 1575
continued
B usiness finance
T a ble 6.1 continued
3. Factory
The cost and the

c u rre n t resale value o f
th e fa c to ry are b o th
irre le v a n t
(a) Cancel lease (150)
(b) N e t cash flo w

forgo ne due to re n t
forgone (150) (150) (150) (150) (150)
4. M a rk e t research o u tla y (500)
5. A d d itio n s to cu rre n t
assets (225) 225
6. N e t cash flow s fro m

operations:
Year 1: $2 000 000 2000
Year 2: $ 2 5 0 0 000 2500
Year 3: $ 3 2 5 0 0 0 0 3250
Year 4: $ 3 0 0 0 0 0 0 3000
Year 5: $ 1 5 0 0 0 0 0 1500
T otal (4375) 1350 2350 3100 2850 3150
D is c o u n t fa c to r a t 10% 1.000 00 0.909 09 0.826 45 0.751 31 0.683 01 0.620 92
Present value o f n e t cash flow s (4375) 1227.3 1942.1 2329.1 1946.6 1955.9
N e t pre sen t value $5026
O n th e b a s is o f th is q u a n tita tiv e a n a ly s is th e c o m p a n y s h o u ld a d d th e n e w p r o d u c t to its p r o d u c t

lin e .
6.3 Tax issues in project evaluation

So fa r in o u r d iscu ssio n o f a lte rn a tiv e m e th o d s o f p ro je c t e v a lu a tio n w e have o u tlin e d th e reasons fo r
LEARNING p r e fe r r in g th e use o f th e n e t p re s e n t va lu e m e th o d . H o w e ve r, th e e ffe cts o f taxes have so fa r b e en ig n o re d .
OBJECTIVE 2
The e ffe c ts o f taxes are c o n sid e re d in th is se ctio n .
Explain the effects
of taxes on project
cash flows
6.3.1 | Effect of taxes on net cash flows
I f th e re w e re n o taxes, th e m a g n itu d e a n d t im in g o f a p ro je c ts cash in flo w s a n d o u tflo w s w o u ld be th e
o n ly re le v a n t cash flo w in fo r m a tio n f o r p ro je c t e v a lu a tio n p u rp o se s. H o w e ve r, u n d e r th e p ro v is io n s o f th e
Income TaxAssessmentAct 1936} ta x is assessed o n th e ta x a b le in c o m e o f in d iv id u a ls a n d com p an ies. Taxable
in co m e is th e d iffe re n c e b e tw e e n gross in c o m e a n d c e rta in a llo w a b le d e d u c tio n s s p e c ifie d in th e A c t. In c o m e
ta x pa yab le is g e n e ra lly c a lc u la te d as a pe rce n ta g e o f ta x a b le in co m e . In c o m e ta x is a m a jo r cash o u tflo w
f o r m o s t co m p a n ie s a n d its e ffe c t s h o u ld be co n sid e re d to g e th e r w it h o th e r cash in flo w s a n d o u tflo w s .
The ta x re la tin g to a p ro je c t s h o u ld be tre a te d as a cash o u tflo w w h e n th e ta x is p a id . F o r exa m ple, i f
ta x w ere u s u a lly p a id a t th e en d o f th e y e a r fo llo w in g th e ye a r o f in c o m e , th e n a 1 2 -m o n th la g w o u ld be
^0^
a p p ro p ria te f o r c a lc u la tin g a fte r-ta x n e t cash flo w s . H o w e ve r, f o r ease o f c a lc u la tio n , w e assum e t h a t ta x

is p a id w h e n th e associated cash in flo w is received.
A p ro je c ts a fte r-ta x n e t cash flo w s f o r each p e rio d m a y be c a lc u la te d as:
A fte r-ta x n e t cash flo w = n e t cash flo w b e fo re ta x x (1 - tc) m
w h ere tc = s ta tu to r y c o m p a n y in c o m e ta x ra te 2
H ow ever, th is e q u a tio n ig n o re s th e e ffe c t o f th e ta x d e d u c tib ility o f expenses t h a t do n o t in v o lv e a cash
o u tflo w . In p a rtic u la r, d e p re c ia tio n o f n o n -c u rre n t assets, e x c lu d in g la n d an d, in som e cases, b u ild in g s ,
is an a llo w a b le d e d u c tio n f o r in c o m e ta x p u rp o se s. D e p re c ia tio n is n o t it s e lf a n o u tflo w o f cash, b u t th e
fa ct th a t d e p re c ia tio n is d e d u c tib le f o r ta x p u rp o se s reduces th e in c o m e ta x th a t w o u ld o th e rw is e be
payable— a n d in c o m e ta x is d e fin ite ly a cash o u tflo w . The h ig h e r is th e d e p re c ia tio n charge, th e lo w e r
is th e in co m e ta x payable b y th e co m p a n y a n d hence th e h ig h e r w ill be th e c o m p a n y s a fte r-ta x n e t cash
flow . This increase in a fte r-ta x n e t cash flo w s is re p re s e n te d b y th e ta x savings o n d e p re c ia tio n , w h ic h is
calcula ted as fo llo w s :
Tax savings o n d e p re c ia tio n = d e p re c ia tio n x tc

6.2
T herefore, th e a fte r-ta x n e t cash flo w s g e n e ra te d b y an in v e s tm e n t p ro je c t m a y be c a lc u la te d b y
s u m m in g E q u a tio n s 6.1 a n d 6 .2 as fo llo w s :
A fte r - ta x n e t cash flo w = n e t cash flo w x (1 - tc) + d e p re c ia tio n x tc 6.3

E xam p le 6.3 illu s tra te s th e a p p lic a tio n o f E q u a tio n 6.3.
Example 6.3
A p ro je c t's b e fo re -ta x n e t c a s h f lo w is e x p e c te d to b e $ 1 0 0 0 0 0 p e r a n n u m . F o r ta x p u rp o s e s th e
d e p r e c ia tio n c h a r g e is $ 1 0 0 0 0 p e r a n n u m a n d th e c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r .
The a fte r-ta x n e t c a s h f lo w is c a lc u la te d a s fo llo w s :
After-tax net cash flow = $ 1 0 0 000(1 - 0 . 3 0 ) + $ 1 0 0 0 0 (0.30)

= $ 7 0 0 0 0 + $7000
=$77000
The e ffe c t o f d e p re c ia tio n o n p ro je c t cash flo w s is m o re co m p le x th a n E xa m p le 6.3 suggests because

th e Income Tax A ssessm en t A ct a llo w s tw o m e th o d s o f c a lc u la tin g d e p re c ia tio n : th e straight-line (or prime-
cost) method a n d th e reducing-balance (or dim inishing-value) method. I f th e re d u cin g -b a la n ce m e th o d is
used, th e a llo w a b le d e p re c ia tio n ra te is g e n e ra lly tw ic e th e s tra ig h t-lin e ra te .3
The d e p re c ia tio n charge c a lc u la te d f o r ta x p u rp o se s m a y b e a r n o re la tio n s h ip to t h a t ca lcu la te d f o r
fin a n c ia l r e p o rtin g p u rp o s e s . F o r exa m ple, a co m p a n y m a y use th e s tra ig h t-lin e m e th o d f o r re p o rtin g
p u rpo ses a n d th e re d u c in g -b a la n c e m e th o d f o r in c o m e ta x p u rp o se s. S tra ig h t-lin e d e p re c ia tio n in v o lv e s
a llo c a tin g th e asse ts co st in e q u a l a m o u n ts o v e r its e s tim a te d u s e fu l life . T h a t is, g iv e n th e a sse ts in it ia l
cost, C, a n d its e s tim a te d u s e fu l life o f n years, th e s tra ig h t-lin e d e p re c ia tio n charge in each ye a r o f th e
assets life is C /n .4SF o r e xa m p le , i f an asset costs $ 1 0 0 0 0 0 a n d has a 1 0 -y e a r life , th e a n n u a l d e p re c ia tio n
charge is $ 1 0 0 0 0 0 / 1 0 = $ 1 0 0 0 0.
2 As discussed in Section 14.3, under the imputation system that exists in Australia, a company's effective tax rate may be less
than the statutory tax rate and in most cases it is appropriate for the effective tax rate to be used.
3 For eligible assets purchased after 10 May 2006, the allowable depreciation rate using the reducing-balance method is
twice the straight-line rate. For assets purchased prior to that date, the allowable depreciation rate using the reducing-
balance method is 1.5 times the straight-line rate. Taxpayers have at times been able to claim an investment allowance that
is essentially an additional depreciation deduction—for example, as part of its economic stimulus package announced in
2009, the Australian Government permitted small businesses to claim a one-off additional 50 per cent tax deduction on the
purchase of eligible new assets or the improvement of eligible existing assets. Assets that qualified for the allowance were
basically those that could be depreciated for tax purposes.
4 This contrasts with the method of calculating depreciation for financial reporting purposes. In accounting, the straight-line
depreciation charge is:
(C -S )/n
where C = initial cost
S = estimated residual value or scrap value
n = estimated useful life in years
B usiness finance
Example 6.4
Table 6.2 shows the calculation of the present value of the tax effects associated with depreciation
and disposal of an asset that costs $100000, has an estimated useful life of 5 years and a
disposal value of $7776 at the end of the fifth year. The company income tax rate is 30 per cent
and the after-tax discount rate is 10 per cent per annum. Table 6.2 shows that the reducing-balance
method should be preferred because it results in a higher present value of tax savings and net sale
proceeds.
TABLE 6.2 Tax effects of depreciation and sale of an asset

- I
Depreciation method
-------------------------------------------------------------------- -------------------------------
Straight lin e ^ Reducing balance⑹
—
Present Present
value of value of
tax savings tax savinqs
and and
Present Allowable Tax proceeds Allowable Tax proceeds
End of value depreciation savings^ of sale, net depreciation savings of sale, net
year factor expense ($)' ($) of tax ($) expense ($) ($) of tax ($)
1 0.90909 20000 6000 5454 40000 12 000 10909
2 0.82645 20000 6000 4959 24000 7200 5 950
3 0.75131 20000 6000 4508 14400 4320 3 246
4 0 .6 8 3 0 1 20000 6000 4098 8640 2592 1770
5 0.62092 20000 6000 3 726 5184 1555 966
Disposal — 7 7 7 6 (b ) — 4828 7776 — 4828

value
G ain on — 7776 — — 0 — —
sale
Tax on — — (2332) (1448) — 0 0

gain
T o ta l — 一 _ 26124 一一 27669
(a) Straight-line depreciation is charged at a rate of 20 per cent of acquisition cost, and reducing-balance depreciation
is charged at a rate of 40 per cent of the written-down value.
(b) It is assumed that at the end of Year 5 the asset is sold for $7776. Under the reducing-balance method of
depreciation, this is equal to the written-down value at the end of Year 5 and there is no gain or loss on sale.
Consequently, there is no tax effect on the $7776. The present value of the cash inflow is calculated in the usual
way and equals $7776 x (0.620 92) = $4828. Under the straight-line method of depreciation, as the whole of the
asset's acquisition cost has been written off for tax purposes by the end of Year 5, the $7776 received at that time
is regarded as a gain on sale for tax purposes, and increases tax payable by $2332. The present value of this tax
payment is $ 1448.
(c) Tax savings are equal to allowable depreciation expenses x 0.30.
In c o n tra s t, re d u c in g -b a la n c e d e p re c ia tio n in v o lv e s c h a rg in g a fix e d percentage (ra th e r th a n a fix e d

amount) o f th e asse ts w r itte n - d o w n (o r a d ju s ta b le ) v a lu e in each year. The a sse ts w r itte n - d o w n value
is equal to its cost o r o th e r v a lu e (such as a re v a lu e d a m o u n t) less a c c u m u la te d d e p re c ia tio n , w h e re
a ccu m u la te d d e p re c ia tio n is eq u a l to th e s u m o f th e d e p re c ia tio n charges in p re v io u s years. In c o m p a ris o n
w ith s tra ig h t-lin e d e p re c ia tio n , th e re d u cin g -b a la n ce m e th o d o f d e p re c ia tio n re s u lts in la rg e r d e p re c ia tio n
charges in th e e a rly years o f a n a s s e ts life a n d s m a lle r charges in la te r years. T h ere fore, co m p a re d w ith
th e s tra ig h t-lin e m e th o d , re d u c in g -b a la n c e d e p re c ia tio n re s u lts in lo w e r taxes a n d h ig h e r a fte r-ta x cash
flo w s in th e e a rly years. The t o t a l in c o m e ta x p a id is n o t re d u ce d b y u s in g th e re d u cin g -b a la n ce m e th o d .
H ow ever, a p o r tio n o f th e ta x payable is p o s tp o n e d in th e e a rly years o f th e p ro je c ts life . G ive n t h a t a
d o lla r to d a y is w o r th m o re th a n a d o lla r in a y e a rs tim e , i t fo llo w s t h a t th e use o f th e re d u cin g -b a la n ce
m e th o d is g e n e ra lly a d va n ta g e o u s to an asset’s ow ne r.
The a fte r-ta x cash flo w s a sso cia te d w it h o w n e rs h ip o f a d e p re cia b le asset also d e p e n d o n th e
re la tio n s h ip b e tw e e n th e a s s e ts d isp o sa l v a lu e a n d its w r itte n - d o w n value. I f th e d isp o sa l va lu e is eq ua l
to th e w r itte n - d o w n va lu e , th e n sale o f th e asset has n o e ffe c t o n ta x p a id b y th e seller. H o w e ve r, i f th e
tw o values d iffe r, th e re are tw o p o s s ib ilitie s :
a The asse ts d isp o sa l v a lu e is less th a n it s w r itte n - d o w n value

Suppose t h a t an asset is s o ld f o r $ 1 0 0 0 0 0 b u t its w r itte n - d o w n va lu e is $ 2 5 0 00 0. The d iffe re n c e o f
$ 1 5 0 0 0 0 is reg ard ed as a loss o n sale, w h ic h is ta x d e d u c tib le . I f t c = 0 .3 0 , th e ta x sa vin g o n th e loss
o f $ 1 5 0 0 0 0 is $ 1 5 0 0 0 0 x 0 .3 0 = $ 4 5 0 0 0. T his ta x s a vin g is tre a te d as a cash in flo w , so th e n e t a fte r
ta x proceeds are $ 1 4 5 0 0 0.
b The asset s d is p o s a l va lu e is m o re th a n its w r itte n - d o w n value
Suppose t h a t an asset is s o ld f o r $ 3 0 0 00 0, w h ic h is $ 5 0 0 0 0 m o re th a n its w r itte n - d o w n va lu e . In
th is case th e g a in o n sale o f $ 5 0 0 0 0 is re g ard ed as re c o v e ry o f d e p re c ia tio n d e d u c tio n s t h a t w ere
p re v io u s ly cla im e d . T h e re fo re , th e g a in is ta xa b le b u t th e ta x m a y be d e fe rre d b y d e d u c tin g th e g a in
fro m th e w r itte n - d o w n v a lu e o f a re p la c e m e n t asset o r o th e r de p re cia b le assets.5 I f th e g a in is ta xe d
im m e d ia te ly , th e n e t sale pro cee ds are $ 3 0 0 0 0 0 - $ 5 0 0 0 0 x 0 .3 0 = $ 2 8 5 0 0 0 .
The ta x e ffe cts o f th e s tra ig h t-lin e a n d re d u cin g -b a la n ce m e th o d s are co m p a re d in E xa m p le 6.4.
6 .3 .2 1 Illustration of cash-flow information in project evaluation

with taxes
E a rlie r in th is c h a p te r w e co n s id e re d th e c a s h -flo w in fo r m a tio n t h a t s h o u ld be c o m p ile d f o r p ro je c t
e va lu a tio n . E xam p le 6.5 illu s tra te s h o w taxes s h o u ld be in c o rp o ra te d in to th e c o m p ila tio n o f cash flo w s.
E xample 6.5
The C la r e n d o n C o m p a n y is c o n s id e r in g th e in tr o d u c tio n o f a n e w p r o d u c t. G e n e r a lly , th e c o m p a n y 's
p ro d u c ts h a v e a life o f a b o u t 5 y e a rs , a fte r w h ic h th e y a r e d e le te d fro m th e ra n g e o f p ro d u c ts th a t
th e c o m p a n y sells.
T he n e w p r o d u c t r e q u ire s th e p u rc h a s e o f n e w e q u ip m e n t c o s tin g $ 6 0 0 0 0 0 , in c lu d in g f r e ig h t
a n d in s ta lla tio n c h a rg e s . T h e u s e fu l life o f th e e q u ip m e n t is 5 y e a rs , w ith a n e s tim a te d r e s id u a l v a lu e
o f $ 2 3 6 5 0 0 a t th e e n d o f th a t p e r io d . T h e e q u ip m e n t w ill b e d e p r e c ia te d fo r ta x p u rp o s e s b y th e
r e d u c in g - b a la n c e m e th o d a t a ra te o f 2 0 p e r c e n t p e r a n n u m .
T he n e w p r o d u c t w ill b e m a n u fa c tu re d in a f a c t o r y a lr e a d y o w n e d b y th e c o m p a n y . T h e f a c t o r y
o r ig in a lly c o s t $ 2 0 0 0 0 0 to b u ild a n d h a s a c u rre n t re s a le v a lu e o f $ 5 0 0 0 0 0 , w h ic h s h o u ld re m a in
f a ir ly s ta b le o v e r th e n e x t 5 y e a rs . T h is f a c t o r y is c u rre n tly b e in g re n te d to a n o th e r c o m p a n y u n d e r
a le a s e a g r e e m e n t th a t h a s 5 y e a r s to ru n a n d p r o v id e s f o r a n a n n u a l re n ta l o f $ 2 0 0 0 0 . U n d e r th e
continued
5 Replacement decisions are discussed in Section 6.5.2.

continued
le a s e a g r e e m e n t th e C la r e n d o n C o m p a n y c a n c a n c e l th e le a s e b y p a y in g th e le sse e c o m p e n s a tio n
e q u a l to 1 y e a r 's re n ta l p a y m e n t. T h is a m o u n t is n o t d e d u c tib le fo r in c o m e ta x p u rp o s e s .
It is e x p e c te d th a t th e p r o d u c t w ill in v o lv e th e c o m p a n y in s a le s p r o m o tio n e x p e n d itu re s , w h ic h w ill
a m o u n t to $ 6 0 0 0 0 d u r in g th e firs t y e a r th e p r o d u c t is o n th e m a rk e t. T h is a m o u n t is d e d u c tib le fo r
in c o m e ta x p u rp o s e s in th e y e a r in w h ic h th e e x p e n d itu re is in c u rre d .
A d d it io n s to c u rre n t a sse ts w ill re q u ire $ 3 2 0 0 0 a t th e c o m m e n c e m e n t o f th e p r o je c t a n d a re
a s s u m e d to b e fu lly r e c o v e r a b le a t th e e n d o f th e fifth y e a r.
T he n e w p r o d u c t is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s (b e fo re d e p r e c ia t io n a n d in c o m e
ta x ) a s fo llo w s :
• Y e a r 1: $ 3 0 0 0 0 0
• Year 2: $ 3 7 5 0 0 0
• Year 3: $ 4 9 0 0 0 0
• Year 4: $ 4 5 0 0 0 0
• Year 5 : $ 2 2 5 0 0 0
It is a s s u m e d th a t a ll c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r a n d th a t in c o m e t a x is p a id
a t th e e n d o f th e y e a r in w h ic h th e in flo w o c c u rre d .
T h e c o m p a n y in c o m e t a x ra te is 3 0 c e n ts in th e d o lla r . T h e c o m p a n y h a s a r e q u ire d ra te o f re tu rn
o f 1 0 p e r c e n t a fte r ta x .
T h e s o lu tio n to th is e x a m p le is se t o u t in T a b le 6 . 3 .
SOLUTION
TABLE 6 . 3 C a s h - flo w in f o r m a tio n f o r th e e v a lu a tio n o f th e p u r c h a s e o f

n e w e q u ip m e n t
After-tax cash flows
Item Year 0 Year 1 Year 2 ； Year 3 j Year 4 Year 5
1. I n itia l o u tla y (600000)

2. D e p re c ia tio n
Year Written- Depreciation Tax

down ( %) ( $ ) savings at
value ($) 30c in $
1 600000 20 120000 36000 — 36000 — — — —
2 480000 20 96000 28800 — — 28800 — — —
3 384000 20 76800 23040 — — — 23 040 — —
4 307200 20 61440 18432 — — — — 18432 —
5 245 760 20 49152 14746 — — — — — 14746
3. S ale o f e q u ip m e n t
Sale $236500
W ritten-down value $196608
Gain on sale $39892
Tax on gain at 30% $11968
Total proceeds $236500 — — — — — 224532

-$ 1 1 9 6 8
T able 6 .3 continued
4. Factory — — — — —
The cost and th e c u rre n t resale value o f the
fa c to ry are b o th irre le v a n t
a. Cancel lease (2 0 0 0 0 )
b. N e t cash flo w forgone due to re n t
forgone
$20000 ( 1 -0 .3 0 ) — (1 4 0 0 0 ) (1 4 0 0 0 ) (1 4 0 0 0 ) (1 4 0 0 0 ) (1 4 0 0 0 )
5. Market research outlays

O u tla y $60000
Less n e t ta x savings a t 30% $18000
$42000 — (4 2 0 0 0 ) ______ ______________________________
6. Addition to current assets (32 000) — — _ — 32000
7. Net cash flows from operations after

deducting company income tax
Year 1: $ 3 0 0 0 0 0 (1 - 0 .3 0 ) — 210000 — — — —
Year 2: $ 3 7 5 0 0 0 (1 - 0 .3 0 ) — — 262500 — — —
Year 3: $ 4 9 0 0 0 0 (1 - 0.30) — — — 343000 — —
Year 4: $ 4 5 0 0 0 0 (1 - 0 .3 0 ) — — — — 315000 —
Year 5: $ 2 2 5 0 0 0 (1 - 0 .3 0 ) — — — — — 157500
Total -6 5 2 0 0 0 190000 277300 352040 319432 414778
D iscoun t fa c to r a t 10% 1.0000 0.90909 0.82645 0.75131 0.68301 0.62092
Present value o f n e t cash flow s -6 5 2 000 172727 229173 264493 218176 257544
N et present value = $ 4 9 0 1 1 4
O n th e b a s is o f th is q u a n tita tiv e a n a ly s is , th e n e w p r o d u c t s h o u ld b e m a n u fa c tu re d .
6.4 C om paring mutually exclusive projects

that have different lives
LEARNING
In C h a p te r 5 w e c o m p a re d m u t u a lly e xclu sive p ro je c ts t h a t h a d th e sam e life . In p ra c tic e , m a n a g e m e n t OBJECTIVE 3
w ill fr e q u e n tly have to c o m p a re m u tu a lly e x c lu s iv e p ro je c ts t h a t ha ve d iffe re n t e c o n o m ic liv e s . Such Compare mutually
p ro je c ts w i ll o fte n in v o lv e e q u ip m e n t t h a t is o f d iffe re n t q u a lity a n d th e re fo re also o f d iff e r e n t cost. exclusive projects that
have different lives
Suppose t h a t a coffee sh o p can b u y e ith e r a T it a n co ffe e m a k e r w it h a life o f 3 yea rs o r th e h ig h e r
q u a lity , m o re e xp e n sive , V u lc a n co ffe e m a k e r w it h a lif e o f 5 yea rs to p e r fo r m th e sam e jo b . B o th
coffee m a ke rs ge n e ra te th e sam e cash in flo w s , so one w a y to co m p a re th e m w o u ld be to c a lc u la te th e
p re s e n t v a lu e o f th e cash o u tflo w s f o r each o f th e m . S uppose t h a t th e p re s e n t v a lu e o f cash o u tflo w s
is $ 4 0 0 0 f o r th e T ita n a n d $ 5 0 0 0 f o r th e V u lc a n . T h is does n o t n e c e s s a rily m e a n t h a t th e T it a n s h o u ld
be p re fe rre d . I f th e T it a n is p u rc h a s e d , i t w i ll have to be re p la c e d 2 years e a rlie r th a n th e V u lc a n .
The a lte rn a tiv e s are n o t d ir e c tly c o m p a ra b le because th e d iffe re n c e in liv e s m e a n s t h a t th e y in v o lv e
d iffe re n t f u tu r e cash flo w s , w h ic h have n o t b e e n co n s id e re d . O n e s o lu tio n w o u ld be to assum e t h a t th e
V u lc a n is s o ld a fte r 3 years. H o w e v e r, th e d is p o s a l v a lu e m a y n o t re fle c t it s v a lu e in use, a n d i t is u s u a l
B usiness finance
to m a ke o th e r a s s u m p tio n s a b o u t w h a t w i ll h a p p e n a t th e e n d o f th e u s e fu l liv e s o f th e e q u ip m e n t.
CONSTANT CHAIN C o n s id e r th e fo llo w in g tw o ap pro ache s:
OF REPLACEMENT
ASSUMPTION a I t m a y be assum ed t h a t th e co m p a n y w ill re in v e s t in a p ro je c t t h a t is id e n tic a l to t h a t w h ic h is
may be used to c u r r e n tly b e in g a n alysed. T his is k n o w n as th e con stan t chain o f replacem ent assum ption,
evaluate mutually
b S pe cific a s s u m p tio n s m a y be m ade a b o u t th e re in v e s tm e n t o p p o r tu n itie s t h a t w ill be com e ava ila ble
exclusive projects of
unequal lives; in this in th e fu tu re .
case, each project
The second ap p ro a ch is th e m o re re a lis tic a n d c o u ld be im p le m e n te d w h e re th e fu tu r e in v e s tm e n t
is assumed to be
replaced at the end of o p p o r tu n itie s are k n o w n . H o w e ve r, in p ra c tic e th is a p p ro a ch is d iff ic u lt to im p le m e n t unless m anagers
its economic life by an have co n sid e ra b le fo re s ig h t. T h ere fore, th e f ir s t a p p ro a ch is o fte n used. T his a p p ro a ch is illu s tra te d in
identical project E xa m p le 6.6.
E xample 6 .6
A s s u m e th a t a c o m p a n y is c o n s id e r in g th e p u rc h a s e o f t w o d iffe r e n t p ie c e s o f e q u ip m e n t, A a n d B,
th a t w i ll p e rfo rm th e s a m e ta s k a n d g e n e r a te th e s a m e c a s h in flo w s . T h e re fo re , A a n d B c a n b e
c o m p a r e d o n th e b a s is o f th e ir c a s h o u tflo w s . T he in fo r m a tio n in T a b le 6 . 4 re la te s to A a n d B.
TABLE 6.4 Cash outflows for equipment
In itia l a n d o p e r a tin g costs ($ )
E q u ip m e n t Year 0 Year 1 Year 2 Year 3
A (life 1 year) 15 000 6000
B (life 3 years) 20000 10000 10000 10000
A s s u m in g a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t p e r a n n u m f o r b o th p ie c e s o f e q u ip m e n t, c a lc u la te
th e p re s e n t v a lu e s o f th e costs o f A a n d B.
SOLUTION
T he p re s e n t v a lu e s o f th e co sts o f A a n d B a r e a s fo llo w s :
PV of costs for A = $ 15 000 + $ 6 〇〇〇

1.1
= $ 20 45 5
PV of costs for B = $20 000 + $ 10 000 n . i) 3

0.1
=$ 44 869
If m a n a g e m e n t c o m p a re s th e se fig u re s , th e n in v e s tm e n t in E q u ip m e n t A w o u ld a p p e a r to b e m o re
d e s ir a b le . H o w e v e r, th is c o m p a r is o n is in v a lid b e c a u s e it ig n o re s th e fa c t th a t A a n d B h a v e d iffe re n t
live s. To m a k e a v a lid c o m p a r is o n it is a s s u m e d th a t a t th e e n d o f b o th th e firs t a n d th e s e c o n d y e a rs
E q u ip m e n t A w o u ld b e p u rc h a s e d a g a in . If E q u ip m e n t A w e r e r e p la c e d a t th e e n d o f Y e a rs 1 a n d 2
w ith th e s a m e e q u ip m e n t (a c h a in o f re p la c e m e n t), th e co sts w o u ld b e as s h o w n in T a b le 6 . 5 .
TABLE 6.5 Costs for chain of replacement over 3i years

In itia l a n d o p e r a tin g costs ($)
E q u ip m e n t Year 0 Year 1 Year 2 Year 3
A 15 000 15000 15 000
A 6000 6000 6000
T otal 15 000 21000 21000 6000

C hapter SIX T he APPLICATION 〇F PROJECT EVALUATION METHODS
In th is c a s e ,
DV/ , ‘ f A ⑴ 識 $21000 $21000 $6000

PVof costs for A = $ 15 0 0 0 + ------------- + -----------
1.1 ( l.l) 2 ( l. l) 3
= $ 5 5 954
B a s e d o n th is c o m p a r is o n o v e r 3 y e a rs , th e p re s e n t v a lu e o f th e co sts f o r A ( $ 5 5 9 5 4 ) is g r e a te r
th a n th e p re s e n t v a lu e o f th e co sts f o r B ( $ 4 4 8 6 9 ) a n d , th e re fo re , B s h o u ld b e p u rc h a s e d .
In th e re m a in d e r o f th is s e c tio n i t is assum ed t h a t m a n a g e m e n t a d o p ts th is a p p ro a ch a n d t h a t each

p ro je c t is re p lic a te d o v e r th e years. A v a lid c o m p a ris o n o f tw o cha in s o f re p la c e m e n t can be m ade o n ly
w h e n b o th cha in s are o f e q u a l le n g th . T his c o m p a ris o n can be ach ie ved in tw o ways:
a S uppose t h a t P ro je c t A has a life o f 6 years a n d P ro je c t B has a life o f 9 years. I f A is u n d e rta k e n

th re e tim e s a n d B tw ic e , th e re p la c e m e n t c h a in s w i ll be o f eq ua l le n g th — t h a t is, 18 years. In th is
exam ple, 18 is th e lo w e s t c o m m o n m u ltip le o f 6 a n d 9, so th is a p p ro a ch is u s u a lly called th e lowest
common multiple method. A lth o u g h th e use o f th is m e th o d c o rre c tly ra n k s m u tu a lly e xclusive p ro je c ts
w ith d iffe re n t live s, i t can be cu m b e rso m e . F o r e xa m p le , tw o p ro je c ts w ith liv e s o f 1 9 a n d 21 years,
resp ective ly, have a lo w e s t c o m m o n m u ltip le o f 3 9 9 years a n d th e cash flo w s f o r each o f these
3 9 9 years w o u ld have to be d is c o u n te d to a p re s e n t value,
b A less c o m p le x a p p ro a c h , w h ic h ra n k s p ro je c ts id e n tic a lly to th e lo w e s t c o m m o n m u ltip le m e th o d ,
is to assum e t h a t b o t h c h a in s c o n tin u e in d e fin ite ly . In t h is case th e ‘le n g th s ’ o f th e c h a in s are
^ q u a r in th e sense t h a t th e y are b o th in fin it e . T his m e th o d is k n o w n as th e constant chain of
replacement in perpetuity method. I f th e N P V o f each re p la c e m e n t p ro je c t is N d o lla rs a n d th e life
o f each p ro je c t is n yea rs, th e n th e c o n s ta n t c h a in o f re p la c e m e n t is e q u iv a le n t to re c e iv in g a
cash in flo w o f N d o lla rs a t tim e s 0, n, 2rz, 377, a n d so o n , fo re v e r. T h e re fo re , th e N P V o f th e c h a in
c o n sists o f N d o lla rs a t t im e 0 p lu s a p e r p e tu ity o f N d o lla rs pa yab le a t n, 2n, 3n, a n d so on.
T h ere fore:
N N
NPV = N + 2n
(1 + k )n (1 + k)
1 1
N
(1 + k)n (1 + k)2n
1
N 1
. ( l + k )n j
(1 + k)n
N
(1 + k)n- l
The n e t p re s e n t v a lu e o f th e in fin it e ch a in , N P V ^ , is th e re fo re :
層一。 6.4
w h e re N P V 〇 = n e t p re s e n t v a lu e o f each re p la ce m e n t.
A v a r ia n t o f t h is m e th o d is th e equivalent annual value m ethod. T his m e th o d in v o lv e s a n s w e rin g EQUIVALENT A N N U A L
th e q u e s tio n : W h a t a m o u n t, to be re ce ive d each y e a r f o r n yea rs, is e q u iv a le n t to re c e iv in g th e n e t VALUE METHOD

involves calculating
p re s e n t v a lu e o f a p ro je c t w h o s e life is n years? T his a m o u n t, w h ic h is k n o w n as th e equivalent annual
the annual cash flow
value (E A V ), is c a lc u la te d f o r each p ro je c t. The p ro je c t w it h th e h ig h e r E A V is p re fe rre d to th e p ro je c t of an annuity that has
w it h th e lo w e r EAV, p ro v id e d t h a t b o th p ro je c ts have th e sam e r is k , a n d th e re fo re th e sam e re q u ire d the same life as the
ra te o f re tu rn . project and whose
The s tre a m o f EAVs o v e r n years is an o rd in a ry a n n u ity a n d th e re fo re th e n e t p re s e n t v a lu e o f th e present value equals
the net present value
a n n u ity is g iv e n by:
of the project
or:
(1 + k )n
NPV = EAV
〇
k
T herefore:
NPV 〇
EAV =
(1 W 7
k
The re la tio n s h ip b e tw e e n th e c o n s ta n t c h a in o f re p la c e m e n t a n d E A V m e th o d s is s tra ig h tfo rw a rd .

A ssu m e t h a t a p ro je c t is re p lic a te d in d e fin ite ly . The p re s e n t v a lu e o f an in f in it e s tre a m o f EAVs is:
EAV
PV--
k
NPV 〇
(1 + k )n
1
■NPV - 〇
1
(1 w
(1 + k )u
NPVq
(1 + k )r
NPVoo
T h a t is, th e p re s e n t v a lu e o f an in fin it e s tre a m o f EAVs is e q u a l to th e n e t p re s e n t v a lu e o f th e c o n s ta n t

c h a in o f re p la c e m e n t in p e rp e tu ity . T h e re fo re , i f th e n e t p re s e n t v a lu e o f th e in fin it e c h a in NPV^ has been
c a lcu la te d , th e n th e E AV can be fo u n d b y m u ltip ly in g NPV^ b y th e re q u ire d ra te o f r e t u r n — t h a t is, th e
E A V is g iv e n by:
EAV=kNPV(X 6.6
The c o n s ta n t c h a in o f re p la c e m e n t a n d e q u iv a le n t a n n u a l va lu e m e th o d s are illu s tr a te d in E xa m p le 6.7.
Example 6.7
S u p p o s e th a t tw o a sse ts, A a n d B, a r e m u tu a lly e x c lu s iv e p ro je c ts a n d h a v e th e c h a r a c te r is tic s s h o w n
in T a b le 6 . 6 .
TABLE 6.6 Characteristics of two mutually exclusive projects
C a sh in flo w s ($ )
A sset Life ( Y r s ) , In itia l cash Year 1 Year 2 Year 3 Year 4 Year 5

o u tla y ($ )
A 3 10000 10000 23000 25 000 — —
B 5 30000 12000 15000 25 000 30000 30000
It is a ls o a s s u m e d th a t th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m fo r b o th p ro je c ts . W h ic h
a s s e t s h o u ld b e p u rc h a s e d ?
C hapter SIX T he APPLICATION OF PROJECT EVALUATION METHODS
SOLUTION
The n e t p re s e n t v a lu e o f A s s e t A a t tim e z e r o is:
N PVAo = -$ 1 0 0 0 0 . ^ 00 + + $25000
1.1 ( l. l) 2 ( l.l) 3
= $ 3 6 8 8 2 .0 4
T he n e t p re s e n t v a lu e o f A s s e t B a t tim e z e r o is:
md' / d $12000 $15000 $25000 $30000 $30000

NPVBr, = -$30000 + ----------+ -------- + ------------------------- — + ------- 广
1.1 ( i . i )2 ( i . i )3 ( i . i )4 ( i . i )5
=$51 206.70
U s in g E q u a tio n 6 . 4 , th e n e t p re s e n t v a lu e s o f th e in fin ite c h a in s o f re p la c e m e n t a re :
NPVAX = ($36 882.04) (1^ —
=$148 308.14
N P V B 〇c = ($51 2 0 6 .7 0 )-^ — '
=$135081.98
T h e re fo re , A s s e t A s h o u ld b e a c c e p te d , n o tw ith s ta n d in g th a t its n e t p re s e n t v a lu e (o v e r its 3 -y e a r

life ) is less th a n th e n e t p re s e n t v a lu e o f A s s e t B (o v e r its 5 - y e a r life ).
U s in g E q u a tio n 6 . 5 , th e e q u iv a le n t a n n u a l v a lu e m e th o d , it is fo u n d th a t:
$36 882.04
EAVA =
" '1 1
(1 H -0 .1 0 )3
0.10
$14830.81
$51 206.70
EAVb
T T T Z Z r ^ r
(1 + 0 . 1 0 ) 5
a io
$13508.20
T h e re fo re , A s s e t A s h o u ld b e c h o s e n b e c a u s e its E A V is g r e a te r th a n th a t o f A s s e t B. A lte r n a tiv e ly ,

th e e q u iv a le n t a n n u a l v a lu e s c o u ld h a v e b e e n c a lc u la te d fro m th e n e t p re s e n t v a lu e s o f th e in fin ite
c h a in s o f r e p la c e m e n t ( N P V ^ ) u s in g E q u a tio n 6 . 6 , E AV = fc N P V ^ a s fo llo w s :
EAVA= (0.1)($148 308.14

=$14830.81
EAVB= (0.1)($135081.98
=$13508.20
T hese resu lts a r e id e n tic a l to th o s e o b ta in e d u s in g E q u a tio n 6 . 5 .

In s u m m a ry , th e resu lts fo r A s s e t A s h o w th a t a n in v e s to r w o u ld b e in d iffe r e n t b e tw e e n re c e iv in g
p a y m e n ts o f $ 3 6 8 8 2 . 0 4 e v e r y 3 y e a rs , o r a s in g le p a y m e n t o f $ 1 4 8 3 0 8 . 1 4 now , or annual
p a y m e n ts o f $ 1 4 8 3 0 . 8 1 fo re v e r. T h e c o r r e s p o n d in g a m o u n ts fo r A s s e t B a r e $ 5 1 2 0 6 . 7 0 e v e ry
5 y e a rs , $ 1 3 5 0 8 1 . 9 8 n o w , o r $ 1 3 5 0 8 . 2 0 a n n u a lly f o r e v e r . 〇f th e se th re e p a ir s o f fig u re s , th e
s e c o n d a n d th ird p a ir s a d ju s t f o r th e u n e q u a l live s o f th e a sse ts, a n d b o th s h o w th a t A s s e t A s h o u ld
b e p re fe rre d .
B usiness finance
E xa m p le 6 .8 p ro v id e s a m o re d e ta ile d illu s t r a t io n o f th e c o n s ta n t c h a in o f re p la c e m e n t m e th o d .
E xample 6 .8
A s s u m e t h a t M a d is o n C o m p a n y , w h ic h o p e ra te s a fle e t o f tru c k s , is c o n s id e r in g r e p la c in g th e m w ith
a n e w m o d e l. T h e d a t a in T a b le 6 . 7 a r e a v a ila b le f o r th e o ld a n d th e n e w tru c k s .
TABLE 6.7 Data for old and new trucks

Item O ld tru cks N e w tru c k s
1. N e t cash flow s $45 000 p.a. $ 5 0 0 0 0 p.a.
2. E s tim a te d life 2 years 4 years
3. D isposal value:
(a) at pre se n t $10000
(b) in 4 years, tim e N il $10000
4. Cost o f new tru cks $60000
5. R equired rate o f re tu rn (real) 10% p.a. 10% p.a.
M a n a g e m e n t is c o n s id e r in g tw o p r o p o s a ls :
a) R e p la c e th e o ld tru c k s n o w a n d a s s u m e th a t th e n e w tru c k s a r e o p e r a te d f o r 4 y e a r s a n d r e p la c e d
in p e rp e tu ity .
b) R e p la c e th e o ld tru c k s in 2 y e a r s ' tim e a n d a s s u m e th a t th e n e w tru c k s a r e o p e r a te d f o r 4 y e a rs

a n d r e p la c e d in p e rp e tu ity .
W h ic h o f th e se p r o p o s a ls s h o u ld m a n a g e m e n t a c c e p t?
SOLUTION
O b v io u s ly th e re a r e o th e r a lte r n a tiv e s th a t m a n a g e m e n t c o u ld c o n s id e r, su ch a s r e p la c in g th e p re s e n t
tru c k s in 1 y e a r ’s tim e o r r e p la c in g th e o ld tru c k s n o w a n d th e n e w o n e s in 2 y e a r s ' tim e . H o w e v e r,
it is a s s u m e d th a t th e se p o s s ib ilitie s h a v e b e e n c o n s id e r e d a n d r e je c te d b y m a n a g e m e n t. It is a ls o
a s s u m e d th a t th e re a r e n o e x p e c te d im p ro v e m e n ts in tru c k d e s ig n th a t w o u ld m a k e th e n e w tru c k
o b s o le te .
P ro p o s a ls (a) a n d (b) w ill th e re fo r e b e e v a lu a te d a s s u m in g a c o n s ta n t c h a in o f re p la c e m e n t. T he
p r o p o s a l w ith th e la r g e r n e t p re s e n t v a lu e , p r o v id e d th a t it is g r e a te r th a n z e r o , w ill b e a c c e p te d , o th e r
th in g s b e in g e q u a l. In th e f o llo w in g e v a lu a tio n th e n e t p re s e n t v a lu e f o r a s in g le tru c k is c a lc u la te d . If
th e re a r e 1 0 tru c k s in th e fle e t, th e n th e n e t p re s e n t v a lu e s o f th e t w o p r o p o s a ls w ill b e m u ltip lie d b y
1 0 to f in d th e ir to ta l n e t p re s e n t v a lu e s .
a) R e p la c e th e o ld tru c k s n o w , o p e r a te th e n e w tru c k s f o r 4 y e a r s a n d r e p la c e th e m in p e rp e tu ity .
T h e n e t p re s e n t v a lu e o f a n e w tru c k is:
(1 + 0 . 1 0 ) 4 $10000
NPV0 = - $ 6 0 0 0 0 + $50000
0.10 ( i.i) 4
= - $ 6 0 0 0 0 + $ 1 5 8 4 9 3 .2 7 + $6 8 3 0 .1 3
= $ 1 0 5 3 2 3 .4 0
T h e p re s e n t v a lu e o f a n in fin ite c h a in o f th e s e tru c k s is th e re fo re :
NPV 〇〇 = ($ 1 0 5 3 2 3 .4 0 ) O ' 1/
= $ 3 3 2 265
C hapter s ix T he application of project evaluation methods
In a d d itio n , a t th e s ta rt o f th is c h a in M a d is o n C o m p a n y re c e iv e s a c a s h in flo w o f $ 1 0 0 0 0 fro m

th e d is p o s a l o f th e o ld tru c k . T h e re fo re , th e total n e t p re s e n t v a lu e is:
$332265 + $10000 = $342265
b) R e p la c e th e o ld tru c k s in 2 y e a r s ' tim e , o p e r a te th e n e w tru c k s f o r 4 y e a rs , a n d r e p la c e th e m in

p e rp e tu ity .
A s in th e p re v io u s c a lc u la tio n , N P V 00= $ 3 3 2 2 6 5 . H o w e v e r, th e firs t o f th e c h a in o f n e w tru c k s is

n o w p u rc h a s e d a t Y e a r 2 in s te a d o f a t Y e a r 0 a s p re v io u s ly . A s a re su lt, NPV 〇
〇m u st b e d is c o u n te d
to Y e a r 0 :
$332 265
(I.” 2
=$274 599.17
In a d d itio n , M a d is o n C o m p a n y o b ta in s th e n e t p re s e n t v a lu e o f o p e r a tin g th e o ld tru c k s f o r th e

firs t 2 y e a rs . T h is is g iv e n b y :
$45 000 $45 000

i. i ( i.i) 2
=$78 099.17
The total n e t p re s e n t v a lu e is th e re fo re :
$ 2 7 4 5 9 9 .1 7 + $ 7 8 0 9 9 .1 7 = $ 3 5 2 6 9 8 .3 4
T he n e t p re s e n t v a lu e o f P ro p o s a l (b) is g r e a te r th a n th e n e t p re s e n t v a lu e o f P ro p o s a l (a) a n d
m a n a g e m e n t s h o u ld r e p la c e th e o ld tru c k s in 2 y e a r s 7 tim e .
Chain of replacement methods and inflation

C h a in o f re p la c e m e n t m e th o d s re ly o n th e a s s u m p tio n t h a t each p ro je c t w ill, a t th e e n d o f its life , be
replaced b y an id e n tic a l p ro je c t— t h a t is, each re p la c e m e n t w i ll c o st th e sam e a m o u n t, g e n e ra te th e sam e
cash flo w s , a n d la s t f o r th e sam e tim e . C learly, i f th e re is in fla tio n , fu tu r e costs a n d cash flo w s w ill n o t be
exp ected to re m a in th e sam e in n o m in a l te rm s , b u t th e y m a y re m a in th e sam e in re a l te rm s . To e n sure
t h a t in fla t io n is tre a te d c o n s is te n tly , a ll cash flo w s a n d th e re q u ire d ra te o f r e t u r n s h o u ld g e n e ra lly be
expressed in re a l te rm s w h e n a c h a in o f re p la c e m e n t m e th o d is use d .6
Is the chain of replacement method realistic?

A possible p ro b le m w ith th e c o n s ta n t c h a in o f re p la c e m e n t m o d e l is t h a t i t em p lo ys u n re a lis tic a s s u m p tio n s
a b o u t th e re p la c e m e n t assets in th e ch a in , n a m e ly th a t th e assets a n d th e services th e y p ro v id e are
id e n tic a l in e ve ry respect. These a s s u m p tio n s are u n re a lis tic . H o w eve r, th e fa c t t h a t th e re p la ce m e n ts
m ay be m a n y years in th e fu tu re , a n d th e fa c t t h a t t h e ir cash flo w s w ill be d is c o u n te d to a p re s e n t value,
reduces th e im p a c t o f m a k in g such u n re a lis tic a s s u m p tio n s . I t m a y be even m o re u n re a lis tic to assum e th a t
m a n a g e m e n t has s u ffic ie n t fo re s ig h t to be able to p re d ic t such fa c to rs as th e c a p ita l o u tla y, n e t cash flo w s ,
life a n d re s id u a l value o f re p la ce m e n t assets. H o w eve r, i f such in fo r m a tio n is available, i t is n o t a d iffic u lt
m a tte r to in s e rt in to th e a n alysis th e re p la c e m e n t o f an e x is tin g asset w it h an asset o f im p ro v e d d e sig n .7
The m e th o d s discussed in th is se ctio n are v e ry u s e fu l b u t som e p o in ts s h o u ld be n o te d . F irs t, i t is n o t
necessary to use the se m e th o d s in a ll cases w h e re p ro je c ts have d iffe re n t lives. F o r in d e p e n d e n t p ro je c ts , th e
n e t p re se n t value m e th o d a u to m a tic a lly a llo w s f o r a n y such diffe re nce s. The d iffe re n t lives p ro b le m , arises
o n ly f o r m u tu a lly e xclusive p ro je cts. Second, i t is p a rtic u la rly im p o r ta n t, w h e n u s in g c h a in o f re p la ce m e n t
m e th o d s, to be c o n s is te n t in th e tre a tm e n t o f in fla tio n . T h ird , in m a n y cases m u tu a lly exclusive p ro je c ts w ill
in v o lv e th e same b e n e fits (cash in flo w s ) b u t d iffe re n t costs (cash o u tflo w s ). In these cases th e cash in flo w s
can be ig n o re d a nd th e a lte rn a tiv e s can be co m p a re d o n th e basis o f th e ir cash o u tflo w s , as in E xam p le 6.3.
6 For a discussion of this issue and presentation of a nominal version of the constant chain of replacement model, see Faff and
Brailsford (1992).
7 Brown and Davis (1998) highlight the real options that are ignored in using the constant chain of replacement model. For a
discussion of real options, see Chapters 5 and 18.
B usiness finance
continued
SOLUTION
If th e m a c h in e is p u rc h a s e d , u s e d fo r o n ly 1 y e a r a n d th e n s o ld , its n e t p re s e n t v a lu e w o u ld b e as
fo llo w s :
吟 -$ 2 〇o〇〇+ $I ^ 2 + i l ^
1 1.1 1.1
= $ 5 455
If th e m a c h in e is u se d f o r 2 y e a rs a n d th e n s o ld , th e n e t p re s e n t v a lu e w o u ld b e a s fo llo w s :
$12000 $11500 $14000

NPV2 = - $ 2 0 0 0 0 +
i.i ( i . i )2 ( i . i r
$11 983
S im ila rly , n e t p re s e n t v a lu e s c a n b e c a lc u la te d b a s e d o n use f o r 3 , 4 a n d 5 y e a r s . H o w e v e r , th e se

n e t p re s e n t v a lu e s c a n n o t b e c o m p a r e d , b e c a u s e th e y a r e b a s e d o n d iffe r e n t liv e s . A s w e n o te d in
S e c tio n 6 . 4 , th is d iff ic u lt y c a n b e o v e r c o m e b y a s s u m in g a c o n s ta n t c h a in o f r e p la c e m e n t. If it is
a s s u m e d th a t th e m a c h in e is r e p la c e d e v e r y y e a r in p e rp e tu ity , th e n e t p re s e n t v a lu e w ill b e a s fo llo w s :
(1 1 )
NPV(1,〇〇 ) = $5 4 5 4 .5 5
( l- l) - l
=$60000
If th e m a c h in e is r e p la c e d e v e r y s e c o n d y e a r in p e rp e tu ity , th e n e t p re s e n t v a lu e w ill b e a s fo llo w s :
,2
( i.ir
NPV(2/X)) = $ 1 1 9 8 3 .4 7
= $69048
T h e n e t p re s e n t v a lu e s , a s s u m in g th a t th e m a c h in e is r e p la c e d in p e rp e tu ity , a t th e e n d o f th e th ir d ,
fo u rth a n d fifth y e a rs , re s p e c tiv e ly , a r e a s fo llo w s :
(1 .1 ) 3
NPV[3, ) = $ 1 7 6 9 3 .4 6
〇〇
= $ 7 1 148
(1 -1 )4 '
NPV 〇
〇) = $ 1 9 9 4 7 -41
= $ 6 2 92 6
(1 .1 ) 5
NPV(5o〇) = $22 0 5 8 .5 4
= $ 5 8 190
T h e se resu lts s h o w th a t th e m a c h in e s h o u ld b e r e p la c e d a fte r 3 y e a rs . In g e n e r a l th e d e c is io n ru le

is to c h o o s e th e re p la c e m e n t fr e q u e n c y th a t m a x im is e s th e p r o je c t's n e t p re s e n t v a lu e f o r a p e rp e tu a l
c h a in o f r e p la c e m e n t, o r th a t m a x im is e s its e q u iv a le n t a n n u a l v a lu e .
Non-identical replacement
Suppose t h a t a m a c h in e is p h y s ic a lly s o u n d b u t te c h n ic a lly ob solete. W h e n th e m a c h in e is replaced,
its re p la c e m e n t w ill be o f a n e w d e sig n t h a t m a y have th e sam e ca p a c ity b u t costs less to op era te . The
q u e s tio n is: W h e n s h o u ld th e o ld m a c h in e be d isca rd e d in fa v o u r o f th e n e w one? The s o lu tio n in v o lv e s tw o
steps. F irs t, th e o p tim u m re p la c e m e n t fre q u e n c y f o r th e n e w m a c h in e is d e te rm in e d u s in g th e m e th o d
illu s tra te d in E xa m p le 6.1 0. Second, th e e q u iv a le n t a n n u a l va lu e o f th e n e w m a c h in e a t it s o p tim u m
re p la c e m e n t fre q u e n c y is c o m p a re d w it h th e n e t p re s e n t va lu e o f c o n tin u in g to o p e ra te th e o ld m a ch in e ,
as s h o w n in E xam p le 6.9. The d e c is io n ru le is t h a t th e cha n g e o ve r s h o u ld be m ade w h e n th e n e t p re s e n t

value o f c o n tin u in g to o p e ra te th e o ld m a c h in e f o r one m o re y e a r is less th a n th e e q u iv a le n t a n n u a l v alue
o f th e n e w m a ch in e .
6.6 Analysing project risk

The e ffe c t o f r is k o n th e v a lu e o f a p ro je c t is n o r m a lly in c lu d e d in th e e v a lu a tio n b y u s in g a re q u ire d ra te
o f re tu r n t h a t re fle c ts th e r is k o f th e p ro je c t. H o w e ve r, th e c a lc u la te d n e t p re s e n t v a lu e is o n ly an e s tim a te LEARNING
OBJECTIVE 5
th a t relies o n foreca sts o f th e p ro je c ts cash flo w s . In p ra c tic e the se fo re ca sts w ill, a lm o s t c e rta in ly , t u r n
Explain how sensitivity
o u t to be in c o rre c t, p e rh a p s because th e v o lu m e o f sales tu r n s o u t to be m o re o r less th a n expected, analysis, break
th e p ric e o f th e p ro d u c t is h ig h e r o r lo w e r th a n expected, o r o p e ra tin g costs d iffe r fr o m th e fo re ca st. even analysis and
Therefore, in m a n y cases m a n a g e rs a n a ly s in g p ro p o s e d p ro je c ts w ill ne ed to a n sw e r q u e s tio n s such as: simulation assist in
analysing project risk
• W h a t are th e k e y v a ria b le s t h a t are lik e ly to d e te rm in e w h e th e r th e p ro je c t is a success o r a fa ilu re ?
• H o w fa r can sales fa ll o r costs increase b e fo re th e p ro je c t loses m on ey?
M an ag ers can use v a rio u s te c h n iq u e s to a n s w e r the se a n d o th e r re la te d q u e s tio n s . The te c h n iq u e s we

discuss are s e n s itiv ity an alysis, bre a k-e ve n a n a lysis a n d s im u la tio n .
6 .6 .1 1 Sensitivity analysis
A p ro je c ts cash flo w s a n d re q u ire d ra te o f r e tu r n are u s u a lly s p e c ifie d as cb e s t e stim a te s* o r exp ected
values1 an d th e re s u ltin g n e t p re s e n t value , o fte n re fe rre d to as th e base-case net present value, is also a
best e s tim a te o r e xp e cte d va lu e . Sensitivity an alysis in v o lv e s assessing th e e ffe c t o f changes o r e rro rs SENSITIVITY ANALYSIS
in th e e s tim a te d v a ria b le s o n th e n e t p re s e n t v a lu e o f a p ro je c t. T his is a ch ie ved b y c a lc u la tin g n e t p re s e n t analysis of the effect

of changing one or
values based o n a lte rn a tiv e e s tim a te s o f th e va ria b le s. F o r in sta n ce , m a n a g e m e n t m a y w is h to k n o w th e
more input variables
e ffe ct o n n e t p re s e n t va lu e i f a p ro je c ts n e t cash flo w s are e ith e r 20 p e r c e n t less th a n , o r 20 p e r ce n t
to observe the effects
g re a te r th a n , th o se e s tim a te d . K n o w le d g e o f th e s e n s itiv ity o f n e t p re s e n t va lu e to changes o r e rro rs in on the results
th e va ria b le s places m a n a g e m e n t in a b e tte r p o s itio n to decide w h e th e r a p ro je c t is to o r is k y to accept.
A lso , i f m a n a g e m e n t k n o w s t h a t th e n e t p re s e n t va lu e is s e n s itiv e to changes in p a r tic u la r v a ria b le s , i t
can e xa m in e th e e stim a te s o f the se v a ria b le s m o re th o ro u g h ly , o r c o lle c t m o re d a ta in an e f f o r t to reduce
e rro rs in fo re ca stin g .
A s s u m in g t h a t a ll v a ria b le s in th e a n a lysis are u n c e rta in , a s im p le e xa m p le o f s e n s itiv ity a n alysis
in vo lve s th e fo llo w in g steps:
a P essim istic, o p tim is tic a n d e xp ected e s tim a te s are m ad e f o r each v a ria b le .

b N e t p re s e n t va lu e is ca lcu la te d u s in g th e e xp ected e s tim a te s f o r e v e ry v a ria b le exce pt one, th e value
fo r w h ic h is, in t u r n , its o p tim is tic a n d p e s s im is tic e s tim a te . This p ro c e d u re is re p e a te d u n t il a n e t
p re s e n t va lu e has been ca lcu la te d u s in g an o p tim is tic a n d p e s s im is tic e s tim a te f o r each v a ria b le , in
c o m b in a tio n w it h th e e xp ected values o f th e o th e r v a ria b le s.
C The d iffe re n c e b e tw e e n th e o p tim is tic a n d p e s s im is tic n e t p re s e n t values is ca lcu la te d f o r each
va ria b le . A s m a ll d iffe re n c e b e tw e e n th e n e t p re s e n t value s suggests t h a t th e p ro je c ts n e t p re s e n t
value is in s e n s itiv e to changes o r e rro rs in t h a t v a ria b le . A la rg e d iffe re n c e b e tw e e n th e n e t p re s e n t
values suggests th e o p p o s ite .
F o r exa m ple, suppose t h a t in a p ro je c t in v o lv in g th e use o f a n e w m a c h in e , th e re are o n ly fiv e u n c e rta in

variab les: sales p rice , v a ria b le cost, sales v o lu m e , fix e d o p e ra tin g costs a n d th e life o f th e m a c h in e . In th is
case, e ig h t n e t p re s e n t v a lu e c a lc u la tio n s are m ade, u s in g th e d a ta in p u ts s h o w n in T able 6 .1 0 . The s y m b o l
O in d ic a te s th e o p tim is tic v a lu e o f th e v a ria b le , P in d ic a te s th e p e s s im is tic va lu e o f th e v a ria b le , a n d E
in d ic a te s th e e xp ected va lu e o f th e v a ria b le .
The a p p lic a tio n o f s e n s itiv ity a n a lysis to p ro je c t e v a lu a tio n in a case such as t h a t s h o w n in Table 6.1 0
is illu s tra te d in E xam p le 6.1 1.
The use o f s e n s itiv ity a n a lysis in v o lv e s som e p ro b le m s . O ne is t h a t fr e q u e n tly i t is d iff ic u lt to
sp e cify p re c is e ly th e re la tio n s h ip b e tw e e n a p a r tic u la r v a ria b le a n d n e t p re s e n t value . I f th e assum ed
re la tio n s h ip is based o n p a s t o u tco m e s, th e re is alw ays th e p o s s ib ility t h a t th is re la tio n s h ip m a y n o t
h o ld in th e fu tu re . I t is f u r t h e r c o m p lic a te d b y re la tio n s h ip s b e tw e e n th e v a ria b le s . F o r e xa m p le , i t is
TABLE 6.10 Combinations of variable values for sensitivity analysis
Estim ates (i) (iii) N (v) M (v ii) (v iii) (ix ) (x)
Sales price 0 P E E E E E E E E
Variable cost E E 〇 P E E E E E E
Sales vo lu m e E E E E 〇 P E E E E
Fixed o p e ra tin g E E E E E E 〇 P E E
costs
M ach in e life E E E E E E E E 〇 P
E xample 6.11
A s s u m e th a t a m a n a g e r is c o n s id e r in g w h e th e r to p u rc h a s e a n e w m a c h in e th a t c o sts $ 5 0 0 0 0 0 . It
is a s s u m e d th a t th e re a r e o n ly fiv e u n c e rta in v a r ia b le s : sa le s p r ic e , v a r ia b le c o s t, s a le s v o lu m e , fix e d
o p e r a tin g co sts a n d th e life o f th e n e w m a c h in e . T he sa le s p r ic e is e x p e c te d to b e $ 7 0 p e r u n it, th e
v a r ia b le c o s t is e x p e c te d to b e $ 4 8 p e r u n it, s a le s v o lu m e is e x p e c te d to b e 1 5 0 0 0 u n its p e r a n n u m ,
w ith fix e d o p e r a tin g co sts o f $ 2 0 0 0 0 0 d u r in g a n e x p e c te d life o f 1 0 y e a rs . A ll o th e r v a r ia b le s a re
e x p e c te d to re m a in c o n s ta n t d u r in g th e m a c h in e 's life . T h e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r
annum .
T he e x p e c te d a n n u a l n e t c a s h flo w s a r e ( $ 7 0 - $ 4 8 ) x 1 5 0 0 0 - $ 2 0 0 0 0 0 = $ 1 3 0 0 0 0 , a n d th e
b a s e -c a s e n e t p re s e n t v a lu e is:
Base-case N P V = -$500 000 + $ 130 000 — 1 J

0.1
=$298 794
T he in fo r m a tio n n e e d e d f o r th e s e n s itiv ity a n a ly s is is s h o w n in T a b le 6 .1 1, w h ic h p re s e n ts :
• f o r e a c h u n c e rta in v a r ia b le , e x p e c te d (c o lu m n 1), o p tim is tic (c o lu m n 2 ) a n d p e s s im is tic (c o lu m n 3 )

e s tim a te s
• th e n e t p re s e n t v a lu e (c o lu m n 4 ) w h e n o n e o f th e u n c e rta in v a r ia b le s is set a t its o p tim is tic e s tim a te

a n d e a c h o f th e o th e r v a r ia b le s is set a t its e x p e c te d v a lu e
• th e n e t p re s e n t v a lu e (c o lu m n 5 ) w h e n o n e o f th e u n c e rta in v a r ia b le s is se t a t its p e s s im is tic e s tim a te

a n d e a c h o f th e o th e r v a r ia b le s is set a t its e x p e c te d v a lu e
• in c o lu m n 6, th e d iffe re n c e b e tw e e n c o lu m n s 4 a n d 5, w h ic h is fr e q u e n tly c a lle d th e 'r a n g e o f th e

n e t p re s e n t v a lu e ’ .
T a b le 6 .1 1 s h o w s th a t th e e s tim a te o f n e t p re s e n t v a lu e is m o re s e n s itiv e to c h a n g e s in s a le s p ric e

th a n to c h a n g e s in th e o th e r u n c e rta in v a r ia b le s . In a d d it io n , it s h o w s th a t if th e p e s s im is tic e s tim a te
o f e ith e r s a le s p r ic e o r s a le s v o lu m e o c c u rs , th e p u rc h a s e o f th e m a c h in e w i ll g e n e r a te a n e g a tiv e n e t
p re s e n t v a lu e .
B e fo re d e c id in g to p u rc h a s e th e n e w m a c h in e , m a n a g e m e n t is th e re fo re lik e ly to g a th e r m o re
in fo r m a tio n o n s a le s p r ic e a n d s a le s v o lu m e in a n e ffo r t to m in im is e fo r e c a s tin g e rro rs . In c o n tra s t,
th e v a lu e o f a d d itio n a l d a ta a b o u t th e m a c h in e 's v a r ia b le co sts, fix e d o p e r a tin g c o sts a n d u s e fu l life
is r e la tiv e ly s m a ll. T he p r o je c t is still a c c e p ta b le , b a s e d o n th e p e s s im is tic v a lu e s f o r th o s e v a r ia b le s ,
a n d th e re fo re th e c o m p a n y is u n lik e ly to m a k e a lo ss o n th e p r o je c t e v e n if th e s e v a r ia b le s h a v e b e e n
in c o r r e c tly e s tim a te d .
TABLE 6.11 Sensitivity analysis of the purchase of a new machine, based on

optimistic and pessimistic estimates of the values of each variable
NPV: NPV:
o p tim is tic p e s s im is tic R ange o f
V a r ia b le E x p e cte d O p tim is tic P essim istic e s tim a te ($1 ⑹ e s tim a te ($)⑹ N P V ($ )
.
⑴ ⑵ (31 (4) (5 ) —1 6 T
Sales price $ 70 76 63 (i) 8 5 1 8 0 5 (ii) 3 4 6 3 8 6 1198191
Variable 48 46 50 (iii) 4 8 3 1 3 1 (iv) 1 1 4 4 5 7 368674

cost $
Sales volum e 15 000 17000 12500 (v) 5 6 9 1 5 5 (vi) 3 9 1 5 7 608312
Fixed 200000 190000 205000 (v ii) 3 6 0 2 3 9 (v iii) 2 6 8 0 7 1 92169

operating
costs $
Life o f 10 12 9 (ix) 385 780 (x) 248 673 137107

machine
(years)
The figures in lower case Roman numerals in these columns indicate the net present value calculation that corresponds
to the input shown in Table 6.10.
in a p p ro p ria te to e xa m in e th e e ffe c t o n n e t p re s e n t va lu e o f a 20 p e r c e n t re d u c tio n in sales v o lu m e

w ith o u t re c o g n is in g t h a t lo w e r sales v o lu m e m a y also m e a n t h a t th e s e llin g p ric e is lo w e r th a n expected.
A llo w in g f o r these in te rd e p e n d e n c ie s w i ll c o m p lic a te th e an alysis. A n o th e r p ro b le m is t h a t th e te rm s
‘o p tim is tic ’ a n d ‘p e s s im is tic ’ are su b je c t to in te r p r e ta tio n , a n d th e re s u lts m a y be s o m e w h a t a m b ig u o u s.
F o r exa m ple, th e m a rk e tin g d e p a rtm e n t’s ‘o p t im is t ic ’ sales fo re ca sts m a y be so o p tim is tic t h a t th e y are
v ir t u a lly u n a ch ie va b le , w h ile a n o th e r d e p a rtm e n ts o p t im is t ic , e s tim a te s o f o th e r v a ria b le s m a y be m o re
co n se rva tive .
6 .6 .2 1 Break-even analysis
B r e a k - e v e n a n a ly s is is a f o r m o f s e n s itiv ity an alysis. S e n s itiv ity a n a lysis g e n e ra lly in v o lv e s fin d in g BREAK-EVEN ANALYSIS
answ ers to *w ha t if* q u e s tio n s such as: W h a t w ill be th e n e t p re s e n t v a lu e o f th e p ro je c t i f sales are 10 p e r analysis of the
amounts by which
cen t less th a n expected? In b re a k-e ve n a n alysis th e q u e s tio n is tu r n e d a ro u n d , in t h a t th e m a n a g e r asks:
one or more input
H o w p o o r can sales v o lu m e be co m e b e fo re th e p ro je c t loses m o n e y? The b re a k-e ve n p o in t is th e sales variables may change
v o lu m e a t w h ic h th e n e t p re s e n t va lu e is zero. B reak-even a n a lysis is illu s tra te d in th e fo llo w in g e xa m ple before a project
b y re -e x a m in in g th e in fo r m a t io n in E xa m p le 6.11. ceases to be profitable
Example 6.12
F or e a c h o f th e fiv e u n c e rta in v a r ia b le s , th e n e t p re s e n t v a lu e is c a lc u la te d u s in g th e e x p e c te d v a lu e s
o f th e o th e r fo u r v a r ia b le s , w ith th e v a lu e s o f th e fifth v a r ia b le b e in g th e o n e th a t re su lts in th e n e t
p re s e n t v a lu e b e in g z e ro . T h e resu lts f o r a ll v a r ia b le s a r e s h o w n in T a b le 6 .1 2 w ith th e resu lts f o r s a le s
v o lu m e a ls o b e in g s h o w n in F ig u re 6 . 1 .
T he n e t p re s e n t v a lu e o f p u r c h a s in g th e m a c h in e w ill b e p o s itiv e if th e e x p e c te d v a lu e s o f th e o th e r
fo u r u n c e rta in v a r ia b le s a r e a c h ie v e d a n d th e s a le s p r ic e is g r e a te r th a n o r e q u a l to $ 6 7 . S im ila rly ,
th e n e t p re s e n t v a lu e o f p u r c h a s in g th e m a c h in e w ill b e p o s itiv e if th e e x p e c te d v a lu e s o f th e o th e r fo u r
u n c e rta in v a r ia b le s a r e a c h ie v e d a n d s a le s v o lu m e is 1 2 7 9 0 o r m o re un its.
continued
B usiness finance
continued
TABLE 6.12 Breat:-even analysis of the purchase of a

new rnachine
Variable Expected Break even
Sales p rice $ 70 67
V ariable cost $ 48 51
Sales volum e 15000 12 790
Fixed o p e ra tin g costs $ 200000 248627
Life o f m achine (years) 10 6
6 .6 .3 1 Simulation
S e n s itiv ity a n alysis in v o lv e s c h a n g in g one v a ria b le a t a tim e a n d e x a m in in g th e e ffe cts o f th e changes
SIMULATION o n th e p r o f it a b ilit y o f a p ro je c t. O n th e o th e r h a n d , sim ulation a llo w s a m a n a g e r to c o n s id e r th e effects
analysis of the effect o f c h a n g in g a ll th e v a ria b le s w h ose values are u n c e rta in . The f ir s t ste p in a s im u la tio n is to id e n tify th e
of changing all of the
re le v a n t v a ria b le s a n d to s p e c ify th e p ro b a b ility d is tr ib u tio n o f each v a ria b le . F o r e xa m p le , in th e case
input variables whose
values are uncertain to o f th e pu rcha se o f th e n e w m a c h in e in E xam p le s 6 .1 1 a n d 6 .1 2 , th e v a ria b le s c o u ld in c lu d e s e llin g p rice ,
observe the effects on v a ria b le cost, sales v o lu m e , fix e d o p e ra tin g costs a n d th e u s e fu l life o f th e m a ch in e . The second step
the results is to s p e c ify a n y re la tio n s h ip s b e tw e e n th e va ria b le s. F o r exa m ple, a h ig h e r sales v o lu m e m a y re s u lt in
夺
econom ies o f scale in p r o d u c tio n a n d d is tr ib u tio n , w h ic h s h o u ld be re fle c te d in th e v a ria b le costs. The

t h ir d step in v o lv e s u s in g a c o m p u te r to s im u la te th e p ro je c t s cash flo w s . E sse n tia lly, th e p ro c e d u re is as
fo llo w s:
a The c o m p u te r selects value s ra n d o m ly fr o m th e d is tr ib u tio n o f each o f th e sp e cifie d v a ria b le s,

b In th e f ir s t ru n o f th e s im u la tio n th e c o m p u te r calcula tes values f o r th e p ro je c ts cash flo w s f o r each
year.
C The re s u lts o f th e f ir s t r u n are s to re d a n d a n e w s e t o f values is cho sen a n d used in th e seco nd ru n
o f th e s im u la tio n , w h ic h gives f u r t h e r re su lts t h a t are also sto re d . T his p ro c e d u re is re p e a te d a t le a s t
one h u n d re d an d p e rh a p s th o u s a n d s o f tim e s .
d The re s u lts o f a ll th e in d iv id u a l ru n s are c o m b in e d to p ro d u ce a p r o b a b ility d is tr ib u tio n f o r th e
p ro je c ts cash flo w s.
S im u la tio n is a p o te n tia lly va lu a b le to o l t h a t a llo w s m an ag ers to analyse m a n y aspects o f th e ris k s

associated w it h a p ro je c t. I t is g e n e ra lly used fo r la rge p ro je c ts w h e re th e size o f th e in v e s tm e n t can ju s t if y
th e cost o f d e v e lo p in g th e s im u la tio n m o d e l. W h ile s p e c ify in g th e m o d e l can be tim e c o n s u m in g , once i t
has been d e ve lo p e d i t is re la tiv e ly easy to e xa m in e th e e ffe cts o f c h a n g in g th e p r o b a b ility d is tr ib u tio n f o r
one o r m o re va ria b le s. H o w e ve r, users o f th e te c h n iq u e s h o u ld rea lise it s lim ita tio n s . These in c lu d e th e
fo llo w in g :
• S im u la tio n is a te c h n iq u e f o r p ro ce ssin g in fo r m a tio n a n d p re s e n tin g th e re s u lts o f t h a t p ro ce ssin g

in a p a rtic u la r way. T h e re fo re , th e re s u lts o f a s im u la tio n c a n n o t be a n y m o re re lia b le th a n th e in p u t
d a ta a n d th e m o d e l t h a t spe cifie s th e re la tio n s h ip s b e tw e e n v a ria b le s. P ro v id in g re a lis tic e s tim a te s
o f th e p ro b a b ility d is tr ib u tio n s f o r th e v a ria b le s a n d o f th e re la tio n s h ip s b e tw e e n th e v a ria b le s can
be v e ry d iffic u lt.
• S im u la tio n re s u lts can be d iff ic u lt to in te r p r e t. The o u t p u t fr o m th e s im u la tio n co n sists o f a
p ro b a b ility d is tr ib u tio n f o r th e p ro je c ts cash flo w s f o r each ye a r o f its life . H o w s h o u ld a m a n a g e r
use th is data? The o b v io u s f ir s t ste p is to use th e m e a n o r e xp e cte d fo re c a s t cash flo w s f o r each y ea r
to e s tim a te th e p ro je c ts n e t p re s e n t v alue . The n e x t ste p m ig h t be to use o th e r p o ssib le v alue s fo r
th e cash flo w s to calcula te a d is tr ib u tio n o f n e t p re s e n t values. Suppose t h a t the se steps are c a rrie d
o u t a n d th e re s u lts s h o w t h a t th e e xp ected n e t p re s e n t va lu e o f a p ro je c t is $2 m illio n , b u t th e re is
a 20 p e r c e n t p ro b a b ility t h a t th e a c tu a l n e t p re s e n t v a lu e w ill be n e g a tive . D iffe r e n t in d iv id u a ls are
lik e ly to have d iffe re n t o p in io n s a b o u t w h e th e r th e p ro je c t s h o u ld be accepted— t h a t is, s im u la tio n
does n o t p ro v id e an u n a m b ig u o u s a c c e p t/re je c t sig n a l f o r p ro je c ts .
• S im u la tio n focuses o n th e to t a l r is k o f a p ro je c t a n d ig n o re s th e p o s s ib ility t h a t m u c h o f th is
ris k m ig h t be re m o v e d b y d iv e rs ific a tio n . As discussed in S e ctio n 7.5, i t is th e s y s te m a tic o r n o n -
d iv e rs ifia b le r is k o f a p ro je c t t h a t is im p o r t a n t in d e te rm in in g its re q u ire d ra te o f r e tu rn .
In s u m m a ry, s im u la tio n is a p o te n tia lly va lu a b le te c h n iq u e f o r a n a ly s in g th e ris k s a sso cia te d w ith a

p ro je c t, b u t users s h o u ld be aw are o f it s lim ita tio n s .
6.7 Decision-tree analysis

M a n a g e m e n t is s o m e tim e s faced w it h th e ne ed to e va lu a te a lte rn a tiv e s in v o lv in g a sequence o f
ove r tim e . D e c is io n -tre e a n a lysis p ro v id e s a m eans o f e v a lu a tin g such d e cisio ns. The d e c is io n -tre e
d e cisio n s
m
LEARNING
OBJECTIVE 6
a p pro ach takes in to a c c o u n t th e p ro b a b ility o f v a rio u s e ve n ts o c c u rrin g a n d th e e ffe c t o f th o s e eve nts
Use decision-tree
o n th e expected n e t p re s e n t v a lu e o f a p ro je c t. D e c is io n -tre e a n a lysis uses th e c o n c e p t o f ‘ro ll-b a c k ’ to analysis to analyse
eva lu ate a lte rn a tiv e d e cisio n s. T his is illu s tra te d in E xa m p le 6 .1 3 .8 sequential decisions
This ap p ro a ch to e v a lu a tin g a sequence o f d e cisio n s re la tin g to an in v e s tm e n t in a r is k y p ro je c t is
o p e ra tio n a l f o r o u r s im p le exa m p le . I t has th e ad van ta ge t h a t i t forces m a n a g e m e n t to c o n s id e r fu tu re
in v e s tm e n t d e cisio n s w h e n m a k in g c u rre n t in v e s tm e n t de cisio n s. H o w e ve r, th e c o m p le x ity o f d e c is io n -
tre e analysis is in crea sed c o n s id e ra b ly since a d d itio n a l a lte rn a tiv e s , such as a llo w in g f o r a m e d iu m -s iz e d
p la n t a n d a m e d iu m le vel o f d e m a n d , are in c lu d e d in th e d e c is io n process.
8 For a simple discussion of decision-tree analysis, see Levin, Kirkpatrick and Rubin (1992).
B usiness finance
Example 6.13
T he m a n a g e m e n t o f a V ic to r ia n - b a s e d c o m p a n y is c o n s id e r in g th e p r o p o s e d c o n s tru c tio n o f a p la n t to
m a n u fa c tu r e its p ro d u c ts in C h in a . In itia lly , m a n a g e m e n t is fa c e d w ith th e c h o ic e o f c o n s tru c tin g e ith e r
a la r g e o r a s m a ll p la n t. If it c o n s tru c ts a la r g e p la n t, th e in itia l o u tla y w ill b e $ 2 m illio n , w h e r e a s if
it c o n s tru c ts a s m a ll p la n t, th e in it ia l o u tla y w ill b e $1 m illio n . If a s m a ll p la n t is c h o s e n , m a n a g e m e n t
w ill r e c o n s id e r its d e c is io n a fte r 2 y e a rs . A t th a t tim e , m a n a g e m e n t m a y , if it b e lie v e s th a t fu rth e r
e x p a n s io n is w a r r a n t e d , e x p a n d th e s m a ll p la n t to a c h ie v e th e s a m e c a p a c ity a s a la r g e p la n t. The
e x p a n s io n w ill c o s t $ 1 . 2 5 m illio n .
T he c o m p a n y h a s e s tim a te d th e e x p e c te d n e t c a s h flo w s to b e g e n e r a te d b y a la r g e p la n t, a s m a ll
p la n t a n d a n e x p a n d e d p la n t o n th e b a s is o f a tw o - w a y c la s s ific a tio n o f d e m a n d : h ig h d e m a n d a n d
lo w d e m a n d . T h e se e x p e c ta tio n s a r e s u m m a ris e d in T a b le 6 . 1 3 .
TABLE 6.13 Expected net cash flows for different plants

and levels of demand
P o s s ib ilitie s E x p e c te d n e t c a sh f lo w p .a . ($ m )
Large p la n t, h ig h dem and 0.8000
Large p la n t, lo w dem and 0.1000
Sm all p la n t, h ig h dem and 0.4000
Sm all p la n t, lo w dem and 0.3500
Expanded p la n t, h ig h dem and 0.5000
Expanded p la n t, lo w dem and 0.0750
M a n a g e m e n t h a s a ls o e s tim a te d th e p r o b a b ilit y o f a c h ie v in g e ith e r h ig h d e m a n d o r lo w d e m a n d

d u r in g th e p r o je c t's 1 0 - y e a r life . It h a s e s tim a te d th e lik e lih o o d o f h ig h d e m a n d t h r o u g h o u t th e p ro je c t's
life to b e 0 . 6 , th e p r o b a b ilit y o f a c h ie v in g h ig h d e m a n d f o r th e firs t 2 y e a rs a n d lo w d e m a n d fo r
th e re m a in in g 8 y e a rs to b e 0 . 2 , a n d th e p r o b a b ilit y o f lo w d e m a n d th r o u g h o u t th e p ro je c t's life to
b e 0 . 2 . T he p r o b a b ilit ie s a n d th e e x p e c te d n e t c a s h flo w s a r e s h o w n in F ig u re 6 . 2 in th e fo rm o f a
decision tree.
T he s q u a re s in F ig u re 6 . 2 re p re s e n t d e c is io n p o in ts a n d th e s m a ll c irc le s re p re s e n t c h a n c e e v e n ts
th a t m a y o c c u r d u r in g th e life o f th e p r o je c t. T he b a s e o f a d e c is io n tre e is th e b e g in n in g , D e c is io n
p o in t 1. Its b ra n c h e s b e g in a t th e firs t c h a n c e e v e n t. E a ch c h a n c e e v e n t p r o d u c e s tw o o r m o re p o s s ib le
o u tc o m e s , s o m e o f w h ic h le a d to o th e r c h a n c e e v e n ts a n d / o r s u b s e q u e n t d e c is io n p o in ts .
T h e o p tim u m s e q u e n c e o f d e c is io n s is d e te r m in e d u s in g a ro llb a ck p r o c e d u r e , w h ic h m e a n s th a t
th e m o s t d is ta n t d e c is io n — in th is c a s e , th e d e c is io n w h e th e r to e x p a n d th e s m a ll p la n t — is e v a lu a te d
firs t. E a c h a lte r n a tiv e is e v a lu a te d o n th e b a s is o f its e x p e c te d n e t p re s e n t v a lu e . T h e r e q u ir e d ra te o f
re tu rn is a s s u m e d to b e 9 p e r c e n t p e r a n n u m .
Decision 2: Whether to expand the small plant
EXPAND:
r, 1 i [1 1 1
(1+0.0918 (1+0 .0 9)8
N P V = 0 .7 5 [$0 .5 m ) + 0.25($0.075m) - $ 1.25m
0.09 0.09
=$929355
D O N O T EXPAND:
「 1- 1 1 [1 1 1
(1 +0.09)8 |1 +0.09)8
NPV= 0.75 ($0.4m) + 0.25($0.035m)
0.09 0.09
$2 144 743
Demand Expected Demand Expected

level P robability cash flo w level P rob ab ility cash flo w
- Years 0 -2 — Years 3 - 1 0
0 . 7 5 --------- $0.8rr
0.8 $0.8m
0 .25 ---------- $0.1n
0.2 $0.1 r 1.0 $0.1 m
0.75 $0.5m
0.25 $0.075m
0.8 $0.4m
0.75 $0.4m
Small
plant
($lm) 0.25 $0.35m
0.2 $0.35rr 1.0 $0.35m
T h e re fo re , th e o p tim u m c h o ic e is n o t to e x p a n d th e s m a ll p la n t a t th e e n d o f th e s e c o n d y e a r.
T he r o llb a c k m e th o d s im p lifie s th e e v a lu a tio n b y e lim in a tin g th e a lte r n a tiv e o f b u ild in g a s m a ll p la n t
a n d th e n e x p a n d in g it a fte r 2 y e a rs . O n c e m a n a g e m e n t k n o w s w h a t it o u g h t to d o if fa c e d w ith th e
e x p a n s io n d e c is io n , it c a n 'r o ll b a c k 7 to t o d a y 's d e c is io n . T h is d e c is io n is w h e th e r to b u ild a la r g e
p la n t o r a s m a ll p la n t to b e o p e r a te d f o r 1 0 y e a rs .
Decision 1: Construct either a large plant or a small plant and operate for 10 years
LAR G E PLANT:
( 1 + 0 .0 9 〆
Expected NPV = 0 .8 ($0 .8 m )
0 .0 9
(1 + 0 . 0 9 广 -2
■ 0 .8 [0 .7 5 ($ 0 .8 m ) (1 .0 9 )
0 .0 9
-0 .2 5 ($ 0 .1 m )
(1 + 0 . 0 9 广 (1 .0 9 )-2]
0 .0 9
1
10
(1 + 0 . 0 9 )
-0 .2 0 ($ 0 .1 m ) - $2m
0 .0 9
$ 1 5 8 3 0 0 0 (to the nearest thousand dollars)
continued
B usiness finance
continued
S M A L L PLA N T:
(1 + 0 . 0 9 卜
Expected NPV = 0 .8 ($0 .4 m )
0 .0 9
+ 0 .0 8 [$ 2 1 4 4 743 (1 .0 9 )-2 ]
(1 + O .Q 9 )10
•0 .2 ($ 0 .3 5 m ) ■$lr
0 .0 9
= $ 1 4 5 6 0 0 0 (to the nearest thousand dollars)
In th is c a s e th e e x p e c te d n e t p re s e n t v a lu e o f b u ild in g a la r g e p la n t e x c e e d s th a t o f b u ild in g a s m a ll
p la n t.
6.8 Q ualitative factors and the selection

of projects
LEARNING
OBJECTIVE 7
A f te r th e q u a n tita tiv e a n alysis has been co m p le te d , m a n a g e m e n t has to decide w h ic h p ro je c ts to
Explain the role of
im p le m e n t. W h ile th e a im is to m a x im is e s h a re h o ld e rs , w e a lth , i t does n o t ne ce ssa rily f o llo w t h a t p ro je c t
qualitative factors in
project selection s e le c tio n d e cisio n s s h o u ld be g u id e d o n ly b y th e re s u lts o f th e q u a n tita tiv e an alysis. M a n a g e m e n t s h o u ld
also c o n s id e r a n y q u a lita tiv e fa c to rs t h a t m a y a ffe c t th o s e p ro je c ts .
E s s e n tia lly , q u a lita tiv e fa c to rs are th o se t h a t m a n a g e m e n t w o u ld lik e to in c lu d e in th e q u a n tita tiv e
an alysis b u t is u n a b le to in c lu d e because th e y are d iffic u lt, i f n o t im p o s s ib le , to m ea sure in d o lla rs . F o r
th is rea son th e y are assessed separately, a fte r th e q u a n tita tiv e a n a lysis o f th e a lte rn a tiv e s has been
co m p le te d .
Q u a lita tiv e fa c to rs m a y p la y a v it a l ro le in p ro je c t se le ctio n . F o r e xa m p le , suppose t h a t q u a n tita tiv e
a n a lysis sho w s t h a t i t is che ap er f o r a tr a n s p o r t c o m p a n y to c o n tin u e u s in g som e o ld tru c k s f o r a n o th e r
ye a r ra th e r th a n re p la c in g th e m no w . H o w e ve r, m a n a g e m e n t m a y decide to replace th e o ld tru c k s n o w
because o f q u a lita tiv e fa c to rs such as th e de sire to m a in ta in a m o d e rn im a ge f o r th e c o m p a n y a n d th e
im p ro v e d s a tis fa c tio n , a n d c o n s e q u e n tly th e im p ro v e d p ro d u c tiv ity , o f th e d riv e rs re s u ltin g fr o m th e
c o m fo rt o f th e n e w tru c k s .
Som e f u r t h e r exa m ples o f q u a lita tiv e fa c to rs t h a t m a y a ffe c t m a n a g e m e n ts d e cisio n s a b o u t p ro je c ts
are:
• The in tr o d u c tio n o f la b o u r-s a v in g m a c h in e ry m a y be d e fe rre d (p e rh a p s in d e fin ite ly ) because o f

u n io n o p p o s itio n , even th o u g h o n th e basis o f th e q u a n tita tiv e a n a lysis th e p ro p o s a l to in tro d u c e
th e m a c h in e ry has a n e t p re s e n t v a lu e g re a te r th a n zero.
• T w o m u tu a lly e xclu sive in v e s tm e n ts m a y have n e t p re s e n t values t h a t are a lm o s t eq ua l, b u t one
re q u ire s m u c h m o re m a n a g e m e n t s u p e rv is io n , o r th e use o f som e o th e r scarce h u m a n resource. The
use o f th is scarce reso urce in v o lv e s an o p p o r tu n ity cost th a t, w h ile re co g n ise d b y m a n a g e m e n t, is
d iff ic u lt to q u a n tify . T h e re fo re , ra th e r th a n a tte m p tin g to m ea sure th e o p p o r tu n it y co st o f u s in g th e
scarce h u m a n resources, m a n a g e m e n t m a y s im p ly select th e p ro p o s a l t h a t i t b e lie ve s w ill use fe w e r
o f th o s e resources, o th e r th in g s b e in g equal.
I t is e s s e n tia l t h a t such q u a lita tiv e fa c to rs be c o n sid e re d b e fo re s e le c tin g a p ro je c t. H o w eve r, th e

re c o g n itio n o f q u a lita tiv e fa c to rs is n o t a g e n e ra l p re s c rip tio n f o r ig n o r in g o r re d u c in g th e im p o rta n c e
o f th e q u a n tita tiv e a n a lysis. As a ll fa c to rs c a n n o t be in c o rp o ra te d in to th e q u a n tita tiv e an alysis, a
c o m p a ris o n o f a lte rn a tiv e in v e s tm e n t p ro p o s a ls is in c o m p le te w ith o u t an asse ssm en t o f th e po ssib le
e ffe cts o f th e q u a lita tiv e fa c to rs . Ind e e d , th e in flu e n c e o f q u a lita tiv e fa c to rs m a y be s u ffic ie n tly im p o r ta n t
to cause m a n a g e m e n t to select p ro p o sa ls w ith lo w e r c a lc u la te d n e t p re s e n t values.
6.9 Project selection with resource

constraints
LEARNING
OBJECTIVE 8
So fa r i t has been a ssu m ed t h a t m a n a g e m e n t is w illin g a n d able to accept a ll in d e p e n d e n t in v e s tm e n t
Explain the effects of
p ro je c ts th a t have a n e t p re s e n t v a lu e g re a te r th a n zero an d, i f m u tu a lly e xclusive p ro je c ts are b e in g resource constraints on
com pared, th o se p ro je c ts w it h th e h ig h e s t p o s itiv e n e t p re s e n t value. H o w e ve r, so m e tim e s a c o m p a n y s project selection
m anagers be lie ve t h a t th e y are p re v e n te d fr o m u n d e rta k in g a ll acceptable p ro je c ts because o f a sho rta ge *
o f fu n d s . C apital ration in g is th e te rm used to de scrib e such a s itu a tio n . I t m a y be c la s s ifie d f u r t h e r in to CAPITAL RATIO NING
in te rn a l (o r ‘s o f t ’）c a p ita l ra tio n in g a n d e x te rn a l (o r ‘h a rd ’）c a p ita l ra tio n in g . a condition where
a firm has limited
Internal capital rationing occurs w h e n m a n a g e m e n t lim it s th e a m o u n t t h a t can be in v e s te d in n e w
resources available for
p ro je c ts d u rin g som e s p e c ifie d tim e p e rio d . There are seve ral reasons w h y m a n a g e m e n t m a y im p o s e a li m it investment
o n c a p ita l e x p e n d itu re . O n e is t h a t m a n a g e m e n t is c o n s e rv a tiv e a n d has a p o lic y o f fin a n c in g a ll p ro je c ts
fro m in te r n a lly g e n e ra te d cash because i t is u n w illin g to b o rro w . S im ila rly , m a n a g e m e n t m a y be u n w illin g
to issue m o re shares because o f p o ssib le e ffe cts o n th e c o n tro l o f th e com p an y. A lte rn a tiv e ly , im p o s in g
c a p ita l e x p e n d itu re lim it s can be a w a y o f m a in ta in in g fin a n c ia l c o n tro l. F o r e xa m p le , in a la rg e com p an y,
m anagers m a y a tte m p t to e x p a n d t h e ir d iv is io n s b y p ro p o s in g m a n y n e w p ro je c ts , som e o f w h ic h o n ly
appear to be p ro fita b le because th e cash flo w fo re ca sts are v e ry o p tim is tic . To a v o id th is p ro b le m , to p
m a n a g e m e n t m a y delegate a u t h o r ity f o r c a p ita l e x p e n d itu re d e cisio n s to d iv is io n a l m an ag ers, b u t re ta in
o ve ra ll c o n tro l b y g iv in g each d iv is io n a c a p ita l e x p e n d itu re lim it . The a im is to fo rce each d iv is io n a l
m an ag er to decide w h ic h o f th e p o ssib le p ro je c ts re a lly s h o u ld be a d op te d.
A n o th e r p o s s ib ility is t h a t i t m a y be d e sira b le to li m i t th e ra te a t w h ic h a c o m p a n y exp an ds because o f
th e o rg a n is a tio n a l d iffic u ltie s in h e re n t in h ir in g a n d t r a in in g m a n y a d d itio n a l s ta ff. M a n a g e m e n t m a y be
con cern ed t h a t ra p id e x p a n s io n w ill le a d to in e ffic ie n c y a n d h ig h e r costs. To a v o id th e se p ro b le m s i t m a y
lim it th e n u m b e r o f n e w p ro je c ts t h a t are im p le m e n te d . In th is case, a c a p ita l e x p e n d itu re li m i t is used to
im p ose th e d e sire d r e s tr ic tio n , b u t i t is n o t capital t h a t is th e scarce resource. R a th e r, th e scarce resource
is m a n a g e m e n t tim e , a n d th e re a l c o n ce rn is t h a t th is c o n s tra in t m a y re s u lt in s u p e rv is io n p ro b le m s .
External capital rationing occu rs w h e n th e c a p ita l m a rk e t is u n w illin g to s u p p ly th e fu n d s necessary
to fin a n ce th e p ro je c ts t h a t a c o m p a n y s m a n a g e m e n t w ishes to u n d e rta k e . I n th is case, th e c o m p a n y
has p ro je c ts t h a t o ffe r p o s itiv e n e t p re s e n t value s b u t c a n n o t raise, a t a co st t h a t m a n a g e m e n t con sid ers
acceptable, th e fu n d s necessary to fin a n c e th e m . T h is s itu a tio n can o ccu r i f fin a n c ia l in te rm e d ia rie s are
sub je ct to c o n tro ls such as lim it s o n th e v o lu m e o r g r o w th ra te o f t h e ir le n d in g . H o w e ve r, i t is d iffic u lt
to see w h y i t s h o u ld o ccu r in d e re g u la te d fin a n c ia l m a rk e ts . A n y c o m p a n y t h a t has a p ro je c t exp ected
to be p ro fita b le s h o u ld be able to o b ta in th e necessary c a p ita l, n o m a tte r h o w s m a ll its c a p ita l b u d g e t.
F or exam ple, suppose t h a t a s m a ll com p an y, w h ic h p la n s to in v e s t n o m o re th a n , say, $ 5 0 0 0 0 in th e
c u rre n t year, discove rs an in e x p e n s iv e w a y o f e x tra c tin g g o ld fr o m th e oceans. R a is in g c a p ita l to b u ild th e
e x tra c tio n p la n t s h o u ld n o t be a p ro b le m .
E m p iric a l evidence suggests t h a t c a p ita l r a tio n in g is m o re lik e ly to re s u lt fr o m e x p e n d itu re lim it s
im p o se d b y m a n a g e m e n t o f its o w n v o lit io n th a n fr o m an u n w illin g n e s s o f th e c a p ita l m a rk e t to s u p p ly
fu n d s (P ike 1 9 8 3 ). I f m a n a g e m e n ts de cisio n s re s u lt in th e re je c tio n o f p ro je c ts w it h p o s itiv e n e t p re s e n t
values, th e n m a n a g e m e n t is a d o p tin g a p o lic y in c o n s is te n t w it h th e o b je c tiv e o f m a x im is in g th e m a rk e t
value o f th e c o m p a n y ’s shares. I f c a p ita l ra tio n in g is e s s e n tia lly an in te r n a l ‘p ro b le m ’, i t m ig h t a p p e a r th a t
th e s o lu tio n s h o u ld be sim p le . M a n a g e m e n t s h o u ld re m o ve th e c o n s tra in ts so t h a t a ll p o s itiv e n e t p re s e n t
value p ro je c ts can be im p le m e n te d . In som e cases, th is does occur. F o r e xa m p le , in cases w h e re c a p ita l
e x p e n d itu re lim it s are used to m a in ta in fin a n c ia l c o n tro l, th e lim it s are lik e ly to be fle x ib le , a n d a d d itio n a l
fu n d s w ill be p ro v id e d i f a p ro fita b le in v e s tm e n t o p p o r tu n ity arises u n e xp e cte d ly.
H o w eve r, as discussed above, c a p ita l e x p e n d itu re lim it s m a y be im p o s e d f o r v a lid reasons t h a t do
n o t re fle c t a sh o rta g e o f c a p ita l. R a th e r, th e re a l c o n s tra in t m a y be a s h o rta g e o f o th e r resources such
as m a n a g e m e n t tim e . T h e re fo re , c a p ita l r a tio n in g can be a real p h e n o m e n o n a n d m an ag ers m a y ne ed to
choose th e set o f p ro je c ts t h a t m a x im is e s n e t p re s e n t value , s u b je c t to a reso urce c o n s tra in t. O n th e o th e r
ha n d , i f e x te rn a l c a p ita l r a tio n in g e xists, a tte m p ts to m a x im is e n e t p re s e n t value , su b je c t to a c a p ita l
e x p e n d itu re lim it , in v o lv e a n in h e re n t c o n tra d ic tio n . The p ro b le m is t h a t a p ro je c ts n e t p re s e n t va lu e
is ca lcula ted u s in g a re q u ire d ra te o f r e tu r n , b u t th e existe nce o f an e x te rn a l l i m i t o n th e a v a ila b ility
o f c a p ita l im p lie s t h a t once th e li m it is reached, th e re q u ire d ra te o f r e tu r n is in fin ite . In th e fo llo w in g
d iscu ssio n , th e re fo re , i t w ill be assu m ed t h a t c a p ita l r a tio n in g e xists o n ly because o f in te r n a lly im p o s e d
c o n s tra in ts . A m a n a g e r a tte m p tin g to ‘m a x im is e , th e m a rk e t value o f th e c o m p a n y ’s shares w it h in these
s e lf-im p o s e d c o n s tra in ts s h o u ld calcula te th e n e t p re s e n t value o f each p ro je c t b y d is c o u n tin g its cash
flo w s a t th e re q u ire d ra te o f re tu rn , a n d th e n choose th e c o m b in a tio n o f p ro je c ts t h a t m a xim ise s n e t
p re s e n t v a lu e . The fo llo w in g e xa m p le illu s tra te s th is ap pro ach.
E xample 6.14
S u p p o s e th a t a c o m p a n y is c o n s id e r in g th e p r o p o s a ls lis te d in T a b le 6 . 1 4 . A s s u m e th a t it h a s a c a p it a l
e x p e n d itu re lim it o f $ 6 0 0 0 0 0 , a ll p ro je c ts a r e in d e p e n d e n t, th e p ro je c ts a r e n o t d iv is ib le a n d it is n o t
e n v is a g e d th a t a n e x p e n d itu re lim it w ill e x is t in fu tu re y e a rs .
TABLE 6.14 Ranking of projects under capital rationing

Project Initial cash outlay ($) Net present value ($)
A 200000 28000
B 200000 20000
C 200000 15 000
D 200000 35 000
E 400000 45 000
F 400000 22000
M a n a g e m e n t m u st f in d th e c o m b in a tio n o f p ro je c ts th a t m a x im is e s n e t p re s e n t v a lu e , s u b je c t to th e
e x p e n d itu re lim it o f $ 6 0 0 0 0 0 .
SOLUTION
In th is e x a m p le , e x a m in a tio n o f a ll p o s s ib le o u tc o m e s s h o w s th a t th e la rg e s t n e t p re s e n t v a lu e w ill b e
a c h ie v e d b y th e c o m b in a tio n o f P ro je cts D, A a n d B. T h is c o m b in a tio n resu lts in a n e t p re s e n t v a lu e
o f $ 8 3 0 0 0 . B y c o m p a r is o n , th e n e x t b e s t a lte r n a tiv e , a c o m b in a tio n o f P ro je cts D a n d E, resu lts in
a n e t p re s e n t v a lu e o f $ 8 0 0 0 0 . A s a re s u lt o f th e e x p e n d itu re lim it, e v e n th o u g h P ro je c ts C , E a n d
F h a v e p o s itiv e n e t p re s e n t v a lu e s , th e c o m p a n y is u n a b le to im p le m e n t th e m th is y e a r . W it h o u t th e
e x p e n d itu r e lim it, a ll th e p ro je c ts s h o w n in T a b le 6 . 1 4 c o u ld h a v e b e e n a c c e p te d a n d th e to ta l n e t
p re s e n t v a lu e w o u ld h a v e b e e n $ 1 6 5 0 0 0 in s te a d o f $ 8 3 0 0 0 .
In re a lity , ra n k in g o f in v e s tm e n t p ro je c ts w h e re th e re is c a p ita l r a tio n in g is m u c h m o re co m p le x

because o f th e la rg e n u m b e r o f in v e s tm e n t a lte rn a tiv e s g e n e ra lly a va ila b le to a co m p a n y. To f in d s o lu tio n s
to such p ro b le m s , m a th e m a tic a l p ro g ra m m in g m o d e ls have b e en de velope d.
W e n o w r e tu r n to th e e a rlie r p o in t t h a t th e im p o s itio n o f c a p ita l r a tio n in g b y m a n a g e m e n t can p re v e n t
th e m a x im is a tio n o f s h a re h o ld e rs ’ w e a lth . C a p ita l r a tio n in g is n o t in th e s h a re h o ld e rs ’ b e s t in te re s t i f
p ro je c ts w it h p o s itiv e n e t p re s e n t values are rejected . In E x a m p le 6 .1 4 , P ro je cts C, E a n d F, w ith p o s itiv e
n e t p re s e n t values t o t a llin g $ 8 2 00 0, are re je cte d because o f a c a p ita l c o n s tra in t. U n less th e c o m p a n y faces
a re a l c o n s tra in t, such as a s h o rta g e o f p e rs o n n e l, o r ra p id e x p a n s io n in v o lv e s excessive r is k , m a n a g e m e n t
s h o u ld raise th e fu n d s necessary to fin a n c e the se p ro je c ts b y re d u c in g d iv id e n d s , b o rro w in g , is s u in g m o re
shares o r som e c o m b in a tio n o f the se a ctio n s.
C H A P T E R SIX R E V I E W
SUMMARY
This c h a p te r h a s d is c u s s e d s e v e ra l im p o r ta n t a s p e c ts c h a in of re p la c e m e n t m e th o d or by c a lc u la tin g
o f p r o je c t e v a lu a tio n , b e g in n in g w ith th e e s tim a tio n o f th e e q u iv a le n t a n n u a l v a lu e o f e a c h p r o je c t. T hese
c a s h flo w s . m e th o d s a ls o p r o v id e a c o n v e n ie n t w a y o f a n a ly s in g
• In e s tim a tin g c a s h flo w s , f in a n c in g c h a rg e s s h o u ld a s s e t r e p la c e m e n t d e c is io n s .
b e e x c lu d e d , a s to o s h o u ld a llo c a te d costs a n d su n k • W h ile th e e ffe c ts o f ris k c a n be in c o r p o r a t e d in
costs. C o n v e rs e ly , a ll in c re m e n ta l c a s h flo w s m ust b e p r o je c t e v a lu a tio n b y u s in g a ris k -a d ju s te d d is c o u n t
in c lu d e d . T he c o r r e c t tre a tm e n t o f in fla tio n re q u ire s ra te , th e re a r e s e v e ra l m e th o d s o f p r o je c t a n a ly s is
th a t c a s h flo w s a n d th e r e q u ir e d ra te o f re tu rn b e th a t c a n b e u se fu l in d e s c r ib in g ris k a n d p r o v id in g
d e fin e d in a c o n s is te n t m a n n e r. m a n a g e rs w ith in fo r m a tio n a b o u t th e ris k o f a p r o je c t.
• In d iv id u a ls a n d firm s a r e r e q u ire d to p a y in c o m e T he m e th o d s d is c u s s e d in th e c h a p te r a r e s e n s itiv ity
ta x e s to th e g o v e rn m e n t. H e n c e , it is im p o r ta n t th a t a n a ly s is , b re a k -e v e n a n a ly s is and s im u la tio n .
p r o je c t e v a lu a tio n m e th o d s ta k e in to a c c o u n t ite m s D e c is io n -tre e a n a ly s is can be a u se fu l to o l fo r
th a t q u a lif y as a s s e s s a b le in c o m e a n d ite m s th a t e v a lu a tin g s e q u e n tia l d e c is io n s w h e r e p r o b a b ilit ie s
q u a lify as a llo w a b le d e d u c tio n s . An in c re a s e in c a n b e a tta c h e d to th e p o s s ib le o u tc o m e s .
a s s e s s a b le in c o m e resu lts in a h ig h e r ta x p a y m e n t,
w h ile a n in c re a s e in a llo w a b le d e d u c tio n s re su lts in T he c h a p te r a ls o p r o v id e d a d is c u s s io n o f th e
a lo w e r t a x p a y m e n t. im p o r ta n c e o f c o n s id e r in g q u a lita tiv e fa c to rs in p r o je c t
• P ro je c ts th a t a re m u tu a lly e x c lu s iv e and have e v a lu a tio n , a n d c o n c lu d e d w ith a d is c u s s io n o f th e
d iffe re n t liv e s c a n b e c o m p a r e d u s in g th e c o n s ta n t e ffe c ts o f re s o u rc e c o n s tra in ts o n p r o je c t e v a lu a tio n .
KEY TERMS
b re a k -e v e n a n a ly s is 151 re s id u a l v a lu e 131
c a p ita l r a tio n in g 157 s e n s itiv ity a n a ly s is 149
c o n s ta n t c h a in o f re p la c e m e n t a s s u m p tio n 140 s im u la tio n 152
e q u iv a le n t a n n u a l v a lu e m e th o d 141 su n k co st 131
SELF-TEST PROBLEMS
A c o m p a n y is c o n s id e r in g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 8 4 0 0 0 , w h ic h w ill p e r m it it to re d u c e its
e x is tin g la b o u r co sts b y $ 2 0 0 0 0 a y e a r fo r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d
$ 2 0 0 0 e v e r y 2 y e a rs o v e r h a u lin g th e e q u ip m e n t. The e q u ip m e n t m a y b e d e p r e c ia te d f o r t a x p u rp o s e s
b y th e s tr a ig h t-lin e m e th o d , o v e r a 1 2 -y e a r p e r io d . T he c o m p a n y ta x ra te is 3 0 c e n ts in th e d o lla r a n d th e
a fte r-ta x c o s t o f c a p it a l is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h flo w s , in c lu d in g ta x p a y m e n ts , a r e
m a d e a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t?
T he m a n a g e m e n t o f th e T M T C o m p a n y is c o n s id e r in g p u r c h a s in g a n e w m a c h in e a n d it h a s g a th e r e d th e
f o llo w in g d a ta :
a) The c a s h n e e d e d to p u rc h a s e th e n e w m a c h in e is $ 6 4 0 0 0 .
b) The re s id u a l v a lu e a n d a n n u a l c a s h o p e r a tin g e x p e n s e s fo r th e n e x t 5 y e a rs a r e e s tim a te d to be:
R e sid u a l v a lu e a t e n d A n n u a l ca sh o p e r a tin g
Year o f y e a r ($ ) e xp e n se s ($ }
1 50000 11000
2 40000 13000
3 30000 18000
4 23000 24000
5 3500 28000
B usiness finance
c) N o cha ng es in residual values o r a n n u a l cash o p e ra tin g expenses a re exp ected .

d) The re q u ire d rate o f return is 15 per cent pe r annum .
e) The effects o f c o m p a n y in com e ta x m a y be ig n o re d .
W h a t is the o p tim u m re p la ce m e n t p o lic y fo r this m achine?
3 The m a n a g e m e n t o f A B C T ra n sp o rt Ltd, w h ic h is e n g a g e d in interstate tra n s p o rt, is c o n s id e rin g the
re p la c e m e n t o f its pre sen t fle e t o f 1 0 CB sem i-trailers w ith six A Z F lexivans. A su rve y has re ve a le d the
fo llo w in g estim ates o f costs, a n d so on, p e r vehicle:
CB s e m i-tra ile rs E stim ate s A Z F le x iv a n s E stim ates 1
R em aining life 3 years E stim ate d life 5 years
Residual value:
A t th e p re se n t tim e $5 000 Cost $70000
In 3 years’ tim e $1000 A n n u a l n e t cash flow s $40000
A n n u a l n e t cash flow s $30000 Residual value a fte r $5 000

5 years’ o p e ra tio n
O th e r in fo r m a tio n is a s fo llo w s :
• N e t c a s h flo w s a r e to b e r e g a r d e d a s re c e iv e d a t th e e n d o f e a c h y e a r.
• T he r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .
S h o u ld m a n a g e m e n t:
a) re ta in th e C B s e m i-tra ile rs f o r 3 y e a rs a n d th e n re p la c e th e m w ith A Z F le x iv a n s ?
b) re p la c e th e C B se m i-tra ile rs w ith th e A Z F le x iv a n s n o w ?
Solutions to self-test problems ore available in Appendix B.
QUESTIONS
1 [LO 1! A p r o p e r ty d e v e lo p m e n t c o m p a n y p la n s to d e m o lis h th e b u ild in g o n a site th a t it a lr e a d y o w n s , a n d
th e n b u ild a c o n v e n ie n c e sto re . W h ic h o f th e f o llo w in g ite m s s h o u ld b e in c lu d e d a s in c re m e n ta l c a s h flo w s
w h e n th e p r o je c t is e v a lu a te d :
a) th e m a rk e t v a lu e o f th e p r o p e r ty
b) th e c o s t o f d e m o lis h in g th e o ld b u ild in g
c) th e co st o f n e w w a te r a n d e le c tric p o w e r c o n n e c tio n s in s ta lle d 3 m o n th s a g o
d) a p o rtio n o f th e c o s t o f le a s in g c a rs use d b y th e c o m p a n y 's e x e c u tiv e s
e) m o n e y th a t ha s a lr e a d y b e e n s p e n t o n a rc h ite c tu ra l c o n c e p t p la n s fo r th e n e w b u ild in g ?
2 [L O 1] E x p la in th e re la tio n s h ip b e tw e e n nominal a n d real d is c o u n t ra te s . O u t lin e its a p p lic a t io n to p r o je c t

e v a lu a tio n in th e c o n te x t o f a n in fla t io n a r y e c o n o m y .
3 [LO 1] L e a v in g a s id e th e e ffe c t o f ta x e s , w h ic h o f th e f o llo w in g ite m s s h o u ld b e c o n s id e r e d in th e in itia l

o u tla y o n a n e w m a c h in e f o r p r o je c t e v a lu a tio n p u rp o s e s ? G iv e re a s o n s .
a) T he d is p o s a l v a lu e o f th e o ld m a c h in e , w h ic h is $ 6 0 0 0 .
b) T he $ 4 0 0 c o s t o f in s ta llin g th e n e w m a c h in e .
c) A d d it io n a l in v e s tm e n t o f $ 1 0 0 0 0 in c u rre n t assets th a t w ill b e re q u ire d .
d) C o sts o f $ 3 0 0 0 re c e n tly in c u rre d in a sse ssin g th e s u ita b ility o f th e n e w m a c h in e .
4 [L O 2 】It
doesn't matter whether the straight-line method or reducing-balance method o f depreciation is
used since the total tax b ill over the life o f the project is the some. C o m m e n t o n th is s ta te m e n t.
5 [LO 3 】 O u t lin e tw o m e th o d s o f s o lv in g p r o je c t e v a lu a tio n p ro b le m s w h e r e th e p ro je c ts u n d e r c o n s id e r a tio n
d o n o t h a v e c o m m o n te r m in a l d a te s .
160
6 [L O 3 ] D e fin e th e te rm 'm u tu a lly e x c lu s iv e p r o je c ts ' a n d p r o v id e a s im p le e x a m p le . O u tlin e a n d ju s tify th e
b a s ic n e t p re s e n t v a lu e ru le a p p lic a b le to th e m . H o w s h o u ld th is ru le b e m o d ifie d w h e n such p ro je c ts h a v e
u n e q u a l live s?
7 [L O 4 ] H o w s h o u ld th e o p tim u m life o f a p r o je c t b e d e te rm in e d ?
8 [L O 4 ] D is tin g u is h b e tw e e n re p la c e m e n t d e c is io n s a n d re tire m e n t d e c is io n s .
9 Sensitivity analysis may be used to identify the variables that ore most important for a project's
[L O 5 ]
success. D iscuss.
10 [L O 5 ] O u tlin e th e w e a k n e s s e s o f s e n s itiv ity a n a ly s is .
11 [LO 5 ] Simulation is only useful for large-scale investment projects. D iscuss.

12 Simulation is extremely valuable because it is useful in refining cash flow forecasts and it avoids the
[L 0 5 ]
need to estimate a project's required rote o f return. D o y o u a g r e e w ith th e se c la im s ? G iv e re a s o n s f o r y o u r
a n s w e r.
13 [LO 8 ] D is tin g u is h b e tw e e n in te rn a l a n d e x te rn a l c a p it a l r a tio n in g . G iv e e x a m p le s o f e a c h .
14 [L0 8]
a) O u tlin e p o s s ib le re a s o n s fo r th e im p o s itio n b y m a n a g e m e n t o f c a p ita l ra tio n in g . D o e s th e im p o s itio n o f
in te rn a l c a p ita l r a tio n in g im p ly th a t m a n a g e m e n t is f a ilin g to m a x im is e s h a re h o ld e rs 7 w e a lth ?
b) If a c o m p a n y is s u b je c t to c a p ita l ra tio n in g , d o e s th is m a k e a n y d iffe re n c e to p r o je c t e v a lu a tio n u s in g th e

n e t p re s e n t v a lu e m e th o d ? G iv e re a so n s.
CA
1
PROBLEMS
Application of the N P V method [LO 1]
The fu rn itu re d iv is io n o f P la y fu rn Ltd, a p ro fita b le , d iv e rs ifie d c o m p a n y , p u rc h a s e d a m a c h in e 5 y e a rs a g o
fo r $ 7 5 0 0 0 . W h e n it w a s p u rc h a s e d th e m a c h in e h a d a n e x p e c te d use ful life o f 1 5 y e a rs a n d a n e s tim a te d
v a lu e o f z e ro a t th e e n d o f its life . T h e m a c h in e c u rre n tly h a s a m a rk e t v a lu e o f $ 1 0 0 0 0 . T he d iv is io n
m a n a g e r re p o rts th a t he c a n b u y a n e w m a c h in e fo r $ 1 6 0 0 0 0 (in c lu d in g in s ta lla tio n ) w h ic h , o v e r its 1 0 -y e a r
life , w ill re su lt in a n e x p a n s io n o f sa le s fro m $ 1 0 0 0 0 0 to $1 1 0 0 0 0 p e r a n n u m . In a d d itio n , it is e s tim a te d th a t
th e n e w m a c h in e w ill re d u c e a n n u a l o p e r a tin g costs fro m $ 7 0 0 0 0 to $ 5 0 0 0 0 . If th e r e q u ire d ra te o f re tu rn is
1 0 p e r c e n t p e r a n n u m , s h o u ld P la y fu rn b u y th e n e w m a c h in e ?
2 Application of the N P V method [LO 1]

T he T w o-B it M in in g C o m p a n y h a s c o n s tru c te d a to w n a t B ig B o re , n e a r th e site o f a ric h m in e ra l d is c o v e r y
in a re m o te p a r t o f A u s tr a lia . T he to w n w ill b e a b a n d o n e d w h e n m in in g o p e ra tio n s c e a s e a fte r a n e s tim a te d
1 0 -y e a r p e r io d . T he fo llo w in g e s tim a te s o f in v e s tm e n t costs, sa le s a n d o p e r a tin g e x p e n s e s re la te to a p r o je c t to
s u p p ly B ig B o re w ith m e a t a n d a g ric u ltu r a l p ro d u c e o v e r th e 1 0 -y e a r p e r io d b y d e v e lo p in g n e a r b y la n d .
a) In v e s tm e n t in la n d is $ 1 0 m illio n , fa rm b u ild in g s $ 2 0 0 0 0 0 0 a n d fa rm e q u ip m e n t $ 4 0 0 0 0 0 0 . T he la n d
is e x p e c te d to h a v e a re a lis a b le v a lu e o f $ 5 0 0 0 0 0 0 in 1 0 y e a rs ' tim e . T he re s id u a l v a lu e o f th e b u ild in g s
a fte r 1 0 y e a rs is e x p e c te d to b e $ 5 0 0 0 0 0 . T he fa rm e q u ip m e n t ha s a n e s tim a te d life o f 1 0 y e a rs a n d a
z e r o re s id u a l v a lu e .
b) In ve stm e n t o f $ 2 5 0 0 0 0 0 in c u rre n t assets w ill b e re c o v e re d a t th e te rm in a tio n o f th e v e n tu re .
c) A n n u a l c a s h sales a r e e s tim a te d to b e $ 2 4 . 8 m illio n .
d) A n n u a l c a s h o p e r a tin g costs a r e e s tim a te d to b e $ 2 2 m illio n .
Is th e p ro je c t p r o fita b le , g iv e n th a t th e r e q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m ?

A s o ftw a re p r o v id e r b u y s b la n k B lu -ra y D V D s a t $ 5 5 0 p e r h u n d re d a n d c u rre n tly uses 2 m illio n D V D s p e r y e a r.
The m a n a g e r b e lie v e s th a t it m a y b e c h e a p e r to m a k e th e D V D s ra th e r th a n b u y th e m . D ire c t p r o d u c tio n costs
(la b o u r, m a te ria ls , fu e l) a r e e s tim a te d a t $ 2 . 5 0 p e r D V D . T he e q u ip m e n t n e e d e d w o u ld c o s t $ 3 m illio n . T he
e q u ip m e n t s h o u ld la s t fo r 1 5 y e a rs , p r o v id e d it is o v e rh a u le d e v e ry 5 y e a rs a t a c o s t o f $ 2 5 0 0 0 0 e a c h tim e .
The o p e r a tio n w ill re q u ire a d d itio n a l c u rre n t assets o f $ 4 0 0 0 0 0 . The c o m p a n y 's r e q u ire d ra te o f re tu rn
is 1 2 p e r c e n t. E v a lu a te th e p ro p o s a l.
161
B usiness finance

O z z ie N a tio n w id e In d u strie s Ltd is a la r g e c o m p a n y w ith in te re sts in m in in g , s h ip b u ild in g , e n te rta in m e n t, fo o d
p ro c e s s in g a n d in te rs ta te fr e ig h t h a u la g e . Its fo o d p ro c e s s in g d iv is io n is in v e s tig a tin g th e p o s s ib ility o f a d d in g
m a n d a rin -fla v o u re d y o g h u r t to its c u rre n t ra n g e o f b a n a n a , s tr a w b e r r y a n d a p p le . C u rre n tly , a ll fla v o u rs a re
s o ld a t a p ric e o f $ 1 . 5 0 p e r c a rto n a n d sa le s a re e ve n th ro u g h o u t th e y e a r. O z z ie re c e n tly h ir e d M e lb o u r n e
M a r k e t R e se a rch Ltd to s u rv e y co n s u m e rs to ju d g e th e lik e ly p o p u la r ity o f th e n e w fla v o u r. The r e p o r t c o s t
$ 4 0 0 0 0 a n d s u g g e s te d th a t th e c o m p a n y s h o u ld b e a b le to sell 4 0 0 0 0 0 c a rto n s o f th e n e w fla v o u r n e x t y e a r,
a n d 8 0 0 0 0 0 in e a c h o f th e f o llo w in g 2 y e a rs . A fte r th a t tim e , th e fa d fo r m a n d a r in fla v o u r is e x p e c te d to
h a v e run its c o u rs e . O z z ie 's c o s tin g d e p a rtm e n t h a s a d v is e d th a t th e in c re m e n ta l c o s t o f p ro d u c tio n is $ 1 . 2 0
p e r c a rto n . O z z ie 's sales d e p a rtm e n t h a s a d v is e d th a t it is e s s e n tia l th a t a ll fla v o u rs in th e ra n g e s h o u ld b e
so ld a t th e s a m e p ric e . O z z ie 's e n g in e e rs h a v e a d v is e d th a t th e re is n o s p a re p ro d u c tio n c a p a c ity a lth o u g h
th e re is p le n ty o f s p a re flo o r s p a c e in th e fa c to ry . T h e y h a v e a ls o a d v is e d th a t y o g h u r t p ro c e s s in g m a c h in e s
h a v e a p r o d u c tio n c a p a c ity o f 4 0 0 0 0 0 c a rto n s p e r a n n u m a n d th a t th e c o s t o f o n e m a c h in e , fu lly in s ta lle d ,
is $ 2 3 0 0 0 0 . O z z ie 's fin a n c e d iv is io n ha s a d v is e d th a t th e c o m p a n y 's re q u ire d ra te o f re tu rn (n o m in a l) is
e s tim a te d to b e 1 5 p e r c e n t p e r a n n u m . T he m a c h in e s h a v e a life o f 3 y e a rs a n d a t th a t p o in t h a v e o n ly a
s c ra p v a lu e , w h ic h is e s tim a te d to b e o n ly $ 1 0 0 0 0 . H o w e v e r, th is a m o u n t u s u a lly o n ly ju st c o v e rs th e costs o f
re m o v in g th e m a c h in e fro m th e fa c to ry .
O z z ie 's p r o je c t a n a ly s t h a s re c o m m e n d e d a g a in s t p r o c e e d in g w ith th e n e w fla v o u r, b a s in g this

r e c o m m e n d a tio n o n a n e t p re s e n t v a lu e a n a ly s is . T he n e t c a s h in flo w s w e r e fo re c a s t to b e $ 1 2 0 0 0 0 in th e
firs t y e a r, a n d $ 2 4 0 0 0 0 in th e s e c o n d y e a r a n d th e th ird y e a r. T he in itia l o u tla y w a s $ 5 0 0 0 0 0 . T he N P V w a s
c a lc u la te d as:
K(m/ $ 1 2 0 0 0 0 $240000 $240000

N P V = --------------- + -------------------1- -$ 5 0 0 0 0 0
1.1 50 5 1 .1 5 15 1 .1 5 2-5
一 $ 2 4 2 64
The p r o je c t a n a ly s t's re p o r t c o n ta in e d th e u su al r a n g e o f s e n s itiv ity a n a ly s e s a n d s u p p o rtin g d is c u s s io n a n d

d o c u m e n ta tio n b u t th is c a lc u la tio n w a s th e c e n tra l result.
You h a v e b e e n a s k e d to r e v ie w th e p r o je c t a n a ly s t’s w o r k a n d re p o r t o n a n y e rro rs y o u d e te c t. P ro v id e

re a s o n s. Ig n o re ta x . N o te th a t it is n o t n e c e s s a ry to re d o th e a n a ly s is , o r to s u g g e s t h o w th e a n a ly s is m ig h t b e
e x te n d e d . Y o u r ta s k is to id e n tify e rro rs .

T he B e rtie H a m ilto n F is h in g C o m p a n y (BHF) p u rc h a s e d a tr a w le r 6 y e a rs a g o fo r $ 4 2 0 0 0 0 . A t th e tim e
it w a s p u rc h a s e d , th e t r a w le r h a d a use ful life o f 1 0 y e a rs . If BHF w e r e to re ta in th is b o a t, it is a n tic ip a te d
th a t u ltra s o n ic d e te c tio n e q u ip m e n t w o u ld h a v e to b e in s ta lle d in th e s e c o n d -la s t y e a r o f its life a t a c o s t o f
$ 4 0 0 0 0 . H o w e v e r, th e C o m m e rc ia l T ra w le r C o m p a n y (CT) ha s re c e n tly la u n c h e d a fa ste r, co m p u te r-a s s is te d
tr a w le r th a t BHF is c o n s id e rin g a s a re p la c e m e n t. T his tr a w le r w ill c o s t $ 6 0 0 0 0 0 b u t w ill n e e d im m e d ia te
re fittin g to s u it th e p u rc h a s e r's s p e c ific a tio n s a t a n a d d itio n a l c o s t o f $ 1 5 0 0 0 . It h a s a n e x p e c te d use ful life o f
1 2 y e a rs .
If p u rc h a s e d , th e n e w tr a w le r is lik e ly to in c re a s e c a s h o p e r a tin g costs b y $ 1 0 p e r to n n e o f fish , w h ic h

c u rre n tly sells f o r $ 3 0 p e r to n n e . H o w e v e r, fu tu re c a tc h e s a re lik e ly to in c re a s e s ig n ific a n tly b y 6 0 0 0 to n n e s in
th e firs t y e a r, a n d the n a t a ra te o f 1 0 0 0 to n n e s p e r a n n u m , s ta b ilis in g a t 1 2 0 0 0 to n n e s fro m Y e a r 7 o n w a r d .
O w in g to in te n s iv e u s a g e , it is e x p e c te d th a t to w a r d s th e e n d o f th e fifth y e a r th e n e w tr a w le r w ill re q u ire a
m in o r e n g in e o v e rh a u l a t a c o s t o f $ 3 0 0 0 0 . P a rt o f th e p u rc h a s e a g re e m e n t a ls o in v o lv e s a m a in te n a n c e
c o n tra c t w ith C T c o v e rin g th e nets a n d t r a w lin g a p p a ra tu s , w h ic h w ill c o s t BHF $ 1 2 0 0 0 , p a y a b le a t th e e n d
o f e v e r y fo u rth y e a r.
A s a c o m p e titiv e stra te g y, C T o ffe rs a n o p tio n a l fin a n c in g p a c k a g e fo r u p to 8 0 p e r c e n t o f th e in v o ic e p ric e

o n a n y b o a t. T h e ra te o f in te re s t o n th is a m o u n t is 1 2 p e r c e n t p e r a n n u m , w ith th e firs t p a y m e n t d e fe rre d
1 y e a r. If th e fin a n c in g p a c k a g e is a d o p te d , BHF m ust u n d e rta k e to sell th e tr a w le r b a c k to C T in 1 2 y e a rs '
tim e fo r $ 5 0 0 0 0 . BHF e s tim a te s th a t th e c u rre n t s e c o n d -h a n d p r ic e o f its p re s e n t tr a w le r is o n ly $ 1 4 0 0 0 0 . It is
e s tim a te d th a t th e n e w tr a w le r c a n b e s o ld f o r $ 1 0 0 0 0 0 a t th e e n d o f its use fu l life . T h e c o m p a n y 's n o m in a l
re q u ire d ra te o f re tu rn is 3 0 p e r ce n t.
a) E stim a te th e n e t c a s h f lo w (N C F ) a t th e b e g in n in g o f Y e a r 1.
bj E stim a te th e N C F in Y e a r 4 .
c) M a n a g e m e n t b e lie v e s th a t re la tiv e to to d a y 's p ric e s , th e a v e r a g e in fla tio n ra te is e x p e c te d to b e 8 p e r c e n t
p e r a n n u m o v e r th e n e x t 1 2 y e a rs . W h a t is th e Y e a r 3 in fla tio n -a d ju s te d N C F ?
d) E stim a te th e a p p r o p r ia te d is c o u n t ra te to p e rfo rm a n N P V a n a ly s is in re a l te rm s.

A c o m p a n y m ust c h o o s e b e tw e e n tw o m a c h in e s . M a c h in e A costs $ 5 0 0 0 0 a n d th e a n n u a l o p e r a tin g
e x p e n s e s a re e s tim a te d to b e $ 2 0 0 0 0 , w h ile M a c h in e B costs $ 8 5 0 0 0 a n d ha s e s tim a te d a n n u a l o p e r a tin g
e x p e n s e s o f $ 1 5 0 0 0 . B o th m a c h in e s h a v e a 1 0 -y e a r life a n d w ill h a v e a z e ro re s id u a l v a lu e .
a) The c o m p a n y h a s a r e q u ire d ra te o f re tu rn o f 1 0 p e r c e n t p e r a n n u m . W h ic h m a c h in e s h o u ld it p u rc h a s e ?
b) R e w o rk th e p ro b le m fo r a 7 p e r c e n t r e q u ire d ra te o f re tu rn .

A c o m p a n y is c o n s id e rin g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 1 2 5 0 0 0 th a t w ill p e rm it it to re d u c e its e x is tin g
la b o u r costs b y $ 2 0 0 0 0 a y e a r f o r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d $ 3 0 0 0 e v e r y
2 y e a rs o v e rh a u lin g th e e q u ip m e n t. T h e re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h
flo w s a re m a d e a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t?
Explaining the effects of taxes on project cash flows [LO 2 】
The F o u r a n d S ix S tore s Pty Ltd is c o n s id e rin g lo c a tin g a n o th e r o u tle t in a n e a s te rn s u b u rb o f M e lb o u r n e .
Estim ates o f sales a n d o p e r a tin g e x p e n s e s h a v e b e e n m a d e a n d a n e s tim a te d p r o fit a n d loss s ta te m e n t fo r
the n e w s to re d r a w n u p . T he p r o fit a n d loss s ta te m e n t fo r Y e a r 1 is th o u g h t to b e re p re s e n ta tiv e o f e a c h o f
th e 1 0 y e a rs o f th e e x p e c te d life o f th e n e w F o u r a n d S ix s to re . T he in itia l o u tla y to c o n s tru c t th e s to re is
$ 4 0 0 0 0 0 0 , w h ile th e o u tla y n e c e s s a ry to sto ck th e s to re is $ 2 0 0 0 0 0 0 . T h e e s tim a te d s ta te m e n t o f fin a n c ia l
p e rfo rm a n c e fo r th e n e w s to re fo r Y e a r 1 is s h o w n in th e fo llo w in g ta b le :
Revenue 4000000
Less sales re tu rn s, discou nts 400 000
N et revenue 3 600000
O pe ra ting expenses
Cost o f goods sold 1600000
A d m in is tra tio n costs 600000
D e pre ciatio n 360000
In te re st 240000 2800000
N e t p ro fit before tax 800000
Tax (30% tax rate) 240000
N e t p ro fit a fte r tax 560000
E stim ate th e p ro je c t's a n n u a l a fte r-ta x c a s h flo w .
Explaining the effects of taxes on project cash flows [LO 2]

A ll- N ig h t C o ffe e S h o p s Ltd is a su cce ssful p r o fita b le c o m p a n y o p e r a tin g s e v e ra l d o z e n c o ffe e sh o p s th ro u g h o u t
th e m e tro p o lita n a r e a o f M e lb e r r a . H o w e v e r, th e s h o p in th e s u b u rb o f B u rn a b y h a s n o t b e e n w e ll p a tro n is e d ,
g e n e ra tin g a b e fo re -ta x n e t c a sh f lo w o f o n ly $ 5 0 0 0 0 in th e p a s t y e a r. T he B u rn a b y s h o p b e g a n tr a d in g
2 y e a rs a g o in p re m is e s le a s e d fro m C B D Ltd. T he le a s e is a b o u t to e x p ir e a n d A ll- N ig h t w ill n o t re n e w it.
A c o m p e tito r, B ra z il C o ffe e S h o p s Ltd, h a s o ffe re d to b u y th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t in th e
B u rn a b y s h o p fo r $ 4 0 0 0 0 0 . A ll- N ig h t ha s a g r e e d to th is fig u re , e ve n th o u g h it is $ 3 0 0 0 0 0 less th a n th e c o s t
o f th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t 2 y e a rs a g o . A s s u m e th a t:
a) fo r ta x p u rp o s e s th e fix tu re s a n d fittin g s a n d th e e q u ip m e n t w e re d e p r e c ia te d o n a s tra ig h t-lin e b a s is a t

10 pe r cent pe r annum
b) th e a fte r-ta x c o m p a n y ta x ra te is 3 0 p e r ce n t.
W h a t is th e a fte r-ta x n e t ca sh f lo w (fo r Y e a r 2 ) a ttr ib u ta b le to A ll- N ig h t's B u rn a b y sh o p ?
163
10 Explaining the effects of taxes on project cash flows [LO 2 】
It doesn't matter whether the straight-line or reducing-balance method o f depreciation is used, since the total tax
bill over the life o f the project is the same. D iscuss th e v a lid ity (o r o th e rw is e ) o f this s ta te m e n t in th e c o n te x t o f
th e fo llo w in g e x a m p le :
A s s e t co st (n o w ) $10000
A sset life 5 years
Residual value (in 5 years) $4700
A n n u a l n e t cash in flo w be fore ta x $6000
S tra ig h t-lin e d e p re cia tio n rate (per an nu m ) 10%
Reducing-balance de p re cia tio n rate (per a n nu m ) 20%
C om pany incom e ta x rate 30%
Cost o f cap ital 10% p.a.
11 Explaining the effects of taxes on project cash flows [LO 2]

A c o m p a n y is c o n s id e r in g p u rc h a s in g a n e w m a c h in e a t a c o s t o f $ 9 0 0 0 0 0 to re p la c e a m a c h in e p u rc h a s e d
6 y e a rs a g o f o r $1 m illio n . T h e d is p o s a l v a lu e o f th e o ld m a c h in e is $ 2 5 0 0 0 0 a n d th e a c c u m u la te d
d e p r e c ia tio n , w h ic h h a s b e e n a llo w e d fo r ta x p u rp o s e s , is $ 6 0 0 0 0 0 . B oth m a c h in e s w ill h a v e s im ila r o u tp u ts
a n d w ill p r o d u c e w o r k o f id e n tic a l q u a lity . T he e s tim a te d y e a r ly costs o f o p e r a tin g e a c h m a c h in e a re as
fo llo w s :
O ld m a c h in e ($) N e w m a c h in e ($ ) 1
Wages 225 000 75 000
D e pre ciatio n 100000 225000
Supplies, repairs, po w e r 65 000 30000
Insurance and m iscellaneous 36000 20000
426000 350000
B oth m a c h in e s h a v e a n e s tim a te d re m a in in g life o f 4 y e a rs , a t w h ic h tim e b o th m a c h in e s w ill h a v e a n

e s tim a te d d is p o s a l v a lu e o f $ 9 0 0 0 0 . A s s u m e th a t:
a) th e a fte r-c o m p a n y -ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m
b) th e o p e r a tin g co sts o f th e o ld m a c h in e a n d th e n e w m a c h in e a r e in c u rre d a t th e e n d o f e a c h y e a r
c) th e c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r.
S h o u ld th e c o m p a n y p u rc h a s e th e n e w m a c h in e ?
12 Mutually exclusive projects with different lives [LO 3]

T h e m a n a g e m e n t o f H a r b o u r F e rrie s Ltd is c o n s id e rin g th e re p la c e m e n t o f its e x is tin g fle e t o f s ix ste a m fe rrie s
w ith th re e h y d ro fo ils . T he fo llo w in g e s tim a te s o f costs, a n d so o n , fo r e a c h vesse l h a v e b e e n c a lc u la te d :
I S te a m fe rrie s E stim ates H y d ro fo ils E stim ate s
E stim ate d re m a in in g life 5 years Cost $500000
E stim a te d scrap value: E stim ate d life 10 years
N ow $50000 E stim ate d scrap value:
In 5 years’ tim e $10000 In 5 years’ tim e $200000
In 10 years’ tim e $100000
A n n u a l n e t cash flow s $100000 A n n u a l n e t cash flow s $200000

M a n a g e m e n t is a ls o a w a r e o f th e d e v e lo p m e n t o f h o v e rc ra ft, w h ic h th e m a n u fa c tu re r e s tim a te s w ill b e
a v a ila b le in 5 y e a rs 7 tim e . T he fo llo w in g e stim a te s o f costs, a n d so o n , p e r h o v e rc ra ft h a v e b e e n p r o v id e d b y
th e m a n u fa c tu re r:
H o v e rc ra ft E stim ate s
Cost $600000
E stim ated life 15 years
E stim ate d disposal value:
A fte r 5 years* o p era tion $200000
A fte r 15 years* op e ra tio n $50000
A n n u a l n e t cash flow s $250000
It is c o n s id e re d th a t tw o o f th e n e w h o v e rc ra ft w ill b e a d e q u a te to c a r r y th e e s tim a te d n u m b e r o f p a s s e n g e rs .
O th e r in fo rm a tio n is a s fo llo w s :
• M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e h o v e rc ra ft.
• T he a n n u a l n e t c a s h flo w s a r e re c e iv e d a t th e e n d o f e a c h y e a r.
• T he c o m p a n y 's re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .
You a re re q u ire d to a d v is e m a n a g e m e n t w h e th e r it s h o u ld :
a) re p la c e th e stea m fe rrie s w ith h y d ro fo ils n o w , a n d re p la c e th e la tte r w ith h o v e rc ra ft in 5 y e a r s ' tim e
b) re ta in th e ste a m fe rrie s fo r 5 y e a rs , a n d th e n re p la c e th e m w ith h o v e rc ra ft
c) re p la c e th e stea m fe rrie s w ith h y d ro fo ils n o w , a n d re p la c e th e la tte r w ith h o v e rc ra ft in 1 0 y e a r s 7 tim e .
O th e r a lte rn a tiv e s a re n o t to b e c o n s id e re d .

H e rm e s Pty Ltd o p e ra te s a c o u r ie r s e rv ic e . A n e w v a n is r e q u ire d to m e e t th e in c re a s e d d e m a n d fo r the
c o m p a n y ’s s e rv ic e s . T he c h o ic e h a s b e e n n a r r o w e d d o w n to th re e v a n s , A , B a n d C , e a c h c o s tin g $ 1 0 0 0 0 0 .
N e t c a s h f lo w e s tim a te s a r e as fo llo w s :
N e t c a sh f lo w e stim a te s ($)
Year Van A VanB Van C
1 $47000 $48000 $47000
2 $50000 $40000 $48000
3 $50000 $40000 $48000
4 $58000 $52000 $55000
5 0 $42000 0
Required rate o f re tu rn 20% 20% 20%
NPV $30795 $32881 $26801
By d is c o u n tin g e a c h n e t c a s h flo w , s h o w th a t th e n e t p re s e n t v a lu e o f V a n A h a s b e e n c a lc u la te d p ro p e rly .

W h ic h v a n s h o u ld b e p u rc h a s e d ? G iv e re a so n s.
16 5
The m a n a g e m e n t o f H u n te r A ir Ltd is c o n s id e rin g th e re p la c e m e n t o f its e x is tin g fle e t o f seve n A 6 1 6 a ir c r a ft
w ith th re e B 7 2 7 a ir c r a ft. T he fo llo w in g e s tim a te s fo r e a c h a ir c r a ft h a v e b e e n c a lc u la te d :
A 6 1 6 a ir c r a ft E stim ates B 7 2 7 a e ro p la n e s Estim ates
E stim ate d re m a in in g 5 years Cost $ 5 00 m illio n

life
E stim ated scrap value E stim ated life 10 years
N ow $50 m illio n E stim ate d disposal

value
In 5 years’ tim e $10 m illio n In 5 years’ tim e $200 m illio n
In 10 years’ tim e $100 m illio n
A n n u a l n e t cash flow s $100 m illio n A n n u a l n e t cash flow s $200 m illio n
M a n a g e m e n t is a ls o a w a r e o f th e d e v e lo p m e n t o f th e C 8 9 8 , w h ic h th e m a n u fa c tu re r e s tim a te s w ill
b e a v a ila b le in 5 y e a rs 7 tim e . T h e fo llo w in g e s tim a te s fo r a C 8 9 8 a ir c r a ft h a v e b e e n p r o v id e d b y th e
m a n u fa c tu re r.
I C 8 9 8 a ir c r a ft E stim ates
Cost $600 m illio n
E stim a te d life 15 years
E stim ate d disposal value
A fte r 5 years’ op e ra tio n $200 m illio n
A fte r 15 years’ op e ra tio n $50 m illio n
A n n u a l n e t cash flow s $250 m illio n
It is c o n s id e re d th a t t w o o f th e n e w C 8 9 8 a ir c r a f t w ill b e a d e q u a te to c a r r y th e e s tim a te d n u m b e r o f
p a s s e n g e rs . O th e r in fo rm a tio n is a s fo llo w s :
i) M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e C 8 9 8 a ir c r a ft.
ii) T he a n n u a l n e t c a sh flo w s a re re c e iv e d a t th e e n d o f e a c h y e a r.
iii) T he c o m p a n y 's a fte r-ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m .
iv) T he c o m p a n y 's ta x ra te is 3 0 cen ts.
v) T he A 6 1 6 a ir c r a f t a re a s s u m e d to b e fu lly d e p re c ia te d .
vi) S tra ig h t-lin e d e p r e c ia tio n m a y b e a ss u m e d .
You a re re q u ire d to a d v is e m a n a g e m e n t w h e th e r it s h o u ld :
a) re p la c e th e A 6 1 6 a ir c r a ft w ith B 7 2 7 a ir c r a ft n o w , a n d re p la c e th e la tte r w ith C 8 9 8 a ir c r a f t in

5 y e a r s ' tim e
b) re ta in th e A 6 1 6 a ir c r a ft fo r 5 y e a rs , a n d th e n re p la c e th e m w ith C 8 9 8 a ir c r a ft
c) re p la c e th e A 6 1 6 a ir c r a ft w ith B 7 2 7 a ir c r a ft n o w , a n d re p la c e th e la tte r w ith C 8 9 8 a ir c r a f t in

1 0 y e a r s ' tim e .
O th e r a lte rn a tiv e s a r e n o t to b e c o n s id e re d .

S p e e d y Pty Ltd o p e ra te s a s u b u rb a n d o c u m e n t d e liv e r y bu sin e ss. It is c o n s id e rin g th e r e p la c e m e n t o f a 2 -to n n e
tru c k w ith a 3 -to n n e tru c k . D e ta ils o f th e re s p e c tiv e v e h ic le s a re a s fo llo w s :
2 -to n n e tru c k E stim ates 3 -to n n e tru c k E stim ates
Rem aining life 5 years E stim ate d life 6 years
Residual value: Cost $25 000
N ow $6000 Residual value a fte r 6 years’ $2000

op e ra tio n
In 4 years $0 D e pre ciatio n (allow able fo r tax $4000 p.a.

purposes)
W ritte n -d o w n value (fo r ta x $7500 (before N e t cash flo w $ 2 0 0 0 0 p.a.

purposes) ta xa tio n )
D e pre ciatio n (fo r ta x purposes) $1200 p.a.
N et cash flo w (before ta x a tio n ) $ 1 2 0 0 0 p.a.
O th e r in fo rm a tio n is a s fo llo w s :
i) N e t c a s h flo w s a re to b e r e g a r d e d a s re c e iv e d a t th e e n d o f e a c h y e a r.
ii) T he e ffe c tiv e a fte r-ta x c o s t o f c a p ita l is 1 0 p e r c e n t p e r a n n u m .
iii) T he c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r.
M a n a g e m e n t is c o n s id e rin g th e fo llo w in g a lte rn a tiv e s :
a) R e p la c e th e 2 -to n n e tru c k w ith th e 3 -to n n e tru c k n o w .
b) R e p la c e th e 2 -to n n e tru c k w ith th e 3 -to n n e tru c k in 5 y e a r s ' tim e .
A ll o th e r a lte rn a tiv e s m a y b e ig n o r e d . A d v is e m a n a g e m e n t as to w h ic h a lte rn a tiv e it s h o u ld a d o p t, a n d ju s tify

y o u r a n a ly s is .
16 Replacement decision [LO 4]

A c o m p a n y is c o n s id e r in g th e in s ta lla tio n o f a n e w m a c h in e a t a c o s t o f $ 6 0 0 0 0 to re p la c e a m a c h in e
p u rc h a s e d 7 y e a rs a g o f o r $ 1 0 0 0 0 0 . T he d is p o s a l v a lu e o f th e o ld m a c h in e is $ 1 5 0 0 0 . B oth m a c h in e s w ill
h a v e s im ila r o u tp u ts a n d w ill p ro d u c e w o r k o f id e n tic a l q u a lity . T he e s tim a te d y e a r ly costs o f o p e r a tin g e a c h
m a c h in e a re as fo llo w s :
O ld m a c h in e ($ ) N e w m a c h in e ($ ) 1
Wages 15000 5 000
Supplies, repairs, pow er 5000 3 000
Insurance and m iscellaneous 2000 3000
T otal 22000 11000
Both m a c h in e s h a v e a n e s tim a te d re m a in in g life o f 3 y e a rs , a t w h ic h tim e b o th m a c h in e s w ill h a v e a n

e s tim a te d d is p o s a l v a lu e o f $ 5 0 0 0 . A s s u m e th a t:
a) th e re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m
b) th e o p e r a tin g costs o f th e o ld m a c h in e a n d th e n e w m a c h in e a r e in c u rre d a t th e e n d o f e a c h y e a r.
S h o u ld th e c o m p a n y p u rc h a s e th e n e w m a c h in e , o r c o n tin u e to o p e r a te th e o ld o n e ?

T he m a n a g e m e n t o f N e w W o r ld A irlin e s is c o n s id e rin g th e re p la c e m e n t o f its p re s e n t fle e t o f 1 0 p is to n e n g in e
p la n e s w ith fiv e tu rb o p ro p s . A s u rv e y ha s re v e a le d th e f o llo w in g e s tim a te s o f costs, a n d so o n , p e r p la n e :
Piston e n g in e E stim ates T u rb o p ro p E stim ate s j
R em aining life 5 years Life 5 years
Residual value: Cost $3430000
167
I P iston e n g in e E stim ates T u rb o p ro p E stim ate s
A t p resent tim e $10000 A n n u a l n e t cash flow s $1000000
In 2 years’ tim e $5 000 Residual value:
In 5 years’ tim e $0 A fte r 2 years’ o p e ra tio n 30% o f purchase price
A n n u a l n e t cash flow s $100000 A fte r 5 years’ o p e ra tio n 5% o f purchase price
a) S h o u ld re p la c e m e n t b e u n d e rta k e n n o w o r in 5 y e a r s 7 tim e ?
Im m e d ia te ly a fte r th e d e c is io n ha s b e e n re a c h e d , m a n a g e m e n t is in fo rm e d o f a s u p e rje t th a t w ill b e c o m e

a v a ila b le in 2 y e a r s ' tim e . T he e stim a te s fo r th e n e w p la n e a re :
S u p e rje t Estim ates
Cost $4500000
A n n u a l n e t cash in flo w s $1200000
Life 5 years
Residual value a fte r 3% o f purchase price

5 years’ o p e ra tio n
It is c o n s id e re d th a t fo u r o f th e n e w s u p e rje ts w ill b e a d e q u a te to c o v e r th e e s tim a te d p a s s e n g e r lo a d .
O th e r in fo r m a tio n is as fo llo w s :
• M a n a g e m e n t c a n n o t fo re s e e a n y fu rth e r d e v e lo p m e n ts b e y o n d th e s u p e rje t.
• A n n u a l n e t c a s h flo w s a r e a s s u m e d to b e re c e iv e d a t th e e n d o f e a c h y e a r.
• T he r e q u ir e d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m ,
b) S h o u ld m a n a g e m e n t:
i) re ta in th e p is to n e n g in e p la n e s fo r 5 y e a rs a n d re p la c e th e m w ith su p e rje ts
ii) re p la c e th e m im m e d ia te ly w ith tu rb o p ro p s , o p e ra te th e m fo r 5 y e a rs , a n d th e n re p la c e th e m w ith

s u p e rje ts
iii) re p la c e th e m n o w w ith tu rb o p ro p s , o p e ra te th e m fo r 2 y e a rs , a n d th e n re p la c e th e m w ith su p e rje ts
iv) re ta in th e p is to n e n g in e p la n e s fo r 2 y e a rs a n d th e n re p la c e th e m w ith s u p e rje ts?
O th e r re p la c e m e n t d a te s a re n o t to b e c o n s id e re d .

A .B . Pty Ltd is c u rre n tly o p e r a tin g a s u b u rb a n ta x i-tru c k b u sin e ss. It is c o n s id e rin g th e re p la c e m e n t o f a
1 .5 to n n e v e h ic le w ith a 2 to n n e v e h ic le . D e ta ils o f th e re s p e c tiv e v e h ic le s a re a s fo llo w s :
I 1 .5 -to n n e v e h ic le Estim ates 2 -to n n e v e h ic le Estim ates
R em aining life 4 years E stim ate d life 7 years
Residual value: Cost $15000
N ow $4000 Residual value a fte r $1000

7 years’ op e ra tio n
In fo u r years $0
A n n u a l n e t cash flo w $6000 N e t cash flo w $10000

O th e r in fo rm a tio n is as fo llo w s :
• N e t ca sh flo w s a r e to b e re g a r d e d as re c e iv e d a t th e e n d o f e a c h y e a r.
• T he re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m .
M a n a g e m e n t is c o n s id e rin g th e f o llo w in g a lte rn a tiv e s :
a) re p la c e th e 1 .5 to n n e v e h ic le w ith th e 2 to n n e v e h ic le n o w
b) re p la c e th e 1 .5 to n n e v e h ic le w ith th e 2 to n n e v e h ic le in 4 y e a r s 7 tim e .
A ll o th e r a lte rn a tiv e s m a y b e ig n o r e d .
A d v is e m a n a g e m e n t a s to w h ic h a lte r n a tiv e it s h o u ld a d o p t, a n d ju s tify y o u r a n a ly s is .
19 Retirement decision [LO 4 】

P ulp a n d P a p e r Ltd h a s ju st p la n te d p in e tre e s a t a c o s t o f $ 1 2 0 0 0 p e r h e c ta re o n 5 0 0 h e c ta re s o f la n d , w h ic h
it p u rc h a s e d fo r $ 4 0 0 0 0 0 . T he tre e s a r e e x p e c te d to g r o w r a p id ly a n d th e c o m p a n y 's e s tim a te s o f th e n e t
fu tu re v a lu e o f th e c u t tim b e r a re :
T im e o f h a rv e s t e n d N e t fu tu re v a lu e ($ p e r
o f year h e c ta re )
2 17320
3 20000
4 22360
5 24495
6 26450
T he re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m a n d ta x e s c a n b e ig n o r e d .
a) C a lc u la te th e o p tim u m tim e to h a rv e s t th e c r o p o f tre e s. A s s u m e th a t th e v a lu e o f th e c le a re d la n d in c re a s e s

a t a ra te o f 1 0 p e r c e n t p e r a n n u m .
b) E stim a te th e n e t p re s e n t v a lu e o f th e p ro je c t, a s s u m in g s a le o f th e la n d a fte r th e tre e s a re h a rv e s te d . N o te

a n y a s s u m p tio n s y o u m a k e .

A c o m p a n y is c o n s id e r in g th e re p la c e m e n t o f a n o ld m a c h in e w ith a n e w m a c h in e . T he o ld m a c h in e w a s
p u rc h a s e d a y e a r a g o f o r $ 1 2 5 0 0 . A d d it io n a l in fo r m a tio n re la tin g to th e se m a c h in e s (cash flo w s a re in
n o m in a l term s) is a s fo llo w s :
E stim ates
Item O ld m a c h in e ($) N e w m a c h in e ($)
M a rk e t value (now ) $7000 $5000
Service life (w hen 6 years 5 years

purchased)
Residual value in 5 years’ $0 $1000

tim e
Cash op e ra tin g receipts - $500 p.a. in excess o f o ld

m achine
T he re a l re q u ire d ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m , a n d th e a n tic ip a te d in fla tio n ra te is 1 0 p e r c e n t p e r

a n n u m . C a lc u la te th e n e t p re s e n t v a lu e o f r e p la c in g th e o ld m a c h in e w ith th e n e w m a c h in e .
169
21 Sensitivity analysis [LO 5]
M a n a g e m e n t o f R id e Ltd is c o n s id e rin g th e p o s s ib ility o f m a n u fa c tu rin g a n e w m o to ris e d g o lf b u g g y . The
in itia l o u tla y f o r th e n e w p la n t to m a n u fa c tu re th e v e h ic le is $1 m illio n . T h e s ta ff o f R id e Ltd h a v e p r o v id e d th e
f o llo w in g e s tim a te s fo r th e p ro je c t:
Estim ates
Item P essim istic M o s t lik e ly O p tim is tic
Sales (u n its ) 3000 3500 4000
S elling price ($) 750 800 850
Fixed o p e ra tin g costs p e r a n n u m ($) 100000 90000 80000
Variable o p e ra tin g costs pe r a n nu m 25 24 23

per u n it o f sales ($)
Life o f the p la n t (years) 4 5 6
A s s u m in g a re q u ire d ra te o f re tu rn o f 1 0 p e r c e n t, c o n d u c t a s e n s itiv ity a n a ly s is . W h a t a re th e m a jo r

u n c e rta in tie s if th e p r o je c t is u n d e rta k e n ?
22 Break-even analysis [LO 5]

T he m a n a g e r o f A ls p o rts Ltd is c o n s id e rin g a p la n to m a n u fa c tu re a lu m in iu m b a s e b a ll b a ts. E q u ip m e n t to
m a n u fa c tu re th e b a ts w ill c o s t $ 8 5 0 0 0 0 a n d is e x p e c te d to h a v e a use ful life o f 3 y e a rs . F ix e d costs a re
e s tim a te d to b e $ 8 0 0 0 0 p e r a n n u m a n d th e b a ts a r e e x p e c te d to sell fo r $ 4 0 e a c h , w h ile v a r ia b le costs w ill
b e $ 2 8 p e r b a t. A b o u t 5 0 0 0 0 0 b a s e b a ll b a ts a re s o ld e a c h y e a r a n d A ls p o rts h a s a re q u ire d ra te o f re tu rn o f
1 0 p e r c e n t. C a lc u la te th e b re a k -e v e n sales v o lu m e .
23 Decision-tree analysis [LO 6]

P asha B u lk e r Ltd is c o n s id e rin g p r o d u c in g a n e w p ro d u c t. It e x p e c ts th a t th e p r o d u c t w ill h a v e a life o f
1 0 y e a rs , b y w h ic h tim e th e m a rk e t f o r th e p r o d u c t w ill b e s a tu ra te d a n d fh e assets n e c e s s a ry to p ro d u c e it
w ill b e s o ld . T h e c o m p a n y is u n c e rta in a s to w h e th e r th e p r o d u c t s h o u ld b e m a n u fa c tu re d o n a la r g e s c a le
in a la r g e p la n t, o r o n a s m a ll s c a le in a s m a ll p la n t. If th e c o m p a n y c h o o s e s a s m a ll p la n t, it w o u ld c o n s id e r
e x p a n d in g th e p la n t a fte r 3 y e a rs .
T he c o m p a n y e s tim a te s th a t th e re is a 5 0 p e r c e n t p r o b a b ilit y th a t a h ig h le ve l o f d e m a n d w ill b e a tta in e d

o v e r th e 1 0 y e a rs d u r in g w h ic h th e p r o d u c t w ill b e m a rk e te d , a 2 5 p e r c e n t p r o b a b ilit y th a t d e m a n d w ill b e
h ig h d u rin g th e firs t 3 y e a rs a n d th e n d r o p to a lo w le ve l o v e r th e s u c c e e d in g 7 y e a rs , a n d a 2 5 p e r c e n t
p r o b a b ilit y th a t a lo w le ve l o f d e m a n d w ill p e rs is t o v e r th e e n tire 1 0 y e a rs .
T he f o llo w in g ta b le in d ic a te s th e e x p e c te d a n n u a l n e t c a s h flo w s a n d re s id u a l v a lu e s a s s o c ia te d w ith e a c h

s c a le o f p ro d u c tio n a n d le ve l o f d e m a n d :
I P o s s ib ilitie s A n n u a l n e t c a sh f lo w ($ ) R e sid u a l v a lu e ($ ) 1
Large p la n t, h ig h dem and 500000 500000
Large p la n t, lo w dem and 150000 200000
Sm all p la n t, h ig h dem and 200000 200000
Sm all p la n t, lo w dem and 150000 100000
Expanded p la n t, h ig h dem and 300000 400000
Expanded p la n t, lo w dem and 100000 150000
T he in itia l c o s t a s s o c ia te d w ith th e c o n s tru c tio n o f a la r g e p la n t is $ 2 m illio n , a n d th a t a s s o c ia te d w ith a

sm a ll p la n t is $1 m illio n . T he e x p e c te d c o s t o f e x p a n d in g fro m a s m a ll p la n t to a la r g e p la n t a fte r 3 y e a rs is
$1 m illio n . T h e c o m p a n y 's re q u ire d ra te o f re tu rn o f 1 2 p e r c e n t p e r a n n u m is re le v a n t fo r a ll a lte rn a tiv e s .
a) W h ic h p o lic y s h o u ld th e c o m p a n y p u rsu e ?
b) Is it lik e ly th a t th e s a m e d is c o u n t ra te w ill b e a p p r o p r ia te fo r a ll a lte rn a tiv e s ? G iv e re a so n s.

REFERENCES
Brown, C. & Davis, K., 'O ptions in mutually exclusive Levin, R.I., Kirkpatrick, C.A. & Rubin, D.S., Quantitative
projects of unequal lives', Quarterly Review of Economics Approaches to Management, 8th edn, M cG raw-Hill, N ew
and Finance, Special Issue 1998, pp. 5 6 9 -7 7 . York, 1992, pp. 2 3 1 -7 .
Faff, R. & Brailsford, T., 'The constant chain of replacement Pike, R.J., The capital budgeting behaviour and corporate
model and inflation', Pacific Accounting Review, December characteristics of capital-constrained firms', Journal of
1992, pp. 4 5 -5 8 . Business Finance and Accounting, W inter 1983, pp. 6 6 3 -7 .
171
CHAPTER CONTENTS
7
3
m
g g
ED I n t r o d u c t io n P o r t f o lio t h e o r y a n d d iv e r s if ic a t io n 179
7
3
m R e tu rn a n d ris k T h e p r ic in g o f r is k y a s s e ts 190
7
6
EB T h e in v e s to r 's u t ilit y fu n c tio n

EB A d d it io n a l f a c t o r s t h a t e x p la in re tu rn s 19 7
7
9
m T h e ris k o f a s s e ts P o r t f o lio p e r f o r m a n c e a p p r a is a l 19 8
LEARNING OBJECTIVES
A f t e r s tu d y in g th is c h a p t e r y o u s h o u ld b e a b le to :
1 u n d e r s ta n d h o w r e tu r n a n d r is k a r e d e f in e d a n d m e a s u r e d
2 u n d e r s ta n d th e c o n c e p t o f r is k a v e r s io n b y in v e s to rs
3 e x p la in h o w d iv e r s if ic a t io n r e d u c e s ris k
4 e x p la in th e c o n c e p t o f e f f ic ie n t p o r t f o lio s
5 u n d e r s ta n d th e im p o r t a n c e o f c o v a r ia n c e b e t w e e n re tu rn s o n r is k y a s s e ts in d e t e r m in in g th e r is k o f a
p o r t f o lio
6 e x p la in th e d is tin c t io n b e t w e e n s y s te m a tic a n d u n s y s te m a tic r is k
7 e x p la in w h y s y s te m a tic ris k is im p o r t a n t to in v e s to rs
8 e x p la in th e r e la t io n s h ip b e t w e e n re tu rn s a n d ris k p r o p o s e d b y th e c a p it a l a s s e t p r ic in g m o d e l
9 u n d e r s ta n d th e r e la t io n s h ip b e t w e e n th e c a p it a l a s s e t p r ic in g m o d e l a n d m o d e ls t h a t in c lu d e a d d i t i o n a l
fa c to r s
1 0 e x p la in th e d e v e lo p m e n t o f m o d e ls t h a t in c lu d e a d d i t i o n a l f a c to r s
11 d is tin g u is h b e t w e e n a lt e r n a t iv e m e th o d s o f a p p r a is in g th e p e r f o r m a n c e o f a n in v e s tm e n t p o r t f o lio .
C hapter seven Risk a n d return
Introduction
A fin a n c ia l d e c is io n ty p ic a lly in v o lv e s r isk . F o r e x a m p le , a c o m p a n y t h a t b o r r o w s m o n e y f a c e s th e r is k
th a t in t e r e s t r a t e s m a y c h a n g e , a n d a c o m p a n y t h a t b u ild s a n e w f a c t o r y f a c e s th e r i s k t h a t p r o d u c t s a l e s
m a y b e lo w e r th a n e x p e c te d . T h e se a n d m a n y o t h e r d e c is io n s in v o lv e fu t u r e c a s h flo w s t h a t a r e risk y .
In v e s t o r s g e n e r a lly d is lik e r i s k , b u t th e y a re a ls o u n a b le to a v o id it. Th e v a lu a t io n f o r m u la e fo r s h a r e s a n d
d e b t s e c u r itie s o u tlin e d in C h a p t e r 4 sh o w e d t h a t th e p ric e o f a r is k y a s s e t d e p e n d s o n i t s e x p e c t e d fu tu r e
c a s h flo w s, th e tim e v a lu e o f m o n e y , a n d r isk . H o w ev e r, little a t t e n t i o n w a s p a id to th e c a u s e s o f r i s k o r to
h o w r is k s h o u ld b e d e fin e d a n d m e a s u r e d .
T o m a k e e ffe c tiv e fin a n c ia l d e c is io n s , m a n a g e r s n e e d to u n d e r s t a n d w h a t c a u s e s r is k , h o w i t s h o u ld
b e m e a s u r e d a n d th e e ffe c t o f r is k o n th e r a te o f r e t u r n r e q u ir e d b y in v e s t o r s . T h e se i s s u e s a r e d is c u s s e d
in t h is c h a p te r u s in g th e fr a m e w o r k o f p o r t f o lio th e o r y , w h ic h s h o w s h o w in v e s t o r s c a n m a x im is e th e
e x p e c te d r e tu r n o n a p o r t f o lio o f r is k y a s s e t s fo r a g iv e n le v e l o f r isk . Th e r e la t io n s h ip b e t w e e n r is k a n d
e x p e c te d r e tu r n is fir s t d e s c r ib e d b y th e c a p it a l a s s e t p r ic in g m o d e l (C A P M ), w h ic h lin k s e x p e c t e d r e t u r n
to a sin g le so u r c e o f r is k , a n d s e c o n d , b y m o d e ls t h a t in c lu d e a d d it io n a l f a c t o r s to e x p la in r e t u r n s .
To u n d e r s ta n d th e m a t e r ia l in t h is c h a p t e r i t i s n e c e s s a r y to u n d e r s t a n d w h a t is m e a n t b y re tu rn a n d
risk. T h e re fo re , w e b e g in b y d i s c u s s i n g t h e s e c o n c e p ts .
7.2 Return and risk

The re tu r n o n a n in v e s t m e n t a n d th e r i s k o f a n i n v e s t m e n t a r e b a s ic c o n c e p t s in fin a n c e . R e tu r n o n a n
in v e s t m e n t is th e fin a n c ia l o u t c o m e f o r th e in v e sto r . F o r e x a m p le , i f s o m e o n e i n v e s t s $ 1 0 0 in a n a s s e t L E A R N IN G
O B JEC TIVE 1
a n d s u b s e q u e n t ly s e lls t h a t a s s e t f o r $ 1 1 1 , th e d o lla r retu rn is $ 1 1 . U su a lly a n i n v e s t m e n t s d o lla r r e t u r n is
U nde rstand h o w return
c o n v e r te d to a ra te o f retu rn b y c a lc u la tin g th e p r o p o r t io n o r p e r c e n ta g e r e p r e s e n t e d b y th e d o lla r r e tu r n . a n d risk are defined
F o r e x a m p le , a d o lla r r e t u r n o f $ 1 1 o n a n in v e s t m e n t o f $ 1 0 0 is a r a t e o f r e t u r n o f $ 1 1 / $ 1 0 0 , w h ic h is a n d m easured
0 .1 1 , o r 1 1 p e r c e n t. In th e r e m a in d e r o f t h is c h a p t e r th e w o rd re tu rn is u s e d to m e a n ra te o f re tu rn .
R isk is p r e s e n t w h e n e v e r i n v e s t o r s a r e n o t c e r ta in a b o u t th e o u t c o m e s a n in v e s t m e n t w ill p r o d u c e .
S u p p o s e , h o w e v e r, t h a t in v e s t o r s c a n a t ta c h a p r o b a b ility t o e a c h p o s s ib le d o lla r r e t u r n t h a t m a y o ccu r.
In v e sto r s c a n t h e n d r a w u p a p r o b a b ility d is tr ib u t io n f o r th e d o lla r r e t u r n s fr o m th e in v e s t m e n t .
A p ro b ab ility d istrib u tio n is a l is t o f th e p o s s ib le d o lla r r e t u r n s f r o m th e in v e s t m e n t t o g e t h e r w ith th e
p r o b a b ility o f e a c h r e tu r n . F o r e x a m p le , a s s u m e t h a t th e p r o b a b ilit y d is t r ib u t io n in T a b le 7 .1 i s a n
i n v e s t o r s a s s e s s m e n t o f th e d o lla r r e t u r n s t h a t m a y b e re c e iv e d f r o m h o ld in g a s h a r e in a c o m p a n y fo r
1 year.
TABLE 7.1
D o lla r re tu rn , Rt ($ ) P ro b a b ility , P,
9 0.1
10 0 .2
11 0 .4
12 0 .2
13 0 .1
S u p p o s e th e in v e s t o r w is h e s to s u m m a r is e t h is d is t r ib u t io n b y c a lc u la tin g tw o m e a s u r e s , o n e to
r e p r e s e n t th e s iz e o f th e d o lla r r e t u r n s a n d th e o t h e r to r e p r e s e n t th e r i s k in v o lv e d . Th e s iz e o f th e d o lla r
r e t u r n s m a y b e m e a s u r e d b y th e e x p e c t e d v a lu e o f th e d is t r ib u t io n . Th e e x p e c t e d v a lu e E (R ) o f th e d o lla r
r e t u r n s is g iv e n b y th e w e ig h te d a v e r a g e o f all th e p o s s ib le d o lla r r e t u r n s , u s i n g th e p r o b a b ilit ie s a s
w e ig h t s — t h a t is:
E (R ) = ($ 9 ) (0 .1 ) + ( $ 1 0 ) ( 0 .2 ) + ($ 1 1 ) (0 .4 ) + ($ 1 2 ) (0 .2 ) + ( $ 1 3 ) (0 .1 )
= $11
In general, the expected return on an investment can be calculated as:
w h ic h c a n b e w r it t e n a s fo llo w s:
n
E{R) = Y ^ R iP i
i= l
The c h o ic e o f a m e a s u r e f o r r is k is l e s s o b v io u s . In t h is e x a m p le , r i s k is p r e s e n t b e c a u s e a n y o n e o f
fiv e o u t c o m e s ($ 9 , $ 1 0 , $ 1 1 , $ 1 2 o r $ 1 3 ) m ig h t r e s u lt fr o m th e i n v e s t m e n t . I f th e i n v e s t o r h a d p e r fe c t
fo r e s ig h t , th e n o n ly o n e p o s s ib l e o u tc o m e w o u ld b e in v o lv e d , a n d th e r e w o u ld n o t b e a p r o b a b ility
d i s t r ib u t io n t o b e c o n s id e r e d . T h is s u g g e s t s t h a t r i s k is r e la t e d to th e d is p e r s io n o f th e d is tr ib u t io n . The
VARIANCE
m o r e d i s p e r s e d o r w id e s p r e a d th e d is tr ib u t io n , th e g r e a t e r th e r is k in v o lv e d . S t a t i s t i c i a n s h a v e d e v e lo p e d
m easure of variability;
a n u m b e r o f m e a s u r e s to r e p r e s e n t d is p e r s io n . T h e se m e a s u r e s in c lu d e th e r a n g e , th e m e a n a b s o lu t e
the m ean of the
squared deviations d e v ia tio n a n d th e v a r ia n c e . H o w e v e r, it is g e n e r a lly a c c e p te d t h a t in m o s t in s t a n c e s t h e variance (o r
from the m ean or i t s s q u a r e r o o t, th e stan d ard deviation, a) is th e m o s t u s e f u l m e a s u r e . A c c o rd in g ly , t h is m e a s u r e o f
expected value d i s p e r s io n is th e o n e w e w ill u s e to r e p r e s e n t th e r is k o f a s in g le in v e s t m e n t . T h e v a r ia n c e o f a d is tr ib u t io n
o f d o lla r r e t u r n s is th e w e ig h te d a v e r a g e o f th e s q u a r e o f e a c h d o lla r r e t u r n s d e v ia tio n f r o m th e e x p e c te d
STANDARD DEVIATION
square root of the d o lla r r e t u r n , a g a in u s i n g th e p r o b a b ilit ie s a s th e w e ig h ts . F o r th e s h a r e c o n s id e r e d in T a b le 7 .1 , th e
varian ce v a r ia n c e is:
cr2 = (9-11)2(0.1) + (10-11)2(0.2) + (11-11)2(0.4) + (12-11)2(0.2) + (13 - 11)2(0.1)

= 1.2
In g e n e r a l th e v a r ia n c e c a n b e c a lc u la te d a s:
〇2 - [/?, -£(/?)]2p, + [R2 - E ( R ) Y P 2 + ... + [/?„-£(/?)]2p„
w h ic h c a n b e w r it t e n a s fo llo w s:
n
o2 = J 2 ^ R' ~ E(R^ 2pi
i= l
In t h is c a s e th e v a r ia n c e is 1 .2 s o th e s t a n d a r d d e v ia tio n is:
a = \/L 2
= $ 1 .0 9 5
In t h e s e c a lc u la tio n s w e h a v e u s e d d o lla r r e t u r n s r a t h e r t h a n r e t u r n s m e a s u r e d in th e fo r m o f a ra te .
T h is is b e c a u s e i t is g e n e r a lly e a s ie r to v is u a lis e d o lla r s t h a n r a t e s , a n d b e c a u s e i t a v o id s c a lc u la tio n s w ith
a la r g e n u m b e r o f z e r o s fo llo w in g th e d e c im a l p o in t . H o w e v e r, th e r e is n o d iffe r e n c e in s u b s t a n c e , a s m a y
b e s e e n f r o m r e w o r k in g th e e x a m p le u s i n g r e t u r n s in r a te fo r m . I f th e s u m in v e s t e d is $ 1 0 0 , th e n a d o lla r
r e tu r n o f $ 9 , f o r e x a m p le , is a r e t u r n o f 0 .0 9 w h e n e x p r e s s e d a s a ra te . T a b le 7 .2 sh o w s r a t e s o f r e t u r n t h a t
c o r r e s p o n d to th e d o lla r r e t u r n s in T a b le 7 .1 .
TABLE 7.2
R etu rn, P ro b a b ility , P,
0 .0 9 0 .1
0 .1 0 0 .2
0 .1 1 0 .4
0 .1 2 0 .2
0 .1 3 0 .1
U s i n g r a t e s , th e e x p e c t e d r e t u r n E (R ) is:
E (R ) = (0 .0 9 ) (0 .1 ) + (0 .1 0 ) (0 .2 ) + ( 0 .1 1 ) ( 0 .4 ) + (0 .1 2 ) (0 .2 ) + (0 .1 3 ) (0 .1 )
= 0.11
= 11%
The v a r ia n c e o f r e t u r n s is:
a 2 = (0.09-0 .1 1 )2(0.1) + (0 .1 0 -0 .1 1 )2(0.2) + (0.11-0 .1 1 )2(0.4) + (0 .1 2 -0 .1 1 )2(0.2)
+ ( 0 . 1 3 - 0 . 1 1 ) 2( 0 . 1 )
= 0 .0 0 0 12
The s t a n d a r d d e v ia tio n o f r e t u r n s is t h e r e fo r e :
ct= v/0.00012
= 0 .0 1 0 9 5
= 1 .0 9 5 %
It is o ft e n a s s u m e d t h a t a n i n v e s t m e n t s d is t r ib u t io n o f r e t u r n s fo llo w s a n o r m a l d is tr ib u t io n . T h is
is a c o n v e n ie n t a s s u m p t i o n b e c a u s e a n o r m a l d is t r ib u t io n c a n b e fu lly d e s c r ib e d b y i t s e x p e c t e d v a lu e
a n d s t a n d a r d d e v ia tio n . T h e r e fo re , a n i n v e s t m e n t s d is t r ib u t io n o f r e t u r n s c a n b e fu lly d e s c r ib e d b y i t s
e x p e c te d r e t u r n a n d r is k . A s s u m i n g t h a t r e t u r n s fo llo w a n o r m a l p r o b a b ility d is tr ib u t io n , th e t a b le o f
a r e a s u n d e r th e s t a n d a r d n o r m a l c u rv e (s e e T a b le 5 o f A p p e n d ix A ) c a n b e u s e d t o c a lc u la te th e p r o b a b ility
th a t th e in v e s t m e n t w ill g e n e r a t e a r e tu r n g r e a t e r t h a n o r l e s s t h a n a n y s p e c ifie d r e tu r n . F o r e x a m p le ,
s u p p o s e t h a t th e r e t u r n s o n a n in v e s t m e n t in C o m p a n y A a r e n o r m a lly d is tr ib u t e d , w ith a n e x p e c t e d
r e tu r n o f 1 3 p e r c e n t p e r a n n u m a n d a s t a n d a r d d e v ia tio n o f 1 0 p e r c e n t p e r a n n u m . S u p p o s e a n in v e s t o r
in th e c o m p a n y w ish e s to c a lc u la te th e p r o b a b ilit y o f a l o s s — t h a t is , th e in v e s t o r w is h e s to c a lc u la te th e
p r o b a b ility o f a r e tu r n o f l e s s th a n z e r o p e r c e n t. A r e t u r n o f z e r o p e r c e n t is 1 .3 s t a n d a r d d e v ia t io n s b e lo w
th e e x p e c te d r e t u r n (b e c a u s e 0 .1 3 / 0 .1 0 = 1 .3 ). F ig u r e 7 .1 illu s t r a t e s t h is c a s e . Th e s h a d e d a r e a r e p r e s e n t s
th e p r o b a b ility o f a lo s s . Th e ta b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e (T a b le 5, A p p e n d ix A o r th e
N O R M S D IS T f u n c tio n in M ic r o s o ft E x c e l*) in d ic a t e s t h a t th e p r o b a b ility o f a l o s s o c c u r r in g is 0 .0 9 6 8 o r
a lm o s t 9 .7 p e r c e n t.
T o h ig h lig h t th e i m p o r t a n c e o f th e s t a n d a r d d e v ia tio n o f th e r e t u r n d is tr ib u t io n , a s s u m e t h a t th e
s a m e in v e s t o r a ls o h a s th e o p p o r t u n it y o f in v e s t in g in C o m p a n y B w ith a n e x p e c t e d r e t u r n o f 1 3 p e r c e n t
a n d a s t a n d a r d d e v ia tio n o f 6 .9 1 p e r c e n t. Th e p r o b a b ility d i s t r ib u t io n s o f th e r e t u r n s o n in v e s t m e n t s in
c o m p a n ie s A a n d B a re s h o w n in F ig u r e 7 .2 .
B o th in v e s t m e n t s h a v e t h e s a m e e x p e c t e d r e tu r n b u t, o n th e b a s i s o f th e d is p e r s io n o f th e r e t u r n s ,
a n in v e s t m e n t in C o m p a n y A (w ith a s t a n d a r d d e v ia tio n o f 1 0 p e r c e n t) is r is k ie r t h a n a n in v e s t m e n t in
C o m p a n y B (w ith a s t a n d a r d d e v ia tio n o f 6 .9 1 p e r c e n t).
S u p p o s e t h a t th e in v e s t o r d e c id e s t h a t a r e t u r n o f z e r o p e r c e n t o r l e s s i s u n s a t is f a c t o r y . A r e tu r n
o f z e r o p e r c e n t o n a n in v e s t m e n t in C o m p a n y B is 1 .8 8 s t a n d a r d d e v ia tio n s b e lo w th e e x p e c t e d r e tu r n
(b e c a u se 0 . 1 3 / 0 .0 6 9 1 = 1 .8 8 ). Th e p r o b a b ilit y o f t h is o c c u r r in g is 0 .0 3 . T h e r e fo re , th e p r o b a b ilit y t h a t
a n in v e s t m e n t in o n e o f t h e s e c o m p a n ie s w ill g e n e r a t e a n e g a tiv e r e t u r n is 3 p e r c e n t fo r C o m p a n y B
c o m p a r e d w ith 9 .7 p e r c e n t f o r C o m p a n y A . H o w e v e r, w h e n th e i n v e s t o r c o n s id e r s r e t u r n s a t th e u p p e r
e n d o f th e d i s t r ib u t io n s i t i s fo u n d t h a t a n i n v e s t m e n t in C o m p a n y A o f f e r s a 9 .7 p e r c e n t c h a n c e o f a
B usiness finance
Figure 7.2
retu rn in excess o f 26 per cent, compared w ith only a 3 per cent chance fo r an investm ent in Company
B. In summ ary the p robability o f both very low returns and very high returns is much greater in the
case o f Company A. The fact th a t the investor is more uncertain about the retu rn from an investm ent in
Company A does n o t mean th a t the investor w ill necessarily prefer to invest in Company B. The choice
RISK-AVERSE INVESTOR depends on the investors a ttitude to risk.
an investor who A lternative attitudes to risk and the effects o f risk are considered in the next section, which can safely
dislikes risk and who be o m itte d by readers who are prepared to accept th a t investors are generally risk averse. Risk aversion
will only choose a
does not mean th a t an investor w ill refuse to bear any risk at all. Rather i t means th a t an investor regards
risky investment if the
expected return is high risk as something undesirable, b ut which may be w o rth tolerating i f the expected retu rn is sufficient to
enough to compensate compensate fo r the risk. Therefore, a ris k -a v e rs e in v e s to r would prefer to invest in Company B because
for bearing the risk A and B offer the same expected return, b u t B is less risky.
7.3 The investor’s utility function

Consider the decision to invest in either Company A or Company B. As discussed in Section 7.2, both
LEARNING companies offer the same expected return, b ut differ in risk. A preference fo r investing in either Company
OBJECTIVE 2
A or Company B w ill depend on the investors a ttitude to risk. An investor may be risk averse, risk
Understand the
concept of risk neutral o r risk seeking. A risk-averse investor attaches decreasing u tility to each increm ent in wealth; a
aversion by investors risk -n eu tral in vestor attaches equal u tility to each increm ent in wealth; while a risk -seek in g investor
attaches increasing u tility to each increm ent in wealth. Typical u tility -to -w e a lth functions fo r each type
RISK-NEUTRAL o f investor are illustrated in Figure 7.3.
INVESTOR The characteristics o f a risk-averse investor w arrant closer examination, as risk aversion is the
an investor who
standard assumption in finance theory. Assume th a t a risk-averse investor has wealth o f $ W* and has the
neither likes nor
dislikes risk o p p o rtu n ity o f p articipating in the follow ing game: a fa ir coin is tossed and i f it falls tails (probability 0.5),
then $1000 is won; i f i t falls heads (probability 0.5), then $1000 is lost. The expected value o f the game is
RISK-SEEKING
INVESTOR
$0 and it is, therefore, described as a *fair game*. Would a risk-averse investor participate in such a game?
an investor who I f he or she participates and wins, wealth w ill increase to $(PV* + 1000), b ut i f he or she loses, wealth w ill
likes risk and who fall to $(PV* - 1000). The results o f this game are shown in Figure 7.4.
will choose a risky The investors current level o f u tility is U2. The investors u tility w ill increase to U3 i f he or she wins
investment even if the
the game and w ill decrease to [7Xin the event o f a loss. W hat is the expected u tility i f the investor decides
expected return is less
than the expected to participate in the game? There is a 50 per cent chance th a t his or her u tility w ill increase to U3, and a
return on a less risky 50 per cent chance th a t i t w ill decrease to Uv Therefore, the expected u tility is 0 . 5 ^ + 0.5U3. As shown
investment in Figure 7.4, the investors expected u tility w ith the gamble (0.5U1 + 0.5U3) is lower than the u tility
obtained w ith o u t the gamble (U2). As it is assumed th a t investors maximise th e ir expected u tility , a risk-
averse investor would refuse to participate in this game. In fact, a risk-averse investor may be defined as
ure 7.3 Utility-to-wealth functions for different types of investors
Risk seeking
IM
ln Risk neutral
ir
un
Wealth (W )
someone who would n ot participate in a fa ir game. Similarly, it can be shown th a t a risk-neutral investor
would be indifferent to participation, and a risk-seeking investor would be prepared to pay fo r the rig h t
to participate in a fa ir game.
Now consider the preferences o f a risk-averse investor w ith respect to an investm ent in either
Company A or Company B. As we have seen, the expected retu rn from each investm ent is the same but
the investment in A is riskier. An investm ent in A offers the possibility o f making either higher returns
or lower returns, compared w ith an investm ent in B. However, from Figure 7.2, the increased spread o f
returns above the expected retu rn tends to increase expected u tility . But this increase w ill be outweighed
by the decrease in expected u tility resulting from the greater spread o f returns below the expected return.
Therefore, the risk-averse investors expected u tility would be greater i f he or she invests in B.
As both investments offer the same expected return, the risk-averse investors choice implies th a t the
increased dispersion o f returns makes an investm ent riskier. This suggests th a t the standard deviation
o f the return distribu tio n may be a useful measure o f risk fo r a risk-averse investor. Similarly, it can be
argued th a t the risk-neutral investor would be ind iffe re nt between these tw o investments. For any given
amount to be invested, such an investor w ill always choose the investm ent th a t offers the higher return,
命
B usiness finance
irrespective o f the relative risk o f other investm ents— th a t is, the standard deviation is ignored. The risk
seeking investor would choose to invest in A. I f a given am ount is to be invested, and the investor has
the choice o f two investments th a t offer the same expected return, the risk-seeking investor w ill always
choose the investm ent w ith the higher risk.
An investors preferences regarding expected retu rn and risk can be illustrated using indifference
curves. For a given am ount invested, an indifference curve traces out all those combinations o f expected
return and risk th a t provide a particular investor w ith the same level o f u tility . Because the level o f
u tility is the same, the investor is indifferent between all points on the curve. A risk-averse investor has
a positive attitude towards expected retu rn and a negative a ttitude towards risk. By this, we mean th a t a
risk-averse investor w ill prefer an investm ent to have a higher expected retu rn (for a given risk level) and
lower risk (for a given expected return).
Risk aversion does not mean th a t an investor w ill refuse to bear any risk at all. Rather it means th a t an
investor regards risk as something undesirable, b u t which may be w o rth tolerating i f the expected return
is sufficient to compensate fo r the risk. In graphical terms, indifference curves fo r a risk-averse investor
m ust be upward sloping as shown in Figure 7.5.
The risk-re tu rn coordinates fo r a risk-averse investor are shown in Figure 7.5 fo r three investments— A,
B and C. I t is apparent that this investor would prefer Investment B to Investment A, and would also prefer
Investment B to Investment C. This investor prefers a higher expected return at any given level o f risk (compare
investments B and A) and a lower level o f risk at any given expected return (compare investments B and C).
However, this investor would be indifferent between investments A and C. The higher expected return on
investm ent C compensates this investor exactly fo r the higher risk. In addition, fo r a given expected return
the expected u tility o f a risk-averse investor falls at an increasing rate as the dispersion o f the distribution
o f returns increases. As a result, the rate o f increase in expected return required to compensate for every
increment in the standard deviation increases faster as the risk becomes larger. Note that indifference curves
for a risk-averse investor are n ot only upward sloping, but also convex, as shown in Figure 7.5.
So far we have concentrated on the characteristics and behaviour o f a risk-averse investor. However,
there are instances where individuals behave in a way contrary to risk aversion. For example, a risk-averse
person w ill never purchase a lo tte ry ticket, as the expected value o f the gamble is less than the price o f
the ticket. However, many individuals whose current level o f wealth is quite low relative to the lo tte ry
prize are prepared to purchase lo tte ry tickets because, w hile only a small outlay is required, there is the
small chance o f achieving a relatively large increase in wealth. In decisions th a t involve larger outlays,
risk aversion is much more likely. As the financial decisions considered in this book generally involve
Figure 7.5
Increasing utility
| EIRB) = EIRC)
0)
J
I 肌 )
aA = aB °C
Risk (o)
large investments and small rates o f retu rn (at least relative to w inning a lo tte ry prize), i t is assumed
throughout that investors behave as i f they are risk averse.
7.4 The risk of assets

I f investors, expectations o f the returns from an investm ent can be represented by a norm al probability
distribution, then the standard deviation is a relevant measure o f risk fo r a risk-averse investor. I f two
investments offer the same expected return, b ut differ in risk, then a risk-averse investor w ill prefer
the less risky investm ent. Further, it has been shown th a t a risk-averse investor is prepared to accept
higher risk fo r higher expected return, w ith the result th a t the required retu rn on a particular investm ent
increases w ith the investors perception o f its risk.
The standard deviation o f the retu rn from a single investm ent is a relevant measure o f its riskiness
in cases where an individual is considering the investm ent o f all available funds in one asset. However,
it is exceptional to lim it investm ents in this way. M ost people invest in a num ber o f assets; they may
invest in a house, a car, th e ir human capital and numerous other assets. In addition, where they invest
in shares, i t is likely th a t they w ill hold shares in a num ber o f companies. In other words, people typically PORTFOLIO
combined holding of
invest th e ir wealth in a p o rtfolio o f assets and w ill be concerned about the risk o f th e ir overall p ortfo lio .
more than one asset
This risk can be measured by the standard deviation o f the returns on the p o rtfo lio . Therefore, when an
individual asset is considered, an investor w ill be concerned about the risk o f th a t asset as a component o f
a p o rtfo lio o f assets. W hat we need to know is how individual p o rtfo lio components (assets) contribute
to the risk o f the p o rtfo lio as a whole. An apparently plausible guess would be th a t the co ntribu tion
o f each asset is p ro p o rtio n a l to the assets standard deviation. However, p o rtfo lio theory, w hich is
discussed in the next section, shows th a t this guess turns o ut to be alm ost always incorrect.
7.5 Portfolio theory and diversification

m
Portfolio theory was in itia lly developed by M arkow itz (1952) as a norm ative approach to investm ent
choice under uncertainty.1 Two im p o rta n t assumptions o f p o rtfo lio theory have already been discussed. LEARNING
OBJECTIVE 3
These are:
Explain how
a The returns from investments are norm ally distributed. Therefore, two parameters, the expected diversification reduces
risk
return and the standard deviation, are sufficient to describe the d istrib u tio n o f returns.2
b Investors are risk averse. Therefore, investors prefer the highest expected retu rn fo r a given standard
deviation and the lowest standard deviation fo r a given expected return.
Given these assumptions, it can be shown th a t i t is rational fo r a utility-m axim isin g investor to hold
a well-diversified p o rtfo lio o f investments. Suppose th a t an investor holds a p o rtfo lio o f securities. This
investor w ill be concerned about the expected retu rn and risk o f the p ortfolio. The expected retu rn on a
portfolio is a weighted average o f the expected returns on the securities in the p ortfolio. Let E(Rt) be the
expected return on the zth security and E(Rp) the expected retu rn on a p o rtfo lio o f securities. Then, using
the n otation introduced earlier:
n
E(R„) = ^ 2 w iE(Ri)
i= \
where = the proportion o f the to ta l current m arket value o f the p o rtfo lio constituted by the current
m arket value o f the zth security— th a t is, it is the ‘w eight’ attached to the security
n = the number o f securities in the p ortfo lio
Calculation o f the expected return on a p o rtfo lio is illustrated in Example 7.1.
1 For a more extensive treatment, see Markowitz (1959).

2 Other parameters may exist if the distribution is non-normal. In this case it is assumed that investors base decisions on
expected return and standard deviation and ignore other features such as skewness.
Example 7.1
A s s u m e th a t th e re a r e o n ly t w o s e c u ritie s (1 a n d 2 ) in a p o r tf o lio a n d E(R}) = 0 . 0 8 a n d E(/?2) = 〇• 1 2 .
A ls o a s s u m e th a t th e c u r r e n t m a rk e t v a lu e o f S e c u rity 1 is 6 0 p e r c e n t o f th e to ta l c u rre n t m a rk e t v a lu e
o f th e p o r tf o lio (th a t is, w 1 = 0 . 6 a n d w 2 = 0 . 4 ) . T h e n :
E(/?p) = ( 0 . 6 ) ( 0 .0 8 ) + ( 0 . 4 ) ( 0 .1 2 )
= 0 . 0 9 6 o r 9 .6 %
Example 7.1 illustrates the fact th a t the expected retu rn on a p o rtfo lio is sim ply the weighted average
o f the expected returns on the securities in the p ortfo lio . However, the standard deviation o f the return
on the p o rtfo lio (c p) is not sim ply a weighted average o f the standard deviations o f the securities in the
p ortfo lio . This is because the riskiness o f a p o rtfo lio depends n ot only on the riskiness o f the individual
securities b ut also on the relationship between the returns on those securities. The variance o f the return
on a p o rtfo lio o f two securities is given by:
# = 4 cr| + 2 Cov(/?卜 i?2)
where Cov(Rv R2) = the covariance between the returns on securities 1 and 2
The covariance between the returns on any pair o f securities is a measure o f the extent to which the
returns on those securities tend to move together or covary*. This tendency is more commonly measured
using the correlation coefficient p, which is found by dividing the covariance between the returns on
the tw o securities by the standard deviations o f th e ir returns. Therefore, the correlation coefficient for
securities 1 and 2 is:
Cov(/?i,/?2)
Pi,2 = 7.3
The correlation coefficient is essentially a scaled measure o f covariance and it is a very convenient
measure because it can only have values between +1 and -1 . I f the correlation coefficient between the
returns on two securities is +1, the returns are said to be perfectly positively correlated. This means th a t
i f the retu rn on security z is ^ ig h 1(compared w ith its expected level), then the retu rn on se curity; w ill,
unfailingly, also be ‘high’ （compared w ith fts expected level) to precisely the same degree. I f the correlation
coefficient is -1 , the returns are perfectly negatively correlated; high (low) returns on security i w ill always
be paired w ith low (high) returns on security A correlation coefficient o f zero indicates the absence of
a systematic relationship between the returns on the tw o securities. Using Equation 7.3 to substitute for
the covariance, Equation 7.2 can be expressed as:
= w \ 〇\ -f- W2 O 2 + 2 W \W 2 P \ 2 (J \ (T2 7.4

As may be seen from Equation 7.4, the variance o f a p o rtfo lio depends on:
a the com position o f the p o rtfo lio — th a t is, the p roportion o f the current m arket value o f the
p o rtfo lio constituted by each security
b the standard deviation o f the returns fo r each security
c the correlation between the returns on the securities held in the p ortfo lio .
The effect o f changing the composition o f a p o rtfo lio o f tw o securities is illustrated in Example 7.2.
7.5.1 I Gains from diversification

Example 7.2 shows th a t some portfolios enable an investor to achieve simultaneously higher expected
retu rn and lower risk; fo r example, compare portfolios (d) and (f) in Figure 7.6. It should be noted th a t
Portfolio (d) consists o f both securities, whereas Portfolio (f) consists o f only Security 1— th a t is, Portfolio
(d) is diversified, whereas Portfolio (f) is not. This illustrates the general principle th a t investors can gain
from diversification.
E xample 7.2
A n in v e s to r w is h e s to c o n s tru c t a p o r tf o lio c o n s is tin g o f S e c u rity 1 a n d S e c u rity 2 . T h e e x p e c te d re tu rn s
o n th e tw o s e c u ritie s a r e E(R}) = 8 % p .a . a n d E(R2) = 1 2 % p .a . a n d th e s ta n d a r d d e v ia tio n s a re
= 2 0 % p .a . a n d a 2 = 3 0 % p .a . T he c o r r e la tio n c o e ffic ie n t b e tw e e n th e ir re tu rn s is p ] 2 = - 〇.5. The
in v e s to r is fre e to c h o o s e th e in v e s tm e n t p r o p o r tio n s w ] a n d w 2/ s u b je c t o n ly to th e re q u ire m e n ts th a t
+ w 2 = 1 a n d th a t b o th a n d vv2 a r e p o s itiv e .3 T h e re is n o lim it to th e n u m b e r o f p o r tfo lio s th a t
m e e t th e se re q u ire m e n ts , s in c e th e re is n o lim it to th e n u m b e r o f p r o p o r tio n s th a t sum to 1. T h e re fo re ,
a re p re s e n ta tiv e s e le c tio n o f v a lu e s is c o n s id e r e d fo r W ]：
0 , 0 . 2 , 0 . 4 , 0 . 6 , 0 . 8 a n d 1.
U s in g E q u a tio n 7 . 1 , th e e x p e c te d re tu rn o n a tw o -s e c u rity p o r tf o lio is:
E(/?p) = w .E iR ,) + w 2E(R2)
= w ^ O .0 8 ) + w 2( 0 . 1 2 )
U s in g E q u a tio n 7 . 4 , th e v a r ia n c e o f th e re tu rn o n a tw o -s e c u rity p o r tf o lio is:
ap = + w^ + 2w 1vv2Pir2a l °2
= w2(〇.20)2 + w2(0.30)2 + 2Wl w2(-0.5)(0.20)(0.30)
= 0.04w^ + 0.09w^ - 0.06W] vv2
T he s ta n d a rd d e v ia tio n o f th e p o r tf o lio re tu rn s is fo u n d b y ta k in g th e s q u a re r o o t o f a . E a ch p a ir o f
p r o p o r tio n s is n o w c o n s id e r e d in tu rn :
a) w 1 = 0 and w 2 = 1
q /y = (o .〇8 i( o ) + ( o .i 2 )⑴
= 0 . 1 2 o r 1 2 % p .a .
〇 p = (〇.〇4)(0)2 + (0.09)(1)2 -(0.06)(0)(1)

o2
p = 0.09
〇 p - 0.30 or 30% p.a.
b) W! = 0 . 2 a n d w 2 = 0 . 8 E(Rp) = ( 0 . 0 8 ) ( 0 . 2 ) + ( 0 . 1 2 ) ( 0 . 8 ) = 0 . 1 1 2 o r 1 1 . 2 % p .a .
o2
p = (0.04)(0.2)2 + (0.09)(0.8)2 -(0.06)(0.2)(0.8)
o2
p = 0.0496
.-.〇 p = 0.2227 or 22.27% p.a.
c) W l = 0 . 4 a n d w 2 = 0 . 6 E[Rp) = ( 0 . 0 8 ) ( 0 . 4 ) + ( 0 . 1 2 ) ( 0 . 6 ) = 0 . 1 0 4 o r 1 0 . 4 % p .a .
〇 p = (〇.〇4)(0.2)2 + (0.09)(0.6)2 -(0.06)(0.4)(0.6)

〇 p = 0.0244
〇 p = 0.1562 or 15.62% p.a.
d) W l = 0 . 6 a n d w 2 = 0 . 4 E(/?p) = ( 0 . 0 8 ) ( 0 . 6 ) + ( 0 . 1 2 ) ( 0 . 4 ) = 0 . 0 9 6 o r 9 . 6 % p .a .
〇 l = (0.04)(0.6)2 + (0.09)(0.4)2 -(0.06)(0.6)(0.4)

=0.0144
= 0.12 or 12% p.a.
e) vvt = 0 . 8 a n d w 2 = 0 . 2 E(/?p) = ( 0 . 0 8 ) ( 0 . 8 ) + ( 0 . 1 2 ) ( 0 . 2 ) = 0 . 0 8 8 o r 8 .8 % p .a .
a2
p = (0.04)(0.8)2 + (0.09)(0.2)2 - (0.06)(0.8)(0.2)
=0.0196
〇 p = 0.14 or 14% p.a.
continued
3 Negative investment proportions would indicate a short sale', which means that the asset is first sold and later purchased.
Therefore, a short-seller benefits from price decreases.
^0^
B usiness finance
continued
f) vvt = 1 . 0 a n d w 2 = 0 E(/?p) = ( 0 . 0 8 ) ( 1 ) + ( 0 .1 2 ) ( 0 ) = 0 . 0 8 o r 8 % p .a .
〇l = (〇.〇
4 ) ( l) 2 + (0 .0 9 )(0 )2 - ( 0 . 0 6 ) ( l) ( 0 )
〇 p = 0.04
〇 p = 0.20 or 20% p.a.
T h e se re su lts a r e s u m m a ris e d in T a b le 7 . 3 .
TA B LE 7 .3
P o rtfo lio
(a) (b) (Cl (d) (e) (f)
Proportion in Security 1 (Wj) 0.0000 0.2000 0.4000 0.6000 0.8000 1.0000
Proportion in Security 2 (w2) 1.0000 0.8000 0.6000 0.4000 0.2000 0.0000
Expected return E (Rp) 0.1200 0.1120 0.1040 0.0960 0.0880 0.0800
Standard deviation a 0.3000 0.2227 0.1562 0.1200 0.1400 0.2000
R e a d in g a c ro s s T a b le 7 .3 , th e in v e s to r p la c e s m o re w e a lth in th e lo w -re tu rn S e c u rity 1 a n d less in

th e h ig h -re tu rn S e c u rity 2 . C o n s e q u e n tly , th e e x p e c te d re tu rn o n th e p o r tfo lio d e c lin e s w ith e a c h step.
T he b e h a v io u r o f th e s ta n d a rd d e v ia tio n is m o re c o m p lic a te d . It d e c lin e s o v e r th e firs t fo u r p o rtfo lio s ,
re a c h in g a m in im u m v a lu e o f 0 . 1 2 0 0 w h e n Nv! = 0 . 6 , b u t th e n rises to 0 . 2 0 0 0 a t th e sixth p o r tfo lio ,
w h ic h co n sists e n tire ly o f S e c u rity 1 .4 T his is a n im p o rta n t fin d in g a s it im p lie s th a t so m e p o rtfo lio s
LEARNING
w o u ld n e v e r b e h e ld b y risk-a ve rse in ve sto rs. F or e x a m p le , n o risk-a ve rse in v e s to r w o u ld c h o o s e P o rtfo lio
OBJECTIVE 4
(e) b e c a u s e P o rtfo lio (d) o ffe rs b o th a h ig h e r e x p e c te d re tu rn a n d a lo w e r ris k th a n P o rtfo lio (e). P o rtfo lio s
Explain the concept of
efficient portfolios th a t o ffe r th e h ig h e s t e x p e c te d re tu rn a t a g iv e n le ve l o f risk a re re fe rre d to a s 'e ffic ie n t’ p o rtfo lio s . T he
d a ta in T a b le 7 . 3 a re p lo tte d in F ig u re 7 . 6 .
A s c a n b e se e n fro m F ig u re 7 .6 , p o r tfo lio s (e) a n d (f) a r e n o t e ffic ie n t.
■
E n J P9p9dx
ai
uj
4 me minimum value of the standard deviation actually occurs slightly beyond Portfolio (d) at proportions Wj = 0.6333, and
w2= 0.3667. The standard deviation for this portfolio is 0.11.92% p.a. and its expected return is 9.48% p.a.
C h apter s e ven Risk a n d return
The magnitude o f the gain from diversification is closely related to the value o f the correlation
coefficient, p12- To show the importance o f the correlation coefficient, securities 1 and 2 are again
considered. This tim e, however, the investm ent proportions are held constant at = 0.6 and w2 = 0.4
and different values o f the correlation coefficient are considered. Portfolio variance is given by:
= o ^ C T j - f 1〇2 〇 2 + 2 W \ W 2 p \ , 2 ^ \ ^ 2
= (0.6)2(0.20)2 + (0.4)2(0.30)2 + 2(0.6)(0.4)pi,2(0.20)(0.30)

=0.0144 + 0.0144 + 0.0288pi,2
(Tp = ^/0.0288 + 0.0288^! 2
a Pi,2 = +1.00
(Tp = x/0.0288 4-0.0288pi,2
CTp = 0.2400
b Pi,2 = +0.50
CTp = ^/0.0288 + 0.0288/), i2
(Tp = 0.2079
c Pi,2 = 0.00
〇 "p = ^0.0288 + 0.0288^1^
CTp = 0.1697
d Pi,2 = -0.50
(Tp = ^ 0 .0 2 8 8 + 0.0288p1<2
(Tp = 0.1200
e Pi,2 = -1.00
(Tp = ^0.0288 + 0.0288/?,,2
(Tp = 0
These results are summarised in Table 7.4.
TABLE 7.4 Effect of correlation coefficient on portfolio standard deviation

C o r r e la tio n c o e ffic ie n t S ta n d a rd d e v ia tio n
P i 2= + l.
〇〇 0 .2 4 0 0
Pi 2 = +0.50 0.2 0 7 9
P i 2 = 〇
.〇〇 0 .1 6 9 7
p i 2 = -0 .5 0 0.1 2 0 0
P i 2 = - 1 .0 0 0 .0 0 0 0
Table 7.4 shows three im p o rta n t facts about p o rtfo lio construction:
a Combining two securities whose returns are perfectly positively correlated (that is, the correlation
coefficient is +1) results only in risk averaging, and does n ot provide any risk reduction. In th is case
the p ortfo lio standard deviation is the weighted average o f the two standard deviations, which is
(0.6)(0.20) + (0.4)(0.30) = 0.2400.
b The real advantages o f diversification result from the risk reduction caused by com bining securities
whose returns are less than perfectly positively correlated.
B usiness finance
C The degree o f risk reduction increases as the correlation coefficient between the returns on the two
securities decreases. The largest risk reduction available is where the returns are perfectly negatively
correlated, so the tw o risky securities can be combined to form a p o rtfo lio th a t has zero risk (<Jp = 0).
By considering different investm ent proportions w 1 and w 2, a curve sim ilar to th a t shown in Figure 7.6
can be plo tte d fo r each assumed value o f the correlation coefficient. These curves are shown together in
Figure 7.7.
Figure 7.7
I t can be seen th a t the lower the correlation coefficient, the higher the expected re tu rn fo r any given
level o f risk (or the lower the level o f risk fo r any given expected return). This shows th a t the benefits o f
diversification increase as the correlation coefficient decreases, and when the correlation coefficient is -1 ,
risk can be elim inated completely. The significance o f the dotted lines in Figure 7.7 is th a t a risk-averse
investor would never hold combinations o f the two securities represented by points on the dotted lines.
A t any given level o f correlation these combinations o f the tw o securities are always dom inated by other
com binations th a t offer a higher expected retu rn fo r the same level o f risk.
7 .5 .2 1 Diversification with multiple assets

LEARNING
OBJECTIVE 5 W hile the above discussion relates to the tw o-security case, even stronger conclusions can be drawn fo r
Understand the
larger portfolios. To examine the relationship between the risk o f a large p o rtfo lio and the riskiness o f
importance of
covariance between the individual assets in the p ortfo lio , we sta rt by considering tw o assets. Using Equation 7.2, the p ortfo lio
returns on risky assets variance is:
in determining the risk
of a portfolio ojj = W y〇 i + U/2〇2 + ^ w l W 2C 〇v (R \ , R 2 )
^0^
The variances and covariances on the right-hand side of this equation can be arranged in a matrix as follows:
1 2
1 C ov(R v R 2)
2 C〇v(i?2,i?1) °2
W ith two assets the variances and covariances form a 2 x 2 m atrix; three assets w ill result in a
3 x 3 m atrix; and in general w ith n assets there w ill be ann x n m atrix. Regardless o f the num ber o f assets
involved, the variance-covariance m a trix w ill always have the follow ing properties:
a The m atrix w ill contain a total o f n2 terms. O f these terms, n are the variances o f the individual assets
and the remaining (n2 - n) terms are the covariances between the various pairs o f assets in the portfolio,
b The two covariance terms fo r each pair o f assets are identical. For example, in the 2 x 2 m a trix above,
C o v (R v R 2) = C o v (R 2>^ i )-
c Since the covariance term s fo rm identical pairs, the m atrix is sym metrical about the m ain diagonal,
which contains the n variance terms.
Remember th a t the significance o f the variance-covariance m atrix is th a t it can be used to calculate

the p ortfo lio variance. The p o rtfo lio variance is a weighted sum o f the terms in the m atrix, where the
weights depend on the proportions o f the various assets in the p ortfolio.
The firs t property o f the m a trix listed above shows th a t as the number o f assets increases, the number
o f covariance terms increases much more rapidly than the number o f variance terms. For a p o rtfo lio o f
n assets there are n variances and {n2 - n) covariances in the m atrix. This suggests th a t as a p o rtfo lio
becomes larger, the effect o f the covariance terms on the risk o f the p o rtfo lio w ill be greater than the
effect o f the variance terms.
To illustrate the effects o f diversification and the significance o f the covariance between assets, consider
a portfolio o f n assets. Assume th a t each o f these assets has the same variance {cr\). Also assume, initially,
that the returns on these assets are independent— that is, the correlation between the returns on the assets
is assumed to be zero in all cases. I f we form an equally weighted p o rtfo lio o f these assets, the proportion
invested in each asset w ill be (1/n). Given the assumption o f zero correlation between all the asset returns,
the covariance terms w ill all be zero, so the variance o f the p ortfo lio w ill depend only on the variance terms.
Since there are n variance term s and each such term is the variance o f the p o rtfo lio w ill be:
aP 7.5
Equation 7.5 shows that as n increases, the p o rtfo lio variance w ill decrease and as n becomes large,
the variance o f the p o rtfo lio w ill approach zero; th a t is, i f the returns between all risky assets were
independent, then i t would be possible to elim inate all risk by diversification.
However, in practice, the returns between risky assets are not independent and the covariance
between returns on most risky assets is positive. For example, the correlation coefficients between the
returns on company shares are m ostly in the range 0.5 to 0.7. This positive correlation reflects the fact
that the returns on m ost risky assets are related to each other. For example, i f the economy were growing
strongly we would expect sales o f new cars and construction o f houses and other buildings to be increasing
strongly. In turn, the demand fo r steel and other b uilding materials would also increase. Therefore, the
profits and share prices o f steel and b uilding m aterial manufacturers should have a tendency to increase
at the same tim e as the p ro fits and share prices o f car manufacturers and construction companies.
To reflect the relationships among the returns on individual assets, we relax the assumption th a t
the returns between assets are independent. Instead, we now assume th a t the correlation between the
returns on all assets in the p o rtfo lio is p*. I f the p o rtfo lio is again equally weighted, the p o rtfo lio variance
w ill now be equal to the sum o f the variance terms shown in Equation 7.5, plus (n2 - n) covariance terms
2
where each such term w ill be p*a^- Therefore, the variance o f the p o rtfo lio w ill be:
T + ( 1 ~ n )p^ 7.6
40V
B usiness finance
Equation 7.6 illustrates an im p o rta n t result: w ith identical positively correlated assets, risk cannot be
completely eliminated, no m atter how many such assets are included in a p ortfolio. As n becomes large,
(1/n) w ill approach zero so the firs t term in Equation 7.6 w ill approach zero, b ut the second term w ill
approach p*G^; th a t is, the variance o f the p o rtfo lio w ill approach which is the covariance between
the returns on the assets in the p ortfolio. Thus, the positive correlation between the assets in a p ortfolio
imposes a lim it on the extent to which risk can be reduced by diversification.
In practice, the assets in a p o rtfo lio w ill n ot be identical and the correlations between the assets
w ill d iffer rather than being equal as we have assumed. However, the essential results illustrated in
Equation 7.6 remain the same— th a t is, in a diversified p o rtfo lio the variances o f the individual assets w ill
contribute little to the risk o f the p ortfo lio . Rather, the risk o f a diversified p o rtfo lio w ill depend largely
on the covariances between the returns on the assets. For example, Fama (1976, pp. 245-52) found that
in an equally weighted p o rtfo lio o f 50 random ly selected securities, 90 per cent o f the p o rtfo lio standard
deviation was due to the covariance terms.
7 .5 .3 1 Systematic and unsystematic risk

As discussed in Section 7.5.2, i f we diversify by combining risky assets in a p o rtfo lio , the risk o f the
p o rtfo lio returns w ill decrease. Diversification is most effective i f the returns on the individual assets are
LEARNING negatively correlated, b u t i t s till works w ith positive correlation, provided th a t the correlation coefficient
OBJECTIVE 6
is less than +1. We have noted that, in practice, the correlation coefficients between the returns on
Explain the distinction
between systematic company shares are m ostly in the range 0.5 to 0.7. We also noted th a t this positive correlation reflects the
and unsystematic risk fact th a t the returns on the shares o f m ost companies are economically related to each other. However,
UNSYSTEMATIC the correlation is less than perfect, which reflects the fact th a t much o f the va riab ility in the returns on
( d iv e r s if ia b l e ) RISK shares is due to factors th a t are specific to each company. For example, the price o f a company’s shares
that component of may change due to an exploration success, an im p o rta n t research discovery or a change o f chief executive.
total risk that is unique Over any given period, the effects o f these company-specific factors w ill be positive fo r some companies
to the company and
and negative fo r others. Therefore, when shares o f different companies are combined in a p ortfo lio , the
may be eliminated by
diversification effects o f the company-specific factors w ill tend to offset each other, which w ill, o f course, be reflected in
reduced risk fo r the p ortfolio. In other words, p a rt o f the risk o f an individual security can be eliminated
SYSTEMATIC (MARKET-
RELATED OR N O N - by diversification and is referred to as unsystem atic risk or diversifiable risk. However, no m atter
DIVERSIFIABLE) RISK how much we diversify, there is always some risk th a t cannot be elim inated because the returns on all
that component of risky assets are related to each other. This p art o f the risk is referred to as sy stem atic risk or non-
total risk that is due to
diversifiable risk. These tw o types o f risk are illustrated in Figure 7.8.
economy-wide factors
igure 7.8
Figure 7.8 shows th a t m ost unsystematic risk is removed by holding a p o rtfo lio o f about 25 to 30
securities. In other words, the returns on a well-diversified p o rtfo lio w ill n ot be significantly affected by
the events that are specific to individual companies. Rather, the returns on a well-diversified p o rtfo lio
w ill vary due to the effects o f market-wide or economy-wide factors such as changes in interest rates,
changes in tax laws and variations in com m odity prices. The systematic risk o f a security or p o rtfo lio w ill
depend on its sensitivity to the effects o f these market-wide factors. The d istin ction between systematic
and unsystematic risk is im p o rta n t when we consider the risk o f individual assets in a p o rtfo lio context,
which is discussed in Section 7.5.4, and the pricing o f risky assets, which is discussed in Section 7.6.
7 .5 .4 | The risk of an individual asset

The reasoning used above can be extended to explain the factors th a t w ill determine the risk o f an * *
individual asset as a component o f a diversified portfolio. Suppose th a t an investor holds a p o rtfo lio o f
LEARNING
50 assets and is considering the addition o f an extra asset to the p ortfolio. The investor is concerned
OBJECTIVE 7
w ith the effect that this extra asset w ill have on the standard d e la tio n o f the p ortfo lio . The effect is Explain why
determined by the p o rtfo lio proportions, the extra assets variance and the 50 covariances between systematic risk is
the extra asset and the assets already in the portfolio. As discussed above, the covariance terms are the important to investors
dom inant influence— th a t is, to the holder o f a large p o rtfo lio the risk o f an asset is largely determined
by the covariance between the retu rn on th a t asset and the retu rn on the holders existing p ortfolio. The
variance o f the return on the extra asset is o f little importance. Therefore, the risk o f an asset when it is
held in a large p o rtfo lio is determ ined by the covariance between the return on the asset and the return
on the portfolio. The covariance o f a security z w ith a p o rtfo lio P is given by:
Cov{Ri,Rp) = pip(Tiap 7.7

The holders o f large p ortfo lio s o f securities can s till achieve risk reduction by adding a new security
to their portfolios, provided th a t the returns on the new security are n o t perfectly positively correlated
w ith the returns on the existing p ortfo lio . However, the increm ental risk reduction due to adding a new
security to a p o rtfo lio decreases as the size o f the p o rtfo lio increases and, as shown in Figure 7.8, the
additional benefits from diversification are very small fo r portfolios th a t include more than 30 securities
(Statman 1987).
I f investors are well diversified, th e ir portfolios w ill be representative o f the m arket as a whole.
Therefore, the relevant measure o f risk is the covariance between the retu rn on the asset and the return
on the m arket or Cov(Ri}RM). The covariance can then be scaled by dividing it by the variance o f the return
on the m arket th a t gives a convenient measure o f risk, the b e ta factor, j3{) o f the asset— th a t is, fo r any BETA
asset z, the beta is: measure of a security’s
systematic risk,
。 Cov(i?/, Rm) describing the amount
of risk contributed
by the security to the
Beta is a very useful measure o f the risk o f an asset and i t w ill be shown in Section 7.6.2 th a t the market portfolio
capital asset pricing model proposes th a t the expected rates o f retu rn on risky assets are directly related
to th e ir betas. ^w w ^J
Value Line (w w w .valueline.com ) is a US website based on the Value Line Investm ent Survey and
contains inform a tion to help determine a share s level o f risk.
VALUE AT RISK (VaR)-AN O TH ER WAY OF LOOKING AT RISK Finance

Since the m id -1990s, a new measure o f risk exposure has become popular. This measure IN A C T IO N
was developed by the investment bank J.P. M organ and is known as value at risk (VaR).5 It is
defined as the worst loss that is possible under normal market conditions during a given time
period. It is therefore determined by w hat are estimated to be normal market conditions and
by the time period under consideration. For a given set o f market conditions, the longer the
continued
5 A detailed examination of value at risk is provided by Jorion (2006), while an excellent online resource for those interested in
the topic is provided at www.gloria-mundi.com.
B usiness finance
continued
VALUE AT RISK
worst loss possible tim e h o r iz o n th e g r e a t e r is th e v a lu e a t ris k . T h is m e a s u re o f r is k is b e in g in c r e a s in g ly u s e d b y
under normal market c o r p o r a t e tr e a s u r e r s , fu n d m a n a g e r s a n d f in a n c ia l in s titu tio n s a s a s u m m a r y m e a s u r e o f th e to ta l
conditions for a given r is k o f a p o r t f o lio .
time horizon
To illu s tra te h o w v a lu e a t ris k is m e a s u re d , s u p p o s e th a t $ 1 5 m illio n is in v e s te d in s h a re s in
G r a d s t a r ts Ltd. S h a re s in G r a d s ta r ts h a v e a n e s tim a te d re tu rn o f z e r o a n d a s ta n d a r d d e v ia tio n
o f 3 0 p e r c e n t p e r a n n u m . 6 T h e s ta n d a r d d e v ia tio n o n th e in v e s tm e n t o f $ 1 5 m illio n is th e re fo r e
$ 4 . 5 m illio n . S u p p o s e a ls o t h a t re tu rn s f o llo w a n o r m a l p r o b a b ilit y d is tr ib u tio n . T h is m e a n s th a t th e
t a b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e (see T a b le 5 o f A p p e n d ix A , o r th e N O R M S D IS T
fu n c tio n in M ic r o s o f t E xcel® ) c a n b e u s e d to c a lc u la te th e p r o b a b ilit y th a t th e re tu rn w ill b e g r e a t e r
th a n a s p e c ifie d n u m b e r. S u p p o s e a ls o th a t a b n o r m a lly b a d m a r k e t c o n d itio n s a r e e x p e c te d 5 p e r
c e n t o f th e tim e . T h e t a b le o f a r e a s u n d e r th e s t a n d a r d n o r m a l c u r v e in d ic a te s t h a t th e re is a 5 p e r
c e n t c h a n c e o f a lo ss o f g r e a t e r th a n $ 7 . 4 0 2 5 m illio n p e r a n n u m . T h is f ig u r e is e q u a l to 1 . 6 4 5
m u ltip lie d b y th e s t a n d a r d d e v ia tio n o f $ 4 . 5 m illio n . A s s h o w n in F ig u re 7 . 9 , th e v a lu e a t ris k o f
th e in v e s tm e n t in G r a d s t a r ts is th e re fo r e $ 7 . 4 0 2 5 m illio n p e r a n n u m .
Figure 7.9 Value of Gradstarts Ltd

!l!
2 >
-e
OJd
_Q
S u p p o s e t h a t $ 1 0 m illio n is a ls o in v e s te d in s h a re s in C u r z o n C r e a t iv e Id e a s Ltd . T h e s e
C u r z o n C r e a t iv e Id e a s s h a re s h a v e a n e s tim a te d re tu rn o f z e r o a n d h a v e a s t a n d a r d d e v ia t io n
o f 2 0 p e r c e n t p e r a n n u m . T h e s t a n d a r d d e v ia t io n o n th e in v e s tm e n t o f $ 1 0 m illio n is th e r e f o r e
$ 2 m illio n p e r a n n u m . It is a g a in a s s u m e d t h a t re tu rn s f o ll o w a n o r m a l p r o b a b il it y d is t r ib u t io n
a n d t h a t a b n o r m a lly b a d m a r k e t c o n d it io n s a r e e x p e c t e d 5 p e r c e n t o f th e tim e . A s im ila r
c a lc u la t io n to t h a t f o r G r a d s t a r ts p r o v id e s a v a lu e a t r is k o f th e in v e s tm e n t in C u r z o n C r e a t iv e
Id e a s o f $ 2 m illio n m u lt ip lie d b y 1 . 6 4 5 o r $ 3 . 2 9 m illio n p e r a n n u m .
T h e b e n e fits o f d iv e r s if ic a t io n m a y b e d e m o n s tr a te d b y c a lc u la t in g th e v a lu e a t r is k o f a
p o r t f o lio c o m p r is in g a $ 1 5 m illio n in v e s tm e n t in G r a d s t a r t s a n d a $ 1 0 m illio n in v e s tm e n t in
C u r z o n C r e a t iv e Id e a s . T h e w e ig h t o f th e in v e s tm e n t in G r a d s t a r t s is $ 1 5 m illio n o f $ 2 5 m illio n
o r 0 . 6 o f t h e p o r t f o lio . T h e w e ig h t o f th e in v e s tm e n t in C u r z o n C r e a t iv e Id e a s is 0 . 4 . S u p p o s e
t h a t th e c o r r e la t io n b e tw e e n th e re tu rn s o n th e s h a re s is 0 . 6 5 . U s in g E q u a t io n 7 .4 , th e v a r ia n c e
o f th e re tu r n s o n th e p o r t f o lio is:
a 2= ( 0 . 6 ) 2 ( 0 . 3 ) 2 + ( 0 .4 ) 2 ( 0 . 2 ) 2 + 2 ( 0 . 6 ) ( 0 . 4 ) ( 0 . 3 ) ( 0 . 2 ) ( 0 . 6 5 )
= 0 .0 5 7 5 2
T h e s ta n d a r d d e v ia tio n o f p o r t f o lio re tu rn s , a , is th e r e fo r e 0 . 2 3 9 8 3 3 o r 2 3 . 9 8 3 3 p e r c e n t
a n d th e s ta n d a r d d e v ia tio n o n th e in v e s tm e n t is $ 2 5 m illio n x 0 . 2 3 9 8 3 3 = $ 5 . 9 9 5 8 m illio n .
T h e v a lu e a t ris k o f th e p o r t f o lio is $ 5 . 9 9 5 8 m u ltip lie d b y 1 . 6 4 5 o r $ 9 . 8 6 3 1 m illio n p e r a n n u m .
6 It is usual in calculating value at risk to assume an expected return of zero. This is a reasonable assumption where the
expected return is small compared with the standard deviation of the expected return.
T h e t o t a l v a lu e a t r is k o f t h e in d iv id u a l in v e s tm e n ts in G r a d s t a r t s a n d C u r z o n C r e a t iv e Id e a s
w a s $ 7 . 4 0 2 5 m illio n p lu s $ 3 . 2 9 m illio n o r $ 1 0 . 6 9 2 5 m illio n p e r a n n u m . T h e d if f e r e n c e
b e tw e e n t h a t a m o u n t a n d th e v a lu e a t r is k o f th e p o r t f o lio o f $ 9 . 8 6 3 1 m illio n is d u e to th e
b e n e fits o f d iv e r s if ic a t io n . If, h o w e v e r , th e re tu rn s o n th e s h a re s o f th e t w o c o m p a n ie s w e r e
p e r fe c t ly c o r r e la t e d , th e v a lu e a t r is k o f th e p o r t f o lio w o u ld e q u a l th e v a lu e a t r is k f o r th e
in v e s tm e n t in G r a d s t a r t s p lu s th e v a lu e a t r is k o f th e in v e s tm e n t in C u r z o n C r e a t iv e Id e a s .
V a R is a t e c h n iq u e t h a t is c o m m o n ly u s e d b y f in a n c ia l in s titu tio n s t o m o n it o r t h e ir e x p o s u r e
to lo s s e s t h r o u g h a d v e r s e c h a n g e s in m a r k e t c o n d it io n s . A p e r t in e n t e x a m p le o f th e u s e o f V a R
is p r o v id e d b y th e J a n u a r y 2 0 0 4 a n n o u n c e m e n t o f a $ 3 6 0 m illio n f o r e ig n e x c h a n g e lo s s b y
th e N a t io n a l A u s t r a lia B a n k . W h i l e a n in d e p e n d e n t in v e s t ig a t io n b y P r ic e w a t e r h o u s e C o o p e r s
a ttr ib u t e d m o s t o f th e b la m e f o r th e lo s s to d is h o n e s t y o n th e p a r t o f th e c u r r e n c y t r a d e r s
in v o lv e d a n d th e la c k o f s u it a b le c o n t r o l m e c h a n is m s in p la c e to u n c o v e r s u c h b e h a v io u r , th e
r e p o r t a ls o m a d e s o m e in te r e s t in g c o m m e n ts o n th e b a n k ’s u s e o f V a R . T h e N a t i o n a l A u s t r a lia
B a n k 's b o a r d o f d ir e c t o r s h a d a u t h o r is e d a V a R m a r k e t r is k e x p o s u r e lim it o f $ 8 0 m illio n p e r
d a y f o r th e b a n k in g g r o u p a s a w h o le . T h is lim it w a s d i v id e d b e t w e e n t h e v a r io u s d iv is io n s o f
th e b a n k . T h e c u r r e n c y o p t io n s d e s k h a d a V a R lim it o f $ 3 . 2 5 m illio n p e r d a y . T h is lim it w a s
p e r s is te n tly b r e a c h e d o v e r th e 1 2 -m o n th p e r io d p r i o r to th e a n n o u n c e m e n t o f th e $ 3 6 0 m illio n
lo s s . In r e la t io n to th e im p le m e n t a t io n o f a f la w e d V a R s y s te m th e P r ic e w a t e r h o u s e C o o p e r s
r e p o r t c o m m e n te d th a t:
... m a n a g e m e n t h a d little c o n fid e n c e in the VaR num bers d u e to systems a n d d a ta issues,

a n d e ffe ctive ly ig n o re d VaR a n d o th e r lim it breaches. There w a s n o sense o f u rg e n c y in
resolving the VoR c a lc u la tio n issues w h ic h h o d been a p ro b le m fo r a p e rio d o f tw o o r
m ore ye a rs.7
7 .5 .5 1 The efficient frontier

When all risky assets are considered, there is no lim it to the num ber o f portfolios th a t can be formed,
and the expected return and standard deviation o f the retu rn can be calculated fo r each p ortfo lio . The
coordinates fo r all possible p ortfo lio s are represented by the shaded area in Figure 7.10.
Figure 7.10
j E n
s '
UJ
J
Qj
p a p a d x
LIJ
Risk (a)
7 See PricewaterhouseCoopers (2004, p. 4).

B usiness finance
Only portfolios on the curve between points A and B are relevant since all portfolios below this curve
yield lower expected return and/or greater risk. The curve AB is referred to as the efficient frontier and it
includes those portfolios that are efficient in that they offer the m aximum expected return for a given level
o f risk. For example, Portfolio 1 is preferred to an internal p oint such as Portfolio 3 because Portfolio 1 offers
a higher expected return fo r the same level o f risk. Similarly, Portfolio 2 is preferred to Portfolio 3 because
it offers the same expected return for a lower level o f risk. No such <dominance, relationship exists between
efficient portfolios— that is, between portfolios whose risk-re tu rn coordinates plot on the efficient frontier.
Given risk aversion, each investor w ill want to hold a p ortfo lio somewhere on the efficient frontier.
Risk-averse investors w ill choose the p o rtfo lio th a t suits th e ir preference fo r risk. As investors are a diverse
group there is no reason to believe th a t they w ill have identical risk preferences. Each investor may therefore
prefer a different p oint (portfolio) along the efficient frontier. For example, a conservative investor would
choose a p ortfo lio near p o in t A while a more risk-tolerant investor would choose a p ortfo lio near p oint B.
In summary, the m ain points established in this section are that:
a diversification reduces risk

b the effectiveness o f diversification depends on the correlation or covariance between returns on the
individual assets combined into a p o rtfo lio
C the positive correlation th a t exists between the returns on m ost risky assets imposes a lim it on the
degree o f risk reduction th a t can be achieved by diversification
d the to ta l risk o f an asset can be divided in to two parts: systematic risk th a t cannot be elim inated by
diversification and unsystematic risk th a t can be elim inated by diversification
e the only risk th a t remains in a well-diversified p o rtfo lio is systematic risk
f fo r investors who diversify, the relevant measure o f the risk o f an individual asset is its systematic
risk, which is usually measured by the beta o f the asset
g risk-averse investors w ill aim to hold p ortfolios th a t are efficient in th a t they provide the highest
expected retu rn fo r a given level o f risk.
The concepts discussed in this section can be extended to model the relationship between risk and
expected return fo r individual risky assets. This extension o f p o rtfo lio theory is discussed in Section 7.6
and we discuss below an alternative technique to measuring risk th a t focuses on the maximum dollar
losses th a t would be expected during norm al trading conditions.
7.6 The pricing of risky assets

Section 7.5 focused on investm ent decision making by individuals. We now s h ift the focus from the
behaviour o f individuals to the pricing o f risky assets and we introduce the assumption th a t investors can
also invest in an asset th a t has no default risk. The return on this risk-free asset is the risk-free interest
rate, R^. Typically, this is regarded as the interest rate on a government security, such as Treasury notes.
We continue to assume th a t all investors in a particular m arket behave according to p o rtfo lio theory,
and ask: How would prices o f individual securities in th a t m arket be determined? In tu itive ly, we would
expect risky assets to provide a higher expected rate o f retu rn than the risk-free asset. In other words, the
expected retu rn on a risky asset could be viewed as consisting o f the risk-free rate plus a premium fo r risk,
and this prem ium should be related to the risk o f the asset.
However, as discussed in Section 7.5.3, part o f the risk o f any risky asset— unsystematic risk — can be
eliminated by diversification. It seems reasonable to suggest that in a competitive market, assets should be
priced so that investors are not rewarded fo r bearing risk that could easily be eliminated by diversification.
On the other hand, some risk — systematic risk— cannot be eliminated by diversification so it is reasonable
to suggest that investors w ill expect to be compensated fo r bearing that type o f risk. In summary, in tu itio n
suggests that risky assets w ill be priced such that there is a relationship between returns and systematic risk.
The remaining question is: W hat sort o f relationship w ill there be between returns and systematic risk? The
work o f Sharpe (1964), Lintner (1965), Fama (1968) and Mossin (1969) provides an answer to this question.8
8 Although we have referred to the pricing5of assets, much of this work deals with expected returns, rather than asset prices.
However, there is a simple relationship between expected return and price in that the expected rate of return can be used to
discount an assets expected net cash flows to obtain an estimate of its current price.
7 .6 .1 1 The capital market line
W ith the opp ortu nity to borrow and lend at the risk-free rate, an investor is no longer restricted to
holding a p o rtfo lio th a t is on the efficient fro n tie r AB. Investors can now invest in combinations o f risky
assets and the risk-free asset in accordance w ith th e ir risk preferences. This is illustrated in Figure 7.11.
%
◦s
L
U
C J n oJ
p a p a d x
L
U
Risk [a)
The line R^T represents p o rtfo lio s th a t consist o f an investm ent in a p o rtfo lio o f ris k y assets T
and an investm ent in the risk-free asset. Investors can achieve any com bination o f ris k and re tu rn on
the line RrT by investing in the risk-free asset and P o rtfo lio T. Each p o in t on the line corresponds to
different p ro po rtio ns o f the to ta l funds being invested in the risk-free asset and P o rtfo lio T. However,
it would n o t be ratio na l fo r investors to hold p o rtfo lio s th a t p lo t on the line RjT, because they can
achieve higher returns fo r any given level o f risk by com bining the risk-free asset w ith o the r p o rtfo lio s
th a t p lo t above T on the efficient fro n tie r (AB). This approach suggests th a t investors w ill achieve the
best possible re tu rn fo r any level o f ris k by holding P o rtfo lio M rather th an any other p o rtfo lio o f risky
assets.
The line R^MN is tangential at the p o in t M to the efficient fro n tie r (AB) o f portfolios o f risky assets.
This line represents p ortfo lio s that consist o f an investm ent in Portfolio M and an investm ent in the
risk-free asset. Points on the line to the le ft o f M require a positive am ount to be invested in the risk-free
asset— that is, they require the investor to lend at the risk-free rate. Points on the line to the rig h t o f
M require a negative am ount to be invested in the risk-free asset— th a t is, they require the investor to
borrow at the risk-free rate.
It is apparent th a t the line R^MN dominates the efficient fro n tie r AB since at any given level o f risk a
portfolio on the line offers an expected return at least as great as th a t available from the efficient fro n tie r
(curve AB). Risk-averse investors w ill therefore choose a p o rtfo lio on the line R^MN— th a t is, some
combination o f the risk-free asset and Portfolio M. This is true fo r all risk-averse investors who conform
to the assumptions o f p o rtfo lio theory. The portfolios th a t m ig ht be chosen by three investors are shown
in Figure 7.11. Having chosen to invest in Portfolio M, each investor combines this risky investm ent w ith
a position in the risk-free asset. In Figure 7.11, Investor 1 w ill invest p a rtly in Portfolio M and p a rtly in
the risk-free asset. Investor 2 w ill invest all funds in Portfolio M , while Investor 3 w ill borrow at the risk
free rate and invest his or her own funds, plus the borrowed funds, in Portfolio M . A fo u rth strategy, n o t
shown in Figure 7.11, is to invest only in the risk-free asset. This is the least risky strategy, whereas the
strategy pursued by Investor 3 is the riskiest.
B usiness finance
MARKET PORTFOLIO I f all investors in a particular m arket behave according to p o rtfo lio theory, all investors hold Portfolio
portfolio of all risky
M as at least a p art o f th e ir to ta l p o rtfo lio .9 In turn, this implies th a t Portfolio M m ust consist o f all risky
assets, weighted
according to their assets. In other words, under these assumptions, a given risky asset, X, is either held by all investors as
market capitalisation part o f Portfolio M or it is n o t held by any investor. In the la tte r case, Asset X does n o t exist. Therefore,
Portfolio M is often called the m arket portfolio because it comprises all risky assets available in the
CAPITAL MARKET LINE
m arket. For example, i f the to ta l m arket value o f all shares in Company X represents 1 per cent o f the
efficient set of
to ta l m arket value o f all assets, then shares in Company X w ill represent 1 per cent o f every investors
all portfolios that
provides the investor to ta l investm ent in risky assets.
with the best The line R^MN is called the capital m arket line because i t shows all the to ta l portfolios in which
possible investment investors in the capital m arket m ight choose to invest. Since investors w ill choose only efficient portfolios,
opportunities when
it follows th a t the m arket p o rtfo lio is predicted to be efficient* in the sense th a t it w ill provide the
a risk-free asset is
available. It describes
m axim um expected retu rn fo r th a t particular level o f risk. The capital m arket line, therefore, shows the
the equilibrium risk- trade-off between expected return and risk fo r all efficient portfolios. The equation o f the capital m arket
return relationship for line is given b y:10
efficient portfolios,
where the expected ' E(Rm ) - R f 、
E(Rp) = Rf +
return is a function of 7.8
the risk-free interest
rate, the expected where 〇 M is the standard deviation o f the retu rn on the m arket Portfolio M
market risk premium
and the proportionate The slope o f this line is 丑( 只以)— and this measures the m arket price o f risk. It represents the
risk of the efficient
portfolio to the risk of additional expected retu rn th a t investors would require to compensate them fo r in cu rring additional
the market portfolio risk, as measured by the standard deviation o f the p ortfolio.
7 .6 .2 |T h e Capital Asset Pricing Model (CAPM) and the

security market line
LEARNING A lthough the capital m arket line holds fo r efficient portfolios, it does n o t describe the relationship between
OBJECTIVE 8 expected return and risk fo r individual assets or inefficient portfolios. In equilibrium , the expected return
Explain the on a risky asset (or inefficient p ortfo lio ), z, can be shown to be:11
relationship between
returns and risk f E(R M) - R f \
E(R i) = Rf + f ^ f j Cow(Rh RM)
proposed by the 7.9
capital asset pricing
model
where = the expected retu rn on the zth risky asset
C ov(R j} Rm) = the covariance between the returns on the zth risky asset and the m arket p o rtfo lio
9 This ignores the extreme case of investors who hold only the risk-free asset.
10 The fact that Equation 7.8 is the equation for the capital market line can be shown as follows: let Portfolio p consist of an
investment in the risk-free asset and the market portfolio. The investment proportions are w f in the risk-free asset and
w M = 1 - W fin the market portfolio. Therefore, Portfolio p is, in effect, a two-security portfolio and its expected return is
given by:
£(Kp) = w R f + (1 - w f ) E (RM)
and the variance of its return is:
+ _ w)2〇
2m + 2My(! -
By definition, = 0 so the variance reduces to:
a2P = ^ ~ wf)Z〇
2M
Therefore:
(Tp = ( l - Wf)crM
Since the expected return and standard deviation of Portfolio p are linear functions of w^, it follows that R f M in Figure 7.11
is a straight line. This result is not specific to portfolios consisting of the risk-free asset and Portfolio M: rather it applies to a ll
portfolios that include the risk-free asset.
The equation for a straight line can be expressed as y = m x + c where m is the slope of the line and c is the intercept on the
y axis. Referring to Figure 7.11, it can be seen that:
n 」 E (R M - R f )
c = Rr and m = --------- —
O 'M
Therefore, the equation for the line rf M N is Equation 7.8.

11 This is a purely mathematical problem. For a derivation see Levy and Sarnat (1990) or Brailsford and Faff (1993).
Equation 7.9 is often called the CAPM equation. An equivalent version is given in Equation 7.11. The
CAPM equation shows th a t the expected return demanded by investors on a risky asset depends on
the risk-free rate o f interest, the expected retu rn on the m arket p ortfo lio , the variance o f the retu rn on
the m arket p ortfolio, and the covariance o f the return on the risky asset w ith the retu rn on the market
portfolio.
The covariance term Cov(Rj} RM) is the only explanatory factor in the CAPM equation specific to
asset z. The other explanatory factors (R厂，£(RM) and c r^) are the same, regardless o f which asset z. is being
considered. Therefore, according to the CAPM equation, i f tw o assets have different expected returns, this
is because they have different covariances w ith the m arket p ortfo lio . In other words, the measure o f risk
relevant to pricing a risky asset is Cov(Rif RM)t the covariance o f its returns w ith returns on the m arket
portfolio, as this measures the contribution o f the risky asset to the riskiness o f an efficient p ortfolio. In
contrast, fo r the efficient p o rtfo lio itse lf the standard deviation o f the p o rtfo lio s return is the relevant
measure o f risk (see Figure 7.11).
As discussed in Section 7.5.4, the measure o f risk fo r an investm ent in a risky asset i is often referred
to as its beta factor, where:
Cov(i?/, Rm)
Pi 7.10
Because Cov(Rj} RM) is the risk o f an asset held as part o f the m arket p ortfo lio , while crM is the risk (in
terms o f variance) o f the m arket p ortfolio, it follows th a t J3f measures the risk o f i relative to the risk o f
the market as a whole. Using beta as the measure o f risk, the CAPM equation can be rew ritten:
£( r ) = v z p (r m) - 〜
] HD
When graphed, Equation 7.11 is called the security m arket line and is illustrated in Figure 7.12. SECURITY MARKET LINE
graphical
representation of the
capital asset pricing
model
■ ure 7.12 Security market line
Security
market
line
b / )CJ n 4J
UJ
a}
p a p a d x
LU
0.5 1.0 1.5

Risk (A)
The significance o f the security m arket line is that in equilibrium each risky asset should be priced so that
it plots exactly on the line. Equation 7.11 shows that according to the capital asset pricing model, the expected
return on a risky asset consists o f two components: the risk-free rate o f interest plus a premium for risk.
The risk premium for each asset depends on the assets beta and on the market risk premium [E(RM) - Rr].
B usiness finance
The betas o f individual assets w ill be distributed around the beta value o f the market portfolio, which is l . 12
A risky asset w ith a beta value greater than 1 (that is, higher risk) w ill have an expected return greater than
E(Rm), while the expected return on a risky asset w ith a beta value o f less than 1 (that is, lower risk) w ill be
less than E(RM). Assuming that the risk-free rate o f interest is 10 per cent and the m arket risk premium
[E(Rm) - is 5 per cent, the expected return on risky Asset 1 w ith a beta value o f 0.5 w ill be 12.5 per cent.
The expected return on risky Asset 2 w ith a beta value o f 1.5 w ill be 17.5 per cent.
The capital asset pricing model applies to individual assets and to portfolios. The beta factor fo r a
p o rtfo lio p is simply:
^ _ Cov (Rp ,R m)
Pp 一 Z2^ 7.12
where Cov(R yRM) = the covariance between the returns on p o rtfo lio p and the m arket p ortfo lio .
Equation 7.12 is sim ply Equation 7.10 rew ritten in term s o f a p o rtfo lio pt instead o f a particular
asset i. Fortunately there is a simple relationship between a p o rtfo lio s beta (J3p) and the betas o f the
individual assets th a t make up the p ortfo lio . This relationship is:
n
0p = Y l 7.13
i= \
where n = the num ber o f assets in the p ortfo lio

= the proportion o f the current m arket value o f p o rtfo lio p constituted by the zth asset
Equation 7.13 states th a t the beta factor fo r a p o rtfo lio is sim ply a weighted average o f the betas o f
the assets in the p o rtfo lio .13 One useful application o f Equation 7.13 is to guide investors in choosing
the investm ent proportions to achieve some target p ortfo lio beta, /3p. An im p o rta n t special case is to
construct such a p o rtfo lio using only the m arket p o rtfo lio (J3 = 1) and a position in the risk-free asset
(J3 = 0). In this case, investors place a pro po rtio n wM o f th e ir to ta l funds in the m arket p ortfolio, and a
p roportion Wr = (1 - wM) in the risk-free asset. Using Equation 7.13, the target beta is given by:
P p = wf 0 f + w m P m
Substituting /3f= 0 and j3 m = 1 gives:
wM=^*p
and W f r = l- J3*
For example, if / ^ = 0.75, investors should invest 75 per cent o f their funds in the m arket portfolio and
lend 25 per cent o f their funds at the risk-free rate. I f = 1.3, investors should borrow an amount equal to
30 per cent o f their own investment funds and invest the total amount (130 per cent) in the market portfolio.
12 Since
Cov (/?,, R m)
P i = ----------5--------
we have
_ C o v (/?a/ ,/? a/)
13 Our discussion has omitted the steps between Equations 7.12 and 7.13. For the interested reader, these steps are as follows.
Since:
R P = ^ 2 WjRj
/=i
it follows that:
C o v (R r , R m ) = Cov
5 3 ^/C 〇v(/?„ R m)
/=i
Substituting in Equation 7.12:
WiCov (/?,, Rm)

i=i
(î =
= Wi(3i
i=l
7 .6 .3 1 Implementation of the CAPM

Use o f the CAPM requires estim ation o f the risk-free interest rate, the systematic risk o f equity, fie and
the m arket risk premium, E(RM) - Rf：. Each o f these variables is discussed in turn.
The risk-free interest rate (Rfj

The assets closest to being risk free are government debt securities, so interest rates on these securities are
norm ally used as a measure o f the risk-free rate. However, as discussed in Section 4.6.1, unless the term
structure o f interest rates is flat, the various government securities w ill offer different interest rates. The
appropriate risk-free rate is the current yield on a government security whose term to m a tu rity matches
the life o f the proposed projects to be undertaken by the company. Since these activities undertaken by
the company typically provide returns over many years, the rate on long-term securities is generally used.
The share's systematic risk [jSJ

The betas o f securities are usually estimated by applying regression analysis to estimate the follow ing
equation from tim e series data:
Ri t = a i + ^ iRM + eit
where ^ = a constant, specific to asset z
eit = an error term
Equation 7.14 is generally called the m arket model. Its relationship to the security m arket line can MARKET MODEL
time series regression
be readily seen by rew riting Equation 7.11 as follows:
of an asset's returns
E (R )= R f + ^ E (R M) - A R f
7.15
Therefore, the m arket m odel is a counterpart (or analogue) o f Equation 7.15. The magnitude o f the
betas th a t result from using this model when i t is applied to returns on shares is illustrated in Table 7.5,
which contains a sample o f betas fo r the shares o f selected listed companies. The values are calculated
using ordinary least squares (OLS) regression.
TABLE 7.5 Betas of selected Australian listed companies calculated using daily
share price and index data for the period January 2009 - December 2013
N am e o f com pany M a in in d u s tria l a c tiv ity Beta
ANZ Banking Group Banking 1.16
Amcor Packaging 0.75
BHP Billiton Minerals exploration, production and 1.32

processing
Coca-Cola Amatil Food, beverage and tobacco 0.41
Fairfax Media Media 1.16
Harvey Norman Retailing 1.03
QBE Insurance Insurance 0.95
Woolworths Food and staples retailing 0.46
The m arket model, as specified in Equation 7.14, is often used to obtain an estimate o f ex-post
systematic risk. To use the m arket model, it is necessary to obtain tim e series data on the rates o f return
on the share and on the m arket p o rtfo lio — th a t is, a series o f observations fo r both Rit and RMt is needed.
However, when using the m arket model, choices m ust be made about two factors. First, the model may be
estimated over periods o f different length. For example, data fo r the past 1, 2 ,3 or more years may be used.
Five years o f data are commonly used, but the choice is somewhat arbitrary. Second, the returns used in
the m arket model may be calculated over periods o f different length. For example, daily, weekly, monthly,
quarterly or yearly returns may be used. Again this choice is subject to a considerable degree o f judgment.
From a statistical perspective, it is generally better to have more rather than fewer observations,
because using more observations generally leads to greater statistical confidence. However, the greater the
num ber o f years o f data th a t are used, the more likely i t is th a t the company s riskiness w ill have changed.
This fact highlights a fundam ental problem o f using the m arket model. The m arket model provides a
measure o f how risky a company s equity was in the past. W hat we are seeking to obtain is an estimate of
future risk. Therefore, the choice o f both the number o f years o f data and the length o f the period over
which returns are calculated involves a trade-off between the desire to have many observations and the
need to have recent and consequently more relevant data.14
The market risk premium [E{RM] - Rf]

The m arket p o rtfo lio specified in the CAPM consists o f every risky asset in existence. Consequently, it
is impossible in practice to calculate its expected rate o f retu rn and hence impossible to also calculate
the m arket risk premium. Instead, a share m arket index is generally used as a substitute fo r the m arket
p ortfolio. As the rate o f retu rn on a share m arket index is highly variable from year to year, it is usual
to calculate the average retu rn on the index over a relatively long period. Suppose th a t the average rate
o f return on a share m arket index such as the All-Ordinaries Accum ulation Index over the past 10 years
was 18.5 per cent per annum. I f this rate were used as the estimate o f E(RM) and today s risk-free rate is
8.5 per cent, the m arket risk prem ium [E(RM) - R^\ would be 10 per cent.
A problem w ith using this approach is th a t the estimate o f ^ re fle c ts the m arkets current expectations
o f the future, whereas E(RM) is an average o f past returns. In other words, the two values may n ot match,
and some unacceptable estimates may result. For example, [E(RM) - RJ estimated in this way may be
negative i f the rate o f in fla tio n expected now, which should be reflected in is greater than the realised
rate o f in fla tio n during the period used to estimate E(RM).
A better approach is to estimate the market risk prem ium directly, over a relatively long period. For
example, Ibbotson and Goetzmann (2005) compare the returns on equities w ith the returns on bonds
in the US between 1792 and 1925 and report an average difference o f approximately 3.8 per cent per
annum. The Credit Suisse Global Investment Returns Yearbook provides an annual update o f m arket risk
premiums across 20 countries. The 2013 yearbook authored by Dimson et al. (2013) reports that over the
113 years from 1900 to 2012 the average prem ium in the US was 5.3 per cent per annum. Over the same
period, the country w ith the lowest premium was Denmark, at 2.7 per cent per annum, and the country
w ith the highest premium was Australia, at 6.4 per cent per annum. Brailsford, Handley and Maheswaran
(2012) provide sim ilar estimates fo r Australia. They report that, over the 128 years from 1883 to 2010, the
premium was approximately 6.1 per cent per annum. Using a shorter tim e period during which the quality
o f the data is higher, they estimate th a t the premium from 1958 to 2010 was also 6.1 per cent per annum.
However, estim ating the m arket risk premium directly also has some problems. R itte r (2002) uses
the example o f Japan at the end o f 1989 to illustrate th a t historical estimates can result in nonsensical
numbers. He notes th a t estim ating the m arket risk prem ium at the end o f 1989 using historical data
starting when the Japanese stock m arket reopened after W orld War II would have provided a m arket risk
premium o f over 10 per cent per annum. The Japanese economy was booming, corporate profits were
high and average price-earnings (P-E) ratios were over 60. I t was considered th a t the cost o f equity for
Japanese companies was low. However, it is n ot possible fo r the cost o f equity to be low and the market
risk premium to be high. O f course, it is possible fo r the historical m arket risk premium to be high and the
expected m arket risk prem ium (and therefore the expected cost o f equity capital) to be low.
In an im p o rta n t theoretical paper, Mehra and Prescott (1985) showed th a t a long-term risk premium
such as th a t found in the US, Canada, the UK and Australia cannot be explained by standard models o f
risk and return. This fin ding has led to arguments th a t historical measures o f the risk prem ium are subject
to errors in th e ir measurement. For example, Jorion and Goetzmann (1999) argue th a t estimates o f the
m arket risk premium based solely on data obtained from the US w ill be biased upwards sim ply as a result
14 For a discussion of the issues associated with calculating systematic risk from historical data, see Brailsford, Faff and Oliver
( 1997) .
of the outperformance o f the US m arket relative to other equity markets over the tw e ntie th century.
Others, such as Heaton and Lucas (2000), argue th a t increased opportunities fo r p o rtfo lio diversification
mean th a t the m arket risk prem ium has fallen.
These concerns have led to new techniques being employed to estimate the m arket ris k prem ium .
Fama and French (2002), among others, use the dividend g ro w th m odel and conclude th a t the m arket
risk prem ium is now o f the order o f 1 per cent per annum . Claus and Thomas (2001) use forecasts by
security analysts and conclude th a t the m arket risk prem ium is approxim ately 3 per cent per annum.
Duke U niversity and CFO magazine have conducted a qua rte rly survey o f chief financial officers since
1996 (see w w w .cfosurvey.org). The average estimated ris k prem ium fo r the US over th a t tim e has
been approxim ately 4 per cent per annum . For the fo u rth quarter o f 2013, when asked how much 卜， |
they expect returns in the equity m arket in the US to exceed the returns on governm ent bonds over
the next 10 years, the average response was 3.6 per cent per annum . In summary, the d isp a rity o f
estimates o f the m arket risk prem ium is considerable, ranging from 1 to in excess o f 6 per cent per
annum.
7 .6 .4 | Risk, return and the CAPM

The d istin ction between systematic and unsystematic ris k is im p o rta n t in explaining why the CAPM
should represent the ris k -re tu rn relationship fo r assets such as shares. This issue was discussed in
Section 7.5.3 b ut is reiterated here because o f its importance in understanding the CAPM. The returns
on a company s shares may vary fo r many reasons: fo r example, interest rates may change, or the
company may develop a new product, attract im p o rta n t new customers or change its chief executive.
These factors can be divided in to tw o categories: those related only to an individual company (company-
specific factors) and those th a t affect all companies (m arket-wide factors). As the shares o f different
companies are combined in a p o rtfo lio , the effects o f the company-specific factors w ill tend to cancel
each other out; this is how diversification reduces risk. However, the effects o f the m arket-wide factors
w ill remain, no m atter how many d ifferent shares are included in the p o rtfo lio . Therefore, systematic
risk reflects the influence o f m arket-wide factors, w hile unsystematic risk reflects the influence o f
company-specific factors.
Because unsystematic risk can be elim inated by diversification, the capital m arket w ill n o t reward
investors fo r bearing this type o f risk. The capital m arket w ill only reward investors fo r bearing risk that
cannot be elim inated by diversification— th a t is, the risk inherent in the m arket p ortfo lio . There are
cases when, w ith hindsight, we can id e n tify investors who have reaped large rewards from taking on
unsystematic risk. These cases do n ot im p ly th a t the CAPM is invalid: the model sim ply says th a t such
rewards cannot be expected in a competitive market. The reward fo r bearing systematic risk is a higher
expected retu rn and, according to the CAPM, there is a simple linear relationship between expected
return and systematic risk as measured by beta.
A d d itio n a l factors that explain returns

In 1977 Richard Roll published an im p o rta n t article th a t pointed out th a t while the CAPM has strong
theoretical foundations, there is a range o f difficulties th a t researchers face in testing i t empirically. For LEARNING
OBJECTIVE 9
example, in testing fo r a positive relationship between an assets beta and realised returns, a researcher
Understand the
first needs to measure the correlation between the assets returns and the returns on the m arket p ortfolio. relationship between
The m arket p o rtfo lio theoretically consists o f all assets in existence and is therefore unobservable in the capital asset
practice— im plying th a t ultim ately the CAPM itse lf is untestable. pricing model and
Aside from the problems associated w ith testing fo r a relationship between estimates o f beta and models that include
additional factors
realised returns, voluminous empirical research has shown th a t there are other factors th a t also explain
returns. These factors include a company s dividend yield, its price-earnings (P-R) ratio, its size (as
measured by the m arket value o f its shares), and the ratio o f the book value o f its equity to the m arket
value o f its equity. This last ratio is often called the company s book-to-m arket ratio. In a detailed study,
Fama and French (1992) show th a t the size and book-to-m arket ratio were dom inant and th a t dividend
yield and the price-earnings ratio were n o t useful in explaining returns after allowing fo r these more
dom inant factors.
B usiness finance
In another im p o rta n t paper, Fama and French (1993) tested the follow ing three-factor model of
expected returns:
£(Rit) - Rf, = Pm [E{Rm ) - Rf,} + j3 iS £(SMBt) + J3m £(H M Lt) S B

LEARNING In Equation 7.16, the firs t factor is the m arket risk premium, which is the basis o f the CAPM discussed
OBJECTIVE 10 earlier in this chapter. The next factor, SMB, refers to the difference between the returns o f a diversified
Explain the
p o rtfo lio o f small and large companies, while H M L reflects the differences between the returns o f a
development of
models that include diversified p o rtfo lio o f companies w ith high versus low book-to-m arket values. j3iM, j3jS and j3jH are the
additional factors risk parameters reflecting the sensitivity o f the asset to the three sources o f risk. A ll three factors were
found to have strong explanatory power. Brailsford, Gaunt and O b rie n (2012) found th a t in Australia,
over the period 1982 to 2006, all three factors provided strong explanatory power.
I t is possible th a t both the size and book-to-m arket ratio factors m ig ht be explicable by risk. For
example, Fama and French (1996) argue th a t smaller companies are more likely to default than larger
companies. Further, they argue th a t this risk is likely to be systematic in th a t small companies as a group
are more exposed to default during economic downturns. As a result, investors in small companies w ill
require a risk premium. Similarly, Zhang (2005) argues th a t companies w ith high book-to-m arket ratios
w ill on average have higher levels o f physical capacity. Much o f this physical capacity w ill represent excess
capacity during economic dow nturns and therefore expose such companies to increased risk.
However, as discussed in detail in Chapter 16, the relationship between these additional factors and
returns may n o t be due to risk. Further, Carhart (1997) added a fo u rth factor to the three described in
Equation 7.16 to explain returns earned by m utual funds. In an earlier paper, Jegadeesh and Titm an
(1993), using US data from 1963 to 1989, identified better perform ing shares (the winners) and poorer
perform ing shares (the losers) over a period o f 6 months. They then tracked the performance o f these
shares over the follow ing 6 months. On average, the biggest winners outperform ed the biggest losers by
10 per cent per annum. When Carhart added this m om entum effect to the three-factor model, he found
th a t it too explained returns. Unlike the size and book-to-m arket ratio factors, it is d iffic u lt to construct
a simple risk-based explanation fo r this factor.
W hile the CAPM is clearly an incomplete explanation o f the relationship between risk and returns,
it is im p o rta n t to note th a t it is s till widely applied. This p o in t is perhaps best demonstrated by the
Coleman, Maheswaran and Pinder (2010) survey o f the financial practices adopted by senior financial
managers in Australia. Financial managers employ asset pricing models to estimate the discount rate
used in project evaluation techniques such as the net present value approach. Coleman, Maheswaran
and Pinder reported that more than twice as many respondents used the trad ition al single-factor CAPM
compared w ith models th a t used additional factors.
7.8 Portfolio perform ance appraisal

A fundam ental issue th a t faces investors is how to measure the performance o f th e ir investm ent p ortfolio.
LEARNING To illustrate the problem, assume th a t an investor observes th a t during the past 12 m onths, his or her
OBJECTIVE 11
p o rtfo lio has generated a return o f 15 per cent. Is this a good, bad or indifferent result? The answer to
Distinguish between
alternative methods that question depends, o f course, on the expected return o f the p o rtfo lio given the p o rtfo lio s risk. That
of appraising the is, in order to answer the question, we need a measure o f the risk o f the investors p o rtfo lio , and then
performance of an compare its performance w ith the performance o f a benchmark p o rtfo lio o f sim ilar risk. However, even
investment portfolio after accounting fo r the specific risk o f the p ortfo lio , the performance o f a p o rtfo lio may d iffer from that
o f the benchmark fo r four reasons:
• Asset allocation. Investors m ust decide how much o f th e ir wealth should be allocated between
alternative categories o f assets such as corporate bonds, government bonds, domestic shares,
international shares and property. This decision w ill ultim ately affect the performance o f the
p o rtfo lio because in any given period a particular asset class may outperform other asset classes on a
risk-adjusted basis.
• M arket timing. In establishing and adm inistering a p ortfo lio , investors need to make decisions
about when to buy and sell the assets held in a p ortfo lio . For example, investors m ig h t choose to
move out o f domestic shares and in to corporate bonds or alternatively sell the shares o f companies
that operate in the telecomm unication ind ustry and invest these funds in the shares o f companies
operating in the retail industry. Clearly, the performance o f a p o rtfo lio w ill be affected by an
investors success in selling assets before th e ir prices fall and buying assets before th e ir prices rise.
• Security selection. Having made a decision about the desired m ix o f different asset classes w ith in a
portfolio, and when that desired m ix should be implemented, investors m ust then choose between
many different individual assets w ith in each class. For example, having determined th a t they wish
to hold half o f th e ir p o rtfo lio in domestic shares, investors m ust then decide which o f the more than
2000 shares listed on the Australian Securities Exchange they should buy. The a rt o f security selection
requires the investors to id e n tify those individual assets th a t they believe are currently underpriced
by the m arket and hence whose values are expected to rise over the holding period. Similarly, if
investors believe th a t any o f the assets held in the p o rtfo lio are currently overpriced, they would sell
these assets so as to avoid any future losses associated w ith a reduction in th e ir m arket value.
• Random influences. Ultim ately, investing is an uncertain a ctivity and in any given period the
performance o f a p o rtfo lio may n o t reflect the skills o f the investor who makes the investm ent
decisions. That is, good decisions m ig ht yield poor outcomes and poor decisions m ight yield good
outcomes in what we would label as ‘bad luck’ or ‘good luck’, respectively. Over enough time, though,
we would expect the influence o f good luck and bad luck to average out.
We now consider four comm only used ways o f measuring the performance o f a p ortfo lio . Each o f these
measures has a different approach to try in g to determine the ‘expected’ performance o f the benchmark
portfolio in order to determ ine whether the p ortfo lio has met, exceeded or failed to meet expectations.
Simple benchmark index

This is probably the m ost comm only used approach to appraising the performance o f a p o rtfo lio and
involves a simple comparison between the p o rtfo lio s retu rn and the retu rn on a benchmark index that
has (or is assumed to have) sim ilar risk to the p o rtfo lio being measured. For example, a well-diversified
portfolio o f domestic shares m ig h t be benchmarked against the S&P/ASX 200 Index, which measures
the performance o f the shares in the 200 largest companies listed on the Australian Securities Exchange.
The advantages associated w ith using this approach to performance appraisal are th a t it is easy to
implement and to understand. The main problem w ith this approach is th a t i t implies th a t the risk o f the
portfolio is identical to the risk o f the benchmark index, whereas, w ith the exception o f so-called passive
funds, which are specifically established to m im ic (or track) the performance o f benchmark indices, this
w ill rarely be the case.
The Sharpe ratio

The Sharpe ratio, developed by W illiam Sharpe15, is a measure o f the excess retu rn o f the p o rtfo lio per
u n it o f total risk and is calculated using the follow ing formula:
where fp is the average re tu rn achieved on the p o rtfo lio over the tim e period, 7y is the average risk-free
rate o f return over the same tim e period and crp is the standard deviation o f the returns on the p ortfo lio
over the tim e period and is a measure o f the to ta l risk o f the p ortfo lio . I f the Sharpe ratio o f the investors
p ortfo lio exceeds the Sharpe ratio o f the m arket p ortfolio, then the investors p o rtfo lio has generated a
greater excess return per u n it o f to ta l risk and hence is regarded as exhibiting superior performance to
the m arket p ortfolio. Conversely, i f the p o rtfo lio s Sharpe ratio is less than th a t o f the m arket p ortfo lio
then the p o rtfo lio has generated less excess return per u n it o f to ta l risk than the m arket p o rtfo lio and the
p ortfo lio can be seen as having underperform ed th a t benchmark.
15 See Sharpe (1966).

B usiness finance
The rationale behind the use o f the Sharpe ratio is best demonstrated by considering the ratios links
w ith the ris k -re tu rn trade-off described by the capital m arket line discussed in section 7.6.1. Consider
Figure 7.13, which illustrates the risk and retu rn profile fo r a superannuation fu nd s p o rtfo lio relative to
the m arket p ortfolio.
Note from Figure 7.13 that the superannuation fu nd s p ortfo lio has generated a lower rate o f return
than the m arket p o rtfo lio but has also generated a lower level o f to ta l risk. That is, while fp is less than
is also less than The key point, however, is th a t the realised excess retu rn per unit o f risk
is higher fo r the fu nd s p o rtfo lio compared w ith the m arket p o rtfo lio and hence the fu n d s p ortfo lio is
regarded as having exhibited superior performance. This is illustrated in Figure 7.13 by the fu nd s p ortfolio
p lo ttin g above the capital m arket line. I f the fu nd s p o rtfo lio had generated a lower excess retu rn per u n it
o f risk than the m arket p ortfo lio , then i t would have plotted below the capital m arket line and this would
have im plied th a t the p o rtfo lio had underperformed the benchmark on a to ta l risk-adjusted basis.
Note th a t the Sharpe ratio assumes th a t in determ ining the risk-adjusted performance o f a p ortfo lio
the appropriate measure o f risk is to ta l risk. Following on from our discussion earlier in the chapter, it is
clear th a t to ta l risk is an appropriate measure only when we are dealing w ith well-diversified portfolios
rather than individual assets or undiversified portfolios.
The Treynor ratio

The Treynor ratio, named after Jack T re yn o r16, is a measure th a t is related to the Sharpe ratio of
performance measurement, in th a t it measures excess returns per u n it o f risk, b ut differs in th a t it
defines risk as non-diversifiable (or systematic) risk instead o f to ta l risk. I t can be calculated using the
follow ing form ula:
P p
where Op and fr are the returns on the p o rtfo lio and the risk-free asset as defined earlier, and f3P is slu
estimate o f the systematic risk o f the p o rtfo lio over the period in which the returns were generated,
as measured by beta and defined in Section 7.6.2. As w ith the Sharpe ratio, insights in to the rationale
behind the use o f the Treynor ratio are provided by considering the lin k between ris k and expected
retu rn — b u t this tim e, instead o f considering the trade-off fo r efficient portfolios im plied by the capital
16 See Treynor (1966).

market line, we tu rn instead to the security m arket line, which applies to individual assets and inefficient
portfolios. In Figure 7.14 we compare the ex-post systematic risk and excess returns o f a superannuation
fund relative to the m arket p o rtfo lio over the same period o f time.
Recall th a t the security m arket line is sim ply the graphical representation o f the CAPM. The slope
o f the security m arket line describes the extra return, in excess o f the risk-free rate, th a t is expected for
each additional u n it o f systematic risk (as measured by beta) and is w hat we have previously defined as
the m arket risk premium The slope o f the line th a t intersects the realised systematic risk and
return o f the funds p o rtfo lio is in tu rn the Treynor ratio. Hence, the decision rule used in assessing the
performance o f a p o rtfo lio using this technique requires a comparison o f the Treynor ratio calculated fo r
the p ortfolio over a specified interval w ith the market risk prem ium generated over th a t same interval.
Example 7.3 illustrates the three approaches to p o rtfo lio appraisal discussed above.
E xample 7.3
An investor holds a portfolio that consists of shares in 15 companies and wants to assess the
performance using a simple benchmark index as well as calculating the portfolio's Sharpe and Treynor
ratios. She estimates the parameters shown in Table 7.6 for the financial year ended 30 June 2014.
TABLE 7.6
Realised return Standard deviation of returns Systematic risk
(% p.a.) (a) (% p.a.) estimate (p)
Portfolio 13 30 1.2
S&P/ASX 200 share 11 20 1.0

price index
Government bonds 5 0 0
Based solely on the benchmark index approach, the portfolio appears to have performed well in
that it has generated an additional 2 per cent return above the proxy for the market (S&P/ASX 200).
A s d is c u s s e d e a r lie r , h o w e v e r, th is a s s e s s m e n t fa ils to a c c o u n t fo r d iffe re n c e s in th e ris k p ro file s o f th e
tw o p o r tfo lio s .
T h e S h a r p e r a t io is e s tim a te d u s in g E q u a tio n 7 . 1 7 f o r b o th th e in v e s to r's p o r tf o lio a n d th e A S X 2 0 0
a s fo llo w s :
5 = ^
(7 P
1 3 -5
SPortfolio •
0.27
30 ~
1 1 -5
ÂSX 200 = 0.30
20
A s th e S h a r p e r a t io f o r th e p o r tf o lio is less th a n th a t o f th e S & P /A S X 2 0 0 , th e in v e s to r c o n c lu d e s
th a t th e p o r tf o lio h a s u n d e r p e r fo rm e d th e m a rk e t o n a ris k -a d ju s te d b a s is . A p o s s ib le p r o b le m w ith
th is c o n c lu s io n is th a t, a s d e s c r ib e d a b o v e , th e S h a rp e r a t io a ssu m e s th a t th e r e le v a n t m e a s u re o f
ris k fo r th e in v e s to r is to ta l ris k , a s m e a s u re d b y th e s ta n d a r d d e v ia tio n o f re tu rn s . T h is is n o t th e c a s e
w h e r e , f o r e x a m p le , th e p o r tf o lio o f s h a re s re p re s e n ts o n ly o n e c o m p o n e n t o f th e in v e s to r’s o v e r a ll
set o f assets.
T h e T re y n o r ra tio s f o r th e p o r tf o lio a n d f o r th e A S X 2 0 0 a r e m e a s u re d a s fo llo w s :
rp -'rf
Pp
1 3 -5
1Portfolio 6.67
1.2
T 1 1 -5 6
'A S X 200 •
1.0
N o te th a t th e T re y n o r r a t io f o r th e S & P /A S X 2 0 0 is s im p ly e q u a l to th e m a rk e t ris k p re m iu m o f 6 p e r
c e n t. A s th e T re y n o r r a tio o f th e p o r tf o lio e x c e e d s th is a m o u n t th e in v e s to r c o n c lu d e s th a t th e p o r tf o lio
h a s o u tp e r fo r m e d th e m a rk e t o n a s y s te m a tic ris k -a d ju s te d b a s is . W e c a n r e c o n c ile th is re s u lt w ith th e
s e e m in g ly c o n t r a r y re su lts p r o v id e d b y th e S h a rp e r a t io b y a c k n o w le d g in g th a t s o m e o f th e p o r tf o lio
ris k th a t is a c c o u n te d fo r in th e S h a rp e r a tio m a y a c tu a lly b e d iv e r s ifie d a w a y o n c e w e a c c o u n t fo r
th e o th e r asse ts in th e in v e s to r's p o r tf o lio . T h e re fo re , in th is c a s e , th e T re y n o r r a t io p r o v id e s th e m o re
s u ita b le a s s e s s m e n t o f th e p e r fo r m a n c e o f th e p o r tf o lio re la tiv e to th e m a rk e t g e n e r a lly , as it c o n s id e rs
o n ly th a t ris k th a t c a n n o t b e e lim in a te d b y d iv e r s ific a tio n .
Jensen’s alpha
Jensens alpha is a measure pioneered by Michael Jensen17 and relies on a m ulti-pe rio d analysis o f the
performance o f an investm ent p o rtfo lio relative to some proxy fo r the m arket generally. Recall that
the CAPM suggests th a t the relationship between systematic risk and retu rn is fu lly described by the
follow ing equation:
E iR ^ R f+ m R ^ -R f)
The CAPM is an ex-ante single-period model, in the sense th a t it is concerned w ith the returns that
m ig ht be expected over the next tim e period. Its conclusion is relatively simple: the retu rn in excess o f
the risk-free rate th a t we expect any asset i to generate is determ ined only by the level o f systematic risk
reflected in the assets fi. We compute Jensens alpha by im plem enting an ex-post m ulti-period regression
analysis o f the returns on the p o rtfo lio and the returns on the m arket and ask the question: Is there
any evidence o f systematic abnormal retu rn performance th a t cannot be explained by the p o rtfo lio s
systematic risk? The regression equation estimated is as follows:
rP ，t _ r f ，
t= a P + [rM,r_ rfA + e t
where t and are the returns from the p ortfo lio , the risk-free asset and the proxy fo r the m arket
p o rtfo lio th a t have been observed in period t. /3P is an estimate o f the p o rtfo lio s beta over the entire
period in which returns were collected. Qp is an estimate o f Jensens alpha and reflects the incremental
17 See Jensen (1968 & 1969).

performance o f the p o rtfo lio after accounting fo r the variation in p o rtfo lio returns th a t can be explained
by market-wide returns.
I f 〇 tp is positive, and statistically significant, then this is an indication th a t the p o rtfo lio has
outperformed the market, on a risk-adjusted basis, and may be interpreted as evidence o f a p o rtfo lio
managers skill in managing the p ortfolio. Conversely, a statistically significant negative estimate o f
Qp m ight be interpreted as evidence th a t the p o rtfo lio managers actions in managing the p o rtfo lio are
actually destroying value!
There are many other techniques th a t have been developed by academics and practitioners to try
to assess the performance o f investm ent portfolios and each technique brings w ith it both advantages
and disadvantages over the alternative approaches.18 W hile much o f the preceding discussion has been
concerned w ith measuring the relative performance o f a p ortfolio, another issue facing managers and
investors is how much o f the performance o f a p o rtfo lio may be a ttributed to the different decisions made
by the investment manager. Specifically, as described at the beginning o f Section 7.8, an investor may be
concerned w ith how the performance has been affected by the managers decisions w ith respect to asset
allocation, market tim in g and security selection as well as the possible interactions between each o f these
decisions.
CHAPTER SEVEN REVIEW

SUMMARY
This c h a p te r d is c u s s e d tw o m a in issues. The firs t, • S y s te m a tic ris k depends on th e c o v a r ia n c e
p o r tfo lio th e o ry , c o n c e rn s th e a p p r o a c h th a t c a n b e b e tw e e n th e re tu rn s o n th e a sse t a n d re tu rn s o n th e
use d b y ris k -a v e rs e in v e s to rs to s e c u re th e b e s t tr a d e m a rk e t p o r tf o lio , w h ic h c o n ta in s a ll ris k y assets.
o ff b e tw e e n risk a n d re tu rn . S e c o n d , th e c h a p te r d e a lt T he s y s te m a tic ris k o f a n a s s e t is u s u a lly m e a s u re d
w ith th e p r ic in g o f ris k y a sse ts, w h ic h in v o lv e s th e b y th e a s se t's b e ta fa c to r, w h ic h m e a s u re s th e risk
r e la tio n s h ip b e tw e e n ris k a n d re tu rn in th e m a r k e t fo r o f th e a s s e t re la tiv e to th e ris k o f th e m a rk e t as
ris k y assets. a w h o le . R isk-a ve rse in v e s to rs w ill a im to h o ld
p o r tfo lio s th a t a r e e ffic ie n t in th a t th e y p r o v id e th e
• T he e s s e n tia l m e s s a g e o f p o r tf o lio th e o ry is th a t
h ig h e s t e x p e c te d re tu rn fo r a g iv e n le ve l o f risk.
d iv e r s ific a tio n re d u c e s ris k . It is a ls o show n th a t
T he set o f e ffic ie n t p o r tfo lio s fo rm s th e e ffic ie n t
th e e ffe c tiv e n e s s o f d iv e r s ific a tio n d e p e n d s o n th e
fro n tie r, a n d in a m a rk e t w h e r e o n ly ris k y assets
c o r r e la tio n o r c o v a r ia n c e b e tw e e n re tu rn s o n th e
a r e a v a ila b le , e a c h in v e s to r w ill a im to h o ld a
in d iv id u a l assets c o m b in e d in to a p o r tf o lio . T he
p o r tf o lio s o m e w h e re o n th e e ffic ie n t fro n tie r.
g a in s fro m d iv e r s ific a tio n a r e la rg e s t w h e n th e re is
• In tro d u c tio n o f a ris k -fre e a s s e t a llo w s th e a n a ly s is to
n e g a tiv e c o r r e la tio n b e tw e e n a s s e t re tu rn s , b u t th e y
b e e x te n d e d to m o d e l th e r e la tio n s h ip b e tw e e n ris k
still e x is t w h e n th e re is p o s itiv e c o r r e la tio n b e tw e e n
a n d e x p e c te d re tu rn f o r in d iv id u a l ris k y a sse ts. T he
a s s e t re tu rn s , p r o v id e d th a t th e c o r r e la tio n is less
m a in re s u lt is th e C A P M , w h ic h p ro p o s e s th a t th e re
th a n p e rfe c t. In p r a c tic e , th e p o s itiv e c o r r e la tio n
is a lin e a r r e la tio n s h ip b e tw e e n th e e x p e c te d ra te
th a t e xis ts b e tw e e n th e re tu rn s o n m o st ris k y assets
o f re tu rn o n a n a s s e t a n d its ris k a s m e a s u re d b y its
im p o s e s a lim it o n th e d e g r e e o f ris k r e d u c tio n th a t
b e ta fa c to r.
c a n b e a c h ie v e d b y d iv e r s ific a tio n .
• A lte r n a tiv e asset p r ic in g m o d e ls p ro p o s e th a t
• T he to ta l ris k o f a n a s s e t c a n b e d iv id e d in to tw o
e x p e c te d re tu rn s a re lin e a r ly re la te d to m u ltip le
p a rts : s y s te m a tic ris k th a t ca n n o t b e e lim in a te d b y
fa c to rs ra th e r th a n th e s in g le m a rk e t fa c to r p ro p o s e d
d iv e r s ific a tio n , a n d u n s y s te m a tic ris k th a t can b e
b y th e C A P M .
e lim in a te d b y d iv e r s ific a tio n . It f o llo w s th a t th e o n ly
• A s s e s s m e n t o f th e p e r fo r m a n c e o f an in v e s tm e n t
ris k th a t re m a in s in a w e ll- d iv e rs ifie d p o r tf o lio is
p o r tf o lio re q u ire s th e s p e c ific a tio n o f th e 'e x p e c t e d '
s y s te m a tic ris k .
p e r fo r m a n c e o f a b e n c h m a r k p o r tfo lio .
• T he ris k o f a w e ll- d iv e rs ifie d p o r tf o lio can be
m e a s u re d b y th e s ta n d a r d d e v ia tio n o f p o r tf o lio An e x c e lle n t s ite w ith a w e a lth of in fo r m a tio n
re tu rn s . H o w e v e r, a n a ly s is o f th e fa c to rs th a t r e la tin g to th is t o p ic is vsww.wsharpe.com. P ro fe s s o r
c o n trib u te to th is s ta n d a r d d e v ia tio n s h o w s th a t, W illia m S h a rp e 's w o r k w a s r e c o g n is e d w ith a N o b e l
fo r in v e s to rs w h o d iv e rs ify , th e re le v a n t m e a s u re P riz e in 1 9 9 0 . F in a n c ia l a d v is o r y in fo r m a tio n c a n a ls o
o f ris k f o r a n in d iv id u a l a s s e t is its s y s te m a tic risk. b e fo u n d a t www.moneysmart.gov.au.
18 See Chapter 24 of Bodie, Kane and Marcus (2013) for an excellent review of some of these alternative techniques, and a
comprehensive description of other issues faced when assessing portfolio performance.
B usiness finance
KEY TERMS
b e ta 187 s e c u rity m a rk e t lin e 193
c a p ita l m a rk e t lin e 192 s ta n d a rd d e v ia tio n 174
m a rk e t m o d e l 195 s y s te m a tic (m a rk e 卜re la te d o r n o n -d iv e rs ifia b le )
m a rk e t p o r tfo lio 192 ris k 186
p o r tfo lio 179 u n s y s te m a tic (d iv e rs ifia b le ) ris k 186
ris k -a v e rs e in v e s to r 176 v a lu e a t ris k 187
ris k -n e u tra l in v e s to r 176 v a r ia n c e 174
ris k -s e e k in g in v e s to r 176
SELF-TEST PROBLEMS
1 A n in v e s to r p la c e s 3 0 p e r c e n t o f h is fu n d s in S e c u rity X a n d th e b a la n c e in S e c u rity Y. T he e x p e c te d
re tu rn s o n X a n d Y a r e 1 2 a n d 1 8 p e r c e n t, re s p e c tiv e ly . T he s ta n d a rd d e v ia tio n s o f re tu rn s o n X a n d Y
a r e 2 0 a n d 1 5 p e r c e n t, re s p e c tiv e ly .
a) C a lc u la te th e e x p e c te d re tu rn o n th e p o r tfo lio .
b) C a lc u la te th e v a r ia n c e o f re tu rn s o n th e p o r tfo lio a s s u m in g th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n

th e tw o s e c u ritie s is:
i) + 1 . 0
ii) + 0 . 7
iii) 0
iv) - 0 . 7
2 A n in v e s to r h o ld s a p o r tf o lio th a t c o m p ris e s 2 0 p e r c e n t X, 3 0 p e r c e n t Y a n d 5 0 p e r c e n t Z . T h e s ta n d a rd
d e v ia tio n s o f re tu rn s o n X, Y a n d Z a re 2 2 , 1 5 a n d 1 0 p e r ce n t, re s p e c tiv e ly , a n d th e c o r r e la tio n b e tw e e n
re tu rn s o n e a c h p a ir o f s e c u ritie s is 0 . 6 . P re p a re a v a r ia n c e - c o v a r ia n c e m a tr ix f o r th e se th re e s e c u ritie s a n d
use th e m a tr ix to c a lc u la te th e v a r ia n c e a n d s ta n d a rd d e v ia tio n o f re tu rn s f o r th e p o r tfo lio .
3 T he ris k -fre e r a te o f re tu rn is c u r r e n tly 8 p e r c e n t a n d th e m a rk e t ris k p re m iu m is e s tim a te d to b e
6 p e r c e n t. T h e e x p e c te d re tu rn s a n d b e ta s o f fo u r s h a re s a r e a s fo llo w s :
I S h a re Expected return [%) Beta 丨
Carltown 13.0 0.7
Pivot 17.6
Forresters 14.0 i.i
Brunswick 10.4 0.4
W h ic h sh a re s a re u n d e rv a lu e d , o v e r v a lu e d o r c o rre c tly v a lu e d b a s e d o n th e C A P M ?
t y QUESTIONS
1 [LO 1] F a rm e rs c a n in s u re th e ir c r o p s a g a in s t d a m a g e b y h a ils to rm s a t r e a s o n a b le ra te s . H o w e v e r , th e s a m e
in s u ra n c e c o m p a n ie s re fu s e to p r o v id e f lo o d in s u ra n c e a t a n y p r ic e . E x p la in w h y th is s itu a tio n e xists.
2 [LO 2] Is ris k a v e rs io n a r e a s o n a b le a s s u m p tio n ? W h a t is th e re le v a n t m e a s u re o f ris k f o r a ris k -a v e rs e

in v e s to r?
204
C H A P T E R SEVEN! R E V I E W
3 [L O 3 i W h a t a r e th e b e n e fits o f d iv e r s ific a tio n to a n in v e s to r? W h a t is th e k e y fa c to r d e te r m in in g th e e x te n t
o f th e se b e n e fits ?
4 [LO 4 ] E x p la in e a c h o f th e f o llo w in g :
a) th e e 仟ic ie n t fro n tie r
b) th e c a p ita l m a rk e t lin e
c) th e s e c u rity m a rk e t lin e .
5 [L O 5 ] Risky assets con be combined to form a riskless asset. D iscuss.

6 [L O 5 】Whenever an asset is added to a portfolio, the total risk o f the portfolio w ill be reduced p rovided the
returns o f the asset and the portfolio ore less than perfectly correlated. D iscuss.
7 [L O 6 ] Total risk can be decomposed into systematic and unsystematic risk. E x p la in e a c h c o m p o n e n t o f ris k ,
a n d h o w e a c h is a ffe c te d b y in c re a s in g th e n u m b e r o f s e c u ritie s in a p o r tfo lio .
8 [L O 7 】Diversification is certainly good for investors. Therefore, investors should be prepared to p ay a

premium for the shores o f companies that operate in several lines o f business. E x p la in w h y th is s ta te m e n t is
tru e o r fa ls e .
9 [L O 7 】M in c o Ltd, a la r g e m in in g c o m p a n y , p r o v id e s a s u p e r a n n u a tio n fu n d fo r its e m p lo y e e s . T he fu n d 's

m a n a g e r s a y s : 'W e k n o w th e m in in g in d u s try w e ll, so w e fe e l c o m fo r ta b le in v e s tin g m o s t o f th e fu n d in a
p o r tf o lio o f m in in g c o m p a n y s h a re s ’ . A d v is e M in c o ’s e m p lo y e e s o n w h e th e r to e n d o rs e th e fu n d ’s in v e s tm e n t
p o lic y .
10 [L O 8 ] An important conclusion o f the CAPM is that the relevant measure o f an asset's risk is its systematic
risk. O u tlin e th e s ig n ific a n c e o f th is c o n c lu s io n fo r a m a n a g e r m a k in g f in a n c ia l d e c is io n s .
11 [L O 8 】F o r in v e s to rs w h o a im to d iv e rs ify , s h a re s w ith n e g a tiv e b e ta s w o u ld b e v e r y u se fu l in v e s tm e n ts , b u t
such s h a re s a r e v e r y ra re . E x p la in w h y f e w s h a re s h a v e n e g a tiv e b e ta s .
12 [LO 8 ] C o m p a r e a n d c o n tra s t th e c a p it a l a s s e t p r ic in g m o d e l a n d m o d e ls th a t in c lu d e a d d itio n a l fa c to rs .
13 [L O 1 1 ] In w h a t s itu a tio n s w o u ld it b e a p p r o p r ia t e to use a s im p le b e n c h m a r k in d e x , such a s th e S & P /A S X

2 0 0 s h a re p r ic e in d e x , to assess th e p e r fo r m a n c e o f a p o r tfo lio ?
14 [L O ll]When assessing the performance o f o set o f portfolios it does not really matter if you choose the
Shorpe ratio or the Treynor ratio to do so os both approaches account for the risk inherent in the portfolios.
D iscuss.
PROBLEMS
1 V a lu e a t r is k [L O 1 ]
C o n s id e r a p o r tfo lio c o m p ris in g a $ 3 m illio n in v e s tm e n t in O u tlo o k P u b lis h in g a n d a $ 5 m illio n in v e s tm e n t in
Russell C o m p u tin g . A s s u m e th a t th e s ta n d a rd d e v ia tio n s o f th e re tu rn s fo r sh a re s in the se c o m p a n ie s a r e 0 . 4
a n d 0 . 2 5 p e r c e n t p e r a n n u m re s p e c tiv e ly . A s s u m e a ls o th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n th e sh a re s
in these c o m p a n ie s is 0 . 7 . A s s u m in g a 1 p e r c e n t c h a n c e o f a b n o r m a lly b a d m a rk e t c o n d itio n s , c a lc u la te th e
v a lu e a t risk o f th is p o r tfo lio . S tate a n y a s s u m p tio n s th a t y o u m a k e in y o u r c a lc u la tio n s .
2 In v e s tm e n t a n d r is k [L O 2 ]
M r B o b N e il is c o n s id e r in g a 1 -y e a r in v e s tm e n t in sh a re s in o n e o f th e f o llo w in g th re e c o m p a n ie s .
• C o m p a n y X: e x p e c te d re tu rn = 1 5% w ith a s ta n d a rd d e v ia tio n o f 1 5%
• C o m p a n y Y: e x p e c te d re tu rn = 1 5 % w ith a s ta n d a rd d e v ia tio n o f 2 0 %
• C o m p a n y Z : e x p e c te d re tu rn = 2 0 % w ith a s ta n d a rd d e v ia tio n o f 2 0 %
R a n k th e in ve s tm e n ts in o r d e r o f p re fe re n c e fo r e a c h o f th e ca s e s w h e r e it is a s s u m e d th a t M r B o b N e il is:
a) risk a v e rs e
b) risk n e u tra l
c) risk s e e k in g .
G iv e re a s o n s .
205
Portfolio standard deviation and diversification [LO 3]
The s ta n d a rd d e v ia tio n s o f re tu rn s o n assets A a n d B a r e 8 p e r c e n t a n d 1 2 p e r c e n t, re s p e c tiv e ly . A p o r tfo lio
is c o n s tru c te d c o n s is tin g o f 4 0 p e r c e n t in A s s e t A a n d 6 0 p e r c e n t in A sse t B. C a lc u la te th e p o r tfo lio s ta n d a rd
d e v ia tio n if th e c o r r e la tio n o f re tu rn s b e tw e e n th e tw o assets is:
a) 1
b) 0 .4
c) 0
d) -1
G om m ^nt on y o u 「a n s w e rs .
Expected return, variance and risk [LO 3]
You b e lie v e th a t th e re is a 5 0 p e r c e n t c h a n c e th a t th e s h a re p r ic e o f C o m p a n y L w ill d e c re a s e b y 1 2 p e r c e n t
a n d a 5 0 p e r c e n t c h a n c e th a t it w ill in c re a s e b y 2 4 p e r ce n t. F urther, th e re is a 4 0 p e r c e n t c h a n c e th a t th e
s h a re p r ic e o f C o m p a n y M w ill d e c re a s e b y 1 2 p e r c e n t a n d a 6 0 p e r c e n t c h a n c e th a t it w ill in c re a s e b y
2 4 p e r ce n t. T h e c o rre la tio n c o e ffic ie n t o f th e re tu rn s o n sh a re s in th e tw o c o m p a n ie s is 0 . 7 5 . C a lc u la te :
a) th e e x p e c te d re tu rn , v a r ia n c e a n d s ta n d a rd d e v ia tio n fo r e a c h c o m p a n y 's sh a re s
b) th e c o v a r ia n c e b e tw e e n th e ir return s.
Variance of return [LO 5]
A n in v e s to r p la c e s 4 0 p e r c e n t o f h e r fu n d s in C o m p a n y A 's sh a re s a n d th e r e m a in d e r in C o m p a n y B7s sha res.
T he s ta n d a rd d e v ia tio n o f th e re tu rn s o n A is 2 0 p e r c e n t a n d o n B is 1 0 p e r c e n t. C a lc u la te th e v a r ia n c e o f
re tu rn o n th e p o r tfo lio , a s s u m in g th a t th e c o r r e la tio n b e tw e e n th e re tu rn s o n th e tw o se c u ritie s is:
a) + 1 .0
b) + 0 .5
c) 〇
d) -0 .5
Expected return, risk and diversification [LO 5 】

H a r r y Jo n e s h a s in v e s te d o n e -th ird o f his fu n d s in S h a re 1 a n d tw o -th ird s o f his fu n d s in S h a re 2 . H is
asse ssm en t o f e a c h in v e s tm e n t is as fo llo w s :
Item S h a re 1 S h a re 2
Expected return (%) 15.0 21.0
Standard deviation (%) 18.0 25.0
Correlation between the 0.5

returns
a) W h a t a re th e e x p e c te d re tu rn a n d th e s ta n d a rd d e v ia tio n o f re tu rn o n H a r r y 's p o rtfo lio ?
b) R e c a lc u la te th e e x p e c te d re tu rn a n d th e s ta n d a rd d e v ia tio n w h e r e th e c o r r e la tio n b e tw e e n th e re tu rn s is
0 a n d 1 .0 , re s p e c tiv e ly .
c) Is H a r r y b e tte r o r w o r s e o ff as a re su lt o f in v e s tin g in tw o s e c u ritie s ra th e r th a n in o n e se c u rity ?

Expected return, risk and diversification [LO 5]
A 12.5 40 1.00 0.20 0.35
B 16.0 45 0.20 1.00 0.10
C 20.0 60 0.35 0.10 1.00

CHAPTER SEVEN REVIEW

T h e re is a ls o a risk-fre e A s s e t F w h o s e e x p e c te d re tu rn is 9 . 9 p e r ce n t.
a) P o rtfo lio 1 co n sists o f 4 0 p e r c e n t A s s e t A a n d 6 0 p e r c e n t A sse t B. C a lc u la te its e x p e c te d re tu rn a n d s ta n d

a r d d e v ia tio n .
b) P o rtfo lio 2 co n sists o f 6 0 p e r c e n t A sse t A , 2 2 . 5 p e r c e n t A s s e t B a n d 1 7 .5 p e r c e n t A s s e t C . C a lc u la te its

e x p e c te d re tu rn a n d s ta n d a rd d e v ia tio n . C o m p a re y o u r a n s w e rs to (a) a n d c o m m e n t.
c) P o rtfo lio 3 co n sists o f 4 . 8 p e r c e n t A s s e t A , 7 5 p e r c e n t A s s e t B a n d 2 0 . 2 p e r c e n t in th e risk-fre e asset.

C a lc u la te its e x p e c te d re tu rn a n d s ta n d a rd d e v ia tio n . C o m p a re y o u r a n s w e rs to (a) a n d (b) a n d c o m m e n t.
d) P o rtfo lio 4 is a n e q u a lly w e ig h te d p o r tfo lio o f th e th re e ris k y assets A , B a n d C . C a lc u la te its e x p e c te d

re tu rn a n d s ta n d a rd d e v ia tio n a n d c o m m e n t o n the se results.
e) P o rtfo lio 5 is a n e q u a lly w e ig h te d p o r tfo lio o f a ll fo u r assets. C a lc u la te its e x p e c te d re tu rn a n d s ta n d a r d

d e v ia tio n a n d c o m m e n t o n th e se results.
8 Expected return and systematic risk [LO 7 】
The e x p e c te d re tu rn o n th e /th a sse t is g iv e n b y:
E L R f+_ R M]-R f 、
a) W h a t is th e e x p e c te d re tu rn o n th e /th a sse t w h e r e Rf = 0 . 0 8 , fi- = 1 . 2 5 a n d f(/?yvi) = 0 . 1 4 ?
b) W h a t is th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio w h e r e E(Rj) = 0 . 1 1 , = 0 . 0 8 a n d p y= 0 . 7 5 ?
c) W h a t is th e s y s te m a tic ris k o f th e /th a sse t w h e re E(Rt ) = 0 . 1 4 , ^ = 0 . 1 0 a n d E(RM) = 0 . 1 5 ?

9 Assessing diversification benefits [LO 7 】
You a re a s h a re a n a ly s t e m p lo y e d b y a la r g e m u ltin a tio n a l in v e s tm e n t fu n d a n d h a v e b e e n s u p p lie d w ith th e
fo llo w in g in fo rm a tio n :
A sse t E x p e c te d re tu rn (%) S ta n d a rd d e v ia tio n (%) 1
BHZ Ltd 9 8
ANB Ltd 13 48
You a re a ls o to ld th a t th e c o r r e la tio n c o e ffic ie n t b e tw e e n th e re tu rn s o f th e tw o c o m p a n ie s is 0 . 8 . A c lie n t

c u rre n tly h a s a ll o f h e r w e a lth in v e s te d in B H Z s h a re s. S he w is h e s to d iv e r s ify h e r p o r tf o lio b y re d is trib u tin g h e r
w e a lth such th a t 3 0 p e r c e n t is in v e s te d in B H Z sh a re s a n d 7 0 p e r c e n t in A N B sh a re s.
a) W h a t w ill b e th e e x p e c te d re tu rn o f th e n e w p o r tfo lio ?

b) W h a t w ill b e th e s ta n d a rd d e v ia tio n o f re tu rn s fo r th e n e w p o rtfo lio ?
A fte r c o n s tru c tin g th e p o r tfo lio a n d r e p o r tin g th e results to y o u r c lie n t, she is q u ite u p se t, s a y in g , 7I th o u g h t
th e w h o le p u rp o s e o f d iv e r s ific a tio n w a s to re d u c e risk? Yet y o u h a v e ju st to ld m e th a t th e v a r ia b ility o f m y
p o r tfo lio h a s a c tu a lly b e e n in c re a s e d fro m w h a t it w a s w h e n I in v e s te d o n ly in B H Z ’ .
c) P ro v id e a re s p o n s e to y o u r c lie n t th a t d e m o n s tra te s th a t th e n e w p o r tfo lio d o e s o r d o e s n o t re fle c t th e b e n e

fits o f d iv e rs ific a tio n . S h o w a ll n e c e s s a ry c a lc u la tio n s .
10 Portfolio weights systematic risk and unsystematic risk [LO 8 】
T he ta b le p ro v id e s d a ta o n tw o ris k y assets, A a n d B, th e m a rk e t p o r tf o lio M a n d th e ris k-fre e a sse t F.
Asset E x p e c te d re tu rn (%) A
A 10.8 324 60 48 0
B 15.6 60 289 96 0
M 14.0 48 96 80 0
F 6.0 0 0 0 0
A n in v e s to r w is h e s to a c h ie v e a n e x p e c te d re tu rn o f 1 2 p e r c e n t a n d is c o n s id e rin g th re e w a y s this m a y b e
done:
a) in v e s t in A a n d B
b) in v e s t in B a n d F
c) in v e s t in M a n d F.
207
B usiness finance
F or e a c h o f th e se o p tio n s , c a lc u la te th e p o r tfo lio w e ig h ts r e q u ire d a n d th e p o r tfo lio s ta n d a rd d e v ia tio n . S h o w

th a t assets A a n d B a re p r ic e d a c c o r d in g to th e c a p ita l a sse t p r ic in g m o d e l a n d , in th e lig h t o f th is result,
c o m m e n t o n y o u r fin d in g s .
11 Portfolio performance appraisal [LO 11 ]

In 2 0 1 4 th e re tu rn o n th e F o rt K n o x Fund w a s 1 0 p e r ce n t, w h ile th e re tu rn o n th e m a rk e t p o r tfo lio w a s
1 2 p e r c e n t a n d th e risk-fre e re tu rn w a s 3 p e r ce n t. C o m p a ra tiv e sta tistics a r e s h o w n in th e ta b le b e lo w .
S ta tis tic F o rt K n o x fu n d S & P /A S X 2 0 0 sh a re

p r ic e in d e x
Standard deviation of return 15% 30%
Beta 0.75 1.00
C a lc u la te a n d c o m m e n t o n th e p e rfo rm a n c e o f th e fu n d u s in g th e fo llo w in g th re e a p p ro a c h e s :
a) th e s im p le b e n c h m a rk in d e x
b) th e S h a rp e ra tio
c) th e T re y n o r ra tio .
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209
CHAPTER CONTENTS
ED I n t r o d u c t io n 21 1 EB F in a n c ia l in t e r m e d ia r ie s 220
EQ F in a n c ia l a g e n c y in s titu tio n s 215 ESI In v e s tin g in s titu tio n s 224
LEARNING OBJECTIVES Z
1 u n d e r s ta n d th e f u n c tio n s o f a c a p it a l m a r k e t
2 d is tin g u is h b e t w e e n f in a n c ia l a g e n c y in s titu tio n s , f in a n c ia l in t e r m e d ia r ie s a n d in v e s tin g in s titu tio n s
3 id e n t if y a n d e x p la in th e r o le o f f in a n c ia l a g e n c y in s titu tio n s
4 id e n t if y a n d e x p la in th e r o le o f f in a n c ia l in t e r m e d ia r ie s
5 o u t lin e th e r o le o f s e c u r it is a tio n
6 id e n t if y a n d e x p la in th e r o le o f in v e s tin g in s titu tio n s .

C hapter eight T he capital market
■ jjJ ~ l^ tr o d u c tio n
In Chapters 5 and 6 we discussed the methods used to select a company s assets. The company also has
to decide how to finance those assets. Where w ill the money come from? Is the money needed fo r a long FINANCIAL ASSETS
assets such as shares,
time, or only a short time? Depending on the answers to these and related questions, the company w ill
bonds and bank
enter in to different arrangements and different types o f financial assets w ill be created. deposits, as distinct
Financial a sse ts are legally enforceable claims to future cash flows. Bank deposits, trade creditors, from real assets
debt securities and shares are different types o f financial assets. The markets in which financial assets are
bought and sold are commonly referred to as financial markets and include the equity (share) market, the CAPITAL MARKET
market in which long
bond m arket and the foreign exchange m arket. The financial markets in which companies raise long-term
term funds are raised
funds are referred to collectively as the capital m arket. In this chapter we discuss the benefits o f having and long-term debt
a capital m arket and the m ajor features o f the Australian capital m arket, paying p articular attention to and equity securities
the characteristics o f the im p o rta n t in stitu tio n s th a t participate in the market. are traded
Over a given period an economic e n tity such as an individual, a company or an unincorporated business
w ill be either a ‘deficit u n it’ or a ‘surplus u n it’. A deficit u n it is one whose expenditure exceeds its income
for a particular period, whereas a surplus u n it is one whose income exceeds its expenditure fo r a particular
period. The financing process involves a flow o f funds from the surplus units to the deficit units.
I f a company wishes to grow, b ut does n o t generate sufficient funds interna lly to finance an increase
in its assets— th a t is, the company is a deficit u n it— it w ill need to finance the difference by drawing
on the funds held by surplus u nits.1 Surplus units may be households, businesses, governments or the
overseas sector.
The flow o f funds from surplus units to deficit units may be direct or indirect. A direct flow o f funds
may result solely from negotiation between the parties, or a financial in s titu tio n may be involved as an
adviser or underw riter.2 For example, when a company issues (that is, creates and sells) debt securities,
an investm ent bank may advise on and/or underw rite the issue.3 However, the funds w ill flow directly
from the purchasers o f the debt securities to the issuing company. D irect funding is more commonly used
where the borrower has a recognised credit rating and wishes to raise relatively large amounts.
Alternatively, the flow o f funds may be indirect— th a t is, i t occurs through financial interm e
diaries, such as banks and finance companies. In this case the deficit u n it obtains funds from a
financial interm ediary th a t has borrowed the funds from surplus units. Interm ediated funding is FINANCIAL
more commonly used where the credit risk o f the deficit u n it (the borrower) needs to be assessed, and INTERMEDIARY
institution that acts
where the amounts fo r both borrowers and lenders are relatively small. Financial intermediaries have an
as a principal in
im portant role in facilitating the flow o f funds from surplus units to deficit units. accepting funds from
The number o f financial assets th a t are created in the overall financing process is an im p o rta n t depositors or investors
difference between direct and indirect financing. I f a company raises funds directly by, fo r example, and lending them to
issuing a bond to an investor (lender), only one financial asset has been created. The bond is a financial borrowers
asset held by the investor and it is a lia b ility o f the company. In contrast, i f the investor deposits funds in a
bank, which then makes a loan to a company, two financial assets are created. The bank deposit is an asset
owned by the investor and the bank loan is an asset owned by the bank. Corresponding to these tw o assets
are two liabilities. The deposit is a lia b ility o f the bank and the bank loan is a lia b ility o f the borrower.
m
The capital m arket enables the suppliers o f funds (the surplus units) and the users o f funds (the deficit
LEARNING
units) to negotiate the conditions on which the funds w ill be transferred. Equity or share markets involve
OBJECTIVE 1
Understand the
functions of a capital
1 Internally generated funds are discussed in Section 9.8.
market
2 Underwriting is discussed further in Section 8.2.2.
3 The activities of investment banks are discussed in Section 8.2.2. These institutions were generally referred to as merchant
banks until the early 1990s when the US term investment bank' was widely adopted in Australia. In this chapter we use the
latter term, except in cases where the historical context makes the earlier term appropriate.
B usiness finance
ownership and usually a permanent transfer o f funds, w ith returns to shareholders contingent on the
future p ro fita b ility o f the company raising the funds. Debt markets usually involve a transfer o f funds fo r
a fin ite period, w ith predetermined promised returns to lenders. In the finance literature, equity and debt
markets together form the capital m arket.4
Financial markets may be classified in several ways. For example, the d istinction between debt markets
and equity markets is based on the type o f financial asset th a t is traded in the market. Similarly, markets
PRIMARY MARKET fo r financial assets may be either prim ary m arkets, where financial assets are firs t sold by th e ir
market for new issues originators, or secondary m arkets, where pre-existing financial assets are traded.
of securities where
Prim ary markets are im p o rta n t because it is in these markets th a t a deficit u n it— fo r example, a
the sale proceeds go
to the issuer of the
company— raises new funds to finance its investments. For example, a company may make a new share
securities issue or a new bond issue to finance the development o f a new m ine or the acquisition o f another business.
A transaction in the secondary m arket does n ot raise any new funds fo r the issuer o f the securities
SECONDARY MARKET th a t are traded. A ll th a t happens is a change o f ownership; the seller o f the security transfers, fo r a price,
market where
ownership o f the security to the buyer. However, secondary markets are im p o rta n t because they provide
previously issued
securities are traded a way in which securities can be exchanged fo r cash— th a t is, they provide liquidity. The existence o f a
secondary m arket enables companies to raise long-term funds, even though individual suppliers o f funds
may be w illin g to provide funds only fo r much shorter terms. For example, a company may issue a 7-year
bond to an investor who wishes to invest fo r only 3 years. The investor is w illin g to buy the bond because
she knows that, after 3 years have passed, she w ill be able to sell the bond in the secondary m arket. In
this way, the existence o f an active secondary m arket facilitates capital raising in the p rim ary market.
W ith o u t an active secondary m arket, many investors would n o t participate in prim ary markets because
EXCHANGE-TRADED
they require the fle xib ility to redeploy th e ir funds. The secondary m arket provides this flexibility.
MARKET
market in which
A nother im p o rta n t d istin ction between different financial markets is based on the organisational
trading takes place by structure o f the markets. Indirect financing takes place through financial intermediaries, which raise
competitive bidding funds by issuing financial claims against themselves and use those funds to purchase financial assets,
on an organised most o f which cannot be traded in a secondary m arket. For example, a loan provided by a bank is often
exchange
retained as an asset o f th a t bank u n til it has been repaid. In contrast, the financial assets created through
OVER-THE-COUNTER
direct financing are usually marketable securities. These securities may be traded through an organised
MARKET exchange or they may be traded in an over-the-counter market. In an exchange-traded m arket,
there is no organised securities are traded through an organised exchange such as a stock exchange, where brokers carry out
exchange and the d ie nts, instructions to buy or sell nom inated securities. In an over-the-counter m arket there is no
market consists of
organised exchange and the m arket consists o f financial in s titu tio n s (dealers) who trade w ith clients
financial institutions
that are willing and w ith each other. The Australian capital m arket includes financial intermediaries and markets o f both
to trade with a these types. Exchange-traded securities include shares, options on shares and futures contracts. Debt
counterparty securities, swaps and currency options are usually traded in over-the-counter markets.
Some features o f the financial system remain essentially constant over tim e while other features are
subject to change, which may be gradual or, in some cases, very rapid. For example, banks have had
a very im p o rta n t role in Australia since the firs t bank was established in 1817. However, the relative
importance o f banks has varied over tim e — many new banks have entered the market, a few banks have
failed and several have been acquired by other banks. The factors th a t can trigger significant changes in
the financial system include changes in regulation and technology, changes in the demand fo r different
form s o f funding and the effects o f financial crises.
The evolution and expansion o f the Australian financial markets in the last three decades were largely
an outcome o f the deregulation o f those markets in the 1980s. W hile the Australian financial markets
have been largely deregulated, this deregulation has n o t extended to the removal o f controls th a t serve
a prudential purpose. The p rim ary regulator o f Australia’s banks, insurance companies, superannuation
4 In practice, participants in the financial markets usually refer to the direct short-term debt market—that is, where loans are
for 12 months or less—as the m on ey m ark e t. The term c a p ita l m a r k e t is used to describe the direct long-term debt market.
funds, credit unions and b uilding societies is the Australian Prudential Regulation A u th o rity (APRA,
www.apra.gov.au). In 1998, APRA took over prudential supervision functions from Australia’s central
ban k — the Reserve Bank o f Australia (RBA, www.rba.gov.au).
Arguably, the m ost im p o rta n t role fu lfille d by banking regulatory authorities is ensuring that
depositors* funds are adequately protected. One way o f protecting the interests o f depositors is to require CENTRAL BANK
banks to m aintain an adequate level o f ‘capital’ （ fo r example, shareholders’ funds): the more capital a a bank that controls
the issue of currency,
bank has, the more it relies on its shareholders fo r funding and hence the less it relies on its depositors.
acts as banker to the
Therefore, the depositors are safer than they otherwise would be. I f a bank is judged by the regulator to government and the
be carrying too much risk, it can be required to increase its capital, thus sh ifting more o f the cost o f risk banking system and
bearing from the banks depositors to the banks shareholders. sets the interest rate
In 1988, the Basel Committee on Banking Supervision established a set o f recommendations known for overnight cash
as the 1988 Capital Accord (or sim ply the Basel Accord). The Basel Committee was established by the Bank
fo r International Settlements (BIS, w w w .bis.org), which its e lf can be thought o f as a bank fo r central
banks. To illustrate one simple consequence o f the Basel Accord, a banks loan to a company would be
judged to be twice as risky as a loan secured by a firs t mortgage over fam ily-held real estate. Hence, twice
as much capital m ust be m aintained by the bank to protect the depositors.
Gup (2004) notes that during the period from 1980 to 1996, 133 o f the 181 member countries o f the
International M onetary Fund experienced serious banking sector problems, including those countries that
adopted the 1988 accord. Some o f the deficiencies o f the first set o f recommendations have been addressed
in a second accord, commonly referred to as Basel II, which provides a more comprehensive method by which
banks account for risk.5 The Basel II framework has applied in Australia from 1 January 2008.
The adequacy o f m any aspects o f bank regulation was called in to question by the global financial
crisis th a t began in m id-2007 when problems th a t o riginated in credit m arkets in the US became
widespread th ro ug h ou t the developed nations. This crisis saw tu rm o il in m any financial m arkets
during 2008 and 2009 and the failure or near-failure o f many financial in s titu tio n s in the US, the
UK and Europe. I t also involved unprecedented actions by central banks, financial regulators and
governments to restore confidence and s ta b ility in the financial system and to lim it the effects o f the
crisis on economic activity. In several stages beginning in December 2009 the Basel Com m ittee has
proposed fu rth e r refinem ents, inclu ding more detailed regulations aimed at increasing the q u a n tity
and q ua lity o f bank capital and strengthening bank liq u id ity . Together, these proposals have been
referred to as Basel III. In September 2012, APRA announced th a t the capital reform s w ould be
im plem ented on 1 January 2013 (APRA, 2012b). In May 2013 APRA stated th a t i t w ould introduce
changes to liq u id ity regulation based on Basel III in three stages on 1 January 2014, 1 January 2015
and 1 January 2018 (APRA, 2013b).
When the structure o f the financial system is viewed in terms o f the in s titu tio n s th a t operate w ith in
it, four main developments can be identified over the post-deregulation period— th a t is, from 1985 to
2005 (RBA March 2006). These developments are:
• a significant increase in the importance o f banks

• a decrease in the relative importance o f b uilding societies, credit unions, finance companies and
money m arket corporations
• a significant increase in the share o f assets held through managed funds, particularly
superannuation funds
• rapid growth in securitisation.
These developments, which typically occurred gradually, were followed by some much more rapid
changes associated w ith the global financial crisis. In Australia, the effects o f the financial crisis were less
severe than in the US, the U K and Europe b u t the effect on equity prices was comparable to the changes
experienced in other countries: from its peak in November 2007, the Australian stock m arket fell by more
than 50 per cent to a low in March 2009. O ther effects included a fu rth e r strengthening o f the dom inant
position held by banks and a significant reversal o f the previous grow th in securitisation. These, and other
developments, are discussed in Sections 8.2 to 8.4.
5 See Gup (2004) for a detailed discussion of the background to the introduction of Basel II and a critical analysis of its
recommendations •
B usiness finance
Business funding
Sections 8.2 to 8.4 outline the m ajor financial in s titu tio n s in the Australian capital m arket involved in
providing funds to companies. In stitu tio n s such as b uilding societies and credit unions, whose main
LEARNING function is consumer lending, are n o t discussed. The financial in s titu tio n s we discuss can be divided into
OBJECTIVE 2
three broad categories: financial agency institutio ns, financial intermediaries and investing institutions.
Distinguish between
financial agency A financial agency in stitu tio n arranges or facilitates the direct transfer o f funds from lenders to
institutions, financial borrowers; typically, the funds are transferred from investors to companies. Companies usually obtain
intermediaries and the assistance o f a stockbroker or investm ent bank when they wish to raise capital externally. For
investing institutions example, a broker or an investm ent bank may place a company s newly issued shares w ith in stitu tio n a l
clients. Stockbroking firm s and investm ent banks fu nctio n as agency in stitu tio n s and w ill receive a fee or
FINANCIAL AGENCY commission fo r arranging a transaction. Financial agency in s titu tio n s are discussed in Section 8.2.
INSTITUTION
A financial intermediary, such as a bank, provides funds as a principal— th a t is, a company that
arranges or facilitates
borrows from a bank has an obligation to repay the bank, b u t it has no obligation to the banks depositors.
the direct transfer of
funds from lenders to Similarly, a bank acts as a principal in its relationship w ith depositors who have claims against the bank;
borrowers depositors do n ot have claims against those who have borrowed from the bank. In contrast to agents,
whose earnings consist m ostly o f fees and commissions, financial intermediaries obtain a significant part
o f th e ir income from the in te re s t m argin,, which is the difference between the interest rates they charge
for loans and the rates they pay to depositors. M ost financial interm ediaries also charge various fees.
Companies w ith large funding requirements and high credit ratings are well placed to access debt
funds directly. Such companies can therefore raise m ost or all o f th e ir funding requirements w ith o u t the
services o f an interm ediary. However, m ost companies would fin d it either impossible or very expensive
to access debt funds directly, so these companies typically borrow from financial intermediaries. The
funds provided are sourced m ainly from depositors, so financial intermediaries have to provide services
th a t depositors find attractive. Financial intermediaries are discussed in Section 8.3.
INVESTING Investing in stitu tio n s are sim ilar to financial intermediaries in th a t they accept funds from the
INSTITUTION public and invest the funds in assets. However, there are im p o rta n t differences between them. Essentially,
accepts funds
financial intermediaries, such as banks, accept deposits and make loans. The m ajor roles o f investing
from the public
in s titu tio n s — which include superannuation funds, life insurance companies and u n it tru sts— are to
and invests them
in assets; includes provide insurance and funds management. Funds placed w ith these in s titu tio n s are generally n ot in
superannuation the form o f deposits and, while some o f these in s titu tio n s do make loans, they also invest in shares,
funds, life insurance debt securities, infrastructure assets and real estate, giving them a w ider spread o f assets than financial
companies and unit
intermediaries. Another difference is th a t the returns provided by investing in s titu tio n s usually depend
trusts
directly on the performance o f the assets held by them, whereas intermediaries have ‘fixed’ commitments
to depositors th a t m ust be m et even i f an unexpectedly high pro po rtio n o f borrowers fa il to repay th eir
loans. Investing in stitu tio n s are discussed in Section 8.4.
W hile Sections 8.2 to 8.4 discuss financial agency institutio ns, financial intermediaries and investing
in stitu tio n s, tw o qualifications should be noted. First, there are some entities th a t do n ot fit neatly
in to any one o f these three categories. In particular, despite the fact th a t securitisation vehicles do not
conform to our d e fin itio n o f ‘financial interm ediary’，we discuss securitisation in Section 8.3 because it
is a process widely used by financial intermediaries. Second, some o f the differences between these three
types o f in stitu tio n s have become less d istin ct in recent years. Many investing in s titu tio n s now offer
products, such as housing loans, th a t were previously provided almost exclusively by intermediaries. In
addition, there has been a considerable grow th in financial conglomerates th a t provide a wide range of
financial services. For example, many banks have funds management, stockbroking and life insurance
subsidiaries, while some life insurance companies have banking subsidiaries. These developments are
likely to continue. However, there are s till fundam ental differences between financial interm ediation,
the life insurance business and funds management. For example, the assets and liabilities o f a bank and
AUTHORISED DEPOSIT the risks involved in banking are quite different from those o f a life insurance company. Therefore, while
TAKING INSTITUTION customers see a b lu rrin g o f previous distinctions, the differences between, say, banking and insurance
a corporation that is
continue to be im p o rta n t to those involved in managing and regulating financial institutio ns.
authorised under the
Banking Act 1959 to
A nother d ifficu lty arises from the terms used to refer to some institutio ns. In particular, the term
accept deposits from inve stm en t bank* is used despite the fact th a t these in s titu tio n s may n ot be au th orised deposit-taking
the public in stitu tio n s (ADIs) and are therefore n o t p erm itted to use the word ‘bank’ in th e ir title . On the other
hand, many investm ent banks in Australia are the local wholesale m arket operations o f foreign banks.
In summary, activities described as ‘investm ent banking’ may be carried out by a bank or by a non-bank.
The to ta l assets o f the main types o f financial in s titu tio n s are shown in Table 8.1, which shows that
banks are by far the largest group o f in stitu tio n s in the Australian market, followed by life insurance
companies and superannuation funds. The grow th o f banks, life insurance companies and superannuation
funds, other managed funds and p articularly securitisation vehicles was relatively high in the period from
1990 to 2007, while the assets o f other ADIs and registered financial corporations grew more slowly.
Table 8.1 also shows th a t fo r some institutio ns, such as life insurance companies and superannuation
funds, the rate o f asset grow th has slowed since 2007, while fo r registered financial corporations, other
managed funds and securitisation vehicles, the value o f assets has fallen since 2007. Generally, these
differences between pre- and post-2007 conditions reflect the effects o f the global financial crisis.
TABLE 8.1 Assets of Australian financial institutions, $ billi on

r
Life in s u ra n c e
A u th o ris e d R e g iste re d c o m p a n ie s a n d O th e r G e n e ra l
.
d e p o s it-ta k in g fin a n c ia l s u p e ra n n u a tio n m anaged in s u ra n c e S e c u ritis a tio n
in s titu tio n s c o rp o ra tio n s fu n d s fu n d s c o m p a n ie s v e h ic le s Total
___
B a n ks (o th e r O th e r
3 0 Ju n e | th a n RBA) A D Is
1990 325.8 31.4 109.0 158.9 43.3 21.7 5.7 695.9
1995 437.9 27.4 95.6 241.1 57.7 38.9 9.8 908.3
2000 731.0 34.2 134.6 455.1 151.7 61.4 65.0 1633.0
2005 1363.5 49.2 166.7 662.9 243.0 105.1 184.5 2774.8
2006 1581.1 53.6 176.3 787.1 300.6 113.8 216.5 3228.9
2007 1876.9 59.3 222.8 1024.9 378.3 143.7 274.0 3980.0
2008 2324.1 64.6 251.4 997.0 352.7 137.2 239.2 4366.2
2009 2590.2 67.5 215.6 936.5 313.8 134.2 192.7 4450.5
2010 2613.2 73.0 168.6 1050.6 312.6 133.4 146.1 4497.6
2011 2733.2 82.2 171.2 1172.1 287.8 152.9 136.1 4735.6
2012 2964.9 68.7 154.0 1233.7 272.5 163.4 126.8 4984.0
2013 3103.0 66.8 155.5 1421.0 278.0 175.2 127.5 5327.0
Note: The figures for life insurance companies, superannuation funds and other managed funds have been consolidated by the Australian Bureau of
Statistics. They should not be compared with the figures in Tables 8.5, 8.6 and 8.7, which are unconsolidated.
Source: Table B1, Reserve Bank of Australia website, www.rba.gov.au.
8.2 Financial agency institutions

Financial agency in stitu tio n s are those th a t facilitate direct funding b u t do n o t themselves provide
LEARNING
the funds. These in stitu tio n s operate in the p rim ary markets to b ring together surplus units and
OBJECTIVE 3
deficit units, and assist w ith the design o f appropriate contracts. They also operate in the secondary Identify and explain
markets. The m ain financial agency in stitu tio n s in Australia are stockbrokers and investm ent the role of financial
banks. agency institutions
8.2.1 I Brokers and the stock exchange
The trad ition al function o f the stock exchange (and o f stockbrokers) is to provide facilities fo r the trading
o f shares, bonds and other securities such as convertible notes, options and preference shares. As a result,
a stock exchange perform s three functions. First, i t mobilises savings. Because there are large numbers of
investors, issues o f securities can be fo r large sums. The presence o f a stock exchange allows companies to
issue debt or equity securities in relatively small units, and each surplus u n it can then invest its desired
amount. Second, it allocates resources. A stock exchange facilitates the allocation o f resources (savings)
among a large num ber o f competing investm ent opportunities. Third, it allows investments to be realised
through the sale o f securities— th a t is, i t provides investors w ith liquidity, and therefore the o pp ortu nity
to adjust th e ir portfolios. As explained earlier, the existence o f a liq u id secondary m arket encourages
investm ent in the p rim ary market.
Development of the Australian Stock Exchange

In 1987 the Australian Stock Exchange Ltd (ASX, www.asx.com.au) commenced business as a national
stock exchange form ed by amalgamating the six independent exchanges th a t previously operated in
the state capital cities. U n til 1998, the ASX was a company lim ite d by guarantee. However, follow ing
dem utualisation in 1998, i t became a company lim ite d by shares. In 2006 the ASX merged w ith the SFE
Corporation, the owner o f the Sydney Futures Exchange, resulting in an exchange group th a t operated
as the Australian Securities Exchange (ASX) u n til 1 August 2010 when it adopted the name ASX Group.
The ASX is a large and sophisticated m arket. A t the end o f 2012, more than 2000 companies had
equities listed on the exchange, w ith a to ta l m arket capitalisation o f $1335 billion. In th a t year, the
average daily value o f share trading was about $4 b illio n and more than $41 b illio n o f new equity capital
was raised during the year. By market capitalisation o f its listed entities, the ASX ranks te n th in the world;
by the value o f share trading, i t ranks tw e lfth .6
Other equity markets in Australia

There are two smaller stock exchanges in Australia: the Asia Pacific Stock Exchange and the National
Stock Exchange o f Australia.
• The Asia Pacific Stock Exchange (www.apx.com .au), usually referred to as the APX, was started in
1997 and targets grow th-oriented companies based in Australia or elsewhere in the Asia-Pacific
region, including China. I t is owned by AIMS Financial Group.
• The N ational Stock Exchange o f Australia (www.nsxa.com .au), usually referred to as the NSX, is
located in Newcastle and in 2013 had over 100 securities listed. I t is owned by its shareholders and
is its e lf listed on the ASX. It generally attracts smaller companies than the ASX because its listing
requirements are less demanding. For example, to lis t on the ASX a company m ust have at least
300 shareholders and a m arket capitalisation o f at least $10 m illion , whereas the NSX requires only
50 shareholders and a m arket capitalisation o f at least $500 000.
Australia also has other equity markets designed to meet the needs o f small and medium-sized
enterprises. These include the Australian Small Scale Offerings Board (www.assob.com.au) and the
CAPstart Private Equity M arket (w w w.capstart.com .au), which facilitate capital raising by small unlisted
companies.
Automation of trading
Since 1990, all shares have been traded electronically through systems th a t enable stockbrokers to trade
from term inals in th e ir offices; clients can place orders w ith online brokers using the internet. Visitors to
the stock exchanges can now view share prices and other inform ation, such as local and overseas m arket
indices, on video screens in the visitors* gallery. The ju n io r exchanges also use electronic trading and the
prices o f listed securities can be obtained from th e ir websites.
Table 8.2 provides some ASX m arket statistics fo r the period 1990 to 2012.
6 Ranks refer to the 53 members of the World Federation of Exchanges (www.world-exchanges.org).

TABLE 8.2 ASX market statistics as at December, 1990-2012

Year V a lu e o f A ll O r d in a r ie s s h a re , M a r k e t c a p ita lis a tio n d o m e s tic N u m b e r o f c o m p a n ie s w ith
p r ic e in d e x e q u itie s ($ m illio n ) e q u itie s liste d
1990 1280 139572 1136
1995 2203 329647 1178
2000 3155 670918 1406
2005 4709 1109596 1807
2006 5644 1390315 1908
2007 6421 1478651 2077
2008 3659 969046 2086
2009 4883 1403117 2043
2010 4847 1419001 2072
2011 4111 1168712 2079
2012 4665 1335 837 2056

Source: Compiled from Australian Stock Exchange Ltd, Fact Book 2001, 2001 and www.asx.com.au/research/market—
info/index.htm.
The role of the stockbroker

Traditionally, stockbrokers have played a leading role in the new-issues market. In the year to 31 December
2012, ASX-listed entities raised $41.2 b illio n in new equity capital compared w ith the 2010 and 2011
totals o f $56.5 b illio n and $47.8 b illio n respectively. The 2012 to ta l comprised $7.2 b illio n raised in in itia l
public offerings by newly listed entities and $34.0 b illio n raised by entities th a t were already listed (see Jw w ^J
w w w .asx.co m .au /a bo ut/m a rke t-sta tistics.htm ). A company may m aintain a continuing relationship
w ith a stockbroking firm th a t advises it on the m ost appropriate means o f raising funds and the terms
o f a new issue o f securities. The same broker or an associated company may underw rite the issue, which
means th a t the broker or associated company agrees to subscribe to any p o rtio n o f the issue th a t is not
subscribed to by other investors during a given period. In addition, a broker may undertake to sell the issue,
mainly to the brokers clients and in s titu tio n a l investors. The larger stockbroking firm s also frequently
advise companies th a t are considering a merger or acquisition, and may assist w ith negotiations if the
merger or acquisition proceeds.
Many stockbroking firm s have extended th e ir services beyond those trad ition ally offered. O ther
services offered by brokers include advice on financial planning and superannuation, research and trading
of derivative securities (such as options), access to stock markets outside Australia and investments
in commercial bills and other money m arket assets.7 Although a stockbroking firm may provide these
services directly, they are usually provided through associated investm ent banks.
8 .2 .2 1 Investment banks
The role of investment banks

The term investm ent bank* has no official defin itio n in Australia. Rather, investm ent banks are identified
by the range o f financial services th a t they provide. Their m ain activities involve wholesale banking and
trading in the financial markets. The range o f activities is broad and includes financial interm ediation
(borrowing and lending), trading in securities, foreign exchange and derivatives, investm ent management,
7 Derivatives are discussed in Chapters 17 and 18 and commercial bills in Chapter 10.
provision o f corporate advisory services, u nd erw riting and stockbroking. Thus, unlike most banks and
other authorised deposit-taking in s titu tio n s (ADIs), investm ent banks have little involvem ent in retail
banking. Accordingly, they usually have m inim al dealings w ith individuals except perhaps as managers
o f funds such as cash management trusts or as advisers to a small number o f very wealthy individuals.
There is no <typical, investm ent bank because many o f them specialise in particular products and
services. However, as a group, investm ent banks focus on wholesale m arket operations, where they
deal w ith corporations, other financial institutio ns, governments and supranational bodies. Their main
functions can be outlined in four categories:
a The wholesale banking operation provides a service to companies th a t wish to deposit tem porarily idle
cash balances, or to borrow funds fo r a short to m edium period,
b The investment management function involves managing the p ortfolios o f in s titu tio n a l investors and
an investm ent banks own u n it trusts. Part o f this fu nctio n is to direct funds to the new issues o f
Australian companies.
c The corporate financial advisory function involves providing advice to companies about raising
additional capital, or a merger or takeover, and the provision o f und erw riting facilities and
m arketing services fo r new issues. The u n d erw rite rs skills, contacts and knowledge o f the
capital m arket are expected to result in a higher price than i f the issuer attempted to m arket the
securities itself. In addition, the m arketing risk is assumed by the underw riter. I f the issue is
priced appropriately, the supply o f securities w ill match the demand. I f the issue is over-priced, the
u nderw riter w ill be le ft holding the unsold securities,
d Making a market in foreign exchange and derivative securities involves being w illin g to quote b oth a
price to buy and a price to sell in these m arkets— th a t is, this fu nctio n requires the investm ent bank
to be w illin g to deal on both sides o f the m arket at all times.
Regulation of investment banks

The regulatory provisions th a t apply to an investm ent bank w ill depend, at least in p art, on its structure
and the range o f services th a t it provides. An investm ent bank operating in Australia w ill be structured
either as an AD I or as a money m arket corporation. Those th a t are ADIs w ill be subject to the provisions
o f the Banking Act 1959 and to prudential supervision by APRA (w w w .a p ra .g o v .a u ). Investm ent banks
th a t are structured as money m arket corporations are n o t subject to prudential supervision, b ut are
required to register w ith, and provide statistical data to, APRA in accordance w ith the Financial Sector
(Collection of Data) Act 2001. Their name may n ot include the word ânk*, but guidelines issued by APRA
in January 2006 allow registered money m arket corporations to use expressions such as 'merchant bank*
in relation to th e ir business. Because they are corporations, they are also regulated by the Australian
Securities and Investments Commission (ASIC, w w w .a s ic .g o v .a u ) and are subject to the same conduct
and disclosure regulations as other corporations.
As a provider o f financial advice or as a dealer in financial markets, an investm ent bank m ust have
an Australian Financial Services Licence issued by ASIC. In addition, m ost o f those th a t trade in the
financial markets are members o f the Australian Financial M arkets Association (AFMA, w w w .a fm a .
c o m .a u ). AFM A is an ind ustry association th a t represents the in s titu tio n s th a t operate in Australia’s
over-the-counter financial markets. It imposes a degree o f self-regulation through measures such as its
code o f conduct, codification o f m arket conventions and standardisation o f documentation.
Developments in Australian investment banking

A fte r the deregulation o f the banks in the 1980s, lending became a much less im p o rta n t activity o f money
m arket corporations, while other investm ent banking activities have grown considerably. Therefore, the
value o f th e ir assets and the associated m arket shares shown in Table 8.3 (see Section 8.3) are n o t good
measures o f the sectors importance. O ther measures, such as the value o f equity capital raised and fees
earned, are better indicators o f the importance o f investm ent banking. As noted above, investm ent banks
th a t engage in securities trading and u n d erw riting w ill usually be members o f AFM A. In 2013, AFM A
had more than 130 members and there are many investm ent banks th a t are n ot members o f AFMA.
These non-members do n o t trade in the financial markets and focus instead on activities such as advisory
services, investm ent and funds management.
Investm ent banking can involve inherent conflicts o f interest th a t m ust be managed i f they cannot
be avoided. These conflicts are m ost likely to arise in cases where the firm has a wide range o f activities
including stockbroking, securities trading and u nderw riting. In such cases, investors and regulators may
be concerned th a t the broking analysts* recommendations on which shares to buy or sell may be influenced
by th e ir colleagues who are seeking to attract or retain business in u nd erw riting or corporate advisory
activities. Further, i f share trading undertaken by one section o f an investm ent bank is m otivated by
confidential inform a tion gathered by another section o f the bank, then the bank may be subject to a
charge o f insider trading. The standard approach to managing such conflicts o f interest is to employ
internal barriers— know n as inform a tion barriers or, more frequently, Chinese walls_ to lim it the flow
o f confidential client inform a tion between departments.
Concerns about the effectiveness o f Chinese walls were widely publicised in the US in 2001. One outcome
was that M errill Lynch agreed to pay a fine o f US$100 m illion because o f allegations th a t its broking analysts
issued overly optim istic reports on the shares o f companies that were clients o f its investment banking
operation. In Australia, ASIC took civil action against Citigroup in 2006 in the only recorded Australian case to
consider Chinese walls as a defence against insider trading (Overland and Li, 2012). Citigroup was successful
in defending the charges but the outcome o f the case highlights the importance o f m aintaining adequate
Chinese wall arrangements. In particular, the policies and procedures underpinning such arrangements
should be documented extensively, and understood and applied by employees. Some investment banks
avoid any exposure to inherent conflicts o f interest by restricting the scope o f th e ir activities. Firms that
take this approach focus on advisory services and do n ot engage in securities trading or underwriting.
Investment banks and the global financial crisis

The global financial crisis saw m ajor investm ent banks in the US experience severe stress. Bear Stearns
suffered a severe liq u id ity shortage in March 2008 and failure was avoided only when J. P. Morgan Chase
agreed to purchase Bear Stearns in a takeover facilitated by government authorities. By the end o f August
2008, the losses th a t had been recognised by financial in stitu tio n s w ritin g down the values o f assets
had accumulated to a global to ta l o f around US$500 billion. Pressure on the equity prices o f financial
institutions made it more d iffic u lt fo r banks to replenish th e ir depleted capital bases or to raise loan
funds from markets where lenders were unw illing to accept anything other than the lowest credit risks.
W ith th e ir higher leverage and exposures to impaired assets, investm ent banks experienced the greatest
pressure. O f the m ajor US investm ent banks, Lehman Brothers, w ith assets o f about $639 billion, faced
the m ost severe problems and when it was unable to raise urgently needed funding the company filed for
bankruptcy protection in September 2008— the largest ‘bank’ failure in US history.
The failure o f Lehman Brothers and the planned takeover o f M e rrill Lynch by the Bank o f America
would leave just two big investm ent banks: Goldman Sachs Group Inc. and Morgan Stanley. A week after
Lehman Brothers failed, the US central bank, the Federal Reserve, announced that, at a 9 pm meeting, its
Board o f Governors had approved applications delivered earlier th a t day by b oth firm s to become bank
holding companies— th a t is, firm s th a t own or control banks. The im plications o f this change o f status
included regulation by the Federal Reserve instead o f the Securities and Exchange Commission, lower
financial leverage, greater reliance on deposits from retail customers rather than borrow ing by issuing
bonds and probably less risk taking. A report by Bloomberg began:
The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs
Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors
have determined the model is broken.8
W hile the effects in Australia were less severe than in the US, the global financial crisis had significant
effects on investm ent banks in Australia. The Sydney-based investm ent bank Babcock & Brown (B&B),
which listed on the ASX in 2004 and had at its peak 28 offices worldwide and a m arket capitalisation in
excess o f $9 billion , became a victim o f the crisis when it failed in 2009. B&B had a leading role as an adviser
on structured finance including leases and securitisation, invested in real estate and infrastructure as a
principal and managed several satellite* funds th a t i t established. B&B relied heavily on short-term debt
to finance its holdings o f m ostly illiq u id assets, such as real estate and shareholdings in unlisted related
businesses. W ith financial markets disrupted and concerns about the high debt levels o f B&B and its
satellite funds, the company was unable to refinance its debt and was placed in voluntary adm inistration
in March 2009 and then in to liqu id atio n in August 2009. The Australian subsidiaries o f US and European
8 See Harper and Torres (2008).

B usiness finance
investm ent banks such as M e rrill Lynch and UBS reduced th e ir workforces to offset lower revenues.
As financial markets stabilised in 2009 and 2010, these and other investm ent banks were able to earn
substantial fees by arranging and u nd erw riting share issues fo r companies whose managers recognised
the need to reduce th e ir financial leverage.
8.3 Financial interm ediaries

Financial intermediaries borrow funds on th e ir own behalf and then lend the funds to another party.
LEARNING The types o f financial intermediaries in the Australian capital m arket include banks, money m arket
OBJECTIVE 4
corporations, finance companies, building societies and credit unions. Recent statistics on the assets o f
the role of financial
the financial interm ediaries th a t are im p o rta n t as lenders to businesses are shown in Table 8.3.
intermediaries
TABLE 8.3 Total assets of selected financial intermediaries ($ billion) and market
shares (percentage of total)
r B a n ks
M o n e y m a rk e t
c o rp o ra tio n s F in a n c e c o m p a n ie s Total
3 0 June $ b illio n % $ b illio n % $ b illio n , % $ b illio n
1990 325.8 74.9 53.6 12.3 55.4 12.7 434.8
1995 437.9 82.1 51.2 9.6 44.4 8.3 533.5
2000 731.0 84.5 63.7 7.4 70.9 8.2 865.6
2005 1363.5 89.1 80.1 5.2 86.5 5.7 1530.1
2006 1581.1 90.0 79.0 4.5 97.3 5.5 1757.4
2007 1876.9 89.4 106.7 5.1 116.1 5.5 2099.7
2008 2324.1 90.3 121.9 4.7 129.5 5.0 2575.6
2009 2590.2 92.3 94.5 3.4 121.1 4.3 2805.8
2010 2613.2 93.9 64.8 2.3 103.9 3.7 2781.8
2011 2733.2 94.1 66.7 2.3 104.5 3.6 2904.5
2012 2964.9 95.1 49.1 1.6 104.9 3.4 3118.8
2013 3103.0 95.2 43.6 1.3 111.8 3.4 3258.5
8.3.1 | Banks
The to ta l assets o f financial in stitu tio n s in Australia are shown in Table 8.1. As can be seen from the table,
banks are the largest group o f financial in stitu tio n s in Australia. As at June 2013, th e ir assets accounted
directly fo r more than 58 per cent o f the assets held by all financial in stitu tio n s. However, this understates
the overall importance o f banks because many o f them also have interests in other financial institutio ns,
such as investm ent banks, finance companies, insurance companies, fund managers and stockbrokers.
Accordingly, banks— p articularly the larger ones— provide a wide range o f products and financial services
including funds management, insurance, und erw riting , security dealing and stockbroking. In many cases,
these activities are carried out through subsidiaries and affiliated businesses.
A m ajor part o f banking business is borrow ing from depositors and other investors and lending to a
wide range o f borrowers, including governments, businesses and consumers. Therefore, banks need to
offer services th a t attract both borrowers and depositors. The m ain attraction to borrowers is obvious:
access to debt capital. Banks are large lenders to the business sector, and in the 12-m onth period ended
June 2013 accounted fo r more than 90 per cent o f commercial lending by interm ediaries.9 But banks offer
more than mere access to debt capital— they offer a wide range o f loans w ith different characteristics.
For example, there are short-term loans and long-term loans, secured loans and unsecured loans, fixed-
interest rate loans and variable-interest rate loans, and domestic-currency loans and foreign-currency
loans. The most distinctive fo rm o f bank lending is the overdraft facility, which involves an arrangement
whereby borrowers may draw funds, at th e ir discretion, up to a specified lim it.
How do banks attract depositors? A n obvious answer is: by paying interest. But why would someone
deposit money in a bank, which then lends the money to a borrower, when the banks deposit interest
rate is almost certainly less than the interest rate charged to the borrower? In other words, why n o t lend
directly, instead o f going through the bank? The answer is that, in addition to paying interest, banks
provide valuable services to th e ir depositors, including:
• Credit assessment. Banks typically have much greater expertise than depositors in assessing the
quality o f loan applicants, thus reducing default risk. DEFAULT RISK
• Credit enhancement. Partly by applying th e ir credit assessment skills, banks are able to offer low -risk the chance that a
borrower will fail
investments to depositors, even i f some o f the loans made by the bank are high risk.
to meet obligations
• Diversification. Banks reduce risk by lending to a much w ider variety o f borrowers than an individual to pay interest and
depositor could.10 principal as promised
• Maturity transformation. Depositors often wish to lend fo r short periods (such as a few m onths or
a few years) whereas borrowers often wish to borrow fo r term s o f many years; banks make this
transform ation possible.
• Transaction services. Banks assist depositors to receive and pay funds by (for example) cheques and
electronic transfers.11
In addition to m aking loans and meeting the needs o f depositors, banks also provide many other
services. These services include assisting clients to borrow from sources o ther than the bank by providing
guarantees, letters o f credit and b ill acceptances. O ther services assist clients in risk management and
involve market-related activities such as entering in to forw ard rate agreements, transacting in various
foreign-currency contracts and dealing in derivatives.
As at 11 October 2013, 69 banks were authorised to operate in Australia. O f these, 21 were
predominantly Australian owned, eight were subsidiaries o f foreign banks and 40 were branches
o f foreign banks. A foreign bank subsidiary is incorporated in Australia and m ust hold capital w ith in
Australia, whereas a foreign bank branch is essentially just a p art o f the parent bank th a t is authorised
to conduct banking business w ith in Australia. As discussed below, foreign bank branches are subject
to some restrictions th a t do n o t apply to subsidiaries o f foreign banks. Some foreign banks have both
a branch and a subsidiary in Australia. As from 1 July 1998, the responsibility fo r bank supervision
was transferred from the RBA to APRA. The RBA retains responsibility fo r m onetary policy and the
maintenance o f financial stability, including th a t o f the payments system— which is the cash, cheque and
electronic means by which payments are effected. As a result, the current regulatory structure requires
close cooperation between the RBA and APRA.
An a uth ority from APRA is required before a bank is perm itted to operate in Australia. APRA also
imposes a number o f other controls over banks, including m inim um capital requirements and asset
requirements. Banks are also required to provide APRA w ith extensive data on th e ir activities and
management systems. W hile subsidiaries o f foreign banks are subject to the same requirements as
locally owned banks, branches o f foreign banks are n ot subject to m inim um capital requirements in
Australia. However, such branches are effectively confined to operating in the wholesale m arket because
they are n ot perm itted to accept in itia l deposits o f less than $250000 from Australian residents and
non-corporate institutio ns. Therefore, a foreign bank th a t wishes to operate in the retail m arket m ust
establish a subsidiary in Australia.
Before the global financial crisis, the Australian government did n o t explicitly guarantee deposits in
Australian banks. As p art o f its response to the crisis, the government introduced an explicit guarantee
9 This percentage is derived from the Australian Bureau of Statistics publication L e n d in g F in an ce, A u str a lia , cat. no. 5671.0,
Table 3.
10 See Chapter 7 for a discussion of how diversification of a portfolio can reduce risk.
11 Banks are the major participants in the payments system in the settlement of cheques, which is conducted through exchange
settlement accounts at the RBA.
B usiness finance
Finance
GOVERNMENT GUARANTEE EXTENDED O N BANK DEPOSITS
in ACTION
P r io r to th e g lo b a l f in a n c ia l c ris is , b a n k d e p o s its in A u s t r a lia w e r e n o t g u a r a n t e e d , a lth o u g h
d e p o s it in s u r a n c e s c h e m e s w e r e c o m m o n in o t h e r c o u n tr ie s . F a c e d w ith a c ris is o f c o n fid e n c e in
la te S e p t e m b e r / e a r ly O c t o b e r 2 0 0 8 , m a n y g o v e r n m e n ts in c r e a s e d th e lim it o n th e a m o u n t o f
d e p o s its g u a r a n t e e d u n d e r th e s e s c h e m e s w h ile o th e rs w e n t fu r t h e r b y p r o v id in g a g u a r a n t e e
o v e r a ll d e p o s its , t y p ic a lly f o r a s e t p e r io d o f a r o u n d 2 y e a r s . S o m e g o v e r n m e n ts a ls o m o v e d to
p r o v id e a g u a r a n t e e o n w h o le s a le b o r r o w in g b y d e p o s it - ta k in g in s titu tio n s . W h il e m o s t A u s t r a lia n
in s titu tio n s r e m a in e d s o u n d a n d p r o f it a b le , th e A u s t r a lia n g o v e r n m e n t to o k s im ila r m e a s u re s
so t h a t A u s t r a lia n b a n k s a n d o fh e r d e p o s it - ta k in g in s titu tio n s w o u ld n o t b e d is a d v a n t a g e d
in te r n a tio n a lly . A n a r t ic le in T /ie A g e o u t lin e d th e g o v e r n m e n t's in itia tiv e s .
T h e G o v e r n m e n t w i l l g u a r a n t e e t h e $ 6 0 0 —$ 7 0 0 b i l l i o n d e p o s it s in A u s t r a lia n f i n a n c i a l
in s t it u t io n s in a m o v e t o s h o r e u p lo c a l c o n f id e n c e a n d p r o t e c t t h e n a t i o n ’ s in t e r n a t i o n a l
c o m p e t it iv e n e s s . D e c la r i n g t h a t t h e c o u n t r y is in 't h e e c o n o m ic e q u i v a le n t o f a r o l lin g
n a t io n a l s e c u r it y c r is is 7, [ P r im e M in is t e r ] K e v in R u d d h a s a ls o a n n o u n c e d t h a t a l l b o r r o w i n g
b y A u s t r a lia n b a n k s a n d o t h e r d e p o s it - t a k in g in s t it u t io n s f r o m o v e r s e a s w i l l b e g u a r a n t e e d .
T h e d e p o s it a n d le n d in g g u a r a n t e e s a r e u n p r e c e d e n t e d in A u s t r a lia n b a n k i n g h is t o r y
a n d a r e a n im m e d ia t e r e s p o n s e t o t h e d r a m a t i c m o v e s b y o t h e r c o u n t r ie s t o p r o p u p
t h e ir f a i l i n g f i n a n c i a l s y s te m s . . . . A u s t r a lia n b a n k s w e lc o m e d t h e G o v e r n m e n t 's m o v e s .
A u s t r a lia n B a n k e r s A s s o c i a t io n c h i e f e x e c u t iv e D a v id B e ll s a id A u s t r a lia n b a n k s w e r e w e ll
c a p it a l is e d b u t w e r e s till a f f e c t e d b y t h e s e iz u r e o f i n t e r n a t i o n a l f i n a n c i a l m a r k e ts . 'T h is
le v e ls t h e p l a y i n g f ie l d a n d a l lo w s A u s t r a lia n b a n k s t o c o m p e t e e q u a l l y a n d f a i r l y 7, h e
s a id .
Source: 'Rudd's $700 billion bank guarantee,/ Michelle Grattan and Vanessa O'Shaughnessy, The Age, 13 October 2008.
on deposits in banks and other AD Is.12 (See Finance in Action.) Some o f these guarantees were temporary
b u t the government continued to guarantee deposits o f up to $250 000 per person per ADI.
The Australian banking sector is dominated by fo ur m ajor banks, the AN Z Banking Group (www.
|w w w j
anz.com.au), the Commonwealth Bank o f Australia (w w w.com m bank.com .au), the N ational Australia
Bank (w w w .national.com .au) and Westpac Banking Corporation (www.westpac.com .au). These
banks accounted fo r 79 per cent o f the to ta l assets o f the Australian banking sector as at October 2013
(APRA 2013c). Each has a nationwide branch netw ork and provides a fu ll range o f banking services for
individuals as well as business customers b oth locally and overseas. O ther Australian-owned banks are
smaller and many are referred to as Regional banks’ because they originally had a regional base in one
state. M any o f these smaller banks, including the Bendigo and Adelaide Bank, Suncorp Bank and the Bank
o f Queensland, have since expanded to compete w ith the m ajor banks by achieving broader coverage of
the Australian market.
Historically, foreign-owned banks played only a m in o r role in the Australian financial system. However,
in recent years they have attracted increased a tte ntio n through measures such as attractive interest rates
paid on internet-based savings accounts. Foreign banks have also begun to compete more aggressively in
lending in Australia and at the end o f 2008 they held around 16 per cent o f overall Australian bank assets.
However, by the end o f October 2013, th e ir share o f bank assets had declined to 11.5 per cent (APRA
2013c).
Following the collapse o f the m ajor US firm Lehman Brothers in September 2008 and the failure
or near-failure o f many other financial institutio ns, there was a widespread loss o f confidence in the
solvency o f financial in stitu tio n s and the sta bility o f the global financial system. Governments in several
countries, including Australia, moved to restore confidence through measures th a t were in some cases
unprecedented. As m entioned above, in Australia one o f the m ajor changes was the announcement o f an
explicit government guarantee o f bank deposits.
12 For discussion of the guarantee measures, see Schwartz (2010).

8 .3 .2 1 Money market corporations

The activities o f money m arket corporations (MMCs) were discussed in Section 8.2.2. Table 8.3 shows
that the assets o f these in stitu tio n s have declined from around 10 per cent o f the to ta l assets o f banks,
MMCs and finance companies in the mid-1990s to around 5 per cent from 2004 to 2008; they then fell
fu rth e r to only 1.3 per cent in 2013. As discussed in Section 8.2.2, the long-term decline reflects the
ongoing effects o f the deregulation o f the Australian financial system, whereby restrictions th a t applied to
banks were removed, allowing them to strengthen th e ir com petitive position at the expense o f non-bank
financial intermediaries. The more rapid decline over the 2008 to 2013 period coincides w ith the global
financial crisis and its afterm ath. Since MMCs are n o t authorised deposit-taking in s titu tio n s (ADIs) th eir
borrowings were not covered by the government guarantee announced in October 2008.
8 .3 .3 | Finance companies
Initially, finance companies were p rim a rily concerned w ith lending to individuals by providing instalm ent
credit for retail sales. In 1954 this accounted fo r 85 per cent o f finance company lending b ut by June
2010, lending to individuals accounted fo r only 27 per cent o f the to ta l assets o f finance companies.13
Finance companies grew rapidly during the period in which the Australian financial markets were
highly regulated. They offered a wide range o f financial services fo r companies, including instalm ent credit,
lease financing, inventory financing, discounting o f accounts receivable, mortgages and other commercial
loans. Their success was due largely to the regulatory constraints on th e ir natural competitors, the banks.
In fact, each o f the m ajor banks acquired a finance company subsidiary in order to gain access to markets
denied them by bank regulations.
The deregulation o f the banking sector in the 1980s removed much o f the competitive advantage
h itherto enjoyed by finance companies. As can be seen from Table 8.3, the assets o f finance companies
have grown at a much lower average rate than the assets o f banks over the period from 1995 to 2013 and
declined in dollar terms from 2008 to 2013. Many finance companies have become specialised in stitu tio n s
focusing on specific areas such as m otor vehicle finance or the financing o f machinery and equipment.
8 .3 .4 | Securitisation14
S e c u ritis a tio n is the process o f converting illiq u id assets such as bank loans in to tradable securities. In
a typical case, an originator o f financial assets— such as a bank th a t has provided a significant number
o f housing loans— sells a p o rtfo lio o f these loans to a specially created company or trust. This entity, LEARNING
OBJECTIVE 5
generally referred to as a securitisation vehicle or special purpose vehicle (SPV), finances its purchase Outline the role of
o f the loans by issuing tradable securities to investors using the underlying assets (the housing loans) securitisation
as collateral. I f these securities are long term they are generally referred to as asset-backed bonds, or i f
SECURITISATION
the loans involved are all mortgage loans over residential property, the securities may be referred to as
the process of making
residential mortgage-backed securities (RMBS). I f the securities are short term — th a t is, th e ir term to assets marketable by
m aturity is less than a year— they may be referred to as asset-backed commercial paper (ABCP). The end aggregating income-
result is th a t securitisation allows a financial in s titu tio n to fund its lending indirectly through the capital producing assets in a
market instead o f by the trad ition al m ethod o f gathering deposits or borrow ing directly in its own name. pool and issuing new
securities backed by
A traditional interm ediary assesses loan applications and provides funds to approved loan applicants.
the pool
One advantage claimed fo r securitisation is th a t it enables the credit assessment fu nctio n to be separated
from the funding function. That is, the lending in s titu tio n continues to assess loan applicants but, through
securitisation, the funds are provided by investors. One view is th a t this process enables in stitu tio n s to
specialise in either credit assessment or funding, depending on where th e ir expertise lies. A nother view
is that this separation may incur agency costs: the credit assessor may n o t bear the fu ll costs o f making
poor assessments.
The securitisation m arket in Australia has been dominated by securitisation o f residential mortgages
but the range o f assets that can be securitised also includes commercial mortgages, leases, trade receivables
13 See Reserve Bank of Australia, Table B10, www.rba.gov.au.

14 Facts related to the Australian securitisation market mentioned in this section are mostly drawn from Reserve Bank of
Australia (2004) pp. 48-56 and Debelle (2009).
B usiness finance
a n d m o to r v e h icle lo an s. A s s h o w n in Table 8.1, th e assets o f A u s tra lia n s e c u ritis a tio n ve h icle s g re w fro m
a ro u n d $ 1 0 b illio n in J u n e 1 9 9 5 to a p e a k o f $ 2 7 4 b illio n in J u n e 2 0 0 7 b u t th e n fe ll to $ 1 2 8 b illio n in
Ju n e 2 0 1 3 . D u rin g th e p e rio d o f ra p id g ro w th t h a t co m m e n ce d in th e 19 90 s, th e share o f re s id e n tia l
m o rtg a g e lo a n s fu n d e d th ro u g h s e c u ritis a tio n in cre a se d fr o m less th a n 10 p e r c e n t in th e la te 1990s
[ wwn^] to a lm o s t 25 p e r c e n t in J u n e 2 0 0 7 (see D e b e lle 2 0 0 9 , p. 4 3 ). C u rre n t in fo r m a tio n a b o u t s e c u ritis a tio n
is p ro v id e d b y th e A u s tra lia n S e c u ritis a tio n F o ru m (ASF, w w w .securitisation.com .au). The assets o f
A u s tra lia n s e c u ritis a tio n ve h icle s are s h o w n in Table 8.4.
TABLE 8.4 Assets of securitisation vehicles, $ million

O th e r
lo a n s a n d Asse 卜backed O th e r A ll o th e r
3 0 Ju n e M o r tg a g e s p la c e m e n ts bonds se cu ritie s assets Total assets
I
1990 4794 845 5734
1995 5358 1456 928 1229 894 9845
2000 41306 7905 8072 2515 5 216 65014
2005 146984 11293 12286 3972 9970 184505
2006 176288 11162 13738 2946 12327 216461
2007 215201 17319 18907 3025 19525 273977
2008 179669 19106 20997 2753 16715 239240
2009 142885 15346 15858 525 18104 192718
2010 115 794 11922 9229 0 8835 146073
2011 110666 13353 6983 255 4813 136070
2012 106495 13747 1556 0 5 024 12 6 8 2 2
2013 106156 14175 1374 0 5554 127259
The ra p id g ro w th in s e c u ritis a tio n u p to 2 0 0 7 can be a ttr ib u te d to tw o m a in fa c to rs . F irs t, th e d e m a n d

f o r h o u s in g fin a n c e in A u s tra lia re m a in e d s tro n g . Second, th e c o m p o s itio n o f le n d e rs in th e m o rtg a g e
m a rk e t changed, w it h m o rtg a g e o rig in a to rs t h a t s e c u ritis e a lm o s t a ll o f t h e ir lo a n s g a in in g a g ro w in g share
a fte r e n te rin g th e m a rk e t in th e 19 90 s (D e b e lle 2 0 0 9 , p p . 4 3 - 4 ) . The fa ll in th e assets o f s e c u ritis a tio n
vehicles a fte r 2 0 0 7 is a n o th e r o u tc o m e o f th e g lo b a l fin a n c ia l c ris is . A t tim e s d u r in g th is crisis, m a rk e ts
f o r asset-backed s e c u ritie s w e re e ffe c tiv e ly fro z e n , w ith m a n y sellers b u t n o b u ye rs, so th e re was li t t le i f
a n y tra d in g in s e c o n d a ry m a rk e ts . Issuance o f n e w s e c u ritie s d e c lin e d m a rk e d ly a n d in som e cases ceased
a lto g e th e r. W it h re p a y m e n ts o n th e u n d e rly in g lo a n s b e in g a p p lie d to a m o rtis e th e p r in c ip a l o f e x is tin g
s e c u ritie s a n d m in im a l issuance o f n e w s e c u ritie s , th e assets o f s e c u ritis a tio n veh icle s in e v ita b ly fe ll.
8.4 Investing institutions

The m a in in v e s tin g in s titu t io n s in A u s tra lia are life in s u ra n c e com p an ies, s u p e ra n n u a tio n fu n d s , p u b lic
LEARNING u n it tr u s ts a n d ge n e ra l in s u ra n c e co m p a n ie s. A s n o te d e a rlie r, m a n y o f the se in s titu t io n s are o w n e d b y
OBJECTIVE 6
b a n ks o r are m e m b e rs o f fin a n c ia l c o n g lo m e ra te s . There is also s ig n ific a n t o v e rla p b e tw e e n th e categories.
the role of investing In p a rtic u la r, m a n a g e m e n t o f s u p e ra n n u a tio n fu n d s is a m a jo r a c tiv ity o f life in s u ra n c e com p an ies, so
institutions m o s t o f th e assets h e ld b y the se co m p a n ie s are w it h in s u p e ra n n u a tio n fu n d s .
8.4.1 | Insurance companies and superannuation funds

As s h o w n in Table 8.1, th e t o ta l assets o f ge ne ral in s u ra n c e co m p a n ie s are a ro u n d $ 1 7 5 b illio n , w h ic h
is a b o u t 3 p e r ce n t o f th e assets o f a ll A u s tra lia n fin a n c ia l in s titu tio n s . In A u s tra lia , m o s t o f th e g e ne ral
in su ra n ce b u sin ess in vo lve s p r o v id in g in s u ra n c e c o ve r f o r assets such as m o to r veh icle s a n d b u ild in g s
w h ere a n y losses are g e n e ra lly in c u rre d w it h in 12 m o n th s o f re c e iv in g th e p re m iu m . In s u ra n c e com p an ies
u s u a lly m a tc h th e d u ra tio n o f t h e ir assets w ith th e d u ra tio n o f t h e ir lia b ilitie s . T h e re fo re , w h ile g e ne ral
in su ra n ce com panies do m a k e som e lo n g -te rm in v e s tm e n ts , th e m a jo r ity o f t h e ir assets are s h o rt
te rm . This fa c to r, to g e th e r w it h t h e ir re la tiv e ly s m a ll size, m ea ns t h a t ge n e ra l in s u ra n c e co m p a n ie s are
n o t a m a jo r source o f c o m p a n y fin a n ce . Hence, in th is s e c tio n w e fo cu s o n life in s u ra n c e com p an ies
a n d s u p e ra n n u a tio n fu n d s , w h ic h m ake lo n g e r te r m in v e s tm e n ts . In s u ra n c e co m p a n ie s a n d m o s t
s u p e ra n n u a tio n fu n d s are re g u la te d b y A P R A , th e o n ly e x c e p tio n b e in g se lf-m a n a g e d s u p e ra n n u a tio n
fu n d s (SMSFs) w h ic h are re g u la te d b y th e A u s tra lia n T a x a tio n O ffice .
L ife in su ra n ce co m p a n ie s a n d s u p e ra n n u a tio n fu n d s are m a jo r sources o f co m p a n y fin a n ce .
These in s titu tio n s raise la rg e a m o u n ts as p re m iu m s a n d c o n trib u tio n s , w h ic h are la rg e ly lo n g -te rm
c o m m itm e n ts and, a cco rd in g ly, such in s titu t io n s te n d to a cq u ire lo n g -te rm assets such as shares issu e d b y
p u b lic com p an ies, an d b o n d s a n d o th e r fo rm s o f d e b t issu e d b y g o v e rn m e n ts a n d com p an ies. A u s tra lia s
s u p e ra n n u a tio n in d u s tr y has g ro w n ra p id ly since th e e a rly 19 90 s in resp on se to th e C o m m o n w e a lth
G o v e rn m e n t s s u p e ra n n u a tio n g u a ra n te e charge p o lic y , w h ic h a im s to p ro m o te u n iv e rs a l s u p e ra n n u a tio n
coverage. The g ro w th o f assets w it h in th e s u p e ra n n u a tio n s yste m is e xp e cte d to c o n tin u e , a lth o u g h th e
ra te o f g ro w th w ill be in flu e n c e d b y changes in g o v e rn m e n t p o lic y a n d flu c tu a tio n s in in v e s tm e n t re tu rn s .
Table 8.5 show s th e re c e n t g r o w th in b o th th e assets h e ld b y s u p e ra n n u a tio n fu n d s a n d th e to t a l n u m b e r
o f fu n d s .
TABLE 8.5 Assets and number of funds—superannuation funds

N u m b e r o f s u p e ra n n u a tio n e n titie s c la s s ifie d b y ty p e
A s s e ts ~ P u b li 7 _ P o o le d s u p e r
3 0 Jun e ; ($ b illio n ) j C o r p o ra te In d u s try se cto r R e ta il S m a ll a n n u a tio n trusts Total
____ ：
_____________ ____：
___ ：
______ j
2000 484.2 3389 155 81 293 212538 164 216620
2005 751.4 962 90 43 228 296813 130 298266
2006 904.2 555 80 45 192 315924 123 316919
2007 1172.8 287 72 40 176 356309 101 356985
2008 1131.0 226 70 40 169 381413 90 382008
2009 1067.4 190 67 40 166 404131 82 404676
2010 1198.5 168 65 39 154 418928 79 419433
2011 1350.9 143 61 39 143 446597 77 447060
2012 1400.5 122 56 39 135 481538 67 481957
Source: Australian Prudential Regulation Authority, www.apra.gov.au, Annual Superannuation Bulletin, June 2006, June
2010 and June 2013a.
The la rge increase in to t a l s u p e ra n n u a tio n assets o v e r th e 7 years to J u n e 2 0 0 7 re fle c ts th e c o m b in e d

effects o f p o s itiv e n e t c o n tr ib u tio n flo w s — t h a t is, c o n trib u tio n s exceeded b e n e fits p a id — a n d s tro n g
in v e s tm e n t re tu rn s o n som e asset classes, p a r tic u la r ly A u s tra lia n e q u itie s , a fte r 2 0 0 2 . In th e years
im m e d ia te ly a fte r 2 0 0 7 , n e t c o n trib u tio n s re m a in e d p o s itiv e b u t fa lls in th e value s o f m a n y fin a n c ia l
assets, p a rtic u la rly e q u itie s , m e a n t t h a t t o ta l s u p e ra n n u a tio n assets d e c lin e d in 2 0 0 8 a n d 20 09 . Since
20 09 , th e assets h e ld b y s u p e ra n n u a tio n fu n d s have re su m e d t h e ir lo n g -te rm tre n d , g ro w in g b y 31 p e r
ce n t in th e 2 0 0 9 to 2 0 1 2 p e rio d .
The s ig n ific a n t increase in th e n u m b e r o f fu n d s o v e r th e p e rio d covered b y Table 8 .5 is due e n tire ly
to g r o w th in th e n u m b e r o f s m a ll fu n d s , m o s t o f w h ic h are SMSFs. The n u m b e r o f s m a ll fu n d s is
d is p ro p o rtio n a te ly h ig h re la tiv e to th e v a lu e o f t h e ir assets. To illu s tra te , a t 30 J u n e 2 0 1 2 s m a ll fu n d s
a cco u n te d f o r 9 9 .9 p e r c e n t o f th e to t a l n u m b e r o f fu n d s b u t o n ly 31 .5 p e r c e n t o f th e to t a l assets h e ld b y
s u p e ra n n u a tio n fu n d s (A P R A 2 0 1 3 c, Tables 1 a n d 9).
W h ile th e n u m b e r o f s m a ll fu n d s has g ro w n stro n g ly, Table 8.5 shows th a t th e n u m b e r o f fu n d s in o th e r
categories, p a rtic u la rly c o rp o ra te fu n d s , has d e clin e d d ra m a tic a lly in rece nt years. In la rge p a rt, th is decline
refle cts th e effects o f lic e n s in g re q u ire m e n ts th a t w ere phased in d u rin g a tra n s itio n a l p e rio d th a t ended on
30 J u n e 2 0 06 . The tru ste e s o f m a n y sta n d -a lo n e c o rp o ra te fu n d s chose n o t to seek a licence a n d th e m em bers
an d assets o f these fu n d s w ere tra n s fe rre d to o th e r fu n d s , p a rtic u la rly in d u s try fu n d s and re ta il fun ds.
The v a lu e o f assets h e ld b y s u p e ra n n u a tio n fu n d s o u ts id e life in su ra n ce co m p a n ie s is s h o w n in
Table 8.6. I t show s t h a t s u p e ra n n u a tio n fu n d s are la rge , a n d g ro w in g , in v e s to rs in th e shares o f A u s tra lia n
co m p a n ie s a n d in u n its in tru s ts . These assets ty p ic a lly a cco u n te d f o r a b o u t 45 p e r c e n t o f t o ta l fu n d assets
in th e la s t fe w years, co m p a re d w it h less th a n 3 0 p e r c e n t in 1 9 9 0 . These fig u re s , in c o n ju n c tio n w it h tho se
in Table 8.1, s h o w t h a t s u p e ra n n u a tio n fu n d s are p o te n tia lly th e la rg e s t in s titu t io n a l source o f e q u ity
c a p ita l f o r A u s tra lia n co m p a n ie s. O verseas assets m ad e u p 19 p e r c e n t o f to t a l assets in 2 0 1 3 com p are d
w ith 1 1 .4 p e r c e n t in 19 90 . S im ila rly , cash a n d d e p o s its m ade u p 1 6 .4 p e r c e n t o f t o t a l assets in 20 1 3 ,
co m p a re d w it h o n ly 1 0 .7 p e r c e n t in 19 90 . In c o n tra s t, th e d e b t-ty p e in v e s tm e n ts — lo a n s, p la ce m e n ts
a n d s h o r t- te rm s e c u ritie s — decreased fr o m a lm o s t 15 p e r c e n t o f t o ta l assets in 1 9 9 0 to 6 .7 p e r c e n t in
2 0 1 3 , w h ile in v e s tm e n ts in lo n g -te rm g o v e rn m e n t s e c u ritie s d e c lin e d fr o m 10 .1 p e r ce n t o f assets in
1 9 9 0 to o n ly 1.7 p e r c e n t in 2 0 1 3 . W h ile d e b t-ty p e in v e s tm e n ts have d e c lin e d as a pe rce n ta g e o f fu n d
assets, th e a b s o lu te size o f t h e ir asset p o o l is such t h a t s u p e ra n n u a tio n fu n d s re m a in a s ig n ific a n t source
o f d e b t fin a n c e , e ith e r d ire c tly o r in d ire c tly , f o r businesses. F o r exa m ple, th e in v e s tm e n t o f $7 9 b illio n in
s h o r t- te rm s e c u ritie s a t J u n e 2 0 1 3 w o u ld in c lu d e b ills o f exchange issu e d b y c o rp o ra te b o rro w e rs . A lso ,
th e cash a n d d e p o s its o f $ 2 2 7 b illio n h e ld in 2 0 1 3 w o u ld c o n s is t m o s tly o f d e p o s its in b a n ks, w h ic h co u ld
use the se d e p o sits to fu n d lo a n s, in c lu d in g lo a n s to com p an ies.
M a n a g e m e n t o f s u p e ra n n u a tio n fu n d s is a v e ry im p o r ta n t a c tiv ity o f life in s u ra n c e com p an ies:
as a t J u n e 2 0 1 2 , assets h e ld in s u p e ra n n u a tio n fu n d s a cco u n te d f o r o ve r 90 p e r c e n t o f th e assets o f
these c o m p a n ie s, c o m p a re d to a b o u t 65 p e r c e n t in 1 9 9 2 . D e s p ite th is h ig h p r o p o r tio n , th e re has been
TABLE 8.6 Assets held by superannuation funds outside life nsurancec:ompanies, $ million
L o n g -te rm E q u itie s
C ash a n d i Loans a n d S h o rt-te rm g o v e rn m e n t a n d u n its in Land a n d O th e r A ssets
3 0 June d e p o s its 1 p la c e m e n ts se cu ritie s se c u ritie s trusts b u ild in g s assets o v e rs e a s Total assets
1990 8629 4234 7703 8191 23 770 12668 6399 9226 80820
1995 11143 5375 8794 20632 56 715 11006 8 513 21094 143272
2000 23469 16138 19376 19877 144266 17294 21239 68065 329724
2005 57443 5 292 25134 21579 281691 32157 29159 114419 566874
2006 70102 5 756 27261 28032 352674 36602 33 499 147312 701236
2007 114270 7220 36197 29755 476461 48408 49917 184930 947 157
2008 1 1 5 561 7981 40124 27253 453015 56986 52829 179601 933 351
2009 137118 9035 46467 22819 401814 61589 53281 148678 880803
2010 13 8 2 2 0 10272 55 206 25885 463862 66687 61191 171437 992 760
2011 16 8 9 5 0 11148 50200 21254 542262 76685 64796 187637 1122934
2012 208998 11963 60872 20661 525960 86089 66136 201064 1181742
2013 227003 13 232 78924 22857 621688 96450 60984 262926 1384066
Source: Table B15, Reserve Bank of Australia website, wvsrw.rba.gov.au.

TABLE 8.7 Assets held by life insurance companies—statutory funds, $ million

L o n g -te rm E q u itie s
C a sh a n d Loan s a n d S h o rt-te rm g o v e rn m e n t a n d u n its in ; L a n d a n d , O th e r A ssets
3 0 Ju n e ( d e p o s its p la c e m e n ts se cu ritie s se cu ritie s trusts b u ild in g s | assets o ve rse a s Total assets
1990 2 680 10 701 5 347 14 265 24 415 13 397 6 217 8 401 85 422
1995 4 912 5 817 9 927 23 779 38 076 9 486 9 321 17 214 118 532
2000 7 015 8 819 14 040 24 093 78 477 7 474 17 608 32 953 190 478
2005 4 429 2 577 12 757 13 441 156 021 n.a. n.a. 15 828 231 444
2006 4 777 4 396 11261 9 784 172 418 3105 21903 14 299 241 943
2007 5146 3 945 10 772 9 296 200 656 3 367 21 738 12 070 266 990
2008 4 643 3 975 8 771 9 405 173 943 2 710 20 814 11839 236 099
2009 7 816 3 594 10 349 7 091 149 238 1722 21 027 10 057 210 895
2010 7 261 2 337 9 821 7 066 165 534 1719 18 846 10 896 223 481
2011 8 464 2 284 6136 7 324 178 697 1829 18 765 11196 234 695
2012 11348 2 696 6 521 8 614 167 968 1871 21148 14 979 235 146
2013 12 034 1953 5 847 9 667 189 896 1520 19 303 14 986 255 206
Source: Table B1 4, Reserve Bank of Australia website, www.rba.gov.au.
a s ig n ific a n t d e clin e in th e share o f t o ta l s u p e ra n n u a tio n assets h e ld b y life in s u ra n c e co m p a n ie s. T h e ir

share o f th e t o ta l s u p e ra n n u a tio n p o o l p eaked a t 4 4 p e r c e n t in 1 9 9 2 b u t d e c lin e d to less th a n 15 p e r ce n t
b y J u n e 2 0 1 2 (APR A, 2 0 1 2 a ). The assets o f life in s u ra n c e co m p a n ie s are s h o w n in Table 8.7.
W h ile th e d a ta in Table 8 .7 w ill la rg e ly re fle c t th e assets h e ld in s u p e ra n n u a tio n fu n d s m a n a g e d b y
life in su ra n ce com p an ies, th e re are som e n o tic e a b le d iffe re n ce s b e tw e e n th e d is tr ib u tio n s o f assets in
Tables 8.6 an d 8.7. C o m p a re d w it h th e s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e co m p a n ie s, based
on th e 2 0 1 3 fig u re s, th e life in s u ra n c e com p an ies have in v e s te d a h ig h e r p r o p o r tio n o f t h e ir assets
in d o m e s tic e q u itie s a n d tr u s ts (7 4 .4 p e r c e n t versu s 4 4 .9 p e r c e n t), a lo w e r p r o p o r tio n in cash an d
d e po sits (4 .7 p e r c e n t versu s 1 6 .4 p e r c e n t) a n d a lo w e r p r o p o r tio n in overseas assets (5 .9 p e r c e n t versus
19.0 p e r ce n t). Table 8 .7 sho w s t h a t life in s u ra n c e c o m p a n ie s are n o t la rg e le n d e rs to th e c o rp o ra te sector.
H is to ric a lly , m o s t o f t h e ir in v e s tm e n t in d e b t to o k th e fo r m o f g o v e rn m e n t d e b t se c u ritie s . H o w eve r,
h o ld in g s o f ‘o th e r assets’，w h ic h in c lu d e s d e b t s e c u ritie s issu ed b y n o n -g o v e rn m e n t b o rro w e rs , have
te n d e d to increase as t h e ir h o ld in g s o f lo n g -te rm g o v e rn m e n t s e c u ritie s have de clin e d . In c o n tra s t, lik e
s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e com p an ies, th e y are s ig n ific a n t s u p p lie rs o f e q u ity , w ith
shares a n d u n its in tru s ts g e n e ra lly c o n s titu tin g b e tw e e n 70 a n d 75 p e r c e n t o f t h e ir to t a l assets a t th e
end o f J u n e each ye a r fro m 2 0 0 6 to 2 0 1 3 .
W h e n assessing th e asset d is tr ib u tio n s s h o w n in Tables 8 .6 a n d 8.7, tw o q u a lific a tio n s s h o u ld be n o te d .
F irs t, th e in v e s tm e n t b y s u p e ra n n u a tio n fu n d s a n d life in s u ra n c e com p an ies in p r o p e r ty is c o n s id e ra b ly
g re a te r th a n suggested b y th e fig u re s s h o w n f o r 4la n d a n d b u ild in g s 1. M a n y o f the se in s titu t io n s in v e s t
in p ro p e rty b y p u rc h a s in g u n its in re a l esta te in v e s tm e n t tru s ts (R E IT s)15 m a in ly because th e y p re fe r
th e liq u id ity t h a t these tru s ts p ro v id e , p a r tic u la r ly i f th e t r u s t is lis te d o n a s to c k exchange. These
in v e s tm e n ts are in c lu d e d in th e fig u re s f o r ‘E q u itie s a n d u n its in tr u s t s ’. Second, th e ‘s to c k ，fig u re s s h o w n
in these ta b le s do n o t n e ce ssa rily p ro v id e an accu rate in d ic a tio n o f th e w a y in w h ic h new m o n e y flo w in g
in to s u p e ra n n u a tio n is in ve ste d . F o r exa m ple, as n o te d above, th e ta b le s s h o w t h a t e q u itie s a n d u n its
15 Real estate investment trusts (REITs) were traditionally referred to as property trusts, which could be listed or unlisted.
The term REIT was adopted in Australia in 2008. Where such trusts are listed on the ASX, they are referred to as A-REITs.
in tru s ts m a ke u p a la rg e a n d ty p ic a lly g ro w in g p r o p o r tio n o f th e assets o f s u p e ra n n u a tio n fu n d s and
life in s u ra n c e co m p a n ie s. In th e case o f s u p e ra n n u a tio n fu n d s o u ts id e life in s u ra n c e com p an ies, th is
asset class in cre a se d fr o m less th a n 30 p e r c e n t o f to t a l assets in 1 9 9 0 to ju s t o v e r 5 0 p e r c e n t o f to ta l
assets in 2 0 0 7 a n d has since s ta b ilis e d a t a b o u t 4 5 p e r ce n t. Thus, i t m ig h t seem t h a t th e p r o p o r tio n o f
s u p e ra n n u a tio n c o n trib u tio n s d ire c te d in to d o m e s tic e q u itie s pe ake d a ro u n d 2 0 0 6 -0 7 a n d th e n declin ed .
H o w eve r, th e values o f th e v a rio u s assets h e ld a t a n y tim e w ill re fle c t p a s t re tu rn s as w e ll as th e p a tte r n o f
n e w in v e s tm e n t. The r e tu rn s o n A u s tra lia n shares w e re u n u s u a lly h ig h fr o m 2 0 0 2 to 2 0 0 7 b u t n e g a tiv e in
2 0 0 8 a n d 20 0 9 . S pe cifica lly, th e S & P /A S X A ll O rd in a rie s share p ric e in d e x , w h ic h w as 3 1 6 3 .2 a t th e e n d o f
J u n e 2 0 0 2 , a lm o s t d o u b le d to reach 6 3 1 0 .6 a t th e e n d o f J u n e 2 0 0 7 a n d th e n fe ll to 3 9 4 7 .8 a t th e e n d o f
J u n e 2 0 0 9 . T h e re fo re , o v e r th e 2 0 0 2 to 2 0 0 9 p e rio d , a ty p ic a l fu n d c o u ld e x h ib it an in crea se in th e value
o f e q u itie s as a pe rce n ta g e o f it s to t a l assets u p to 2 0 0 7 , fo llo w e d b y a d e clin e , even i f th e p r o p o r tio n o f
n e w c o n trib u tio n s in v e s te d in each asset class re m a in e d c o n s ta n t o v e r tim e . The reverse can also occur:
fr o m J u n e 2 0 0 9 to J u n e 2 0 1 3 , th e S & P /A S X A ll O rd in a rie s share p ric e in d e x rose b y 21 p e r c e n t b u t o ve r
th e sam e p e rio d th e share o f t o t a l assets h e ld as e q u itie s a n d u n its in tru s ts fe ll m a rg in a lly fr o m 4 5 .6 to
4 4 .9 p e r c e n t.
U n it tr u s ts are a c o m m o n f o r m o f c o lle c tiv e in v e s tm e n t in w h ic h th e fu n d s o f in v e s to rs are p o o le d a n d

in v e s te d b y a p ro fe s s io n a l m a n a g e m e n t co m p a n y in a w id e ran ge o f in v e s tm e n ts , u s u a lly o f a specific
asset ty p e . F o r e xa m p le , th e re are R EITs, A u s tra lia n e q u ity tr u s ts a n d in te r n a tio n a l e q u ity tru s ts . These
a n d a v a r ie ty o f o th e r p o o le d in v e s tm e n ts are cla ssifie d as ‘m a n a g e d in v e s tm e n t sche m es’. The re g u la to ry
re g im e f o r the se in v e s tm e n ts is set o u t in th e Managed Investments Act 1998. I t spe cifie s t h a t m an ag ed
in v e s tm e n t schem es are to be o p e ra te d b y a sin g le R esponsible e n tity *, w h ic h m u s t be an A u s tra lia n
p u b lic c o m p a n y h o ld in g an a p p ro p ria te A u s tra lia n F in a n c ia l Services Licence. M o s t o f th e se re sp o n sib le
e n titie s are su b s id ia rie s o f b a n ks, in v e s tm e n t b a n k s o r in s u ra n c e co m p a n ie s. In v e s to rs place t h e ir m o n e y
in p o o le d in v e s tm e n ts to o b ta in a spre ad o f r is k a n d to o b ta in re tu rn s fr o m assets t h a t are to o exp en sive
f o r in d iv id u a ls to p u rcha se d ire c tly .
F o r som e in v e s to rs , tr u s ts m a y also be a ttra c tiv e f o r ta x reasons. In ge n e ra l, a t r u s t is n o t ta xe d
p ro v id e d t h a t i t d is trib u te s a ll o f its in c o m e to in v e s to rs . Each in v e s to r is th e n ta x e d o n th e in c o m e
th e y re ce ive d fr o m th e t r u s t . 16 T h ere fore, t r u s t in c o m e is a lm o s t in v a ria b ly d is tr ib u te d in f u ll w hereas a
co m p a n y can r e ta in a ll o r p a r t o f its p r o f it to fin a n c e exp a n sio n .
M a n y tr u s ts are o p e n -e n d fu n d s , w h ic h m ea ns t h a t n e w u n its m a y be cre a te d c o n tin u a lly as in v e s to rs
c o n trib u te a d d itio n a l cash. These tru s ts are u n lis te d a n d in v e s to rs p u rch a se a n d re d e e m u n its a t values,
c a lc u la te d d a ily b y th e fu n d m an ag er, based o n th e v a lu e o f th e assets h e ld b y th e t r u s t . The t r u s t m a y b u y
a d d itio n a l assets a t a n y tim e a n d m a y ne ed to se ll assets a t tim e s in o rd e r to m e e t re d e m p tio n req ue sts
fr o m e x is tin g in v e s to rs . In J u n e 2 0 1 3 , p u b lic u n it tr u s t s 17 in A u s tra lia h a d t o ta l assets o f $ 2 3 8 b illio n
a n d a f u r t h e r $2 5 b illio n w as h e ld b y cash m a n a g e m e n t tr u s ts (R eserve B a n k o f A u s tra lia , Table B l, www.
rba.gov.au).
A w id e ran ge o f lis te d m a n a g e d in v e s tm e n ts (L M Is ) is also ava ila ble. A t th e e n d o f J u n e 2 0 1 3 , 2 0 4
m an ag ed in v e s tm e n ts w e re lis te d o n th e A S X a n d th e m a rk e t c a p ita lis a tio n o f the se e n titie s to ta lle d $ 1 63
b illio n . Based o n m a rk e t c a p ita lis a tio n a t t h a t tim e , th e la rg e s t c a te g o ry o f L M Is is re a l esta te in v e s tm e n t
tru s ts ($ 9 5 b illio n ) , fo llo w e d b y in fr a s tr u c tu r e fu n d s ($ 4 0 b illio n ) a n d lis te d in v e s tm e n t com p an ies
a n d tru s ts ($ 2 0 b illio n ) (A u s tra lia n S e cu ritie s E xchange, w w w .asx.com .au/products/m anaged-funds/
m arket-update.htm .)
REITs a llo w in v e s to rs to acq uire an in te re s t in a p ro fe s s io n a lly m a n a g e d p o r tf o lio o f re a l estate. Some
R EITs in v e s t o n ly in a p a r tic u la r ty p e o f re a l esta te such as in d u s tr ia l (w a reho use s a n d fa c to rie s ), offices,
h o te ls o r re ta il (s h o p p in g ce n tre s, m a lls a n d cin e m a s). O th e rs are m o re d iv e rs ifie d a n d in v e s t in tw o o r
m o re o f th e se ty p e s o f re a l estate. There are also in te r n a tio n a l R EITs, w h ic h are lis te d o n th e A S X b u t
in v e s t in sp e cific o ffs h o re m a rk e ts such as th e US, E u ro p e o r Japan.
16 In many cases, the distributions from REITs are partly tax deferred, which means that investors do not pay tax on the tax-
deferred component of the distribution until their holding in the trust is sold.
17 Public unit trusts are investment funds, excluding property and trading trusts, that are open to the Australian public.
A R E IT lis te d o n th e A S X w i ll have one o f tw o s tru c tu re s :
• a s ta n d -a lo n e t r u s t t h a t p ro v id e s in v e s to rs w it h e xp o su re o n ly to an u n d e rly in g p o r tf o lio o f real

estate assets; o r
• a g ro u p c o n s is tin g o f a co m p a n y a n d one o r m o re re la te d tru s ts .
P a rtly because o f it s ta x a tio n tre a tm e n t, a s ta n d -a lo n e t r u s t is s u ita b le f o r h o ld in g a n d m a n a g in g a

p o r tfo lio o f assets t h a t p ro d u ce passive r e n ta l in c o m e f o r d is tr ib u tio n to in v e s to rs . P ro p e rty d e v e lo p m e n t
a n d /o r m a n a g e m e n t are u s u a lly b e tte r u n d e rta k e n b y a c o rp o ra te s tru c tu re r a th e r th a n a tr u s t. In a g ro u p
s tru c tu re , in c o m e -p ro d u c in g p ro p e rtie s w ill be h e ld b y th e tru s t(s ) w h ile an a sso cia te d c o m p a n y w i ll c a rry
o u t p ro p e rty d e v e lo p m e n t a n d /o r m a n a g e m e n t. The g ro u p w ill issue s t a p le d s e c u r it ie s c o m p ris in g a STAPLED SECURITIES
share in th e c o m p a n y p lu s a u n it in each o f th e tru s ts . The te r m s ta p le d ' re fe rs to th e re q u ire m e n t t h a t two or more legally

separate instruments,
th e tw o se c u ritie s m u s t be tra d e d to g e th e r as i f th e y w e re a s in g le s e cu rity.
typically an ordinary
In fra s tru c tu re fu n d s in v e s t in assets in v o lv e d in th e s u p p ly o f e s s e n tia l goods a n d services such as share plus units in
p o r t fa c ilitie s , ra ilw a ys, t o ll roa ds, a irp o rts , c o m m u n ic a tio n fa c ilitie s , p o w e r lin e s a n d o il/g a s p ip e lin e s . one or more related
Some in fra s tru c tu re fu n d s in v o lv e a c o m p a n y /tru s t g ro u p th a t issues s ta p le d se c u ritie s . L ike REITs, trusts, which cannot be
in fra s tru c tu re fu n d s g e n e ra lly receive a stab le in c o m e s tre a m a n d p a y re g u la r d is tr ib u tio n s to in v e s to rs . traded separately
In v e s to rs can also choose t o in v e s t b y b u y in g shares in a lis te d in v e s tm e n t co m p a n y (L IC ). T yp ica lly,
an LIC w ill in v e s t in a d iv e rs ifie d p o r tf o lio o f in v e s tm e n ts , o fte n c o n s is tin g o f th e shares o f a w id e range
o f o th e r com p an ies t h a t are also lis te d o n th e ASX. In v e s to rs th e re fo re achieve a d iv e rs ifie d p o r tf o lio
w ith o u t th e need to p e rs o n a lly select, b u y a n d m anage a la rg e n u m b e r o f in v e s tm e n ts . Som e LICs
specialise in p a rtic u la r typ e s o f assets such as in te r n a tio n a l shares, s m a ll co m p a n ie s o r g o ld co m p a n ie s, o r
th e y m a y focus on p a r tic u la r g e o g ra p h ic a l re g io n s such as E u ro p e o r A sia . In c o n tra s t to u n lis te d m an ag ed
in v e s tm e n ts , LICs are e s s e n tia lly clo sed -end , m e a n in g t h a t th e co m p a n y does n o t c o n tin u a lly issue n e w
shares o r cancel shares as s h a re h o ld e rs jo in a n d leave th e com pany. R a th e r, th e co m p a n y s shares are
tra d e d o n th e A S X in th e sam e w a y as o th e r lis te d shares, a n d th e size a n d t im in g o f a n y share issues o r
repurchases w ill be d e te rm in e d b y th e c o m p a n y s m anagers. The m a rk e t p ric e o f th e shares is d e te rm in e d
b y m a rk e t forces. The share p ric e w ill o fte n be s im ila r to th e m a rk e t va lu e o f th e L IC s assets b u t can be a t
a p re m iu m or, m o re o fte n , a t a d is c o u n t to th e n e t asset value.
The fa c t t h a t som e m a n a g e d in v e s tm e n ts are s tru c tu re d as a t r u s t w h ile o th e rs use a c o m p a n y
s tru c tu re creates im p o r t a n t ta x a tio n d iffe re n ce s. F o r exa m ple, i f a t r u s t m akes a p r o fit, th e e n tire p r o fit
w ill be passed o n to in v e s to rs as a d is tr ib u tio n a n d each in v e s to r w ill be ta x e d a t t h e ir in d iv id u a l rate. I f
a lis te d in v e s tm e n t co m p a n y m ake s th e sam e p r o fit, i t w ill p a y ta x a t th e co m p a n y ta x ra te o n t h a t p r o fit.
The a fte r-ta x p r o f it can th e n be d is tr ib u te d to sh a re h o ld e rs as a fra n k e d d iv id e n d .18
The A u s tra lia n c a p ita l m a rk e t is p a r t o f th e g lo b a l c a p ita l m a rk e t a n d f o r m a n y years th e re has b e en a

sizeable flo w o f fu n d s fro m overseas f o r in v e s tm e n t in A u s tra lia n com p an ies. These flo w s have c o m p ris e d
b o th e q u ity a n d d e b t, in c lu d in g e q u ity fu n d in g o f n e w v e n tu re s a n d f o r p o r tf o lio in v e s tm e n t. Some
A u s tra lia n com p an ies, p a r tic u la r ly v e ry la rge ones, b o rro w d ire c tly fr o m overseas, a n d b a n ks a n d o th e r
in te rm e d ia rie s have been v e ry a ctive in o b ta in in g fu n d s f r o m overseas. Because A u s tra lia n b a n ks ty p ic a lly
have h ig h c re d it ra tin g s , th e y are b e tte r p lace d to b o rro w overseas th a n m a n y com p an ies. The fu n d s
b o rro w e d b y th e in te r m e d ia ry are th e n le n t to c u sto m e rs.
W h ile sizeable fu n d s have flo w e d fr o m overseas f o r in v e s tm e n t in A u s tra lia n co m p a n ie s, A u s tra lia
has also been a s ig n ific a n t source o f fu n d s f o r in v e s tm e n t in fo re ig n com p an ies. F o r exa m p le , as s h o w n
in Table 8.6, A u s tra lia n s u p e ra n n u a tio n fu n d s have la rg e in v e s tm e n ts in overseas assets a n d the se
in v e s tm e n ts have a t tim e s exceeded 20 p e r c e n t o f th e fun ds* assets. The in flo w to , a n d o u tflo w o f c a p ita l
fro m , A u s tra lia is c o n s is te n t w it h in v e s to rs re c o g n is in g th e advantages o f d iv e rs ific a tio n , in c lu d in g th e
o p p o r tu n ity to in v e s t in in d u s trie s t h a t m a y n o t be p re s e n t in t h e ir d o m e s tic eco no m ies.
18 Franked dividends are discussed in detail in Section 11.4.1.

SUMMARY
• A t a n y g iv e n tim e , s o m e e n titie s w ill h a v e su rp lu s b y c o m p a n ie s to ra is e e q u ity a n d lo n g -te rm d e b t is
fu n d s (the 's u rp lu s u n its '), w h ile o th e rs w ill b e s e e k in g c o n s id e re d in m o re d e ta il in C h a p te rs 9 a n d 1 0 .
fu n d s (the 'd e f ic it u n its '). A m a jo r ro le o f th e c a p it a l • S e v e ra l ty p e s of f in a n c ia l in s titu tio n s fo rm an
m a rk e t is to tra n s fe r fu n d s fro m th e s u rp lu s u n its to im p o r ta n t p a r t o f th e c a p it a l m a rk e t. T h e se in c lu d e
th e d e fic it un its. in s titu tio n s th a t o p e r a te a s a g e n ts (such a s b ro k e rs ),
• The A u s tra lia n c a p ita l m a rk e t is la rg e , a c tiv e a n d w e ll f in a n c ia l in te r m e d ia r ie s (such as b a n k s ) a n d in v e s to rs
re g u la te d a n d o ffe rs a w id e ra n g e o f o p tio n s fo r surp lu s (such a s in s u ra n c e c o m p a n ie s a n d s u p e ra n n u a tio n
un its a n d d e fic it units. The use o f th e c a p ita l m a rk e t fu n d s ).
KEY TERMS
a u th o ris e d d e p o s i 卜
ta k in g in s titu tio n 214 fin a n c ia l in te r m e d ia r y 211
c a p ita l m a rk e t 211 in v e s tin g in s titu tio n 214
c e n tra l b a n k 213 o v e r-th e -c o u n te r m a rk e t 212
d e fa u lt ris k 22 1 p r im a r y m a rk e t 212
e x c h a n g e -tra d e d m a rk e t 212 s e c o n d a ry m a rk e t 212
fin a n c ia l a g e n c y in s titu tio n 214 s e c u ritis a tio n 223
fin a n c ia l assets 211 s ta p le d s e cu ritie s 229
QUESTIONS
1 [L O 1 D is tin g u is h b e tw e e n d ir e c t f in a n c e a n d in te r m e d ia te d fin a n c e . D iscu ss w h y s o m e b o r r o w e r s m ig h t
p re fe r d ir e c t fin a n c e , w h ile o th e rs m ig h t p r e fe r in te r m e d ia te d fin a n c e .
2 [LO 1] W h y is th e e x is te n c e o f a s e c o n d a r y m a rk e t e x p e c te d to in c re a s e th e d e m a n d f o r s e c u ritie s is s u e d in
th e c o r r e s p o n d in g p r im a r y m a rk e t?
3 [ L O l ] W h a t a r e th e m a in d iffe re n c e s b e tw e e n a n e x c h a n g e -tr a d e d m a rk e t a n d a n o v e r-th e -c o u n te r m a rk e t?
4 [L O 2 ] D is tin g u is h b e tw e e n f in a n c ia l a g e n c y in s titu tio n s , f in a n c ia l in te r m e d ia r ie s a n d in v e s tin g in s titu tio n s .

W h y is th e re s u ch a r a n g e o f in s titu tio n s in th e c a p it a l m a rk e t?
5 [L O 3 ] D iscu ss th e re la tiv e im p o r ta n c e o f th e f o llo w in g in s titu tio n s a s p r o v id e r s o f c o m p a n y fin a n c e :
a) s to c k b ro k e rs
b) in v e s tm e n t b a n k s
c) banks
d) fin a n c e c o m p a n ie s
e) s u p e ra n n u a tio n fu n d s .
6 [L O 3 ] O u tlin e th e s e rv ic e s p r o v id e d b y fin a n c ia l in s titu tio n s , su ch a s s to c k b ro k e rs a n d in v e s tm e n t b a n k s , to

c o m p a n ie s w is h in g to ra is e fu n d s d ir e c t fro m th e c a p it a l m a rk e t.
7 [L O 3 ] W h a t d is tin c tio n s c a n b e m a d e b e tw e e n th e a c tiv itie s o f la r g e A u s tr a lia n b a n k s a n d in v e s tm e n t

banks?
8 [L O 3 ] In v e s tm e n t b a n k s c a n fa c e in h e re n t c o n flic ts o f in te re s t. E x p la in h o w th e se c o n flic ts o f in te re s t u s u a lly

a ris e . H o w c a n th e y b e m a n a g e d ?
9 [L O 3 ] D u rin g th e g lo b a l f in a n c ia l c ris is , a t le a s t o n e A u s tr a lia n - b a s e d in v e s tm e n t b a n k c o lla p s e d , w h ile

o th e rs , in c lu d in g th e s u b s id ia r ie s o f US a n d E u ro p e a n firm s , c o n tin u e d to o p e r a te b u t o n a s o m e w h a t s m a lle r
s c a le . O u tlin e th e m a in d iffe re n c e s th a t c o n trib u te d to th e se v e r y d iffe r e n t o u tc o m e s .
10 [L O 4 ] W h a t s e rv ic e s d o b a n k s o ffe r to d e p o s ito rs ?
11 [ L 0 4 ] W h a t s e rv ic e s d o b a n k s o ffe r to c o r p o r a te c lie n ts ?
C H A P T E R EIGHT R E V I E W
12 [LO 4 】W h a t a re th e m a in r e g u la to r y d iffe re n c e s b e tw e e n a fo r e ig n b a n k s u b s id ia r y o p e r a tin g in A u s tr a lia
a n d a fo r e ig n b a n k b r a n c h o p e r a tin g in A u s tr a lia ? W h a t a r e th e m a in im p lic a tio n s o f th e se d iffe re n c e s ?
13 [LO 5 】The m a jo r b a n k s in A u s tr a lia s e c u ritis e o n ly a s m a ll p r o p o r tio n o f th e ir m o r tg a g e lo a n s , r e g io n a l

b a n k s m a k e g r e a te r use o f th is te c h n iq u e a n d s p e c ia lis t m o r tg a g e o r ig in a t o r s s e c u ritis e m o s t o f th e ir lo a n s .
E x p la in w h y th e se d iffe re n c e s e x is t.
14 [LO 6 ] E x p la in p o s s ib le re a s o n s f o r th e r a p id in c re a s e in th e n u m b e r o f s u p e r a n n u a tio n fu n d s in e x is te n c e as
w e ll a s th e to ta l assets h e ld b y th o s e fu n d s .
15 [LO 6 ] Institutional investors have a lw ays been m a jo r suppliers o f co m p a n y finance. D iscu ss th is s ta te m e n t

a n d e x p la in h o w th is f lo w o f fu n d s o c c u rs .
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231
CHAPTER CONTENTS
g g■
m I n t r o d u c t io n S u b s e q u e n t is s u e s o f o r d in a r y s h a re s 252
T h e c h a r a c t e r is tic s o f o r d in a r y s h a re s E m p lo y e e s h a r e p la n s 265
g
^ 0 P riv a te e q u it y In te r n a l fu n d s 266
I^ Q I n f o r m a tio n d is c lo s u r e M a n a g in g a c o m p a n y ’s e q u it y s tru c tu r e 268
m F lo a tin g a p u b lic c o m p a n y
LEARNING OBJECTIVES
m
1 o u t lin e th e c h a r a c t e r is tic s o f o r d in a r y s h a re s
2 e x p la in th e a d v a n t a g e s a n d d is a d v a n t a g e s o f e q u it y a s a s o u r c e o f f in a n c e
3 o u t lin e th e m a in s o u rc e s o f p r iv a t e e q u it y in th e A u s t r a lia n m a r k e t
4 id e n t it y th e in f o r m a t io n t h a t m u s t b e d is c lo s e d w h e n is s u in g s e c u r itie s
5 o u t lin e th e p ro c e s s o f f lo a t in g a p u b lic c o m p a n y
6 d is c u s s a lte r n a tiv e e x p la n a t io n s f o r th e u n d e r p r ic in g o f in it ia l p u b lic o f f e r in g s
7 o u t lin e e v id e n c e o n th e lo n g - te r m p e r f o r m a n c e o f c o m p a n ie s t h a t a r e f lo a t e d
8 e x p la in h o w c o m p a n ie s r a is e c a p it a l t h r o u g h r ig h ts is s u e s , p la c e m e n ts , s h a r e p u r c h a s e p la n s a n d s h a r e
o p t io n s
9 o u t lin e th e d if f e r e n t ty p e s o f e m p lo y e e s h a r e p la n s
10 o u t lin e th e a d v a n t a g e s o f in te r n a l f u n d s a s a s o u r c e o f f in a n c e
11 o u t lin e th e e ffe c ts o f b o n u s is s u e s , s h a r e s p lits a n d s h a r e c o n s o lid a t io n s .

C hapter n in e S ources of f in a n c e : equity
In th is c h a p te r a n d in C h a p te r 10, w e discuss m e th o d s b y w h ic h a c o m p a n y m a y fin a n c e its assets. In th is

c h a p te r we discuss e q u ity , C h a p te r 10 covers d e b t, a n d le a s in g is co n sid e re d in C h a p te r 15.
In th is cha pter, several w ays o f ra is in g e q u ity are co n sid e re d . The m a jo r ity o f e q u ity in A u s tra lia is
raised b y p u b lic co m p a n ie s a n d u n it tru s ts w it h shares, u n its a n d stapled secu rities lis te d o n a s to c k STAPLED SECURITIES
exchange. I m p o r ta n t sources o f e q u ity f o r lis te d co m p a n ie s in c lu d e in it ia l p u b lic o ffe rin g s (IP O s) o f two or more legally
separate instruments,
shares, w h ic h is an e xa m ple o f a primary raising, V ig hts* issues, share pu rcha se p la n s, p la ce m e n ts a n d
typically an ordinary
re in v e s tm e n t o f d iv id e n d s , each o f w h ic h is a secondary raising o f c a p ita l. O th e r, less s ig n ific a n t sources share plus units in
o f e q u ity in c lu d e share issues to em ployees, calls o n c o n tr ib u tin g shares a n d exercise o f c o m p a n y-issu e d one or more related
o p tio n s . In a d d itio n , th e use o f in te r n a l fu n d s as a source o f fin a n c e is discussed. E q u ity ra ise d b y is s u in g trusts, which cannot be
o rd in a ry shares is an im p o r t a n t source o f fin a n c e f o r A u s tra lia n co m p a n ie s. The im p o rta n c e o f e q u ity traded separately
is illu s tra te d b y th e fa c t t h a t a t th e en d o f D e ce m b e r 2 0 1 3 , th e va lu e o f shares a n d o th e r e q u itie s lis te d
on th e A u s tra lia n S e cu ritie s E xchange (ASX) was $ 1 5 2 7 b illio n . 1 As s h o w n in Table 9.1 , e q u ity c a p ita l o f
a p p ro x im a te ly $ 3 1 5 b illio n was ra ise d th ro u g h th e issue o f shares a n d o th e r s e c u ritie s b y lis te d e n titie s
ove r th e 5 -ye a r p e rio d e n d in g 30 J u n e 20 13 .
TABLE 9.1 Listings and equity raisings by ASX-listed entities, financial year ended
30 June ($ billion)
【Type o f c a p ita l ra is in g 2010 2012 2013
2009 2011
Primary raisings
IPOs 1.9 11.4 35.6 10.2 9.9
Secondary raisings
Rights issues 28.5 23.2 7.4 8.1 4.0
Placements and share 42.0 28.6 10.1 12.8 19.2

purchase plans
R einvestm ent o f 15.0 10.2 7.8 9.3 6.9

dividends
Company-issued o p tio n s 2.1 2.4 2.1 2.4 2.3

and employee share
schemes
O thers 0.5 0.7 0.2 0.1 0.1
Total capital 90.0 76.5 63.2 42.9 42.4
Source: Australian Financial Markets Association, 2 0 1 3 Australian Financial Markets Report, February 2014, p. 55.
A m u ch s m a lle r b u t s t ill im p o r t a n t m a rk e t is th e p riv a te e q u ity m a rk e t, w h e re fin a n c e is ra ise d b y

is s u in g s e c u ritie s t h a t are n o t p u b lic ly tra d e d . P riv a te e q u ity in c lu d e s v e n tu re c a p ita l, w h ic h re fe rs to th e
fin a n c in g o f n e w v e n tu re s o r s ta rt-u p * com p an ies. B efo re d is c u s s in g th e ways in w h ic h co m p a n ie s raise
e q u ity, we o u tlin e th e fe a tu re s o f th e m a in ty p e o f e q u ity s e c u ritie s th e y issu e— t h a t is, o rd in a ry shares.
P reference shares, w h ic h are le g a lly e q u ity b u t also have som e o f th e c h a ra c te ris tic s o f d e b t, are discussed
in C h a p te r 10.
1 Australian Securities Exchange Limited, www.asx.com.au/about/historical-market-statistics.htm#End_of_month_values.

The figure quoted does not include the value of overseas-based equities listed on the ASX. There are also many private and
unlisted companies, most of which are much smaller than listed companies.
B usiness finance
9.2 The characteristics of o rd in a ry shares

E q u ity is th e m o s t fu n d a m e n ta l f o r m o f c o rp o ra te fin a n c e because e v e ry co m p a n y m u s t raise som e e q u ity
LEARNING b y is s u in g ordinary sh ares. A n o rd in a ry share gives th e h o ld e r o w n e rs h ip o f a p r o p o r tio n o f th e e q u ity
OBJECTIVE 1
o f th e com p an y. I f a co m p a n y has 10 0 0 0 0 issu ed shares a n d an in v e s to r h o ld s 1 0 0 0 shares, th e in v e s to r
Outline the
characteristics of has an o w n e rs h ip in te re s t in 1 p e r c e n t o f th e n e t assets o f th e com pany. T h is does n o t m ea n t h a t th e
ordinary shares in v e s to r can exercise o w n e rs h ip rig h ts w it h re sp e ct to sp e cific assets o f th e com p an y. H o w eve r, w h e n
d iv id e n d s are p a id , o r i f th e co m p a n y is ta k e n o v e r b y a n o th e r com pany, o r is p lace d in t o liq u id a tio n , th e
ORDINARY SHARES
securities that in v e s to r has th e r ig h t to receive 1 p e r c e n t o f th e p a y m e n ts m ad e to o rd in a ry s h a re h o ld e rs.
represent an P e rio d ica lly, a co m p a n y s d ire c to rs m a y decide to p a y d iv id e n d s to s h a re h o ld e rs an d, as discussed in
ownership interest in a S e c tio n 4 .3 , th e va lu e o f an o rd in a ry share can be v ie w e d as th e p re s e n t va lu e o f exp ected f u tu r e d iv id e n d s .
company and provide The in te re s t h e ld b y s h a re h o ld e rs is a residual claim in th e sense t h a t s h a re h o ld e rs w ill receive d iv id e n d s
the owner with voting
o n ly a fte r a co m p a n y has m e t its o b lig a tio n s to a ll o th e r c la im a n ts such as su p p lie rs , em ployees, le n d e rs
rights. Holders of
ordinary shares have a n d g o v e rn m e n ts . S im ila rly , i f a c o m p a n y is placed in to liq u id a tio n , o rd in a ry s h a re h o ld e rs have a re s id u a l
a residual interest in c la im o n th e proceeds fr o m th e sale o f th e co m p a n y s assets. Because s h a re h o ld e rs are p a id la s t, th e y face
the net assets of the g re a te r r is k th a n o th e r in v e s to rs in a com pany. To com p en sate f o r th is ris k , in v e s to rs in o rd in a ry shares
issuing company and
exp ect a ra te o f r e tu r n t h a t is g re a te r th a n th e y c o u ld o b ta in b y le n d in g to th e com pany.
are therefore exposed
to greater risk than
other classes of
investors
9.2.1 | Fully paid and partly paid shares
RESIDUAL CLAIM W h e n n e w shares are cre a te d a n d issu ed th e y w ill have a s ta te d issue p rice . T his p ric e m a y be payable in
claim to profit or
f u ll a t th e tim e th e shares are issu e d o r p a r t o f th e issue p ric e m a y be payable in it ia lly w it h th e balance to
assets that remain
after the entitlements
be p a id in s u b se q u e n t in s ta lm e n ts , g e n e ra lly k n o v rn as calls. The a m o u n t a n d t im in g o f each call m a y be
of all other interested sp e cifie d in it ia lly o r th e c o m p a n y s d ire c to rs m a y d e te rm in e th e m la te r. W h e re o n ly p a r t o f th e issue p rice
parties have been met has been p a id , shares are re fe rre d to as p a r tly p a id shares o r c o n trib u tin g shares. O nce th e t o ta l issue
CALL
p ric e has been p a id th e shares are f u lly p a id a n d th e h o ld e r c a n n o t be re q u ire d to c o n trib u te a n y m o re
notice given by a fu n d s to th e com pany, a lth o u g h th e y m a y be g iv e n th e o p p o r tu n it y to do so. A v e ry s im ila r s e c u rity th a t
company that the has b e e n issu e d to in v e s to rs is ca lle d an in s ta lm e n t re c e ip t. C o n tr ib u tin g shares a n d in s ta lm e n t re ce ip ts
holders of partly paid are discussed in d e ta il in S e ctio n 9.6 .3 .
shares must make an
additional contribution
of equity
9 .2 .2 ! Limited liability
LIMITED LIABILITY W h ile s h a re h o ld e rs face g re a te r r is k th a n le n d e rs, t h e ir r is k is lim it e d in t h a t th e y e n jo y lim ited liability.
legal concept that This m ea ns t h a t a s h a re h o ld e r is n o t p e rs o n a lly lia b le f o r th e co m p a n y s de bts. In th e case o f a co m p a n y
protects shareholders
lim ite d b y shares, th e lia b ilit y o f sh a re h o ld e rs is lim it e d to a n y a m o u n t u n p a id o n th e shares h e ld .2 F or
whose liability to meet
a company’s debts is exa m ple, i f an in v e s to r purchases shares w it h an issue p ric e o f $ 2 .5 0 p e r share, t h a t are p a r tly p a id to
limited to any amount $1 .7 5 , th e in v e s to rs lia b ilit y f o r fu tu r e p a y m e n ts is lim it e d to 75 cen ts p e r share. C o n se q u e n tly, i f th e
unpaid on the shares c o m p a n y is placed in to liq u id a tio n a n d has in s u ffic ie n t cash to p a y its c re d ito rs , h o ld e rs o f its p a r tly p a id
they hold shares can be re q u ire d to c o n trib u te u p to 75 cen ts p e r share to w a rd s th e p a y m e n t o f c re d ito rs . H o ld e rs
o f f u lly p a id shares w o u ld n o t be re q u ire d to m ake a n y c o n tr ib u tio n to w a rd s th e p a y m e n t o f c re d ito rs , so
th e m a x im u m a m o u n t th e y can lose is th e a m o u n t a lre a d y p a id to p u rch a se th e shares.
9 .2 .3 | No liability companies
The m a jo r ity o f com p an ies lis te d o n th e A S X are lim it e d lia b ilit y com p an ies, b u t th e re are also m a n y
m in in g co m p a n ie s th a t are re g is te re d as n o lia b ilit y co m p a n ie s. Such com p an ies m u s t in c lu d e th e w o rd s
*No L ia b ility * o r th e a b b re v ia tio n lNV a t th e e n d o f th e co m p a n y s na m e. These c o m p a n ie s ty p ic a lly have
p a r tly p a id shares on issue a n d can raise c a p ita l in stages b y c a llin g u p p a r t o f th e u n p a id c a p ita l. N o
lia b ilit y co m p a n ie s have tw o m a in fe a tu re s t h a t d is tin g u is h th e m fr o m o th e r ty p e s o f com p an ies. O ne
is t h a t th e y are re s tric te d to o p e ra tin g o n ly in th e m in in g in d u s try . The second fe a tu re is t h a t i f th e
c o m p a n y fa ils , sh a re h o ld e rs have n o lia b ilit y f o r th e co m p a n y s de bts. A c c o rd in g ly , h o ld e rs o f p a r tly *5
6
1
2 The advantages and disadvantages of limited liability are discussed in Lipton, Herzberg & Welsh (2010, p. 24). See also section
516 of the C o rp o ratio n s A c t 2 0 0 1 .
C hapter n in e S ources of fin a n c e : equity
p a id shares issued b y a n o lia b ilit y c o m p a n y are n o t o b lig e d to p a y calls m ad e b y th e com pany. H o w eve r,
sha reh old ers w h o fa il to pay a ca ll f o r f e it t h e ir shares. N o lia b ilit y co m p a n ie s are ty p ic a lly in v o lv e d in
m in e ra l o r o il e x p lo ra tio n . T h e re fo re , th is second fe a tu re a llo w s sh a re h o ld e rs to re v ie w t h e ir in v e s tm e n t
in a ris k y v e n tu re w h e n a d d itio n a l fu n d s are b e in g ra ise d a n d gives th e m th e o p p o r tu n ity to a b a n d o n th e
in v e s tm e n t i f th e y be lie ve t h a t its p ro sp e cts are u n a ttra c tiv e .3
9.2.4|T he rights of shareholders

S hareholders in a lis te d co m p a n y have m a n y rig h ts , such as th e r ig h t to receive an a n n u a l re p o rt, to be
n o tifie d o f m e e tin g s a n d to a tte n d th o se m e e tin g s . In p ra ctice , m o s t o f these rig h ts are o f l i t t le im p o rta n c e
and, generally, th e re are ju s t th re e rig h ts t h a t are im p o r t a n t to sh a re h o ld e rs in lis te d com p an ies:
a S ha reh old ers are e n title d to a p ro p o r tio n a l share o f a n y d iv id e n d t h a t is de cla red b y d ire c to rs ,
b As p a rt ow n e rs o f th e com p an y, o rd in a ry s h a re h o ld e rs e x e rt a degree o f c o n tro l o v e r its m a n a g e m e n t
th ro u g h th e v o tin g rig h ts a tta c h e d to t h e ir shares. These rig h ts in c lu d e th e r ig h t to e le ct m e m b e rs
o f th e B o a rd o f D ire c to rs . The B oa rd, w h ic h is u s u a lly e lected a t th e A n n u a l G en eral M e e tin g , has
u ltim a te c o n tro l o ve r th e o p e ra tio n s o f th e com p an y. U su ally, sh a re h o ld e rs have one v o te f o r each
share h e ld .4 The r ig h t o f s h a re h o ld e rs to e le ct th e B o a rd o f D ire c to rs gives th e m som e c o n tro l o ve r
th e co m p a n y s o p e ra tio n s . H o w eve r, in p ra c tic e , t h e ir a b ility to exercise c o n tro l is lim it e d because
th e B oa rd o f D ire c to rs is g e n e ra lly able to m u s te r s u ffic ie n t vo te s, in c lu d in g p ro x ie s , to e n sure th a t
its m e m b e rs are re -e le cte d a t th e A n n u a l G e n e ra l M e e tin g .5
C S ha reh old ers have th e r ig h t to sell t h e ir shares. This r ig h t can be exercised re a d ily in th e case o f
lis te d shares because th e shares can be s o ld th ro u g h th e s to c k exchange.
9 .2 .5 1 Advantages and disadvantages of equity as a source of

finance m
E q u ity raised b y is s u in g o rd in a ry shares has im p o r ta n t advantages as a source o f fin a n ce :
LEARNING
OBJECTIVE 2
• A c o m p a n y is n o t required to pay d iv id e n d s to o rd in a ry sh a re h o ld e rs: p a y m e n t o f d iv id e n d s is a t
Explain the
th e d is c re tio n o f d ire c to rs . T h ere fore, i f a c o m p a n y s u ffe rs a d e clin e in p r o fita b ilit y o r is s h o rt o f
advantages and
cash, i t can o m it th e p a y m e n t o f d iv id e n d s w ith o u t a n y s e rio u s le g a l consequences. In c o n tra s t, disadvantages of
fa ilu re to pay in te re s t o n d e b t, o r delays in p a y in g in te re s t, w ill a lm o s t c e rta in ly have se rio u s legal equity as a source of
consequences a n d can u ltim a te ly le a d to a c o m p a n y b e in g p laced in to liq u id a tio n . finance
• O rd in a ry shares do n o t have a n y m a t u r ity date, w h ic h m ea ns t h a t th e is s u in g c o m p a n y has
no o b lig a tio n to red ee m th e m .6 A g a in , in c o n tra s t, d e b t must be re p a id (o r *redeem ed,) w h e n
i t m a tu re s.
• The h ig h e r th e p r o p o r tio n o f e q u ity in a co m p a n y s c a p ita l s tru c tu re , th e lo w e r is th e r is k th a t
le n d e rs w ill s u ffe r losses as a re s u lt o f th e b o rro w e r e x p e rie n c in g fin a n c ia l d iffic u lty . T h ere fore,
ra is in g e q u ity b y is s u in g o rd in a ry shares lo w e rs th e in te re s t ra te t h a t a c o m p a n y w ill have to pay
o n de bt.
W h ile e q u ity has im p o r t a n t advantages, i t also has som e disad vanta ges.
• I f a co m p a n y issues m o re o r d in a r y shares to raise n e w c a p ita l, e x is tin g sh a re h o ld e rs w i ll have to

e ith e r o u tla y a d d itio n a l cash o r s u ffe r som e d ilu t io n o f t h e ir o w n e rs h ip a n d c o n tro l o f th e com pany.
3 Arguably, another feature of no liability (NL) companies is also important. Historically, NL companies had greater flexibility
than other companies to raise capital by issuing shares at a discount to their par value. When the C o rp o ratio n s A c t was
amended to abolish the par value concept from 1 July 1998, this advantage no longer existed. Subsequently, some NL
companies have converted to limited liability status and the number of new NL companies listing on the ASX has declined.
As at February 2014, only 68 of the 2140 companies listed on the ASX were NL companies (see www.asx.com.au/asx/
research/ASXListedCompanies.csv).
4 The voting rights of a company s shareholders must be specified in its constitution. For companies listed on the ASX, the form
of the voting rights is specified in Chapter 6 of the Exchange’s Listing Rules.
5 As many shareholders do not attend the Annual General Meeting, the right to vote by proxy is provided. Voting by proxy
involves a shareholder assigning to another person the right to vote on resolutions at the Annual General Meeting.
6 While ordinary shares have no maturity date and can, in principle, exist in perpetuity, companies are permitted to repurchase
their ovm shares, which leads to cancellation of those shares. Share buybacks are discussed in Chapter 11.
B usiness finance
B o rro w in g , o n th e o th e r h a n d , a llo w s fu n d s to be ra ise d w ith o u t such d ilu tio n . S m a ll sh a re h o ld e rs

m a y n o t be co n ce rn e d i f t h e ir in te re s t in a co m p a n y is d ilu te d , p ro v id e d th e n e w sh a re h o ld e rs pay a
f a ir p ric e f o r th e shares th e y o b ta in , b u t in v e s to rs w h o o w n a s ig n ific a n t p r o p o r tio n o f a com p an y's
shares m a y be u n w illin g to have t h e ir in te re s t d ilu te d .
• The tra n s a c tio n costs o f ra is in g fu n d s b y is s u in g shares are u s u a lly h ig h e r th a n th e costs o f
b o rro w in g a s im ila r a m o u n t. O n e rea son is th a t, as discussed in S e ctio n 9.4, a share issue b y a p u b lic
co m p a n y o fte n re q u ire s a p ro s p e c tu s . Because o f th e v o lu m e o f in fo r m a tio n t h a t is u s u a lly p ro v id e d ,
a p ro s p e c tu s f o r a share issue ty p ic a lly ru n s to m o re th a n 1 0 0 pages a n d is c o s tly to p re pa re. A lso ,
share issues are o fte n u n d e r w r itte n : th is o fte n in v o lv e s a fee b e in g p a id to th e u n d e r w r ite r w h o
gu a ra n te e s to pu rcha se a n y shares n o t ta k e n u p b y in v e s to rs .
In o u t lin in g th e advan ta ge s a n d disad vanta ges o f e q u ity , ta x a tio n has n o t been m e n tio n e d because,
u n d e r th e A u s tra lia n ta x syste m , th e o v e ra ll ta x b u rd e n s o n d e b t a n d e q u ity are o fte n th e sam e fo r
A u s tra lia n re s id e n t in v e s to rs . A s discussed in S e ctio n 1 2 .5 .2 ，th e s yste m is e ith e r n e u tra l o r biase d
to w a rd s e q u ity d e p e n d in g o n th e in v e s to rs m a rg in a l ta x rate. F o r overseas in v e s to rs in A u s tra lia n
co m p a n ie s th e ta x b u rd e n o n e q u ity m a y be h ig h e r th a n th e ta x b u rd e n o n d e b t. T h e re fo re , in A u s tra lia ,
a n y ta x a tio n ad va n ta g e o r d isa d va n ta g e th a t m a y arise in a p a r tic u la r case de pe nd s o n th e circu m sta nce s
o f th e s h a re h o ld e r co n ce rn e d a n d is n o t an in h e re n t fe a tu re o f e q u ity as a source o f fin a n ce .
9.3 Private equity

M o s t o f th is c h a p te r covers e q u ity c a p ita l ra is in g b y com p an ies w h o se shares are lis te d a n d tra d e d p u b lic ly
LEARNING o n a s to c k exchange. There is also a m u c h s m a lle r b u t s t ill v e ry im p o r ta n t p riv a te e q u ity m a rk e t. The te rm
OBJECTIVE 3
p riv a te e q u ity * is o fte n used to de scrib e tw o d is tin c t typ e s o f in v e s tm e n t. The f ir s t ty p e is also k n o w n as
Outline the main
sources of private V e n tu re capital* a n d re fe rs to fu n d in g f o r s m a lle r a n d r is k ie r co m p a n ie s w it h p o te n tia l f o r s tro n g g ro w th .
equity in the F o r the se co m p a n ie s, p riv a te e q u ity can be m o re a ttra c tiv e th a n a s to c k exchange lis tin g . F o r exa m ple, th e
Australian market a m o u n t o f c a p ita l re q u ire d m a y be to o s m a ll to ju s t if y th e cost o f a share m a rk e t flo a t. A ls o , th e fu tu r e o f
th e v e n tu re — w h ic h a t th e e a rlie s t stage m a y be n o m o re th a n an id e a — m a y be to o u n c e rta in to a ttra c t
fu n d s f r o m a la rge n u m b e r o f in v e s to rs . The second ty p e is th e a c q u is itio n o f a lis te d p u b lic co m p a n y
b y a g ro u p o f in v e s to rs w h o p riv a tis e * th e co m p a n y so t h a t i t is d e lis te d fr o m th e s to c k exchange. Such
a c q u is itio n s u s u a lly in v o lv e a h ig h p r o p o r tio n o f d e b t fin a n c e a n d are c o m m o n ly k n o w n as leveraged
b u y o u ts (LB O s), w h ic h are discussed in S e ctio n 1 9 .7 .3 . The re m a in d e r o f th is s e c tio n focuses o n p riv a te
e q u ity fu n d in g f o r v e n tu re s o th e r th a n LBO s.
9.3.1 | W hat is private equity?

P riv a te e q u ity re fe rs to e q u ity s e c u ritie s t h a t are n o t p u b lic ly tra d e d . P riv a te e q u ity can be ra ised fr o m
v a rio u s sources in c lu d in g fa m ily m e m b e rs, frie n d s a n d ‘bu sin ess angels’，b u t th e m o re fo r m a l p riv a te
e q u ity m a rk e t in v o lv e s fu n d s b e in g c h a n n e lle d to businesses b y p riv a te e q u ity fu n d m an ag ers. P riva te
e q u ity fu n d in g can be d iv id e d in to fo u r ca te g o rie s:7
a start-up fin a n c in g f o r a b u sin ess less th a n 3 0 m o n th s o ld w h e re fu n d s are re q u ire d to de ve lo p th e

c o m p a n y ’s p ro d u c ts
b expansion fin a n c in g w h e re a d d itio n a l fu n d s are re q u ire d to m a n u fa c tu re a n d sell p ro d u c ts
c o m m e rc ia lly
c turnaround fin a n c in g f o r a c o m p a n y in fin a n c ia l d iff ic u lt y
d management buyout (M B O ) fin a n c in g w h e re a b u sin ess is p u rch a se d b y its m a n a g e m e n t te a m w ith
th e assistance o f a p riv a te e q u ity fu n d .
Because p riv a te e q u ity is n o t p u b lic ly tra d e d , th e m a rk e t is illiq u id a n d in v e s to rs m u s t be p re p a re d to

c o m m it fu n d s f o r th e lo n g te rm , w ith p e rio d s o f 5 to 10 years b e in g ty p ic a l.
7 This four-category breakdown is provided by Connolly and Tan (2002).

C hapter NINE $ 〇URCES 〇F FINANCE: EQUITY
E n tre p re n e u rs a n d in v e s to rs in n e w v e n tu re s se e kin g s ta rt-u p fin a n c in g face th re e im p o r t a n t in fo r m a tio n

p ro b le m s .8
a Information gaps: in fo r m a t io n a b o u t th e va lu e o f th e v e n tu re is lik e ly to be in c o m p le te a n d v e ry

u n c e rta in .
b Information asymmetry: im p o r t a n t in fo r m a tio n is u s u a lly d is tr ib u te d u n e v e n ly b e tw e e n th e
p a rtie s , w h ic h is th e p ro b le m k n o w n as in form ation asym m etry. In p a rtic u la r, th e e n tre p re n e u r INFORMATION
w ill a lm o s t c e rta in ly have m o re accurate in fo r m a tio n th a n o u ts id e in v e s to rs a b o u t th e te c h n ic a l ASYMMETRY

situation where all
o r s c ie n tific m e r it o f an id e a a n d o f th e te c h n o lo g y re q u ire d to e x p lo it th e idea. O n th e o th e r
relevant information
ha n d , o u ts id e in v e s to rs m a y have m o re re a lis tic in fo r m a tio n a b o u t th e e co n o m ic v a lu e o f th e is not known by all
idea. H o w eve r, p o te n tia l in v e s to rs in a n e w v e n tu re are n o t co n ce rn e d o n ly w ith th e va lu e o f interested parties.
th e u n d e rly in g idea o r in v e n tio n . T hey also ne ed to assess th e s k ills a n d c o m m itm e n t o f th e Typically, this
e n tre p re n e u r. Som e e n tre p re n e u rs have an accurate a p p re c ia tio n o f t h e ir o w n s k ills , a b ility an d involves company
'insiders' (managers)
c o m m itm e n t, w h ile o th e rs te n d to be less re a lis tic .
having more
C Information leakage: th e re is th e r is k t h a t o th e rs m a y a p p ro p ria te th e e n tre p re n e u r s idea. To information about the
con vin ce p ro s p e c tiv e in v e s to rs t h a t a p ro p o s a l is va lu a b le , th e e n tre p re n e u r w ill have to p ro v id e company’s prospects
th e m w it h som e in fo r m a tio n a b o u t th e idea. U n fo rtu n a te ly , d is c lo s in g th is in fo r m a tio n m a y a llo w than 'outsiders'
som eone else to e x p lo it th e o p p o rtu n ity . (shareholders and
lenders)
The m a rk e t f o r n e w v e n tu re fin a n ce has som e u n iq u e fe a tu re s t h a t have d e velope d to m in im is e th e
effects o f these in fo r m a tio n p ro b le m s . The m a in such fe a tu re is t h a t fin a n c e f o r n e w v e n tu re s is n o rm a lly
p ro v id e d in stages ra th e r th a n as a sin g le lu m p sum . A lso , th e p ro v is io n o f fin a n c e a t each stage is g e n e ra lly
lin k e d to th e a ch ie ve m e n t o f m ile s to n e s , such as c o m p le tio n o f a p ro to ty p e o r successful o p e ra tio n o f a p ilo t
p la n t. A c h ie v e m e n t o f the se m ile s to n e s o r o th e r p e rfo rm a n c e b e n c h m a rk s h e lp s to reduce in fo r m a tio n
a s y m m e try in tw o ways. F irs t, i t p ro v id e s in v e s to rs w ith ta n g ib le evidence a b o u t th e v ia b ilit y o f th e
p ro je ct. Second, i t also p ro v id e s th e m w it h in fo r m a tio n a b o u t th e s k ill a n d a b ility o f th e e n tre p re n e u r.
P ro v id in g th e fin a n ce in stages is c le a rly sen sib le fr o m th e v ie w p o in t o f in v e s to rs . I f a p ro je c t is d e s tin e d
to fa il due to te c h n ic a l d iffic u ltie s , la c k o f c o n s u m e r d e m a n d o r h ig h m a n u fa c tu rin g costs, i t is b e tte r to
discove r these p ro b le m s b e fo re a ll th e fu n d s needed to c o m p le te th e p ro je c t have b e en c o m m itte d to it .
Staged fin a n c in g is also in th e in te re s t o f th e e n tre p re n e u r. F o r an e n tre p re n e u r w ith n o tra c k re c o rd o f
successful v e n tu re s , i t w ill be d iff ic u lt to co n vin ce o th e rs t h a t fu n d s in v e s te d in a n e w v e n tu re w ill be used
p ro fita b ly . F o r th e e n tre p re n e u r, ra is in g m o n e y fr o m o u ts id e in v e s to rs in th e e a rly stages o f a v e n tu re is
ge n e ra lly expensive. In th is c o n te x t, expensive* m eans t h a t th e e n tre p re n e u r w ill have to g ive u p a la rge
fra c tio n o f o w n e rs h ip to raise a r e la tiv e ly s m a ll a m o u n t o f c a p ita l. A c h ie v e m e n t o f each m ile s to n e reduces
u n c e rta in ty an d increases th e va lu e o f a p ro je c t. R a isin g fin a n c e in stages, a fte r m ile s to n e s have been
achieved, th e re fo re h e lp s th e e n tre p re n e u r to r e ta in g re a te r o w n e rs h ip th a n w o u ld o th e rw is e be th e case.
F in a lly, c o n s id e r th e p o s s ib ility t h a t release o f in fo r m a tio n to p ro s p e c tiv e in v e s to rs m a y le a d to
a p p ro p ria tio n o f th e e n tre p re n e u r s idea. The e n tre p re n e u r m a y seek p ro te c tio n b y a s k in g p ro s p e c tiv e
in v e s to rs to sig n c o n fid e n tia lity a g re e m e n ts w h e n th e y are g iv e n a co p y o f th e b u sin ess p la n . H o w eve r,
m a n y in v e s to rs re fu se to sig n such a g re e m e n ts because a le a k o f in fo r m a tio n fr o m a n y source can re s u lt
in c o s tly le ga l d isp u te s. I t is m o re im p o r t a n t to th e e n tre p re n e u r t h a t a p o te n tia l in v e s to r is h o n e s t a n d
can be tru s te d n o t to m isu se c o n fid e n tia l in fo r m a tio n . T h e re fo re , p riv a te e q u ity f u n d m an ag ers w ill t r y to
e sta b lish an d p ro te c t a re p u ta tio n f o r h o n e s ty a n d in te g rity .
There are m a n y p o te n tia l sources o f fin a n c e f o r a n e w v e n tu re . These sources in c lu d e th e e n tre p re n e u r s

p e rso n a l resources, p riv a te e q u ity fu n d s a n d fu n d s ra ise d b y an in itial public offering o f shares IN ITIAL PUBLIC
associated w ith lis tin g o n a s to c k exchange. The s u ita b ility o f th e se a n d o th e r sources o f fin a n c e depends OFFERING
a company's first
o n th e v e n tu re s stage o f d e v e lo p m e n t. E v e ry v e n tu re is d iffe re n t a n d i t is im p o s s ib le to id e n tify a *life
offering of shares to
cycle’ o f d e v e lo p m e n t stages t h a t a p p lie s to a ll n e w v e n tu re s . There are, h o w e ve r, som e id e n tifia b le
the public
stages th a t w ill a p p ly in m a n y cases. M a n y v e n tu re s w ill b e g in w it h a research a n d d e v e lo p m e n t phase
8 Our discussion of these information problems is based on Smith and Smith (2000, pp. 27-8).
B usiness finance
w h ic h , i f successful, w ill be fo llo w e d b y a s ta rt-u p phase w h e re th e e q u ip m e n t a n d p e rs o n n e l needed fo r

p ro d u c tio n are assem bled. I f th e p ro d u c t is accepted b y cu sto m e rs, th e v e n tu re m a y g ro w , p e rha ps v e ry
ra p id ly a t fir s t, a fte r w h ic h th e re w ill o fte n be p e rio d s o f s lo w e r g ro w th , m a t u r ity a n d p e rh a p s decline.
There m a y be n o cle ar d e m a rc a tio n p o in t b e tw e e n the se stages b u t in m a n y cases th e tr a n s itio n w ill
c o rre s p o n d to id e n tifia b le m ile s to n e s . In t u r n , th e re is o fte n a re la tio n s h ip b e tw e e n the se m ile s to n e s and
th e a v a ila b ility o f d iffe re n t sources o f fina nce .
A t th e research an d d e v e lo p m e n t stage th e e n tre p re n e u r w i ll u s u a lly re ly in it ia lly o n p e rso n a l
resources— t h a t is, savings, m o n e y t h a t can be b o rro w e d b y m o rtg a g in g th e fa m ily h o m e a n d p e rha ps
lin e s o f c re d it lin k e d to c re d it cards. U nless th e e n tre p re n e u r is v e ry w e a lth y , these resources m a y be
e x h a u ste d b e fo re th e v e n tu re is f u lly d e velope d a n d i t w ill u s u a lly be necessary to o b ta in fin a n c e fro m
o u ts id e rs such as fa m ily m e m b e rs, frie n d s , in d iv id u a ls k n o w n as ‘b u sin ess an ge ls’ a n d p riv a te e q u ity
fu n d s . O u ts id e fin a n c e ra ise d in th e e a rly stages o f a v e n tu re s d e v e lo p m e n t is n o r m a lly in th e fo r m o f
e q u ity — t h a t is, th e e n tre p re n e u r tra n s fe rs a share o f o w n e rs h ip to th e n e w in v e s to rs a n d th e re tu rn s to
the se in v e s to rs w ill d e p e n d d ire c tly o n th e success o r o th e rw is e o f th e v e n tu re .
9 .3 .4 1 Finance from business angels

B usiness angels are w e a lth y in d iv id u a ls p re p a re d to in v e s t in p ro je c ts t h a t are a t a n e a rly stage o f
d e v e lo p m e n t.9 The a m o u n ts in v o lv e d ty p ic a lly range fr o m te n s o f th o u s a n d s to h u n d re d s o f th o u s a n d s
o f d o lla rs p e r in v e s tm e n t. These in v e s to rs w ill o fte n p ro v id e th e fu n d s ne eded to de ve lo p a v e n tu re to
th e stage w h e re i t is p o ssib le to seek o u ts id e fin a n c e fr o m p riv a te e q u ity fu n d s , b a n ks a n d o th e r fin a n c ia l
in s titu tio n s . B usiness angels are g e n e ra lly p re p a re d to in v e s t in a v e n tu re f o r 5 to 10 years. M a n y o f th e m
have b u sin ess o r te c h n ic a l s k ills a n d a im to add v a lu e to a n e w v e n tu re b y p ro v id in g ad vice a n d e x p e rtis e
as w e ll as fin a n ce . T ra d itio n a lly th e m a rk e t has o p e ra te d in fo r m a lly o n th e basis o f c o n ta c ts a n d re fe rra ls.
H o w eve r, th e m a rk e t has re c e n tly been fo rm a lis e d b y th e d e v e lo p m e n t o f b u sin ess in tr o d u c tio n services
t h a t seek to m a tc h in v e s to rs w it h e n te rp ris e s t h a t need c a p ita l. Som e o f the se services s im p ly p ro v id e
in fo r m a tio n , w h ile o th e rs m a in ta in databases o f b o th in v e s to rs a n d c o m p a n ie s a n d a im to a c tiv e ly m a tc h
the se p a rtie s . Services o p e ra tin g in A u s tra lia in c lu d e Business A n g e ls P ty L td (w w w .businessangels.com .
au) a n d th e A u s tra lia n S m a ll Scale O ffe rin g s B o a rd (w ww.assob.com .au).
Som e b u sin ess angels w ill in v e s t in p e rh a p s one p ro je c t p e r y e a r w h ile o th e rs w ill in v e s t in several.
M o s t r e s tr ic t t h e ir in v e s tm e n ts to in d u s trie s w h e re th e y u n d e rs ta n d th e te c h n o lo g y a n d to p ro je c ts
lo c a te d in t h e ir o w n g e o g ra p h ic a l area. A ty p ic a l e xa m p le is <J o h n ,, a 6 3 -y e a r-o ld c h a rte re d a c c o u n ta n t
w h o has m a d e 12 in v e s tm e n ts in 8 years as a f u ll- tim e e q u ity in v e s to r.10 H e p o in ts o u t t h a t th e e x p e rtis e
t h a t b u sin ess angels can p ro v id e is u s u a lly m o re im p o r t a n t th a n th e m o n e y th e y in v e s t. F in d in g m o n e y
is easy i f a bu sin ess is good. A n g e l in v e s to rs lo o k f o r a b u sin ess w it h a w eakness t h a t th e y can h e lp to
o ve rco m e so t h a t i t becom es a g o o d business. J o h n lo o k s f o r o p p o rtu n itie s in in d u s trie s w it h h ig h g ro w th
p o te n tia l. Because he does n o t w a n t h is m o n e y tie d u p f o r m o re th a n 5 years, he lo o k s f o r a co m p a n y
th a t can b e n e fit v e ry q u ic k ly fr o m re o rg a n is a tio n o r a d d itio n a l e x p e rtis e . Such co m p a n ie s are u s u a lly
s m a ll a n d have a g o o d idea, b u t la ck e x p e rtis e in m a n a g e m e n t, m a rk e tin g , m a n u fa c tu rin g o r d is tr ib u tio n .
J o h n w i ll in v e s t u p to $ 2 0 0 0 0 0 , re q u ire s a seat o n th e B o a rd a n d w ill sp e n d u p to h a lf a d a y each w eek
w o rk in g o n th e com p an y. F in a lly , he lo o k s f o r c o m p a n ie s t h a t can p ro v id e h ig h re tu rn s o n h is in v e s tm e n t
b y d e v e lo p m e n t to a stage w h e re th e c o m p a n y can be s o ld to o r m erg e w it h a la rg e r com pany, a ttra c t th e
in v o lv e m e n t o f a p riv a te e q u ity fu n d o r lis t o n a s to c k exchange.
9 .3 .5 1 Finance from private equity funds

The A u s tra lia n B u re a u o f S ta tis tic s (ABS) e s tim a te s t h a t $ 1 9 .8 b illio n was c o m m itte d to th e p riv a te e q u ity
m a rk e t a t 30 J u n e 2 0 1 3 , o f w h ic h $ 1 3 .8 b illio n was d ra w n d o w n , le a v in g $6 b illio n u n c a lle d .11 A c c o rd in g
to th e ABS, a t J u n e 2 0 1 3 a t o ta l o f 2 3 1 p riv a te e q u ity fu n d s o p e ra te d in A u s tra lia b y 1 2 2 v e n tu re c a p ita l
9 For a detailed discussion of this market in Australia, see Abernethy and Heidtman (1999).
10 This example is cited by Abernethy and Heidtman (1999, pp. 137-40). The remainder of this section relies heavily on that
source.
11 Australian Bureau of Statistics (2014).
m anagers h a d in v e s te d in 7 2 0 com p an ies. V e n tu re c a p ita l m an ag ers have tw o m a in roles: ra is in g m o n e y

fro m in v e s to rs a n d s e le c tin g s u ita b le co m p a n ie s in w h ic h to in v e s t th e c a p ita l. In A u s tra lia , in v e s to rs
in c lu d e s u p e ra n n u a tio n fu n d s , w h ic h are th e la rg e s t source o f fu n d s , w e a lth y in d iv id u a ls a n d ba nks.
W h ile these in v e s to rs have la rg e sum s ava ila ble, p riv a te e q u ity fu n d in g is n o t easy to o b ta in . A c c o rd in g
to th e ABS, th e 1 2 2 m anagers re v ie w e d 6 6 0 4 p o te n tia l n e w in v e s tm e n ts in th e fin a n c ia l yea r e n d in g
Ju n e 20 13 , f u r t h e r an alysis was c o n d u c te d o n 8 5 0 o f th o se a n d o n ly 76 w e re succe ssful in a ttra c tin g
in v e s tm e n t. D u rin g th a t p e rio d the se v e n tu re c a p ita l m an ag ers m ad e n e w a n d fo llo w - o n in v e s tm e n ts
to ta llin g $ 1 1 2 4 m illio n .
V e n tu re c a p ita l fu n d m a n a g e rs g e n e ra lly in v e s t a m o u n ts in th e o rd e r o f $ 5 0 0 0 0 0 to $2 0 m illio n f o r
p e rio d s o f 3 to 7 years. T hey lo o k f o r a bu sin ess w ith g o o d p ro sp e cts f o r g ro w th , m a n a g e d b y p e o p le w h o
are capable, h o n e s t a n d c o m m itte d to th e success o f th e bu sin ess. P riv a te e q u ity in v e s tm e n ts ty p ic a lly
have a h ig h e r le ve l o f r is k th a n m o s t o th e r in v e s tm e n ts . T h ere fore, fu n d m an ag ers seek a re la tiv e ly h ig h
ra te o f r e tu r n t h a t w ill v a ry w it h th e p e rce ive d ris k . F o r e xa m p le , p ro v is io n o f seed a n d s ta rt-u p c a p ita l
in vo lve s a h ig h le v e l o f r is k a n d in v e s to rs m a y seek a ra te o f r e tu r n o f a t le a st 30 to 4 0 p e r c e n t p e r a n n u m
o ve r th e life o f th e in v e s tm e n t. A t a la te r stage w h e n p r o d u c tio n has co m m e n ce d a n d p ro d u c t is b e in g
sold, p ro v is io n o f c a p ita l f o r e x p a n s io n in v o lv e s lo w e r r is k so t h a t th e m in im u m ra te o f r e tu r n s o u g h t
m a y be 20 to 30 p e r c e n t p e r a n n u m .
To o b ta in p riv a te e q u ity i t is e s s e n tia l to have a w e ll-d o c u m e n te d a n d b e lie v a b le b u sin ess p la n . The
p la n s h o u ld p ro v id e in fo r m a t io n on:
• th e s tru c tu re , a c tiv itie s a n d fin a n c ia l h is to r y o f th e bu sin ess

• analysis o f th e in v e s tm e n t o p p o r tu n ity
• th e a m o u n t o f c a p ita l s o u g h t
• h o w th e c a p ita l w ill be used
• fin a n c ia l p ro je c tio n s
• th e q u a lific a tio n s a n d e xp e rie n ce o f th e m a n a g e m e n t team .
As w e ll as b e c o m in g p a r t o w n e rs o f th e businesses th e y in v e s t in , fu n d m an ag ers ty p ic a lly re q u ire a

seat on th e c o m p a n y s B o a rd o f D ire c to rs . This does n o t m e a n t h a t th e y seek d a y -to -d a y c o n tro l. R a th er,
p riv a te e q u ity fu n d s g e n e ra lly ta k e a s ig n ific a n t m in o r it y share in th e c o m p a n y a n d a im to p ro v id e v a lu a b le
advice o n b o th te c h n ic a l a n d m a n a g e m e n t issues. A n e n tre p re n e u r m a y be able to o b ta in c a p ita l fr o m a
v a rie ty o f sources, b u t a fu n d m a n a g e r can also p ro v id e m a n a g e m e n t in p u t based o n th e e xp erience o f
h e lp in g o th e r com p an ies ove rco m e th e p ro b le m s ty p ic a lly e n c o u n te re d b y new , fa s t-g ro w in g businesses.
The in v e s tm e n t veh icle s d iffe r c o n s id e ra b ly in size, th e ty p e o f in d u s trie s th e y in v e s t in an d th e typ e s o f
m a n a g e m e n t s u p p o rt th e y can p ro v id e . T h e re fo re , i t is im p o r t a n t t h a t an e n tre p re n e u r se e kin g p riv a te
e q u ity s h o u ld be aw are o f the se d iffe re n ce s a n d a p p ro a ch th e fin a n c ie rs t h a t are b e s t e q u ip p e d to p ro v id e
th e c a p ita l a n d s u p p o rt t h a t th e b u sin e ss is lik e ly to need.
M o s t fu n d m an ag ers a im t o achieve th e m a jo r ity o f t h e ir r e tu r n in th e f o r m o f c a p ita l g a in ra th e r th a n
d iv id e n d s . A c c o rd in g ly , th e y u s u a lly p la n to d ispo se o f th e in v e s tm e n t, ty p ic a lly w it h in a p e rio d o f 3 to 7
years. D isp o sa l m a y ta k e place in one o f th re e ways:
a an in it ia l p u b lic o ffe rin g a sso cia te d w it h s to c k exchange lis tin g

b sale
C voluntary liquidation.
W h e re a sale occurs th e b u y e r m a y be a la rg e r co m p a n y (a ‘tra d e sale’) ，th e m a jo r ity o w n e r, th e
m a n a g e m e n t o r a n o th e r o u ts id e in v e s to r. W h ile d isp o sa l o f th e in v e s tm e n t can re s u lt in s p e c ta c u la r
gains, th e le ve l o f r is k is h ig h a n d i t is to be e xp ected t h a t a s ig n ific a n t p r o p o r tio n o f th e d isp o sa ls th a t
occur w ill in v o lv e a loss. In som e cases th e p ro je c t w ill fa il a n d th e in v e s tm e n t w i ll be liq u id a te d .
P riva te e q u ity in v e s tm e n t in A u s tra lia has g ro w n ra p id ly since th e e a rly 1 9 9 0 s. F actors t h a t have
c o n trib u te d to th is g ro w th in c lu d e :
• g ro w th in th e v o lu m e o f fu n d s flo w in g in to s u p e ra n n u a tio n , to g e th e r w it h in cre a se d re c o g n itio n b y

fu n d m anagers o f th e ro le o f p riv a te e q u ity in v e s tm e n ts as p a r t o f a d iv e rs ifie d p o r tf o lio
|www j
• g o v e rn m e n t p ro g ra m s to en cou rage in v e s tm e n t in n e w v e n tu re s , such as th e In n o v a tio n In v e s tm e n t
F u n d p ro g ra m a n d th e E a rly Stage V e n tu re C a p ita l L im ite d P a rtn e rs h ip s p ro g ra m (see w w w .
ausindustry.gov.au).
• re g u la to ry changes t h a t a llo w b a n ks to m a ke e q u ity in v e s tm e n ts .
9.4 Information disclosure
C h a p te r 6 D o f th e Corporations Act co n ta in s p ro v is io n s designed to ensure th a t in v e s to rs in p u b lic
LEARNING com panies are p ro te c te d b y disclosu re o f in fo rm a tio n . There are p a rtic u la r disclosure re q u ire m e n ts th a t
OBJECTIVE 4
a p p ly to o ffe rs o f secu ritie s so th a t in v e s to rs s h o u ld be able to m ake an in fo rm e d de cisio n on w h e th e r to
Identify the information
that must be disclosed
purchase th e securities. These re q u ire m e n ts are g e n e ra lly sa tisfie d b y p ro v id in g p o te n tia l in ve sto rs w ith a
when issuing securities disclosure docum ent c o n ta in in g in fo rm a tio n a b o u t th e issu er a nd d e tails o f th e secu ritie s o ffe re d fo r sale.
H ow ever, th e re are v a rio u s e x e m p tio n s th a t m ean a disclosu re d o c u m e n t is n o t needed f o r som e o ffe rs o f
secu ritie s.
DISCLOSURE
In cases w h e re d is c lo s u re is needed, th e d isclo su re re q u ire m e n ts v a ry d e p e n d in g o n w h e th e r th e
DOCUMENT
s e c u ritie s are a lre a d y lis te d o n th e s to c k exchange. W e n o w discuss th e d isclo su re re q u ire m e n ts f o r o ffe rs
prospectus, profile
statement o r offer o f s e c u ritie s t h a t do n o t fa ll in to a n y o f th e e x e m p t categories.
information statement
that must be supplied
to potential investors 9.4.1 | Offers of unlisted securities
to provide information
about an offer of O ffe rs o f u n lis te d s e c u ritie s in c lu d e in it ia l p u b lic o ffe rin g s o f o r d in a r y shares a n d issues b y lis te d
securities
co m p a n ie s o f a n e w class o f se c u ritie s . In the se cases, th e s e c u ritie s do n o t have an o b se rva b le m a rk e t
p ric e a n d in th e case o f an in it ia l p u b lic o ffe rin g th e re m a y be lit t le , i f any, p u b lic ly a va ila b le in fo r m a tio n
a b o u t th e com p an y. T h ere fore, th e disclo su re re q u ire m e n ts t h a t a p p ly to o ffe rs o f u n lis te d se c u ritie s are
m o re s tr in g e n t th a n th o se f o r lis te d se cu ritie s.
The g e n e ra l ru le is t h a t an o ffe r o f s e c u ritie s to in v e s to rs c a n n o t p ro cee d u n t il a d isclo su re d o c u m e n t
has b e e n lo d g e d w it h th e A u s tra lia n S e cu ritie s a n d In v e s tm e n ts C o m m is s io n (A S IC ). D isclo su re
d o c u m e n ts m a y be g iv e n to p o te n tia l in v e s to rs as so o n as th e y have b e en lo d g e d w it h A S IC . F o r u n lis te d
s e c u ritie s , a w a itin g p e rio d o f a t le a st 7 days is im p o s e d b e fo re a p p lic a tio n s b y in v e s to rs can be accepted.
The w a itin g p e rio d a llo w s th e d isclo su re d o c u m e n t to be e x a m in e d b y A S IC a n d o th e r in te re s te d p a rtie s .
I f th e d o c u m e n t is fo u n d to be d e fic ie n t, th e issue o f s e c u ritie s can be delayed u n t il an acceptable
s u p p le m e n ta ry o r re p la c e m e n t d o c u m e n t is p ro v id e d .
The in fo r m a t io n t h a t m u s t be in c lu d e d va rie s w it h th e ty p e o f d is c lo s u re d o c u m e n t. The typ e s m o s t
c o m m o n ly used are:
• a p ro s p e c tu s
• a s h o r t- fo rm p ro sp e ctu s
• an o ffe r in fo r m a t io n s ta te m e n t.12
Prospectuses
PROSPECTUS A p ro sp ectu s is th e m o s t c o m p re h e n sive d o c u m e n t a n d g e n e ra lly c o n ta in s in fo r m a t io n o f fo u r m a in
a docum ent that, types:
a m o ng other things,
provides details of a in fo r m a t io n a b o u t th e s e c u rity issue— h o w m u c h c a p ita l is s o u g h t, th e s u b s c rip tio n p ric e , h o w th e
the co m p a n y and fu n d s w ill be used, a n y u p p e r o r lo w e r lim it s o n th e a m o u n t t h a t each in d iv id u a l can in v e s t a n d any
the terms of the issue
m in im u m s u b s c rip tio n le ve l th a t m u s t be ach ie ved
of securities, w hich
must be pro vided to
b n o n -fin a n c ia l in fo r m a t io n a b o u t th e issu e r— a d e ta ile d d e s c rip tio n o f it s b u sin ess a n d re p o rts fro m
potential investors by d ire c to rs o r e x p e rts in th e in d u s tr y
a co m p a n y seeking to C a d e ta ile d d is c u s s io n o f th e ris k s associated w ith th e bu sin ess
issue shares or other d fin a n c ia l in fo r m a tio n a b o u t th e is s u e r— th e m o s t re c e n t a u d ite d fin a n c ia l s ta te m e n ts an d, in m a n y
securities
cases, fin a n c ia l fo re ca sts in c lu d in g fo re ca sts o f p r o fits a n d d iv id e n d s .
The t e x t o f a ll p ro sp e ctu se s issu ed in A u s tra lia since 2 0 0 1 is a va ila ble a t w w w .s e a rc h .a s ic .g o v .a u /

o f f e r li s t / o f f e r l is t 一 is s u e r 一 n a m e .h tm l.
A p ro s p e c tu s is th e m o s t exp e n sive o f th e d o c u m e n ts to p re p a re , p r i n t a n d d is trib u te . The fa c to rs th a t
c o n trib u te to these costs in c lu d e th e size o f th e d o c u m e n t a n d th e fees payable to e x p e rts w h ose re p o rts
12 These disclosure documents apply in the case of security issues by companies. If funds are being raised for a managed
investment, such as a property trust, a different type of disclosure document known as a product disclosure statement (PDS)
is required.
are in clu d e d . M o re o v e r, d e ficie n cie s in a d isclo su re d o c u m e n t can lead to p e op le w h o w ere in v o lv e d in its

p re p a ra tio n o r in th e is s u in g o f s e c u ritie s b e in g lia b le f o r c r im in a l p ro s e c u tio n . T hey m a y also be re q u ire d
to com pensate in v e s to rs f o r losses su ffe re d as a re s u lt o f a m is s ta te m e n t in , o r an o m is s io n fro m , th e
d o cu m e n t. H o w eve r, th e Corporations Act p ro v id e s a *due d ilig e n c e , defence in re la tio n to a p ro s p e c tu s and
o th e r d isclo su re d o cu m e n ts. T his is a defence a g a in s t a c la im o f m is s ta te m e n t o r o m is s io n i f th e p e rso n
m ade a ll reasonable e n q u irie s a n d b e lie ve d o n rea son able g ro u n d s t h a t th e s ta te m e n t w as n o t m is le a d in g
o r de ceptive, o r th a t th e re w as n o o m is s io n . The p re p a ra tio n o f a p ro s p e c tu s can in v o lv e e x te n s iv e an d
c o s tly in v e s tig a tio n s to e n su re t h a t th e in fo r m a tio n p ro v id e d is as accurate as p o ssib le a n d t h a t th e due
d ilig e n ce defence w ill be a va ila b le i f a n y d e fic ie n c y is fo u n d .
The p ro sp e ctu s d is tr ib u te d to p o te n tia l in v e s to rs can be in a s h o r t f o r m 1, w h ic h m ea ns t h a t i t re fe rs
to m a te ria l in d o c u m e n ts lo d g e d w ith A SIC in s te a d o f p ro v id in g t h a t m a te ria l in th e p ro sp e ctu s. A s h o rt
fo rm pro sp e ctu s m u s t in fo r m in v e s to rs t h a t th e y are e n title d to a fre e cop y o f th e a d d itio n a l m a te ria l o n
request.
O ffer information statements

A n o ffe r in fo r m a tio n s ta te m e n t (O IS ) m a y be used in s te a d o f a p ro s p e c tu s i f th e a m o u n t o f m o n e y to
be raised is re la tiv e ly sm a ll. S p e cifica lly, an O IS m a y be used o n ly i f th e a m o u n t o f m o n e y to be ra ise d
b y th e issuer, w h e n adde d to a ll a m o u n ts p re v io u s ly raised, is less th a n $ 1 0 m illio n . A n O IS is m u c h less
c o s tly to p re p a re th a n a p ro s p e c tu s because th e in fo r m a tio n to be disclose d is m in im a l a n d e x te n s iv e *due
d ilig e n c e ’ e n q u irie s are n o t needed.
9 .4 .2 1 Offers of listed securities

The d isclosu re re q u ire m e n ts are less o n e ro u s f o r o ffe rs o f s e c u ritie s t h a t are a lre a d y lis te d o n a s to c k
exchange. A n exa m ple is a rig h ts issue w h e re n e w shares are o ffe re d to e x is tin g sh a re h o ld e rs. As
discussed in S e ctio n 9.6 .1 , a p ro s p e c tu s is n o lo n g e r re q u ire d f o r a rig h ts issue, b u t th e re m a y be cases
w h ere such issues are a cco m p a n ie d b y a p ro sp e ctu s. A lis te d e n t it y is s u b je c t to c o n tin u o u s d isclo su re
re q u ire m e n ts u n d e r s to c k exchange lis tin g ru le s backed b y th e Corporations Act. A n y m a te ria l p ric e -
se n sitive in fo r m a tio n has to be d isclo se d to th e s to c k exchange o n a c o n tin u o u s basis. T h e re fo re , m u c h
o f th e in fo r m a tio n t h a t w o u ld n o rm a lly have to be in c lu d e d in a p ro s p e c tu s is a lre a d y p u b lic ly ava ila ble,
so, i f a rig h ts issue is m ad e u n d e r a p ro sp e ctu s, i t does n o t n e ed to be as d e ta ile d as a p ro s p e c tu s f o r an
issue o f u n lis te d se c u ritie s .
9 .4 .3 1 Offers that do not need disclosure

There are v a rio u s e x e m p tio n s t h a t m e a n a d isclo su re d o c u m e n t is n o t ne eded f o r som e o ffe rs o f
se c u ritie s .13 The m a in e x e m p tio n s are o u tlin e d in Table 9.2.
TABLE 9.2 Main types of offer that do not need disclosure

O ff e r ty p e D e s c rip tio n
Small-scale offerin gs Personal offers th a t re s u lt in issues to no m ore th a n 20 in vestors in a ro llin g

1 2 -m o n th p e rio d , w ith a m a x im u m o f $2 m illio n raised.
Rights issues A p ro -ra ta o ffe r made o f a d d itio n a l shares to e x is tin g shareholders. The term s
o f the o ffe r to each shareholder m u s t be id e n tic a l and the new shares m u s t be
o f the same class as those already held.
S ophisticated investors: The a m o u n t payable fo r securities m u s t be a t least:
• Large offers $ 5 0 0 0 0 0 , OR
continued
13 The circumstances where a disclosure document is not required are set out in section 708 of the C o rp o ratio n s A ct.
B usiness finance
Table 9 .2 continued
O f f e r ty p e D e s c rip tio n
• O ffers to w e a lth y th e in v e s to r had a gross incom e over each o f the previous tw o fin a n c ia l years
in vestors o f a t least $250 000 o r n e t assets o f a t least $2.5 m illio n , OR
• O ffers to experienced th e o ffe r is made th ro u g h a licensed securities dealer w h o is satisfied th a t the

in vestors in v e s to r has s u ffic ie n t previous experience in in v e s tin g in securities to assess
m a tte rs such as th e m e rits o f th e o ffe r and th e risks involved.
Executive officers and O ffers to d irectors and o th e r persons in vo lve d in th e m anagem ent o f the
associates issu ing e n tity and ce rta in o f th e ir relatives and associated e n titie s .
E x is tin g s e c u rity holders O ffers o f fu lly pa id o rd in a ry shares u n d e r a d iv id e n d re in v e s tm e n t plan, bonus

share pla n o r share purchase plan. O ffers o f debentures to e x is tin g debenture
holders.
9.5 Floating a public com pany

W h e n a c o m p a n y f ir s t in v ite s th e p u b lic to su b scrib e f o r shares i t is u s u a l to re fe r to t h is as floating th e
L E A R N IN G com pany. A n a lte rn a tiv e te r m is t h a t th e c o m p a n y m akes an in it ia l p u b lic o ffe rin g (IP O ). A co m p a n y
OBJECTIVE 5
m a k in g it s f ir s t issue o f o rd in a ry shares to th e p u b lic w ill u s u a lly a p p ly f o r s to c k exchange lis tin g , w h ic h
Outline the process
of floating a public m ea ns t h a t sh a re h o ld e rs in th e c o m p a n y can se ll t h e ir shares o n th e s to c k exchange.14 To o b ta in lis tin g ,
co m p a n y th e d ire c to rs o f th e c o m p a n y m u s t e n sure t h a t it s p ro p o s e d s tru c tu re c o m p lie s w it h th e re q u ire m e n ts
o f th e exchange. F o r exa m ple, th e A S X has e xte n sive lis tin g ru le s t h a t are based o n seve ral p rin c ip le s
d e sig n e d to p ro te c t th e in te re s ts o f lis te d e n titie s , in v e s to rs a n d th e r e p u ta tio n o f th e m a rk e t.
L is te d e n titie s m u s t s a tis fy m in im u m s ta n d a rd s o f q u a lity a n d size, a n d c o m p ly w it h s trin g e n t
re q u ire m e n ts o n d isclo su re o f in fo r m a tio n . F o r exa m ple, to achieve lis tin g o n th e ASX, a c o m p a n y m u s t
u s u a lly have a t le a s t 3 0 0 sh a re h o ld e rs, each s u b s c rib in g f o r shares w it h a v a lu e o f a t le a s t $ 2 0 0 0 . E n titie s
to be lis te d m u s t also s a tis fy e ith e r a p r o f it te s t o r an assets te s t. The p r o f it te s t re q u ire s th e co m p a n y
to have g e n e ra te d a m in im u m aggregate p r o f it o f $1 m illio n o v e r th e p re v io u s th re e years a n d a t le ast
$ 4 0 0 0 0 0 in th e p re v io u s 12 m o n th s . The re q u ire m e n ts o f th e assets te s t in c lu d e n e t ta n g ib le assets o f
a t le a st $3 m illio n (a fte r d e d u c tin g th e costs o f fu n d ra is in g ) o r a m a rk e t c a p ita lis a tio n o f a t le a s t $10
m illio n . 15
The A S X sets the se c o n d itio n s in an e f f o r t to ensure t h a t th e re w ill be an a ctive m a rk e t in th e co m p a n y s
shares a fte r th e y are lis te d . C o m pa nie s t h a t are u n a b le to s a tis fy th e re q u ire m e n ts f o r lis tin g o n th e ASX
m a y o p t f o r lis tin g o n one o f th e m a rk e ts t h a t have d e ve lo p e d to m e e t th e needs o f s m a lle r com panies.
WWW
These in c lu d e th e A s ia Pacific S to ck Exchange (w w w .a p x .c o m .a u ) a n d th e N a tio n a l S to ck Exchange o f
A u s tra lia (w w w .n s x a .c o m .a u ), b o th o f w h ic h a im to p ro v id e a m a rk e t in th e shares o f s m a ll a n d m e d iu m
sized e n titie s w it h as fe w as 50 s e c u rity h o ld e rs.
9.5.1 I Public versus private ownership

A co m p a n y u n d e rta k in g a flo a t m a y be e ith e r a n e w c o m p a n y o r an e x is tin g p riv a te com pany. In th e
la tte r case, th e co m p a n y is said to be g o in g p u b lic 1. There are tw o m a in reasons w h y a p riv a te c o m p a n y
m a y go p u b lic . F irs t, lis te d p u b lic com p an ies u s u a lly have b e tte r access to th e c a p ita l m a rk e t th a n p riv a te
com p an ies. A s discussed in S e c tio n 9.3, p riv a te e q u ity in v e s to rs are v e ry se le ctive a n d th e te rm s t h a t th e y
re q u ire m a y n o t be a ttra c tiv e to th e o w n e rs o f a com p an y. G re a te r access to th e c a p ita l m a rk e t is m o s t
v a lu a b le to h ig h -g ro w th co m p a n ie s t h a t re q u ire fu n d s to im p le m e n t a ttra c tiv e n e w p ro je c ts . Second, a
14 While stock exchange listing normally follows a public issue, a company can list without raising any capital at the time of
listing provided it complies with the ASX Listing Rules. This approach is referred to as a compliance listing*. An alternative
way to become a listed public company is by a 'back-door listing*. This involves an unlisted company taking over a company
that is listed on the stock exchange.
15 These and other listing requirements apply to all companies. There are additional requirements that differ depending on
whether the company s main activities involve investment, mining exploration or scientific research. They are set out in
Chapter 1 of the ASX Listing Rules.
p u b lic flo a t a llo w s th e o w n e rs o f a c o m p a n y to cash in o n th e success o f th e bu sin ess th e y have developed.

The cash th e y receive b y s e llin g p a r t o f t h e ir in te re s t in th e co m p a n y can be used to d iv e rs ify t h e ir
in v e s tm e n t p o rtfo lio .
G o in g p u b lic also has several costs t h a t m u s t be co n sid e re d . The m o s t s ig n ific a n t is u s u a lly th e loss
o f c o n tro l associated w it h s h a rin g o w n e rs h ip o f th e co m p a n y w it h m a n y o th e r in v e s to rs . The o rig in a l
owners* v o tin g p o w e r w ill be red uce d a t th e tim e o f a flo a t a n d t h e ir p ro p o r tio n a l o w n e rs h ip m a y d e clin e
ove r tim e as th e y sell som e o f t h e ir shares o r as th e co m p a n y raises c a p ita l b y is s u in g m o re shares to n e w
in ve sto rs.
A p u b lic lis tin g also in v o lv e s d ire c t costs such as s to c k exchange lis tin g fees a n d s h a re h o ld e r s e rv ic in g
costs. In a d d itio n , lis te d c o m p a n ie s in c u r costs associated w it h g re a te r in fo r m a tio n d isclo su re . These costs
in c lu d e p ro d u c in g th e re q u ire d in fo r m a tio n a n d th e tim e s p e n t b y m a n a g e m e n t o n in v e s to r re la tio n s . In
p a rtic u la r, m anagers m a y n e e d to discuss th e c o m p a n y s p la n s a n d p ro sp e cts w it h a n a lysts e m p lo y e d b y
b ro ke rs a n d in s titu t io n s because th e re c o m m e n d a tio n s p ro d u c e d b y a n a lysts can in flu e n c e a co m p a n y s
share p ric e a n d its a b ility to raise c a p ita l b y is s u in g m o re shares. F in a lly , th e in fo r m a tio n t h a t a lis te d
com p an y is re q u ire d to disclose m a y in c lu d e d e ta ils t h a t are v a lu a b le to c o m p e tito rs .
9 .5 .2 | Initial public offering of ordinary shares

As s h o w n in Table 9.3, th e n u m b e r o f IPO s a n d t h e ir v a lu e can v a ry c o n s id e ra b ly fr o m yea r to year.
W h e n a c o m p a n y is to go p u b lic ,, its p ro m o te rs u s u a lly seek th e assistance o f a fin a n c ia l in s t it u t io n w ith
e xp e rtise in a rra n g in g share issues. T y p ic a lly , th is has b e en th e fu n c tio n o f th e la rg e r s to c k b ro k e rs an d
in v e s tm e n t b a n ks. B o th typ e s o f in s t it u t io n can advise o n th e p ric e o f th e issue, u n d e rw rite th e issue a n d
h a n d le th e sale o f th e shares.
TABLE 9.3 New listings on the ASX

Year en d e d June 3 0 2009 2010 2011 2012 2013
N u m be r o f new lis tin g s 45 93 160 99 82
In itia l cap ital raised 1.9 11.5 29.4 10.2 9.9

($ b illio n )
Source: ASX Limited, 2 0 1 3 Annual Report.
9 .5 .3 | Pricing a new issue

D e cid in g o n th e p ric e o f a n e w issue is a d iff ic u lt ta sk. The is s u e r faces p o te n tia l p ro b le m s i f th e o ffe r p ric e
is set to o h ig h o r to o lo w . I f th e p ric e is set to o h ig h , fe w in v e s to rs w ill w a n t to sub scrib e a n d th e issue m a y
fa il unless i t is u n d e rw ritte n , in w h ic h case th e u n d e r w r ite r w ill have to m e e t th e s h o rtfa ll. In t u r n , th is
o u tco m e w ill have a n e g a tive e ffe c t o n th e m a rk e t p ric e o f th e shares a fte r th e y are lis te d . I f th e p ric e is
set to o lo w , th e o w n e rs w ill s u ffe r an o p p o r tu n it y loss because th e y w o u ld have received a h ig h e r p a y m e n t
i f th e n e w issue h a d been m ad e a t a h ig h e r p rice . The a va ila b le evide nce suggests th a t, o n average, n e w
issues in it ia lly tra d e a t a p ric e above th e issue p rice . In t h is sense th e y are u n d e rp ric e d ,. The u n d e rp ric in g
o f in it ia l p u b lic o ffe rin g s is discussed in S e c tio n 9.5 .6 .
The ta s k o f s e ttin g th e issue p ric e is p a r tic u la r ly d iff ic u lt w h e n th e co m p a n y has ju s t b e e n fo rm e d ,
as th e re is n o re co rd o f fin a n c ia l p e rfo rm a n c e . W h e re th e co m p a n y has p re v io u s ly o p e ra te d as a p riv a te
com pany, th e ta s k is n o t as d iff ic u lt because p a s t p r o fits m a y be a g u id e to f u tu r e p ro fits . The m o s t
c o m m o n a p pro ach to p r ic in g used b y advisers is to use h is to ric a l p r o fits as th e basis f o r e s tim a tin g
fu tu re e a rn in g s p e r share. The a d vise r w ill also e x a m in e th e p ric e -e a rn in g s (P /E ) ra tio (th e m a rk e t price
o f a share, d iv id e d b y th e e a rn in g s p e r share) o f e x is tin g co m p a n ie s in th e sam e o r s im ila r in d u s trie s .
Forecasts o f fu tu re e a rn in g s p e r share a n d th e in fo r m a tio n o n p ric e -e a rn in g s ra tio s w ill th e n be used b y
th e a d vise r to suggest a p o ssib le range o f issue p rice s f o r th e co m p a n y s shares. F o r exa m ple, i f a c o m p a n y
is expected to e a rn 30 cen ts p e r share a n d th e p ric e -e a rn in g s ra tio s o f s im ila r co m p a n ie s are b e tw e e n 9
and 14, th is suggests an issue p ric e o f b e tw e e n $ 2 .7 0 a n d $ 4 .2 0 p e r share. I f in s titu t io n s are e n th u s ia s tic
a b o u t th e p ro p o se d issue, th e issue p ric e m a y be set close to $ 4 .2 0 . In c o n tra s t, i f th e re is li t t le in te re s t
A B usiness finance
in th e issue, th e issue p ric e m a y be set clo se r to th e lo w e r e n d o f th e range. As is e v id e n t fr o m th e above

d e s c rip tio n , use o f th is a p p ro a ch to set th e issue p ric e in v o lv e s co n sid e ra b le ju d g m e n t.
In th e case o f a fix e d -p ric e o ffe r, th e p ric e m u s t be se t b e fo re th e p ro s p e c tu s is p r in te d a n d th e o ffe r
is u s u a lly o p e n f o r a t le a s t 2 to 3 w eeks. C o n se q u e n tly, th e success o f th e o ffe r is s u b je c t to general
m o v e m e n ts in share p rice s d u rin g a p e rio d o f seve ral w eeks. F o r exa m ple, i f th e g e n e ra l le v e l o f share
prices increases s ig n ific a n tly d u rin g t h a t p e rio d , i t is lik e ly t h a t th e fix e d p ric e w ill be to o low . H o w eve r,
i f share p rice s decrease s ig n ific a n tly d u r in g t h a t p e rio d , in v e s to rs m a y re g a rd th e fix e d p ric e as b e in g to o
h ig h , a n d th e issue w ill close u n d e rs u b s c rib e d .
A n a lte rn a tiv e a p p ro a ch w h e n p r ic in g a n e w issue is to use book-building— a process t h a t in v o lv e s
c o m p e titiv e b id d in g b y m a rk e t p a rtic ip a n ts , p a r tic u la r ly in s titu t io n a l in v e s to rs . T his a p p ro a ch uses
e ith e r open pricing o r constrained open pricing. In b o th cases, p o te n tia l in v e s to rs place b id s f o r th e shares
w h e re th e y in d ic a te th e q u a n titie s th e y w is h to p u rcha se a t v a rio u s prices. The fin a l p ric e is d e te rm in e d
a t th e e n d o f th e b id d in g process. In th e case o f o p e n p ric in g , shares are u s u a lly a llo c a te d o n ly to b id d e rs
w h o o ffe re d p rice s e q u a l to o r h ig h e r th a n th e fin a l p rice . O p e n p r ic in g has b e en used in som e A u s tra lia n
flo a ts , b u t c o n s tra in e d o p e n p r ic in g is m o re c o m m o n . In c o n s tra in e d o p e n p ric in g , b o th u p p e r an d lo w e r
lim it s are placed o n th e p ric e a n d a ll b id s b e tw e e n th o s e lim it s are co n sid e re d . The p ro s p e c tu s w ill set o u t
th e c r ite r ia to be used in a llo c a tin g shares to b id d e rs . U su a lly, th e p ric e ran ge can be re v is e d d u rin g th e
b id d in g process i f d e m a n d f o r th e shares is fo u n d to be s u b s ta n tia lly g re a te r o r less th a n expected. O nce
th e fin a l p ric e has been d e te rm in e d , a ll successful b id d e rs p a y th e sam e p ric e b u t th o se w h o m ade h ig h e r
b id s have a h ig h e r p r o b a b ility o f re c e iv in g an a llo c a tio n o f shares.
O ffe rs to in s titu t io n s u n d e r a b o o k -b u ild in g process are o fte n a cco m p a n ie d b y an o ffe r to th e general
p u b lic (a 'r e ta il o ffe r*), w h e re a m a x im u m p ric e is sp e cifie d in advance a n d r e ta il in v e s to rs m a y also be
o ffe re d a p ric e d is c o u n t. F o r exa m ple, in th e flo a t o f Q R N a tio n a l L td in N o v e m b e r 2 0 1 0 , th e re was an
in s titu t io n a l b o o k -b u ild w it h an in d ic a tiv e p ric e ran ge o f $ 2 .5 0 to $3 a n d a re ta il o ffe r, w h ic h was su b je ct
to a m a x im u m p ric e o f $ 2 .8 0 p e r share. Successful a p p lic a n ts in th e re ta il o ffe r p a id th e lo w e r o f th e fin a l
p ric e p a id b y in s titu t io n s less a d is c o u n t o f 10 cen ts p e r share a n d th e m a x im u m r e ta il p ric e o f $2 .80.
B o o k -b u ild in g was f ir s t used in A u s tra lia b y th e N e w S o u th W ales G o v e rn m e n t w h e n i t so ld th e
G o v e rn m e n t In s u ra n c e O ffic e (G IO ) in 19 92 . Since th e G IO issue, i t has b e en use d in m a n y la rg e issues,
in c lu d in g th e W o o lw o rth s , Q an ta s, T e ls tra a n d N in e E n te rta in m e n t flo a ts , a n d in som e s m a lle r flo a ts
such as th o s e o f K a th m a n d u H o ld in g s ($ 3 4 0 m illio n in N o v e m b e r 2 0 0 9 ) a n d th e c re d it-c h e c k in g co m p a n y
Veda G ro u p ($ 3 4 1 m illio n in D e cem b er 2 0 1 3 ). The m a in a d va n ta g e o f b o o k -b u ild in g is t h a t i t a llo w s th e
is s u e r a n d its ad vise rs to o b ta in fee dba ck fr o m in fo rm e d in s titu t io n a l in v e s to rs o n t h e ir assessm ent o f
th e va lu e o f th e shares. The in fo r m a tio n g a th e re d fr o m th e se in v e s to rs can be used in s e ttin g th e issue
p rice . W h ile th is a p p ro a ch is e xp ected to re s u lt in a lo w e r le v e l o f u n d e rp ric in g , c o n d u c tin g a b o o k -b u ild is
a c o s tly process, so i t is u s u a lly w o r th w h ile o n ly f o r la rg e r flo a ts . H ence, th e m a jo r ity o f flo a ts in A u s tra lia
s t ill in v o lv e fix e d -p ric e o ffe rs.
W it h a fix e d -p ric e o ffe r, once th e te rm s h a ve b e e n se t, th e a d v is e r u s u a lly e n su re s t h a t th e p ro p o s e d
o ffe r s a tis fie s a ll re le v a n t le g a l re q u ire m e n ts a n d a s sists in p r e p a rin g th e o ffe r d o c u m e n t (u s u a lly
a p ro s p e c tu s ), e n su re s t h a t s to c k exch an ge lis t in g re q u ire m e n ts are m e t, lo d g e s th e p ro s p e c tu s
w it h A S IC a n d m a rk e ts th e shares to in s t it u t io n a l a n d p r iv a te in v e s to rs . The co sts o f p re p a rin g th e
p ro s p e c tu s in c lu d e le g a l fees, fees f o r th e p re p a ra tio n o f a n in v e s tig a tin g a c c o u n ta n t's r e p o r t a n d th e
co st o f p r in t in g . The t o t a l costs o f th e a d v is o ry se rv ic e s , in c lu d in g th e c o sts o f p re p a rin g a p ro s p e c tu s
a n d o b ta in in g s to c k exch a n g e lis tin g , can v a r y w id e ly a n d u s u a lly re p re s e n t b e tw e e n 2 a n d 5 p e r c e n t
o f th e a m o u n t ra is e d . A s discu sse d in S e c tio n 9 .5 .6 , th e costs can be less th a n 2 p e r c e n t o f th e a m o u n t
ra is e d f o r la rg e r flo a ts . C o n ve rse ly, f o r v e r y s m a ll flo a ts t h a t ra is e $ 1 0 m illio n o r less, th e co sts are
u s u a lly m u c h h ig h e r th a n 5 p e r c e n t. I f th e p ro m o te rs agree w i t h th e a d v is e rs re c o m m e n d a tio n s o n
th e te rm s o f th e flo a t, th e sam e a d v is e r w i ll u s u a lly be a p p o in te d to u n d e r w r ite a n d h a n d le th e sale
o f th e shares.
A s p re v io u s ly in d ic a te d , w ith a fix e d -p ric e o ffe r th e is s u e r is s u b je c t to th e vag aries o f th e m a rk e t fr o m

th e tim e w h e n th e p ric e is set u n t il th e issue closes. In m a n y cases th e issu e r w ill pass th is r is k o n to an
u n d e rw rite r, w h ic h is ty p ic a lly an in v e s tm e n t b a n k o r a m a jo r s to c k b ro k e r. I f th e b o o k -b u ild in g process is
used, o n e o r m o re in v e s tm e n t b a n ks o r b ro k e rs w ill be n e ed ed to receive a n d c o lla te th e in s titu t io n a l bids,
advise th e p ro m o te rs o n th e issue p ric e a n d m an ag e th e issue. In th is case, th e in s titu t io n s in v o lv e d are
ty p ic a lly re fe rre d to as 'lea d m anagers* o f th e issu e .16 N a tu ra lly , w h e n an u n d e r w r ite r acts as b o th a lead
m anager as w e ll as f u lf illin g th e m o re t r a d itio n a l u n d e r w r itin g ro le , separate fees are o fte n charged. F o r
exam ple, w h e n T en N e tw o rk H o ld in g s ra ise d $ 1 6 1 m illio n v ia th e in s titu t io n a l tra n c h e o f its e n title m e n t
o ffe r in Ju n e 20 1 2 , i t p a id its ad vise rs, C itig ro u p , 1.8 5 p e r c e n t o f th e gross pro cee ds as an u n d e r w r itin g
fee and a n o th e r 0.5 p e r ce n t as an o ffe r m a n a g e m e n t a n d a rra n g e m e n t fe e ,.
I f th e issue is u n d e rw ritte n , th e o b lig a tio n s o f th e co m p a n y a n d th e u n d e rw rite r are c o n ta in e d in an
u n d e rw ritin g ag ree m ent. The u n d e r w r ite r co n tra c ts to purchase a ll shares f o r w h ic h a p p lic a tio n s have n o t
been received b y th e c lo sin g date o f th e issue. In re tu rn , th e u n d e rw rite r charges a fee, u s u a lly based o n a fix e d
percentage o f th e a m o u n t to be raised b y th e issue. The fee is n e g o tia te d an d w ill re fle c t th e u n d e rw rite r s
p e rce p tio n o f th e d iffic u lty o f s e llin g th e issue a n d th is in t u r n w ill be d e te rm in e d b y fa c to rs such as th e
com pany s sta tu re in th e m a rk e t, th e p ric e o f th e issue an d general m a rk e t c o n d itio n s . The u n d e rw ritin g
agreem ent n o rm a lly in clu d e s escape clauses th a t sp e cify th e circum stances in w h ic h th e u n d e rw rite r w ill be
released fro m its o b lig a tio n s .17 In som e cases, th e ro le o f th e in s titu tio n s th a t m anage a flo a t m a y in clu d e
price s ta b ilis a tio n once th e shares are lis te d . Price s ta b ilis a tio n , also k n o w n as a greenshoe o p tio n (a fte r
th e com p an y th a t f ir s t used it ) , re q u ire s a special d is p e n s a tio n fro m ASIC. A d is p e n s a tio n o f th is ty p e was
o b ta in e d b y th e in v e s tm e n t b a n ks th a t m anaged th e N o ve m b e r 2 0 1 0 flo a t o f ra il o p e ra to r Q R N a tio n a l,
w h ic h was p re v io u s ly w h o lly o w n e d b y th e Q ue enslan d S tate G o v e rn m e n t (see F inance in A c tio n ).
F in a n c e
PRICE STABILISATION IN FLOAT OF RAIL OPERATOR____________ in ACTION
T h e Q R N a t io n a l m e d ia re le a s e a n d A S X a n n o u n c e m e n t a b o u t th e p r ic in g a n d a llo c a t io n o f
N e w s <W
s h a re s in its f lo a t c o n t a in e d th e f o llo w in g s ta te m e n t:
'F o llo w in g th e tr a n s f e r o f Q R N a t i o n a l S h a re s b y th e S ta te to s u c c e s s fu l a p p lic a n t s , th e S ta te

w ill in it ia lly r e ta in 8 2 1 4 3 6 7 3 5 Q R N a t i o n a l S h a re s . T h is a m o u n t m a y in c r e a s e b y u p to
n 墨.
1 4 6 4 0 0 0 0 0 Q R N a t io n a l S h a r e s d e p e n d in g o n w h e t h e r th e J o in t L e a d M a n a g e r s e x e r c is e
a n o p t io n to p u r c h a s e u p t o 6 p e r c e n t o f Q R N a t i o n a l S h a re s o n is s u e to c o v e r a n y o v e r-
a llo c a t io n s m a d e a s p a r t o f th e O ff e r , a s d e s c r ib e d in s e c tio n 2 . 4 . 3 o f th e O f f e r D o c u m e n t /
T h e m e a n in g o f th is s ta te m e n t w a s e x p la in e d a n d d is c u s s e d in a r tic le s b y f in a n c ia l jo u r n a lis ts .
E x c e rp ts fr o m o n e s u ch a r t ic le a p p e a r b e lo w .
R e a d th e Q R N a t io n a l m e d ia r e le a s e a b o u t t o d a y ’ s f lo a t c a r e f u lly a n d y o u r e a lis e th o s e c a n n y
in v e s tm e n t b a n k e r s s o ld 6 6 p e r c e n t o f th e s h a re s in th e c o m p a n y .
W h y s e ttle o n 6 6 p e r c e n t?
T h e a n s w e r ta k e s us to th e d a r k a r t o f th e f lo a t 's jo in t le a d m a n a g e r s e n t e r in g th e m a r k e t a n d
b u y in g s h a re s to s u p p o r t Q R 7s p r ic e . T h e p r ic e s u p p o r t t o o l k n o w n a s 'th e g r e e n s h o e ' is ( v e r y
o p a q u e ly ) d is c lo s e d in th e p r o s p e c tu s . .. T h e t a n g le d t e c h n ic a lit ie s o f th e g r e e n s h o e s p e c if y it is
a n o v e r - a llo c a tio n o p t io n .
T h e te c h n ic a lit ie s m e a n th e o v e r - a llo c a te d s to c k c a n b e b o u g h t b a c k o n th e m a r k e t b y th e
in v e s tm e n t b a n k s , p r o v id in g th e p r ic e s u p p o r t.
G u e s s w h a t ? T h e o v e r - a llo c a t io n o p t io n — a n d th e r e f o r e th e p r ic e s u p p o r t — o n ly k ic k s in a f t e r
th e Q u e e n s la n d g o v e r n m e n t s e lls 6 0 p e r c e n t o f th e s to c k . A n d th e o v e r - a llo c a tio n o p t io n is
lim it e d to 6 p e r c e n t o f th e to ta l s to c k o n is s u e .
N o w 6 0 p e r c e n t p lu s 6 p e r c e n t e x p la in s w h y th e o f f e r s o ld a m a g ic 6 6 p e r c e n t o f th e
c o m p a n y . N o t 6 1 p e r c e n t. N o t 6 4 p e r c e n t. R ig h t o n th e k n o c k e r o f 6 6 p e r c e n t.
A s in a n y f lo a t , it is h a r d to s e e w h e r e t o d a y 's p r ic e la n d s .
continued
16 It is possible for a share issue to be underwritten and priced using book-building. As discussed in Section 9.6.2, this
approach is often used for share placements where issuers desire certainty of funding and, given the short time involved, the
underwriting risk is low and its cost may be acceptable. In the case of IPOs, vendors are generally prepared to accept the risk
that the market clearing price1established in a book-build may be less than they expected. In such cases, the indicative price
range may be lowered or the proposed share issue may be withdrawn.
17 The escape clauses in an underwriting agreement relate to factors that would seriously affect demand for shares in general,
such as the outbreak of war, a significant reduction in a benchmark market index such as the S&P/ASX 200, as well as
company-specific events that could reduce the value of the shares.
B usiness finance
continued
B e c e r t a in o f th is : if th e s h a r e p r ic e f a lls b e lo w th e o f f e r p r ic e , th e r e is p r ic e s u p p o r t
a v a ila b l e in th e fo r m o f f iv e in v e s tm e n t b a n k s w it h a b o u t 9 p e r c e n t o f th e to ta l t r a d e d s h a re s
a v a ila b l e to b u y .
If th e s h a r e p r ic e is h o v e r in g a b o v e a n d b e lo w th e o f f e r p r ic e , r e a d th e Q u e e n s la n d
g o v e r n m e n t 's v ic t o r io u s m e d ia r e le a s e s w it h a d e g r e e o f s c e p tic is m . T h e s h a r e p r ic e is m o r e
th a n lik e ly b e in g g a m e d .
Source: 'Greenshoe on cue may be used to keep QR National 0^001', Stuart Washington, Sydney Morning Herald,
22 November 2010.
The la rg e r s to c k b ro k e rs are m a jo r u n d e rw rite rs , p r im a r ily because th e y have an e s ta b lis h e d c lie n te le

p re p a re d to su b scrib e f o r th e issues th e y u n d e rw rite . A n u n d e r w r ite r w ill fre q u e n tly a tte m p t to li m it its
e xp osu re to th e r is k o f u n d e rs u b s c rip tio n b y in v it in g o th e r in s titu t io n s to a ct as s u b u n d e rw rite rs . These
in s titu t io n s m a y in c lu d e life a n d g e n e ra l in s u ra n c e co m p a n ie s, b a n k s a n d s u p e ra n n u a tio n fu n d s . The ro le
o f th e s u b u n d e rw rite r is to ta k e u p a p r o p o r tio n o f a n y u n d e rs u b s c rip tio n in r e tu r n f o r a fee, p a id b y th e
u n d e rw rite r, w h ic h is based o n a fix e d p r o p o r tio n o f th e issue p ric e .18
I f a s to c k b ro k e r is th e u n d e r w r ite r o r le a d m a n a g e r o f an issue o f shares i t w ill u s u a lly a ct as a s e llin g ag en t

f o r th e issue. By p r o m o tin g an issue, a s to c k b ro k e r p ro te c ts its in te re s ts as u n d e r w r ite r a n d also earns
b ro k e ra g e fees. D e p e n d in g o n th e size o f th e issue, one o r m o re o th e r b ro k in g fir m s m a y also be a p p o in te d
as m a n a g e rs o r co-m a na gers to assist in p u b lic is in g th e issue a n d d is tr ib u tin g th e shares to a w id e range
o f c lie n ts . The fees p a id to the se firm s w ill u s u a lly be s tru c tu re d so t h a t b ro k e rs w h o can d is tr ib u te shares
to c lie n ts have an in c e n tiv e to co m p e te a g a in s t in s titu t io n a l b id s in a b o o k -b u ild . To th is end, th e fees
f o r b ro k e rs m a y be d iv id e d in to a ‘f ir m a llo c a tio n fe e ’ a n d a ‘h a n d lin g fee’. The separate h a n d lin g fee
encourages b ro k e rs to place b id s f o r a d d itio n a l shares above t h e ir f ir m a llo c a tio n in th e e x p e c ta tio n th a t
th e a d d itio n a l shares can be so ld to t h e ir c lie n ts . G re a te r c o m p e titio n b e tw e e n in s t it u t io n a l in v e s to rs and
b ro k e rs ’ c lie n ts (re ta il in v e s to rs ) is, o f course, d e sira b le f o r th e is s u e r a n d th e lead m an ag er.
W h e re a fix e d -p ric e issue is n o t u n d e r w r itte n , a b ro k e r w ill s t ill be engaged to a ssist in d is tr ib u tin g
th e shares. B roke rag e fees are n e g o tia b le a n d d e p e n d o n fa c to rs such as th e size o f th e issue, th e s ta tu s o f
th e is s u in g co m p a n y a n d th e p e rio d f o r w h ic h th e issue is to re m a in open. B roke rag e fees are u s u a lly set
b e tw e e n 1 a n d 2 p e r c e n t o f th e issue p rice .
I t was n o te d in S e c tio n 9 .2 .5 t h a t ra is in g c a p ita l b y is s u in g shares can in v o lv e s ig n ific a n t costs. In th e case

o f c o m p a n y flo a ts th e costs fa ll in to th re e m a in categories:
a Stock exchange listing fees and the costs ofpreparing and distributing a prospectus. These costs in c lu d e
le ga l fees, fees f o r th e p re p a ra tio n o f an in v e s tig a tin g a c c o u n ta n ts r e p o rt, fees f o r e x p e rt re p o rts
a n d p r in t in g costs.
b Fees paid to underwriters or lead managers and commissions paid to brokers for selling the shares. The
t o ta l o f these fees a n d costs can v a ry c o n s id e ra b ly b u t f o r m o s t flo a ts th e costs w o u ld fa ll in th e
ran ge fro m 1 to 5 p e r c e n t o f th e fu n d s raised.
C Underpricing. The t h ir d c a te g o ry o f costs re la te s to th e fa c t t h a t th e issue p ric e o f shares s o ld in an
IP O is u s u a lly less th a n th e m a rk e t v a lu e o f th e shares once th e y are lis te d .
The costs t h a t fa ll in to th e f ir s t tw o cate gories m a y be c o m b in e d to fo r m a t o t a l cost o f lis tin g .

U n d e rp ric in g o f IPO s can be s ig n ific a n t a n d is discussed a fte r we discuss th e costs o f lis tin g .
The fa c to rs t h a t in flu e n c e th e costs o f lis tin g f o r a flo a t in c lu d e its size, th e ris k in e s s o f th e co m p a n y
a n d th e c o m p le x ity o f th e u n d e rly in g bu sin ess. The t o ta l costs w ill g e n e ra lly increase w it h th e size o f th e
18 The subunderwriting fee is usually only slightly less than the underwriting fee. For example, if the underwriting fee was 3 per
cent of the issue price, the subunderwriting fee would usually be about 2.5 per cent of the issue price.
flo a t, b u t because o f th e fix e d n a tu re o f som e c o m p o n e n ts o f th e costs, th e y w ill be la rg e r in p e rcen ta ge

te rm s w h e n th e a m o u n t o f fu n d s s o u g h t is sm a ll. F o r exa m ple, w h e n th e a m o u n t s o u g h t is less th a n
$ 1 0 m illio n , th e costs can be m o re th a n 15 p e r c e n t o f th e a m o u n t s o u g h t. F o r flo a ts t h a t raise m o re th a n
$ 1 0 0 m illio n , th e costs are u s u a lly fr o m 2 to 5 p e r c e n t o f th e a m o u n t s o u g h t a n d can be even lo w e r f o r
la rg e r flo a ts . H o w eve r, v e ry la rg e flo a ts m a y be h a rd e r to sell a n d re q u ire a g re a te r m a rk e tin g e ffo r t. F o r
exam ple, i f a flo a t is so la rge t h a t i t is necessary to a ttr a c t m a n y in te r n a tio n a l in v e s to rs , th e average cost
m a y be h ig h e r th a n f o r a s m a lle r flo a t t h a t is s o ld o n ly in th e A u s tra lia n m a rk e t. I f a co m p a n y has above-
average business ris k , i t w i ll g e n e ra lly be m o re d iff ic u lt to d e te rm in e an a p p ro p ria te p ric e f o r th e shares a n d
m o re d iffic u lt to se ll th e shares to in v e s to rs . T h ere fore, a m in in g e x p lo ra tio n co m p a n y w ill be m o re c o s tly
to flo a t th a n an e s ta b lis h e d in d u s tr ia l co m p a n y w it h sta b le cash flo w s. F in a lly , i f a co m p a n y s o p e ra tio n s
are c o m p le x o r d iff ic u lt to u n d e rs ta n d , i t w ill be m o re c o s tly to c a rry o u t ‘due d ilig e n c e ’ in v e s tig a tio n s o f
th e com pany, a n d to engage in research a n d m a rk e tin g . F o r exa m ple, a d d itio n a l in d e p e n d e n t experts*
re p o rts m a y be re q u ire d a n d a d d itio n a l costs m a y be in c u rre d in p r o m o tin g th e flo a t.
W h e re a flo a t is u n d e r w r itte n , th e u n d e r w r itin g fee g e n e ra lly ranges fr o m 1 to 5 p e r c e n t o f th e
fu n d s so u g h t. H is to ric a lly , th e m a jo r ity o f A u s tra lia n flo a ts have be en u n d e r w r itte n , b u t in re c e n t years
th e p o p u la rity o f u n d e r w r itin g has d e c lin e d as m o re flo a ts have be en p ric e d a n d so ld u s in g th e b o o k
b u ild in g process. W h e re b o o k -b u ild in g is used, in v e s tm e n t b a n ks a n d b ro k e rs are s t ill in v o lv e d in th e IPO.
H ow ever, in s te a d o f b e in g p a id to g u a ra n te e t h a t a c e rta in su m w ill be raised, th e y are p a id to p ro v id e
a range o f services, in c lu d in g p re p a ra tio n o f research re p o rts o n th e com pany, a rra n g in g s e m in a rs an d
a n a lyst b rie fin g s , a n d m a n a g in g th e b o o k -b u ild in g process. T h ere fore, b o o k -b u ild in g in v o lv e s s ig n ific a n t
costs a n d w ill n o t ne ce ssa rily be che ap er th a n h a v in g a flo a t u n d e r w r itte n . In s u m m a ry , th e costs o f
lis tin g are g e n e ra lly lo w e s t f o r la rge , lo w - r is k flo a ts w h e re th e u n d e rly in g b u sin ess is e a sily u n d e rs to o d b y
in v e s to rs . F o r exa m ple, in th e 2 0 1 0 flo a t o f Q R N a tio n a l, w h ic h ra ise d $ 4 .0 5 b illio n , issue costs as d e ta ile d
in se ctio n 1 0 .1 3 .4 o f th e c o m p a n y s O ffe r D o c u m e n t a m o u n te d to $ 7 5 .5 m illio n , w h ic h is less th a n 1.9
p e r ce n t o f th e fu n d s raised.
U n d e rp ric in g o f a n IP O re p re s e n ts a re a l co st to th e o rig in a l sh a re h o ld e rs, w h o are e ffe c tiv e ly s e llin g
assets to th e n e w sh a re h o ld e rs f o r less th a n t h e ir f a ir value. T his d iffe re n c e in v a lu e is o fte n re fe rre d to as
m o n e y le ft o n th e ta b le 1. M o re pre cise ly, m o n e y le f t o n th e ta b le is u s u a lly d e fin e d as th e r e tu r n o n th e
f ir s t day o f tra d in g , an d is ty p ic a lly m e a su re d b y th e n u m b e r o f shares sold, m u ltip lie d b y th e d iffe re n c e
b e tw e e n th e firs t-d a y c lo s in g m a rk e t p ric e a n d th e issue p rice . I t has b e e n w e ll d o c u m e n te d t h a t in IPO s
th e a m o u n t o f m o n e y le f t o n th e ta b le is ty p ic a lly large. F o r exa m ple, R itte r a n d W e lch fo u n d t h a t th e
average firs t-d a y r e tu r n f o r 6 2 4 9 IP O s in th e US b e tw e e n 1 9 8 0 a n d 2 0 0 1 was 1 8 .8 p e r c e n t.19 R itte r a n d
W elch also fo u n d t h a t th e average firs t-d a y r e tu r n v a rie d c o n s id e ra b ly o v e r tim e . In th e 19 80 s, th e average
firs t-d a y r e tu r n was 7 .4 p e r c e n t a n d i t in crea sed to a lm o s t 1 1 .2 p e r c e n t d u r in g 1 9 9 0 -9 4 a n d 1 8 .1 p e r
cent d u rin g 1 9 9 5 -9 8 b e fo re ju m p in g to 65 p e r c e n t d u rin g th e in t e r n e t b u b b le , p e rio d in 1 9 9 9 -2 0 0 0 and
th e n re v e rtin g to 14 p e r c e n t in 2 0 0 1 .20
In A u s tra lia , a s tu d y b y Lee, T a y lo r a n d W a lte r (1 9 9 6 ) o f 2 6 6 in d u s tr ia l IP O s b e tw e e n 1 9 7 6 a n d 1 9 8 9
fo u n d an average firs t-d a y a b n o rm a l r e tu r n o f 11 .9 p e r ce n t. D im o v s k i a n d B ro o ks (2 0 0 3 ) s tu d ie d 3 5 8
in d u s tria l a n d resource IP O s in A u s tra lia fr o m 1 9 9 4 to 1 9 9 9 a n d fo u n d t h a t th e average firs t-d a y r e tu r n
was 25 .6 p e r c e n t, w h ile th e m e d ia n firs t-d a y r e tu r n was 9.3 p e r ce n t. The IP O s th e y s tu d ie d ra ise d a to ta l
o f $ 2 4 ,4 3 9 b illio n in c a p ita l, th e t o ta l a m o u n t o f m o n e y le f t o n th e ta b le was $ 5 ,6 7 8 b illio n a n d t o t a l issue
costs w ere $ 5 9 2 m illio n . Da S ilva Rosa, V e la y u th e n a n d W a lte r (2 0 0 3 ) re p o rte d m e d ia n u n d e rp ric in g o f
12 p e r c e n t f o r t h e ir sam p le o f 3 3 3 A u s tra lia n in d u s tr ia l IP O s f r o m 1 9 9 1 to 19 9 9 . G on g a n d S h e kh a r
(2 0 0 1 ) s tu d ie d a ll 11 g o v e rn m e n t-s e c to r IPO s in A u s tra lia b e tw e e n 1 9 8 9 a n d 19 99 . T hey fo u n d an average
firs t-d a y a b n o rm a l r e tu r n f o r r e ta il in v e s to rs o f a p p ro x im a te ly 11 p e r c e n t a n d c o n c lu d e d t h a t th e re is
n o evidence th a t th e u n d e rp ric in g o f the se IPO s d iffe rs fr o m t h a t o f A u s tra lia n p riv a te -s e c to r IPO s o r o f
g o v e rn m e n t-s e c to r IP O s in o th e r O EC D c o u n trie s . The u n d e rp ric in g p h e n o m e n o n is n o t re s tric te d to
th e US a n d A u s tra lia . P ro fe s s o r Jay R itte r fr o m th e U n iv e rs ity o f F lo rid a is one o f th e w o r ld s fo re m o s t
e xp e rts in th e area o f IP O u n d e rp ric in g a n d has c o lle c te d th e e m p iric a l re s u lts fr o m m a n y stu d ie s
u n d e rta k e n in d iffe re n t c o u n trie s a ro u n d th e w o rld (see h t t p : / / b e a r . w a r r in g t o n . u f l. e d u / r it t e r / ip o d a t a .
|wwwj
h tm ) . F igu re 9.1 d e m o n s tra te s th e in it ia l re tu rn s en jo yed, o n average, b y IP O su b scrib e rs in te r n a tio n a lly
an d illu s tra te s ju s t h o w p e rv a s iv e IP O u n d e rp ric in g has been.
19 Ritter and Welch (2002). The equally-weighted average first-day return measured from the offer price to the first closing price
listed by CRSP is 18.8 per cent.
20 For an analysis of possible reasons for this variation, see Loughran and Ritter (2004).
B usiness finance
Source: Loughran, T., Ritter, J. and Rydqvist, K., Initial public offerings: International insights: 2014 update', 17 January
2014, http://bear.warrington.ufl.edu/ritter/lnt2014.pdif.
Reasons for underpricing

M a n y p o s s ib le e x p la n a tio n s f o r th e u n d e rp ric in g o f IPO s have b e en p ro p o s e d . O n e e x p la n a tio n is based
o n in fo r m a t io n a s y m m e try in t h a t som e in v e s to rs are m o re in fo rm e d th a n th e issu er, p e rh a p s a b o u t
th e g e n e ra l d e m a n d f o r shares in th e m a rk e t. I t is also based o n th e c o n ce p t t h a t som e in v e s to rs are
LEARNING
w e ll in fo rm e d a b o u t th e value o f th e shares b e in g o ffe re d w h ile o th e rs are u n in fo r m e d a n d th e re fo re
OBJECTIVE 6
Discuss alternative have d iff ic u lt y e s tim a tin g th e fu tu r e m a rk e t p ric e o f th e shares. T his a p p ro a ch pro po ses t h a t a degree
explanations for the o f u n d e rp ric in g is necessary to a ttr a c t the se in v e s to rs . U n in fo rm e d in v e s to rs m a y a p p ly f o r a n y IP O
underpricing of initial b u t in fo r m e d in v e s to rs w ill o n ly s u b scrib e w h e n an issue is u n d e rp ric e d . T h e re fo re , w h e n an issue is
public offerings
o v e rp ric e d , a ll th e shares w ill be a llo c a te d to u n in fo rm e d in v e s to rs . C onversely, w h e n an issue is
u n d e rp ric e d , in fo r m e d in v e s to rs w ill c ro w d out* th e u n in fo rm e d , w h o w i ll be a llo c a te d o n ly a fra c tio n o f
th e shares.
T his e x p la n a tio n m a y be illu s tra te d w it h a s im p le exa m ple. C o n s id e r tw o IPO s, one o f w h ic h records
a firs t-d a y r e t u r n o f + 2 0 p e r ce n t, w h ile th e o th e r re co rd s a firs t-d a y r e t u r n o f - 1 0 p e r ce n t. Hence, th e
average firs t-d a y r e tu r n is 5 p e r ce n t. Because th is r e tu r n is p o s itiv e , th e re appears to be u n d e rp ric in g .
N o w c o n s id e r th e r e tu r n e a rn e d b y an u n in fo rm e d in v e s to r w h o a p p lie s f o r $ 1 0 0 0 0 w o r th o f shares in
each o f th e se IP O s a n d is a llo c a te d $ 5 0 0 0 w o r th o f shares in th e f ir s t IP O a n d th e f u ll $ 1 0 0 0 0 w o r th o f
shares in th e second. The u n in fo rm e d in v e s to r s r e t u r n is 0 p e r c e n t. T h e re fo re , fr o m th e v ie w p o in t o f th e
u n in fo r m e d in v e s to r, th e IPO s are o n average f a ir ly p ric e d . In s u m m a ry , w h ile IPO s in v o lv e la rg e average
in it ia l r e tu rn s , th is does n o t n e ce ssa rily m e a n t h a t e v e ry in v e s to r can e xp e ct to e a rn a b n o rm a l r e tu rn s b y
s u b s c rib in g f o r co m p a n y flo a ts .
W IN N E R ^ CURSE U n in fo rm e d in v e s to rs , th e re fo re , face a w inn er^ curse. I f th e y g e t a ll o f th e shares th e y d e m an d,
problem that arises i t is because th e in fo r m e d in v e s to rs d id n o t w a n t th e m . Faced w it h th is s itu a tio n , u n in fo r m e d in v e s to rs
in bidding because
w ill o n ly s u b scrib e to IPO s i f th e y are s u ffic ie n tly u n d e rp ric e d , o n average, to c o m p e n sa te f o r th e bias
the bidder who
in th e a llo c a tio n o f shares ( fo r m o re d e ta ils , see R o ck 1 9 8 6 ). In research re la te d to th e ‘w in n e r ’s curse’
’wins’ is likely to be
the one who most e x p la n a tio n i t is c o m m o n to assum e t h a t la rg e r in v e s to rs are b e tte r in fo rm e d th a n s m a ll in v e s to rs .
overestimates the Lee, T a y lo r a n d W a lte r (1 9 9 9 ) e xa m in e th is issue b y s tu d y in g IPO s o n th e S to ck E xchange o f S in ga pore
value of the assets w h e re d e ta ile d d a ta o n a p p lic a tio n s f o r a n d a llo c a tio n s o f shares are ro u tin e ly p ro v id e d . T h e ir re s u lts are
offered for sale
c o n s is te n t w it h R o c k s (1 9 8 6 ) m o d e l: la rg e r in v e s to rs are m o re in fo rm e d in t h a t th e y a p p ly f o r re la tiv e ly
m o re shares in issues t h a t are u n d e rp ric e d . Thus, s m a ll in v e s to rs are c ro w d e d o u t o f th e m o s t u n d e rp ric e d
issues a n d receive la rg e r p r o p o r tio n s o f th e less a ttra c tiv e issues.
A seco nd e x p la n a tio n f o r th e u n d e rp ric in g o f IP O s is t h a t p o te n tia l in v e s to rs w i ll a tte m p t to ju dg e
th e in te re s t o f o th e r in v e s to rs a n d w ill o n ly s u b scrib e f o r IP O s t h a t th e y b e lie ve w i ll be p o p u la r. I f
an in v e s to r perceives t h a t a flo a t is n o t p o p u la r w it h o th e r in v e s to rs , th e n he o r she m a y decide n o t
to sub scrib e. I f th e is s u e r sets a p ric e t h a t is p e rce ive d as o n ly a l i t t le to o h ig h , th e re is a s ig n ific a n t
p r o b a b ility t h a t th e issue w ill be a fa ilu re , w it h in v e s to rs d e c id in g n o t to s u b scrib e because o th e rs have
also de cid e d n o t to sub scrib e. T h ere fore, issu ers m a y have an in c e n tiv e to u n d e rp ric e an issue in o rd e r
to in d u c e som e p o te n tia l in v e s to rs to buy. The a c tio n o f the se in v e s to rs m a y th e n se t o f f a cascade in
w h ic h o th e r in v e s to rs are w illin g to sub scrib e. R itte r a n d W e lch (2 0 0 2 ) n o te t h a t th is e x p la n a tio n is

s u p p o rte d b y evidence t h a t IP O s te n d to be e ith e r u n d e rs u b s c rib e d o r h e a v ily o v e rsu b scrib e d , w it h fe w
b e in g m o d e ra te ly o v e rsu b scrib e d .
U s in g b o o k -b u ild in g to p ric e an IPO, w h ic h in c re a s in g ly has becom e s ta n d a rd p ra ctice , a llo w s issuers
to o b ta in in fo r m a tio n fro m in fo rm e d in v e s to rs . A f te r an in d ic a tiv e p ric e ran ge has been set, th e issu e r
a n d th e lead m a n a g e r u s u a lly go o n a ‘ro a d s h o w ’ to p ro m o te th e co m p a n y to p ro s p e c tiv e in v e s to rs . The
lead m a n a g e r can th e n gauge d e m a n d f o r th e shares as exp re ssio n s o f in te re s t are rece ive d fr o m p o te n tia l
in ve sto rs. I f d e m a n d is h ig h , th e o ffe r p ric e w ill be set a t th e to p o f th e in d ic a tiv e p ric e range o r i t m a y
be set above th a t le ve l i f d e m a n d is p a r tic u la r ly s tro n g . H o w e ve r, p o te n tia l in v e s to rs w ill be u n w illin g
to reveal t h e ir tru e in te re s t in th e IP O i f th e y k n o w t h a t s h o w in g s tro n g in te re s t is lik e ly to re s u lt in a
h ig h e r o ffe r p ric e — un le ss th e y are o ffe re d s o m e th in g in re tu rn . U n d e rp ric in g th e n becom es p a r t o f th e
in d u c e m e n t needed to g e t p o te n tia l in v e s to rs to t r u t h f u lly re ve a l t h a t th e y are w illin g to pu rcha se th e
shares a t a h ig h price. A n a ly s is o f d a ta o n IPO s p ric e d u s in g b o o k -b u ild in g in th e US is c o n s is te n t w ith
th is a rg u m e n t. F o r e xa m p le , R itte r a n d W e lch fo u n d t h a t o v e r th e 1 9 8 0 to 2 0 0 1 p e rio d , f o r IP O s th a t
were p ric e d w it h in th e in d ic a tiv e p ric e range, average u n d e rp ric in g was 12 p e r ce n t. H o w e ve r, w h e n th e
o ffe r p ric e was above th e in d ic a tiv e p ric e range, average u n d e rp ric in g was 53 p e r ce n t. The a d d itio n a l
u n d e rp ric in g is re g ard ed as c o m p e n s a tio n to in d u c e in v e s to rs to reve al t h e ir h ig h in d iv id u a l d e m a n d
f o r th e shares— b u t as R itte r a n d W e lch n o te , average u n d e rp ric in g o f 53 p e r c e n t seems to be excessive
c o m p e n s a tio n f o r re v e a lin g in fo r m a tio n .
Several stu d ie s have fo u n d t h a t g re a te r u n d e rp ric in g is a sso cia te d w it h h ig h e r tra d in g v o lu m e once
th e shares becom e lis te d . A c c o rd in g ly , a t h ir d e x p la n a tio n f o r u n d e rp ric in g is t h a t i t p ro v id e s b e n e fits
th ro u g h g re a te r liq u id ity . F o r exa m ple, a b ro k e r w h o u n d e rw rite s an IP O can e a rn h ig h e r b ro ke ra g e
fees fo r h a n d lin g tra d e s in th e p o s t-lis tin g m a rk e t i f th e issue is u n d e rp ric e d . L iq u id ity can also b e n e fit
issuers, p a rtic u la rly i f th e y have re ta in e d a h ig h p r o p o r tio n o f th e c o m p a n y s shares. P ham , K a le v an d
Steen (2 0 0 3 ) argue t h a t g re a te r u n d e rp ric in g encourages s m a ll in v e s to rs to su b scrib e f o r an IPO, w h ic h
re su lts in a b ro a d e r an d m o re d iffu s e o w n e rs h ip base. U s in g a sam ple o f A u s tra lia n IPO s th e y s h o w t h a t
these fa c to rs are s ig n ific a n tly a n d p o s itiv e ly a sso cia te d w it h th e liq u id it y o f th e shares once th e y are
lis te d . C onversely, th e y argue t h a t lo w e r u n d e rp ric in g w ill g ive ris e to a m o re c o n c e n tra te d o w n e rs h ip
s tru c tu re , w h ic h m a y be p re fe rre d i f la rge sh a re h o ld e rs o b ta in b e n e fits fr o m c o n tro l o r can p ro v id e
va lua ble m o n ito r in g o f th e c o m p a n y s m a n a g e m e n t.
A f o u r t h e x p la n a tio n is t h a t u n d e rp ric in g o f IPO s is in th e in te re s ts o f th e is s u in g com p an y. O ne
aspect o f th is e x p la n a tio n is t h a t u n d e rp ric e d IP O s *leave a g o o d taste* w it h in v e s to rs , ra is in g th e p ric e
a t w h ic h sub se q u e n t share issues b y th e c o m p a n y can be s o ld .21 A re la te d a rg u m e n t is t h a t u n d e rp ric in g
re fle cts, a t le ast in p a rt, th e co st to th e is s u in g co m p a n y o f p u rc h a s in g research coverage b y a n a lysts.
C liff a n d D e nis (2 0 0 4 ) n o te t h a t in a d d itio n to p re -IP O a c tiv itie s re la te d to th e p r ic in g a n d m a rk e tin g o f
a share issue, in v e s tm e n t b a n k s p ro v id e a ran ge o f p o s t-is s u e services such as m a rk e t-m a k in g a n d a n a ly s t
research coverage. T hey also n o te t h a t is s u in g co m p a n ie s a p p e a r to place a v a lu e o n s e c u rin g research
coverage fr o m a n a lysts, p a r tic u la r ly th o s e w it h s tro n g re p u ta tio n s . A c c o rd in g ly , issu ers p la n n in g an IPO
m a y seek o u t u n d e rw rite rs w h o th e y e xp e ct w ill p ro v id e research coverage b y a h ig h ly ra te d a n a ly s t a n d
issuers w ill be p re p a re d to p a y f o r t h a t a n a ly s t coverage— p e rh a p s d ire c tly b y w a y o f h ig h e r u n d e r w r itin g
fees. H o w eve r, C lif f a n d D e n is fo u n d t h a t u n d e r w r itin g fees are la rg e ly u n ifo r m a n d p ro p o se in s te a d t h a t
gre a te r u n d e rp ric in g serves to in d ir e c tly com p e n sa te u n d e rw rite rs f o r p ro v id in g a n a ly s t coverage. F o r
exam ple, u n d e rw rite rs can b e n e fit fr o m u n d e rp ric in g b y a llo c a tin g shares to fa v o u re d c lie n ts w h o are
expected to p ro v id e th e u n d e r w r ite r w it h in v e s tm e n t b a n k in g o r b ro k in g b u sin e ss in th e fu tu re .
A f if t h e x p la n a tio n is t h a t issu e rs u n d e rp ric e IP O s to reduce th e r is k o f b e in g sued b y in v e s to rs . W h ile
th e p o te n tia l le ga l lia b ilit y o f issu e rs m a y be a fa c to r in som e IPO s, p a r tic u la r ly in th e US, o th e r c o u n trie s ,
w h ere litig a t io n is m u c h less c o m m o n , e xp erience s im ila r levels o f u n d e rp ric in g . T h e re fo re , i t seems
u n lik e ly th a t le ga l lia b ilit y is th e m a in fa c to r t h a t d e te rm in e s th e u n d e rp ric in g o f IPO s.
F in a lly , L o u g h ra n a n d R itte r (2 0 0 2 ) n o te t h a t issuers ra re ly ap p e a r to be u p s e t a b o u t le a v in g
s u b s ta n tia l a m o u n ts o f m o n e y o n th e ta b le in IPO s. T hey p ro p o se a b e h a v io u ra l e x p la n a tio n f o r th is
p u z z lin g p h e n o m e n o n . T h e ir e x p la n a tio n can be illu s tra te d u s in g a h y p o th e tic a l e xa m p le . Suppose th a t
M arcus T h o m p s o n o w n s a la rg e successful b u sin ess an d, a fte r d is c u s s io n w ith an in v e s tm e n t b a n k , he
plan s to sell 60 p e r c e n t o f th e co m p a n y in an IPO , w h ic h w ill be p ric e d u s in g a b o o k -b u ild . The in d ic a tiv e *1
4
9
21 For an analysis of this explanation, see Welch (1989). The explanations for underpricing of IPOs outlined above are only some
of the possible explanations that have been proposed. Further explanations are discussed by Ibbotson, Sindelar and Ritter
(1994) and Brau and Fawcett (2006).
B usiness finance
p ric e ran ge f o r th e b o o k -b u ild is set a t $ 4 .5 0 to $5 p e r share, b u t, a fte r a successful ro a d s h o w , w h e re th e

in v e s tm e n t b a n k reco rds s tro n g in te re s t fr o m in s titu tio n s , i t advises M a rcu s t h a t th e issue p ric e s h o u ld
be in cre a se d to $6 p e r share. G iv e n th e g o o d ne w s t h a t h is c o m p a n y is w o r th a t le a st 2 0 p e r c e n t m o re
th a n he p re v io u s ly th o u g h t, M a rcu s accepts th e advice a n d does n o t b a rg a in f o r a h ig h e r issue price.
W h e n th e shares are lis te d o n th e ASX, th e firs t-d a y c lo s in g m a rk e t p ric e is $1 0. M a rc u s has le f t a large
a m o u n t o f m o n e y o n th e ta b le b u t he has also d isco ve re d t h a t th e in te re s t he re ta in e d — 4 0 p e r c e n t o f th e
shares— is w o r th tw ic e as m u c h as he expected. G ive n th e p le a s a n t s u rp ris e a b o u t h is n e w -fo u n d w e a lth ,
M a rcu s m a y fe e l happy, d e sp ite th e o p p o r tu n it y loss o n th e shares t h a t he so ld to o th e r in v e s to rs .
I f th e la rge in it ia l re tu rn s o n IPO s re fle c t ra tio n a l b e h a v io u r b y issuers a n d in v e s to rs , th e n these
re tu rn s s h o u ld be re la te d to fa c to rs such as th e a m o u n t o f in fo r m a tio n a va ila ble to in v e s to rs a n d th e
b e n e fits t h a t issu ers m a y d e riv e f r o m u n d e rp ric in g . E m p iric a l evide nce s u p p o rts th is e x p e c ta tio n . F or
exa m ple, Lee, T a y lo r a n d W a lte r (1 9 9 6 ) fo u n d a s tro n g in v e rs e re la tio n s h ip b e tw e e n th e le n g th o f th e
de la y b e tw e e n p ro sp e ctu s re g is tra tio n a n d exchange lis tin g a n d th e le v e l o f u n d e rp ric in g . In o th e r w o rd s,
IPO s w it h s h o rte r delays in lis tin g are s ig n ific a n tly m o re u n d e rp ric e d . T his fin d in g is c o n s is te n t w it h th e
^w in n e rs curse* e x p la n a tio n in w h ic h in fo rm e d in v e s to rs w ill q u ic k ly s u b scrib e f o r u n d e rp ric e d issues
th e re b y e n s u rin g t h a t th e issue w ill be fille d in a s h o rt p e rio d . H o w , Iz a n a n d M o n ro e (1 9 9 5 ) also fo u n d
a s tro n g re la tio n s h ip b e tw e e n de la y in lis tin g a n d th e le ve l o f u n d e rp ric in g . F u rth e r, th e y fo u n d th a t
u n d e rp ric in g is re la te d to m easures o f b o th th e q u a lity a n d q u a n tity o f in fo r m a t io n a va ila b le a b o u t th e
com pany. S pe cifica lly, u n d e rp ric in g was lo w e r w h e n th e u n d e r w r ite r h a d a g o o d re p u ta tio n a n d i t was
also lo w e r f o r co m p a n ie s w it h m o re in fo r m a t io n a va ila b le .22
C am p, C o m e r a n d H o w (2 0 0 6 ) s tu d ie d 4 9 N e w Z e a la n d IPO s t h a t lis te d b e tw e e n 1 9 8 9 a n d 2 0 0 2 . They
fo u n d t h a t u n d e rp ric in g was s ig n ific a n tly lo w e r f o r issues t h a t used b o o k -b u ild in g ra th e r th a n a fix e d -
p ric e o ffe r. T his re s u lt is c o n s is te n t w it h th e a rg u m e n t t h a t b o o k -b u ild in g p ro v id e s issuers w ith feedback
fr o m in fo rm e d in v e s to rs , w h ic h a llo w s m o re accurate p r ic in g o f th e IPO. T hey also fo u n d t h a t g re a te r
u n d e rp ric in g is associated w it h h ig h e r tra d in g v o lu m e in th e p o s t-lis tin g m a rk e t, su g g e s tin g a tra d e -o ff
b e tw e e n th e cost (u n d e rp ric in g ) o f g o in g p u b lic a n d th e b e n e fit (g re a te r liq u id ity ) o f d o in g so. C am p e t
al. also fo u n d t h a t u n d e rp ric in g is p o s itiv e ly re la te d to th e p r o p o r tio n o f shares re ta in e d b y th e p re -IP O
sh a re h o ld e rs. C o n s is te n t w it h L o u g h ra n a n d R itt e r s e x p la n a tio n , issu ers w h o re ta in m o re shares in th e
c o m p a n y a p pe ar to be less co n ce rn e d a b o u t u n d e rp ric in g because a n y loss o f w e a lth o n th e shares sold in
th e IP O w i ll be o ffs e t b y a g a in o n th e shares th e y re ta in .
U n d e rp ric in g o f IPO s is a p e rs is te n t p h e n o m e n o n t h a t is y e t to be f u lly e x p la in e d . In e v a lu a tin g th e
p ro p o s e d e x p la n a tio n s o u tlin e d p re v io u s ly , th e q u e s tio n s h o u ld n o t be: ‘W h ic h m o d e l is co rre c t? ’ R a th er,
w e s h o u ld ask q u e s tio n s such as: ‘W h ic h m o d e l is m o re u s e fu l in th is case?’ A lso , w e s h o u ld re m e m b e r
t h a t th e reasons f o r u n d e rp ric in g can change o v e r tim e . F o r exa m ple, th e re is evidence t h a t u n d e rp ric in g
is g e n e ra lly lo w e r f o r com p an ies t h a t engage h ig h e r-q u a lity u n d e rw rite rs a n d h ig h e r-q u a lity a u d ito rs .
These p a rtie s have been v ie w e d as p ro v id in g a c e rtific a tio n role; in v e s to rs are c o n fid e n t t h a t a h ig h -
q u a lity u n d e r w r ite r w ill n o t o v e rp ric e an IP O because d o in g so w o u ld h a rm its r e p u ta tio n w it h in v e s to rs .
H o w e ve r, th e u s u a l re la tio n s h ip b e tw e e n u n d e rp ric in g a n d u n d e r w r ite r q u a lity re ve rse d d u rin g th e
1 9 9 9 -2 0 0 0 in t e r n e t b u b b le \ A s discussed p re v io u s ly , one e x p la n a tio n f o r th is re v e rs a l is t h a t th e
o b je c tiv e s o f issu ers cha ng ed in t h a t th e y becam e less co n ce rn e d a b o u t u n d e rp ric in g a n d w e re p re p a re d
to p a y f o r research coverage b y le a d in g an alysts.
The c o n s is te n t fin d in g t h a t IPO s are o n average u n d e rp ric e d does n o t ne ce ssa rily m e a n t h a t issue prices
are ‘to o lo w ’ 一 i t is also p o ssib le t h a t firs t-d a y m a rk e t p rice s are 'to o h ig h ,. T his p o s s ib ility is c o n s is te n t
LEARNING w it h evide nce t h a t th e p o s itiv e firs t-d a y re tu rn s o n IP O s are o fte n reve rsed o v e r tim e — t h a t is, several
OBJECTIVE 7
stu d ie s have fo u n d t h a t th e shares o f n e w ly lis te d co m p a n ie s te n d to u n d e rp e rfo rm d u r in g th e f ir s t fe w
Outline evidence
on the long-term years a fte r lis tin g . U n fo rtu n a te ly , i t is v e ry d iff ic u lt to a c c u ra te ly assess th e lo n g -ru n p e rfo rm a n c e o f
performance of c o m p a n ie s t h a t go p u b lic . O n e rea son is t h a t th e m a rk e t m o d e l, w h ic h was in tro d u c e d in S e ctio n 7.6.3,
companies that are c a n n o t be used to e s tim a te th e be tas o f th e s e c u ritie s because p re -lis tin g r e tu r n d a ta does n o t e x is t
floated
f o r IPO s. T h ere fore, researchers have used a v a r ie ty o f o th e r approaches to assess w h e th e r p o s t-lis tin g
re tu rn s are a b n o rm a l. O ne a p p ro a ch is to com p are p o s t-lis tin g r e tu rn s o n IP O co m p a n ie s to one o r m o re
22 The underwriting fee as a percentage of the issue proceeds was used as a measure of the underwriters reputation and the size
of the company was used as a measure of the quantity of information.
m a rk e t in d ice s, w ith o u t a n y a d ju s tm e n t f o r ris k . A n o th e r a p p ro a ch is to co m p a re th e re tu rn s o n th e

IPO com panies w ith a c o n tro l sam ple o f o th e r lis te d co m p a n ie s m a tc h e d o n th e basis o f one o r m o re
ch a ra cte ristics such as size (m a rk e t c a p ita lis a tio n ) a n d in d u s try .
R itte r (1 9 9 1 ) s tu d ie d co m p a n ie s t h a t w e n t p u b lic in th e US in th e p e rio d 1 9 7 5 to 1 9 8 4 .23 H e fo u n d
t h a t an in v e s to r w h o p u rc h a s e d shares in IP O co m p a n ie s a t th e c lo s in g p ric e o n th e f ir s t d a y o f p u b lic
tra d in g an d th e n h e ld th e shares f o r 3 years w o u ld have e a rn e d an average t o ta l r e tu r n o f 3 4 .4 7 p e r cen t.
F o r a c o n tro l sam ple o f n o n -IP O com p an ies m a tc h e d b y size a n d in d u s try , th e average t o ta l r e tu r n o ve r
th e same p e rio d was 6 1 .8 6 p e r cen t. The u n d e rp e rfo rm a n c e b y IP O co m p a n ie s v a rie d s ig n ific a n tly fr o m
yea r to yea r a n d across in d u s trie s b u t i t was c o n c e n tra te d a m o n g re la tiv e ly y o u n g , g ro w th com p an ies,
p a rtic u la rly th o s e t h a t w e n t p u b lic in years w h e n th e re was a h ig h v o lu m e o f IPO s.
L o u g h ra n a n d R itte r (1 9 9 5 ) fo u n d t h a t th e p o o r lo n g -te rm p e rfo rm a n c e o f IP O s c o n tin u e d b e y o n d
3 years a n d was sha red b y com p an ies m a k in g su b s e q u e n t e q u ity issues— k n o w n as s e a s o n e d e q u i t y SEASONED EQUITY
o f f e r in g s (SEOs) in th e US. U s in g la rge sam ples o f co m p a n ie s t h a t issu ed e q u ity in th e p e rio d 1 9 7 0 to OFFERING

offer to sell equity
19 9 0 , th e y re p o rte d average a n n u a l re tu rn s o v e r th e 5 years a fte r th e is s u in g o f o n ly 5 p e r c e n t f o r IPO s
securities of a class
a n d 7 p e r c e n t f o r com p an ies m a k in g SEOs. In c o n tra s t, in v e s tin g in n o n -is s u in g com p an ies o f th e same that is already traded
size an d h o ld in g th e in v e s tm e n t f o r th e sam e p e rio d w o u ld have p ro d u c e d an average a n n u a l re tu r n
o f 12 p e r ce n t f o r IPO s a n d 15 p e r c e n t f o r SEOs. L o u g h ra n a n d R itte r p ro p o se t h a t t h e ir evide nce is
c o n s is te n t w ith a m a rk e t w h e re shares are p e rio d ic a lly o v e rv a lu e d a n d t h a t com p an ies ta ke ad van ta ge o f
these E n d o w s o f o p p o r tu n it y 1 b y is s u in g e q u ity a t th o s e tim e s . T h a t idea, a n d th e re la te d p ro p o s itio n
th a t in v e s to rs w ill re s p o n d b y c u ttin g share p rice s w h e n an issue is a n n o u n ce d , are n o t new . F o r e xa m ple,
S m ith (1 9 8 6 ) re p o rte d t h a t w h e n a US co m p a n y a n n o u n ce s an SEO, its share p ric e fa lls b y a b o u t 3 p e r
cen t o n average. L o u g h ra n a n d R itte r p o in t o u t t h a t i f in v e s to rs are to receive th e sam e lo n g -te rm re tu rn s
on issuers as o n n o n -is s u e rs o f th e sam e size, th e fa ll in p ric e w h e n an issue is a n n o u n c e d s h o u ld be m u c h
larger. T h e ir n u m b e rs *im p ly t h a t i f th e m a rk e t re a cte d f u lly to th e in fo r m a tio n im p lie d b y a n e q u ity issue
a n n o u n c e m e n t, th e average a n n o u n c e m e n t e ffe c t w o u ld be - 3 3 p e r c e n t, n o t - 3 p e r cent* (L o u g h ra n an d
R itte r 19 9 5 , p. 4 8 ). L o u g h ra n a n d R itte r r e fe r to th e u n e x p la in e d lo w lo n g -te rm re tu rn s fo llo w in g e q u ity
issues as ‘th e n e w issues p u z z le ’.
The sig n ifica n ce o f th e n e w issues p u z z le is c o n tro v e rs ia l. B rav a n d G o m p e rs (1 9 9 7 ) s h o w t h a t lo w
p o s t-lis tin g re tu rn s te n d to be c o n c e n tra te d a m o n g s m a ll com p an ies, w h ic h m ea ns t h a t m ea sure d
u n d e rp e rfo rm a n c e is m u c h s m a lle r w h e n re tu rn s are v a lu e w e ig h te d ra th e r th a n e q u a lly w e ig h te d . They
also fin d t h a t u n d e rp e rfo rm a n c e is a c h a ra c te ris tic o f s m a ll com p an ies w it h lo w b o o k -to -m a rk e t ra tio s
regardless o f w h e th e r th e y are n e w ly lis te d o r n o t. I n o th e r w o rd s , B ra v a n d G o m p e rs f in d t h a t c om p an ies
th a t go p u b lic do n o t e x h ib it lo n g -te rm u n d e rp e rfo rm a n c e w h e n r e tu rn s are m e a su re d re la tiv e to c o n tro l
com panies m a tc h e d o n b o th size a n d b o o k -to -m a rk e t ra tio .
Eckbo, M a s u lis a n d N o r li (2 0 0 0 ) arg ue t h a t th e *new issues puzzle* id e n tifie d b y L o u g h ra n a n d R itte r
can be reso lve d w ith o u t re s o rtin g to e x p la n a tio n s based o n m a rk e t u n d e rre a c tio n to th e in fo r m a tio n
in a n n o u n c e m e n ts o f s e c u rity issues. E ckbo e t al. analyse re tu rn s fo llo w in g a la rg e sam p le o f seasoned
issues o f b o th e q u ity a n d d e b t fr o m 1 9 6 4 to 1 9 9 5 . T hey argue t h a t th e m a tc h e d -firm te c h n iq u e does n o t
p ro v id e a p ro p e r c o n tro l f o r r is k f o r tw o reasons. F irs t, an e q u ity issue lo w e rs th e fin a n c ia l leverage o f
th e is s u in g c o m p a n y so issu ers also lo w e r t h e ir ris k , a n d th e re fo re t h e ir e xp e cte d r e tu rn , re la tiv e to th e
m a tch e d firm s . Second, th e y f in d t h a t share t u r n o v e r increases s ig n ific a n tly a fte r SEOs, b u t tu r n o v e r does
n o t change f o r th e m a tc h e d firm s . In o th e r w o rd s , liq u id it y increases a fte r SEOs so th e shares o f is s u in g
com panies c o u ld re q u ire lo w e r liq u id it y p re m iu m s a fte r an issue. In sum , th e y con clu de t h a t evidence
o f lo n g -ru n u n d e rp e rfo rm a n c e p ro d u c e d b y th e m a tc h e d -firm te c h n iq u e is an a r tifa c t o f th e te c h n iq u e
its e lf* (Eckbo, M a s u lis & N o r li 2 0 0 0 , p. 2 5 3 ).
G om pe rs a n d L e rn e r (2 0 0 3 ) p o in t o u t t h a t m o s t stu d ie s th a t re p o rt u n d e rp e rfo rm a n c e b y IP O s have
e xa m in e d d a ta fr o m th e tim e p e rio d a fte r fo r m a tio n o f th e N asdaq syste m w h e re m o s t US IPO s are
tra d e d . The N asdaq is th e la rg e s t e le c tro n ic e q u ity s e c u ritie s tra d in g m a rk e t in th e US. W h e n e sta b lish e d
in th e e a rly 19 70 s b y th e N a tio n a l A s s o c ia tio n o f S e cu ritie s D ealers, i t was th e w o r ld s f ir s t e le c tro n ic
sto c k m a rk e t. To te s t w h e th e r th e re is a ‘N a sda q e ffe c t’，G o m p e rs a n d L e rn e r c o n d u c te d an o u t-o f-s a m p le
in v e s tig a tio n u s in g d a ta o n 3 6 6 1 IPO s fr o m 1 9 3 5 to 1 9 7 2 — a p e rio d p r io r to th e c re a tio n o f N asdaq. They
fo u n d t h a t th e re la tiv e p e rfo rm a n c e o f a n IP O sam p le depends c r itic a lly o n th e m e th o d used to assess
p e rfo rm a n c e . O ne m e th o d re ve aled som e u n d e rp e rfo rm a n c e , b u t th is m e a su re d u n d e rp e rfo rm a n c e
23 Updated evidence on the long-term performance of US IPOs from 1970 to 2013 is available at http://bear.w arrington.ufl.
edu/ritter/ipodata.htm.
B usiness finance
d isa p p e a re d w h e n th e sam e sam p le was s tu d ie d u s in g o th e r m e th o d s , in c lu d in g re g re ssio n s based o n th e

C A P M (see S e c tio n 7 .6 .2 ) a n d th e Fam a a n d F re n c h th re e -fa c to r m o d e l (see S e ctio n 7 .7 ). G om pe rs and
L e rn e r co n clu d e t h a t th e evide nce f o r u n d e rp e rfo rm a n c e b y IP O s is w eak.
M ix e d evide nce o n th e lo n g -te rm p e rfo rm a n c e o f c o m p a n ie s t h a t go p u b lic is n o t c o n fin e d to th e US.
F o r A u s tra lia n IPO s, lo n g -te rm u n d e rp e rfo rm a n c e , re la tiv e to th e m a rk e t in d e x , has b e en re p o rte d by
Lee, T a y lo r a n d W a lte r (1 9 9 6 ) o v e r 3 years, a n d D im o v s k i a n d B ro o ks (2 0 0 3 ) o v e r 1 year, a fte r lis tin g .
F o r t h e ir sam p le o f 2 6 6 IPO s, Lee e t al. re p o rte d a m a rk e t-a d ju s te d r e t u r n o f - 5 1 p e r c e n t o v e r 3 years.
D im o v s k i a n d B ro o ks re p o rte d a n average m a rk e t-a d ju s te d r e tu r n o f - 4 . 0 p e r ce n t o v e r 1 ye a r f o r a
sam p le o f 2 5 1 IP O s fr o m 1 9 9 4 to 19 9 8 . H o w e ve r, th e re s u lts w e re n o t u n if o r m ly n e g a tiv e w h e n th e
sam p le w as d iv id e d in to su b g ro u p s. F o r exa m ple, th e average m a rk e t-a d ju s te d r e tu r n f o r 7 8 n o lia b ilit y
co m p a n ie s w as - 3 0 p e r c e n t a fte r 1 ye a r b u t f o r th e 1 7 3 lim it e d lia b ilit y co m p a n ie s th e c o rre s p o n d in g
average r e t u r n w as +7.7 p e r ce n t. The m e d ia n m a rk e t-a d ju s te d r e t u r n a fte r 1 y e a r w as n e g a tiv e f o r th e
sam p le as a w h o le a n d f o r e ve ry su b g ro u p . In c o n tra s t, da S ilva Rosa, V e la y u th e n a n d W a lte r (2 0 0 3 ) used
several b e n c h m a rk s a n d co n clu d e d t h a t th e sam p le th e y s tu d ie d d id n o t u n d e rp e rfo rm in th e 2 years
fo llo w in g lis tin g .
In s u m m a ry , th e evidence o n lo n g -ru n p e rfo rm a n c e fo llo w in g IP O s re m a in s c o n tro v e rs ia l. M a n y
stu d ie s have re p o rte d u n d e rp e rfo rm a n c e b y IP O co m p a n ie s o v e r p e rio d s o f 1 to 5 years a fte r lis tin g .
There is evide nce t h a t co m p a n ie s t h a t issue e q u ity , w h e th e r th r o u g h an IP O o r a seasoned o ffe rin g , te n d
to be p o o r lo n g -te rm in v e s tm e n ts . H o w e ve r, several a u th o rs have q u e s tio n e d w h e th e r th e *new issues
puzzle* is re a l a n d p ro v id e evide nce t h a t suggests t h a t i t m a y be n o m o re th a n a n illu s io n .
9.6 Subsequent issues of o rd in a ry shares

LEARNING
A f te r a c o m p a n y has been flo a te d , a d d itio n a l e x te rn a l fin a n c e w i ll u s u a lly be re q u ire d a t som e tim e to fin a n c e
OBJECTIVE 8
Explain how e x p a n s io n . M a n a g e m e n t has th e choice o f is s u in g m o re shares a n d /o r b o rro w in g . I f i t is de cid e d to issue
companies raise m o re shares, th e re are several choices ava ila ble. I f th e fu n d s are to be ra is e d f r o m e x is tin g sh a re h o ld e rs,
capital through rights th e c o m p a n y can m ake a p ro -ra ta share issue (e n title m e n t o ffe r) o r set u p a share p u rch a se p la n (SPP). A
issues, placements, p ro -ra ta sha re issue m a y in t u r n be e ith e r a tr a d itio n a l r ig h ts issue o r a n a ccelerated e n title m e n t o ffe r an d
share purchase plans
in e ith e r case th e o ffe r m a y be re n o u n ce a b le o r n o n -re n o u n c e a b le . I f m a n a g e m e n t decides to raise fu n d s
and share options
fr o m selected in v e s to rs , w h o m a y o r m a y n o t be e x is tin g s h a re h o ld e rs in th e co m p a n y, i t m u s t choose a
p la c e m e n t. Share issues o f the se typ e s m a y be c a rrie d o u t in d iv id u a lly o r in c o m b in a tio n . F o r exa m ple,
a co m p a n y m a y raise c a p ita l th ro u g h a p la c e m e n t a n d an SPP t h a t are a n n o u n c e d s im u lta n e o u s ly . The
re g u la to ry re g im e t h a t g o ve rn s c a p ita l ra is in g s b y lis te d co m p a n ie s is o u tlin e d in Table 9.4.
TABLE 9.4 The Australian capital-raising regime for listed companies

T yp e o f c a p ita l ra is in g M a in c h a ra c te ris tic s R e g u la to ry re q u ire m e n ts
Renounceable P a rtic ip a tio n is based on each The tim e ta b le fo r e n title m e n t offers is

e n title m e n t o ffe r shareholder s e x is tin g in te re s t in the specified in th e ASX L is tin g Rules. The
company. A prospectus m ay be needed. disclosure req uire m en ts are set o u t in
Shareholders are able to sell th e ir rig h t th e Corporations Act.
to p a rtic ip a te in th e e n title m e n t offer.
N on-renounceable P a rtic ip a tio n is based o n each The tim e ta b le fo r e n title m e n t offers

e n title m e n t o ffe r shareh old er’s e x is tin g in te re s t in the is specified in th e ASX L is tin g Rules.
company. A prospectus m ay be needed. The L is tin g Rules lim it th e size o f the
Shareholders are n o t able to sell th e ir o ffe r to a m a x im u m o f one new share
rig h t to p a rtic ip a te in th e offer. A n y fo r each e x is tin g share. The disclosure
rig h ts n o t take n up m ay be placed a t the re q u ire m e n ts are set o u t in the
d iscre tio n o f th e com pany s Board o f Corporations Act.
D irectors.
Table 9 .4 continued
—
T ype o f c a p ita l ra is in g M a in c h a ra c te ris tic s R e g u la to ry re q u ire m e n ts
Placement P a rtic ip a tio n b y in vestors is at the ASX L is tin g Rules re s tric t placem ents
d is c re tio n o f th e com pany’s Board o f to no m ore th a n 15 p e r cent o f issued
D ire cto rs and m anagem ent. O pen cap ital over a 1 2 -m o n th p e rio d w ith o u t
to ‘s o p h istica te d ’ o r ‘p ro fe ssio nal’ appro val by shareholders. U n de r certain
investors. A prospectus is n o t required. circum stances, th is lim it increases to
25 p e r cent o f issued cap ital fo r sm aller
firm s w ith m a rk e t cap ita lisa tio n s o f less
th a n $300 m illio n . The Corporations Act
p e rm its placem ents w ith o u t a disclosure
d o cu m e n t p ro vid e d a cleansing notice*
is issued.
Share purchase plan P a rtic ip a tio n is open to e x is tin g The SPP m echanism is stip u la te d in the
(SPP) shareholders. There is no re q u ire m e n t L is tin g Rules. The disclosure regim e has
fo r a prospectus p ro v id e d a cleansing been p ro vid e d by ASIC in a series o f
n o tice is issued, offers are lim ite d R e gu latory Guides and Class Orders.
to $15 000 p e r shareholder over a
1 2 -m o n th p e rio d , and th e shares are
fu lly p a id a nd issued a t a d isco u n t to
th e m a rk e t price d u rin g the 30 days o f
tra d in g p rio r to e ith e r th e o ffe r date o r
th e issue date.
9 .6 .1 1 Rights issues
A rig h ts issue— also k n o w n as an e n title m e n t o ffe r— is a n issue o f n e w shares to e x is tin g sh a re h o ld e rs.
U n d e r th e te rm s o f a rig h ts issue, sh a re h o ld e rs receive th e r ig h t to s u b scrib e f o r a d d itio n a l shares in a
fix e d ra tio to th e n u m b e r o f shares a lre a d y h e ld . P ro v id e d each s h a re h o ld e r accepts th e o ffe r, th e re is no
d ilu tio n o f a n y s h a re h o ld e rs pe rce n ta g e o w n e rs h ip in th e com pany.
To illu s tra te th e e le m e n ts o f a r ig h ts issue: assum e t h a t an in v e s to r h o ld s 1 0 0 0 shares, w h ic h re p re s e n t
1 p e r ce n t o f a c o m p a n y s issu e d c a p ita l o f 1 0 0 0 0 0 shares. I f th e c o m p a n y m akes a rig h ts issue th a t
e n title s each s h a re h o ld e r to p u rch a se one a d d itio n a l share f o r e v e ry fo u r shares h e ld , th e s h a re h o ld e r is SUBSCRIPTION PRICE
e n title d to b u y an e x tra 2 5 0 shares, th u s in c re a s in g th e s h a re h o ld in g to 1 2 5 0 . In to ta l, th e c o m p a n y w ill the price that must be

paid to obtain a new
issue 25 0 0 0 n e w shares. T h e re fo re , th e p e rcen ta ge o w n e rs h ip o f th e s h a re h o ld e r in th e c o m p a n y re m a in s
share
un cha ng ed a t 1 p e r ce n t because 1 2 5 0 /1 2 5 0 0 0 = 1 p e r ce n t.
W ith a rig h ts issue, s h a re h o ld e rs b u y a d d itio n a l shares. The com p an y, th e re fo re , has to se t a EX-RIGHTS DATE
subscription price. U su a lly, th e s u b s c rip tio n p ric e is less th a n th e c u rre n t m a rk e t p ric e o f th e shares, date on which a
share begins trading
because o th e rw is e n o -o n e w o u ld w a n t to s u b scrib e f o r th e n e w shares. G ive n t h a t th e s u b s c rip tio n p ric e
ex-rights. After fhis
is b e lo w th e c u rre n t m a rk e t p ric e , th e r ig h t to b u y a n e w share has a value . I f th e rig h ts are re n o u n ce a b le ,
date a share does not
a s h a re h o ld e r is able to se ll th e rig h ts to a n o th e r in v e s to r i f th e y w is h to . have attached to it the
A fo rm u la k n o w n as th e theoretical rights price can be used to e s tim a te th e v a lu e o f a r ig h t. To de ve lo p right to purchase any
th is fo rm u la suppose t h a t a c o m p a n y m akes a 1 - fo r - N re n o u n ce a b le rig h ts issue a t a s u b s c rip tio n p ric e additional share(s) on
the subscription date
of S d o lla rs p e r sha re— t h a t is, each s h a re h o ld e r o b ta in s th e r ig h t to pu rcha se o n e n e w share f o r e v e ry N
shares th a t th e y c u rre n tly h o ld an d w ill p a y S d o lla rs f o r each n e w share. A ll re n o u n ce a b le rig h ts issues CUM RIGHTS
sp e cify a date, called th e ex-rights date. I f an in v e s to r pu rcha ses shares in th e c o m p a n y b e fo re th e when shares are
e x -rig h ts date, th e pu rcha se is said to be cum righ ts a n d th e in v e s to r w ill receive rig h ts to purcha se n e w traded cum rights
the buyer is entitled
shares. The rig h ts th e m s e lv e s m a y be tra d e d s e p a ra te ly f r o m th e shares o n o r a fte r th e e x -rig h ts date.
to participate in the
I f an in v e s to r purchases shares o n o r a fte r th e e x -rig h ts da te th e p u rcha se is sa id to be ex-rights a n d th e forthcoming rights
in v e s to r will not receive a n y rig h ts . issue
A ssu m e t h a t a n in v e s to r purchases N shares ju s t b e fo re th e e x -rig h ts date. The co st o f th is purchase
is NM w h e re M is th e m a rk e t p ric e o f a share cu m rig h ts . T his in v e s to r is e n title d to th e r ig h t to purchase
one n e w share. E x a c tly th e sam e in v e s tm e n t can be a ch ie ved b y e n te rin g th e m a rk e t ju s t a fte r th e shares
b e g in tra d in g e x -rig h ts a n d p u rc h a s in g N shares e x -rig h ts a n d also p u rc h a s in g th e r ig h t to one n e w share.
T his w ill c o st NX + R} w h e re X is th e m a rk e t p ric e o f a share e x -rig h ts a n d R is th e m a rk e t p ric e o f th e r ig h t
to p u rcha se one n e w share. In th e absence o f a n y n e w in fo r m a tio n t h a t causes p ric e s to change, b o th
in v e s tm e n t stra te g ie s s h o u ld co st th e same. T h a t is:
N M =N X +R 9.1
I f th e s u b s c rip tio n p ric e is pa yab le im m e d ia te ly , th e n th e r ig h t to one n e w share can be im m e d ia te ly
c o n v e rte d to a n e w share b y p a y m e n t o f th e s u b s c rip tio n p ric e . T h e re fo re , w h e n th e shares b e g in tra d in g
e x -rig h ts , an in v e s to r c o u ld o b ta in a share e ith e r b y b u y in g th e r ig h t to one n e w share a t a cost o f R and
th e n p a y in g th e s u b s c rip tio n p ric e o f S, o r b y b u y in g a share d ir e c tly a t a p ric e o f X. To p re v e n t a rb itra g e ,
b o th in v e s tm e n t s tra te g ie s m u s t co st th e same. T h a t is: _______
R+ S= X
THEORETICAL RIGHTS
S u b s titu tin g E q u a tio n 9.2 in to E q u a tio n 9.1, a n d re a rra n g in g , gives:
PRICE
N(M -S)
the expected price of R.
one right calculated N+ 1
on the basis of the
S u b s titu tin g E q u a tio n 9.3 in to E q u a tio n 9.2, a n d re a rra n g in g , gives:
cum-rights share price
NM+S
THEORETICAL X
EX-RIGHTS SHARE
PRICE
The p ric e s t h a t r e s u lt fr o m u s in g E q u a tio n s 9.3 a n d 9 .4 are o fte n re fe rre d to as th e theoretical righ ts
the expected price
of one share when price a n d th e theoretical ex-righ ts sh are price, resp ective ly.
shares begin to be W h a t is th e e ffe c t o f a rig h ts issue o n th e va lu e o f an in v e s tm e n t in shares? To a n s w e r th is q u e s tio n ,
traded ex-rights c o n s id e r E xam p le 9.1.
E x a m p l e 9 .1
A th o l o w n s 1 0 0 0 s h a re s in R a ven E n te rp ris e s Ltd (REL), w h o s e c u rre n t s h a re p r ic e (cu m rig h ts ) is $ 2

p e r s h a re . REL m a k e s a l- f o r - 4 rig h ts issu e w ith a s u b s c rip tio n p r ic e o f $ 1 . 4 0 p e r s h a re . A th o l w is h e s
to c a lc u la te :
a) th e v a lu e , R, o f th e r ig h t to b u y 1 n e w s h a re
b) th e e x -rig h ts s h a re p r ic e , X
c) th e v a lu e o f h is in v e s tm e n t c u m rig h ts a n d e x -rig h ts .
In th is c a s e , N = 4 , M = $ 2 . 0 0 a n d S = $ 1 . 4 0 .
SOLUTION
a) U s in g E q u a tio n 9 . 3 , th e v a lu e o f th e r ig h t to b u y 1 n e w s h a re is:
R _ N IM - S )
N+ 1
4($2.00-$1.40)
— 471
= 4 8 cents
b) U s in g E q u a tio n 9 . 4 , th e e x -rig h ts s h a re p r ic e is:
v NM + S
A = -----------------
N+ 1
4($2.00)-$1.40
— 4^1
= $ 1.88
c) C u m rig h ts , th e in v e s tm e n t is w o r th :
( 1000)($2)
=$2000
E x -rig h ts , th e in v e s tm e n t is w o r th :
(1 0 0 0 )($ 1 .8 8 ) + (2 5 0 )($ 0 .4 8 )
=$2000
A c c o r d in g to th is a n a ly s is th e to ta l v a lu e o f th e in v e s tm e n t is u n a ffe c te d . B e fo re th e issu e A th o l o w n e d
1 0 0 0 s h a re s w o r th $ 2 e a c h — a to ta l o f $ 2 0 0 0 . A fte r th e issu e h e o w n s 1 0 0 0 s h a re s w o r th $ 1 . 8 8
e a c h ( $ 1 8 8 0 ) p lu s 2 5 0 rig h ts w o r th 4 8 c e n ts e a c h ( $ 1 2 0 ) , w h ic h in to ta l is a ls o w o r th $ 2 0 0 0 .
C le a rly , th e v a lu e o f th e rig h ts ju st o ffs e ts th e d e c lin e in th e v a lu e o f th e s h a re s . If A th o l d e c id e s to sell
his rig h ts he c a n e x p e c t to r e c e iv e $ 1 2 0 , w h ic h s h o u ld b e r e g a r d e d a s a p a r tia l re tu rn o f c a p it a l as
d is tin c t fro m a p r o fit o r re tu rn on c a p it a l. F in a lly , s u p p o s e th a t in s te a d o f a l- f o r - 4 rig h ts issu e w ith a
s u b s c rip tio n p r ic e o f $ 1 . 4 0 p e r s h a re , REL m a k e s a l- f o r - 2 issu e w ith a s u b s c rip tio n p r ic e o f 7 0 ce n ts
p e r s h a re . C le a rly , b o th issues w o u ld ra is e e x a c tly th e s a m e fu n d s f o r REL a n d r e w o r k in g th e a b o v e
c a lc u la tio n s w o u ld s h o w th a t th e e x -rig h ts v a lu e o f A t h o l’s in v e s tm e n t w o u ld a g a in b e $ 2 0 0 0 .
This a n alysis relates to th e v a lu e o f a n in v e s tm e n t m ad e a t th e tim e o f th e e x -rig h ts da te a n d i t

suggests th re e im p o r t a n t c o n c lu s io n s . F irs t, sha reh old ers* w e a lth is n o t a ffe c te d b y th e m e re fa c t o f
a share b e g in n in g to tra d e o n an e x -rig h ts basis. In t u r n , th is suggests th e second c o n c lu s io n th a t, o f
its e lf, a rig h ts issue has n o v a lu e to sh a re h o ld e rs. T his c o n c lu s io n s h o u ld n o t be a s u rp ris e . I f a rig h ts
issue increased (decreased) sha reh old ers* w e a lth w e w o u ld e xp e ct rig h ts issues to o c c u r m u c h m o re (less)
fre q u e n tly th a n th e y do. T h ird , i t suggests t h a t in th e case o f a rig h ts issue th e le v e l o f th e s u b s c rip tio n
price has n o e ffe c t o n sha reh old ers* w e a lth . I f a ll s h a re h o ld e rs su b scrib e f o r a rig h ts issue, th e n w h e th e r
a co m p a n y raises, say, $2 m illio n b y is s u in g 1 m illio n shares a t $2 each, o r 2 m illio n shares a t $1 each,
s h o u ld n o t m a tte r to its sh a re h o ld e rs.
H o w eve r, th e above a n a lysis ig n o re s som e fa c to rs t h a t can be im p o r ta n t. F irs t, th e announcement o f a
rig h ts issue m a y a ffe c t sha reh old ers* w e a lth because th e a n n o u n c e m e n t can have in fo r m a tio n c o n te n t. F o r
exam ple, US a n d A u s tra lia n evide nce suggests th a t, o n average, th e m a rk e t in te rp re ts th e a n n o u n c e m e n t
o f e q u ity c a p ita l issues, in c lu d in g rig h ts issues, as 'bad* n e w s .24 S m ith (1 9 8 6 ) p ro v id e d an e x p la n a tio n o f
th e n e g a tive a n n o u n c e m e n t e ffe c t: m an ag ers w ill t r y to issue e q u ity w h e n th e y be lie ve i t is o ve rva lu e d .
In v e s to rs are aw are o f m anagers* in fo r m a tio n ad van ta ge a n d w ill re s p o n d b y re d u c in g t h e ir e s tim a te o f
th e co m p a n y s va lu e w h e n an issue is a n n o u n ce d . The im p lic a tio n s f o r fin a n c in g d e cisio n s are discussed
in S ectio n 12 .9.4.
Second, th e te rm s o f a rig h ts issue such as th e s u b s c rip tio n p ric e m a y a ffe c t th e m a rk e t re a c tio n to
an issue w h e n i t is a n n o u n ce d . I f th e s u b s c rip tio n p ric e is se t o n ly s lig h tly b e lo w th e m a rk e t p ric e o f th e
shares, a m in o r fa ll in th e co m p a n y s share p ric e c o u ld cause th e issue to fa il— n o ra tio n a l s h a re h o ld e r w ill
sub scrib e f o r th e rig h ts issue i f th e shares can be p u rch a se d m o re ch e a p ly o n th e s to c k m a rk e t. C learly,
th is ris k can be red uce d b y s e ttin g a lo w e r s u b s c rip tio n p rice , b u t d o in g so m a y w a rn in v e s to rs t h a t
m a n a g e m e n t is fe a rfu l o f a p o ssib le fa ll in th e co m p a n y s share p rice . Hence, s e ttin g a lo w e r s u b s c rip tio n
p rice m a y re s u lt in a la rg e r fa ll in share p ric e w h e n th e issue is a n n o u n ce d .
T h ird , th e a n a lysis assum es t h a t th e s u b s c rip tio n p ric e is payable o n th e e x -rig h ts da te, w h ere as, in
fact, i t is u s u a lly n o t pa yab le u n t il several w eeks la te r. T his gives ris e to th e f u r t h e r p o in t t h a t th e h o ld e r OPTION
the right but not the
o f a r ig h t is p e r m itte d to p u rch a se shares a t th e s u b s c rip tio n p ric e , b u t is n o t o b lig e d to do so. I f th e share
obligation to buy or
p rice o n th e s u b s c rip tio n d a te is less th a n th e s u b s c rip tio n p ric e , th e h o ld e r o f th e r ig h t does n o t have to
sell underlying assets
purchase th e shares. T his ty p e o f a g re e m e n t is k n o w n as an o p t io n , b u t th e th e o re tic a l m o d e l ig n o re s th e at a fixed price for a
o p tio n -lik e fe a tu re s o f a r ig h t a n d is th e re fo re lik e ly to u n d e rs ta te th e v a lu e o f a r ig h t. specified period
24 There is evidence that the market response to the announcement of equity issues differs between countries but is consistently
negative on average. Thus, in the US, Smith reports an average decline of about 3 per cent for rights issues by industrial
companies (see Smith 1986), while in the UK, Marsh found a much smaller decline for such issues (see Marsh 1979). In
Australia, a study of 636 rights issues by Balachandran, Faff and Theobald (2008) found an average fall in share price of
1.74 per cent when the issues were announced.
B usiness finance
The option component o f a rig h ts value is usually small in dollar terms b u t can be a significant
p ro po rtio n o f the value o f a rig ht, particularly i f the share price is close to the subscription price. For
example, the subscription price fo r the rights issue by Colonial Group in 1998 was $4.50, payable no later
than 13 July, and the rights were traded on the ASX from 4 June to 2 July. On 11 June, the closing price
o f Colonial shares was $4.53 while the rights closed at 14.5 cents. I f holders o f the rights were obliged
to pay the subscription price and had to pay it immediately, the rights would have been w orth only
$4.53 - $4.50 = 3 cents. In this case, the option component o f the rig hts’ value was 11.5 cents.
Disclosure and regulation of rights issues

Historically, a company m aking a rights issue was required to supply shareholders w ith a disclosure
document, usually a prospectus. The cost o f preparing a disclosure document was an im p o rta n t factor that
influenced issuers to prefer placements rather than rights issues. The requirements fo r rights issues have
been aligned w ith those fo r placements by changes to the Corporations Act contained in the Corporations
Legislation Amendment (Simpler Regulatory System) Act 2007. From 2007, issuers can proceed w ith a rights
issue w ith o u t a prospectus provided they:
• lodge w ith the ASX a notice known as a ‘rights issue cleansing notice ’
；and
• send to shareholders a short document th a t describes the reasons fo r the rights issue and sets out
the term s and tim in g o f the issue.
In addition to stating th a t the issuer complies w ith certain provisions o f the Corporations Act, a rights
issue cleansing notice m ust deal w ith two issues. First, it m ust contain any excluded* in fo rm a tio n — that
is, in fo rm a tio n that:
• has previously been w ithheld from investors based on one o f the exceptions to disclosure contained
in the listing rules25
• investors would reasonably require and expect to be included in a disclosure document fo r the
purpose o f assessing the financial position, performance and prospects o f the issuer.
Second, the notice m ust provide inform a tion about any effects th a t the issue could have on the control
o f the listed entity.
I f a company has disclosed all price-sensitive info rm a tio n related to its operations and makes a rights
issue fo r a general purpose such as raising w orking capital or repaying debt, a rights issue cleansing notice
would be the obvious choice. In other cases a prospectus may be preferred. For example, suppose th a t a
company makes a rights issue to raise funds fo r a new project th a t has been under development fo r some
tim e b u t whose existence has n o t been disclosed to the shareholders. In th a t case, a rights issue cleansing
notice should contain extensive details o f the new project. However, it may instead be preferable to issue
a prospectus containing the same inform ation. One factor favouring the use o f a prospectus is th a t a
cleansing notice is n o t defined as a disclosure document. Therefore, i f a cleansing notice is found to
contain errors or omissions, the ‘due diligence’ defence outlined in Section 9.4.1 is n o t available.
As discussed in Section 9.4.2, the prospectus fo r a rights issue can be much less detailed than the
prospectus fo r an issue o f unlisted securities. Provided the company s shares have been listed fo r at least
12 m onths p rio r to the issue, the prospectus does n o t have to contain extensive inform a tion on the
assets, liabilities, performance and prospects o f the issuing company. Rather, the prospectus can focus on
details o f the new securities and on the expected effects o f the new issue on the company.
The significance of rights issues

The frequency o f rights issues fluctuates over tim e but they continue to be an im p o rta n t way o f raising
equity fo r Australian companies. In the 2012-13 financial year, ASX-listed companies raised $4 b illio n
through rights issues. In comparison, in the 2008-09 financial year, $28.5 b illio n was raised through
rights issues. Details o f selected rights issues by listed companies are shown in Table 9.5.
25 R u le 3 .1 o f th e A u st r a lia n S e c u r it ie s E x c h a n g e L is t in g R u le s r e q u ir e s im m e d ia t e d is c lo s u r e o f m a t e r ia l in fo r m a t io n b y lis t e d
e n t it ie s b u t R u le 3 .1 A p r o v id e s s o m e e x c e p tio n s t o th e c o n tin u o u s d is c lo s u r e r e q u ir e m e n t s .
TABLE 9.5 Details of selected rights issues by listed companies

Am ount Issue P re-issue s h a re 1U n d e r w r itin g
Com pany D a te a n n o u n c e d Issue r a tio ra is e d ( $ m )：
p r ic e ($ ) p r ic e ($ ) fe e (%)
Wesfarmers Ltd 22/01/2009 3:7 3700 13.50 15.78 2.1
TEN Network 15/06/2012 3:8 200 0.51 0.64 2.35

Holdings
Billabong 21/06/2012 6:7 221 1.02 1.83 2.9

International Ltd
Bionomics Ltd 5/03/2013 1:8 16.4 0.36 0.41 3.0
S o u rc e : Announ cem ents to the A S X a n d c o m p a n y prospectuses.
Designing a successful rights issue

A rights issue that failed to raise all or most o f the planned funds could be very costly fo r the issuing
company. The costs o f planning the issue and preparing a prospectus or other documentation have to be
paid regardless o f the outcome, and failure is likely to harm a company s reputation because it may be
thought th a t existing shareholders lack confidence in the company s prospects and/or the performance
o f its managers. Therefore, managers w ill employ various measures to maximise the probability th a t a
rights issue w ill be successful. An obvious measure o f this type is to have the issue underw ritten. Another
approach m ight be to make the issue renounceable and to set the subscription price substantially below
the current m arket price o f the shares so there is a high probability th a t shareholders w ill either exercise
their entitlem ent, or sell th e ir rights to others who w ill subscribe fo r the shares. In this case, i t m ig ht seem
that there should be no need fo r the company to have the issue underw ritten, b u t in fact the m ajority
o f rights issues in Australia are underw ritten. There appear to be fo ur m ain reasons fo r this practice.
First, while the subscription price may be well below the share price at the tim e an issue is announced, a
substantial unexpected fall in share price is always possible and could spell failure fo r a non-underw ritten
issue. Second, as discussed above, setting a low subscription price may result in a larger fall in the share
price when a rights issue is announced. Therefore, managers may tr y to m inim ise the adverse effect on
shareholders’ wealth by setting a higher subscription price and having the issue underw ritten. Third,
there w ill always be some shareholders who, fo r one reason or another, either do n o t receive n otification
o f an issue, or do n ot respond in tim e to subscribe fo r the new shares. Finally, because o f the high costs
o f complying w ith securities laws in countries such as the US, Australian companies usually specify
that a rights issue w ill be made only to shareholders whose registered address is in Australia or New
Zealand. ASX Listing Rule 7.7 requires th a t where foreign shareholders are n o t eligible to participate
in a renounceable rights issue, they m ust s till be advised o f the issue and th a t the value, i f any, o f th e ir
entitlements should be paid to them. Therefore, one role o f the und erw rite r is to sell any new shares
that represent the entitlem ents o f ineligible foreign shareholders. Orica Lim ited is an Australian-based
manufacturer o f chemicals and explosives w ith operations in about 50 countries and its shareholders
include both Australian and overseas investors. In November 2005, Orica announced a fu lly underw ritten
l-fo r-8 renounceable rights issue at $15 per share, substantially less than the m arket price o f $20.55.
The issue was made to all ordinary shareholders w ith a registered address in Australia or New Zealand
and to in s titu tio n a l ordinary shareholders in Hong Kong, Singapore and the UK. On 19 December 2005,
Orica announced a shortfall, including the entitlem ents o f ineligible foreign shareholders, o f 2.4 m illion
shares, or approximately 7 per cent o f the total. In this case, the sh ortfa ll shares were sold to in s titu tio n a l
investors w ith the issue price determ ined by an overnight book-build conducted by the underwriters. The
issue price fo r these shares was $20.30, which m eant th a t Orica received $15 per share and the balance o f
$5.30 per share was paid to the non-subscribing shareholders and ineligible foreign shareholders.
In summary, u nd erw riting is one way o f ensuring that the issuing company w ill receive all the planned
funds regardless o f the level o f subscriptions by shareholders and may be less costly than attem pting to
increase shareholder take-up by lowering the subscription price. The closer the subscription price on the
rights issue is set to the m arket price o f shares, the greater is the need to have the issue underw ritten,
B usiness finance .
and the higher the u nd erw riting fee. The u nd erw riting fee is usually between 1 and 3 per cent o f the
subscription price.
W hile u nd erw riting ensures th a t all the planned funds w ill be raised, there are other measures that
can be used to increase the likelihood th a t a rights issue w ill be successful. The m ain such measures
SHORTFALL FACILITY are issuing the rights w ith bonus share options as a sweetener* and providing a sh o rtfall facility.
a m echanism under As discussed in Section 9.6.5, bonus share options are issued ‘free’ in a fixed pro po rtio n to the new
w hich a co m p a n y
shares taken up by existing shareholders. Balachandran, Faff and Theobald (2008) studied rights issues
m ay issue shortfall
shares to eligible
announced by Australian companies from 1995 to 2005 and found th a t almost one-third o f the issues in
shareholders or other th e ir final sample provided bonus share options. A nother measure to increase the take-up o f new shares
investors by existing shareholders is the inclusion o f a shortfall facility. In its simplest form , a shortfall fa cility
allows existing shareholders to apply fo r extra shares in addition to th e ir pro-rata entitlem ent. In this
case, any shares n o t subscribed fo r by some shareholders (s h o rtfa ll shares*) w ill be issued to those who
SHORTFALL SHARES applied fo r additional shares. A shortfall fa cility can also allow the company to issue sh o rtfall sh ares to
new shares not other investors, including underw riters, and the company may have the rig h t to accept oversubscriptions.
subscribed for b y
For example, in February 2007 Argo Investments made a rights issue th a t was n o t u nd erw ritte n and was
eligible shareholders
a c c o rd in g to their
expected to raise $441 m illion , b ut shareholders taking up th e ir entitlem ents were invite d to apply for
entitlements under a additional shares and the company reserved the rig h t to accept oversubscriptions. The end result was that
rights issue the issue raised approximately $446 m illion.
As shown in Table 9.4, there is no upper lim it on the size o f a renounceable rights issue so an issue o f
this type can be used to raise a large amount, provided investors are prepared to subscribe fo r the new
shares. Further, provided shareholders take up th e ir entitlem ent, a rights issue w ill have no effect on the
control o f the company as there is no change in shareholders1relative vo ting strengths. For these reasons
a rights issue may appeal to a company s board as a means o f raising finance.
W hile many companies m aking rights issues specify th a t the issue is renounceable, sometimes a
rights issue w ill be non-renounceable. I f a company makes a non-renounceable issue, shareholders
cannot sell th e ir entitlem ent to take up new shares. The only choices available to them are to exercise
th eir entitlem ent, either fu lly or partly, or to p e rm it it to lapse.26 I f investors take the la tte r choices the
issue w ill be undersubscribed. For this reason non-renounceable issues are frequently underw ritten.
As noted earlier, the m arket often interprets the announcement o f equity capital issues, including
rights issues, as ‘bad’ news. Balachandran, Faff and Theobald (2008) found an average abnormal return
o f -1 .7 4 per cent over a 3-day announcement period fo r a sample o f 636 rights issues by Australian
companies from 1995 to 2005. I f the term s o f an issue such as whether the issue is renounceable or
und erw ritte n also convey info rm a tio n to investors, then the price response to issue announcements may
differ between rights issues w ith different terms. Balachandran, Faff and Theobald found th a t there is no
difference between the average m arket reaction to renounceable and non-renounceable issues b ut the
reaction to rights issue announcements is related to the u nd erw riting status o f the issue. Alm ost 60 per
cent o f the issues in th e ir sample were fu lly und erw ritte n and the average abnormal retu rn associated
w ith announcement o f these issues was -1.0 4 per cent, b ut fo r non-underw ritten issues the average
abnormal retu rn was -2.23 per cent.
As discussed in Section 9.5.6, underw riters are seen as certifying the value or quality* o f the securities
being offered. When deciding whether to have an issue underw ritten, issuers w ill consider the benefits
th a t u nd e rw ritin g provides relative to the cost o f the u nd erw rite rs fee. The fee w ill be related to the
risk o f undersubscription and w ill reflect any costs th a t the underw riter incurs in assessing th a t risk.
This is likely to include the costs o f investigating the current financial position and the prospects o f
the issuer. Thus, a decision to fu lly underw rite an issue w ill typically be associated w ith low risk and/or
low investigation costs and is associated w ith a smaller negative m arket reaction. Where the risk and/
or investigation costs are higher, issuers may choose to accept the risk o f undersubscription rather than
pay an underw riting fee. N ot surprisingly, w ith o u t an u n d erw rite rs certification, the m arket reaction is
more negative.
That is n ot to suggest th a t certification by a reputable underw riter guarantees the success o f a capital
raising. To illustrate this point, consider the announcement o f a proposed $225 m illio n 6:7 entitlem ent
offer by Billabong International Ltd in June 2012. The issue was jo in tly u nd erw ritte n by Goldman Sachs
and Deutsche Bank, and was priced at a significant 44 per cent discount to the pre-announcement share
26 I g n o r in g tr a n s a c t io n c o s t s , th e c h o ic e s a v a ila b le to s h a r e h o ld e r s a r e n o t r e d u c e d b y a r ig h t s is s u e b e in g n o n - r e n o u n c e a b le
r a t h e r t h a n re n o u n c e a b le . I f a n is s u e is n o n - r e n o u n c e a b le , s h a r e h o ld e r s c a n t a k e u p th e r ig h t s a n d th e n r e a lis e t h e ir v a lu e b y
s e llin g t h e s h a r e s o b ta in e d .
price. The m arket responded very negatively to the announcement, w ith Billabong shares closing down
48 per cent when the m arket reopened. A lthough the share price subsequently recovered slightly, to be
above the proposed subscription price, approximately 49 per cent o f retail investors s till chose n ot to
participate in the issue, leaving the underw riters to purchase the rem aining 33.2 m illio n shares. In an
amazing example o f managerial o ptim ism the CEO o f Billabong, Launa Inman, issued a statement on the
company s behalf stating that <rThe company is pleased by the support shown by our retail shareholders fo r
the Entitlem ent Offer. The Retail E ntitlem ent O ffer completes an im p o rta n t capital raising fo r Billabong,
allowing the Company to focus on the next phase o f its strategy’.27 As at February 2014, Billabong shares
were trading at about a 30 per cent discount to the subscription price o f the retail offer.
Traditional and accelerated rights issues

One disadvantage o f a trad ition al renounceable rights issue is th a t it is a relatively slow way o f raising
funds. W hile the ASX has revised its timetables to shorten the offer period, a trad ition al renounceable
rights issue cannot be completed in fewer than 23 business days. A non-renounceable issue is potentially
quicker since no rights trading period is required, b u t i t is s till slower than a share placement.
The traditional rights issue structure has been adapted to allow companies to raise funds more
quickly. The ASX commonly grants waivers o f its listin g rules to allow companies to make non-traditional
or Accelerated* rights issues. These issues involve tw o stages: an in itia l accelerated offer o f shares to
institutio ns and a second offer to retail shareholders.28 The structures used fo r these issues include:
• Accelerated Non-Renounceable E ntitlem ent O ffer (or 'JumboO structure. A non-renounceable pro
rata offer is made to in s titu tio n a l shareholders over a period o f 1 or 2 business days. The issue price
may be determined by an in s titu tio n a l book-build or i t may be fixed p rio r to the announcement of
the issue. In the second stage, a non-renounceable pro-rata offer is made to retail shareholders at the
same price as the first-stage pro-rata offer.
• Accelerated Renounceable E ntitlem ent O ffer (AREO), which differs fro m the Uumbo* structure in
two ways: the offer is renounceable and the procedure involves two book-builds. In the firs t stage,
eligible in stitu tio n a l shareholders may subscribe fo r th e ir pro-rata e ntitlem ent to new shares at a
fixed offer price. Any shares n o t taken up by in s titu tio n a l shareholders are then offered to other
in stitu tio n a l investors through a book-build— so there is no trading o f rights on the exchange and
any entitlem ents th a t are renounced are sold off-m arket1. The second stage is a pro-rata entitlem ent
offer to retail shareholders at the same fixed offer price as the in s titu tio n a l entitlem ent offer. Retail
shareholders w ill be provided w ith details o f the offer in a prospectus or offer booklet and w ill
usually have about 2 weeks to decide whether to take up th e ir entitlem ents. Finally, a second book-
build is undertaken where any shares not taken up by retail shareholders are offered to in s titu tio n a l
investors. I f the prices established in either o f the book-builds exceed the fixed offer price, the excess
is paid to the shareholders who did n ot take up th e ir entitlem ents.
• Simultaneous Accelerated Renounceable E ntitlem ent O ffer (SAREO), which is essentially the same
as the AREO structure except th a t any renounced entitlem ents are sold through a single book-
build. This book-build is open only to in s titu tio n a l investors and is carried out after b oth o f the
entitlem ent offers have been completed, so it ensures th a t each group o f investors receives the same
price for any entitlem ents they renounce.
While accelerated rights issues can differ in significant details, all such issues have one im p orta nt
feature: the proceeds o f the in s titu tio n a l component w ill be received very soon after the issue is launched.
For a company w ith large in s titu tio n a l shareholdings, the proceeds o f the in s titu tio n a l offer w ill make up
the m ajority o f the issue proceeds, so the outcome is, to a large extent, sim ilar to m aking a placement.
Because the tim e period involved is short, the risk o f a significant sh ortfa ll is lower than fo r a trad ition al
rights issue, so the cost o f u n d e rw ritin g should also be lower. Im portantly, the accelerated structures
allow funds to be raised quickly w hile retail shareholders can s till participate in the capital raising.
Also, renounceable rights issues are regarded as the m ost equitable because shareholders who choose
not to participate can realise some value by selling th e ir rights. However, the accelerated structures do
27 A S X A n n o u n c e m e n t, 'B illa b o n g c o m p le t e s $ 2 2 5 m illio n c a p it a l r a isin g *, 2 0 J u l y 2 0 1 2 .

28 A m e n d m e n ts to th e C o rp o ratio n s A c t in 2 0 0 7 in t r o d u c e d a n e w d e fin itio n o f l i g h t s 1 is s u e , w h ich r e q u ir e s t h a t th e t e r m s o f
su c h a n is s u e m u s t b e th e s a m e f o r a ll s h a r e h o ld e r s . S in c e a c c e le r a te d is s u e s in v o lv e d iffe r e n t t e r m s fo r in s t it u t io n a l a n d
r e ta il s h a r e h o ld e r s th e y d o n o t c o n fo r m t o t h is d e f in it io n a n d a r e m o r e c o r r e c tly d e s c r ib e d a s e n t it le m e n t o ff e r s . F o r e a s e o f
e x p o s it io n w e u s e th e t e r m r ig h t s is s u e to e n c o m p a s s b o t h t r a d it io n a l r ig h t s is s u e s a n d a c c e le r a te d is s u e s .
not necessarily ensure th a t all shareholders are treated fairly. First, the tim e allowed fo r completion of
the in s titu tio n a l component can disadvantage shareholders who do n o t have sufficient funds available
to take up th e ir fu ll entitlem ents at short notice. Second, the AREO structure w ith tw o separate book-
builds means th a t any prem ium d istributed to shareholders who renounce th e ir entitlem ents can
differ depending on whether the shareholder is an in s titu tio n a l or retail investor. The SAREO structure
addresses the la tte r concern b u t may n o t provide a perfect solution because it means th a t in stitu tio n a l
shareholders who sell1th e ir rights have to w ait fo r some weeks to find out w hat price they w ill receive.
F in a n c e
UNDERWRITER BUYS SHARES TO PROVIDE IMMEDIATE
in ACTION
FUNDING_____________________________________________________
New sC ^^
In s o m e c a s e s it is im p o r t a n t f o r th e is s u e r t o re c e iv e a ll o f th e fu n d s b y a c e r t a in d a t e a n d th is
c a n b e a c h ie v e d b y e x te n d in g th e r o le o f th e u n d e r w r it e r to in c lu d e th e p r o v is io n o f s h o rt-te rm
f u n d in g . F o r e x a m p le , o n 9 M a r c h 2 0 0 7 , S u n c o r p - M e t w a y Ltd a n n o u n c e d a 2 - f o r - 1 5 e n title m e n t
o f f e r to ra is e a p p r o x im a t e ly $ 1 . 1 7 b illio n f r o m s h a r e h o ld e r s . T h e p u r p o s e o f th e is s u e w a s to
= 1
p a r t ia lly fu n d th e c a s h c o m p o n e n t o f th e c o n s id e r a t io n p a y a b le b y S u n c o r p - M e t w a y in c o n n e c tio n
w ith its th e n p r o p o s e d m e r g e r w ith P r o m in a Ltd. T h e S u n c o r p - M e t w a y issu e w a s d iv id e d in to
in s titu tio n a l a n d r e ta il o ffe r s , e a c h f o llo w e d b y a n in s titu tio n a l b o o k - b u ild . T h e m e r g e r in v o lv e d a
S c h e m e o f A r r a n g e m e n t t h a t w a s s u b je c t to c o u r t a p p r o v a l a t a h e a r in g s c h e d u le d to ta k e p la c e
o n 1 2 M a r c h 2 0 0 7 . O n c e th e c o u r t a p p r o v e d th e s c h e m e , S u n c o r p - M e t w a y h a d a n o b lig a t io n to
m a k e p a y m e n ts to P r o m in a s h a r e h o ld e r s , so it n e e d e d a c c e s s to th e issu e p r o c e e d s s h o r tly a ft e r
th e c o u r t h e a r in g . T h is w a s a c h ie v e d b y n e g o tia t in g a n u n d e r w r it in g a g r e e m e n t w h e r e b y th e
u n d e r w r it e r , C it ig r o u p G lo b a l M a r k e ts A u s t r a lia , s u b s c r ib e d f o r a ll o f th e n e w s h a re s t h a t w e r e
o f f e r e d f o r s a le . T h e n e w s h a re s w e r e th e n t r a n s fe r r e d b y C it ig r o u p to s h a r e h o ld e r s w h o c h o s e
t o t a k e u p t h e ir e n title m e n ts a n d to in v e s to rs w h o a c q u ir e d s h a re s t h r o u g h th e t w o b o o k - b u ild s .
T h e c a p it a l r a is in g w a s c o m p le te d w ith th e s e c o n d b o o k - b u ild o n 1 3 A p r i l 2 0 0 7 b u t S u n c o r p -
M e t w a y h a d re c e iv e d th e fu ll p r o c e e d s f r o m C it ig r o u p o n 1 2 M a r c h . O f c o u r s e , th e u n d e r w r it in g
a g r e e m e n t r e q u ir e d S u n c o r p - M e t w a y to p a y a d a ily f u n d in g fe e r e p r e s e n tin g in te re s t o n th e fu n d s
t h a t it e ffe c tiv e ly b o r r o w e d fr o m th e u n d e r w r ite r .
9 .6 .2 1 Placements (private issues)

PLACEMENT A placem ent o f ordinary shares is a new issue o f shares made to a lim ite d number o f investors. These
an issue of securities issues are typically made to larger in s titu tio n s such as life insurance companies and investm ent funds.
direct to chosen
Such organisations are m ajor holders o f Australian shares and have become the prim e targets for
investors rather than
the ge neral public
placements because they have large sums to invest. Hence, a significant am ount o f capital can be raised
quickly by making a placement to a small num ber o f in s titu tio n s o r to a single in s titu tio n . Details o f some
recent placements are shown in Table 9.6.
TABLE 9.6 Details of selected placements 2013-14

Am ount Issue p r ic e as % o f P ric in g a n d
C om pany D a te a n n o u n c e d i ra is e d ($ m ) p re -a n n o u n c e m e n t m a rk e t p ric e issue m e th o d
The Reject Shop A pril 2013 30 96.9 Underwritten
ERM Power November 2013 75 93.4 Underwritten
Insurance December 2013 1200 96.2 Underwritten

Australia Group
Alumina February 2014 452 103.0 Issue to a single

investor
S o u rce : C o m p ile d from c o m p a n y announcem ents.

In some cases the shares are purchased by another company rather than by financial institutio ns,
often as part o f the form ation o f a strategic alliance between tw o companies whose businesses are related.
For example, in December 2006, Queensland Gas Company (QGC) entered in to an agreement w ith AGL
Energy under which AGL Energy purchased a 27.5 per cent ownership interest in QGC fo r $327 m illion.
The two companies also entered in to a 20-year gas supply agreement and AGL Energy was entitled to
appoint three directors on the QGC board.
A company m aking a placement w ill usually n o t be required to issue a disclosure document.
Placements usually involve offers o f securities to sophisticated and in s titu tio n a l investors. As discussed
in Section 9.4.3, these offers o f securities do n o t require a disclosure document.
Many placements are underw ritten, p articularly where the issue is large and /or the new shares
are distributed to many investors. Where an issue is n o t underw ritten, the company m aking the issue
generally uses the services o f a broker or investm ent bank to assist in placing the shares w ith investors.
The broker is n ot obliged to dispose o f all the shares: the brokers task is best described as undertaking the
placement o f the shares on a ‘best-efforts’ basis. U nd erw ritin g fees fo r share placements are influenced
by several factors, including the absolute size o f the placement, the size, liq u id ity and perceived m arket
risk o f the issuing company and the reason fo r raising the equity. For example, a placement to fund a
profitable acquisition w ill involve lower m arket risk, and lower fees, than one th a t is needed to recapitalise
a company whose financial leverage has become excessive. The fees fo r arranging and/or u nd erw riting a
placement are usually n o t disclosed. Macquarie Capital Advisers Lim ited has indicated th a t fo r placements
by ASX-listed companies, u nd e rw ritin g fees can range from around 1 per cent to 5 per cent o f the gross
offer proceeds.
It has become common fo r larger placements to in s titu tio n s to be priced using the book-building
process and in some cases the managers o f the book-build may also underw rite the issue. For example,
in November 2006, O rigin Energy raised $400 m illio n by a placement th a t was priced using a book-build
and also underw ritten by the two investm ent banks th a t conducted the book-build. U nderw ritin g may
be preferred when a company has entered in to a com m itm ent th a t creates a specific need fo r additional
funds. In the case o f the O rigin Energy placement, the proceeds were used to p a rtly fund the acquisition
o f a gas retailing business th a t O rigin had agreed to purchase from the Queensland Government.
There has been considerable opposition from shareholders to companies m aking placements o f
shares. Some shareholders may oppose placements because they reduce the percentage o f ownership and
voting power o f existing shareholders. Also, some shareholders may believe th a t they are being deprived
o f a possible p ro fit from the sale o f the rights. However, we have already shown th a t the retu rn that
shareholders receive from the sale o f rights represents, in effect, a retu rn o f a p o rtio n o f th e ir investm ent
in the company. More im p orta ntly, i f the placement is made to new shareholders at a price below the
current m arket price, there is a reduction in the value o f the existing shareholders’ investment.
The ASX has placed a general lim it o f 15 per cent on the am ount o f capital th a t a company can issue
privately in any 1 year w ith o u t the p rio r approval o f its shareholders.29 However, it is n o t d ifficu lt to
exceed this lim it w ith o u t viola ting the ASX rules. A fte r m aking a placement th a t falls w ith in the 15 per
cent lim it, a company w ill often have the placement ratified by shareholders. Ratification o f a placement
‘refreshes’ the company’s capacity to raise capital because it means th a t the placement w ill n o t be included
when assessing the company s a b ility to make a future placement. In other words, a company may make
two or more placements in a 12-m onth period, provided each placement increases its issued capital by
less than 15 per cent and each placement is ratified by shareholders before the next placement occurs.
Also, the ASX has allowed larger placements in cases where i t is confident th a t a company s issued capital
is about to be increased by another share issue. In such cases, the ASX is w illin g to apply the 15 per cent
lim it to the expanded capital base rather than to the existing issued capital. For example, a company that
is comm itted to m aking a fu lly und erw ritte n 1 -fo r-l e ntitlem ent offer could obtain a waiver o f the '15 per
cent rule, th a t allows i t to make a placement o f 30 per cent o f its issued capital p rio r to the entitlem ent
offer (ISS Governance Services, 2010, p. 13).
29 S e e R u le s 7 .1 a n d 7 .2 o f th e A u s t r a lia n S e c u r it ie s E x c h a n g e L is t in g R u le s, w h ich p r o v id e t h a t , in g e n e r a l, o n ly 1 5 p e r c e n t o f
a c o m p a n y s is s u e d s h a r e c a p it a l m a y b e is s u e d t o n o n - s h a r e h o ld e r s w ith o u t th e p r io r a p p r o v a l o f s h a r e h o ld e r s a t a g e n e r a l
m e e tin g . T h ere a re e x c e p tio n s to t h is r u le t h a t r e la te sp e c ific a lly t o s m a ll a n d m id - siz e c o m p a n ie s w ith m a r k e t c a p it a lis a t io n s
le s s t h a n $ 3 0 0 m illio n .
B usiness finance
CONTRIBUTING SHARES As discussed in Section 9.2, con tributing sh ares, also known as p a rtly paid shares, are shares on which
shares on w hich only only p a rt o f the issue price has been paid. The issuing company can call up the unpaid part o f the issue
part of the issue price
price in one or more instalments (known as calls*) and, in the case o f a lim ite d lia b ility company, the
has been paid. A lso
holder has a legal obligation to pay these calls. C ontributing shares are quite common in Australia and can
known as p a 厂
f/y pa/c/
shares be used to provide a company w ith a reliable source o f funds. The unpaid am ount is referred to as Reserve
capital1and the shares can be created by a rights issue where the issue price is to be contributed in stages
at specified times. Many co ntribu ting shares are issued by m ining and oil exploration companies, which
make calls when additional funds are required. C ontributing shares can be im p o rta n t in raising capital
b ut the amounts involved are typically small in comparison to other sources o f equity.30
INSTALMENT RECEIPT Typically, in stalm en t receipts are issued when existing fu lly paid shares are offered to the public,
marketable security w ith the sale price to be paid in two instalments. A ll three sales by the Australian Government o f shares
for w hich on ly part
in Telstra Ltd involved instalm ent receipts. For example, in the case o f the th ird Telstra share offer in
of the issue price
has been paid. The
November 2006, retail investors paid a firs t instalm ent o f $2 w ith a second instalm ent o f $1.60 payable
balance is p a y a b le in by 29 May 2008. Partly paid shares and instalm ent receipts are very sim ilar b ut there are some im p orta nt
a final instalment on differences between them. These differences include:
or before a specified
date • fo r instalm ent receipts, the amount and tim in g o f all instalm ents are specified at the tim e o f the
original sale rather than being at the discretion o f directors
• instalm ents are payable to the vendor o f the shares rather than to the issuing company
• holders o f instalm ent receipts are usually e ntitled to the same dividends as holders o f fu lly paid
shares, whereas holders o f p artly paid shares usually receive a p artial dividend based on the
p roportion o f the issue price th a t has been paid.
Companies listed on the ASX are p erm itted to raise lim ite d amounts o f funds from existing shareholders
through share purchase plans (SPPs). These issues do n o t require a prospectus provided they comply
w ith ASIC Regulatory Guide 125, which requires th a t SPPs are accompanied by a cleansing notice. ASIC
recognises th a t the costs o f preparing and d istrib u tin g a prospectus could be very high relative to the
benefits when the risk to investors is lim ite d because the am ount th a t can be invested is restricted.
Accordingly, the am ount th a t a listed company can raise in this way is restricted to $15 000 per annum from
each shareholder. Share purchase plans may be attractive to shareholders because the subscription price
m ust be less than the m arket price p rio r to the announcement o f the issue and there is no brokerage. As
discussed in Section 9.6.6’ share purchase plans are sometimes used in conjunction w ith an in s titu tio n a l
placement, giving all existing shareholders the o p p o rtu n ity to purchase additional shares at the price paid
by the in stitu tio n s th a t took up the placement.
An o ption to purchase the shares o f a company gives the holder o f that option the rig h t to take up shares
in the company by a specified date on predeterm ined term s.31 For example, a company may issue, at
no cost, 10000 options th a t may be exercised by the payment o f $1 per option during the next 5 years.
Consequently, option holders can purchase a m axim um o f 10 000 shares fo r $1 each at any tim e during the
next 5 years, regardless o f th e ir m arket price at the tim e. The option holder therefore has the o pp ortu nity
to benefit from an increase in the m arket price o f the company s shares. I f the company s share price
30 C o n t r ib u t in g s h a r e s c a n a ls o b e is s u e d t o d ir e c t o r s a n d o t h e r s a s p a r t o f a c o m p e n s a t io n p a c k a g e . T h is u s e o f c o n tr ib u t in g
s h a r e s is a n a ly s e d b y B ro w n a n d H a th a w a y ( 1 9 9 1 ).
31 A n im p o r t a n t d iffe re n c e b e tw e e n th e o p t io n s d is c u s s e d h e r e a n d th e e x c h a n g e - t r a d e d o p t io n s d is c u s s e d in C h a p t e r 1 8 is th a t
t h is s e c t io n d is c u s s e s o p t io n s is s u e d b y th e c o m p a n ie s t h e m s e lv e s . In c o n t r a s t , a n e x c h a n g e - t r a d e d o p t io n is c r e a te d b y a
c o n tr a c t b e tw e e n tw o in v e s t o r s a n d d o e s n o t in v o lv e th e c o m p a n y w h o se s h a r e s u n d e r lie t h e o p t io n . T h a t is , u p o n e x e r c ise o f
a c o m p a n y - is s u e d o p t io n , th e c o m p a n y c r e a t e s a n d i s s u e s n e w s h a r e s , w h e r e a s w h e n a n e x c h a n g e - t r a d e d o p t io n is e x e r c ise d ,
o n ly e x is t in g s h a r e s c h a n g e o w n e r s h ip a n d n o n e w s h a r e s a r e c r e a te d .
increases to $1.20, then option holders can purchase 10000 shares fo r $10000, which is $2000 below
their current m arket value.
There are three m ajor provisions included in an option agreement:
• the exercise price o f the option

• the period during which the options may be exercised
• the rights o f option holders in the event o f new issues o f shares by the company.
In general, it is usual fo r the exercise price o f an option to be set near the share price at the tim e the
option is issued. The term o f an option may extend fo r several years and, other things being equal, a
long-term option is more valuable than a short-term option. In the case o f company-issued options, the
option holder is often prevented from exercising the option fo r a certain period after it has been granted.
I f a company makes an issue o f shares during the o ptio ns life, it is possible fo r the value o f the option
to be reduced to almost zero. For example, i f a company splits each o f its shares in to two, other things
being equal, the price per share w ill be halved. In tu rn , this w ill result in a corresponding reduction in the
benefit that the option holder w ill receive from any subsequent increase in the share price. As a result,
option agreements usually provide holders w ith the rig h t to participate in share issues by the company
during the life o f the option.
Options may be issued as follows:
a To employees. The objective when m aking o ption issues is to reward employees in a way th a t is likely
to encourage them to w ork towards im proving the company s profitability. Such issues are typically
made w ith an exercise price equal to the current share price, which does n ot expose the employee
to any immediate tax obligation. I f the company becomes more profitable, it is likely to command a
higher share price, which, in tu rn , w ill increase the value o f the option,
b As a sweetener to an equity issue. Many exploration and m in ing companies issue both ordinary
shares and options to subscribe fo r additional shares. For example, an investor purchasing 1000
shares in a new issue may also receive 1000 options, each o f which entitles the investor to buy one
additional share at a fixed price before a specified date. Frequently these options are listed separately
on the stock exchange. Therefore, an investor obtains the o p p o rtu n ity to make an additional gain
from an increase in the company s share price. A company th a t issues shares accompanied by
options hopes to encourage investors to participate in the issue, thereby reducing the possibility o f
undersubscription.
c As a sweetener to a private debt issue. On occasions, a company seeking debt finance w ill offer share
options to the lender. The company benefits either by obtaining debt finance th a t i t would not
otherwise have received o r by obtaining the funds on better term s— fo r example, at a lower interest
rate. However, neither p arty to an agreement o f this type w ill make the options conditional on the
granting o f the loan because this may jeopardise the tax d eductibility o f interest on the debt.
In the cases outlined above, i t is evident th a t options are n ot issued p rim a rily as a means o f raising
finance, although they are often issued as p art o f a finance package. Nevertheless, significant sums can be
raised when company-issued options are exercised.
9.6.6 | Choosing between equity-raising methods

The previous sections have outlined several external methods to raise equity funds, including rights
issues, placements, share purchase plans, calls on p a rtly paid shares and the exercise o f company-issued
options. M ost o f these methods involve long-term arrangements and i f a significant ‘one-off’ equity
raising is needed, it w ill involve a rights issue a nd/or a placement o f shares.
W hat factors influence the choice between these methods? Chan and Brown (2004) studied this
question using Australian data from July 1996 to March 2001, a period in which the ASX increased
the annual ceiling fo r placements w ith o u t shareholder agreement* from 10 per cent to 15 per cent o f
ordinary share capital. They found th a t the ceiling imposed by the lis tin g rules has a strong effect on
company behaviour, w ith a significant tendency fo r the issue size to be chosen so th a t i t falls just under
the prescribed ceiling. As expected, placements w ith o u t shareholder agreement* became more common
after the ceiling was increased to 15 per cent and it was rare fo r companies to make rights issues where
B usiness finance
the am ount o f funds raised was less than the ceiling fo r placements. Where the am ount o f funds sought
exceeded the prescribed ceiling, it was more common fo r companies to make a placement w ith shareholder
agreement than to make a rights issue. In summary, th e ir m ain conclusion was th a t companies generally
prefer placements to rights issues.
A part from the influence o f any ceiling imposed by stock exchange lis tin g rules, the m ain advantages
o f placements are speed (funds can be raised in a few days rather than weeks), certainty (a placement
may be u nd erw ritte n and, given th a t the risk o f a shortfall exists fo r only a short period, i t should n ot be
d ifficu lt to obtain the support o f an underw riter), lower transaction costs and the shares may be placed
w ith investors considered to be frien dly* to the existing management. Rights issues have the advantage
that shareholders can preserve th e ir ownership proportions and voting power. Thus, rights issues are seen
as being more equitable to existing shareholders. A rights issue may require a prospectus and is slower
than a placement, but, as noted in Section 9.6.1, fo r companies w ith m ostly in s titu tio n a l shareholders,
the m a jo rity o f the funds raised by a rights issue can be received quickly i f one o f the accelerated offer
structures is used.
C om bination issues
As noted above, where the am ount o f funds sought is below the ceiling fo r a placement w ith o u t
shareholder agreement,, companies almost invariably opt fo r a placement rather than a rights issue. Where
the am ount o f funds sought is above the ceiling, a rights issue may be chosen b ut the choice involved is
n ot sim ply lig h ts issue versus placement w ith shareholder agreement'. Rather, the company may make a
placement in combination w ith another m ethod o f equity raising, such as a share purchase plan or a non-
renounceable rights issue. Where these com bination issues are used, the placement component is almost
invariably just under the 15 per cent ceiling so th a t shareholder agreement is n ot required.
Another feature o f combination issues is th a t the placement is often priced using an in s titu tio n a l
book-build. The issue price established by the book-build is then used to determine the price o f the shares
fo r the second component o f the issue. Since retail shareholders have the o pp o rtu n ity to participate in
the capital raising at the same price as institutio ns, this approach addresses the concern th a t a placement
alone discriminates against those shareholders who are n o t invited to participate. Com bination issues
involving a placement and an SPP in close p ro xim ity have become common.
W hile the placement/SPP combination may be appealing as a way o f accommodating small
shareholders, it has been criticised as being far less equitable to small shareholders than a rights issue. The
critics make two main points. First, the lim it o f $15 000 per shareholder fo r share purchase plans means
th a t the b ulk o f new shares is issued to institutio ns. Second, i f the SPP price is set at a large discount to
the m arket price, demand w ill be high and retail investors can end up w ith much less than th e ir $15 000
entitlement*. This problem arose w ith the issues by O rigin Energy, which started w ith a $400 m illion
placement to in stitu tio n s in November 2006. The issue price was $7.10 per share, which represented a
discount o f about 2.5 per cent to the m arket price at the tim e. A t the same tim e, O rigin announced th a t
it would raise additional funds on sim ilar term s through an SPP early in 2007. The details announced in
January 2007 included a target o f $75 m illio n fo r the SPP. By the closing date fo r applications, the m arket
price o f O rigin shares had increased to about $9. N ot surprisingly, many shareholders applied to purchase
shares, w ith the result th a t allocations were scaled back to a m axim um o f 200 shares per shareholder.
A nother type o f com bination involves three offers o f shares: a placement, an in s titu tio n a l entitlem ent
offer and a retail entitlem ent offer. For example, Alesco Corporation used this approach to raise a total
o f $193 m illio n in July and August 2007. The closing price o f Alesco shares on 23 July was $13.96, after
which the company announced the acquisition o f another business and details o f an associated capital
raising, including an in s titu tio n a l placement w ith the issue price to be determ ined by a book-build w ith
an indicative price range o f $12.10 to $12.80 per share. The capital raising also included an in stitu tio n a l
e ntitle m e nt offer and a non-renounceable und erw ritte n l-fo r-9 rights issue (retail entitlem ent offer).
It was announced th a t the issue price fo r both o f these offers would be set equal to the price set fo r the
in s titu tio n a l placement. On 26 July, the company announced th a t the issue price had been set at the
top o f the book-build price range at $12.80 per share and th a t the in s titu tio n a l offers were *strongly
oversubscribed’. On 23 August, Alesco announced th a t its retail e ntitlem ent offer had raised approximately
$61 m illio n in addition to the am ount o f approximately $132 m illio n raised from in s titu tio n s in late July.
The company stated th a t the retail offer had been ^strongly supported by existing shareholders w ith over
60 per cent o f the rights being taken up by eligible shareholders1. The approach used by Alesco has been
used by several other companies, including Asciano Group, which raised $2.35 b illio n in June 2009, and
Graincorp, which raised about $600 m illio n in October 2009.
W hile it is n ot very common, i t is also possible to combine an issue to existing shareholders w ith a
public offer o f shares. This approach may be favoured i f the company wishes to attract a wider spread o f
shareholders, or i f the am ount o f funds sought is large relative to the size o f the company. For example,
in October 2007, Essential Petroleum Resources Ltd (EPR) (see Finance in Action), a small explorer w ith a
market capitalisation o f less than $20 m illion , made a l-fo r-2 non-renounceable rights issue and a public
offer to raise a total o f $10 m illio n .32
Finance
ESSENTIAL PETROLEUM MAKES RIGHTS ISSUE A N D PUBLIC in ACTION
OFFER
E s s e n tia l P e tro le u m h a s n 't e x a c t ly s e t th e w o r ld o n f ir e s in c e its F e b r u a r y 2 0 0 1 lis tin g . F r id a y ’s
c lo s in g p r ic e o f 5 . 5 c e n ts a s h a r e te lls a s m u c h . B u t p a t ie n c e w it h th e O t w a y B a s in o il a n d g a s
e x p lo r e r , lik e t h a t s h o w n b y th e g r o u p ’ s b ig g e s t s h a r e h o ld e r , f o r m e r JB W e r e re s o u rc e s g u r u
P e te r W o o d f o r d , m ig h t ju s t d e liv e r s o m e b ig r e w a r d s in 2 0 0 8 . M a n a g in g d ir e c t o r J o h n R e m fry
h a s w o r k e d th e g r o u p in to a p o s it io n w h e r e it w i ll b e a s to c k t o w a t c h n e x t y e a r a s it sets
a b o u t d r illin g n e a r-te rm d e v e lo p m e n t o p p o r t u n it ie s in th e o n s h o r e O t w a y w h ile a ls o c h a s in g
u p th e b ig - t im e p o t e n t ia l o f its o f f s h o r e p e r m its , f la n k in g w h a t E s s e n tia l r e c k o n s c o u ld b e th e
n e x t m a jo r h y d r o c a r b o n p r o v in c e — th e D is c o v e r y B a y ' H i g h 7 o f f s h o r e fr o m P o r tla n d in w e s te r n
V ic t o r ia .
A n o t h e r g e o lo g ic a l f e a tu r e , th e P e c te n 'H i g h 7 o f f s h o r e fr o m P o rt C a m p b e ll h a s a l r e a d y b e e n
p r o v e n a s a h y d r o c a r b o n f a ir w a y . E s s e n tia l re c k o n s t h a t b a c k a t th e b i g g e r D is c o v e r y B a y
H ig h , th e p o t e n t ia l in its p e r m its is f o r m o r e th a n 5 t r illio n c u b ic f e e t o f r e c o v e r a b le g a s a n d
m o re th a n 2 b illio n b a r r e ls o f r e c o v e r a b le o il. T h a t ’s b ig t a lk f r o m a c o m p a n y o f E s s e n tia T s
s iz e , b u t w e l l s o o n k n o w i f it 7s h o t a i r o r n o t.
T h a t's b e c a u s e E s s e n tia l is p u llin g in $ 1 0 m illio n fr o m a $ 6 m illio n r ig h ts is s u e ( u n d e r w r it t e n
b y B e ll P o tte r a n d C o m s e c ) a n d $ 4 m illio n fr o m a p u b lic o f f e r a t 4 c e n ts a s h a r e . A t th e is s u e
p r ic e , th e g r o u p 's m a r k e t c a p it a lis a t io n w i ll b e a ll o f $ 2 2 m illio n .
S o u rc e : 'After a few quiet years, Essential m a y prove it h a s all the ingredie nts,/ B a rry Fitzgerald, The A g e ,
2 9 O c to b e r 2 0 0 7 .
Table 9.1 shows th a t listed companies have raised significant funds through employee share plans,
although the prim ary purpose o f such plans is to m otivate senior managers and other employees by LEARNING
OBJECTIVE 9
giving them an ownership interest in th e ir employer. There are several types o f employee share plans that
O utline the different
have been used in Australia, including:3
33
2 types of em ployee
share plans
• Fully paid share plans. Employees are able to purchase new or existing shares, usually at a discount
from m arket value. The purchases are usually funded by loans from the company th a t are interest-
free or at a low interest rate and dividends on the shares may be used to repay the loans. Sometimes
there is a provision to w rite o ff the loans i f the company fails.
• Partly paid share plans. The shares issued to employees are in itia lly p a rtly paid and converted to
fu lly paid shares by a series o f calls. In this case employees can be liable fo r calls i f the company fails
before the shares are fu lly paid.
32 In th e y e a r t o 3 0 J u n e 2 0 0 8 , E P R r e c o r d e d a n e t lo s s o f $ 1 0 .9 m illio n a n d in th e fo llo w in g y e a r a fu r t h e r lo s s o f a lm o s t $ 2 4 .8
m illio n . In F e b r u a r y 2 0 1 0 , it s s h a r e h o ld e r s a p p r o v e d a c a p it a l r e s t r u c t u r e w h e r e b y d e b t o b lig a t io n s o f $ 2 3 m illio n w ere
c o n v e r te d in t o e q u it y o r fo r g iv e n . F o llo w in g th e r e s t r u c t u r e , 5 1 .9 p e r c e n t o f th e c o m p a n y s v o t in g s h a r e s w e re h e ld b y B e a c h
E n e r g y L t d ， a n e w b o a r d w a s a p p o in t e d a n d t h e c o m p a n y ’s n a m e c h a n g e d t o S o m e r t o n E n e r g y L td .
33 C h a r a c te r istic s o f th e v a r io u s t y p e s o f e m p lo y e e s h a r e p la n s a re d is c u s s e d in d e t a il b y S tr a d w ic k ( 1 9 9 6 ) .
B usiness finance
• Option plans. Under these plans employees in itia lly purchase (or are granted) an option to buy shares
at some future tim e at a specified price. O ption plans involve a small in itia l outlay w ith potential for
large capital gains i f the company is successful.
• Employee share trusts. Employees have an interest in a tru s t th a t holds shares in the employer
company. The tru s t is norm ally funded by the employer. Employees who hold units in the tru s t can
dispose o f the u nits only to other members o f the trust.
• Replicator plans. Replicator plans do n ot involve shares in the employer company. Instead, payments
are made to employees based on the achievement o f certain performance criteria. For example, such
a plan may involve phantom shares* w ith a price th a t is linked to the p ro fita b ility o f the company or
to the performance o f a division.
The popularity o f the various plans varies among different types o f employers. For example, in Australia
the m a jo rity o f employee share plans are option plans and this type o f plan is p articularly popular as a way
o f rewarding the senior executives o f large listed companies. Recent changes in the taxation treatm ent of
employee share plans may encourage more widespread use o f plans o f other types fo r general staff. The
use o f a tru s t structure can be attractive fo r private companies where there are restrictions on ownership
o f shares in the company itself. Replicator plans are popular w ith unlisted companies, where i t is d ifficult
to establish a m arket price fo r the shares, and can also be useful fo r relatively new businesses, where
issuing shares would dilute the ownership and control o f the founders.
Over the years the Commonwealth Government has sought to encourage employee share ownership
by providing tax concessions in cases where shares or rights to shares are given to employees or issued to
them at a discount. The tax status o f employee share plans has been subject to frequent change and some
degree o f uncertainty.
The provisions th a t apply to employee shares mean that, in general, any benefit to an employee under
an employee share plan is taxable in the year in which the share or rig h t is acquired. Consequently, the
difference between the m arket value o f a share and the consideration paid to acquire i t is assessable in the
year o f acquisition. However, where the employee share scheme meets the conditions fo r classification as
a ‘tax-deferred’ scheme, tax may be deferred to a later date. The m ain conditions fo r ‘tax-deferred’ status
would generally be satisfied i f the shares have been purchased via a salary-sacrifice scheme or alternatively
where the employee faces a *real risk o f forfeiture* o f the shares due to em ploym ent circumstances such as
failing to meet performance hurdles or serving a m inim um term o f em ploym ent.34
Under the ASX Listing Rules a company m ust have a proposed employee share plan approved by
shareholders and employees may even have to be provided w ith a prospectus i f the prim ary m otivation
fo r the plan is fundraising as opposed to providing employees w ith the o pp o rtu n ity to participate in
ownership o f the company. Given the complexity o f the taxation provisions and other regulatory
requirements, the financial manager o f a company th a t introduces an employee share plan is likely to
need specialised advice.
9.8 Internal funds

So far we have discussed external sources o f equity finance. However, a company th a t is operating profitably
LEARNING w ill also generate funds internally. The relative importance o f interna l and external sources o f funds
OBJECTIVE 10
may be assessed using different measures o f in te rn a l funds*. One approach is to define internal equity
O u tline the
a d va ntage s of internal finance as retained profits plus depreciation charges, where retained p ro fit is equal to accounting p ro fit
funds a s a source of after company tax, less dividends paid to shareholders. A problem w ith this approach is th a t a company
finance cannot spend its accounting p ro fit— suppliers and employees m ust be paid w ith cash. In other words, the
prim ary source o f interna l funding is cash p ro fit, which can differ significantly from accounting profit,
which is prepared on an accrual basis. Cash p ro fit is reported by companies in th e ir cash flow statements.
The cash flow statement is a funds statement th a t shows the sources and uses o f funds, where funds are
defined as cash. A 2009 Reserve Bank o f Australia (RBA) analysis o f corporate sources and uses o f funds
relied on data from these statements.35 The approach adopted by the RBA divides sources o f funds into
two basic categories: interna l funding and external funding. Internal funding is equal to cash p ro fit— that
34 F o r fu r t h e r in fo r m a t io n o n th e t a x t r e a t m e n t o f e m p lo y e e s h a r e s c h e m e s s e e w w w .a t o .g o v .a u / G e n e r a l/ E m p lo y e e - s h a r e -
sc h e m e s/.
35 S e e R B A ( 2 0 0 9 ).
is, cash received from customers and non-interest-bearing investments (e.g. dividends) less payments to
suppliers, wages and salaries paid to employees and tax payments. Thus, cash p ro fit is measured before
payment o f interest expense and any other financing charges and is n o t affected by depreciation. External
funding comprises tw o sources: net debt and net equity, where net debt is equal to funds borrowed from
intermediated (e.g. bank loans) and non-interm ediated (e.g. issuing corporate bonds) sources. Finally, net
equity is equal to funds raised by issuing new shares, less cash paid o ut to repurchase shares. Funds may
be used in three ways: investm ent in assets, payment o f dividends and payment o f interest.
The use o f internal funds as a source o f finance has im p o rta n t advantages. Using interna l funds does
not affect the control o f the company as it does n o t involve the company in issuing any additional shares.
Therefore, using internal funds does n o t com m it the company to increased dividend payments in the
future, w ith the result that no additional strain is placed on the company s cash resources. A fu rth e r
advantage is that, unlike a new issue o f shares, internal funding involves no issue costs such as brokerage,
fees paid to underw riters and other advisers or costs incurred in preparing a prospectus.
Internal funds are a convenient source o f finance th a t does n ot involve any explicit costs such as
transaction costs, but they are n ot a free source o f finance fo r a company. Internal funds generated by
a company are invested by the company on its shareholders’ behalf. I t follows th a t internal funds have
an o pportunity cost— th a t is, the funds could have been invested elsewhere by shareholders. Therefore,
when a company uses internal funds, shareholders w ill n ot benefit unless the company is able to invest
the funds profitably. This analysis is discussed in more detail in Chapter 14.
The relative importance o f interna l funds in providing a company s to ta l financial requirements is
related to the nature o f a company s business and can also vary considerably over tim e. Between 2003
and 2012, around 86 per cent o f funding fo r resource companies has been sourced internally, whereas
only about 68 per cent o f funding fo r non-resource based companies comes from internal sources.
Furthermore, both o f these percentages rose dramatically during the global financial crisis beginning
in 2007 when external finance was increasingly hard to obtain. (Reserve Bank o f Australia, March
2013, p. 53).
A dividend reinvestment plan (DRP) allows shareholders the choice o f using th e ir dividends to purchase
additional shares instead o f receiving cash.36 The firs t DRPs were introduced by Australian companies
in the early 1980s. W ith in 10 years, m ost o f Australia’s largest companies were offering such plans and
reinvestment o f dividends has become a significant source o f equity fo r listed companies, particularly
larger companies. The main reason fo r the popularity o f DRPs is related to the intro du ction o f the
dividend im putation tax system, which caused investors to demand high dividend payouts. A dividend
reinvestment plan allows a company to meet the demand fo r a high dividend payout w ith o u t straining
its cash resources. Technically, investors who participate in a DRP receive the dividends and therefore
obtain the tax benefits o f im putation, and then reinvest the cash in additional shares. This means that,
for tax purposes, dividends can be considered as being paid* to investors w ith o u t any cash payment by
the company. Provided the shares issued under a DRP are fu lly paid, there is no need fo r a prospectus and
shares issued under a DRP are exempt from the *15 per cent in 12 m onths1capital raising lim it contained
in the Listing Rules. DRPs are inflexible in th a t the tim in g o f any capital raising is tied to the tim in g o f
dividend payments and may n o t provide a reliable source o f funds because participation by shareholders
is voluntary. The la tte r problem can be overcome, at a cost, by having a company s DRP underw ritten.
The main advantage o f DRPs centres on transaction costs: fo r many companies, the costs o f operating
a DRP are lower than the costs involved in m aking rights issues and share placements to replace cash
paid out as dividends. D uring the 2012-13 financial year, A ustralian-listed companies used DRPs to raise
$6.9 b illion (Australian Financial Markets Association, 2013, p. 55).
36 A S X s t a t is t ic s in c lu d e d iv id e n d r e i n v e s t m e n t a s p a r t o f e q u it y r a is e d e x te rn a lly . H o w e v e r, w e d is c u s s D R P s in th e c o n te x t
o f in t e r n a l fu n d s b e c a u s e d iv id e n d r e in v e s t m e n t la r g e ly in v o lv e s fu n d s t h a t c o m p a n ie s w o u ld h a v e r e ta in e d , b u t fo r th e
h ig h e r d iv id e n d p a y o u t s n e e d e d t o t r a n s f e r f r a n k in g c r e d it s t o s h a r e h o ld e r s . In o t h e r w o r d s, e q u it y 'ra ise d * th r o u g h d iv id e n d
r e in v e st m e n t is, in e ffe c t, in t e r n a l fu n d s t h a t h a v e b e e n <r e la b e lle d , a s e x t e r n a lly p r o v id e d . D iv id e n d r e in v e s t m e n t p la n s a re
d is c u s s e d in m o re d e t a il in C h a p t e r 1 1 .
9.9 M a n a g in g a com pany’s equity
structure
In this chapter we have discussed the various sources o f equity individually. In practice, the financial
manager w ill usually have a long-term plan fo r the management o f a company s capital structure,
including its equity structure. The m ost im p o rta n t aspect o f such a plan involves the tim in g and amounts
o f future capital raisings based on forecasts o f the company s cash flows, capital expenditures and loan
repayments. As part o f this process, companies, equity structures are sometimes rearranged through
procedures th a t change the number o f shares on issue w ith o u t either raising capital or returning capital
to shareholders. These procedures— which include bonus issues, share splits and consolidations— are
now considered.
9.9.1 | Bonus issues and share splits

A bonus issue is a ‘free’ issue o f shares made to existing shareholders in p ro p o rtio n to th e ir current
investm ent. Bonus issues used to be common in Australia and were used as a way o f increasing the
L E A R N IN G
dividends paid to shareholders. A bonus issue is equivalent to a rights issue w ith a zero subscription
O B JEC TIVE 11
price. In accounting terms, a company could make a bonus issue by using the balances o f reserves, such
Outline the effects of
bonus issues, share as a share premium reserve, and /or retained earnings— th a t is, p art o f a reserve is converted to issued
splits a n d share capital b u t the to ta l o f shareholders’ funds remains unchanged.
consolidation s Regulatory changes, including the intro du ction o f the dividend im p utatio n tax system and the
abolition o f par value fo r shares, removed any tax advantage associated w ith bonus issues. Accordingly,
companies th a t have the capacity to pay higher dividends usually increase the rate o f dividend per existing
share rather than making a bonus issue and m aintaining the same dividend rate.
W hile bonus issues have virtu a lly disappeared from the Australian market, companies can achieve a
sim ilar result by sp littin g th e ir shares. For example, a share s p lit th a t doubles the num ber o f a company s
issued shares has the same effect fo r shareholders as a 1 -fo r-l bonus issue. Australian companies that
have made share splits since 2002 include Toll Holdings, W H K Group, CSL Lim ited, Incitec Pivot and
Fortescue Metals Group.
A bonus issue or share sp lit involves no cash flow — apart from the adm inistration costs involved—
and should n o t have any effect on shareholders’ wealth. Therefore, i f a company makes, say, a 1 -fo r-l
bonus issue, the num ber o f shares on issue w ill double and the m arket price o f each share should decrease
by half, leaving unchanged the to ta l m arket value o f the shares held by each investor. The Australian
evidence is consistent w ith this expectation— th a t is, bonus issues do n o t affect shareholders1wealth.37
A lthough a bonus issue— by its e lf— would n o t be expected to have an im pact upon shareholder wealth,
the in fo rm a tio n contained w ith in the announcement o f a bonus issue may result in a significant change
in wealth. Bonus issues and share splits are typically made by companies th a t have been perform ing well
and th a t have recently experienced significant increases in share price. Investors are aware that, follow ing
a bonus o r split, companies usually do n o t reduce dividends per share to the extent necessary to m aintain
the same to ta l dividend payout. For example, after a 1 -fo r-l bonus issue, a company currently paying
a dividend o f 10 cents per share would need to pay a dividend o f only 5 cents per share to m aintain its
dividend payout. However, companies w ill often n ot reduce th e ir dividend per share to th a t extent. For
example, the company may end up paying a dividend of, say, 7.5 cents per share after the bonus issue has
been made. I f the behaviour o f m ost companies after a bonus issue follows this pattern, the m arket w ill
be confident th a t a company m aking a bonus issue w ill probably increase its to ta l dividend payout (Ball,
Brown & Finn 1977). This, in tu rn , indicates the confidence o f management in the company s future.
Consequently, the share price may increase in response to this new inform ation. Therefore, bonus issues
may result in an increase in shareholder wealth— n o t sim ply because o f the new shares issued— but
instead because the announcement o f the issue provides an o pp o rtu n ity fo r management to signal to the
m arket positive info rm a tio n th a t was n o t already incorporated into the company s share price.
37 S e e S lo a n ( 1 9 8 7 ) . T h is e v id e n c e c o n t r a s t s w ith th e U S e v id e n c e , w h ich h a s fo u n d p o s it iv e a b n o r m a l r e t u r n s o n th e e x -b o n u s
d a y fo r U S s t o c k d iv id e n d s a n d s h a r e s p lit s ; s e e L a k o n is h o k a n d V e r m a e le n ( 1 9 8 6 ) a n d G r in b la t t , M a s u lis a n d T it m a n ( 1 9 8 4 ).
C hapter n in e S ources 〇 f fin a n c e : equity
The dividend-based explanation fo r the m arket reaction to bonus and sp lit announcements, which
was firs t proposed by Fama et al. (1969), does n o t appear to explain fu lly the m arket reaction to such
announcements. Asquith, Healy and Palepu (1989) studied share splits by companies th a t did n o t pay
cash dividends. They found th a t these companies had large earnings increases before the split, b u t no
unusual changes in earnings or in itia tio n o f dividends after the split. An im p o rta n t conclusion o f th eir
study was th a t the announcement o f a sp lit leads investors to expect th a t past earnings increases are
permanent.
A share split may be made by a company w ith a *thin, market fo r its shares. Management may believe
that reducing the m arket price per share w ill increase the demand fo r the company s shares. In September
2008, fe rtiliser and explosives m anufacturer Incitec Pivot, which had a share price around $140, made
a 2 0 -fo r-l share split. The stated purpose was to benefit shareholders by m aking the company s shares
more affordable to retail investors. W hile there is evidence th a t both announcement and execution
o f share splits are associated w ith significant positive returns, empirical evidence that splits lead to
improved liq u id ity and m arketability is mixed. On the one hand, there is evidence th a t both the number
o f shareholders and the num ber o f share transactions increase after splits, b ut little evidence th a t the
dollar value o f trading increases. On the other hand, there is evidence th a t splits increase bid-ask spreads
and return volatility, both o f which suggest a decrease in liq u id ity .38
A share consolidation— also know n as a reverse sp lit— decreases the number o f shares on issue and
increases the price per share. For example, i f a company w ith 100 m illio n issued shares makes a l-fo r-1 0
consolidation, i t w ill end up w ith 10 m illio n issued shares. A fte r the consolidation, the m arket price per
share should increase by a factor o f 10. Consolidations are unusual in Australia b ut have become more
common follow ing the global financial crisis. For example, in September 2010, gold m iner St Barbara
Ltd announced th a t it planned a share consolidation o f six existing shares fo r one new share. Directors
noted th a t the company s share price o f around 40 cents meant th a t some international in s titu tio n s that
were potential investors in the company were precluded from investing in companies w ith share prices
less than US$1. Sim ilar reasons usually given fo r consolidations include raising the share price into a
popular trading range, overcoming perceptions th a t a company is n o t respectable because o f its low share
price, and reducing shareholder servicing costs. O ther companies th a t have recently consolidated th e ir
securities include Australand, Boart Longyear and GPT Group.
I f these suggested reasons are correct and consolidations provide benefits fo r shareholders, the
market response to these events should be positive. This does n o t appear to be the case: several US studies
report th a t consolidations are associated w ith negative share returns. For example, Desai and Jain (1997)
report an average abnormal retu rn o f -4.5 9 per cent in the m onth th a t consolidations are announced.
They also found th a t negative returns in the announcement period were followed by a d rift th a t averaged
10.76 per cent in 1 year and 33.90 per cent in 3 years. One interpretation is th a t consolidations convey
a signal th a t management lacks confidence th a t there w ill be future share price increases resulting from
improvements in earnings. There is evidence th a t consolidations are followed by higher trading volume
and a decrease in bid-ask spread. This finding suggests th a t consolidations enhance the liq u id ity o f a
stock, which should be beneficial fo r investors. Taken together, the evidence suggests th a t consolidations
*may be better characterised as a device th a t management, given its assessment o f future earnings, can
use to improve the liq u id ity o f the stock’ （Han 1995, p. 169).
38 S tu d ie s t h a t r e p o r t e v id e n c e o n t h e e ffe c t s o f s h a r e s p l i t s o n liq u id ity in c lu d e Ik e n b e r ry , R a n k in e a n d S tic e ( 1 9 9 6 ) a n d

M u sc a r e lla a n d V e ts u y p e n s ( 1 9 9 6 ) .
B usiness finance
SUMMARY
• In th is c h a p te r w e c o n s id e r e d th e w a y s in w h ic h • A rig h ts issu e (e n title m e n t o ffe r) is a n o ffe r to
a c o m p a n y m a y ra is e e q u ity b y is s u in g o r d in a r y e x is tin g s h a re h o ld e rs o f n e w s h a re s in a fix e d
s h a re s . E v e ry c o m p a n y m u st issu e o r d in a r y s h a re s. r a t io to th e n u m b e r o f s h a re s a lr e a d y h e ld . A
• Those who in v e s t in new v e n tu re s w h e re an t r a d itio n a l rig h ts issu e is s lo w and in v o lv e s
e n tre p re n e u r n e e d s f in a n c e fo r th e d e v e lo p m e n t h ig h e r co sts th a n a p la c e m e n t b u t c a n b e u se d to
o f a n in v e n tio n o r id e a in c lu d e w e a lt h y in d iv id u a ls ra is e la r g e a m o u n ts o f fu n d s . R ig h ts issues m a y
a n d p r iv a te e q u ity fu n d s . b e r e n o u n c e a b le o r n o n -re n o u n c e a b le a n d c a n
• W h e re c a p it a l is ra is e d by is s u in g s e c u ritie s , b e m a d e w ith o u t a p ro s p e c tu s . T h e fu n d s c a n b e
p o te n tia l in v e s to rs m u st g e n e r a lly b e s u p p lie d re c e iv e d s o o n e r th a n u s u a l b y a d o p tin g o n e o f
w ith a d is c lo s u re d o c u m e n t. T h is d o c u m e n t, th e a c c e le r a te d o ffe r s tru ctu re s.
often a p ro s p e c tu s , sets o u t in fo r m a tio n to e n a b le • A p la c e m e n t is a n issu e o f s h a re s to b r o k e r s 7
in v e s to rs to assess th e risks in v o lv e d and th e c lie n ts a n d /o r in s titu tio n a l in v e s to rs s u ch as
v a lu e o f th e s e c u ritie s . life in s u r a n c e c o m p a n ie s a n d in v e s tm e n t fu n d s .
• O r d in a r y s h a re h o ld e rs fa c e h ig h e r ris k th a n o th e r Issue c o sts a r e lo w e r f o r p la c e m e n ts th a n fo r
in v e s to rs, b u t a re p ro te c te d to so m e e x te n t b y rig h ts issu e s, b u t f o r a lis te d c o m p a n y a lim it
lim ite d lia b ility . A s p a rt-o w n e rs o f th e c o m p a n y , of 15 p e r c e n t is p la c e d on th e am ount of
o r d in a r y s h a re h o ld e rs e x e rt a d e g r e e o f c o n tro l b y c a p it a l th a t it c a n ra is e b y p la c e m e n ts in a n y
v irtu e o f th e ir r ig h t to e le c t m e m b e rs o f th e B o a rd o f y e a r w ith o u t th e p r io r a p p r o v a l o f s h a r e h o ld e r s .
D ire c to rs . S h a re h o ld e rs in a liste d p u b lic c o m p a n y W h e re th e a m o u n t o f fu n d s sought exceeds
m a y sell th e ir sh a re s o n a s to ck e x c h a n g e . th e 15 per cent c e ilin g , c o m p a n ie s o fte n
• E q u ity has im p o r ta n t a d v a n ta g e s as a s o u rc e of m a k e a p la c e m e n t w ith s h a r e h o ld e r a p p r o v a l.
fin a n c e . C o m p a n ie s a r e n o t re q u ire d to p a y d iv id e n d s A lte r n a tiv e ly , a p la c e m e n t c a n be c o m b in e d
o r to re d e e m (re p a y ) o r d in a r y s h a re s. R a isin g n e w w ith a s h a re p u rc h a s e p la n a n d /o r a rig h ts
e q u ity c a p ita l lo w e rs fin a n c ia l ris k a n d lo w e rs th e issu e.
in te re s t ra te th a t th e c o m p a n y w ill h a v e to p a y w h e n • E q u ity c a n a ls o b e ra is e d b y is s u in g c o n trib u tin g
it b o rro w s . s h a re s , o p tio n s on s h a re s and sh a re s to
• M a k in g a n in it ia l p u b lic o ffe r in g (IPO ) o f o r d in a r y e m p lo y e e s . E m p lo y e e s h a re p la n s c a n q u a lif y
s h a re s is re fe r r e d to as f lo a t in g a c o m p a n y a n d is fo r ta x c o n c e s s io n s .
u s u a lly a c c o m p a n ie d b y th e lis tin g o f th e s h a re s o n • A m a jo r s o u rc e o f e q u ity fin a n c e is in te rn a l in th e
a s to c k e x c h a n g e . D e te r m in in g th e issu e p r ic e f o r a n se n se th a t it re su lts fro m th e p o s itiv e n e t c a s h flo w s
IP O c a n b e d iff ic u lt a n d in la r g e flo a ts it h a s b e c o m e th a t a s u c ce ssfu l com pany g e n e ra te s . In te rn a lly
c o m m o n to use c o m p e titiv e b id d in g b y in s titu tio n s g e n e r a te d fu n d s have s e v e ra l a d v a n ta g e s over
to set th e p ric e . D e ta ils o f th e issu e a n d th e is s u in g e q u ity fu n d s ra is e d e x te rn a lly . In c o n ju n c tio n w ith
c o m p a n y m u st b e p r o v id e d in a p ro s p e c tu s . F lo a tin g h ig h e r d iv id e n d p a y m e n ts u n d e r th e im p u ta tio n ta x
a com pany in v o lv e s s ig n if ic a n t co sts. O fte n , th e syste m , m a n y A u s tr a lia n c o m p a n ie s h a v e in tro d u c e d
la rg e s t c o s t is a s s o c ia te d w ith th e u n d e r p r ic in g o f d iv id e n d re in v e s tm e n t p la n s th a t a llo w in v e s to rs to
th e s h a re s — th e issu e p r ic e f o r a n IP O is u s u a lly less use th e ir cash d iv id e n d s to p u rc h a s e a d d itio n a l
th a n th e m a rk e t p r ic e w h e n t r a d in g c o m m e n c e s . s h a re s . T h is a llo w s d iv id e n d s to b e p a id a n d f r a n k in g
• A fte r a c o m p a n y h a s b e e n flo a te d , a d d itio n a l e q u ity c re d its to b e d is tr ib u te d to in v e s to rs w h ile re ta in in g
can be ra is e d in s e v e ra l w ays, in c lu d in g rig h ts c a s h w ith in th e c o m p a n y .
issu es, p la c e m e n ts a n d s h a re p u rc h a s e p la n s .
KEY TERMS
c a ll 234 p la c e m e n t 260
c o n trib u tin g sh a re s 262 p ro s p e c tu s 240
c u m rig h ts 253 re s id u a l c la im 234
d is c lo s u re d o c u m e n t 240 se a s o n e d e q u ity o ffe r in g 25 1
e x -rig h ts d a te 253 s h o rtfa ll f a c ility 258
in fo rm a tio n a s y m m e try 237 s h o rtfa ll sh a re s 258
in itia l p u b lic o ffe r in g 237 s ta p le d se c u ritie s 233
in s ta lm e n t re c e ip t 262 s u b s c rip tio n p ric e 253
lim ite d lia b ilit y 234 th e o re tic a l e x -rig h ts s h a re p ric e 254
o p tio n 255 th e o re tic a l rig h ts p ric e 254
o r d in a r y sh a re s 234 w in n e r ’s cu rs e 248
270
C H A P T E R IsflÊ R E V I E W
QUESTIONS
1 [L0 1] The interest held by ordinary shareholders is a residual claim. E x p la in th e m e a n in g a n d s ig n ific a n c e
o f th is s ta te m e n t.
2 [L O 1] W h a t a re th e m o s t im p o r t a n t rig h ts o f s h a re h o ld e rs in a c o m p a n y ?
3 [ L O l ] W h a t a r e th e m a in s im ila ritie s b e tw e e n c o n tr ib u tin g s h a re s a n d in s ta lm e n t re c e ip ts ? H o w d o th e y

d iffe r?
4 [LO 2 ] W h a t a r e th e m a in a d v a n ta g e s o f r a is in g e q u ity ra th e r th a n b o r r o w in g ?
5 [LO 2: D is tin g u is h b e tw e e n lim ite d lia b ilit y a n d n o lia b ilit y c o m p a n ie s . W h y a r e n o lia b ilit y c o m p a n ie s
c o n fin e d to e x p lo r a t io n a n d m in in g c o m p a n ie s ?
6 [LO 3 ] D e fin e p r iv a te e q u ity . W h a t a r e th e m a in fe a tu re s th a t d is tin g u is h p r iv a te e q u ity fro m o th e r fo rm s o f

e q u ity fin a n c e ?
7 [LO 31 P riv a te e q u ity fu n d in g fo r n e w v e n tu re s is t y p ic a lly p r o v id e d in s ta g e s . W h a t a r e th e m a in re a s o n s fo r

th is a p p r o a c h ?
8 [LO 4 ] W h a t ty p e o f in fo r m a tio n is g e n e r a lly r e q u ire d in th e o f fe r d o c u m e n ts is s u e d p r io r to c a p it a l r a is in g ?

W h y d o y o u th in k r e g u la to rs m ig h t h a v e a v o id e d p r o v id in g a s im p le 'c h e c k lis t7 o f ite m s f o r in c lu s io n a n d
in s te a d ta k e n a b r o a d e r a p p r o a c h to r e g u la tio n ?
9 [L O 5 ] Listed p u b lic c o m p a n ie s h a v e th e a d v a n ta g e o f g r e a te r a c c e s s to th e c a p it a l m a rk e t th a n p r iv a te o r
u n lis te d c o m p a n ie s . H o w e v e r, th is a d v a n ta g e a ls o in v o lv e s s ig n ific a n t costs. W h a t a r e th e m a in co sts?
10 [L O 5 ] A com pany is floated by m aking a public issue of ordinary shores. O u t lin e th e p ro c e d u re s in v o lv e d

in f lo a tin g a c o m p a n y .
11 [L O 5 ]A company usually seeks the assistance o f a financial institution before undertaking any large capital
raising. E x p la in w h y th is is so . D e s c rib e fu lly th e re le v a n t s e rv ic e s th a t a f in a n c ia l in s titu tio n p ro v id e s .
12 [L O 5 ] O u tlin e th e m a in a d v a n ta g e s o f u s in g b o o k - b u ild in g fo r a n in it ia l p u b lic o ffe r in g o f s h a re s ra th e r th a n
m a k in g a fix e d - p r ic e o ffe r. W h a t a r e th e d is a d v a n ta g e s o f b o o k - b u ild in g ?
13 [ L 0 5 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f h a v in g a s h a re issu e u n d e r w r itte n ?
14 [L O 5 ] W h y a r e u n d e r w r it in g fe e s h ig h e r f o r c o m p a n y flo a ts th a n f o r rig h ts issues?
15 [L O 6 In itia l p u b lic o ffe r in g s o f s h a re s a re t y p ic a lly u n d e r p r ic e d b u t v e n d o rs a r e r a r e ly u p s e t a b o u t le a v in g

la r g e a m o u n ts o f m o n e y o n th e ta b le . H o w is 'm o n e y le ft o n th e t a b le 7 u s u a lly m e a s u re d ? H o w c a n th e
p u z z lin g a ttitu d e o f v e n d o rs b e e x p la in e d ?
16 [ L 0 6 ] In d is c u s s in g th e ir re s e a rc h o n IP O s, C a m p e t a l. ( 2 0 0 6 ) c o n c lu d e th a t 'th e c h o ic e s issu ers m a k e a t

th e o ffe r in g re fle c t th e tr a d e - o ff b e tw e e n th e co sts a n d b e n e fits o f th e IP O 7. F o r issu e rs, th e m a in c o s t o f a n
IP O is re p re s e n te d b y u n d e r p r ic in g . W h a t a r e th e m a in b e n e fits ?
17 [L O 7 ] O u tlin e th e 'n e w issues p u z z le 7. W h y is th e e v id e n c e f o r its e x is te n c e c o n tro v e rs ia l?
18 [L O 8 ] A lth o u g h m o st c o m p a n ie s p e r m it rig h ts to b e tr a d e d o n th e s to c k e x c h a n g e , a n u m b e r o f c o m p a n ie s
h a v e m a d e n o n -re n o u n c e a b le rig h ts issu es. W h y w o u ld c o m p a n ie s w is h to m a k e th e ir rig h ts issues
n o n -re n o u n c e a b le ?
19 [ L 0 8 ] T h e re h a s b e e n re s is ta n c e to c o m p a n ie s r a is in g fu n d s b y a p r iv a te p la c e m e n t o f s h a re s . D e s c rib e th e
a d v a n ta g e s a n d d is a d v a n ta g e s to e x is tin g s h a re h o ld e rs o f a p r iv a te p la c e m e n t.
20 [ L 0 8 ] M W B Ltd is a p r o fita b le c o m p a n y w h o s e o r d in a r y s h a re s a r e lis te d o n th e A S X . T h e c o m p a n y ha s

p a id r e g u la r d iv id e n d s to s h a re h o ld e rs a n d h a s g e n e r a lly fin a n c e d its g r o w th b y r e ta in in g a b o u t 5 0 p e r c e n t
o f p ro fits . Its c u rre n t 5 - y e a r p la n in c lu d e s in v e s tm e n t in f ix e d a sse ts o n a s c a le th a t w ill re q u ire th e r a is in g o f
e x te rn a l e q u ity fin a n c e d u r in g th e p la n n in g p e r io d . A d v is e th e d ir e c to r s o n th e m a in fa c to rs th a t th e y s h o u ld
c o n s id e r in d e c id in g h o w to ra is e e q u ity . T he d ir e c to r s a r e c o n s id e r in g :
a) a rig h ts issue
b) a se rie s o f s h a re p la c e m e n ts
c) e s ta b lis h in g a d iv id e n d re in v e s tm e n t p la n .
21 Combining a shore purchase plan with a placement to institutions should satisfy shareholders who
[L O 8 ]
argue that as far as possible, companies should raise equity through rights issues. D o y o u a g r e e w ith th is
s ta te m e n t? E x p la in y o u r a n s w e r.
271
B usiness finance
22 [ L 0 8 ] N o w that rights issues con be made without a prospectus, they w ill become much more popular and
placements may become rare. D o y o u a g r e e w ith th is s ta te m e n t? E x p la in y o u r a n s w e r.
23 [L O 8 ] O u tlin e th e m a in fe a tu re s o f a n a c c e le r a te d r e n o u n c e a b le e n title m e n t o ffe r. W h a t a r e th e m a in
d iffe re n c e s b e tw e e n su ch a n o ffe r a n d a t r a d itio n a l r e n o u n c e a b le rig h ts issue?
24 [L O 8 ] A lis te d c o m p a n y m a y m a k e a p u b lic o f fe r o f s h a re s , p o s s ib ly in c o n ju n c tio n w ith a rig h ts issue.

Id e n tify fa c to rs th a t m a y f a v o u r th e use o f a fu rth e r p u b lic o ff e r o f s h a re s ra th e r th a n a p la c e m e n t o r a rig h ts
issue a lo n e .
25 [L O 8 ] Options are often used as on incentive to various groups or individuals. D e s c rib e h o w o p tio n s c a n b e
u se d to th e a d v a n ta g e o f a c o m p a n y a n d its s h a re h o ld e rs .
26 [ L 0 9 ] W h a t is th e in c e n tiv e fo r a c o m p a n y to p r o v id e c o m p e n s a tio n f o r m a n a g e rs in th e fo rm o f sh a re s
ra th e r th a n s a la r y ? W h a t is th e a d v a n ta g e o f s h a re c o m p e n s a tio n o v e r a n d a b o v e c o m p e n s a tio n u s in g
s h a re o p tio n s ?
27 [L O 1 0 ] W h a t a r e in te rn a l fu n d s ? W h a t a r e th e ir a d v a n ta g e s a s a s o u rc e o f e q u ity ?
28 [L O 1 0 ] O u t lin e th e im p a c t o f th e g lo b a l f in a n c ia l c ris is o n A u s tr a lia n c o m p a n ie s in te rm s o f th e ir m ix o f

in te rn a l ve rsu s e x te rn a l fu n d in g o v e r th e 2 -y e a r p e r io d fro m m id - 2 0 0 7 .
29 [L O ll] W h a t is a s h a re s p lit? W h y m ig h t th e d ir e c to r s o f a c o m p a n y w is h to s p lit its s h a re s ?
30 [L O ll] W h a t is a s h a re c o n s o lid a tio n ? E v a lu a te th e re a s o n s th a t m a y b e g iv e n to ju s tify a s h a re

c o n s o lid a tio n .
31 [L O 1 1 ] E x p la in b r ie f ly w h y th e s h a re p r ic e o f a c o m p a n y m a y in c re a s e w h e n th e c o m p a n y a n n o u n c e s a
b o n u s issu e o r s h a re s p lit.
PROBLEMS
1 E co n o m ic fa c to rs a n d f in a n c in g p o lic y [L O 2 】
C h o o s e a c o m p a n y a n d tra c e th e m a jo r c h a n g e s in its c a p ita l stru ctu re d u rin g th e p a s t 1 0 y e a rs . O u tlin e th e
e c o n o m ic fa c to rs th a t y o u c o n s id e r h a v e c o n trib u te d to th e m a jo r c h a n g e s in its fin a n c in g p o lic y d u r in g this
p e rio d .
2 P u b lic s h a re issu e [L O 5 ]
K a tz Pty Ltd is a w e ll-e s ta b lis h e d c o m p a n y w h o s e d ire c to rs h a v e d e c id e d to c o n v e rt to p u b lic c o m p a n y status,
m a k e a p u b lic s h a re issue a n d list o n th e s to ck e x c h a n g e . T he c o m p a n y n e e d s to ra is e $ 7 9 2 0 0 0 0 to e x p a n d
its o p e ra tio n s . Its p ro s p e c tu s fo re c a s ts a d iv id e n d o f 2 0 cen ts p e r sh a re in its firs t y e a r a s a p u b lic c o m p a n y
a n d d iv id e n d s a r e e x p e c te d to g r o w a t 6 p e r c e n t p e r a n n u m in d e fin ite ly . S h a re h o ld e rs re q u ire a re tu rn o f
1 4 p e r c e n t p e r a n n u m a n d th e c o s t o f lis tin g a m o u n ts to 1 2 p e r c e n t o f th e g ro s s p ro c e e d s fro m th e issue.
H o w m a n y s h a re s m ust K a tz issue?
3 R ig h ts issu e [L O 8 ]
C o m p a n y A h a s 4 m illio n sh a re s o n issue a n d w is h e s to ra is e $ 4 m illio n b y a l- f o r - 4 rig h ts issue.
a) W h a t is th e th e o re tic a l v a lu e o f 1 r ig h t if th e m a rk e t p r ic e o f 1 s h a re (cum rig h ts) is $ 5 ?
b) W h a t is th e th e o re tic a l s h a re p r ic e (ex-rights)?
c) D o e s a n in v e s to r g a in th ro u g h a rig h ts issue?
C r o s lin g Ltd sh a re s a re tr a d in g a t $ 1 2 e a c h . Its d ire c to rs h a v e a n n o u n c e d a l- fo r - 6 rig h ts issue w ith a
s u b s c rip tio n p r ic e o f $ 1 0 . 6 0 p e r sh a re . W h a t is:
a) th e th e o re tic a l v a lu e o f a r ig h t to o n e n e w s h a re
b) th e th e o re tic a l e x -rig h ts s h a re p ric e ?
M a x w e ll Ltd is a liste d b io te c h n o lo g y c o m p a n y . O n 5 M a y 2 0 1 4 it a n n o u n c e d a l- fo r - 3 re n o u n c e a b le
rig h ts issue a t a s u b s c rip tio n p r ic e o f $ 6 . 2 0 p e r sh a re w ith a n e x -rig h ts d a te o f 2 5 M a y . T he c o m p a n y a ls o
a n n o u n c e d th a t fu n d s ra is e d b y th e issue w o u ld b e use d to e s ta b lis h p r o d u c tio n fa c ilitie s fo r its n e w a n ti-
m a la r ia d ru g th a t re c e n tly p a s s e d its fin a l c lin ic a l tria ls . T he s h a re p r ic e ro s e fro m $ 6 . 9 0 to $ 7 . 0 5 a fte r th o se
a n n o u n c e m e n ts . T he c lo s in g p ric e o f M a x w e ll sh a re s o n 2 4 M a y w a s $ 7 p e r sh a re .
272
C H A P T E R NINE R E V I E W
a) W h a t is a r e n o u n c e a b le rig h ts issue?
b) W h a t is th e m o st lik e ly e x p la n a tio n fo r th e s h a re p ric e ris e o n 5 M a y a fte r th e c o m p a n y 's a n n o u n c e m e n ts ?
c) W h a t d o y o u e x p e c t th e p r ic e o f th e sh a re s to b e o n 2 5 M a y ? S h o w a ll c a lc u la tio n s .
d) W h a t is th e th e o re tic a l v a lu e o f a rig h t? S h o w a ll c a lc u la tio n s .
e) E x p la in w h y th e sh a re p ric e c h a n g e fro m 2 4 M a y to 2 5 M a y d o e s n o t re fle c t a n y c h a n g e in s h a re h o ld e rs 7

w e a lth .
6 Alternative w ays of raising equity [LO 8 】

G e o rg e B a n ks In te rn a tio n a l (G B I) Ltd h a s 1 0 0 m illio n fu lly p a id o r d in a r y sh a re s o n issue a n d its sh a re s a r e
liste d o n th e A S X . A b o u t 6 0 p e r c e n t o f th e sh a re s a r e h e ld b y A u s tra lia n fin a n c ia l in s titu tio n s a n d th e c lo s in g
p ric e o f th e s h a re s o n 1 5 O c to b e r 2 0 1 4 w a s $ 4 . The c o m p a n y h a s a fu lly d r a w n $ 5 0 0 m illio n b a n k lo a n
fa c ility , w h ic h is d u e to b e r o lle d o v e r o r r e p a id o n 3 0 N o v e m b e r 2 0 1 4 . G B I Ltd is c lo s e to b re a c h in g a n
im p o rta n t c o v e n a n t a n d its d ire c to rs h a v e re s o lv e d to ra is e e q u ity to r e p a y th e lo a n o n o r b e fo re th e d u e d a te .
The c o m p a n y 's la s t sh a re issue o c c u rre d in 2 0 1 1.
a) A s s u m in g a n issue p r ic e o f $ 3 . 8 0 p e r s h a re , w h a t is th e m a x im u m a m o u n t th a t G B I Ltd c a n ra is e b y
m a k in g a s h a re p la c e m e n t w ith o u t s h a re h o ld e r a p p r o v a l?
b) A d v is e th e d ire c to rs o n th e fe a s ib ility o f ra is in g th e re q u ire d fu n d s b y a tr a d itio n a l re n o u n c e a b le o r

n o n -re n o u n c e a b le rig h ts issue.
c) A fte r r e c e iv in g y o u r a d v ic e , th e d ire c to rs a re c o n s id e rin g th e c o m b in a tio n o f a n in s titu tio n a l p la c e m e n t

fo llo w e d im m e d ia te ly b y a n a c c e le ra te d e n title m e n t o ffe r.
i) D o e s th e m a x im u m a m o u n t th a t c a n b e ra is e d b y th e p la c e m e n t re m a in th e s a m e a s in (a)? W h y , o r
w h y not?
ii) R e v ie w y o u r a n s w e r to (b). H o w w ill y o u r a d v ic e c h a n g e , g iv e n th a t a n a c c e le ra te d o ffe r s tru c tu re is to

b e used?
d) A s s u m e th a t th e c o m p a n y p ro c e e d s w ith a n a c c e le ra te d e n title m e n t o ffe r. F rom th e v ie w p o in t o f G B I's

s h a re h o ld e rs , w h a t is th e m a in e ffe c t o f m a k in g th e o ffe r re n o u n c e a b le ra th e r th a n n o n -re n o u n c e a b le ? W ill
a re n o u n c e a b le o ffe r n e c e s s a rily e n s u re th a t a ll s h a re h o ld e rs a re tre a te d e q u a lly ? W h y , o r w h y not?
Lj
Abernethy, M.
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2010 . May 2003, pp. 919-47.
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and the underpricing of initial public offerings: Australian and uses of funds7, Bulletin, October 2009, pp. 1-12.
evidence', Accounting and Finance, May 1995, — /Funding the Australian resources investment boom',
pp. 87-105. Bulletin, March 2013, pp. 51-61.
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with the pricing of initial public offerings', Journal of Applied Journal of Finance, March 1991, pp. 3-27.
Corporate Finance, Spring 1994, pp. 66-74. Ritter J. & Welch, l.; yA review of IPO activity, pricing
Ikenberry, D., Rankine, G. & Stice, E., ’What do stock and allocations^ Journal of Finance, August 2002,
splits really signal?', Journal of Financial and Quantitative pp. 1795-828.
Analysis, September 1996, pp. 357-75. Rock, K., 'Why new issues are underpriced7, Journal
ISS Governance Services, Equity Capital Raising in Australia of Financial Economics, January-February 1986,
during 2008 and 2009, ISS Governance Services, August pp. 187-212.
2010 . Sloan, R.G., 'Bonus issues, share splits and ex-day share
Lakonishok, J. & Vermaelen, J., 'Tax induced trading around price behaviour: Australian evidence', Australian Journal of
ex-dividend days', Journal of Financial Economics, 1986, Management, December 1987, pp. 2 7 7 -9 ].
pp. 287-319. Smith, C.W. Jr, 'Raising capital: theory and evidence',
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1996, pp. 1189-210. New York, 2000.
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from investor application and allocation schedules', Journal Publishing, Melbourne, 1996.
of Financial and Quontitotive Analysis, December 1999,
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Lipton, Pw Herzberg, A. «& Welsh, M .; Understanding
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Loughran, T. & Ritter, J., 'The new issues puzzle', Journal of June 1989, pp. 421-49.
Finance, March 1995, pp. 23-51.
CHAPTER CONTENTS
10.1 I n t r o d u c t io n 276 D e b t s e c u r itie s 289
G e n e r a l c h a r a c t e r is tic s o f debt 277 10.6 P r o je c t f in a n c e 301
10.3 S h o rt-te rm b o r r o w i n g fr o m b a n k s a n d o th e r 10.7 H y b r id s o f d e b t a n d e q u it y 302

f in a n c ia l in s titu tio n s 282
10.4 L o n g -te rm b o r r o w i n g f r o m b a n k s a n d o t h e r
f in a n c ia l in s titu tio n s 285
LEARNING OBJECTIVES
1 id e n t if y th e m a in fo r m s o f b o r r o w i n g b y A u s t r a lia n c o m p a n ie s
2 e x p la in th e g e n e r a l c h a r a c t e r is tic s o f d e b t
3 u n d e r s ta n d th e m a in fo r m s o f s h o rt-te rm b a n k le n d in g a n d r e c o g n is e w h e n e a c h m a y b e s u ita b le to a
b o r r o w e r ’s n e e d s
4 u n d e r s ta n d d e b t o r f in a n c e , in v e n t o r y lo a n s a n d b r i d g in g f in a n c e a n d b e a b le to d is tin g u is h b e t w e e n th e m
5 id e n t if y a n d e x p la in t h e f e a tu r e s o f th e m a in ty p e s o f lo n g - te r m lo a n s
6 c o m p a r e a n d c o n t r a s t th e m a in fe a tu r e s o f s h o rt-te rm a n d lo n g - te r m d e b t s e c u r itie s
7 u n d e r s ta n d th e p r o c e s s o f u s in g c o m m e r c ia l p a p e r to r a is e fu n d s a n d h o w c o m m e r c ia l p a p e r is p r ic e d
8 u n d e r s ta n d th e p r o c e s s o f u s in g b ills o f e x c h a n g e t o r a is e fu n d s a n d h o w b ills o f e x c h a n g e a r e p r ic e d
9 id e n t if y a n d e x p la in th e fe a tu r e s o f th e m a in ty p e s o f lo n g - te r m d e b t s e c u r itie s
10 id e n t if y a n d e x p la in th e m a in f e a tu r e s o f p r o je c t f in a n c e
11 id e n t if y a n d e x p la in th e fe a tu r e s o f s e c u r itie s t h a t h a v e c h a r a c t e r is tic s o f b o th d e b t a n d e q u ity .

B usiness finance
10.1 Introduction
The types o f debt finance used by Australian businesses can be divided in to tw o categories based on the
LEARNING source o f the funds. First, there are loans from banks and other financial institutio ns. In this case, cash
OBJECTIVE 1
th a t has been deposited w ith a financial interm ediary or invested w ith an in s titu tio n such as an insurance
Identify the main
forms of borrowing by company is le n t to a business. Thus, the flow o f funds from the ultim ate investors to the borrower is
Australian companies indirect. This process is referred to as in te rm e d ia tio n . Im portantly, a financial interm ediary acts as a
principal and the term s on which funds are advanced to the borrow er may be quite different from the
INTERMEDIATION
terms on w hich funds are len t to the interm ediary. For example, a bank may raise short-term deposits at an
process in which a
bank or other financial interest rate o f 5 per cent and provide long-term loans on which it charges interest at a rate o f 8 per cent.
institution raises funds Second, businesses can raise funds by issuing debt secu rities such as commercial paper, bills
from investors and o f exchange and corporate bonds. In this case, financial in s titu tio n s are usually involved in the fund
then lends those funds raising b u t they act as agents rather than as principals. For example, a bank or investm ent bank may
to borrowers
underw rite an issue o f debt securities and distribute the securities to investors. In th is case the flow o f
SECURITIES
funds fro m the investor to the borrow er is essentially direct. This m ethod o f raising debt is sometimes
in the context of referred to as ‘borrow ing in the capital m arket’ or ‘issuing securities in open financial m arkets’. When this
financial markets, m ethod is used in a case in which bank debt would previously have been used, the process is referred to
financial assets that as d isin term ed ia tio n .
can be traded
The d istin ction between indirect and direct debt finance is im p orta nt. For ease o f exposition, we refer
DISINTERMEDIATION to these tw o types o f debt finance as ‘loans’ and ‘debt securities’, respectively. The largest providers o f loans
movement of funds are banks, so when discussing loans we focus on bank loans. Table 10.1 shows the relative importance o f
from accounts debt securities and bank loans as sources o f debt finance fo r Australian businesses.
with deposit
taking financial
intermediaries and the TABLE 10.1 Debt securities (outstanding) issued by non-financial corporations
reinvestment of those
funds in securities and bank lending to business as at September 2013 ($ billion)
D e b t s e c u ritie s $ b illio n
Short-term securities issued in Australia 2.4
Long-term securities issued in Australia 52.0
Securities issued offshore 180.0
Total 234.4
B a n k le n d in g to bu sin e ss
Variable interest rate loans 262.1
Fixed interest rate loans 184.8
Subtotal: bank loans 446.9
Bills outstanding 272.8
Total 719.7
Source: Tables D4 and D8, Reserve Bank of Australia website, www.rba.gov.au.
The figures in Table 10.1 show th a t at September 2013 bank loans to ta llin g almost $447 b illio n were
the largest source o f debt finance fo r Australian businesses, followed by bills outstanding o f $272.8 billion.
When a b ill is issued, finance is provided directly by the discounter to the drawer. W hile the finance is
direct rather than intermediated, banks are s till involved in the process because a b ill requires an acceptor
(effectively a guarantor) and the acceptor is usually a m ajor bank. Part o f the to ta l o f $272.8 b illio n would
comprise bills th a t were also discounted (bought) by banks, so at September 2013 debt finance provided
by or through banks to businesses was $719.7 b illio n or 75 per cent o f the to ta l debt shown in Table 10.1.
It is also common to categorise debt as either short term or long term . Short-term debt is defined
as debt due fo r repayment w ith in a period o f 12 months. The m ajor short-term borrow ing choices
available to Australian businesses include borrow ing from banks and other financial in s titu tio n s , which
C hapter ten S ources 〇卩 fin a n c e : debt
is discussed in Section 10.3, and issuing short-term debt securities such as commercial paper and bills
o f exchange, which is discussed in Sections 10.5.2 and 10.5.3. Long-term debt— th a t is, debt w ith a
term to m a tu rity greater than 12 m onths— can be raised by borrow ing from banks and other financial
institutio ns as discussed in Section 10.4. Businesses th a t are incorporated can also borrow long term
by issuing securities such as debentures, unsecured notes and corporate bonds, which are discussed in
Sections 10.5.4 to 10.5.6.
In the next section, we outline the main characteristics o f debt, the m ain effects o f using debt and
discuss security arrangements fo r debt. Next, we discuss the m ain types o f short- and long-term debt
provided by banks and other financial institutio ns. This is followed by discussion o f the m ajor types
o f debt securities used by Australian businesses, and by discussion o f project finance. The chapter
concludes by considering preference shares and convertible securities th a t are hybrids o f debt and equity
securities.
10.2 G eneral characteristics of debt

Debt involves a contract whereby the borrower promises to pay future cash flows to the lender. Short
term debt often involves only a single cash flow payable by the borrower at the end o f the contract. In LEARNING
OBJECTIVE 2
the case o f long-term debt, the promised cash flows usually include payments at regular intervals b ut the
Explain the general
parties can negotiate arrangements th a t involve any set o f cash flows. A debt contract w ill specify either characteristics of debt
the size and tim in g o f interest payments or a set o f rules th a t w ill be used to calculate those payments. For
example, a contract may specify th a t interest w ill be calculated daily b ut charged m on thly at a rate equal
to the 90-day bank-bill rate plus a m argin o f 3 per cent per annum. The contract w ill also specify how the
principal is to be repaid. PRINCIPAL
In addition to specifications about cash flows, a debt contract w ill usually also specify: the amount borrowed
at the outset of a loan
• whether the borrower is required to pledge assets as security (also known as collateral) fo r the debt
• whether ownership o f the debt is transferable
• any requirements or restrictions th a t m ust be m et by the borrower
• the rights o f the lender i f the borrower defaults. DEFAULT
failure to perform a
I f the borrower is required to support its promise to repay the debt w ith a pledge o f assets, the debt contractual obligation
is classified as secured debt. I f the debt is unsecured, the borrow er has an obligation to repay the loan but
this obligation is n o t supported by any pledge o f assets. Security arrangements fo r debt are discussed in
Section 10.2.4.
I f ownership o f the debt is transferable, the original lender can sell the contract to another investor.
I f the debt is transferable i t usually takes the fo rm o f securities such as commercial paper, bonds or
debentures th a t are issued directly to investors and can then be traded in a secondary m arket. The
ownership o f all securities is transferable and some securities are traded actively in markets th a t are
very liquid, while the markets fo r other securities are much less liquid. Therefore, the term ‘marketable
securities* is typically used to refer to securities th a t are easily sold and readily converted in to cash. M ost
non-marketable debt takes the fo rm o f loans arranged privately between two parties, where the lender is
usually a bank or other financial in stitu tio n .
A debt contract usually places some requirements and/or restrictions know n as covenants on the COVENANT
borrower. For example, i f debt is secured by pledged assets, the borrower w ill be required to m aintain provision in a loan
agreement to protect
those assets in good condition. W hether debt is secured or unsecured, the borrow er may be restricted
lenders' interests by
from increasing its borrow ing and other liabilities beyond a specified pro po rtio n o f its to ta l assets. requiring certain
The rights o f the lender i f the borrow er defaults w ill depend on the nature o f the default and whether actions to be taken
the debt is secured or unsecured. Any breach by the borrow er o f the terms o f the contract may constitute and others refrained
default and act as a trigger fo r the lender to enforce its rights under the contract. For example, the lender from
may have the rig h t to increase the interest rate on the debt to a penalty rate. I f the breach is o f a m in or or
technical nature the lender may waive its rig h t to act b ut i f the breach is more serious, such as the failure
to make a promised payment, the lender w ill usually enforce its rights. For example, i f a borrow er defaults
on secured debt, the lender has the rig h t to take possession o f the assets th a t were pledged as security
and sell them to pay o ff the loan.
M ost types o f debt have some common characteristics th a t we now discuss.
B usiness finance
10.2.1 | The interest cost of debt

When a company borrows, i t is com m itted to the payment o f interest and to the repayment o f the
principal. In Chapter 4, the default-risk structure o f interest rates was discussed. It was pointed out that,
given the general structure o f interest rates at a p o in t in tim e, the interest rate a company has to pay to
borrow funds fo r a specified period w ill depend on the risk characteristics o f the company. For example,
at a tim e when the Commonwealth Government has to pay an interest rate o f 8 per cent per annum to
borrow funds fo r 5 years, a secure ind ustria l company may have to pay 9.5 per cent, while a less secure
industrial company may have to pay 12 per cent.
The interest rate applicable to debt may be fixed or variable. The interest rates on short-term and
INTERBANK CASH RATE variable-rate debt are closely related to the interbank cash rate (or sim ply the cash rate), which is an
the interest rate on im p o rta n t benchmark rate in the economy. Each bank holds an Exchange Settlement Account w ith the
overnight loans
Reserve Bank o f Australia (RBA), which is used to make payments between the banks. I f a bank has
between a bank
and another bank insufficient (excess) funds in its Exchange Settlement Account, i t can borrow from (lend to) other banks
(including the Reserve at an interest rate th a t reflects current m arket forces. However, the RBA has a very significant impact on
Bank of Australia) interest rates in the interbank m arket. From tim e to tim e the RBA publicly announces the target cash rate
and stands ready to lend to (borrow from ) banks at interest rates th a t are 0.25 per cent above (below) the
target rate. The actual cash rate is therefore almost certain to be w ith in ±0.25 per cent o f the target rate
and, in practice, the actual cash rate is rarely very different from the target cash rate. In the 5-year period
from January 2009 to December 2013, there were only 25 days when the cash rate deviated from the
target and in all cases b ut one the deviation was less than 0.01 percentage p oints.1 The data in Table 10.2
show the cash rate and, fo r the purposes o f comparison, include indicator lending rates on variable-rate
loans made by banks to small businesses.
As would be expected, the cash rate is well below the indicator rates fo r business lending. A significant
gap is needed to cover the banks1 costs and to compensate fo r the greater risk o f lending to customers
rather than to another bank.
M ost long-term debt securities have a fixed interest rate, known as the coupon rate*, which does n ot
vary over the life o f the security. Long-term loans can also have a fixed interest rate. Where a variable
interest rate applies, the rate w ill generally consist o f a base rate, or indicator lending rate, plus a margin
th a t depends on the risk o f the borrower. In some variable interest rate loans the base rate (and therefore
the interest rate payable) may be changed at any time. In other variable interest rate loans, the interest
rate is reviewed at fixed intervals. For example, the interest rate may be reset every quarter to reflect the
general m ovement in interest rates since the last quarterly reset date.
Lenders rank ahead o f shareholders in th a t dividends cannot be paid unless all accrued interest
payments to lenders have been met. Further, i f a company is liquidated, all obligations to lenders have
TABLE 10.2 Selected short-term interest rates (%p.a.), 2000-13

In d ic a to r ra te s : s m a ll b u sin e ss^)
[ i
D a te C a s h ra te (
。） O v e r d r a f t — re s id e n tia l s e cu re d O v e rd ra ft-o th e r
June 2000 6.00 8.55 9.10
June 2005 5.50 8.30 8.95
June 2010 4.50 9.45 10.30
June 2011 4.75 9.85 10.65
June 2012 3.54 8.85 9.75
June 2013 2.75 8.20 9.20
(°) Average of daily figures for the interbank cash rate for the month.
^ Average indicator rates for lending by major banks to small businesses on a variable-rate basis.
Source: Tables FI and F5, Reserve Bank of Australia website, www.rba.gov.au.
1 Analysis by the authors of data in Reserve Bank of Australia, www.rba.gov.au, Table FI.
G hapter TEN S ources OF FINANCE: DEBT
p rio rity and shareholders have only a residual claim to any cash raised fro m the sale o f the company s
assets. As a consequence, lenders are subject to less risk than are shareholders and they are therefore
prepared to accept a lower expected rate o f return. However, n o t all lenders rank equally in terms o f th e ir
claims when it comes to interest and principal repayments. Some debt can be subordinated to other debt SUBORDINATED DEBT
and, as a consequence, the holders o f subordinated debt require a higher interest rate than the holders debt that ranks below
other debt in the event
o f unsubordinated debt. Where borrowed funds are used to generate taxable income, interest on the
that a company is
debt is tax deductible. However, interest income is taxable in the hands o f lenders and this increases wound up
the interest rate th a t lenders would otherwise require. Therefore, the fact th a t interest is tax deductible
UNSUBORDINATED
does n ot necessarily give debt a cost advantage over equity finance. Under the im p utatio n system, taxes DEBT
are v irtu a lly neutral in terms o f th e ir effect on the costs o f debt and equity finance. This is discussed in debt that has not been
Chapters 12 and 13. subordinated
As noted earlier, a feature th a t distinguishes the various types o f debt securities is th e ir m arketability.
M arketability is the ease w ith which the holder is able to trade the security. Investors favour being
able to sell securities at short notice. In other words, they favour securities th a t are traded actively in
a liquid market. Therefore, marketable securities tend to be issued at a lower interest rate than other
types o f debt, provided, o f course, th a t the other characteristics o f the debt are equivalent. In addition
to interest, other costs associated w ith borrow ing may be significant. Some fees apply only to loans,
while other fees apply only to debt securities. From the borrow ers view point, it is the overall cost
that matters.
10.2 .2 ! Effect of debt on risk

While the rate o f return required by lenders is less than the rate o f return required by shareholders,
increasing the am ount o f debt also increases the company s financial risk. The effects o f financial risk FINAN C IAL RISK
include effects on the rate o f re tu rn required by shareholders. A company financed solely by ordinary risk attributable to
the use of debt as a
shares is n ot required to pay dividends and therefore has no financial risk. Borrowing introduces financial
source of finance
risk, which involves tw o separate b ut related effects.
First, because the returns to lenders are ^ e d * , debt has a leverage effect— th a t is, i t increases the
variability o f returns to shareholders and increases the rate o f retu rn they require.
Second, the more a company borrows, the greater the interest and principal repayments to which it
is committed, and therefore the greater is the risk o f financial d istress. In the extreme case, where a FINANCIAL DISTRESS
company has insufficient cash to meet its contractual obligations, the consequences can be far reaching situation where a
company’s financial
and may result in the company being placed in to liquidation. In such a situation, the shareholders w ill
obligations cannot be
usually receive little or no retu rn from the sale o f the company s assets because the company s lenders met, or can be met
have a p rio r claim to the proceeds. However, financial distress is costly and many o f the costs fall on only with difficulty
lenders. For example, the costs incurred by the liqu id ator in arranging the sale o f the assets are, in effect,
paid by the lenders. Therefore, lenders require a m argin to compensate fo r the expected level o f these
costs and this w ill be reflected in higher interest rates on loans to borrowers th a t have a higher risk o f
default. Also, to lim it th e ir exposure to risk, lenders w ill generally impose a covenant th a t sets an upper
lim it on the financial leverage o f borrowers. The effects o f financial risk are discussed in more detail in
Chapter 12.
10.2 .3 ! Effect of debt on control

Another im p o rta n t feature o f debt is that, provided the company meets its obligations, lenders have
no control over the company s operations. Unlike shareholders, lenders have no voting rights. However,
if a company fails to meet its obligations, lenders can exert, either directly or indirectly, significant
influence over the operations o f the company. In this case the lenders, or frequently a trustee acting on
th eir behalf, can seek to protect th e ir interests. This may be achieved by taking control o f the security
fo r the loan, appointing an adm inistrator, having the company placed in to receivership or having
the company placed in to liquidation. Therefore, while lenders usually exert little or no control over a
company, they have a large degree o f potential control, which they can exert i f the company breaches a
loan agreement.
1 0 .2 .4 1 Security for debt
Lenders, particularly those providing long-term debt, generally require th a t the borrow er enter into a
loan agreement th a t includes various requirements designed to protect the lender against possible loss.
These requirements are commonly referred to as security* arrangements, although s tric tly speaking a
MORTGAGE loan is secured only i f it involves a m ortgage or other charge over assets. The security arrangements that
a type of security for a may be applied to debt finance used by companies include the following.
loan in which specific
land or other tangible
property is pledged
Legal ownership
by the borrower Instead o f providing a loan to a company to enable i t to buy an asset, a bank or other financier can
(mortgagor) to the purchase the asset and lend* the asset to the company. This form o f debt finance is know n as leasing.
lender (mortgagee)
A lease is an agreement under which one party who owns an asset (the lessor) gives another (the lessee)
the rig h t to possess and use an asset fo r a specified period in retu rn fo r rental payments. The financier
has the security o f legal ownership o f the leased asset and can therefore repossess the asset quickly in the
event o f default by the lessee. Leasing is an im p o rta n t means o f financing the use o f assets by companies
and is discussed in Chapter 15.
Fixed charge
A fixed charge means th a t the lender has a charge over a specific asset or group o f assets. For example,
a loan may be secured by a mortgage over land and buildings owned by the borrower. I f the borrower
defaults, the lender can take possession o f the assets and sell them in order to recover the outstanding
debt. A fixed charge restricts the ability o f the borrower to deal in the asset(s). For example, an asset that
has been mortgaged cannot be sold unless the mortgage is discharged p rio r to settlem ent. Borrowers may
therefore prefer the fle x ib ility inherent in a floating charge.
Floating charge
In this case, the lender has a charge over a class o f assets such as inventory. This means th a t the borrower
can deal in the inventory b ut m ust undertake to m aintain the stock o f inventory above a specified level. I f
the borrow er defaults, the floating charge is said to crystallise and becomes a fixed charge over the items
o f inve ntory currently held by the borrower.
Covenants
When banks lend to small and medium-sized businesses they generally require loans to be secured by
a mortgage or other charge over assets. In the case o f larger loans such as loans to listed companies,
the loan may be unsecured b ut include various covenants to protect the lender against possible loss by
im posing various restrictions on the borrower. Similarly, covenants are commonly used where borrowers
issue debt securities such as bonds or debentures. Common financial covenants require the borrower
to lim it the size o f dividend payments, to m aintain a m in im u m ratio o f p ro fit to interest cost (known
as In te re st cover1) and lim it to ta l liabilities to no more than a certain percentage o f to ta l assets. O ther
covenants may be designed to protect investors in the event o f a m ajor asset sale or a change o f control.
I f a borrow er breaches a covenant i t is in technical default and the lender may have the rig h t to
call fo r immediate repayment o f the loan or take other actions to lim it its risk o f loss. For example,
the lender may waive its rig h t to demand immediate repayment b ut the waiver may be conditional on
the borrow er taking actions such as suspending dividend payments and m eeting p ro fita b ility and/or
cash flow targets. Thus, breaching loan covenants can effectively result in the im position o f additional
covenants (see Finance in Action). Alternatively, i f the breach is considered to be m in or and the borrower
has adhered to the agreed repayment schedule, the lender is likely to allow the loan to continue on the
original terms.
N egative pledge
Financial in stitu tio n s may be prepared to lend on an unsecured basis where the loan agreement includes
a negative pledge provision. The basic principle o f a negative pledge is th a t the borrower agrees n ot to
do certain things. In particular, the borrower w ill agree n o t to pledge existing or future assets o f the
company or group to anyone else w ith o u t the consent o f the lender.
C hapter ten S ources of fin a n c e : debt
F in a n c e
COVENANT WAIVER BUYS TIME FOR NUFARM________________ in A C T IO N
O n 1 5 J u ly 2 0 1 0 a g r ic u lt u r a l c h e m ic a l m a n u f a c t u r e r N u f a r m L im ite d re v e a le d t h a t b a s e d o n
fo re c a s ts f o r th e r e m a in d e r o f its f in a n c ia l y e a r , w h ic h e n d s o n 31 Ju ly , it e x p e c te d to b r e a c h o n e
o f its m a in b a n k in g c o v e n a n ts . O n 1 S e p te m b e r it a n n o u n c e d t h a t its n e t d e b t a t 31 J u ly w o u ld b e
a p p r o x im a t e ly $ 6 2 0 m illio n (m u c h h ig h e r th a n its e s tim a te p r o v id e d o n 1 4 J u ly o f $ 4 5 0 m illio n ) ,
w h ic h w o u ld c a u s e a s e c o n d c o v e n a n t b r e a c h . N u f a r m a ls o c o n f ir m e d t h a t it w a s p r o g r e s s in g
to w a r d s s e c u rin g a w a iv e r f r o m its b a n k le n d e rs r e la te d to th e c o v e n a n ts in v o lv e d in its e x is tin g
b a n k in g fa c ilitie s . O n 2 7 S e p te m b e r N u fa r m a n n o u n c e d th e o u tc o m e o f th e d is c u s s io n s w it h its
b a n k le n d e rs .
D e b t- la d e n N u f a r m h a s g a in e d a s h o r t r e p r ie v e a s in v e s to r s b r a c e f o r its c r u c ia l f u ll- y e a r re s u lt
to d a y .
N u fa r m y e s t e r d a y s e c u r e d a t e m p o r a r y w a iv e r o n its b a n k in g c o v e n a n t b r e a c h e s b u t s a id it
w o u ld n o t p a y a f u ll- y e a r d iv id e n d . T h e w a iv e r w i ll b e in p la c e u n til th e e n d o f n e x t m o n th a s it
se e k s a lo n g - te r m s o lu tio n .
C r e d it S u is s e a n a ly s t R o h a n G a lla g h e r s a id th is w a s p r o m is in g b u t it w a s m e r e ly b u y in g
tim e . 'W h a t is n o t b e in g s a id is th e lik e ly p r o h ib it iv e c o s t o f r e c e iv in g s u c h a w a iv e r a n d th e
c o s t in v o lv e d in s e c u r ity o v e r th o s e a s s e t s / M r G a ll a g h e r s a id .
N u fa r m a ls o a g r e e d to a s h o rt-te rm f u n d in g f a c il it y o f $1 8 0 m illio n to m id - D e c e m b e r w it h
its le n d e r s , to m e e t r e p a y m e n t s t h a t w i ll f a ll d u e b y th e e n d o f th e y e a r . T h e f a c il it y is s u b je c t to
s a t is f a c to r y p e r f o r m a n c e a g a in s t 'in t e r im m ile s to n e s b a s e d o n th e c o m p a n y 's o w n p r o je c tio n s
a n d o b je c tiv e s ’ ，a s w e ll a s 'p r o g r e s s r e la t in g to s t r a t e g y a n d m a n a g e m e n t p la n s ', a s a g r e e d
w ith its le n d e rs .
Source: Philip Wen, 'Provisional waiver for Nufarm,/ The Age, 28 September 2010.
L a te r p re s s r e p o r ts r e v e a le d a d d it io n a l d e ta ils , w h ic h in c lu d e th e f o llo w in g :
• o n e o f th e c o m p a n y ’s b a n k s r e g is te r e d t w o fix e d a n d f lo a t in g c h a r g e s o v e r N u fa r m 's a sse ts o n
2 7 S e p te m b e r
• N u fa r m w o u ld b e u n a b le to b o r r o w a n y m o r e fr o m its e x is tin g $ 1 . 2 b illio n u n s e c u re d fa c ility ,
w h ic h w a s th e n d r a w n d o w n b y $ 7 0 1 m illio n
• th a t f a c ilit y h a d b e e n r e p la c e d b y a $ 1 7 6 m illio n s e c u re d lin e o f c r e d it o f w h ic h $ 5 5 m illio n
w a s a v a ila b le im m e d ia te ly w it h a c c e s s to th e r e m a in d e r s u b je c t to th e p r o v is io n o f e x tr a s e c u rity
to th e le n d e rs a n d to m e e tin g c o n f id e n t ia l p r o f it a b ilit y a n d c a s h f lo w ta rg e ts .
As well as agreeing n ot to borrow additional funds on a secured basis, the loan agreement usually
includes other covenants th a t restrict the borrow ing company. These covenants may include a restriction
on increasing its borrow ing and to ta l external liabilities beyond a specified p roportion o f to ta l tangible
assets. Other covenants in the loan agreement may lim it the size o f dividend payments and require the
borrower to m aintain its interest coverage ratio above a specified level. The aim o f such covenants is to
provide protection fo r lenders, while also allowing the company to be managed in ways th a t maximise
profits fo r shareholders. Borrowing on this basis in itia lly became popular in Australia among companies
that found the covenants in debenture tru s t deeds unduly restrictive.
Limited recourse
Lim ited recourse debt is com m only used fo r project finance, which is discussed in Section 10.6.
Guarantee
A guarantee is a promise from another party to cover a debt obligation in the event o f default by the
borrower. Lenders may require a guarantee i f a borrower does n ot have sufficient assets to pledge as
security fo r a loan but other related parties are in a stronger financial position. For example, i f a loan is
made to a subsidiary w ith lim ite d financial strength, the lender may require a guarantee from the parent
company.
Short-term borrow ing from banks and
i^ ： other financial institutions 2
LEARNING
OBJECTIVE 3
Banks are the m ost im p o rta n t in s titu tio n s th a t lend to Australian companies, b u t short-term funding
Understand the main
forms of short-term may also be obtained from other financial in s titu tio n s such as finance companies, investm ent banks and
bank lending and (for small businesses) from credit unions. In this section we discuss the m ajor form s o f direct lending
recognise when each available from banks and other financial institutio ns. However, a m ajor lender such as a bank w ill often
may be suitable to a provide a company w ith a funding package th a t includes various kinds o f both short-term and long-term
borrower’s needs
loans. In addition, banks may also assist companies th a t borrow by issuing securities such as commercial
paper and bills o f exchange. This assistance may be in the fo rm o f a commercial paper und erw riting fa cility
and a b ill acceptance and/or discount facility. Borrowing by issuing short-term securities is discussed in
Section 10.5.
10.3.1 | Bank overdraft

An overdraft perm its a company to run a bank account— often its current (cheque) account— in to deficit
OVERDRAFT LIMIT up to an agreed lim it. The overdraft lim it specifies the am ount by which the company can overdraw its
level to which a account. S trictly speaking, the am ount by which the company s current account is overdrawn is usually
company is permitted
a t call, which means th a t the bank can w ithdraw the overdraft fa cility at any tim e and require repayment
to overdraw its
account
o f the overdrawn amount. However, banks rarely exercise this right.
The cost o f a bank overdraft includes interest and fees. O verdraft interest rates are negotiated between
AT CALL
the bank and the borrower and w ill depend on factors such as the borrow ers credit-worthiness and the
money repayable
immediately, at the purposes fo r which the overdraft is sought. The interest rate charged is norm ally on the basis o f a m argin
option of the lender above an indicator rate published regularly by the bank. Interest is charged only on the am ount by
INDICATOR RATE which the borrow ers account is overdrawn, n ot on the am ount o f the overdraft lim it. The interest cost
interest rate set and is calculated daily by applying the interest rate to the overdrawn balance and is then charged m onthly or
published by a lender quarterly in arrears.
from time to time and
O verdraft fees w ill usually include an establishment fee and an ongoing fee. Details vary between
used as a base on
which interest rates on
banks and between customers b u t the follow ing arrangements are typical. The establishment, or approval,
individual loans are fee is payable at the commencement o f the overdraft. The ongoing fee is payable periodically (for example,
determined, usually by quarterly in arrears) and may be a fixed am ount or a percentage o f the approved lim it.
adding a margin In assessing an application fo r an overdraft, a bank can use the applicant company s financial
statements to obtain an indication o f its financial performance and financial position. In addition, an
applicant may be required to supply a cash budget to assist the bank in assessing the applicants ability to
service an overdraft. The bank w ill be particularly interested in the reasons fo r an overdraft application
and the likely effects th a t providing an overdraft w ill have on the company s future financial performance
and financial position. Generally speaking, banks regard an overdraft as suitable fo r funding the purchase
o f inve ntory th a t w ill quickly be converted in to cash, to assist a company through seasonal downturns in
liquidity, to meet unexpected short-term cash flow problems and to enable short-term opportunities to
be exploited.
Some companies may be granted an overdraft w ith o u t any security, b u t in m ost cases a bank w ill insist
th a t an overdraft be secured. Indeed, the terms o f the overdraft are likely to depend on the security that
is offered. For a small business, the personal assets o f the owner(s) may need to be pledged as security. In
addition, the bank may include various covenants in the loan agreement. For example, in an e ffo rt to lim it
the chance o f a borrow er running into excessive short-term liq u id ity problems, the bank may impose a
covenant requiring the borrower to m aintain some m inim um ratio o f current assets to current liabilities.
A fte r an overdraft has been granted, the borrower can draw on the account u n til the overdraft lim it
is reached. Therefore, an overdraft provides a convenient source o f funds th a t can be accessed simply
by w ritin g cheques and m aking electronic fund transfers. A borrower w ill generally draw on only part
2 M o s t b a n k s u s e t h e in t e r n e t t o p r o v id e u p - t o - d a t e in fo r m a t io n o n t h e ir lo a n p r o d u c ts . T h e w e b s it e s o f t h e fo u r la r g e s t
A u s t r a lia n b a n k s a r e w w w .a n z .c o m .a u , w w w . c o m m b a n k .c o m .a u , w w w .n a b .c o m .a u a n d w w w .w e s t p a c .c o m .a u .
o f the available lim it so th a t it has ready access to cash in an emergency. The overdraft lim it is likely to
be reviewed by the bank at regular intervals. In general, a borrow er w ill be able to m aintain the same
overdraft lim it from year to year unless its financial performance or financial position has markedly
deteriorated. Therefore, a profitable company can often regard a significant p roportion o f its overdraft as
a relatively long-term source o f funds, even though technically speaking the overdraft is at call.
W hile overdrafts are an im p o rta n t fo rm o f corporate borrowing, th e ir significance has declined in
recent years. Correspondingly, other methods o f acquiring short-term finance have grown in importance.
m
LEARNING
OBJECTIVE 4
For example, many companies have turned to corporate credit cards as an alternative source o f short-term
Understand debtor
funding. For larger companies, other alternatives include the issuing o f bills o f exchange and commercial
finance, inventory
paper (or promissory notes). loans and bridging
finance and be able to
distinguish between
them
Debtor finance3 allows a company to raise funds by using its accounts receivable as security fo r a loan. DEBTOR FINANCE
ongoing form of
The two main types o f debtor finance are invoice discounting and factoring. The loan providers are
funding in which
known as an invoice discounter and factor respectively. Debtor finance is provided by most banks or bank a finance provider
subsidiaries and by independent financiers specialising in this form o f lending. advances funds to a
The follow ing example shows how a typical invoice discounting agreement works. borrower using the
Suppose th a t Lewis P rin tin g Ltd enters into an invoice discounting agreement w ith Debtor Finance borrower’s accounts
receivable as security
Ltd (DFL). Lewis has just completed a p rin t job o f $100000 fo r its customer Books Ltd. Lewis sends an
for the loan
invoice fo r this am ount to Books Ltd, thus creating an account receivable. Lewis then inform s DFL o f the
INVOICE DISCOUNTING
account receivable and, perhaps after assessing the credit-worthiness o f Books Ltd, DFL advances 80 per
form of debtor finance
cent (that is, $80 000) o f the invoiced am ount to Lewis.4 DFL then begins charging Lewis interest on the in which the borrower
$80000. Books Ltd is unaware o f the invoice discounting agreement between Lewis and DFL and in due retains control of its
course pays Lewis the $100000 it owes. Lewis then passes this payment to DFL, which then credits this sales ledger and debt
amount to Lewis’s account w ith DFL, in effect causing the interest charge on the $80 000 to cease. Lewis collection functions
and passes account
can then w ithdraw the rem aining $20000, or i t can leave the $20000 w ith DFL to reduce the balance
payments on to the
owing on other loans th a t DFL has advanced to Lewis in respect o f other accounts receivable. Note th a t discounter
Lewiss customers are unaware o f the agreement and the borrower (Lewis) retains the functions o f
FACTORING
administering its sales ledger and collecting debts owed to it. form of debtor finance
Suppose, instead, th a t the agreement between Lewis and DFL had been a factoring agreement. In this in which the finance
case, DFL takes over from Lewis the adm inistration o f Lewis’s sales ledger and debt collection. Lewis’s provider (the factor)
customers are inform ed th a t future account payments should be made to DFL, n o t to Lewis. DFL invoices takes control of the
borrower’s sales ledger
Books Ltd on Lewiss behalf and simultaneously advances $80000 to Lewis. DFL then begins to charge
and debt collection
Lewis interest on the advance o f $80 000. When Books Ltd pays the $100 000 to DFL, this am ount is functions and passes
credited to Lewiss account w ith DFL. As in the case o f an invoice discounting agreement, the interest account payments on
charge then ceases and Lewis can w ithdraw the rem aining $20000 or leave i t in its account w ith DFL to to the borrower
reduce the balance owing on o the r loans th a t DFL has made to Lewis. DEBTOR FINANCE WITH
From the borrow ers view point, both form s o f debtor finance accelerate its cash inflo w from accounts RECOURSE
receivable and, depending on the term s o f the agreement, may relieve the borrower o f some, or all, o f the debtor finance
agreement under
associated adm inistrative burden. In addition, debtor finance does n o t require a small business owner
which the provider
to mortgage personal property to secure the loan. From the providers view point, the account receivable is reimbursed by the
provides security fo r the funds it has advanced and it earns a retu rn from the interest i t charges. In borrower if the debtor
addition, in both invoice discounting and factoring, there w ill be various fees payable by the borrower to defaults
the provider. These fees may include an application fee, an adm inistration fee and an activity fee. DEBTOR FINANCE
W hat i f the customer does n o t pay the account receivable in fu ll or on time? That is, who bears the credit W ITH O U T RECOURSE
risk? Most debtor finance agreements in Australia provide fo r debtor finance with recourse, which debtor finance
agreement under
means th a t i f an account receivable becomes a bad debt the borrower has to compensate the provider fo r
which the provider is
the loss. Nevertheless, to spread the risk, many providers impose a lim it on the funds they w ill provide not reimbursed by the
against any one debtors account. Debtor finance w ithout recourse means th a t the account receivable borrower if the debtor
is effectively sold to the provider who thereafter bears the bad debt risk. defaults
3 D e b to r fin a n c e is a ls o k n o w n a s re c e iv a b le s fin a n c e , in v o ic e fin a n c e a n d c a sh - flo w fin a n c e .

4 Th e p e r c e n ta g e a d v a n c e d is u s u a lly b e tw e e n 7 5 p e r c e n t a n d 9 0 p e r c e n t.
B usiness finance
Debtor finance is based on a simple principle. Accounts receivable are a valuable asset o f a company
and, like other valuable assets such as land and buildings, can be used as security fo r a loan. Debtor finance
is well suited to companies th a t have a large number o f short-term debtors, none o f w hom represents a
significant p roportion o f its to ta l debtors. In general, companies operating in a service in d u stry may find
debtor finance attractive because accounts receivable are often th e ir m ajor asset. Compared w ith, say,
a m anufacturing company th a t owns plant and machinery, a service company w ill have fewer physical
assets to offer as security fo r a loan. Examples o f industries in which companies have found debtor
finance particularly attractive include labour hire, wholesale trade, transport, p rin tin g and smash repairs.
Factoring is p articularly w ell suited to smaller companies, especially those th a t expect to grow quickly.
Smaller companies may n o t have the specialised staff needed to assess credit-worthiness, adm inister the
sales ledger and collect debts; factoring shifts most o f these responsibilities to the factor. Further, as a
company’s sales increase, so do its accounts receivable and, in tu rn , so also does the flow o f finance from
the factor— th a t is, the finance available keeps pace automatically w ith the company s growth. O ther
form s o f finance, such as overdrafts, have a set lim it and therefore these agreements w ill need to be
renegotiated as the company grows.
Debtor finance in Australia grew rapidly from 2002 to 2009 b ut its use has been stable in recent
years. Statistics compiled by the Debtor and Invoice Finance Association o f Australia and New Zealand
from surveying its members show th a t to ta l turnover fo r the year to the end o f December 2013 was
$63.3 b illion , while the corresponding figure fo r the year to the end o f December 2009 was $63.0 billion.
However, the components have changed: whereas factoring accounted fo r only about 5 per cent o f debtor
finance in 2009, it accounted fo r 9 per cent in 2013 (Debtor and Invoice Finance Association o f Australia
and New Zealand, 2013). Debtor finance has been used fo r an increasing variety o f purposes. For example,
debtor finance has been used as p art o f a funding package to finance some management buyouts and
company takeovers.
A company s inve ntory is p art o f its asset base and, as w ith accounts receivable, can be used to secure loan
funds. Inventory loans are usually provided by finance companies. Inventories o f m ost durable items,
including raw materials, finished goods and agricultural outputs such as grain, may be used to secure an
inve ntory loan. The proceeds o f an inventory loan are often used to acquire the inventory but may be used
FLOOR-PLAN (OR fo r any purpose in the company. In Australia, the bulk o f inventory loans take the fo rm o f floor-plan
w h o lesale) FINANCE (or w holesale) finance, which is a loan designed to assist retailers to purchase the inventory th a t then
loan, usually made form s the security fo r the loan. For example, a finance company may lend a m otor vehicle retailer the
by a wholesaler to a
funds needed to purchase an inventory o f vehicles and the finance company then uses those vehicles as
retailer, that finances
an inventory of security fo r the loan. The interest rate charged on inventory loans is based on the current interest rate on
durable goods such as a specified short-term security, plus a margin.
motor vehicles
BRIDGING FINANCE Bridging finance refers to a short-term loan, often in the form o f a mortgage over property, used to
short-term loan ‘bridge’ a short period o f tim e. O ften the need fo r this type o f funding arises from the tim in g o f a series
to cover a need o f transactions. For example, a property investor may wish to sell one building and use the sale proceeds
often arising from
to buy another building but, unfortunately, the tim in g o f the transactions is such th a t the payment for
timing differences
between two or more the second building m ust be made, say, a m onth before the sale proceeds from the firs t are received. A
transactions loan is required to bridge this gap o f 1 m onth. D uring this period the investor w ill own both properties,
and i f necessary both may therefore be mortgaged to secure the bridging loan. Corporate uses o f bridging
finance include short-term funding in the lead-up to a m ajor transaction such as a financial restructure5
or a new issue o f securities.
5 F o r e x a m p le , in J u l y 2 0 1 3 th e A u st r a lia n s u r f in g w e a r c o m p a n y B illa b o n g o b t a in e d a b r id g in g lo a n fr o m a c o n s o r t iu m o f
p r iv a t e e q u it y fir m s a s p a r t o f a fin a n c ia l r e s t r u c t u r e . S e e S to c k ( 2 0 1 3 ).
10.4 Long-term borrow ing from banks and

other financial institutions
LEARNING
OBJECTIVE 5
As shown in Table 10.1, Australian companies obtain debt finance largely through loans rather than by
issuing debt securities. Banks are the largest providers o f business loans. However, investm ent banks, life the features of the
insurance companies and other financial in stitu tio n s also provide long-term loans. We illustrate the main main types of long
features o f long-term loans in Example 10.1. term loans
Exam ple 1 0 .1
A tla s G lo b a l S ystem s Ltd (A G S ) m a n u fa c tu re s p o r ta b le g lo b a l p o s itio n in g system (GPS) u n its. A G S

6
n e e d s to b o r r o w $ 2 0 m illio n to c o n s tru c t a n d in s ta ll a p la n t th a t w ill a llo w it to p r o d u c e a n e w m o d e l
th a t is w a t e r p r o o f a n d w ill flo a t. T h e se u n its a r e e x p e c te d to b e p o p u la r w ith b o a t o p e r a to r s b e c a u s e
n o n e o f th e c u r r e n tly a v a ila b le u n its is d e s ig n e d f o r use in a m a r in e e n v iro n m e n t. A G S a p p lie s to its
b a n k fo r a te rm lo a n a n d th e b a n k a g re e s to le n d th e c o m p a n y $ 2 0 m illio n r e p a y a b le o v e r 5 y e a rs
a t a n in te re s t ra te o f 7 . 5 p e r c e n t p e r a n n u m w ith e q u a l m o n th ly re p a y m e n ts . T he lo a n w ill re q u ire
6 0 re p a y m e n ts a n d th e e ffe c tiv e in te re s t ra te is 7 . 5 / 1 2 = 0 . 6 2 5 p e r c e n t p e r m o n th . T he re p a y m e n ts
fo rm a n o r d in a r y a n n u ity a n d use o f E q u a tio n 3 . 1 9 s h o w s th a t e a c h p a y m e n t w ill b e $ 4 0 0 7 5 9 w ith
th e firs t p a y m e n t r e q u ire d 1 m o n th a fte r th e p r in c ip a l o f $ 2 0 m illio n is a d v a n c e d b y th e b a n k .
The loan obtained by AGS has four im p o rta n t features. The company has borrowed a fixed am ount
($20 m illion), repayable over a fixed period (5 years) at a fixed interest rate (7.5 per cent per annum)
w ith fixed repayments ($400 759 per m onth) th a t cover b oth principal and interest. In practice, i t is n ot
necessary th a t all o f these characteristics should be fixed. However, the one element common to all term
loans is th a t they are entered in to fo r a fixed period.
10.4.1 | Long-term loan choices available to borrowers

While the period m ust be fixed, the borrower can choose the length o f th a t period w ith in m inim um and
maximum lim its th a t may be specified by the bank. Similarly, the borrower can generally exercise choices
related to the am ount borrowed, the interest rate and the repayment pattern. We outline the choices that
are generally offered by Australian banks.
The amount borrowed

Each bank w ill generally specify a m inim um am ount fo r term loans b u t there is usually no m axim um
amount— the amount that may be borrowed depends on the borrow ers financial position and capacity to
repay the loan. As w ith the loan obtained by AGS, a term loan may be advanced in a lum p sum or the bank
may provide the funds in separate tranches over time.
The term of the loan

Each bank w ill usually specify m inim um and m axim um terms fo r its long-term loans. These loans are
typically available fo r periods o f up to 10 years b ut longer term s are possible in some cases.
The interest rate

The interest rate on a term loan may be fixed or variable. Banks w ill typically quote fixed interest rates for
periods ranging from 1 to 10 years. These rates are higher than, b u t related to, the yields on government
bonds o f the same term to m aturity. I f the borrow er chooses a variable interest rate, i t w ill be charged
a rate that is variable at the banks discretion. In Australia, the interest rates on variable-rate loans
generally change in response to changes in the cash rate set by the RBA, b ut can also vary in response to
B usiness finance
other factors th a t cause changes in the cost and composition o f banks* funds. For example, follow ing the
global financial crisis, which saw tu rm o il in many financial markets, particularly during 2008, the funding
m ix o f banks operating in Australia changed. In particular, banks increased th e ir use o f deposits and long
term debt and reduced th e ir use o f short-term debt and securitisation. Deposits and long-term debt have
the advantage o f being relatively stable sources o f funds, b ut often they are also more costly than short
term debt. Therefore, between June 2007 and January 2010, the banks1overall funding costs increased
relative to the cash rate and th eir lending rates also rose relative to the cash rate.6
Banks generally publish weekly notices stating the current interest rates on th e ir loans and these rates
are also available on each banks website. For smaller loans, such as a loan to a small business secured by a
mortgage over residential property, the published rate w ill usually be a set rate that applies to all loans of
a given type. For larger loans, banks w ill undertake a detailed analysis o f each borrow ers credit risk and
w ill establish individual margins th a t are added to a published base rate.
W hether the interest rate on a loan is fixed or variable, the level o f the rate w ill depend on whether the
loan is secured, and may also depend on the type o f assets th a t are pledged as security.
Loan repayments
Borrowers can exercise choices in terms o f the pattern o f repayments and the frequency o f those
repayments. The loan obtained by AGS involved equal m onthly repayments w ith each repayment
consisting p a rtly o f interest and p a rtly o f principal. A loan w ith th a t repayment pattern is known as a
CREDIT FONCIER LOAN principal-and-interest loan, a credit foncier loan or an instalment loan.7 Because the principal outstanding
type of loan that is reduced over tim e— at firs t gradually and then more rapidly— this type o f loan is also referred to as a
involves regular
reducible loan.
repayments that
include principal and
A related b u t d iffe re n t repaym ent p atte rn involves a fixed program o f repayments covering
interest p rin cip a l only w ith the in te re st being paid separately. For example, p rincip al repayments may be made
yearly, w ith interest being paid m onthly. This repaym ent p attern may be described as p rin cip a l plus
interest* and differs fro m the <principal-fl??c?-interest, pattern in th a t the payments w ill decline over
tim e rath er than rem aining constant in each period. A lternatively, the borrow er can choose to make
in te re s t o n ly, payments d u rin g the loan te rm w ith a fin al lum p sum repaym ent o f the p rincipal.
A large fin a l loan repaym ent is know n as a balloon paym ent or a b u lle t paym ent. In cases where
the interest rate has been fixed fo r a period such as a year, the bank may allow borrow ers to pay
interest in advance. This may be advantageous where the borrow er wishes to claim a tax deduction
fo r interest earlier th an w ould otherwise be the case. As noted above, the frequency o f payments
can also vary w ith borrow ers allowed to choose weekly, fo rtn ig h tly , m on thly, q u a rte rly or half-yearly
payments.
In summary, a variety o f choices is available to borrowers who take o ut term loans b u t it should
be noted th a t these choices are often linked to other choices. In particular, i f the borrow er chooses a
variable-rate loan this usually opens up a w ider variety o f other choices than is the case w ith a fixed-rate
loan. We now discuss the variable- and fixed-rate term loans offered by banks.
As discussed earlier, a term loan covers a fixed period and has three other m ain features— the interest
rate, the am ount borrowed and the repayment pattern. I f the borrow er chooses a variable interest
rate, there is considerable fle xib ility fo r the last two features. W hile the m axim um am ount th a t can be
borrowed w ill be specified, the bank w ill usually allow the funds to be drawn down progressively or fu lly
drawn in a single amount.
A variable-rate loan is flexible in th a t it can be repaid early w ith o u t penalty, and a redraw fa cility
is often available. This fa cility allows borrowers access to any excess repayments th a t have been made.
Also, a variable-rate loan can usually be converted to a fixed-rate loan at any tim e w ith o u t penalty fees.
6 S e e B ro w n e t al. ( 2 0 1 0 ) .
7 F o r d e t a ils o n p r ic in g t h is ty p e o f lo a n , s e e S e c t io n 3 .7 .
Borrowers who wish to be protected against possible increases in interest rates may be offered a capped
option*, which means th a t the interest rate can go up, b ut w ill n ot exceed a specified ceiling rate fo r a
specified term.
The purest form o f a fixed-rate term loan is one in which the interest rate is fixed fo r the whole term o f
the loan. W hile loans o f this type are made in Australia, many so-called fixed-rate loans fix the interest
rate fo r a period that is less than the term o f the loan. For example, a loan may be repayable over a term o f
10 years, w ith the interest rate fixed fo r the firs t 3 years. A t the end o f the th ird year, the borrower m ust
decide whether to fix the interest rate fo r a fu rth e r period, o r switch to a variable-rate loan. In either case,
the loans m a tu rity date is unchanged, unless the borrow er and lender agree otherwise. The maximum
fixed-rate period offered is usually between 5 and 10 years.
By fixing the interest rate, the borrower gives up some o f the fle x ib ility th a t is inherent in a variable-
rate loan. In a fixed-rate loan, progressive draw-down may n ot be allowed— th a t is, the loan may have
to be drawn down in a lum p sum. However, the equivalent o f progressive advances can be achieved by
arranging to take out a series o f separate fixed-rate loans, each having its own separate documentation,
loan account number and fixed interest rate. This approach is likely to involve higher transaction costs.
The borrower may be able to choose any o f the usual repayment patterns, including interest only in
advance, and the frequency o f repayments can range from weekly to annually. However, the repayments,
once set, cannot be changed during the fixed-rate period (unless the parties agree otherwise), b ut can be
renegotiated at the end o f the fixed-rate period. In some fixed-rate loans, borrowers w ill n ot be penalised
i f they make early repayments up to an agreed maximum. In other loans, borrowers who make early
repayments, including early repayment o f the fu ll amount, w ill be required to pay an adm inistration fee
and, i f interest rates have fallen, an am ount to compensate the lender fo r the lost future interest income.
In addition to the interest payable on a term loan, borrowers are usually required to pay an establishment
fee and periodic loan service fees.
As noted above, banks norm ally require th a t term loans are secured and this may take the form o f a
charge over property or other company assets, or the guarantee o f an overseas bank or parent company.
A loan that is secured by a mortgage over land or other property is often referred to as a mortgage loan.
Mortgage finance is often used by borrowers who wish to finance th e ir own offices, shops and factories,
and by property developers who wish to undertake activities such as the construction o f buildings and
the subdivision o f land.
The risk management measures used by banks include lim its on a banks exposure to a single borrower
or group o f related borrowers. Accordingly, there are often cases where a credit-w orthy borrower may
require more funds than a single lender is w illin g to provide. This problem can be overcome by obtaining a
syn dicated lo a n . The main feature o f these loans is th a t a num ber o f banks jo in together to provide what SYNDICATED LOAN
is in effect a term loan, w ith each lender having identical rights. Because each lender provides only p art o f loan arranged by one
or more lead banks,
the funds, the credit risk exposure is divided between the lenders. Such loans are generally unsecured and
funded by a syndicate
have a variable interest rate, usually based on the bank-bill rate. A lending syndicate often involves both that usually includes
Australian and foreign banks. For example, in 2007, Wesfarmers Lim ited obtained a loan o f $10 b illio n other banks
from a syndicate o f domestic and offshore banks to finance its takeover o f the Coles Group (see Finance in
Action). The loan was originally underw ritten by a group o f three banks, which then arranged fo r at least
10 more banks to provide the m ajority o f the funds.
As well as borrow ing locally, Australian companies frequently borrow overseas. Reasons fo r borrowing
overseas include diversification o f funding sources and achieving exposure to one or more foreign
currencies. Decisions on borrow ing overseas should be based on an assessment o f exchange risk as
well as the interest cost. An Australian borrower o f foreign currency w ill benefit (lose) i f the value o f an
Australian dollar rises (falls) in foreign currency terms.
B usiness finance
Finance WESFARMERS CAN BANK O N COLES LOAN__________________

in ACTION
T h e b i g g e s t b a n k lo a n in A u s t r a lia n c o r p o r a t e h i s t o r y is l a r g e ly c o m p le t e , d e s p i t e a c r e d it
c r u n c h p u t t in g f e a r in t o b a n k s . T h e f u n d in g w i l l u n d e r p in A u s t r a l i a ’s la r g e s t t a k e o v e r :
W e s f a r m e r s 7 $ 2 0 b i lli o n b u y - o u t o f C o le s . T h e t h r e e le a d a r r a n g e r s o f t h e lo a n , A N Z
B a n k , B N P P a r ib a s a n d N A B , s a y t h e y a n d 1 0 o th e r b a n k s h a v e ta k e n u p 8 5 p e r c e n t o f
t h e $ 1 0 b i l l i o n lo a n o n t e r m s d r a w n u p b e f o r e t h e w o r s t o f t h e c r u n c h h it.
B N P P a r ib a s w o u ld n o t d is c lo s e th e a m o u n t o f d e b t e a c h le a d a r r a n g e r h a d d e c id e d to ta k e
in its o w n r ig h t , a lth o u g h m a r k e t s o u rc e s s p e c u la t e d it c o u ld b e a b o u t $1 b illio n b e t w e e n th e m .
In te re s t r a te s o n th e lo a n h a v e n o t b e e n d is c lo s e d , b u t W e s f a r m e r s u s e d a r a te o f 7 . 4 5 p e r c e n t
in its s c h e m e b o o k le t to c a lc u la t e its p a y m e n ts , o r 5 8 b a s is p o in ts a b o v e th e 9 0 - d a y b ill r a te
w h e n t h e b o o k le t w a s p u b lis h e d .
T h e 1 0 b a n k s ' c o m m itm e n t to th e W e s f a r m e r s d e a l p a in ts a p ic tu r e o f a t w o - s p e e d d e b t
m a r k e t s in c e c r e d it fe a r s g r ip p e d le n d e r s in m id - A u g u s t. O n th e o n e h a n d , th e r e a r e m a jo r
b a n k s t h a t a r e la r g e ly u n r u f f le d b y th e c r is is a n d w i lli n g to le n d to g o o d c r e d it ris k s . O n th e
o th e r , th e r e a r e lo w e r - q u a lit y a s s e ts t h a t n o - o n e is w i lli n g to le n d o n , a n d d e b t m a r k e ts t h a t
h a v e e f f e c t iv e ly c lo s e d . S o m e m a r k e t c o m m e n t a t o r s s p e c u la te th e m o r t g a g e - b a c k e d s e c u r itie s
m a r k e t in th e U S m a y n e v e r r e a p p e a r .
' W h a t w e 'r e s e e in g is q u it e a lo t o f a p p e t it e f o r w e ll- s tr u c tu r e d t r a n s a c t io n s 7, s a id S te p h e n
B o y d , N A B C a p i t a l ’s s p o k e s m a n f o r th e d e a l. M r B o y d s a id th e s y n d ic a tio n w a s o n s c h e d u le ,
d e s p ite s o m e v ie w s t h a t p r o g r e s s h a d b e e n s lo w s in c e th e th r e e b a n k s c o m m itt e d to th e d e a l
o n J u ly 1 0 . ' W h a t w e h a v e s e e n is, c e r t a in ly , b a n k s a r e m o r e s e n s itiv e in d is c e r n in g c r e d it
q u a l it y 7, M r B o y d s a id . 'E a c h b a n k is d if f e r e n t in h o w th e y h a v e b e e n im p a c t e d in th is c r e d it
c ru n c h .’
T h e d e a l n o w e n te rs p h a s e t w o , w h ic h in c lu d e s r o a d s h o w s in S y d n e y , S in g a p o r e a n d H o n g
K o n g , a s th e le a d b a n k s t r y to p la c e th e r e m a in in g $ 1 . 5 b illio n in d e b t . B a n k s t h a t h a v e s ig n e d
u p a r e W e s t p a c , C o m m o n w e a lt h , A B N A m r o , B a n k o f T o k y o - M its u b is h i UFJ, JP M o r g a n C h a s e ,
S u m ito m o M it s u i, W e s tL B , M iz u h o C o r p o r a t e , S o c ie te G e n e r a le a n d B a r c la y s C a p it a l.
Source: 'Wesfarmers can bank on Coles loan', Stuart Washington, The Age, 27 October 2007.
1 0 .4 .5 1 W h y do borrowers use term loans instead of

security issues?
The in te re s t ra te o n a te rm lo a n is u s u a lly h ig h e r th a n th e y ie ld s o n d e b t s e c u ritie s o f th e sam e te rm to
m a tu r ity . This fa c t p ro m p ts th e q u e s tio n : W h y do businesses use te r m lo a n s ra th e r th a n issue t h e ir o w n
s e c u ritie s d ire c tly to in v e s to rs ?
F irs t, th e re m a y be g re a te r eco no m ies o f scale in is s u in g a s e c u rity th a n in ra is in g a lo a n . In th is case,
s e c u rity issues w o u ld be fa v o u re d i f th e a m o u n t s o u g h t is re la tiv e ly la rge , w h ile lo a n s w o u ld be fa v o u re d
i f th e a m o u n t s o u g h t is re la tiv e ly sm a ll. Table 10 .3 gives som e s u p p o rt to th is su g g e stio n . W h e re a b a n k
p ro v id e s a c re d it f a c ilit y o f less th a n $2 m illio n , v a ria b le -ra te a n d fix e d -ra te lo a n s (in te rm e d ia te d fin a n ce )
p re d o m in a te o v e r b ills (d ire c t fin a n c e ). I n c o n tra s t, f o r fa c ilitie s o f $2 m illio n a n d over, th e va lu e o f
b ills is u s u a lly s im ila r to th e c o m b in e d va lu e o f b a n k lo a n s. A lth o u g h o n ly s h o r t- te rm s e c u ritie s (b ills )
are in c lu d e d in Table 10 .3, th e a rg u m e n t also a p p lie s to lo n g e r te rm s e c u ritie s such as b o n d s: is s u in g a
s e c u rity ty p ic a lly in v o lv e s tra n s a c tio n costs t h a t in c lu d e s ig n ific a n t fix e d co m p o n e n ts .
Second, a b o rro w e r can p ro v id e in fo r m a tio n a b o u t its fin a n c ia l p o s itio n , fo re c a s t cash flo w s , p ro sp e cts
a n d s tra te g ic p la n s p r iv a te ly to a b a n k , w h ic h w ill use th e in fo r m a tio n to assess th e c re d it r is k a n d p rice
th e lo a n . In c o n tra s t, a c o m p a n y t h a t b o rro w s b y is s u in g d e b t s e c u ritie s has to disclose m u c h in fo r m a tio n
p u b lic ly , w h ic h m a y p ro v id e va lu a b le in s ig h ts to c o m p e tito rs .
T h ird , b a n k lo a n s are m u c h m o re fle x ib le th a n d e b t s e c u ritie s . F o r exa m ple, th e re p a y m e n t p a tte rn o f
a b a n k lo a n can be ta ilo re d to s u it th e b o rro w e rs cash flo w s and, i f c ircu m sta n ce s change u n e xp e cte d ly,
th e te rm s o f a b a n k lo a n can o fte n be re n e g o tia te d . In c o n tra s t, th e re p a y m e n t p a tte r n a n d o th e r te rm s
o f d e b t s e c u ritie s are set a t th e tim e o f th e issue a n d i t is e x tre m e ly d iff ic u lt to m a ke a n y changes to th o se
te rm s la te r.
TABLE 10.3 Bank lending to businesses, total credit outstanding by size and by
type of facility ($ million)
U n d e r $ 2 m illio n
1 $ 2 m illio n a n d o v e r
V a r ia b le V a r ia b le
ra te F ix e d ra te Bills Total ra te F ix e d ra te Bills Total
June 2000 43068 43 902 19956 106926 20683 30456 93500 144638
June 2005 85 941 42166 30324 158431 85 749 24026 105854 215 628
June 2010 11 0 6 1 9 78546 35 731 224897 147863 58781 215009 421653
June 2011 117443 77979 32 757 228179 145660 58327 205878 409865
June 2012 116452 82 543 40732 239728 151665 69263 233166 454094
June 2013 113920 86610 42539 243069 144690 95292 227321 467304
Source: Table D8, Reserve Bank of Australia website, www.rba.gov.au.
F o u rth , d e b t se c u ritie s m a y be d iff ic u lt to se ll to in v e s to rs un le ss th e y have a r a tin g fr o m one o f th e

ra tin g agencies such as S ta n d a rd & P o o rs . U n less th e b o rro w e r is v e ry la rge i t m a y be che ap er to deal w ith
a b a n k th a n i t is to o b ta in a ra tin g .
In s u m m a ry, te rm lo a n s ha ve several advan ta ge s t h a t m ake th e m a ttra c tiv e co m p a re d to s e c u rity
issues, p a rtic u la rly w h e re s m a lle r b o rro w in g s are in v o lv e d .
10.5 Debt securities

W h ile lo a n s fro m ba n ks a n d o th e r le n d e rs are a va ila b le to businesses o f a n y ty p e , la rg e r businesses are
able to b o rro w b y c re a tin g a n d is s u in g d e b t s e c u ritie s . These s e c u ritie s in c lu d e c o m m e rc ia l paper, b ills o f LEARNING
OBJECTIVE 6
exchange, d e b e n tu re s, n o te s a n d b o n d s.
Compare and contrast
the main features of
short-term and long
term debt securities
10.5.1 I Debt securities: the general principles
C om panies can o b ta in s h o r t- te rm d e b t fu n d in g b y is s u in g (s e llin g ) s e c u ritie s such as c o m m e rc ia l p a p e r
and b ills o f exchange. The sam e g e ne ral p rin c ip le s are a p p lica b le to b o th typ e s o f s e c u rity an d, in b ro a d
te rm s , are as fo llo w s . The s e c u ritie s are a p ro m is e to pay a su m o f m o n e y o n a fu tu r e da te, k n o w n as th e
m a tu r ity date, w h ic h is less th a n 1 yea r in to th e fu tu r e .8 P ro v id e d t h a t th e p ro m is e is m ad e b y an e n t it y o f
cred ib le fin a n c ia l s ta n d in g , such a p ro m is e is va lu a b le a n d hence m a y be sold. In p rin c ip le , th e p u rc h a s e r
m a y be a n y e n t it y w it h fu n d s a va ila b le f o r le n d in g . H o w m u c h th e p u rc h a s e r is w illin g to p a y w ill d e pe nd
o n several fa c to rs , in c lu d in g th e c u rre n t le ve l o f in te re s t rates. W h e n th e s e c u rity is sold, th e issu e r
receives th e sale p ric e b u t is, o f course, c o m m itte d to m a k in g th e fu tu r e p a y m e n t p ro m is e d . Thus, in
effect, th e s e c u rity is a s h o r t- te rm lo a n w h e re th e lo a n p rin c ip a l is e q u a l to th e sale p rice . The pu rcha ser,
how ever, is n o t c o m m itte d to h o ld in g th e s e c u rity f o r th e w h o le p e rio d fr o m th e da te o f purcha se u n t il
th e m a t u r ity date. A t a n y tim e , th e p u rc h a s e r m a y se ll th e s e c u rity to som e o th e r p a rty . Such a sale is
k n o w n as a s e c o n d a r y m a r k e t t r a n s a c t io n . M a n y such tra n s a c tio n s m a y be u n d e rta k e n d u r in g th e life SECONDARY MARKET
o f one o f these s e c u ritie s .9 W h o e v e r o w n s th e s e c u rity o n th e m a t u r ity d a te w ill th e n seek p a y m e n t o f TRANSACTION
purchase or sale of an
th e su m p ro m is e d . C o m m e rc ia l p a p e r a n d b ills o f exchange are discussed in S ectio ns 1 0 .5 .2 a n d 1 0 .5 .3 ,
existing security
respectively.
8 This definition is standard but in Australia virtually all such securities have terms of 6 months or less.
9 At one time physical transactions were made but today most trades are recorded through Austraclear, which is a computerised
central clearing house for promissory notes, bank bills and other money market securities. Austraclear is a subsidiary of the
Australian Securities Exchange. For further details visit w w w .a s x .c o m .a u .
B usiness finance
C o m pa nie s can also issue s e c u ritie s w it h a te rm to m a t u r ity g re a te r th a n 1 year. These s e cu ritie s

in c lu d e d e b e n tu re s, n o te s a n d c o rp o ra te b o n d s. There can be im p o r t a n t d iffe re n ce s b e tw e e n these types
o f s e c u ritie s , b u t th e y share m a n y fe a tu re s. In c o m m o n w it h g o v e rn m e n t b o n d s, th e se se c u ritie s are
u s u a lly issu ed a t face value . In som e cases, th e issue p ric e is d e te rm in e d b y a te n d e r process, w h ic h can
re s u lt in th e issue p ric e b e in g g re a te r o r less th a n th e face value . A f t e r th e se c u ritie s ha ve been issued,
COUPON PAYMENTS th e b o rro w e r m akes re g u la r in te re s t p a y m e n ts k n o w n as coupon paym ents a n d th e n repays th e face
periodic payments of va lu e (p rin c ip a l) in f u ll a t m a tu rity . A lte rn a tiv e ly , th e s e c u rity m a y be c o n v e rtib le in to o rd in a ry shares,
interest, often at half-
in w h ic h case th e h o ld e r has a choice. I f th e h o ld e r chooses n o t to exercise th e c o n v e rs io n o p tio n , th e n
yearly intervals, on
th e p rin c ip a l w ill be re p a id . The c h a ra c te ris tic s o f d e b e n tu re s, u n se cu re d n o te s a n d c o rp o ra te b o n d s are
debt securities such as
debentures and bonds discussed in S ectio ns 1 0 .5 .4 to 1 0 .5 .6 . F o r d e ta ils o f th e v a lu a tio n o f the se s e c u ritie s , re fe r to S e ctio n 4.4.
C o n v e rtib le n o te s a n d c o n v e rtib le b o n d s are discussed in S e ctio n 10 .7.1.
1 0 .5 .2 1 Commercial paper
C o m m e r c ia l p a p e r is th e te r m t h a t is c o m m o n ly used to re fe r to m a rk e ta b le , s h o r t- te rm , un se cu re d
d e b t s e c u ritie s w ith th e le g a l s ta tu s o f p ro m is s o ry n o te s .10 A p ro m is s o ry n o te is s im p ly a p ro m is e to pa y a
LEARNING
s ta te d s u m o f m o n e y (such as $ 5 0 0 0 0 0 ) o n a s ta te d fu tu re date (such as a da te 90 days he nce ). The sta te d
OBJECTIVE 7
su m o f m o n e y is re fe rre d to as th e p a p e rs fa c e v a lu e . The is s u e r o f th e p a p e r— t h a t is, th e b o rro w e r— is
Understand the
process of using th e o n ly p a r ty w it h an o b lig a tio n to p a y th e face va lu e a t m a tu rity , so c o m m e rc ia l p a p e r is s o m e tim e s
commercial paper to called one-name paper.11 In p ra c tic e , o n ly *blue c h ip J co m p a n ie s— t h a t is, la rge , re p u ta b le co m p a n ie s w ith
raise funds and how a h ig h c re d it r a tin g — a n d g o v e rn m e n t e n titie s are able to raise fu n d s b y is s u in g c o m m e rc ia l paper. Issuers
commercial paper o f c o m m e rc ia l p a p e r in A u s tra lia have in c lu d e d A m c o r, B H P B illito n , O ric a a n d W o o lw o rth s , as w e ll as
is priced
several n o n -b a n k fin a n c ia l in s titu tio n s .
COMMERCIAL PAPER C o m m e rc ia l p a p e r is u s u a lly issu e d w it h a te r m to m a t u r ity w it h in th e range o f 30 days to 1 8 0 days,
(OR PROMISSORY a lth o u g h o th e r te rm s m a y be po ssib le. In p ra ctice , a lm o s t a ll c o m m e rc ia l p a p e r is issu e d to th e m em b ers
note) o f d e aler p anels, m ade u p o f la rg e b a n ks, w h ic h b id f o r th e p a p e r w h e n a co m p a n y a n n o u n ce s th e te rm s o f
short-term marketable
a p la n n e d issue. The pu rch a se rs are k n o w n as d is c o u n t e r s a n d th e y m a y h o ld th e p a p e r u n t il i t m a tu re s
debt security in which
the borrower promises or, m o re u su a lly, se ll i t to o th e r in v e s to rs . I f an is s u e r s u b s e q u e n tly fin d s t h a t i t does n o t re q u ire th e
to pay a stated sum on fu n d s f o r th e f u ll p e rio d o f th e lo a n , i t can re p urch ase th e p a p e r b y b u y in g th e s e c u ritie s in th e se co n d a ry
a stated future date. m a rk e t a t th e c u rre n t m a rk e t p rice .
Also known as one- The a m o u n t t h a t th e s e lle r o f a s e c u rity receives fr o m th e d is c o u n te r de pe nd s o n m a rk e t forces. F or
name paper
exa m ple, suppose t h a t J in d a b y n e Resources L td issues 9 0 -d a y c o m m e rc ia l p a p e r w it h a face va lu e o f
FACE VALUE $ 5 0 0 0 0 0 a n d is able to se ll th e p a p e r to K lo n d ik e In v e s tm e n ts f o r $ 4 9 4 0 0 0 . J in d a b y n e Resources w ill
sum promised to be have to re p a y $ 5 0 0 0 0 0 o n th e m a t u r ity da te, so th e in te re s t cost is $ 6 0 0 0 o n a lo a n o f $ 4 9 4 0 0 0 f o r a
paid in the future on a te rm o f 9 0 days. The s im p le a n n u a lis e d y ie ld is ($ 6 0 0 0 /$ 4 9 4 0 0 0 ) x (3 6 5 /9 0 ) = 4 .9 2 6 p e r c e n t p e r a n n u m .
debt security, such as In d e c id in g to p a y $ 4 9 4 0 0 0 f o r th e s e c u rity , K lo n d ik e In v e s tm e n ts w o u ld , o f course, have c o m p a re d th e
commercial paper or
y ie ld o f 4 .9 2 6 p e r ce n t p e r a n n u m w it h y ie ld s (in te re s t rates) a va ila b le a t t h a t tim e o n s im ila r se cu ritie s.
a bill of exchange
T his lo g ic , w h ic h is re a lly ju s t an a p p lic a tio n o f s im p le in te re s t, is s u m m a ris e d in E q u a tio n 10.1:
DISCOUNTER (OF P=
COMMERCIAL PAPER)
the initial purchaser of
1+ r x d
365 IBfl
commercial paper
w h e re F = face va lu e (= fu tu r e su m payable)
r = y ie ld p e r a n n u m o n a s im p le in te re s t basis
d = n u m b e r o f days to m a t u r ity
In p ra c tic e , m a rk e t p a rtic ip a n ts w ill agree o n a y ie ld a n d th e p ric e w ill th e n be d e te rm in e d u s in g th e
agreed fo rm u la . The use o f s im p le in te re s t to calcula te th e p ric e o f a se c u rity , g iv e n th e y ie ld , is illu s tra te d
in E xa m p le 10.2.
10 The term commercial paper* is also used as a generic term to cover other short-term debt securities known by various terms,
including certificates of deposit, short-term notes and transferable deposits, as well as promissory notes.
11 The term 'one-name paper1includes securities such as Treasury notes, which are issued by the government, and certificates of
deposit, which are issued by banks.
E xample 10.2
C o m m e r c ia l p a p e r w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 a n d 9 0 d a y s to m a tu r ity is is s u e d a t a y ie ld o f
6
4 . 9 2 6 p e r c e n t p e r a n n u m . C a lc u la te th e p r ic e o f th e s e c u rity .
SOLUTION
U s in g E q u a tio n 1 0 .1 :
1 + rx 355
= $500000
1 +0.049 26 x 晶
$500000
_ 1.012 146 301
=$493 999.73
E qu atio n 10.1 also applies to co m m e rcia l pa p e r w h e n i t is tra d e d in th e secondary m a rk e t. Exam ple 10.3
provides an illu s tra tio n .
E xample 10.3
S u p p o s e th a t 3 0 d a y s a fte r p u r c h a s in g th e c o m m e r c ia l p a p e r (see E x a m p le 1 0 . 2 ) , K lo n d ik e In ve stm e n ts
6
d e c id e s to sell th e s e c u rity in th e s e c o n d a r y m a rk e t a n d a g re e s to sell it to St A n d r e w B a n k a t a y ie ld
o f 5 . 0 5 p e r c e n t p e r a n n u m . W h a t p r ic e w ill St A n d r e w B a n k p a y ?
SOLUTION
T he c o m m e rc ia l p a p e r n o w h a s 6 0 d a y s le ft u n til m a tu rity . U s in g E q u a tio n 1 0 . 1 , th e p r ic e is:
$500000
1 + 0.0505 x ^
$500000
_ 1.008 301 370
=$495 883.49
F or f u r t h e r d iscu ssio n o f c a lc u la tin g p rice s a n d y ie ld s , see S e ctio n 3.3 .4 .

C o m m e rcia l p a p e r is g e n e ra lly issu e d th ro u g h a p ro g ra m a rra n g e d b y a m a jo r b a n k o r in v e s tm e n t
b a n k. The p ro g ra m a rra n g e r (o r le a d m a n a g e r) w i ll fo r m a d e a le r p a n e l, g e n e ra lly m ad e u p o f la rge banks.
The d o c u m e n ts t h a t e s ta b lis h th e p ro g ra m w i ll u s u a lly sp e c ify an u p p e r li m i t o n th e v a lu e o f th e se cu ritie s
o u ts ta n d in g a t a n y tim e . As e x is tin g s e c u ritie s m a tu re , n e w s e c u ritie s can be cre a te d a n d d is c o u n te d
i f re q u ire d b y th e issuer. I f th e p ro g ra m is to be u n d e r w r itte n , an u n d e r w r itin g s y n d ica te w ill also be
fo rm e d . The d e aler p a n e l is g iv e n th e f ir s t o p p o r tu n it y to p u rcha se th e se c u ritie s . I f th e re is a s h o r tfa ll
in th e a m o u n t o f th e issue p u rc h a s e d b y th e d e aler pa ne l, th e balance is b o u g h t b y th e u n d e r w r itin g
syndicate. Each m e m b e r o f th e sy n d ic a te agrees th a t, i f re q u ire d b y th e issuer, i t w ill p u rch a se s e c u ritie s
up to a sp e cifie d a m o u n t. To fa c ilita te tra d in g , i t is u su a l f o r c o m m e rc ia l p a p e r issues to have a c re d it
ra tin g fro m a ra tin g s agency (see S e ctio n 4 .7 ).
B usiness finance
The size o f a c o m m e rc ia l p a p e r p ro g ra m w ill d e p e n d o n fa c to rs such as th e b o r r o w e r ^ n e ed f o r fu n d s ,

its c re d it ra tin g a n d th e co st o f c o m m e rc ia l p a p e r in c o m p a ris o n w it h o th e r sources o f fu n d s . Because o f
th e costs in v o lv e d in e s ta b lis h in g a p ro g ra m , c o m m e rc ia l p a p e r issues are g e n e ra lly n o t v ia b le un le ss th e
a m o u n t t o be b o rro w e d is a t le a s t $ 2 0 0 m illio n . The m a x im u m a m o u n t t h a t a g iv e n is s u e r can b o rro w w ill
de p e n d o n its c re d it ra tin g a n d its re p u ta tio n w ith in v e s to rs .
A t th e e n d o f S e p te m b e r 2 0 1 3 , th e re was $ 3 4 3 .3 b illio n in o u ts ta n d in g o n e -n a m e p a p e r issued b y
A u s tra lia n b o rro w e rs . O f th is a m o u n t, $ 2 1 4 .9 b illio n (6 3 p e r c e n t) was issu ed in A u s tra lia a n d $ 1 2 8 .4
b illio n (3 7 p e r c e n t) was issu ed overseas. M o re th a n 8 0 p e r c e n t o f th e o u ts ta n d in g o n e -n a m e p a p e r was
issu ed b y b a n ks; o n ly 2.5 p e r c e n t was issu e d b y p riv a te co m p a n ie s o u ts id e th e fin a n c e s e c to r.12
LEARNING
OBJECTIVE 8
10 .5 .3 ! Bills of exchange
Understand the
process of using bills
of exchange to raise The usual w ay bills of exchange are created and traded
funds and how bills
In p ra c tic e , i f a c o m p a n y does n o t have a c re d it r a tin g fr o m a ra tin g s agency, i t w ill fin d i t v e ry d iffic u lt
of exchange are
priced to issue a n d se ll c o m m e rc ia l paper. F o r the se co m p a n ie s an a lte rn a tiv e is to issue a b i l l o f e x c h a n g e .
There are m a n y s im ila ritie s b e tw e e n c o m m e rc ia l p a p e r a n d b ills o f exchange. B o th are s h o r t- te rm d e b t
BILL OF EXCHANGE in s tru m e n ts t h a t p ro m is e to p a y a s ta te d s u m (k n o w n as th e face va lu e ) o n a s ta te d fu tu r e date; b o th can
marketable short-term
be tra d e d in a c tiv e s e c o n d a ry m a rk e ts ; a n d b o th are s o ld a t p rice s t h a t re fle c t th e c u rre n t le ve l o f in te re s t
debt security in which
one party (the drawer) rates. The m a jo r d iffe re n c e is in th e n u m b e r o f p a rtie s to th e in s tr u m e n t. In th e case o f c o m m e rc ia l paper,
directs another party o n ly th e is s u e r p ro m is e s to p a y th e face v a lu e o n th e m a t u r ity date. In a b ill o f exchange th e re is also
(the acceptor) to pay a a n o th e r p a rty , k n o w n as th e acceptor, so n a m e d because th is p a r ty accepts th e re s p o n s ib ility to pay th e
stated sum on a stated
face v a lu e o n th e m a t u r ity date. M o s t o fte n , th is ro le is fille d b y a b a n k . The b o rro w e r pays a fee to th e
future date
b a n k f o r t h is service a n d also agrees to re im b u rs e th e b a n k f o r p a y in g th e face v a lu e o n th e m a t u r ity date.
DRAWER Because th e a cce p to r is a w e ll-k n o w n in s t it u t io n w it h a h ig h c re d it ra tin g , th e re w ill be le n d e rs w illin g to
in a bill of exchange, p u rcha se th e b ill even i f th e b o rro w e r is n o t so w e ll k n o w n . The y ie ld o n a b ill w i ll re fle c t th e c re d it ra tin g
the party initiating the o f th e a c c e p to r a n d b ill y ie ld s are a lm o s t alw ays lo w e r th a n th e y ie ld s o n c o m m e rc ia l p a p e r o f th e same
creation of the bill;
te rm to m a tu rity .
usually the borrower
The p a rtie s in v o lv e d in th e c re a tio n o f a b ill o f exchange are re fe rre d to as th e d r a w e r , th e a c c e p to r
ACCEPTOR (OR (o r d ra w e e ) a n d th e d is c o u n t e r . In th e u s u a l w a y b ills o f exchange are crea te d, th e d ra w e r is th e b o rro w e r
a n d th e a c c e p to r pays th e face va lu e a t m a t u r ity o n b e h a lf o f th e b o rro w e r. The face va lu e is p a id to
in a bill of exchange,
w h o e v e r h o ld s (o w n s ) th e b ill o n th e m a t u r ity date. The ro le o f th e d is c o u n te r is to p ro v id e (le n d ) th e
the party agreeing
to pay the holder the fu n d s b y p u rc h a s in g th e b ill fr o m th e dra w e r. In p rin c ip le , th e d is c o u n te r c o u ld be a n y e n t it y w it h fu n d s
bill’s face value on the to le n d , b u t in p ra c tic e is u s u a lly a fin a n c ia l in te rm e d ia ry o r som e o th e r fin a n c ia l in s titu t io n . As w it h
maturity date; usually c o m m e rc ia l pa pe r, th e a m o u n t p a id b y th e d is c o u n te r w i ll d e p e n d o n m a rk e t forces an d, in p a rtic u la r,
a bank or other
o n y ie ld s c u r r e n tly a va ila b le o n s im ila r s e c u ritie s . By c o n v e n tio n , s im p le in te re s t is use d to ca lcu la te b ill
financial institution
p ric e s .13 The a cce p to r a n d d is c o u n te r m a y be th e sam e e n tity . F ig u re 10 .1 show s th e steps in th e c re a tio n
DISCOUNTER (OF A o f a b ill w h e re th e a cce p to r a n d th e d is c o u n te r are d iffe re n t e n titie s .
BILL OF EXCHANGE) The d is c o u n te r has th e choice o f e ith e r h o ld in g th e b ill u n t il m a tu r ity , w h e n p a y m e n t w i ll be rece ive d
the initial purchaser of fr o m th e acceptor, o r s e llin g ( r e d is c o u n t in g ) th e b ill. H o w e ve r, i f th e b ill is sold, th e s e lle r n o rm a lly
a bill of exchange
endorses th e b ill a t th e tim e o f sale. E n d o r s e m e n t m ea ns t h a t i f th e a cce p to r is u n a b le to p a y th e face value
REDISCOUNTING o n th e m a t u r it y da te, an e n d o rs e r m a y be o b lig e d to p a y a su b se q u e n t h o ld e r o f th e b ill. C o n se q u e n tly,
selling a short-term w h e n a s e lle r endo rses a b ill th e s e lle r has a c o n tin g e n t lia b ilit y u n t il th e b ill m a tu re s a n d is p a id .14 O n th e
debt security in the
b ills m a t u r it y d a te th e a cce p to r pays th e face va lu e to th e h o ld e r o f th e b ill a n d th e a c c e p to r w ill re q u ire
secondary market
th e d ra w e r to re im b u rs e th e a cce p to r f o r th is p a y m e n t. In th e u n lik e ly e v e n t t h a t th e a c c e p to r is u n a b le to
ENDORSEMENT p a y th e face value , lia b ilit y f o r p a y m e n t fa lls n e x t o n th e dra w e r. I f th e d ra w e r is also u n a b le to pay, each
the seller of a bill in
e n d o rs e r becom es lia b le to pay s u b se q u e n t en do rsers; th u s th e re is a ‘c h a in o f p r o te c tio n ’ c o n s is tin g o f
the secondary market
accepts responsibility a ll th o se e n titie s t h a t have e n d o rse d th e b ill. H o w e ve r, in p ra c tic e i t is ra re f o r p ro b le m s to arise a n d th e
to pay the face value a cce ptor pays th e face va lu e as expected. The n o rm a l process o f re p a y m e n t is illu s tr a te d in F ig u re 10.2.
if there is default by
the acceptor, drawer
and earlier endorsers
12 See Australian Bureau of Statistics (September 2013).
13 Equation 10.1 can be used. For further details, see Section 3.3.4.
14 For some lenders, this fact may make commercial paper, which is rarely endorsed when sold, a more attractive investment
than bills of exchange.
Figure 10.2
approaches approaches
Current the acceptor Acceptor the drawer
holder for
repayment recompense
initially the acceptor the drawer reimburses

pays the holder the the acceptor for this
face value of the bill payment to the holder
Bank accepted bills

W h e n a b a n k accepts a b ill, i t is o b lig e d to re p a y th e b ill a t m a tu r ity , a n d f o r th is rea son such a b ill is
u s u a lly re fe rre d to as a bank accepted bill o r s im p ly a bank bill. In p rin c ip le , in s titu t io n s o u ts id e th e BANK BILL (OR BANK
ACCEPTED BILL)
b a n k in g se cto r c o u ld also accept b ills . W h e re th is occurs, th e b ill is k n o w n as a non-bank bill, b u t in
bill of exchange that
p ra ctice n e a rly a ll b ills in A u s tra lia are accepted b y ba nks. has been accepted or
The g ro w th o f th e A u s tra lia n b ill m a rk e t since 1 9 9 0 is s h o w n in Table 10.4. endorsed by a bank
NON-BANK BILL
bill of exchange
TABLE 10.4 Bills on issue ($ billion), 1990-2013 that has been
neither accepted nor
D a te B ills o n issue
endorsed by a bank
June 1990 68.3
June 1995 59.1
June 2000 76.4
June 2005 91.4
June 2010 138.1
June 2011 125.9
June 2012 121.8
June 2013 110.7

Source: Table D2; Reserve Bank of Australia website, www.rba.gov.au.
B usiness finance
BILL DISCOUNT
FACILITY Bill facilities
agreement in which M a n y co m p a n ie s do n o t r e s tr ic t t h e ir use o f b ill fin a n c in g to th o se occasions w h e n th e y re q u ire fu n d s to
one entity (normally
m e e t t h e ir im m e d ia te needs, a n d in s te a d m a in ta in a c o n tin u in g b ill fa c ilit y w ith a b a n k .15 A b ill fa c ility
a bank) undertakes
to discount (buy) bills m a y be e ith e r a d is c o u n t f a c ility o r an acceptance fa c ility . In a bill discount facility, th e b a n k u n d e rta k e s
of exchange drawn to d is c o u n t (b u y ) b ills o f exchange d ra w n b y th e b o rro w e r u p to a sp e cifie d t o ta l a m o u n t— t h a t is, th e
by another entity (the b a n k p ro m is e s to le n d u p to th e s p e c ifie d to t a l a m o u n t. F ro m th e b a n k s v ie w p o in t, th e a d va n ta g e o f th is
borrower) m e th o d o f le n d in g is t h a t th e b a n k h o ld s a m a rk e ta b le s e c u rity in th e fo r m o f th e b ill, w h ic h i t can la te r
BILL ACCEPTANCE sell i f i t w ish e s. Thus, w h ile th e b a n k is c o m m itte d to p ro v id in g th e fu n d s in itia lly , i t is n o t c o m m itte d to
FACILITY p r o v id in g th e fu n d s f o r th e f u ll te r m o f th e b ill. In a bill acceptance facility, th e b a n k agrees to accept
agreement in which
b ills d ra w n b y th e b o rro w e r u p to a sp e cifie d t o ta l a m o u n t. The c o m p a n y is th e n able to b o rro w elsew here
one entity (normally
a bank) undertakes in th e c a p ita l m a rk e t b y s e llin g b ills . T his is a re la tiv e ly easy ta s k because th e re is a re a d y m a rk e t f o r
to accept bills of b a n k b ills .
exchange drawn by B ill fa c ilitie s are o f tw o basic type s.
another entity (the
borrower) • A fully drawn bill facility p ro v id e s a co m p a n y w ith a s p e c ifie d a m o u n t f o r a s p e c ifie d p e rio d . In
th is case th e co m p a n y has to b o rro w th e f u ll a m o u n t, w h ic h is p ro v id e d b y is s u in g a series o f b ills .
N e w b ills are issu e d as th e e x is tin g b ills m a tu re — a process re fe rre d to as ‘r o llin g o v e r，a b i ll— u n t il
FULLY DRAWN BILL
th e agreed p e rio d o f th e f a c ility exp ire s. The in te re s t ra te is re ca lc u la te d each tim e a n e w b ill is
FACILITY
bill facility in which issued. F o r exa m ple, a 3 -y e a r fa c ilit y m a y be covered b y s ix 1 8 0 -d a y b ills . In som e in sta n ce s p a rtia l
the borrower must re p a y m e n t m a y be re q u ire d d u rin g th e p e rio d o f th e lo a n .
issue bills so that the • A revolving credit bill facility d iffe rs fr o m a f u lly d ra w n f a c ilit y in t h a t th e c o m p a n y is p e rm itte d
full agreed amount
to d ra w o n th e f a c ilit y as th e fu n d s are re q u ire d , p ro v id e d t h a t i t does n o t b o rro w m o re th a n th e
is borrowed for the
agreed to t a l a m o u n t. In th is re sp e ct a re v o lv in g c re d it f a c ilit y is s im ila r to a b a n k o v e rd ra ft.
period of the facility
REVOLVING CREDIT W it h in the se b ro a d categories, m a n y v a ria tio n s are p o ssib le . F o r e xa m p le , som e b i ll fa c ilitie s f ix in
BILL FACILITY advance th e in te re s t co st to th e b o rro w e r, w h ile o th e rs p ro v id e fu n d s a t th e c u rre n t m a rk e t rate, o r a t th e
bill facility in which
c u rre n t m a rk e t ra te su b je c t to an agreed m a x im u m ra te o r ‘cap’. G en erally, h o w e v e r，th e te r m a n d cost
the borrower can issue
bills as required, up to c o n d itio n s f o r b ill fa c ilitie s are as fo llo w s :
the agreed limit TERM: A c o m p a n y issues a b ill to o b ta in a s h o r t- te rm lo a n . U s u a lly th e te rm o f a b ill is 30, 60, 90, 120
o r 1 8 0 days. O fte n , h o w e ve r, a c o m p a n y w ill w a n t g u a ra n te e d access to s h o r t- te rm fu n d in g , a n d
w i ll seek a b ill f a c ility fo r, say, 3 years.
COSTS: The co st o f a b ill fa c ility has th re e e le m e n ts. T hey are th e fees f o r e s ta b lis h in g a n d m a in ta in in g
th e fa c ility , th e in te re s t cost a n d th e acceptance fee. The first element o f th e costs com p en sates
th e le n d e r f o r th e cost in c u rre d in e s ta b lis h in g a n d a d m in is te rin g th e fa c ility . T y p ic a lly , these
fees are expressed as a pe rcen ta ge o f th e a m o u n t o f th e fa c ility . The second element o f th e costs
is th e in te re s t co st re p re s e n te d b y th e d iffe re n c e b e tw e e n th e b ills face va lu e a n d th e p ric e p a id
b y th e d is c o u n te r. A t a n y g iv e n tim e , th e re is a m a rk e t-d e te rm in e d d is c o u n t ra te (expressed as
a y ie ld ) a p p lica b le to b ills w ith th e sam e te r m to m a t u r ity a n d c re d it-w o rth in e s s .16 A lth o u g h a ll
b ills t h a t have b e en accepted a n d /o r e n d o rse d b y a b a n k are n o r m a lly ca lle d b a n k b ills , th e re
can be s lig h t d iffe re n c e s in y ie ld , d e p e n d in g o n th e c re d it r a tin g o f th e b a n k in v o lv e d . Y ie ld s
in d ic a tiv e o f th o se a p p ly in g to b a n k b ills are s h o w n in Table 10 .5. The third element o f th e cost
o f a b ill f a c ilit y is th e acceptance fee. T his fee is th e a c c e p to rs r e tu r n f o r ta k in g on th e ris k s
a sso cia te d w ith th e b ill fa c ility . The m a in r is k is t h a t th e c o m p a n y m a y d e fa u lt o n its o b lig a tio n s
u n d e r th e fa c ility . The m a rg in cha rge d b y th e le n d e r depe nd s o n th e a m o u n t a n d te r m o f th e
fa c ilit y a n d th e s e c u rity g iv e n b y th e b o rro w e r.
F o r a b o rro w e r, th e re are a n u m b e r o f advan ta ge s in c h o o s in g b ill fin a n c e o v e r o th e r fo rm s o f s h o rt

te r m d e b t. The m a jo r ad van ta ge is access to m a rk e t-b a s e d f u n d in g sources th a t, w it h o u t th e c re d it-
w o rth in e s s p ro v id e d b y acceptance, w o u ld n o t be ava ila ble. A n o th e r im p o r t a n t a d va n ta g e is th e v a rie ty
o f b ill fa c ilitie s ava ila ble, w h ic h m eans t h a t b ill fu n d in g p ro v id e s f le x ib ilit y f o r th e b o rro w e r. H o w eve r,
15 A bill facility may also be offered by an investment bank or other financial institution. However, to simplify our discussion we
will assume that the facility is offered by a bank.
16 Participants in the bill market, like participants in the commercial paper market, typically agree on a yield, which is then
converted to a price using simple interest. For details, see Section 3.3.4.
C hapter ten S ources 〇卩 fin a n c e : debt
TABLE 10.5 Yields for 30-day, 90-day and 180-day bank accepted
bills, 2000-13
I D a te 3 0 - d a y y ie ld (% p .a .) 9 0 - d a y y ie ld (% p .a .) 1 8 0 - d a y y ie ld (% p .a .) I
30 June 2000 6.15 6.17 6.23
30 June 2005 5.62 5.66 5.69
30 June 2006 5.87 5.97 6.09
29 June 2007 6.34 6.43 6.58
30 June 2008 7.59 7.80 7.97
30 June 2009 5.87 5.97 6.09
30 June 2010 4.71 4.89 4.97
30 June 2011 4.91 4.99 5.06
29 June 2012 3.59 3.54 3.49
28 June 2013 2.82 2.82 2.81
Source: Table F I, Reserve Bank of Australia website, www.rba.gov.au.
fo r a b o rro w e r w it h a c re d it r a tin g e q u a l o r s u p e rio r to t h a t o f a b a n k th e re m a y be fe w i f a n y b e n e fits

associated w it h o b ta in in g b a n k acceptance. Thus, f o r the se b o rro w e rs , c o m m e rc ia l p a p e r m a y be an
a ttra c tiv e a lte rn a tiv e to b a n k b ills .
1 0 .5 .4 1 Debentures
A d e b e n tu re is a lo n g -te rm d e b t s e c u rity th a t, in A u s tra lia , is u n iq u e to com p an ies.
A d is tin g u is h in g fe a tu re o f m o s t d e b e n tu re s in A u s tra lia is t h a t th e lo a n is secured b y a charge o v e r
LEARNING
ta n g ib le p ro p e rty o f th e b o rro w e r.17 O th e r fe a tu re s o f d e b e n tu re s u s u a lly in c lu d e th e fo llo w in g :
OBJECTIVE 9
• th e in te re s t ra te payable b y th e b o rro w e r is fix e d a t th e tim e th e d e b e n tu re s are issued Identify and explain
the features of the
• th e te rm to m a t u r ity is fix e d a n d is u s u a lly in th e ran ge fr o m 1 ye a r to 5 years
main types of long
• p o te n tia l in v e s to rs m u s t be p ro v id e d w it h a p ro s p e c tu s
term debt securities
• th e s e c u rity o ffe re d to d e b e n tu re h o ld e rs w ill be e ith e r a fix e d charge o v e r sp e cific assets o r a flo a tin g
charge o ve r a p o o l o f assets
DEBENTURE
a type of fixed interest
• th e o w n e rs h ip o f d e b e n tu re s m a y be tra n s fe ra b le , so th e y can be lis te d o n an exchange such as
security issued by
th e ASX a company, usually
• d e ta ils such as th e n a tu re o f th e s e c u rity ( i f an y) f o r th e d e b e n tu re s, re p o rtin g re q u ire m e n ts , o th e r secured by a charge
o b lig a tio n s o f th e is s u e r a n d th e rig h ts o f d e b e n tu re h o ld e rs m u s t be set o u t in a t r u s t deed over tangible assets
• a tru s te e m u s t be a p p o in te d to p ro te c t th e in te re s ts o f d e b e n tu re h o ld e rs .18
17 Section 9 of the C o rp o ratio n s A c t 2 0 0 1 states that a debenture *may (but need not) include a security interest over property of
the body [the borrower] to secure payment of the money,. However, in practice, it appears that in Australia most debentures
are secured over property. ASICs Money Smart website advises that, *The issuer [borrower] may give you ... security for
repayment of your money. If that security is tangible property the notes can be called debentures* (see www.moneysmart.
gov.au/investing/investments-paying-interest/unlisted-debentures-and-unsecured-notes). Note also that, traditionally,
British (and Australian) terminology on this point is exactly the opposite of North American: in the former, debentures are
typically secured against assets, whereas in the latter they are not secured (see www.oxforddictionaries.com/definition/
american_english/debenture).
18 For details on pricing debentures, see Section 4.4.
feM i B usiness finance
The im p o rta n c e o f d e b e n tu re s as a source o f fin a n c e f o r A u s tra lia n co m p a n ie s has d e c lin e d in th e pa st

decade a n d o n ly a s m a ll n u m b e r o f d e b e n tu re issues are lis te d o n th e ASX. P u b lic issues o f de b e n tu re s
are exp e n sive because o f th e costs in v o lv e d in p re p a rin g a p ro s p e c tu s a n d m a n y co m p a n ie s have fo u n d
t h e ir d e b e n tu re t r u s t deed u n d u ly re s tric tiv e . M o s t co m p a n ie s are n o w able to o b ta in fix e d -in te re s t d e b t
fin a n c e a t lo w e r c o st b y ta k in g o u t a v a ria b le -ra te b a n k lo a n a n d th e n e n te rin g in to an in te re s t ra te swap.
T his m e c h a n is m is e x p la in e d in S e c tio n 1 7 .1 2 .2 .
M a n y d e b e n tu re issues in A u s tra lia are u n lis te d a n d /o r have n o t b e en ra te d b y on e o f th e ra tin g
agencies. C o n se q u e n tly, re lia b le a n d u p -to -d a te in fo r m a t io n o n p a r tic u la r d e b e n tu re issues has been
d iff ic u lt to o b ta in . R e g u la tio n has m o s tly fo cu se d o n tw o aspects: d is c lo s u re o f in fo r m a t io n th r o u g h th e
p ro s p e c tu s re q u ire m e n ts a n d m o n it o r in g o f p e rfo rm a n c e b y th e a p p o in te d tru s te e . In re c e n t years, th e re
have b e e n a n u m b e r o f h ig h -p ro file fa ilu re s o f d e b e n tu re issu ers, p a r tic u la r ly th o s e t h a t o n -le n d th e
fu n d s ra is e d th r o u g h a d e b e n tu re issue. O n e o f th e m o re n o ta b le fa ilu re s was t h a t o f B a n ksia F in a n c ia l
G ro u p in 2 0 1 2 (see F in a n ce in A c tio n ). In F e b ru a ry 2 0 1 3 , th e A u s tra lia n S e c u ritie s a n d In v e s tm e n ts
C o m m is s io n released a c o n s u lta tio n p a p e r t h a t p ro p o s e d s ig n ific a n tly t ig h t e r re g u la tio n o f d e b e n tu re
issuers.
Finance
in ACTION
BA N KSIA^ LESSON: INVESTORS, YOU ARE
ESSENTIALLY ALONE__________________________________________
T h e f a ilu r e o f B a n k s ia F in a n c ia l G r o u p in N o v e m b e r 2 0 1 2 r e ig n it e d d e b a te a b o u t th e r e g u la tio n
o f d e b e n t u r e issu e s in A u s t r a lia . O f c o u rs e , o f its e lf a f a ilu r e d o e s n o t n e c e s s a r ily im p ly t h a t t ig h t e r
r e g u la t io n is r e q u ir e d : in v e s tm e n t is r is k y a n d h a m - fis te d r e g u la t o r y a tte m p ts to r e d u c e r is k m a y in
th e lo n g ru n d o m o r e h a r m th a n g o o d . B u t, a ll o th e r th in g s b e in g e q u a l, s im ila r r e g u la tio n s s h o u ld
a p p ly in s im ila r c irc u m s ta n c e s . A c c o r d in g to f in a n c ia l jo u r n a lis t J o n a th a n S h a p ir o th e r e g u la t io n
o f d e b e n tu r e s is a t o d d s w it h th e r e g u la t io n o f b a n k s . T h e f o llo w in g is a n e x c e r p t f r o m a n a r t ic le
p u b lis h e d s o o n a f t e r th e B a n k s ia f a ilu r e w a s a n n o u n c e d .
T h e y s a id it w o u ld n e v e r h a p p e n a g a in . T h e c o lla p s e o f p r o p e r t y f in a n c in g f ir m W e s t p o in t w a s
b r a n d e d a 'n a t io n a l s h a m e 7 a n d s p a r k e d a r o y a l c o m m is s io n t h a t w a s m e a n t to o v e r h a u l th e
lo c a l r e g u la t o r y f r a m e w o r k a n d p r e v e n t a r e p e a t.
B u t it h a s h a p p e n e d a g a in .
T h e c o lla p s e o f B a n k s ia F in a n c ia l G r o u p , w h ic h h a s le ft $ 6 5 0 m illio n o f fu n d s in je o p a r d y ,
is ir r e f u t a b le p r o o f t h a t m o n e y lo s t b y in v e s to rs in W e s t p o in t w a s la r g e ly in v a in . M o r e
im p o r t a n tly , it is a t im e ly r e m in d e r t h a t in d iv id u a l in v e s to rs c a n n o t le a n o n th e r e g u la t o r to
p r o t e c t th e m .
T h e s ta r k e s t le s s o n fr o m th e c o lla p s e o f B a n k s ia — a n d s a d ly th e f a ilu r e s t h a t p r e c e d e d i t — is
th e v a s t g u lf b e t w e e n h e a v ily r e g u la t e d b a n k s a n d u n lis te d , u n r a t e d in s titu tio n s t h a t e s s e n tia lly
e n g a g e in b a n k - lik e a c t iv itie s .
B a n k s ia 's b u s in e s s m o d e l w a s n o t d is s im ila r to t h a t o f a b a n k . It b o r r o w e d m o n e y fr o m th e
p u b lic b y is s u in g d e b e n t u r e s a n d th e n le n t th e fu n d s to th e p u b lic b y f in a n c in g r e s id e n t ia l a n d
c o m m e r c ia l m o r t g a g e s . B u t d e s p ite its b u s in e s s a n d u n lik e its n a m e , it w a s n o t e v e n c lo s e to
b e in g a b a n k .
B a n k s , o r r e g u la t e d a u t h o r is e d d e p o s it - ta k in g in s titu tio n s (A D Is ) a r e c a r e f u lly m o n it o r e d
b y th e A u s t r a lia n P r u d e n tia l R e g u la tio n A u t h o r it y (A P R A ), w h ic h is ta s k e d w it h e n f o r c in g th e
B o n k in g A c f a n d p r o t e c t in g d e p o s it o r s 7 fu n d s .
M o s t b a n k s m u s t h o ld $ 1 0 o f c a p it a l f o r e v e r y $ 1 0 0 o f lo a n s w r itt e n .
B a n k s ia h a d le ss t h a n $ 3 . 6 0 f o r e v e r y $ 1 0 0 o f lo a n s . S o w h e n a r e v ie w o f th e lo a n b o o k
r e v e a le d m o r e lo s s e s , it d i d n 't t a k e m u c h f o r d e b e n t u r e in v e s to r s to h a v e t h e ir fu n d s t h r e a t e n e d .
Source: 'Banksia's lesson: investors, you are essentially alone', Jonathan Shapiro, Australian Financial Review,
3 November 2012.
1 0 .5 .5 1 Unsecured notes
U n secu red n o te s are s im ila r to d e b e n tu re s , b u t d iffe r in t h a t h o ld e rs are u s u a lly u n se cu re d c re d ito rs w h o
ra n k b e lo w a n y secured c re d ito rs f o r re p a y m e n t o f d e b t. H o w e ve r, in som e cases, d e sp ite t h e ir na m e,
un secu red notes* m a y be secu red b y a charge o v e r shares o r o th e r in ta n g ib le assets. A re la te d d iffe re n c e
is th a t a t r u s t deed f o r u n se cu re d n o te s w ill u s u a lly in c lu d e co ve n a n ts t h a t are less re s tric tiv e th a n th o se
in a d e b e n tu re t r u s t deed. F ro m th e h o ld e r s p o in t o f vie w , th e re fo re , u n s e c u re d n o te s are a ris k ie r
in v e s tm e n t th a n d e b e n tu re s. T o com p en sate f o r th e g re a te r r is k o f u n se cu re d n o te s , a c o m p a n y u s u a lly
o ffe rs a h ig h e r in te re s t ra te o n u n s e c u re d n o te s th a n o n d e b e n tu re s.
In c o n tra s t to a d e b e n tu re , w h e re th e in te re s t ra te is fix e d , th e in te re s t ra te o n a n o te m a y v a ry b y
b e in g lin k e d to an in d ic a to r ra te such as th e b a n k -b ill sw ap ra te (BBSW ). N o te s o f th is ty p e are re fe rre d to
as 'flo a tin g -ra te notes*. Som e flo a tin g -ra te n o te s are lis te d o n th e A u s tra lia n S e cu ritie s Exchange. M a n y
o f these se cu ritie s have b e en issu e d b y fin a n c ia l c o rp o ra tio n s such as b a n ks a n d in s u ra n c e co m p a n ie s b u t
issuers have also in c lu d e d O r ig in E nergy, C a lte x A u s tra lia a n d W o o lw o rth s .
1 0 .5 .6 1Corporate bonds
In th e A u s tra lia n m a rk e t, th e te r m c o rp o ra te b o n d , g e n e ra lly re fe rs to lo n g -te rm d e b t s e c u ritie s w ith
cou po n p a y m e n ts e ve ry 6 m o n th s based o n a d e fin e d ra te o f in te re s t, issu e d b y n o n -g o v e rn m e n t e n titie s
in a m o u n ts o f a t le a st $ 5 0 0 0 0 0 p e r in v e s to r. In A u s tra lia , th e d is tin c tio n b e tw e e n a c o rp o ra te b o n d a n d a
d e b e n tu re is s o m e w h a t b lu rre d , b u t a d e b e n tu re is u s u a lly secured b y a charge o v e r ta n g ib le assets o f th e
b o rro w e r, w hereas a c o rp o ra te b o n d m a y o r m a y n o t be secu red .19 In a d d itio n , a d e b e n tu re o ffe rs a fix e d
co u p o n rate, w hereas a c o rp o ra te b o n d m a y o ffe r a fix e d o r flo a tin g c o u p o n rate.
U sually, b o n d s issu ed o n th e se te rm s are p lace d p riv a te ly , m o s tly w it h in s titu t io n a l in v e s to rs , a n d are
n o t lis te d o n a s to c k exchange. Som e co m p a n ie s, in c lu d in g H e rita g e B a n k a n d P en ta g o n C a p ita l, have
issued lo n g -te rm d e b t s e c u ritie s d e sig n e d to a p pe al to in d iv id u a l in v e s to rs . In ^re ta il1 c o rp o ra te b o n d
issues, th e m in im u m in v e s tm e n t is m u c h s m a lle r, c o u p o n p a y m e n ts m a y be m ade q u a rte rly o r m o n th ly
and th e se cu ritie s m a y be lis te d o n th e ASX. The co ve n a n ts used f o r c o rp o ra te b o n d s are u s u a lly less
re s tric tiv e th a n th o se in a d e b e n tu re t r u s t deed.
W h ile A u s tra lia n b a n ks fa v o u r lo a n s a n d s e c u ritie s w it h e x te n s iv e c o v e n a n t p ro te c tio n , fo re ig n b a n ks
w ill co n sid e r d e b t w it h few , i f any, co ve n a n ts. T his so ca lle d c o v e n a n t-lig h t1 d e b t p la ye d an im p o r t a n t
ro le in th e s tr u c tu r in g o f a n a tte m p t b y A ir lin e P a rtn e rs A u s tra lia (APA) to acq uire a n d p riv a tis e Q a n ta s
A irw a y s (see F ina nce in A c tio n ).
Finance
APA USES CASH TO REDUCE RISKS IN QANTAS BID___________
in ACTION
A P A , a c o n s o r tiu m t h a t in c lu d e d M a c q u a r ie B a n k a n d T e xa s P a c ific , o f f e r e d to p a y $1 3 . 5 b illio n
f o r Q a n ta s , f in a n c e d b y a b o u t $ 1 0 b illio n o f d e b t a n d th e re s t e q u ity . G iv e n t h a t Q a n ta s h a d n e t
d e b t o f $ 4 . 8 b illio n , its d e b t w o u ld b e m o r e th a n d o u b le d , in c r e a s in g th e e x p e c te d re tu rn s , a n d
ris k s , f o r e q u ity h o ld e rs . T h e le v e l o f d e b t in le v e r a g e d b u y o u t tr a n s a c tio n s is t y p ic a lly asse sse d
b y c a lc u la t in g th e r a t io o f th e v a lu e o f d e b t to e a r n in g s b e f o r e in te re s t, ta x , d e p r e c ia t io n a n d
a m o r tis a t io n (E B IT D A ). T h e f o llo w in g e x c e r p t o u tlin e s a n in n o v a t iv e a p p r o a c h u s e d to s tru c tu re th e
f in a n c in g o f th e p r o p o s e d Q a n t a s p r iv a t is a tio n .
R e c e n t le v e r a g e d b u y o u t t r a n s a c t io n s in A u s t r a lia h a v e b e e n s tru c k a t a d e b t-to -E B lT D A m u ltip le

o f 7 . 5 tim e s . O f th a t, a b o u t 6 m u ltip le p o in ts is s e n io r d e b t a n d th e b a la n c e s u b o r d in a t e d .
continued
19 The Australian Securities and Investments Commission regards a debenture as a type of corporate bond, the main distinction
being that 'To be called a debenture, a corporate bond must be secured against property. Corporate bonds generally may or
may not be secured against property* (Australian Securities and Investments Commission, 2010, p. 6). In the US, corporate
bonds are senior securities', whereas debentures are unsecured. Hence, in most cases, an Australian debenture would be
called a corporate bond in the US, while an Australian corporate bond would be called a debenture in the US.
B usiness finance
continued
G iv e n Q a n t a s h a s a m o r e v o la t ile e a r n in g s p r o f ile , le v e r a g e in th is p r iv a t is a t io n is n o t a s
h ig h a t 6 . 4 tim e s E B IT D A . A p p ly i n g t h a t t y p ic a l L B O s tru c tu re w o u ld h a v e r e s u lte d in a s e n io r
d e b t le v e l o f 5 . 2 tim e s a n d th e re s t s u b o r d in a t e d .
T h e p r o b le m is t h a t s e n io r d e b t c o m e s w it h m y r ia d c o v e n a n ts th a t, if b r e a c h e d , c a n re s u lt
in th e le n d e r s s e e k in g r e m e d ia l a c t io n , e v e n f o r e c lo s in g . A t y p ic a l c o v e n a n t w o u ld b e t h a t
E B lT D A -to -in te re s t c o v e r c o u ld n o t f a ll b e lo w a s p e c if ie d le v e l.
If a h ic c u p o c c u r s th e o w n e r s c a n q u ic k ly f in d th e m s e lv e s in a n a s ty s itu a tio n . B u t th is is th e
a i r lin e in d u s tr y a n d th e re a r e a lw a y s t e m p o r a r y s h o c k s . It's n o t lik e th e b u s in e s s is in d a n g e r o f
g o in g b r o k e .
S o e s s e n t ia lly M a c q u a r ie h a d e n lis te d f iv e b a n k s to t r y a n d f it a s q u a r e p e g in to a r o u n d
h o le . M o r g a n S ta n le y , w h ic h w a s n o t in v it e d to t e n d e r f o r th e d e b t p a c k a g e , h a d a s tro n g
r e la t io n s h ip w it h T e x a s P a c ific a n d c o u ld s e e th e p r o b le m . S o it k n o c k e d o n th e d o o r to p r e s e n t
a n a lt e r n a t iv e s tru c tu re — th e o n e u ltim a t e ly a d o p t e d .
O f th e $ 1 0 b illio n in d e b t , h a lf w o u ld b e in th e f o r m o f t r a d a b le b o n d s b a c k e d b y a ir c r a f t
le a s e s . T h e b a la n c e is a la y e r o f f ix e d a n d f lo a t in g - r a t e n o te s , d e n o m in a t e d in d if f e r e n t
c u r r e n c ie s , a n d f in a lly , s u b o r d in a t e d d e b t . T h e b e a u ty is t h a t th e r e a r e n o c o v e n a n ts o n th e
b o n d s , k n o w n a s e n h a n c e d e q u ip m e n t tru s t c e r t if ic a te s . T h e o n ly r e q u ir e m e n t is to m e e t
th e $ 9 0 0 m illio n in a n n u a l in te r e s t p a y m e n ts . T h a t’s it. It’s a f a r s im p le r a n d m o r e s u ita b le
f in a n c in g s tru c tu r e th a n s e n io r d e b t .
To e n s u r e in te r e s t p a y m e n ts c a n a lw a y s b e m e t, A P A w i ll k e e p $ 2 b i lli o n in c a s h a s a
b u ffe r . It a ls o h a s a $ 9 5 0 m illio n c r e d it lin e 'r e v o lv e r ', w h ic h a g a i n is f r e e o f th o s e a n n o y in g
c o v e n a n ts .
R ic k S c h ifte r o f T e x a s P a c ific w a s so a p p r e c ia t iv e o f th e w o r k M o r g a n S ta n le y in N e w Y o rk
d i d t h a t h e s h ip p e d th e m t w o c a s e s o f B a r o s s a V a lle y E & E B la c k P e p p e r S h ir a z 2 0 0 1 . A t $ 7 0
a p o p it's a s m o k y a n d d u s ty , b u t b y a ll a c c o u n ts w o n d e r f u l, d r o p .
Source: 'Two cases of shiraz for innovative debt structuring7, Brett Clegg, Australian Financial Review, 15 December 2006.
S ta tis tic s o n th e va lu e o f lo n g -te rm n o n -g o v e rn m e n t d e b t s e c u ritie s issu ed b y A u s tra lia n b o rro w e rs

are s h o w n in Table 10 .6. Panel A sho w s th e s e c u ritie s issu ed in th e A u s tra lia n d o m e s tic m a rk e t to d o m e s tic
in v e s to rs , w h ile Panel B covers s e c u ritie s issu ed in th e c a p ita l m a rk e ts o f o th e r c o u n trie s . The issuers o f
the se s e c u ritie s are d iv id e d in to th re e categories:
a banks, finance companies and other financial institutions

b ‘non-financial corporations’ consisting of industrial and mining companies
C issuers of asset-backed securities.
A sse t-b a cke d se c u ritie s are m a rk e ta b le d e b t s e c u ritie s issu e d b y spe cia lise d e n titie s associated
w ith fin a n c ia l in s titu tio n s , a n d the se s e c u ritie s are ba cked b y n o n -m a rk e ta b le fin a n c ia l assets such as
m o rtg a g e lo an s a n d c re d it card receivables. In th e A u s tra lia n m a rk e t, m o s t o f the se issues have been
backed b y re s id e n tia l m o rtg a g e s. W h e n asset-backed s e c u ritie s are c o m b in e d w it h th o s e issu ed b y
b a n ks a n d o th e r fin a n c ia l c o rp o ra tio n s , i t is cle ar t h a t m o s t o f th e c o rp o ra te b o n d s issu e d b y A u s tra lia n
b o rro w e rs are issu ed b y fin a n c ia l in s titu tio n s . B la ck e t al. (2 0 1 2 ) e s tim a te d t h a t in th e p e rio d J u ly 2 0 0 7
to D e cem b er 2 0 1 1 , th e f o u r m a jo r b a n ks a cco u n te d f o r a b o u t 6 0 p e r c e n t o f a ll p riv a te s e c to r asset-backed
b o n d s, d e b e n tu re s a n d u n se cu re d b o n d s o n issue.
The c o rp o ra te b o n d m a rk e t in A u s tr a lia has g ro w n r a p id ly sin ce 1 9 9 5 w h e n th e v a lu e o f lo n g
te r m n o n -g o v e rn m e n t d e b t s e c u ritie s o n issu e w as a b o u t $ 2 1 b illio n . A s s h o w n in T a b le 1 0 .6 , th e
BOND m a rk e t re a ch e d $ 2 4 9 b illio n in J u n e 2 0 0 7 , b u t as n o te d a b o ve m o s t o f th e ‘c o rp o ra te ’ b o n d s are issu ed

debt security issued b y b a n k s a n d o th e r fin a n c ia l in s t it u t io n s ra th e r th a n b y n o n - fin a n c ia l c o m p a n ie s . The g r o w th ra te
with a medium or sin ce 2 0 0 7 has s lo w e d s o m e w h a t a n d as a t J u n e 2 0 1 3 s to o d a t ju s t o v e r $ 3 0 0 b illio n . I n M a y 2 0 1 0 ,
long term to maturity A S IC is s u e d R e g u la to ry G u id e 2 1 3 Facilitating debt raising to e n co u ra g e th e d e v e lo p m e n t o f th e r e ta il
by borrowers such
c o rp o ra te b o n d m a rk e t b y s im p lif y in g th e d is c lo s u re re q u ire m e n ts f o r V a n illa * b o n d s. B o n d s m a y be
as governments,
state authorities and d e s c rib e d as V a n illa 1 i f th e y do n o t ha ve a n y u n u s u a l o r c o m p le x te rm s o r c o n d itio n s . A S IC d e fin e d
corporations in return th e m as u n s u b o rd in a te d , n o n - c o n v e r tib le b o n d s d e n o m in a te d in A u s tr a lia n d o lla rs w i t h a fix e d te r m
for cash from investors o f 10 ye a rs o r less a n d th e p r in c ip a l re p a y a b le a t m a t u r ity , is s u e d a t th e sam e p ric e to a ll in v e s to rs
TABLE 10.6 Long-term non-government debt securities outstanding ($ billion)

1995- 2013
A Long-term non-government debt securities issued in Australia by Australian
borrowers to Australian resident investors
B a n ks a n d
o th e r fin a n c ia l N o n - fin a n c ia l
D a te c o rp o ra tio n s c o rp o ra tio n s A sse 卜
backed Total
June 1995 7.9 6.0 7.2 21.1
June 2000 19.4 17.3 24.5 61.2
June 2005 48.0 38.8 79.3 166.2
June 2006 64.0 42.3 98.9 205.3
June 2007 78.2 48.3 122.3 248.8
June 2008 99.4 45.4 111.5 256.3
June 2009 135.4 41.4 98.5 275.3
June 2010 172.1 40.6 80.6 293.3
June 2011 188.4 43.5 84.1 316.0
June 2012 187.3 45.3 86.1 318.7
June 2013 166.6 49.0 89.4 305.0
B Long-term non-government debt securities issued offshore by Australian

borrowers
B a n ks a n d
o th e r fin a n c ia l N o n - fin a n c ia l
D a te c o rp o r a tio n s c o rp o r a tio n s A s s e t-b a c k e d Total
June 1995 33.7 29.1 1.4 64.2
June 2000 72.3 33.6 20.1 125.9
June 2005 183.5 74.2 65.3 323.0
June 2006 206.3 77.2 72.3 355.7
June 2007 225.3 87.6 100.2 413.1
June 2008 262.8 90.4 68.4 421.5
June 2009 295.9 104.8 57.9 458.6
June 2010 355.8 114.5 35.3 505.6
June 2011 341.9 129.1 23.4 494.4
June 2012 331.6 148.2 17.7 497.6
June 2013 331.7 165.7 15.2 512.6

Source: Table D4, Reserve Bank of Australia website, www.rba.gov.au.
and paying interest on specified dates at e ither a fixed rate or a flo a tin g rate com prising a m arket
indicator rate plus a fixed m argin. Nevertheless, i t appears th a t fu rth e r steps w ill be needed i f the
retail corporate bond m arket is to grow.
1 B usiness finance
The volume o f bonds issued offshore by Australian borrowers is considerably larger than the volume
issued onshore and, as shown in Table 10.6, the largest Australian issuers o f bonds in offshore markets
are financial institutio ns, o f which banks are the largest borrowers. Moreover, the value o f financial
corporations* bonds on issue in offshore markets has typically been roughly double the value o f th eir
domestic bonds. Issues by non-financial corporations have also grown significantly b u t are less than
one-third o f the total. Issues o f asset-backed securities grew rapidly u n til 2007 b ut have since declined
considerably, reflecting the effects o f the global financial crisis on the popularity o f securitisation.
Some indication o f the reasons fo r issuing bonds offshore rather than domestically can be obtained by
examining the characteristics o f issues made by Australian borrowers in the two markets. The main reason
appears to be th a t offshore markets, particularly the US market, have greater capacity to absorb securities
o f lower credit quality.20 For both the financial and the non-financial sectors, the credit ratings o f Australian
domestic bond issues are higher, on average, than those o f offshore issues. As shown in Table 10.7, almost
all Australian bond issuance has been lim ited to the three highest ratings o f AAA, AA and A.
TABLE 10.7 Australian corporate bond and debenture issuance: percentage of

total issuance by rating
R a tin g
P e rio d __A A A _ AA A BBB
1983-89 32 57 11 0
1990-92 22 70 8 0
1993-June 2007 28 46 22 3
July 2007-2011 30 45 19 7
Source: S. Black, J. Kirkwood, A. Rai & T. Williams, 'A history of Australian corporate bonds7, Research Discussion Paper
No. 2012-09, Reserve Bank of Australia, December 2012.
Issuing bonds in a variety o f offshore markets also provides a larger and more diversified funding
base, which can be advantageous i f markets differ in terms o f the costs and availability o f funds. Financial
intermediaries such as banks are known to prefer a diversified funding base.
O ther reasons th a t have been suggested fo r issuing offshore include differences in te rm to m aturity,
amounts borrowed and currency o f denom ination. However, these do n o t appear to be m ajor factors. For
a sample o f domestic and offshore bond issues by Australian banks from 2001 to 2006, the m aturities
o f both types ranged from 3 to 5 years. Larger issues are possible in offshore markets, b ut in practice
domestic and offshore issues tend to be sim ilar in size. For the 2001 to 2006 sample, the average domestic
issue by Australian banks was $304 m illio n while the average offshore issue was $356 m illion.
M ost offshore issues are denominated in foreign currency, p rim a rily US dollars although there have
FOREIGN BOND been significant issues in euro and yen. Issuers almost invariably hedge against foreign currency risk,
bond issued outside m ainly by swapping the foreign currency back in to Australian dollars.21 Therefore, w hile gaining access
the borrower's country to a broader range o f investors may be im p orta nt, exposure to different currencies does n ot appear to be
and denominated in
a m otivating factor. Comparisons o f the interest cost o f domestic bond issues and offshore issues, after
the currency of the
country in which it is allowing fo r the cost o f hedging, show th a t there is no systematic cost difference between the domestic
issued and offshore markets. Bonds issued by an Australian borrower in a foreign country and denominated in
Eurobond the currency o f th a t country are known as foreign bonds. Examples include bonds denominated in US
medium- to long-term dollars and issued in the US domestic m arket by offshore borrowers and bonds denominated in yen and
international bearer issuedin Jap an byo ffsh o re bo rro w e rs.
security sold in
Australian companies can also raise funds offshore by issuing Australian dollar Eurobonds. Eurobonds
countries other than
the country of the
are medium - to long-term securities sold in countries other than the country o f the currency in which the
currency in which the bond is denominated. An Australian dollar Eurobond is a debt security denominated in Australian dollars
bond is denominated b ut issued outside Australia w ith a view to attracting non-Australian investors.
20 For a more detailed discussion of this topic see Battellino (2002). Facts and statistics in the next two paragraphs are also
drawn from Reserve Bank of Australia (August 2006). See also Black et al. (2010).
21 For further discussion of this process, see Section 17.12.3.
C hapter ten S ources of f in a n c e : debt
10.6 Project finance

Project finance is a technique th a t is commonly used to raise funds fo r m ajor m ining and natural resource
projects, infrastructure such as power stations, pipelines and to ll roads, to u ris t resorts and other property LEARNING
OBJECTIVE 10
developments.22 I t can also be used to fund the acquisition o f assets th a t w ill be used in large industrial
operations. Partly because Australia has a large m ining sector, project finance has frequently been used the main features of
in Australia.23 project finance
Project finance has been defined as:
A method of raising long-term debt financing for major projects through 'financial engineering, based
on lending against the cash flow generated by the project alone; it depends on a detailed evaluation of a
projects construction, operating and revenue risks, and their allocation between investors, lenders and
other parties through contractual and other arrangements. (Yescombe, 2002, p. 1)
This d efinition shows th a t an im p o rta n t feature o f project finance loans is th a t the lenders rely
essentially on the cash flows o f a single project as the source o f the loan repayments. The projects
involved are usually large and the loans required can exceed $1 billion. For example, Transurbans City
Link to ll road project in M elbourne cost $1.7 billion , o f which $1.25 b illio n was provided by lenders.
W ith such large projects it is usual fo r a syndicate o f lenders to provide funds so the credit risk is spread
between them.
10.6.1 | The main features of project finance

Each project is unique and there is no such th in g as Standard* project finance, b ut several features th a t are
common to many project finance transactions can be identified. These include:
• The project is established as a special purpose legal e n tity whose sole business a ctivity is the
project. This e n tity is the legal owner o f the project assets and is the borrow er in all project finance
loans. The special purpose e n tity is usually a company b ut in some cases a partnership, u n it tru s t
or unincorporated jo in t venture may be used. For sim plicity we w ill refer to this e n tity as the
‘project com pany'
• Project finance is usually raised to undertake a new project rather than a business th a t is already
established.
• A high p roportion o f debt finance is used. In typical cases debt may provide 70 to 90 per cent o f the
cost o f the project. The project sponsors who own equity in the project company provide the balance
o f the funds.
• The lenders* decision on w hether to provide funds is based on the expected cash flows and assets
o f the project rather than on the assets and financial positions o f the project sponsors.
• The debt finance is provided on a limited-recourse basis, which means th a t the project sponsors
provide only lim ite d guarantees in relation to the project debt. Typically, these guarantees allow
lenders to claim against the sponsors only u n til the project is constructed and becomes operational.
Thereafter, the lenders rely entirely on the project s cash flows and assets.
• The main security fo r lenders is in the form o f intangible assets, such as the project company s
contracts or rights to natural resources. I f the project company s tangible assets have to be sold
follow ing default on the debt finance, th e ir m arket value is likely to be much lower than the
outstanding debt.
• Project finance loans are generally fo r much longer terms than norm al corporate loans. However, the
life o f a project is finite, and the loans m ust be repaid by the end o f th a t life. In contrast, lenders th a t
provide corporate loans are concerned to see th a t the company has the capacity to pay interest on
the loan but w ill assume th a t the company s debt is likely to be rolled over when it matures.
22 This section relies heavily on Yescombe (2002), Chapter 2.

23 For example, in 2012 Australian-based projects secured project finance of US$42 billion, representing more than 20 per cent
of the years global total of US$195 billion (Australian Trade Commission, 2013).
B usiness finance
10.6.21 When is project finance a 什「active?

In addition to the usual features o f project finance outlined above, the assessment and management o f
risk is a v ita l p a rt o f any project finance transaction. Lenders m ust be confident n ot only th a t the project
is technically sound b ut also th a t the project can be completed w ith in the budgeted capital cost and that
its operation w ill generate sufficient cash flows to service the debt. I t follows th a t lenders need to evaluate
carefully the term s o f any project contracts th a t may affect its construction and operating costs. They also
need to ensure that, wherever possible, project risks fa ll on parties other than the project company. For
example, i f the project involves construction and operation o f a power station, the lenders may require
that a government a uth ority guarantees to purchase all o f the output.
The process o f evaluating risks and negotiating suitable contracts can be slow, complex and costly,
so the m argin th a t lenders charge over th e ir cost o f funds can be considerably higher than fo r norm al
corporate loans. Therefore, any suggestion th a t project finance loans are 4cheap debt* is false. Despite the
higher cost o f debt, project finance can be viable in cases where the operating cash flows are relatively
predictable so the low risk o f the project allows a high p ro po rtio n o f debt to be used. High financial
leverage can gear the rate o f return on equity to an attractive level, while the limited-recourse nature
o f project debt reduces the risk exposure o f equity investors. I t is common fo r the original debt to be
refinanced when the project reaches completion and many o f the original risks have been resolved. In
some cases, refinancing p rio r to completion can achieve significant savings in interest costs (see Finance
in Action).
Finance
in ACTION
REFINANCING OF CQNNECTEASrS DEBT FACILITIES_________
C o n n e c t E a s t G r o u p is e x p e c t e d t o a n n o u n c e a r e f in a n c in g o f its $ 2 . 1 b i l l i o n d e b t f a c il it ie s
t o d a y a m i d s p e c u la t io n t h a t t h e g r o u p , o w n e r o f th e E a s t lin k t o ll r o a d , is u p t o a y e a r
a h e a d o f s c h e d u le o n t h e c o n s t r u c t io n t im e t a b le .
T h e d e a l h a s im p r o v e d th e te rm s o f th e g r o u p 's f in a n c in g o n th e p r o je c t in s o u th -e a s t
M e lb o u r n e . In te re s t o n d e b t d u r in g th e c o n s tr u c tio n p h a s e is s e t to f a ll b y 4 0 b a s is p o in ts to
1 1 0 b a s is p o in ts J ° ) It w i ll r e m a in a t th is le v e l f o r th e fir s t t w o y e a r s o f o p e r a t io n s o n c e th e r o a d
h a s o p e n e d . It h a d b e e n s e t to in c r e a s e to 1 6 5 b a s is p o in ts d u r in g th is p e r io d .
T h is is s e t t o s a v e 1 .3 c e n ts a u n it e a c h y e a r , w h ic h w i ll b e a v a ila b le to s u p p o r t d is tr ib u tio n s .
T h is a m o u n t r e p r e s e n ts 2 0 p e r c e n t o f th e 6 . 5 c e n ts in d is t r ib u t io n s p a id b y th e g r o u p f o r th e
y e a r to J u n e 3 0 . T h e r e f in a n c in g is th e f ir s t o f its k in d o n a g r e e n fie ld s to ll r o a d p r o je c t in
A u s t r a lia a n d in v o lv e d a c o n s o r tiu m o f s e v e n b a n k s .
Source: 'ConnectEast may refinance debt facilities', Henry Byrne, Australian Financial Review, 21 December 2006, p. 36.
In this article, the interest on debt is expressed as a margin over a benchmark rate such as the bank-bill swap rate.
In summary, project finance does n ot allow projects th a t should be rejected as uneconomic to become
viable through ^financial magic*. However, through the use o f measures such as jo in t ventures to spread
risk and careful contracting to allocate risks to parties who are best placed to bear them, m ajor projects
that would be d iffic u lt fo r any single company to im plem ent can often go ahead.
LEARNING
OBJECTIVE 11
10.7 Hybrids of debt and equity
the features of In this section we consider securities th a t have characteristics common to both debt and equity and
securities that have the are therefore regarded as hybrids. Australia has an active m arket in hybrid securities. Some hybrids are
characteristics of both complex b ut m ost are based on a convertible note or a preference share. Because convertible notes are
debt and equity simpler, they are discussed first, followed by preference shares.
4^^
10.7.1 | Convertible notes and convertible bonds

Convertible notes and convertible bonds are usually unsecured debt th a t is issued fo r a fixed term at a
fixed interest rate, w ith the additional feature th a t the holder has the rig h t to convert the note or bond
to ordinary shares at a specified date(s). For sim plicity, in this section we refer to both types o f security
as ^convertibles*. CONVERTIBLE
In effect, the purchaser o f a typical convertible acquires a fixed-interest security plus an option to security issued for a
fixed term, usually at a
purchase ordinary shares in the company at a specified conversion price. As a result, convertible holders
fixed interest rate, with
gain from an increase in the company s share price. Assume th a t a company issues 10-year, 8 per cent the additional feature
convertibles w ith a face value o f $10, th a t at m a tu rity can be converted to shares at a conversion ratio that the holder has the
o f 1 -fo r-l. The holder w ill convert i f the price o f the company s shares on the note s m a tu rity date is right to convert the
above $10. For example, i f the share price at th a t tim e is $11, the holder w ill make a gain o f $1 on each security to ordinary
shares on a specified
security by converting, rather than allowing the securities to be redeemed. I t is usual fo r convertible
future date or dates.
holders to be able to participate in new issues, such as rights issues and bonus issues, in the same ratio as Convertibles issued in
if the securities had already been converted. I t is also usual fo r issuers to give holders the o p p o rtu n ity to Australia are usually
convert the notes into shares immediately, i f there is a takeover offer fo r the issuing company. called convertible
Investors accept lower interest rates on convertibles than they do on notes or bonds because the notes but may be
called convertible
option inherent in a convertible is valuable. The conversion price can be set at an am ount th a t is greater
bonds
than the current m arket price o f the company s shares because the option to convert w ill have a value,
provided that there is some chance th a t the share price may eventually exceed the conversion price.
Convertibles typically have terms o f up to 10 years, which make them attractive to issuers requiring
long-term, fixed-rate debt finance. Because convertibles are unsecured they can be issued by companies
whose existing assets are pledged as security fo r other loans. As long-term securities, convertibles are
a natural investm ent fo r life insurance companies and superannuation funds, which have long-term
liabilities.
Convertibles can be issued to existing shareholders or by a placement to in s titu tio n s . Placements o f
convertible notes by listed companies are restricted under ASX lis tin g rule 7.1, the *15 per cent rule',
which provides th a t issues o f E q uity securities* w ith o u t shareholder approval are restricted to no more
than 15 per cent o f a company s issued ordinary shares in any 12-m onth period. Since convertible
notes are convertible in to o rd in a ry shares, they are defined as equity securities by the ASX. In February
2014, 185 issues o f convertible debt were listed on the ASX.24 These securities had been issued by
136 companies.
The convertible fram ew ork allows scope fo r innovative security design, and some issues by Australian
companies have been undated a nd /or subordinated. Undated convertibles can usually be converted to
ordinary shares at any tim e during a specified period, which may be several years. I f a holder does n ot
exercise the rig h t o f conversion by the final date, the convertibles become irredeemable or ‘perpetual’
debt. Therefore, such notes w ill generally be treated as equity fo r the purpose o f calculating balance sheet
ratios used in loan agreements, b u t can be designed so th a t they w ill be treated as debt fo r tax purposes.
Why do companies issue convertibles?

Convertibles may appear to be ‘cheap’ debt— the interest rates on convertible debt securities are lower
than fo r straight debt, while they also allow companies to issue shares at a prem ium , over the current
price. For example, a company th a t could borrow at an interest rate o f 8 per cent and whose current
share price is $9 may issue a 5-year convertible w ith a coupon interest rate o f 6 per cent and a face
value o f $10, convertible in to ordinary shares on a 1 -fo r-l basis. A m om ents reflection should show
that there m ust be som ething wrong w ith this suggested explanation. I f convertibles really offer cheap
finance*, they should be m uch more popular than they are. In a com petitive m arket, convertibles should
be issued on terms th a t are fa ir fo r both issuers and investors, rather than being cheap fo r issuers and
hence under-rewarding fo r the investors. The interest rate on a convertible debt w ill be lower than on
24 Most of these securities were described as convertible notes. Some were described as convertible bonds or convertible
debentures. Convertible preference shares were excluded from this count.
otherwise equivalent debt sim ply because i t also provides an option to convert the security in to shares.
This o ptio n is valuable, so its value is reflected in the lenders requiring a lower interest rate than they
would on ordinary debt.
SWEETENED DEBT Traditionally, tw o types o f convertible have been distinguished: those described as sw eetened debt
convertible which is and those described as delayed equity.25 This d istin ction plays an im p o rta n t role in explaining why
predominantly debt
companies issue convertibles. Sweetened debt is a convertible th a t is p rim a rily debt b u t also has a small
but has some equity
like features; typically
component o f equity-like features. Delayed equity is a convertible th a t is p rim a rily equity b u t early in
has a low probability its life it has the debt-like characteristic o f paying interest. I f a convertible note specifies a high (low)
of being converted to conversion price, then there is a low (high) probability th a t subsequently it w ill be converted to equity
equity and accordingly the security is considered debt-like (equity-like). N ot surprisingly, convertible issues
DELAYED EQUITY identified as sweetened debt tend to have debt-like characteristics, while convertible issues identified as
convertible which is delayed equity tend to have equity-like characteristics (D utordoir & Van de Gucht, 2009).
predominantly equity The decision to issue a new security can be thought o f as a two-stage process. In the firs t stage, the
but has some debt-like company decides whether it prefers to issue equity or debt. Straight equity issues and straight debt issues
features; typically has
b oth involve costs fo r the issuing company. On the one hand, a straight equity issue may be interpreted
a high probability
of being converted
by investors as a sign th a t the company s managers wish to sell new shares because, based on th e ir inside
to equity knowledge, they believe th a t the shares are currently overvalued. Issuing new equity may therefore be
seen by investors as a negative signal, thus causing the m arket price o f the shares to fall. Such a company
has an incentive to issue debt. On the other hand, a straight debt issue may significantly increase the
p ro ba bility o f financial distress, causing the cost o f debt to be p ro hib itive ly high. Such a company has
an incentive to issue equity. In the second stage, the company m ust choose between a straig ht security
issue and a convertible security issue. I f the company rejects a straight equity issue in the firs t stage,
then in the second stage it m ust choose between issuing straight debt and issuing convertible debt o f
the sweetened debt variety. I f the company rejects a straight debt issue in the firs t stage, then in the
second stage i t m ust choose between issuing straight equity and issuing convertible debt o f the delayed
equity variety.
W hy m ig h t sweetened debt impose lower costs on an issuer than straight debt? Suppose th a t a heavily
indebted company issues more straight debt. Potential lenders may fear that, after the issue has been
made, the company may take on very risky projects— in an extreme case, these projects may even have
negative net present values— th a t benefit shareholders at the expense o f lenders. The reason is th a t i f
the project succeeds, the shareholders keep nearly all the benefits b ut i f i t fails, nearly all the costs w ill
be borne by the lenders because the shareholders have little to lose in the firs t place.26 Because o f this
fear, lenders would demand a very high interest rate. A debt-like convertible issue mitigates this fear
because, even i f the company does act as feared, the convertible holders w ill also benefit through the
equity component o f th e ir securities. The optim al choice may therefore be to issue a debt-like convertible
rather than straight debt.
W hy m ig h t delayed equity impose lower costs on an issuer than straight equity? Suppose a company s
managers genuinely believe th a t the company has a b rig h t future b ut the high cost o f issuing debt has
caused them to prefer an equity issue. As explained above, potential investors may in te rp re t a new equity
issue as signalling th a t the company has poor prospects. An equity-like convertible may help resolve this
problem. I f the company managers* belief proves correct, the company w ill do well, so the share price w ill
increase, the investors w ill convert and new equity w ill be issued. So, the company s managers achieve
th e ir objective, albeit w ith a delay. But issuing a convertible w ill also m itigate the investors, concern
because, in the m edium term , they w ill receive returns in the form o f interest. The optim al choice may
therefore be to issue an equity-like convertible rather than straight equity.
Evidence suggests th a t both the sweetened debt and the delayed equity interpretations have
explanatory power. In the US, i t appears th a t convertible issues tend to be o f the delayed equity variety,
although both varieties have been identified empirically. US issuers o f convertibles tend to be small, high-
grow th high-risk companies, w ith correspondingly high debt issuance costs (Lewis, Rogalski & Seward,
1999). In Western Europe, nearly all convertible issues tend to be o f the sweetened debt variety. European
issuers o f convertibles tend to be very large, mature and financially sound companies w ith high debt
capacity (D utordoir & Van de Gucht, 2009).
25 An alternative term for delayed equity is ^back-door equity*.

26 For further discussion, see Section 12.7.1.
10.7.21 Preference shares

A preference share is a security th a t gives the holder preference over ordinary shareholders w ith respect PREFERENCE SHARES
to the payment o f dividends, and usually w ith respect to capital repayment in the event o f the company s shares that rank before
ordinary shares for the
liquidation. As a result, dividends cannot be paid to ordinary shareholders u n til preference dividends
payment of dividends
have been paid. In many instances the dividend is fixed fo r the life o f the preference share. The dividends and, usually, in the
on preference shares may be franked— th a t is, may have tax advantages fo r the investor. Alternatively, event of liquidation of
the terms o f the issue may specify th a t all dividends w ill be unfranked. The franking o f dividends is the issuing company.
discussed in Chapter 11. W ith respect to capital repayment, preference shareholders may be entitled to They often provide an
entitlement to a fixed
fu ll repayment o f the am ount subscribed before any payment is made to ordinary shareholders, b u t they
dividend
w ill rank after lenders and other creditors.
In legal terms, preference shares, as the name implies, are a fo rm o f equity. But preference shareholders
rank between creditors and ordinary shareholders and, while fixed dividends resemble fixed interest,
preference share dividends can be le ft unpaid w ith o u t risking liquidation o f the company. In financial
terms, therefore, preference shares have characteristics o f b oth debt and equity and hence are often
described as hybrids o f debt and equity.
Both the Corporations A ct and the lis tin g rules o f the Australian Securities Exchange require th a t
the rights o f preference shareholders be stated fu lly in the company s co nstitu tion . A company th a t
issues preference shares m ust abide by the provisions specified in its co n stitu tio n w ith respect to those
shares.
Traditional preference shares

The characteristics o f preference shares can differ widely between issuers b ut traditionally, preference
shares were cumulative, irredeemable, non-participating and non-voting. The meaning o f each o f these
characteristics is now discussed.
C um ulative
A company th a t issues cumulative preference shares is required to pay any accumulated preference
dividends before a d istrib u tio n may be made to ordinary shareholders. For example, i f a company that
has issued 1 m illio n 10 per cent preference shares at an issue price o f $1 fails to pay preference dividends
fo r 2 years, it has accumulated an obligation to pay $200 000 in preference dividends.
Irred eem ab le
Like ordinary shares, irredeemable preference shares are intended to be perpetual and have no m atu rity date.
Redeemable preference sh ares are issued w ith a specified m atu rity (redemption) date and are therefore REDEEMABLE
similar to debt. Redeemable preference shares are discussed below (see Modern preference shares). PREFERENCE SHARE
a preference share
N o n -p a rticip atin g that has a finite life
The dividends paid on a non-participating preference share are restricted to the fixed dividend rate
specified at the tim e the security is issued. I f the company grants preference shareholders the rig h t to
participate in the d istrib u tio n o f p ro fit available to ordinary shareholders, preference shareholders may
be entitled to a retu rn in excess o f the stated preference dividend rate. For example, a company may
issue participating preference shares, which allow the holders to share in any p ro fit earned in excess o f a
certain amount. As a result, holders o f participating preference shares can obtain a dividend in excess o f
the stated preference dividend rate i f the company has a very profitable year.
N on -vo tin g
Holders o f non-voting preference shares are n o t e n title d to vote at general meetings o f shareholders
unless particular circumstances have arisen. For example, preference shareholders may be e ntitle d to
vote i f the payments o f preference dividends are in arrears or i f there is a proposal to w ind up the
company.
Ignoring the cumulative nature o f trad ition al preference shares, these securities are simply
perpetuities paying a fixed am ount per period. Hence, the pricing o f a non-cum ulative irredeemable
B usiness finance
preference share is an application o f the form ula fo r the present value o f an ordinary perpetuity, which is
shown in Equation 10.2.27
10.2
where P = the price o f the preference share
D = the fixed dividend am ount payable per period
r = required yield per period
For example, i f a preference share pays a dividend o f $4 once per year, has just paid a dividend, and
the required yield is 12.5 per cent per annum, then the price is $4/0.125 = $32. A more realistic example
is provided in Example 10.4.
E xample 10.4
6 ^ T o o w o o m b a R e so u rce s Ltd h a s o n issu e a n o n -c u m u la tiv e ir r e d e e m a b le p re fe r e n c e s h a re w ith a p a r
v a lu e o f $ 1 0 a n d a f ix e d d iv id e n d ra te o f 1 2 p e r c e n t p e r a n n u m . T h e c u r r e n t y ie ld is 8 . 5 p e r c e n t
p e r a n n u m . P re fe re n c e d iv id e n d s a r e p a id tw ic e e a c h y e a r. A p r e fe re n c e d iv id e n d h a s just b e e n p a id .
W h a t is th e p ric e ?
SOLUTION
F o llo w in g s ta n d a r d c o n v e n tio n , b e c a u s e d iv id e n d s a r e p a id tw ic e e a c h y e a r, th e a n n u a l ra te s a re
h a lv e d , so th e d iv id e n d ra te is 6 p e r c e n t p e r h a lf-y e a r a n d th e r e q u ire d y ie ld is 4 . 2 5 p e r c e n t p e r
h a lf-y e a r. T h e a m o u n t o f e a c h d iv id e n d is th e re fo re 0 . 0 6 x $ 1 0 = $ 0 . 6 0 p e r s h a re . U s in g E q u a tio n
1 0 .2 , th e p r ic e is:
_ $0.60
_ 0.0425
=$14.12
T he p r ic e o f th e p re fe re n c e s h a re is $ 1 4 . 1 2 .
Some trad ition al preference shares are s till listed on the ASX. For example, Webster Ltd, which
describes its e lf as Australia’s fo u rth oldest business, has on issue nearly 400 000 cumulative irredeemable
preference shares w ith a fixed dividend rate o f 9 per cent per annum (Webster, 2013). However, in the
past tw o decades, many different form s o f preference shares have been issued in Australia. Some o f these
modern developments are discussed next.
Modern preference shares

M ost modern preference shares may be redeemed in one way or another. In m ost cases, these securities
were designed to achieve advantages from an income taxation and/or a regulatory p o in t o f view. Many
o f the m ajor issuers have been banks. In this section we describe three o f these securities: converting
CONVERTING preference shares, reset preference shares and step-up preference shares.28
PREFERENCE SHARE
a preference share
C o n v e rtin g p re fe re n ce sh a re s
that will automatically
convert into an A converting preference sh are offers a promised dividend p rio r to a specified conversion date, at
ordinary share on a
which tim e the preference shares autom atically convert to ordinary shares in the company.29 Since the
specified date unless
it is redeemed by
conversion to ordinary shares is automatic, these converting preference shares differ fro m convertible
the issuer prior to preference shares, where the holder can exercise a choice. The conversion date fo r converting preference
that date shares is typically 5 to 10 years from the date o f issue, w ith the issuer often having the option to enforce
27 For a derivation, see Section 3.6.3.

28 Two others are convertible preference shares and exchangeable preference shares. At the option of the holder, a convertible
preference share can be converted into ordinary shares. An exchangeable preference share can be exchanged for a security
issued by a subsidiary or affiliate of the issuer.
29 For a detailed discussion of converting preference shares and factors motivating their use, see Davis (1996).
4^^
early conversion. The num ber o f ordinary shares received by the holder o f each converting preference CONVERSION RATIO
share is known as the conversion ratio, which maybe fixed at the tim e the shares are issued. For example, relationship that
determines how
each preference share may convert in to one ordinary share. Alternatively, the conversion ratio may be
many ordinary shares
expressed in terms o f the price o f the ordinary shares at the tim e o f the conversion. This conversion will be received in
mechanism ensures th a t the holder receives at least a m inim um num ber o f ordinary shares at the date exchange for each
o f conversion. This m inim um num ber o f ordinary shares is usually set so th a t the value o f the ordinary converting security
shares received is at least equal to the issue price o f the hybrid. The effect o f arranging the conversion in when the conversion
occurs
this way is shown in Example 10.5.
E xample 10.5
In O c to b e r 2 0 1 4 , A B C Ltd is s u e d c o n v e r tin g p r e fe re n c e s h a re s w ith a fa c e v a lu e o f $ 2 0 w h ic h
6
c o n v e rt to o r d in a r y s h a re s o n 3 0 O c to b e r 2 0 1 8 . A t th e d a te o f th e issu e, th e m a rk e t p r ic e o f A B C
o r d in a r y s h a re s w a s $ 7 . 5 0 . T h e te rm s o f th e issu e p r o v id e th a t th e c o n v e rs io n r a t io w ill b e d e te rm in e d
b y d iv id in g $ 2 0 b y :
a) a n a m o u n t e q u a l to th e p r ic e o f A B C 's o r d in a r y s h a re s o n 3 0 O c to b e r 2 0 1 8 ; less 1 0 p e r c e n t; o r
b) $20,
w h ic h e v e r y ie ld s th e g r e a te r n u m b e r o f s h a re s .
W h a t is th e c o n v e rs io n r a t io a n d th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d in e x c h a n g e f o r e a c h
c o n v e rtin g p re fe re n c e s h a re , if th e o r d in a r y s h a re p r ic e o n 3 0 O c to b e r 2 0 1 8 is:
i) $ 8 .2 3
ii) $ 1 7 .7 8
iii) $ 2 2 . 2 2
iv) $ 2 5 ?
SOLUTION
i) The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 8 . 2 3 x 0 . 9 = $ 7 , 4 0 7 , so th e c o n v e rs io n r a t io w ill
b e $ 2 0 / $ 7 . 4 0 7 = 2 . 7 . T h e v a lu e o f th e o r d in a r y s h a re s r e c e iv e d is 2 . 7 x $ 8 . 2 3 = $ 2 2 . 2 2 .
ii) The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 1 7 . 7 8 x 0 . 9 = $ 1 6 , so th e c o n v e rs io n r a t io w ill b e

$ 2 0 / $ 1 6 = 1 . 2 5 . T h e v a lu e o f th e o r d in a r y s h a re s re c e iv e d is 1 . 2 5 x $ 1 7 . 7 8 = $ 2 2 . 2 2 .
iii) The a m o u n t s p e c ifie d in (a) a b o v e is e q u a l to $ 2 2 . 2 2 x 0 . 9 = $ 2 0 . In th is c a s e , b o th (a) a n d (b)

g iv e th e s a m e re s u lt— a c o n v e r s io n r a t io o f 1. T h e re fo re , th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d
is a g a in $ 2 2 . 2 2 .
iv) S in c e th e o r d in a r y s h a re p r ic e is g r e a te r th a n $ 2 2 . 2 2 , (b) w ill g iv e a h ig h e r c o n v e rs io n r a tio ,

w h ic h w ill a g a in b e e q u a l to 1. T h e re fo re , th e v a lu e o f th e o r d in a r y s h a re s re c e iv e d is $ 2 5 .
In s u m m a ry , th e resu lts s h o w th a t fo r a n y o r d in a r y s h a re p r ic e u p to $ 2 2 . 2 2 , e a c h p re fe re n c e
s h a re w ill c o n v e r t to o r d in a r y s h a re s w orth $ 2 2 . 2 2 . G iv e n th e o r d in a r y s h a re p r ic e a t th e tim e o f
th e issue ( $ 7 .5 0 ) , th is is b y f a r th e m o st lik e ly o u tc o m e .
A lte rn a tiv e ly , if th e o r d in a r y s h a re p r ic e is g r e a te r th a n $ 2 2 . 2 2 , e a c h p re fe re n c e s h a re w ill c o n v e rt
to o n e o r d in a r y s h a re w o r th , p e rh a p s , $ 2 5 . T h e re fo re , th e h o ld e r o f e a c h p r e fe re n c e s h a re is a s s u re d
o f r e c e iv in g o r d in a r y s h a re s , w o r th a t least $ 2 2 . 2 2 a t th e tim e o f c o n v e rs io n . W h ile it is p o s s ib le
th a t th e s h a re s re c e iv e d w ill b e w o r th m ore than $ 2 2 .2 2 , th e p r o b a b ilit y o f th is o u tc o m e is v e r y lo w .
R eset p re fe ren ce sh a re s
Several companies, including banks and other financial institutions, have issued reset preference sh ares RESET PREFERENCE
that were, at the time, classified as equity. Reset preference shares have no fixed repayment date and an SHARE
a preference share
in itia l dividend entitlem ent th a t may be a fixed rate or i t may be specified as a margin over a benchmark
where the dividend
rate such as the 90-day bank b ill swap rate. The in itia l dividend applies fo r a specified period, typically rate can be varied at
5 years. A t the end o f th a t period, the shares are usually re-marketed, w ith possible outcomes generally specified intervals
including redemption, conversion to ordinary shares or the setting o f a new dividend rate. In summary,
reset preference shares provide issuers w ith a debt-like, essentially fixed-cost source o f funds fo r several
years. I f they are n ot redeemed or converted to ordinary shares at the reset date, the reset mechanism
should ensure th a t the subsequent dividend rate is in line w ith current interest rates.
4 ^^
Under International Financial Reporting Standards (IFRS), which were adopted in Australia in 2005,
reset preference shares th a t had been classified as equity were reclassified as debt. This change was
followed by an increase in the popularity o f perpetual step-up preference shares, which, under IFRS, can
be classified as equity in a company s statement o f financial position.
S te p -u p p re fe ren ce sh a re s
STEP-UP PREFERENCE The name used to id e n tify issues o f step-up preference sh ares (SPSs) w ill differ between issuers,
SHARE b ut most issues have essentially the same m ain features. SPSs have no fixed repayment date and pay
a preference share distributions based on a floating rate, usually set at a m argin over a benchmark interest rate u n til a
where the dividend
specified step-up date. When th a t date is reached, the issuer has the rig h t to choose between tw o or more
rate is reset at a
higher rate on a alternatives. These can include:
specified date unless
• re-m arketing the securities to establish a new m argin and to adjust certain other term s o f the
the securities have
been re-marketed, securities
redeemed or • redeeming the securities at face value
converted • converting the securities in to ordinary shares.
Following the step-up date, i f the securities have n ot been successfully re-marketed, redeemed or
converted, the d istrib u tio n w ill be automatically increased (stepped up) to a higher margin. SPSs rank
before ordinary shares, b ut after other preference shares fo r the payment o f d istributions and for
payments in a w inding up o f the issuer.
Classification as debt or equity

For tax and accounting purposes it is usually necessary to classify each financial instrum ent as either debt
or equity. Traditionally, this classification has been based on the security s legal form . However, since 2001,
Australian legislation has required th a t fo r tax purposes, a set o f detailed objective tests m ust be applied at
the tim e a security is issued to determine whether it should be classified as either debt or equity. These tests
are based on the economic substance o f the rights and obligations o f the parties rather than their legal form.
Essentially, an interest in a company th a t provides contingent returns*— th a t is, where the returns
depend on the economic performance o f the company— w ill generally be treated as equity fo r tax
purposes, whereas an interest th a t provides ‘non-contingent returns’ w ill generally be treated as debt,
provided th a t the value o f the returns is at least equal to the issue price. Under these rules, preference
shares may be either debt or equity depending on th e ir individual characteristics. For example, preference
shares th a t are redeemable at the issue price w ill be classified as debt, whereas perpetual non-cumulative
preference shares w ill be classified as equity because the issuer is n o t required to repay the capital invested
and payment o f dividends is contingent on the solvency o f the issuer. Similarly, converting preference
shares w ill generally be considered as equity before conversion b ut i f the contingent component o f the
returns is negligible they may be considered as debt. I f a p articular preference share is classified as debt,
the ‘dividends’ paid to holders w ill be treated in the same way as interest payments fo r tax purposes.
Therefore, the payments w ill be deductible fo r the issuer and fu lly taxable fo r the investor. Conversely, i f
the share is classified as equity, the dividends w ill, like dividends on ordinary shares, be non-deductible
b ut can be franked, in which case they w ill provide tax credits th a t can be used by resident shareholders.
W h y do companies issue preference shares?

When the properties o f preference shares are compared w ith those o f ordinary shares and debt, three
advantages can be identified.30 First, like debt, preference shares can be non-voting, so issuing preference
shares allows a company to raise capital w ith o u t affecting the control o f ordinary shareholders. Second,
unlike lenders, preference shareholders cannot force a company in to liquidation, so the advantage is that
issuing preference shares does n ot cause the same increase in the risk o f corporate failure th a t would occur
w ith greater borrowing. Third, some types o f preference shares are easier to value than ordinary shares
because they usually pay a fixed dividend th a t is readily observable. Thus, new investors who are not
well inform ed about a company s financial situation and its prospects may be prepared to buy preference
shares even though they would be reluctant to buy ordinary shares issued by the same company.
30 The three advantages of preference shares outlined here are discussed in more detail in Baskin and Miranti (1997). In addition
to these advantages, the tax treatment of preference shares can also be a significant factor.
4^^
C H A P T E R TENT R E V I W W
SUMMARY
In th is c h a p te r, w e c o n s id e r e d th e s o u rc e s o f d e b t c o m m e rc ia l p a p e r, th e p ro m is e is m a d e o n ly b y th e
fin a n c e . T h e re a r e m a n y ty p e s o f d e b t, in c lu d in g lo a n s , b o r r o w e r , w h ile in a b ill o f e x c h a n g e th e re is a ls o a n
w h ic h a re n o n -m a rk e ta b le , a n d d e b t s e c u ritie s , w h ic h a c c e p to r, w h o in th e u su a l c a s e re p a y s th e d e b t o n
a re m a rk e ta b le , b u t a ll ty p e s in v o lv e a te m p o ra ry b e h a lf o f th e b o r r o w e r . B oth ty p e s o f s e c u rity c a n b e
tra n s fe r o f fu n d s w h ic h m u st b e r e p a id b y th e b o r r o w e r . tr a d e d in s e c o n d a r y m a rk e ts . In th e se m a rk e ts , it is
• B a n ks a n d o th e r f in a n c ia l in s titu tio n s o ffe r s e v e ra l c o n v e n tio n a l f o r p a r tic ip a n ts to sell c o m m e r c ia l p a p e r
k in d s o f lo a n s . B a n ks o f f e r o v e rd ra fts , w h ic h a re w ith o u t e n d o rs e m e n t b u t to sell b ills o f e x c h a n g e w ith
a f le x ib le fo rm o f f in a n c e in w h ic h th e b o r r o w e r e n d o rs e m e n t. C o m m e r c ia l p a p e r is u s u a lly issu e d
o b ta in s , a n d is c h a r g e d in te re s t o n , o n ly th e le v e l u n d e r a p r o g r a m th a t m a y b e u n d e r w r itte n , a n d a
o f d e b t fu n d in g th a t is r e q u ire d fro m tim e to tim e . b ill o f e x c h a n g e m a y b e issu e d a s p a r t o f a n o n g o in g
O th e r, m o re s p e c ia lis e d fo rm s o f fin a n c e in c lu d e a rr a n g e m e n t k n o w n a s a b ill fa c ility .
d e b to r fin a n c e , w h ic h uses a c o m p a n y ’s a c c o u n ts • C o m p a n ie s c a n a ls o issu e lo n g -te rm d e b t s e c u ritie s ,
r e c e iv a b le as a b a s is fo r s h o rt-te rm f u n d in g , a n d in c lu d in g d e b e n tu re s , u n s e c u re d n o te s a n d c o r p o r a te
in v e n to r y lo a n s and b r id g in g fin a n c e . B a n ks, bonds. P u b lic issues of th e se s e c u ritie s a re a
fin a n c e c o m p a n ie s and o th e r n o n -b a n k fin a n c ia l r e la tiv e ly m in o r s o u rc e o f fin a n c e in th e A u s tr a lia n
in s titu tio n s a re o fte n in v o lv e d in o ffe r in g th e se fo rm s m a rk e t, a n d c o m p a n ie s th a t re q u ire lo n g -te rm fix e d -
o f fin a n c e . D e b t w ith a te rm to m a tu rity o f m o re th a n ra te d e b t o fte n issu e s e c u ritie s in o ffs h o re m a rk e ts .
1 2 m o n th s is c la s s ifie d a s lo n g te rm . Loan s fro m • P ro je c t fin a n c e is im p o r ta n t in th e A u s tr a lia n m a rk e t
banks a n d o th e r f in a n c ia l in te r m e d ia r ie s a re th e a n d it a llo w s la r g e n a tu ra l re s o u rc e a n d in fra s tru c tu re
m o s t im p o r ta n t ty p e s o f lo n g -te rm d e b t fin a n c e fo r p ro je c ts to b e fin a n c e d w ith a h ig h p r o p o r tio n o f
A u s tra lia n c o m p a n ie s . B a n k s p r o v id e v a r ia b le - r a te d e b t.
a n d fix e d -ra te te rm lo a n s . • A u s tr a lia n c o m p a n ie s a ls o issu e h y b r id s e c u ritie s
• A c o m p a n y c a n ra is e fu n d s b y is s u in g d e b t s e c u ritie s . such as c o n v e r tib le n o te s and v a r io u s ty p e s of
C o m m e rc ia l p a p e r a n d b ills o f e x c h a n g e a r e s h o rt p r e fe re n c e s h a re s . The m a in fe a tu re of th e se
te rm d e b t s e c u ritie s . B oth ty p e s o f s e c u rity p ro m is e s e c u ritie s is th a t th e y h a v e fe a tu re s o f b o th d e b t a n d
th e p a y m e n t o f a fix e d sum o n a s ta te d fu tu re d a te e q u ity a n d in s o m e c a s e s m a y b e c o m e o r d in a r y
a n d a re s o ld o n a s im p le in te re s t b a s is . In th e c a s e o f sh a re s in th e fu tu re .
KEY TERMS
a c c e p to r (o r d ra w e e ) 292 d is c o u n te r (o f a b ill o f e x c h a n g e ) 292
a t c a ll 282 d is c o u n te r (o f c o m m e rc ia l p a p e r) 290
b a n k b ill (o r b a n k a c c e p te d b ill) 293 d is in te r m e d ia tio n 276
b ill a c c e p ta n c e fa c ility 294 d ra w e r 292
b ill d is c o u n t fa c ility 294 e n d o rs e m e n t 292
b ill o f e x c h a n g e 292 E u ro b o n d 300
bond 298 fa c e v a lu e 290
b r id g in g fin a n c e 284 fa c to r in g 283
c o m m e rc ia l p a p e r ( o r p ro m is s o ry n o te ) 290 fin a n c ia l distre ss 279
c o n v e rs io n r a tio 307 fin a n c ia l ris k 279
c o n v e rtib le 303 flo o r - p la n ( o r w h o le s a le ) fin a n c e 284
c o n v e rtin g p re fe re n c e sh a re 306 fo re ig n b o n d 300
c o u p o n p a y m e n ts 290 fu lly d r a w n b ill fa c ility 294
covenant 277 in d ic a to r ra te 282
c re d it fo n c ie r lo a n 286 in te rb a n k c a sh ra te 278
d e b e n tu re 295 in te rm e d ia tio n 276
d e b to r fin a n c e 283 in v o ic e d is c o u n tin g 283
d e b to r fin a n c e w ith re c o u rs e 283 m o r tg a g e 280
d e b to r fin a n c e w ith o u t re c o u rs e 283 n o n -b a n k b ill 293
d e fa u lt 277 o v e r d r a ft lim it 282
d e la y e d e q u ity 304 p re fe re n c e sh a re s 305
309
B usiness finance
p r in c ip a l 277 se c u ritie s 276

re d e e m a b le p re fe re n c e s h a re 305 s te p -u p p re fe re n c e s h a re 308
re d is c o u n tin g 292 s u b o rd in a te d d e b t 279
rese t p re fe re n c e s h a re 307 sw e e te n e d d e b t 304
re v o lv in g c re d it b ill fa c ility 294 s y n d ic a te d lo a n 287
s e c o n d a ry m a rk e t tra n s a c tio n 289 u n s u b o rd in a te d d e b t 279
SELF-TEST PROBLEMS
1 W h a t is th e p r ic e o f a 1 8 0 - d a y b ill o f e x c h a n g e , w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 , if th e y ie ld is
5 .5 0 pe r cent pe r annum ?
2 If th e p u rc h a s e r in th e p re v io u s p ro b le m sells th e b ill 6 0 d a y s la te r, a t w h ic h tim e it is p r ic e d to y ie ld
5 . 3 0 p e r c e n t p e r a n n u m , w h a t e ffe c tiv e a n n u a l in te re s t ra te h a s b e e n e a rn e d ?
tu
1
QUESTIONS
[L O 1] G o to th e w e b s ite o f th e R e se rve B a n k o f A u s tr a lia (w w w . r b a . g o v . a u ), fin d s ta tis tic a l ta b le s D 4 a n d
D 8 a n d use th e m to u p d a te T a b le 1 0 . 1 . W h a t in fe re n c e s d o y o u d r a w fro m th e u p d a te d ta b le ?
2 [L O 2 ] A debt contract w ill always include specifications about cosh flows. O u t lin e th e fo rm s th a t th e se
s p e c ific a tio n s m a y ta k e . Id e n tify th e n a tu re o f o th e r s p e c ific a tio n s u s u a lly in c lu d e d in a d e b t c o n tra c t.
3 [L O 2 ] D is tin g u is h b e tw e e n :
a) s e c u re d d e b t a n d u n s e c u re d d e b t
b) s u b o rd in a te d d e b t a n d u n s u b o rd in a te d d e b t
c) d ir e c t a n d in d ir e c t d e b t fin a n c e .
4 [L O 2 The financial risk associated with borrowing involves two separate effects. O u tlin e th e s e e ffe c ts .
5 [L O 2 ] Lenders usually have little or no control over o company's operations but they have considerable
potential control. E x p la in .
6 [L O 2 】T he fo rm s o f s e c u rity a v a ila b le to c o m m e r c ia l le n d e rs in c lu d e a fix e d c h a r g e , a f lo a t in g c h a r g e a n d
a n e g a tiv e p le d g e . W h a t a r e th e m a in s im ila r itie s b e tw e e n th e se th re e fo rm s o f s e c u rity ? W h a t a r e th e m a in
d iffe re n c e s b e tw e e n th e m ?
7 [L O 3 ] D iscu ss th e fa c to rs th a t a ffe c t th e te rm s o f a b a n k o v e r d r a ft n e g o tia te d b y a b o r r o w e r .
8 [L O 3 】
A bank overdraft provides a company with a flexible source o f funds. D iscu ss th e s ig n ific a n c e o f th is
f le x ib ilit y fo r th e f in a n c ia l m a n a g e r a n d th e d iffic u ltie s it m a y c a u s e fo r th e b a n k .
9 [L O 3 ] 〇n /y s m a // c o m p a n /e s e v e r n e e d b r / d g / n g f/n a n c e . D o y o u th in k th is s ta te m e n t is lik e ly to b e tru e o r

u n tru e ? W h y ?
10 [L O 3 ] D e s c rib e th e m a jo r ty p e s o f b a n k le n d in g o th e r th a n b a n k o v e r d r a ft.
11 [L 0 3 ,4 】F ro m th e v ie w p o in t o f th e b o r r o w e r , c o m p a r e a n d c o n tra s t d e b t o r f in a n c e a n d a b a n k o v e r d r a ft.
12 [L O 4 ] D is tin g u is h b e tw e e n in v o ic e d is c o u n tin g a n d f a c to r in g .
13 [L O 4 】D is tin g u is h b e tw e e n 'w it h re c o u rs e d e b t o r f in a n c e ’ a n d 'w it h o u t re c o u rs e d e b to r fin a n c e ’ .
14 [L 0 3 , 5 ]
a) S e le c t o n e o f th e fo u r m a jo r A u s tra lia n b a n k s ( A N Z , C B A , N A B o r W e s tp a c ) a n d , fro m th e b a n k ’s w e b s ite ,

id e n tify th e ty p e s o f b u sin e ss lo a n s o ffe re d b y th e b a n k . R e co rd th e c u rre n t in te re s t ra te s o n the se bu sin ess
lo a n s a n d o n o v e rd ra fts o ffe re d b y th e sa m e b a n k . E x p la in th e d iffe re n c e s b e tw e e n th e se ra te s,
b) In J a n u a ry 2 0 0 8 , th e n F e d e ra l T re a s u re r W a y n e S w a n c ritic is e d a d e c is io n b y th e A N Z b a n k to lift in te re st
ra te s o n v a r ia b le - r a te m o rtg a g e s b y 0 . 2 p e r c e n t. T he T re a s u re r s a id : ;W e b e lie v e th e rise is e x c e s s iv e , a n d
310
CHAPTER TEN REVIEW

o v e r a n d a b o v e a n y th in g th a t c o u ld b e ju s tifie d b y th e in c re a s e in costs f lo w in g to th o se o r g a n is a tio n s fro m
th e fa llo u t fro m th e US s u b -p rim e [m o r tg a g e ] c ris is '. W h a t a s p e c ts o f th e ra te in c re a s e a n n o u n c e d b y th e
A N Z b a n k w e r e u n u s u a l? E v a lu a te th e re a s o n s p u t f o r w a r d b y th e A N Z to ju s tify th e ra te in c re a s e .
15 [LO 5 ] W h a t a r e th e m a in te rm s o f th e t y p ic a l m o r tg a g e a g re e m e n t?
16 [L 0 5 ] Voriable-rate term loons hove much greater flexibility than fixed-rote term loons. E x p la in .
17 [L O 5 ] Bonk loons provide much greater flexibility than borrowing by issuing debt securities. D iscuss.
18 [LO 5 ] D e fin e a m o r tg a g e lo a n . W h a t a r e th e s im ila ritie s b e tw e e n a d e b e n tu r e a n d a m o r tg a g e lo a n ? H o w
d o th e y d iffe r?
19 [LO 6 】W h a t a r e th e m a in d iffe re n c e s b e tw e e n s h o rt-te rm a n d lo n g -te rm d e b t s e c u ritie s ?
20 [ L 0 7 ] D e s c rib e th e m a in fe a tu re s o f c o m m e r c ia l p a p e r. W h y d o issues o f c o m m e r c ia l p a p e r g e n e r a lly

in v o lv e la rg e -s c a le b o r r o w in g ?
21 [L O 7, 8 ] H o w d o e s c o m m e r c ia l p a p e r d if f e r fro m a b ill o f e x c h a n g e ?
22 [L O 7, 8 F rom th e v ie w p o in t o f a p o te n tia l p u rc h a s e r, w h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f a
b a n k b ill c o m p a r e d w ith c o m m e r c ia l p a p e r ?
23 [L 0 7 , 8 】W h a t a r e th e a d v a n ta g e s o f is s u in g c o m m e r c ia l p a p e r ra th e r th a n b ills o f e x c h a n g e ?
24 [LO 8 ] D e s c rib e th e u s u a l ro le s o f th e d r a w e r , a c c e p to r a n d d is c o u n te r o f a b ill o f e x c h a n g e .
25 [LO 8 ] D is tin g u is h b e tw e e n b ill a c c e p ta n c e a n d b ill e n d o rs e m e n t.
26 [LO 8 】D is tin g u is h b e tw e e n a 'f u lly d r a w n b ill f a c ilit y ’ a n d a 'r e v o lv in g c r e d it b ill f a c ilit y ’ .
27 [LO 8 ] In g rid d e p o s its $ 4 0 0 0 0 w ith a fu n d th a t in ve sts m a in ly in b a n k b ills a n d c o m m e r c ia l p a p e r. T h e n e x t

d a y th e R e se rve B a n k o f A u s tr a lia a n n o u n c e s a n in c re a s e in th e c a s h ra te . T h re e d a y s la te r In g rid w ith d r a w s
h e r d e p o s it a n d is s tu n n e d to fin d th a t she h a s lo s t m o n e y . I n te r e s t ra te s h a v e g o n e u p ! H o w c a n I h a v e lo s t
m o n e y ? ' E n lig h te n her.
28 [ L 0 9 ] D iscu ss th e te rm 's e c u r ity 7 a s it re la te s to th e d iffe re n c e b e tw e e n d e b e n tu re s a n d u n s e c u re d n o te s .
29 [ L 0 9 ] W h a t a r e th e fu n c tio n s o f th e tru s te e a n d th e tru s t d e e d in a d e b e n tu re issue?
30 [ L 0 9 ] C o m m e n ta to rs h a v e s u g g e s te d th a t it w o u ld b e d e s ir a b le to e n c o u r a g e th e g r o w th o f th e r e ta il
c o r p o r a te b o n d m a rk e t in A u s tr a lia . W h a t step s d o y o u th in k m ig h t b e u s e fu l in a c h ie v in g th is o b je c tiv e ?
31 [LO 1 0 ] O u tlin e th e m a in fe a tu re s o f p r o je c t fin a n c e . W h a t d is tin g u is h e s p r o je c t f in a n c e fro m o th e r ty p e s o f

lo n g -te rm fin a n c e ? E x p la in w h y /c o m p le tio n , is o f c r itic a l im p o r ta n c e to th e p r o je c t s p o n s o rs a n d th e le n d e rs .
32 [LO ll] It h a s b e e n s u g g e s te d th a t p r e fe re n c e s h a re s o ffe r a d v a n ta g e s o v e r o r d in a r y s h a re s a n d b o n d s in

th re e a re a s : (a) th e c o n tro l o f th e o r ig in a l s h a re h o ld e rs ; (b) th e a b ilit y o f r e la tiv e ly u n in fo r m e d in v e s to rs to
v a lu e th e s e c u ritie s ; a n d (c) th e b a n k r u p tc y ris k o f th e c o m p a n y (B a skin & M ir a n t i 1 9 9 7 , p p . 1 5 1 - 7 ) .
C o n s id e r e a c h o f the se th re e a re a s in tu rn a n d c o m p a r e th e issue o f n e w p re fe re n c e sh a re s w ith the

a lte rn a tiv e s o f is s u in g n e w o r d in a r y sh a re s o r is s u in g n e w b o n d s .
33 [LO ll] In financial terms, traditional preference shores were very similar to debt but modern forms o f
preference shares have many more equity-like features. D iscuss.
34 [LO 1 1 J D is tin g u is h b e tw e e n s w e e te n e d d e b t a n d d e la y e d e q u ity .
35 [L O 1 1 ] O u t lin e th e tw o -s ta g e p r o c e d u r e th a t m a y b e u se d to d e c id e w h e th e r to issu e s tr a ig h t d e b t, s tr a ig h t
e q u ity o r a c o n v e r tib le .
36 [LO 1 1 ] H y b r id s e c u ritie s m a y b e c la s s ifie d a s e ith e r d e b t o r e q u ity f o r ta x p u rp o s e s . W h a t is th e m a in

c r ite r io n f o r th is c la s s ific a tio n ?
37 [LO 1 1 ] Id e n tify th e m a in d iffe re n c e s b e tw e e n a re se t p r e fe re n c e s h a re a n d a s te p -u p p r e fe re n c e s h a re .
W h y h a v e re s e t p r e fe re n c e sh a re s b e e n la r g e ly r e p la c e d b y s te p -u p p r e fe re n c e s h a re s in A u s tra lia ?
PROBLEMS
1 Fixed-rate term loans [LO 5]
S e a le x Ltd h a s a fix e d -ra te te rm lo a n o f $ 2 m illio n a t a n in te re s t ra te o f 8 . 7 5 p e r c e n t p e r a n n u m . T he c o m p a n y
h a s e a rn in g s b e fo re in te re s t a n d ta x (EBIT) o f $ 1 . 4 m illio n p e r a n n u m . A c o v e n a n t in th e lo a n a g re e m e n t
s p e c ifie s th a t EBIT m ust b e a t le a s t 3 . 5 tim e s g r e a te r th a n th e to ta l in te re s t p a id o n th e c o m p a n y 's d e b t. T he
d ire c to rs o f S e a le x a re p la n n in g to ra is e a d d itio n a l d e b t b y b o r r o w in g a t a v a r ia b le ra te , in it ia lly 7 . 5 p e r c e n t
p e r a n n u m . W h a t is th e m a x im u m a m o u n t th a t S e a le x c a n b o r r o w o n th e se te rm s?
Calculating annual repayments and interest rates [LO 5 】
C o m in c o Ltd n e e d s to b o r r o w a p p r o x im a te ly $ 2 m illio n to fin a n c e th e p u rc h a s e o f a g e m -s o rtin g m a c h in e fo r
its d ia m o n d m in e . Its fin a n c ia l m a n a g e r is c o n s id e rin g th e f o llo w in g a lte rn a tiv e s :
i) C o m in c o 's b a n k w ill le n d $ 2 m illio n , r e p a y a b le in fo u r a n n u a l p a y m e n ts a t a n in te re s t ra te o f 8 . 5 p e r c e n t

p ^ r annum .
ii) T he e q u ip m e n t s u p p lie r ha s o ffe re d to fin a n c e th e g e m s o rte r w ith a n in itia l p a y m e n t o f $ 5 0 0 0 0 0 ,

fo llo w e d b y a n n u a l in s ta lm e n ts o f $ 4 6 0 0 0 0 a t th e e n d o f e a c h o f th e n e x t 4 y e a rs .
iii) A fin a n c e b r o k e r c a n a r r a n g e a $ 2 m illio n lo a n r e p a y a b le in a lu m p-sum p a y m e n t o f $ 2 7 6 1 5 1 3 in

4 y e a rs ' tim e . The b ro k e r w ill c h a r g e a n u p -fro n t fe e o f 1 p e r c e n t o f th e lo a n p r in c ip a l.
a) W h a t a re th e a n n u a l re p a y m e n ts o n th e b a n k lo a n ?
b) W h a t is th e in te re s t ra te ( ig n o rin g th e u p -fro n t fee) o n th e fin a n c e b ro k e r's lo a n ?
c) W h ic h o f th e th re e a lte rn a tiv e s p ro v id e s th e lo w e s t c o s t fin a n c e ?
Calculating price of commercial paper [LO 7]

C a lc u la te th e p r ic e o f c o m m e rc ia l p a p e r w ith a fa c e v a lu e o f $1 m illio n a n d 1 8 0 d a y s to m a tu rity if th e y ie ld is
8 .9 pe r cent p e r annum .
Calculating yield on bill of exchange [LO 8]

To ra is e $ 4 8 5 0 0 0 , a c o m p a n y d r a w s u p a b ill o f e x c h a n g e w ith a fa c e v a lu e o f $ 5 0 0 0 0 0 , p a y a b le in
1 8 0 d a y s . W h a t is th e im p lic it s im p le a n n u a l in te re s t ra te (y ie ld ) o n th e b ill? W h a t is th e im p lic it e ffe c tiv e
a n n u a l in te re s t ra te o n th e b ill?
Calculating bill prices [LO 8]

C a lc u la te th e b ill p ric e s n e e d e d to c o m p le te th e f o llo w in g ta b le . A s s u m e in e v e ry c a s e th a t th e fa c e v a lu e is
$1 m illio n .
Yield = 5.1% Yield = 5.2% Yield = 5.3%

30 days
90 days
180 days
W h a t p a tte rn s a re th e re in th e ta b le ?
Bank bill prices and returns [LO 8]

O n 8 M a r c h 2 0 1 4 , JDF Inve stm e nts Ltd p u rc h a s e d a b a n k b ill m a tu rin g o n 7 M a y 2 0 1 4 a t a n a n n u a l y ie ld o f
6 . 9 5 p e r c e n t p e r a n n u m . T he b ill h a d a fa c e v a lu e o f $ 1 m illio n . O n 2 3 M a r c h 2 0 1 4 , JDF s o ld th e b ill a t a
y ie ld o f 6 . 8 0 p e r c e n t p e r a n n u m . C a lc u la te :
a) th e p u rc h a s e p r ic e p a id b y JDF
b) th e s a le p r ic e re c e iv e d b y JDF
c) th e d o lla r re tu rn e a rn e d b y JDF
d) th e s im p le a n n u a l in te re s t ra te e a rn e d b y JDF
e) th e e ffe c tiv e a n n u a l in te re s t ra te e a rn e d b y JDF.

A n in v e s to r b u y s a 9 0 - d a y b a n k b ill p r ic e d a t a y ie ld o f 1 2 . 5 5 p e r c e n t p e r a n n u m a n d sells it a w e e k la te r
p ric e d a t a y ie ld o f 1 3 . 6 0 p e r c e n t p e r a n n u m . W h a t e ffe c tiv e a n n u a l in te re s t ra te h a s th e in v e s to r e a rn e d ?
E x p la in y o u r resu lt.

A n in v e s to r b o u g h t a 9 0 - d a y b a n k b ill p r ic e d a t a y ie ld o f 7 . 4 5 p e r c e n t p e r a n n u m . T h re e w e e k s la te r, th e
m a rk e t y ie ld o n th e b ill h a d fa lle n s lig h tly to 7 . 3 5 p e r c e n t p e r a n n u m . T he R B A th e n u n e x p e c te d ly a n n o u n c e d
th a t it h a d re d u c e d th e ta r g e t c a s h ra te b y 0 . 5 p e r c e n t p e r a n n u m . A s a resu lt, sh o rt-te rm in te re s t ra te s a n d
b ill y ie ld s r a p id ly a d ju s te d d o w n w a r d s a n d th e b ill's y ie ld fe ll to 7 . 0 5 p e r c e n t p e r a n n u m . T he in v e s to r then
s o ld th e b ill. C a lc u la te th e e ffe c tiv e a n n u a l in te re s t ra te th e in v e s to r e a rn e d . W h a t e ffe c tiv e a n n u a l in te re s t ra te
w o u ld th e in v e s to r h a v e e a rn e d if th e RBA h a d n o t a n n o u n c e d a n e w ta r g e t c a sh ra te ?
CHAPTER TEN REVIEW

Pricing non-cumulative irredeemable preference shares [LO 11 ]
T o w n s v ille T ra d e rs Ltd h a s o n issue a n o n -c u m u la tiv e irre d e e m a b le p re fe re n c e s h a re w ith a fa c e v a lu e o f $ 1 0
a n d a fix e d d iv id e n d ra te o f 1 4 p e r c e n t p e r a n n u m . T he y ie ld is 9 . 8 p e r c e n t p e r a n n u m . P re fe re n c e d iv id e n d s
a re p a id e v e ry 6 m o n th s.
a) W h a t is th e p r ic e if a p re fe re n c e d iv id e n d h a s just b e e n p a id ?
b) H o w w o u ld y o u p ric e th e s h a re if th e m o st re c e n t p re fe re n c e d iv id e n d w a s p a id 2 m o n th s a g o ?
Converting preference shares [LO 11 ]
XYZ Ltd c o n v e rtin g p re fe re n c e sh a re s h a v e a fa c e v a lu e o f $ 1 5 a n d a re d u e to c o n v e rt to o r d in a r y s h a re s on
31 J u ly 2 0 1 9 . E ach c o n v e rtin g p re fe re n c e sh a re w ill c o n v e rt to a n u m b e r o f o r d in a r y sh a re s th a t is d e te rm in e d
b y d iv id in g $ 1 5 b y :
i) a n a m o u n t e q u a l to th e p r ic e o f X Y Z o r d in a r y sh a re s o n 31 J u ly 2 0 1 9 , less 5 p e r ce n t; o r
ii) $15,
w h ic h e v e r y ie ld s th e g r e a te r n u m b e r o f o r d in a r y sh a re s.
H o w m a n y o r d in a r y s h a re s w ill b e re c e iv e d b y th e h o ld e r o f o n e c o n v e rtin g p re fe re n c e s h a re if th e p r ic e o f a n
X Y Z o r d in a r y s h a re is:
a) $5
b) $ 7 .5 0
c) $10
d) $15
e) $20?
11 Analysis of conversion terms [LO 11 ]

U s in g th e in fo rm a tio n in P ro b le m 1 0 , c a lc u la te th e v a lu e o f th e o r d in a r y sh a re s th a t w ill b e re c e iv e d o n
c o n v e rs io n o f e a c h c o n v e rtin g p re fe re n c e s h a re in ca se s (a) to (e). B a se d o n y o u r results, s u g g e s t a n a lte rn a tiv e
n a m e th a t d e s c rib e s th e n a tu re o f c o n v e rtin g p re fe re n c e sh a re s.
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CHAPTER CONTENTS
In tr o d u c t io n 316 A g e n c y c o s ts a n d c o r p o r a t e g o v e r n a n c e 335
Is p a y o u t p o lic y im p o r t a n t to B e h a v io u r a l fa c to r s a n d c a t e r in g t h e o r y 339
s h a r e h o ld e r s ? 319
S h a re b u y b a c k s 339
T r a n s a c tio n c o s ts a n d f lo t a t io n c o s ts 324
D iv id e n d r e in v e s tm e n t p la n s a n d d iv id e n d
UJEI D iv id e n d s a n d ta x e s 325 e le c t io n s c h e m e s 346
I n f o r m a tio n e ffe c ts a n d s ig n a llin g to P a y o u t p o lic y a n d c o m p a n y life c y c le 347

in v e s to rs 332
LEARNING OBJECTIVES
1 e x p la in w h y c a s h p a y m e n ts t o s h a r e h o ld e r s a r e im p o r t a n t a n d u n d e r s ta n d s o m e in s titu t io n a l fe a tu r e s o f
d iv id e n d s a n d s h a r e b u y b a c k s
2 o u t lin e th e a r g u m e n t t h a t p a y o u t p o lic y is ir r e le v a n t t o s h a r e h o ld e r s 7 w e a lt h in a p e r fe c t c a p it a l m a r k e t
w it h n o ta x e s
3 d e f in e th e fu ll p a y o u t p o lic y a n d e x p la in w h y it is im p o r t a n t t h a t c o m p a n ie s f o ll o w th is p o lic y
4 e x p la in h o w t r a n s a c t io n c o s ts a n d f lo t a t io n c o s ts m a y a f f e c t p a y o u t p o lic y
5 o u t lin e th e im p u t a t io n t a x s y s te m a n d e x p la in th e e ffe c ts o f im p u t a t io n a n d c a p it a l g a in s t a x o n re tu r n s to
in v e s to rs
6 u n d e r s ta n d th e a r g u m e n t t h a t p a y o u t d e c is io n s m a y h a v e a r o le in p r o v id in g s ig n a ls to in v e s to rs
7 e x p la in th e w a y s in w h ic h a g e n c y c o s ts c a n b e r e la t e d to p a y o u t d e c is io n s
8 e x p la in b e h a v io u r a l f a c t o r s t h a t m a y a f f e c t p a y o u t p o lic y
9 u n d e r s ta n d th e n a tu r e o f s h a r e b u y b a c k s , d iv id e n d r e in v e s tm e n t p la n s a n d d iv id e n d e le c t io n s c h e m e s
10 e x p la in h o w p a y o u t p o lic y m a y c h a n g e a s a c o m p a n y m o v e s t h r o u g h its lif e c y c le .

a B usiness finance
Introduction
Many companies have never distributed any cash to shareholders, while others typically d istribute cash at
LEARNING least twice each year. Companies th a t d istribute cash to th e ir shareholders do so in two m ain ways: by the
OBJECTIVE 1
payment o f dividends and by repurchasing shares.1 Payout policy involves tw o fundam ental questions.
Explain why
cash payments to First, a company s directors m ust decide how much cash, i f any, to pay to shareholders. Second, they must
shareholders are determ ine the form o f the payments— th a t is, should the payment be made as a dividend or through a
important and share buyback? Alternatively, should the company pay dividends and repurchase shares?2
understand some As discussed in Chapter 4, financial assets such as shares are valuable only because o f the benefits they
institutional features of
provide in the form o f cash payouts. It is true that some companies have operated successfully fo r many years
dividends and share
buybacks w ith o u t paying a dividend, while simultaneously th eir shareholders have experienced significant capital
gains. The prim e example o f such a company is M icrosoft, which was founded in 1975, went public in 1986
and did n o t pay its first dividend u n til 2003. From 1986 to 2003, M icrosoft grew rapidly and its cash flows
were retained to finance that growth. M icrosoft s firs t dividend was modest— 8 cents per share, followed
by a dividend o f 16 cents per share in 2004, when it also announced plans to return up to $75 billion to
investors through dividends and share repurchases, including $32 b illion paid as a special dividend o f $3
per share. Presumably, investors were w illing to hold the company s shares during the period 1986 to 2003
because they expected that eventually the company s growth would slow and it would start to return cash
to investors through dividends and/or share repurchases. 'At the most basic level, investors supply capital
to businesses only because they (or the people to whom they m ight sell th e ir securities) have a reasonable
expectation o f eventually receiving payouts in one form or another* (De Angelo & De Angelo 2007, p. 12).
Decisions on a company s payout policy should be consistent w ith the overall objective o f m axim ising
shareholders’ wealth. However, payout decisions can involve several factors and the optim al policy
may be fa r from obvious. For example, consider a profitable copper m ining company th a t has paid the
same dividend each year fo r the last 5 years. Suppose th a t this year, the company s operating cash flow
and p ro fit doubles because o f a large increase in the price o f copper. W hat payout decision w ill be best
fo r shareholders? Should the extra cash be paid out, and i f so, should the company sim ply pay a larger
dividend or should it repurchase shares? Should the company retain the extra cash and use i t to expand
its exploration program? Should the extra cash be used firs t to repay debt w ith the dividend being
increased only i f surplus cash remains after all existing loans have been repaid? These are only some
o f the possibilities th a t may exist. This example shows th a t payout decisions are often related to other
financial decisions. W hile, in practice, payout decisions should n ot be made in isolation, fo r the purpose
o f analysing payout policy we need to isolate it from other financial decisions by holding constant both
investm ent decisions and other financing decisions.
In addition to determ ining the level and form o f payout, managers also need to consider issues such
as the effects o f changing dividends and whether to adopt a dividend reinvestm ent plan. In Australia,
companies th a t pay dividends usually make two dividend payments each year, so decisions on payouts
need to be made frequently and a company s payout policy may need to be reviewed regularly. In this
chapter we analyse payout policy and discuss the relevant empirical research. But firs t we describe briefly
some in s titu tio n a l features o f dividends and share repurchases.
11.1.1 | Dividend declaration procedures

Provided th a t the legal requirements and the exchange s listin g requirements are met, a company s
dividend decisions are at the discretion o f its directors. In Australia, companies generally pay an interim
dividend after the end o f the firs t h a lf o f the financial year and a final dividend after the company s Annual
General Meeting. A company s Board o f Directors, when announcing a dividend, w ill specify a date,
known as the ‘record date’，on which the company’s ‘books’ w ill dose fo r the purpose o f determ ining who
is currently a shareholder, and hence entitled to receive the dividend. For shares listed on the Australian
1 See s. 6(1) of the Incom e T a x A s s e s s m e n t A c t 1 9 3 6 for a definition of what constitutes a dividend under the Act.
2 Officially, the term share buyback is used in Australia while the term share (or stock) repurchase is more common in the US.
In this chapter, the terms buyback and repurchase are used interchangeably.
4^^
C h a p te r eueven Payout policy
Securities Exchange (ASX), the rules o f the exchange specify an e x -d iv id e n d d a te , which is fo u r business EX-DIVIDEND DATE
days before the record date.3 Investors who purchase shares before the ex-dividend date buy the shares date on which
a share begins
c u m -d ivid e n d and are entitled to receive the dividend. Those who purchase shares on or after the
trading ex-dividend.
ex-dividend date are n o t e ntitled to receive the dividend. A share purchased
ex-dividend does not
include a right to the
forthcoming dividend
payment
Dividends are norm ally paid in cash, b u t many Australian companies have adopted dividend reinvestm ent CUM-DIVIDEND PERIOD
period during which
plans th a t give shareholders the o ption o f using all or p art o f th e ir dividend to purchase additional shares the purchaser of a
in the company. These plans are discussed in Section 11.9. Dividends are sometimes given a designation share is qualified to
such as special1to indicate th a t shareholders should n o t expect them to be repeated. receive a previously
announced dividend.
The cum-dividend
period ends on the
ex-dividend date
Historically, the Corporations A ct 2001 specified th a t a company s dividend may be paid only out o f
profits, and m ust n ot be paid o ut o f capital.4 The purpose o f this restriction was to protect creditors by
m aintaining a company s capital. Under amendments to the Corporations Act, which came in to effect on
28 June 2010, the profits test was replaced by new requirements th a t p ro h ib it a company from paying a
dividend unless:
• the company s assets exceed its liabilities im m ediately before the dividend is declared and the excess
is sufficient fo r the payment o f the dividend
• the payment o f the dividend is fa ir and reasonable to the company s shareholders as a whole
• the payment o f the dividend does n o t m aterially prejudice the company s a b ility to pay its creditors.
The new requirements are intended to focus on the solvency o f the company and mean th a t a company
may be able to pay a dividend in the absence o f accounting profits. For example, a company w ith surplus
cash may have recorded a net loss (in accounting terms) due to large non-cash expenses such as im pairm ent
losses on property, plant and equipment. It could now pay a dividend provided the three requirements
are met. Payments to shareholders may also be restricted by covenants in loan agreements. I f a company
has additional classes o f shares such as preference shares, then any p rio rity rights to dividends m ust be IMPUTATION TAX
observed. I f a share buyback causes a company to become insolvent, the directors may be personally liable SYSTEM
system under which
for insolvent trading and the company s liquidator may seek a court order th a t the buyback transactions
investors in shares
are void and the proceeds can be recovered from shareholders who sold. can use tax credits
The im p u ta tio n ta x syste m allows companies to pay dividends th a t carry credits fo r income tax associated with
paid by the company. Such dividends are know n as fra n k e d d iv id e n d s and the tax credits can be used by franked dividends to
resident shareholders to reduce th e ir income tax. I t is im p o rta n t to note th at, generally, the tax credits offset their personal
income tax. The
associated w ith franked dividends arise only from payment o f Australian company tax. New Zealand
system eliminates
also operates an im p utatio n tax system and in 2003 the Australian and New Zealand im putation the double taxation
systems were extended to include companies resident in the other country. Companies th a t operate in inherent in the
both Australia and New Zealand (*trans-Tasman companies*) are now able to d istribu te both Australian classical tax system
and New Zealand tax credits to all shareholders. However, tax credits origin atin g in each country can FRANKED DIVIDEND
be claimed only by residents o f th a t country. The operation o f the trans-Tasman im p utatio n rules is dividend paid out of
illustrated in Section 11.4.1. Australian company
profits on which
When a dividend is declared, the company m ust state the e xtent to w hich the dividend is franked.
company income
When a dividend is paid, th e company is required to provide each shareholder w ith a dividend tax has been paid
statement. This statem ent shows the am ount o f the dividend and the date o f paym ent, the am ount and which carries a
o f any franked and unfranked parts o f the dividend and, i f the dividend is fu lly or p a rtia lly franked, franking credit
3 Many Australian companies choose a Friday as the record date, which means that the ex-dividend date will be the previous
Monday. From the start of trading on the ex-dividend date to the close of trading on the record date there are in fact 5 days
of trading. The trading period between the ex-dividend and record dates has been as long as 7 business days. It was reduced to
5 days following full adoption of electronic settlement and transfer procedures.
4 See s. 254T, C o rp o ratio n s A c t 2 0 0 1 .
B usiness finance
FRANKING CREDIT the am ount o f the f r a n k i n g c r e d it . Where dividends are paid to non-residents, the company may be
credit for Australian required to deduct w i t h h o l d i n g t a x , in w hich case the am ount o f any w ith h o ld in g tax deducted m ust
company tax paid,
also be shown.
which, when distributed
to shareholders, can be The im p utatio n system requires a franking account to be m aintained by each company. I f a company
offset against their tax earns a pre-tax p ro fit o f $100 and pays company income tax o f $30, the credit to its franking account
liability w ill be $30. W hen a franked dividend is paid, the franking account m ust be debited and the debit is equal
WITHHOLDING TAX to the franking credits attached to the dividend. Franked dividends received by resident companies are
the tax deducted by handled in the same way as dividends received by individuals and superannuation funds. Partnerships
a company from the and trusts are n ot taxable entities and are therefore unable to use franking credits. However, any franking
dividend payable
credits received by a partnership or tru s t can be passed on to the partners or beneficiaries, who can use
to a non-resident
shareholder
them i f they are Australian residents.
W hile payment o f dividends is the most common way o f paying cash to shareholders, some countries
allow companies to pay out cash by repurchasing or b u y in g back* th e ir own shares. The law may require
TREASURY STOCK th a t repurchased shares are cancelled or i t may allow the company to retain them as t r e a s u r y s to c k .
US term for a In Australia, s. 259A o f the Corporations Act generally precludes a company from purchasing its own
company’s own
shares. However, exceptions to this general p ro hib itio n were introduced in 1989 and revised in 1995 to
shares that have been
repurchased and held sim plify the procedures. Buybacks have since become routine fo r many companies. Five different types
rather than cancelled o f buybacks are specified in the legislation. Each type involves different legal form alities, but in general
companies are able to repurchase up to 10 per cent o f th e ir ordinary shares in a 12-m onth period. This is
often referred to as the 10/12 lim it. In each case, once the transfer o f ownership has been processed the
shares m ust be cancelled.
Further details o f the different types o f share buyback are as follows:
a Equal access buybacks. Offers are made to all ordinary shareholders to purchase the same percentage
o f the shares th a t they hold.5 The proposed buyback m ust be approved by shareholders passing an
ordinary resolution only i f i t exceeds the 10/12 lim it,
b Selective buybacks. In this case offers are made to only some o f the shareholders in a company.
Because some shareholders could be disadvantaged, the procedural requirements are more stringent
than fo r other types o f buyback. A selective buyback m ust be approved by shareholders either
unanim ously or by a special resolution in which the selling shareholders and th e ir associates are
unable to vote.
C On-market buybacks. A listed company is able to buy back its shares in the ordinary course o f trading
on the stock exchange. The Australian Securities and Investments Commission (ASIC) and the ASX
m ust be n otified o f the proposed buyback, b u t shareholder approval via an ordinary resolution is
required only i f the 10/12 lim it is exceeded.
d Employee share scheme buybacks. A company may buy back shares held by or fo r employees who
in itia lly acquired the shares through an employee share scheme. The procedural requirements are the
same as fo r on-market buybacks.
e Minimum holding buybacks. A listed company may buy back parcels o f shares th a t are smaller than
a specified m inim um . No resolution is needed and the only legal requirem ent is th a t ASIC m ust be
notified o f the cancellation o f the shares.
Im portantly, the tax treatm ent depends on whether the buyback takes place on- or off-m arket. In the
case o f an off-m arket buyback, the transaction can be structured so th a t p art o f the paym ent received by
a shareholder is treated as a dividend fo r tax purposes. Any such dividend can be franked. An on-market
buyback cannot include a dividend component and the whole am ount paid to the shareholder is treated
as proceeds from the sale o f the shares. Accordingly, on-m arket buybacks are subject only to the capital
gains tax provisions— th a t is, the tax treatm ent is the same as i f the shares were sold to a th ird party.
There is another difference between regular dividends and share buybacks th a t can be im portant.
A regular dividend affects taxes fo r all shareholders, b ut a share buyback w ill affect taxes only fo r
5 Off-market share buybacks take place under the equal access provisions. Section 257B of the C o rp o ratio n s A c t states that
the company must offer to purchase the same percentage of the shares held by each shareholder. In practice, ASIC allows
companies to invite shareholders to tender some or all of their shares.
C hapter eleven Payout policy
shareholders who decide to sell and, at least fo r on-m arket buybacks, only i f the investor realises a capital
gain. These differences mean th a t a share buyback can have tax advantages fo r shareholders.
On-market buybacks are more common in Australia than off-m arket buybacks but, on average, the
latter are larger so the total am ount o f capital returned to shareholders over tim e by each m ethod is
similar. For example, during the 1996 to 2003 period, listed companies paid out a to ta l o f $10.5 b illion
in 350 on-market share buybacks. Over the same period, $12.1 b illio n was paid out via 45 off-m arket
buybacks (Brown 2007). D uring the 2007 calendar year, Australian listed companies returned about
$12 b illio n to shareholders by repurchasing shares. But in 2008 and 2009, when companies and
financial markets were affected by the global financial crisis, such repurchases declined to $4.6 b illio n
and $2.1 billion, respectively. In 2010, 2011 and 2012 this decline was reversed, w ith repurchases being
$16.0 billion, $13.0 b illio n and $8.6 b illio n respectively (ASX 2013, p. 3).
The remainder o f the chapter consists o f nine main sections. First, we analyse the prim ary question: Is
payout policy im portant to shareholders? Second, we discuss the effects o f transaction costs, flotation costs
and behavioural factors. Third, we discuss the effects o f taxes, including both the taxation o f dividends and
the taxation o f capital gains. Fourth, we discuss inform ation effects and signalling as reasons for the relevance
of payout policy. Fifth, we discuss the role o f agency costs as a factor that influences payout decisions. Sixth,
we discuss share repurchases as a way o f distributing cash to shareholders. Seventh, we cover behavioural
factors and catering theory. Eighth, we discuss dividend reinvestment plans and dividend election schemes.
Finally, we examine how a company s payout policy may evolve as the company moves through its life cycle.
Is payout policy im portant to

shareholders?
LEARNING
OBJECTIVE 2
Before discussing reasons w hy payout policy may or may n ot be im p o rta n t to shareholders, we outline
Outline the argument
some o f the payout policies a company s directors m ight adopt. that payout policy
is irrelevant to
shareholders7 wealth
11.2.1 | Alternative payout policies in a perfect capital
market with no taxes
Payout policy involves two fundam ental questions. One is whether to pay any cash to shareholders and
the other is the form o f the payment. In many cases a payment may be inappropriate— perhaps because
the company has attractive investm ent opportunities and shareholders are expected to receive a greater
benefit i f the company's cash is used to take up these opportunities instead o f paying it out now. I f
cash is to be paid out, the directors m ust decide whether it w ill be paid as a dividend, or whether the
company w ill repurchase some o f its shares or whether it w ill both pay a dividend and repurchase shares.
We now outline three payout policies th a t m ig ht be adopted. For ease o f expression they are referred to
as ‘dividend’ policies, but, in practice, the cash paid out could be w holly or p a rtly in the form o f a share
buyback. Also, since these policies have a long h isto ry in many countries we continue to describe them by
referring to dividends being paid from a company s profits.
Residual dividend policy

One possibility is sim ply to treat dividends as a residual. A company th a t adopts this policy would pay out
as dividends any profits that, in the opinion o f management, cannot be p rofitably invested. Alternatively,
if the company s investm ent needs are greater than its p ro fit, then no dividend would be paid and extra
finance would be raised externally. This policy can result in dividends fluctuating significantly from year
to year.
Stable (or progressive) dividend policy

A more popular policy is the stable dividend policy. Under this policy, management sets a target DIVIDEND-PAYOUT
dividend-payout ratio — th a t is, a target p ro po rtio n o f annual p ro fit to be paid out as dividends. This RATIO
percentage of
target is such th a t dividends are related to the long-run difference between expected profits and expected
profit paid out to
investm ent needs. The am ount o f each dividend is changed only when this long-run difference changes. shareholders as
For example, the dividend per share w ill be increased if there is an increase in p ro fit th a t is regarded as dividends
sustainable, b ut it w ill n o t be changed in response to fluctuations in p ro fit th a t are believed to be only
temporary. Similarly, i f p ro fit falls, the dividend per share w ill be m aintained unless the outlook fo r
profits is so poor th a t the current dividend level is considered to be unsustainable. The aims o f a stable
dividend p olicy are to reduce uncertainty fo r shareholders w hile providing them w ith a reliable income.
Many companies th a t follow a policy o f this type refer to it as a progressive* dividend policy.
PROGRESSIVE There are tw o consequences o f a stable or progressive dividend policy. First, changes in dividends
DIVIDEND POLICY tend to lag behind changes in profits, and dividends are much less variable than profits. Second, the
directors aim to dividend-payout ratio may fluctuate dramatically. For example, i f p ro fit is unexpectedly high in a particular
steadily increase or
year, the dividend-payout ratio w ill fall.
at least m aintain the
divide nd at each
paym ent Constant payout policy
I f management is concerned to avoid fluctuations in payout ratio, then it could adopt a constant payout
policyt whereby the dividend-payout ratio remains essentially the same each year.
1 1 .2 .2 1 Managers and payout decisions

There is abundant empirical evidence th a t managers regard payout decisions as significant. In an
im p o rta n t early study, L intner (1956) interviewed the managers o f 28 US companies and found that in
most cases dividends were an ‘active decision variable， , and were seldom regarded purely as a residual or
influenced significantly by financing requirements. He also found th a t m ost managers were reluctant
to make changes in dividends th a t are likely to have to be reversed in the near future. In a much larger
study, Brav, Graham, Harvey and Michaely (2005) surveyed 384 financial executives o f US companies and
interview ed another 23 to fin d the factors th a t drive dividend and repurchase decisions.
Their findings, some o f which are consistent w ith those o f Lintner, include:6
a M aintaining the current level o f dividend per share is a high p rio rity and is o f sim ilar importance to
investm ent decisions. Managers have a strong desire to avoid dividend cuts. External funds would be
raised to finance planned investments before the dividend would be cut.
b A part from the importance o f m aintaining the level o f dividend per share, payout policy is o f
secondary concern. Managers see little reward fo r increasing dividends and w ill consider doing so
only after investm ent and liq u id ity needs are met.
c Dividends are ‘sticky’, inflexible and ‘smoothed’ over tim e relative to profits. Many companies that
pay dividends would prefer th a t they did not. I f they could *start all over again* they would pay lower
dividends and place greater emphasis on share repurchases,
d In contrast to dividends, share repurchases are very flexible w ith no need fo r sm oothing. Repurchase
decisions are made after investm ent decisions— th a t is, repurchases are made using the residual
cash flow after investm ent spending.
In some cases companies adopt a stated dividend policy. For example, the large resources companies
BHP B illito n and Rio T into have both announced th a t they have adopted a progressive dividend policy.
However, shareholders should be aware th a t when a company adopts such a policy, its directors are stating
th e ir inten tion s rather than providing a guarantee th a t dividends w ill never fall (see Finance in Action).
In other cases, a company may n ot explicitly state a dividend policy b ut investors may be able to infer that
it is follow ing a particular policy by observing its payout record.
The findings outlined above also show th a t there are significant differences between the factors
th a t determ ine dividends and those th a t influence decisions to repurchase shares. In summary, there
is evidence th a t managers treat some aspects o f payout decisions as being very im p orta nt. In contrast,
a well-known analysis by M ille r and M odigliani (M M ) (1961) proved th a t under certain restrictive
assumptions, dividend policy has no effect on shareholders’ wealth.
6 Brav et al. found that Lintners key finding that dividend policy is conservative still holds. That is, managers of companies that
pay dividends are reluctant to cut them and non-payers are reluctant to initiate them because, once they do, they feel they
will be locked in to maintaining dividend payments. Brav et al. identified two important differences relative to Lintner. First,
managers target the dividend payout ratio less than they used to and give more prominence to the current level of dividend
payments. Second, share repurchases have become an important form of payout and are favoured by managers because of
their flexibility relative to dividends.
Finance
DIVIDEND POLICY PROVIDES N O GUARANTEE
in ACTION
FOR SHAREHOLDERS__________________________________________
Several companies have adopted a progressive dividend policy whereby it is intended that
the dividend payout will increase in line with profits but not fall during economic downturns.
Shareholders should be aware that this does not necessarily mean that the dividend income
they receive will never decline. For example, in 2009 some companies reduced their dividends
significantly with the intention that they would be able to resume a progressive dividend policy
from the Vebased level7. In other cases, shareholders have suffered from the effects of exchange
rate changes, as the following excerpts from an article by Barry FitzGerald explains.
BHP Billiton stands alone among the global miners in being able to increase its dividend
payment despite the damage being done to its December half profit from the now waning
impact of the global financial crisis.
But Australian shareholders w ill not be at the front of the line thanking the company
for its generosity.
W hile the interim dividend has been increased 2.4 per cent from 41 US cents to
42 US cents, it has gone backwards in Australian dollar terms by more than 25 per cent
due to the impact of the strong Australian dollar.
There were no apologies from BHP today for the haircut local shareholders will be taking on
their dividends. It extolled the virtue of the group’s 'progressive’ dividend policy, another way
of saying its intent is that dividends w ill always go onwards and upwards, albeit in the group’s
'functional’ currency—the battered US dollar.
S o u rc e : 'B H P 's haircut for local investors', B a rry FitzG erald, S y d n e y M o r n in g H e r a ld , 1 0 Fe b ru ary 2 0 1 0 .
1 1 .2 .3 1The irrelevance of payout policy

The proposition th a t a company s dividend policy has no effect on shareholders' wealth was advanced
by M M (1961).7 Their analysis demonstrated the irrelevance o f dividend policy under the follow ing
assumptions:
a The company has a given investm ent plan, and has determined how much o f the assets to be
acquired w ill be financed by borrowing.
b There is a perfectly com petitive capital m arket, w ith no taxes, transaction costs, flo ta tio n costs or
inform ation costs.
C Investors are rational so they always prefer more wealth to less and are equally satisfied w ith a given
increase in wealth, regardless o f whether i t is in the form o f cash paid out or an increase in the value
o f the shares they hold.
To d e fin e d iv id e n d p o lic y , suppose t h a t a co m p a n y is to increase its d iv id e n d p a y m e n t. W it h th e

in v e s tm e n t p la n a n d th e b o rro w in g d e c is io n fix e d , th e e x tra fu n d s used to pa y th e h ig h e r d iv id e n d can
be replaced fr o m o n ly one source: a n e w share issue. A lte rn a tiv e ly , suppose t h a t th e d iv id e n d is to be
reduced. In th is case, th e re is o n ly one w a y t h a t th e s u rp lu s cash can be use d— t h a t is, to re p u rch a se som e
shares. T here fore, in th e M M fra m e w o rk , dividend policy in v o lv e s a tra d e -o ff b e tw e e n h ig h e r o r lo w e r
d iv id e n d s a n d is s u in g o r re p u rc h a s in g o rd in a ry shares. U s in g th is ap p ro a ch , M M p ro v e d t h a t d iv id e n d
p o lic y is irre le v a n t to s h a re h o ld e rs ’ w e a lth . E xa m p le 11 .1 illu s tra te s th e a p p ro a ch t h a t M M used to p ro ve
th a t d iv id e n d p o lic y is irre le v a n t.
Essentially, M M s argum ent is th a t the value o f a company depends only on its investments. The net
cash that can be paid out to investors is a residual: the difference between profits and investment. This net
payout consists o f cash paid o ut in dividends and share repurchases, less any cash raised by issuing shares.
It follows th a t a company can adjust its payouts to any chosen level by m aking a corresponding adjustm ent
7 MM (1961) only considered dividends and their article does not mention share repurchases, probably because they were rare
at the time. The MM analysis could be extended to include share repurchases and to show that, under their assumptions, the
form in which cash is paid out has no effect on shareholders* wealth.
Example 11.1
The ABC Company has 10000 shares on issue, with a market price of $1 1 each. Its statement of
financial position ('balance sheet') in market values is shown in Table 11.1.
TABLE 11.1 ABC Company market value statement of financial position ($)
Cash 15000 Debt 5000
Non-current assets 100000 Equity 110000
Total assets 115000 Value of company 115000
The $ 1 5 0 0 0 cash has been reserved for an investment opportunity that has not yet been taken up.
Suppose that management decides instead to use the cash to pay a dividend of $15 000, and then
issues more shares to new shareholders to replace the cash and proceed with the new investment.
W hat is the effect of these transactions on the value of the existing shares and shareholders' wealth?
SOLUTION
After the dividend and the share issue, the company still has the same assets, so that its value should
still be $1 15000. The new shares should be worth the amount paid for them, $15000, so that the
value of the original shares is:
V a lu e o f o r ig in a l s h a r e s = v a lu e o f c o m p a n y - v a l u e o f d e b t - v a l u e o f n e w s h a re s
= $ 1 1 5 0 0 0 -$ 5 0 0 0 -$ 1 5 0 0 0
=$95 000
The original shareholders have suffered a capital loss of $15000, exactly offsetting the dividend of
$ 15 000, which is now cash in their hands. By having the ABC Company pay a dividend, its original
shareholders have converted part of their stake in the company into cash of $15000. Since the stake
transferred to the new shareholders is also worth $15000, the net change in the wealth of the original
shareholders is zero.
Paying a dividend and then issuing new shares to replace the cash paid out involves a transfer
of ownership between the 'old' and 'new' shareholders. Provided the terms of this transfer are fair,
neither party gains nor loses—that is, the new shareholders receive shares that are worth the price
paid for them and, for each dollar they receive in dividends, the old shareholders give up future
dividends with a present value of $ 1, which reduces the value of their shares by $ 1.
to the num ber o f shares on issue. In a perfect capital m arket where the company s investm ents remain
the same, these adjustments w ill have no effect on the net payout o f cash and no effect on company value.
As shown in Example 11.1, paying out additional cash— $15 000 in th a t case— and then raising $15 000
by issuing additional shares is sim ply recycling cash and cannot affect shareholders* wealth.
Now suppose that the ABC Company pays the $15 000 dividend and does n o t replace the cash by
issuing more shares. In this case, paying the dividend is effectively a p artial liqu id atio n o f the company
because its assets have been reduced by $15000 and the value o f its equity m ust fa ll to $110000 -
$15 000 = $95 000. The shareholders now have $15 000 cash in hand and have incurred a capital loss on
th e ir shares o f $15 000. As a check, we can calculate th e ir wealth, which is $15 000 + $95 000 = $110 000:
exactly the same as it was p rio r to the dividend. Alternatively, suppose th a t the company does n ot pay
any dividend, but the shareholders w ant to raise $15 000 in cash. The shareholders can do this by selling
p art o f th e ir holding to other investors— which is often referred to as creating a ‘homemade dividend’.
A fte r these transactions, the original shareholders w ill again have cash o f $15 000 and the value o f th e ir
rem aining shares m ust be equal to $110000 - $15 000 = $95 000. Clearly, the wealth o f the original
shareholders is s till $110000. We can conclude th a t the p artial liquidation o f a company (by paying a
dividend) cannot increase shareholders’ wealth because, in the absence o f taxes and transaction costs,
shareholders can achieve the same result by liquidating p art o f th e ir holding.
Since the 1960s, m ost discussions o f payout policy have been based on the M M dividend irrelevance
theorem. For example, empirical research has typically been based on the idea th a t i f dividend policy is
im portant in practice, the reasons fo r its importance m ust relate to factors th a t M M s assumptions excluded
from th e ir analysis. Accordingly, the large body o f research on dividend policy has m ainly examined
whether the policies th a t companies adopt, and share price responses to dividend announcements, can
be explained by m arket imperfections such as taxes, agency costs and the role th a t dividends may play in
conveying inform a tion to investors. More than 40 years after the M M irrelevance theorem was published,
De Angelo and De Angelo (2006) argued th a t i t is inadequate as a starting p o in t fo r understanding payout
policy. De Angelo and De Angelo (DD) do n o t claim th a t the M M analysis is wrong; they accept th a t it
is correct*, given the underlying assumptions. However, DD p o in t out th a t the M M analysis relies on
an unstated but im p licit assumption that, in th e ir view, means th a t M M s irrelevance theorem is its e lf
irrelevant. DD argue th a t the concept o f ‘fu ll payout’ is a more logical starting p o in t fo r discussion o f
payout policy. The fu ll payout policy that DD advocate means th a t the fu ll present value o f a company s
free cash flow should be paid o ut to shareholders. Free cash flows are defined as cash flows in excess
o f those required to fund all available projects th a t have positive net present values. Their argument is
explained in the next section.
To explain DDs criticism s o f M M , we use a sim plified version o f a numerical example provided by DD
(2006). Suppose that an all-equity company undertakes a project w ith a net present value (NPV) of
L E A R N IN G
$10. The project generates free cash flow o f $1 per year in perpetuity and the required rate o f return is
O B JEC T IV E 3
10 per cent. The M M p ro of im p licitly assumes th a t a company w ill distribute all o f its free cash flow in Define the full payout
every period. In this case, the company m ust distribute at least $1 per year. M M show th a t the company policy a n d explain
can distribute more than $1 per year by issuing more shares and d istrib u tin g the proceeds to shareholders. w h y it is important
For example, i f the company s managers wish to pay a dividend o f $1.10 in a given year, the company sells that c o m p an ie s follow
this policy
shares w orth 10 cents to new shareholders and pays a dividend o f $1.10 to the old shareholders. DD
point out th a t by issuing new shares and paying a higher dividend, the company is effectively carrying out
financial interm ediation. In reality, cash o f 10 cents was transferred from new to old shareholders w ith
the company only touching the cash fo r an instant. Accordingly, DD argue th a t the cash actually paid from
the company s resources remains $1, so, in substance, its payout policy has n o t changed.
M M s assumptions constrain a company to paying out all o f its free cash flow each year and this is an
optimal payout policy. Clearly, i t is also true th a t paying higher dividends, financed by issuing more shares,
cannot increase company value or shareholders* wealth. Hence, what M M did prove is th a t changing
payout policy cannot add to the value created by a company s investment policy. However, DD argue that
the M M approach does n ot prove that payout policy is irrelevant because company value can be changed
if companies retain part o f th e ir free cash flow. To continue the numerical example, suppose th a t the
company s managers decide to perm anently distribute only 99 cents per year. The 1 cent th a t is retained is
invested in zero-NPV projects so the company s till has investments w ith an NPV o f $10, b ut the reduced
payout means th a t the value o f its shares is only $9.90. In contrast to the outcomes envisaged by M M , the
value lost through the suboptimal payout policy cannot be restored by investors selling some o f th e ir shares
or borrowing against them to manufacture ‘homemade’ dividends. Given the distributions o f 99 cents per
year, the m arket w ill value the shares at $9.90 and th a t is the price at which investors can sell or borrow
against their shares. Thus, DD distinguish between ‘investm ent value’ and ‘d istribu tio n value’. Investment
value is defined as the present value o f the free cash flow to the company generated by its investments.
D istribution value is the present value o f the cash flow paid out to shareholders. These tw o values can be
equal— but they w ill be equal only i f the company s payout policy is optimal. D istrib utio n value cannot be
more than investment value b ut it w ill be less than investm ent value i f free cash flow is retained.
In contrast to M M , DD conclude that both investm ent policy and payout policy are im portant. Their
approach emphasises the importance o f a full payout policy. In summary, DD argue th a t managers have FULL PAYOUT POLICY
two im portant jobs. First, they are responsible fo r selecting good investm ent projects th a t generate profits distribution of the full
present value of a
and provide the capacity fo r cash to be paid out to investors. Second, they should ensure th a t over the
c o m p a n y ’s free cash
life o f the enterprise, investors receive a d istribu tio n stream w ith the greatest possible present value. And flow to shareholde rs
so managers should th in k fu ll payout and n o t irrelevance when setting payout policy, (DD, 2007, p. 12).
1 1 .2 .5 1 Payout policy in practice
We have discussed tw o models o f payout policy, both o f which assume there is a perfect capital m arket
w ith no taxes. First, the M M dividend irrelevance theorem suggests th a t any payout policy w ill do. Second,
DD argue th a t M M relied on the im p lic it assumption th a t all o f a company s free cash flow is paid out and
p o in t o ut th a t this is a critical requirem ent o f optim al payout policies. I f p a rt o f a company s free cash
flow is never paid out, company value w ill be reduced, so DD support a fu ll payout policy. In the context
o f a perfect or <frictionless, market, fu ll payout means th a t the present value o f free cash flow should be
paid o ut over the life o f the enterprise. However, the model does n ot say anything about the tim in g of
payouts— — tim in g is irrelevant, provided the to ta l payout is optimised. Similarly, neither the M M analysis
nor the fu ll payout model says anything about the fo rm o f the payout— shareholders are equally happy
w ith a dollar o f dividends or a dollar paid out to repurchase shares. Regardless o f which o f these models
is used as a starting point, i f we aim to develop a model th a t managers can use, then i t is necessary to
consider the effects o f the im perfections or friction s* th a t may encourage or discourage the payout o f cash.
We m ust also consider factors th a t may influence the preferred fo rm o f payouts. Lease et al. (2000) divide
the factors th a t may be im p o rta n t in to tw o groups: the ‘big three im perfections’一 taxation, inform ation
asymmetry, and signalling and agency costs and the ‘little three fric tio n s ’ 一 transaction costs, flo tatio n
costs and behavioural considerations. Because discussion o f the la tte r factors raises some issues th a t are
im p o rta n t in assessing the possible effects o f imperfections, they are considered firs t in Section 11.3.
Taxes, in fo rm a tio n asymmetry, and signalling agency costs are discussed in Sections 11.4 to 11.6.
Transaction costs and flotation

costs
L E A R N IN G
O BJEC TIVE 4
Explain ho w 11.3.1 | Transaction costs
transaction costs and
flotation costs m ay I f trading in shares does n ot involve any transaction costs, shareholders have the o p p o rtu n ity to effectively
affect payout policy develop th e ir own payout policy w ith o u t incurring any costs. For example, i f an investor received a dividend
th a t was n ot needed, the cash could be used to buy more shares in the company. Conversely, i f additional
cash was needed, a shareholder could sell some shares to create a 'homemade1dividend. Thus, shareholders
can create th e ir preferred cash flow stream th a t is independent o f the payouts made by the company.
As De Angelo, De Angelo and Skinner (2009) p o in t out, provided the company eventually distributes fu ll
value to investors, all shareholders 'w ill view each such dividend policy as equally valuable, regardless of
the degree o f heterogeneity in th e ir preferences fo r immediate versus future payouts* (p. 203).
In practice, shareholders who buy or sell shares to create a preferred cash flow stream w ill incur
transaction costs such as brokerage fees, so investors who require income may prefer to hold shares
DIVIDEND CLIENTELE th a t pay regular dividends. This is an example o f d iv id e n d c lie n te le s , which may develop when there
gro up of investors w h o are d ifferent classes o f investors w ith different preferences fo r current income— th a t is, a company w ill
c h o o se to invest in
tend to attract a clientele o f investors who are suited by its dividend policy. Companies that do n ot pay
com panies that have
dividends or pay only low or residual dividends would attract investors w ith adequate income from other
dividend policies that
meet their particular sources. Such investors would reinvest any dividends they receive, b u t can avoid the transaction costs o f
requirements doing so by investing in companies th a t retain m ost or all o f th e ir profits. Conversely, companies that
routinely pay high dividends would attract investors such as retirees, who require income from th e ir
share p o rtfo lio to meet consumption needs. Thus, a stable dividend policy may reduce or elim inate the
transaction costs th a t some shareholders would incur i f the company followed a residual dividend policy.
However, th is does n ot necessarily mean th a t the stable policy w ill increase the m arket value o f
the company s shares. I f transaction costs are the only im perfection th a t exists in a m arket, companies
may compete to pay dividends to the clientele o f investors who wish to m inim ise transaction costs.
This com petition among companies could result in an equilibrium , where the supply o f dividends is
equal to investors1demand fo r cash payouts. As M M noted, i f such an equilibrium exists and the needs
o f all investor clienteles are met, then one clientele is as good as another. In other words, there w ill be
no incentive fo r one more company to adopt a dividend policy designed to su it the needs o f a particular
dividend clientele.
11.3 .2 | Flotation costs

I f a company pays dividends and its retained profits are insufficient to meet its investm ent needs, then
one solution is to raise funds externally. Alternatively, the company could increase the funds th a t are
available internally by reducing or even elim inating its dividend. Under the M M assumption o f no
flotation costs, shareholders would be indifferent between these alternatives. In practice, a company th a t
raises funds externally w ill incur flo tatio n costs, which can be substantial. For example, i f a company
needs $1 m illio n and flo ta tio n costs are 5 per cent, the company w ill need to issue shares w ith a value o f
$1000 000/0.95 = $1 052 632 to raise a net $1 m illio n . Existing shareholders may incur an additional cost
i f shares are issued to new shareholders when a company s management has confidential inform ation
that indicates th a t the company s shares are undervalued.8 The existence o f flo ta tio n costs provides an
incentive to preserve shareholders’ wealth by restricting dividends. Therefore, the best outcome fo r
shareholders may be a residual dividend policy, where the company pays dividends only to the extent that
it has profits which it cannot p ro fitab ly invest.
Dividends and taxes

Taxes can either favour or penalise the payment o f dividends, depending on w hether the tax burden on
profits distributed as dividends is greater or less than the tax burden on capital gains arising from retained
profits. Under the classical ta x system , which applied in Australia u n til 30 June 1987, dividends were CLASSICAL TAX SYSTEM
taxed in the hands o f an investor at the investors m arginal tax rate, whereas capital gains were either tax system that
operates in the U S
tax-free or taxed at lower rates than dividends. The classical tax system is s till used in some countries,
a n d w hich operated
including the US.9 Since dividends were paid from profits th a t were subject to company income tax, the in A ustralia until
classical tax system involved double taxation o f company profits. Therefore, from a purely tax view point, 3 0 June 1 9 8 7 ; under
many investors were disadvantaged i f they received a dividend and would have preferred th a t companies this system co m p a n y
retain profits, thus allowing investors to realise returns as tax-advantaged capital gains. Despite the profits, a n d d ivid e nd s
p a id from those
apparent tax disadvantage o f paying dividends, many Australian companies did pay out a significant
profits, are taxed
percentage o f th e ir profits as dividends. O f course, there may be a simple explanation: factors other than se p a ra te ly— that
taxes affect payout decisions and, w ith share repurchases prohibited u n til 1989, payment o f dividends is, profit p a id a s a
was the only way o f transferring cash from companies to th e ir shareholders. However, in the US, where d ivid e n d is effectively
share repurchases were legal and taxes favoured repurchases relative to dividends, the am ount o f cash taxed twice
paid out as dividends exceeded the value o f share repurchases each year u n til 1999. The additional tax
burden on dividends suggested th a t the values o f US companies would probably increase i f cash was paid
out by repurchasing shares instead o f paying dividends. This observation caused Black (1976) to conclude
that the dividend policies o f US companies were a puzzle.
11.4.1 I Dividends and the imputation tax system

The imputation tax system th a t was introduced in July 1987 has im p o rta n t effects on the taxation o f
dividends paid to investors in Australian companies. The basic in te n tio n o f the im p utatio n system is to
L E A R N IN G
eliminate the double taxation o f company profits, which is inherent in the classical tax system previously
O B JEC TIVE 5
used in Australia. This in te n tio n is achieved by giving resident shareholders a credit fo r the Australian O utline the imputation
income tax paid by a company on its taxable income. The overall effect is th a t the p ro fit o f a company tax system a n d
distributed as dividends is effectively taxed only at the investor level, b u t the tax is collected p rim a rily at e xp lain the effects of
the company level. imputation a n d capital
g a in s tax on returns to
investors
8 The effects of this type of information asymmetry, which were analysed by Myers and Majluf (1984), are discussed in
Section 12.9.2.
9 The classical tax system is still used in the US and much of the empirical research on dividend policy is based on US data, so it
is important to have an understanding of the classical tax system.
B usiness finance
The im p utatio n system operates as follows:
a Company income tax is assessed at the company income tax rate tc. Therefore, at the current
company income tax rate o f 30 cents in the dollar, $100 o f company p ro fit w ill result in
$30 being paid in company tax. I t is critic a l to understand th a t th is am ount o f $30 is therefore
both p ro fit earned by the company and company tax paid. The im p u ta tio n system recognises this
dual nature by adding $30 to the shareholder^ income and also givin g shareholders credit fo r
$30 o f tax paid.
b Dividends paid out o f a company s after-tax p ro fit are referred to as franked dividends. In this case,
the m axim um franked dividend th a t could be paid is $70. Each dollar o f franked dividend carries a
franking credit equal to tc/ ( l - tc). Therefore, a franked dividend o f $70 w ill carry a franking credit o f
$70 x 0.30/(1 - 0.30) = $30. Shareholders who receive a franked dividend o f $70 w ill include in th eir
taxable income both the dividend received ($70) and the franking credit ($30). The shareholders’
taxable income is thus $100.
c Shareholders are then taxed at th e ir m arginal tax rate b u t are then allowed a tax credit in
recognition o f the company tax paid. If, fo r example, the shareholders personal tax rate is 45 cents
in the dollar, then th e ir tax lia b ility is 0.45 x $100 = $45, less the tax credit o f $30, so the net
personal tax is $15. Therefore, the to ta l tax on the $100 company p ro fit is $45, o f which $30 was
collected from the company and $15 fro m the shareholder.
The effects o f the im putation system on different types o f resident shareholders who receive a franked
dividend paid from a company p ro fit o f $100 are shown in Table 11.2.
TABLE 11.2 Effects of dividend imputation on resident shareholders

Medium-income
Shareholder Superannuation fund individual High-income individual
Marginal tax rate (%) 15 30 45
Company p rofit ($) 100 100 100
less Company tax ($) 30 30 30
Franked dividend ($) 70 70 70
Net shareholder tax ($) 0 15
After-tax return ($) 85 70 55
•°) E xce ss franking credits a re refunded (that is, p a id in ca sh to the shareh old e r b y the tax authorities).
Table 11.2 shows tw o im p o rta n t features o f the im p utatio n system. First, a company s after-tax
p ro fit paid out as franked dividends is effectively taxed only at the shareholders’ ‘personal’ tax rate. To
pay a franked dividend o f $70 requires pre-tax company p ro fit o f $100 and i f this am ount were simply
taxed at the shareholders* m arginal tax rate, the after-tax returns would be the same as those shown
in the fin al row o f Table 11.2. Second, the after-tax retu rn from franked dividends does not depend on
the company income tax rate, and company income tax can be regarded as a withholding tax against the
personal tax liabilities o f shareholders. In other words, under im putation, payment o f company income
tax is effectively a pre-payment o f personal tax.
Under the im p utatio n system, it is only by payment o f franked dividends th a t credits fo r company tax
paid can be transferred to investors, who can then use the credits to offset th e ir personal tax lia b ilitie s—
th a t is, shareholders are unable to use tax credits u n til franked dividends are paid. Therefore, in an
im putation system, the after-tax retu rn to shareholders depends heavily on the company s dividend
policy.
As discussed in Section 11.1.3, companies w ith operations in both Australia and New Zealand may
elect to distribute Australian franking credits and New Zealand im putation credits to all shareholders.
Such distributions have been allowed since 1 October 2003 and th eir effects are illustrated in Example 11.2.
All Black Ltd is owned 70 per cent by New Zealand residents and 30 per cent by Australian residents.
The company has operations in Australia where it pays A$ 100000 of company tax. It also pays
company tax of N Z $200000. The resultant Australian franking credits and New Zealand imputation
credits are fully distributed and both are attached to the same dividends. W hat are the tax credits
that can be claimed by the Australian and New Zealand resident shareholders? How much of the tax
credits cannot be utilised?
SOLUTION
The Australian and New Zealand tax credits are distributed to all shareholders in proportion to
their shareholdings in All Black Ltd. However, the tax credits from each country can be claimed only
by residents of that country. Therefore, Australian resident shareholders will receive A $3000 0 in
franking credits (30 per cent of the total Australian company tax of A$ 100000) and the remaining
A $7000 0 will be distributed to New Zealand resident shareholders who are unable to use them.
Similarly, New Zealand resident shareholders will receive imputation credits of N Z $140000
(70 per cent of the total New Zealand company tax of N Z$200000) and the remaining N Z$60000
will be distributed to Australian resident shareholders who are unable to use them.
So far we have focused on the taxation o f dividends, but, in practice, a significant pro po rtio n o f the
returns to shareholders are in the form o f capital gains. Example 11.1 showed th a t payment o f dividends
reduces the value o f shares and it follows th a t payment o f dividends reduces the potential fo r shareholders
to incur capital gains tax. I f companies retain profits, the prices o f th e ir shares are likely to rise relative
to those o f companies th a t d istribute p rofits, giving rise to capital gains tax liabilities fo r shareholders if
and when the shares are sold.10
In Australia, capital gains tax applies only to gains on assets acquired on or after 20 September 1985,
and is payable only when gains have been realised. The calculation o f capital gains tax can d iffer depending
on whether the asset was purchased before or after 21 September 1999. However, provided th a t the asset
has been held fo r at least 12 m onths, the m axim um rate o f capital gains tax fo r an individual w ill be h alf
the marginal tax rate on the individuals ordinary* income. In the case o f superannuation funds, the
maximum rate o f capital gains tax on long-term gains is 10 per cent compared w ith th e ir norm al income
tax rate o f 15 per cent. The tim e value o f money means th a t the present value o f any capital gains tax
payable is lower, the longer th a t realisation o f gains is delayed. Also, investors are able to choose the tim e
at which assets are sold and may therefore be able to realise gains at times when th e ir m arginal tax rate
is low. In summary, effective rates o f capital gains tax are likely to be low fo r many investors. However,
where a capital gain arises from retention o f profits th a t have been taxed, any capital gains tax th a t is
payable w ill be in addition to the tax already paid by the company. In other words, retention o f profits can
involve double taxation: company income tax plus capital gains tax.
Future capital gains tax can be reduced by the payment o f dividends, regardless o f whether the dividend
is franked or unfranked. Unfranked dividends are taxed as ordinary income in the hands o f investors and
carry no tax credits— in other words, the classical system o f taxation continues to apply to unfranked
dividends. Given th a t the effective rate o f capital gains tax is likely to be less than an investors m arginal
income tax rate, m ost investors are likely to prefer capital gains rather than unfranked dividends. As
discussed in the next section, many investors w ill also have a tax-based preference fo r franked dividends
rather than capital gains arising from retention o f taxed profits.
The effects o f taxation on dividends and capital gains fo r the m ain classes o f investors in the Australian
m arket are summarised in Table 11.3. Note th a t in relation to capital gains, the table shows details only
o f capital gains tax applicable at the investor level— th a t is, tax in addition to any company tax paid on
retained profits th a t underlie the capital gains.
10 Remember that share prices drop on the ex-dividend date. The significance of this drop in price is discussed in Section 11.4.4.
TABLE 11.3 Taxation of dividends and capital gains
Resident individuals Superannuation funds i Non-residents
Dividends Dividend imputation Franked dividends Introduction o f a W ithholding tax on
effective from 1 July received by a resident 15% tax on earnings dividends, applied
1987. Franking company are handled from 1 July 1988. from 1 July 1960.
credits can be offset using the same Dividend imputation From 1 July 1987,
against income tax gross-up and credit effective from that franked dividends
on the shareholders’ approach that applies date. Excess franking exempt from
income (including to resident individuals credits are refunded withholding tax.
capital gains), but not and superannuation from 1 July 2000. Unfranked dividends
against the Medicare funds. Thus, franking are subject to a 30%
levy. Excess franking credits received withholding tax or
credits are refunded reduce the amount of 15% i f covered by a
from 1 July 2000. company tax payable. double taxation treaty.
Capital Assets acquired after Same as for resident All assets disposed Australian-related
gains 19 September 1985 individuals u ntil of after 1 July 1988 assets acquired after
are subject to capital 20 September 1999. subject to capital 19 September 1985
gains tax. I f the asset From 21 September gains tax at the rate are subject to capital
is held for more than 1999, the capital gain o f 15%. If the asset is gains tax. Indexation
1 year, it applies to is included in the held for more than 1 for inflation applies
the real component company’s taxable year, it applies to the to September 1999.
only u n til September income. Discounting real component only For gains realised on
1999. On or after of gains does not u n til 20 September or after 21 September
21 September 1999, apply to companies. 1999. For capital gains 1999 discounting may
the amount o f any realised on or after apply. Exempt from
capital gain realised 21 September 1999 on Australian capital
on an asset held for at assets held for at least gains tax on shares in
least 12 months may 12 months, a discount resident companies
be discounted by 50%. o f 33 V3% is allowed. if the investor owns
less than 10% of the
company’s shares.
S o u rce : This table is b a se d o n T. C allen, S. M o r lin g & J. Pleban, 'D iv id e n d s a n d taxation: a pre lim in ary investigation',
R e se a rc h D is c u s s io n P aper 921 1, E co n o m ic Research Departm ent, Reserve B a nk of A ustralia, p. 9, a n d updated b a se d on
M a s te r Tax G u id e 2 0 0 4 , C C H A ustralia Ltd, Sydney.
1 1 .4 .3 1 Dividend policy with imputation and capital gains tax

In Section 11.4.1 we showed that company profits paid out as franked dividends are effectively taxed once
at the shareholders marginal tax rate. For example, company p ro fit distributed as franked dividends to
an investor on the top marginal rate w ill be taxed at 45 per cent. For each $1 o f company taxable income,
company tax o f 30 cents w ill be payable, leaving 70 cents th a t can be paid out as a franked dividend. An
Australian resident receiving th a t dividend w ill be taxed on an income o f $1 (the dividend plus the franking
credit o f 30 cents) and can claim the franking credit. W ith a marginal tax rate o f 45 per cent, the net tax
payable by the investor w ill be 15 cents and the dividend income after all taxes w ill be $0.70 - $0.15 = $0.55.
The alternative to payment o f dividends is retention o f profits, which, as discussed in Section 11.4.2,
can involve double taxation: income tax paid by the company plus capital gains tax paid by the
shareholder. Now suppose th a t the after-tax income o f 70 cents is instead retained by the company and
the retained funds result in a capital gain o f 70 cents when the shares are sold. I f the date o f the sale is
less than 1 year after the shares were purchased, the capital gain o f 70 cents w ill be taxed at 45 per cent,
resulting in capital gains tax o f $0.70 x 0.45 = $0.315. Therefore, the shareholders after-tax income
w ill be $0.70 - $0.315 = $0.385. Since this is much less than $0.55, it is clear th a t the Australian tax
system provides a strong incentive fo r companies to pay the m axim um possible in franked dividends. I f
the date o f the sale is more than 1 year after the shares were purchased, the taxable capital gain w ill be
50 per cent o f 70 cents or 35 cents, so the capital gains tax w ill be $0.35 x 0.45 = $0.1575. In this case
the net receipts w ill be $0.70 - $0.1575 = $0.5425, which is s till less, albeit only slightly so, than the
income from p ro fit distributed as a franked dividend. However, as discussed in Section 11.4.2, effective
rates o f capital gains tax can be lower than the rate we have used in this calculation. Thus, while the
im putation system favours d istrib u tio n o f profits, the fact th a t long-term capital gains are taxed at lower
rates than ordinary income reduces the incentive fo r d is trib u tio n and fo r some investors the effective rate
of capital gains tax may be so low th a t they would prefer retention o f profits. Overall, the com bination
o f the im putation system and capital gains tax means th a t investors could d iffer in th e ir preferences fo r
dividend income and capital gains: shareholders w ith low (high) m arginal tax rates w ill tend to prefer
companies th a t pay dividends (retain profits).
Many Australian companies have significant operations offshore. Profits th a t are earned and taxed
outside Australia cannot be paid to investors as franked dividends. Any dividends from these profits
w ill be unfranked and therefore subject to tax at the shareholders’ marginal income tax rate. In general,
shareholders can be divided in to three categories based on th e ir tax position:
a Shareholders who are taxed at the same rate on ordinary income and capital gains. Investors in this
category w ill be indifferent between payment o f unfranked dividends and retention o f profits,
b Shareholders who are taxed at a lower rate on capital gains than on ordinary income. Investors in
this category w ill prefer retention o f profits rather than payment o f unfranked dividends,
c Shareholders who are taxed at a higher rate on capital gains than on ordinary income. Any investors
in this category would prefer all profits to be distributed.
Under the Australian tax system, share traders who sell shares after holding them fo r less than
12 months would fall in to the firs t category. Investors who hold shares fo r more than 12 m onths are in
the second category. I t is unlikely th a t any investors would fall into the th ird category. Therefore, many
investors w ill have a tax-based preference fo r retention o f profits rather than unfranked dividends, some
w ill be indifferent between these alternatives and none should prefer payment o f unfranked dividends.
Pattenden and Twite (2008) examined the dividend policies o f a sample o f Australian companies
over the period 1982 to 1997 to assess the effects o f the intro du ction o f the im p utatio n tax system in
1987. They found significant changes in both the magnitude and form o f dividends, which supports the
argument th a t taxes have an im p o rta n t role in determ ining payout policies. Their study is broad in that
they examined the d istrib u tio n o f tax credits across all types o f dividend payments. Accordingly, they
measured gross dividend payouts defined as the sum o f all cash dividends, scrip dividends, bonus shares
issued in lieu o f dividends and share repurchases. Investor demand fo r d is trib u tio n o f franking credits
was expected to boost dividend payouts after the intro du ction o f the im p utatio n system, b ut corporate
funding needs may well p ro m p t additional share issues to offset the additional payouts. Therefore,
Pattenden and Twite also examined net dividend payouts defined as gross dividend payouts net o f cash
raised by issuing shares through dividend reinvestm ent plans, rights issues, public issues and placements.
In addition, they examined cases where companies began to pay dividends fo r the firs t tim e — known as
dividend in itia tio n s— and also tested fo r changes in the v o la tility o f payouts.
Consistent w ith investor demand fo r d istrib u tio n o f franking credits, Pattenden and Twite found
that the introduction o f the im p utatio n tax system resulted in a higher frequency o f dividend in itia tio n s ,
increases in gross and net dividend payout, greater use o f dividend reinvestm ent plans and th a t the
vo la tility o f the gross dividend payout increased. They also found th a t the effects o f the change in tax
system differed across companies. For example, after the intro du ction o f the im p utatio n system, gross
dividend payouts were higher fo r companies w ith a high effective Australian company tax rate and
companies w ith a greater capacity to frank dividends were more likely to in itia te dividends.
In summary, the im p utatio n system creates an incentive to distribute profits as dividends— b ut only
to the extent th a t the dividends can be franked. Where a company has profits th a t could be d istributed as
unfranked dividends, many investors w ill prefer th a t these profits be retained.
The argument th a t investors w ill prefer franking credits to be d istributed rather than retained assumes
that these tax credits are valuable to investors. There is strong evidence to support this assumption.
Much o f this evidence has been obtained by observing rates o f retu rn on shares on the ex-dividend day
B usiness finance
DIVIDEND and by observing the dividen d d r o p -o ff ratio, which is the ratio o f the decline in the share price on the
DROP-OFF RATIO ex-dividend day to the dividend per share. The basis fo r this approach is straightforw ard. Suppose that
ratio of the decline in
shares in XYZ Ltd w ill begin trading on an ex-dividend basis tom orrow. W hat effect should this have on
the share price on the
ex-dividend d a y to the
the share price? Investors who buy XYZ shares tom orrow are paying fo r an interest in the company s
divide nd per share future net cash flows. Investors who bought XYZ shares today were buying essentially the same interest
in future net cash flows, plus the dividend. Therefore, the drop-off in share price between today and
tom orrow should reflect the value to investors o f the dividend. I f the dividend is franked, then the drop
o ff in share price should reflect the combined value o f the cash dividend and the associated franking
credit. Example 11.3 illustrates the effect o f franking credits on the ex-dividend drop-off.
Example 11.3
Norfolk Ltd shares have a closing price of $10.85 on 9 November 2015. On the next day they
6
will begin trading on an ex-dividend basis. The dividend is 40 cents per share, fully franked at the
company tax rate of 30 per cent. What is the expected ex-dividend share price?
SOLUTION
Investors who buy Norfolk shares on 10 November are paying for an interest in the company's future net
cash flows. Investors who bought the shares on 9 November were buying essentially the same interest
in future net cash flows, plus the dividend. Since the dividend is fully franked, it carries a tax credit that
is equal to (dividend x fc) /( l - tc) = ($0.40 x 0 .3 0 )/0 .7 0 = 17.14 cents. Therefore, if expectations
of Norfolk's future cash flows remain unchanged, and if both the dividend and the tax credit are fully
valued by investors, the ex-dividend drop-off should be 4 0 cents + 17.14 cents = 5 7 .1 4 cents, giving
an expected ex-dividend share price of approximately $ 1 0 .2 8 .11
As shown in Example 11.3, the ex-dividend drop-off fo r franked dividends can be larger than the
dividend because o f the value o f franking credits. There is clear evidence to support this claim in cases
where companies pay large special dividends th a t are franked. In such cases, the share price fa ll on the
ex-dividend date is typically more than the am ount o f the cash dividend. For example, in 1995 Energy
Resources o f Australia Ltd (ERA) paid a special dividend o f $2.50 per share. The dividend was franked and
carried a franking credit o f $1.56 per share.12 The ex-dividend date was 29 June 1995. The closing price o f
ERA shares on 28 June was $6.86 and on 29 June the closing price was $3.10. Thus, based on daily closing
prices, the ex-dividend drop-off was $3.76, which is considerably more than the cash dividend o f $2.50
and somewhat less than $4.06, w hich is the sum o f the cash dividend plus the franking credit.
Several Australian studies o f large samples o f companies also provide evidence th a t franking credits
are valuable. Bellamy (1994, p. 282) found th a t fo r each year in the period 1987-88 to 1991-92, the
mean d ro p-off ratio fo r franked dividends exceeded th a t fo r unfranked dividends. For the whole period,
the mean d ro p-off ratio fo r franked dividends was 0.89 compared w ith 0.66 fo r unfranked dividends.
Brown and Clarke (1993) and Hathaway and Officer (2004) b oth studied the d ro p-off ratio and found
th a t the m arket places a positive value on franking credits, b u t each study encountered difficulties in
q ua ntifyin g th a t value. For example, when th e ir sample was restricted to large companies, Hathaway and
Officer estimated th a t the value o f fran king credits was between 49 and 52 per cent o f th e ir face value.
However, the results fo r small and medium-sized companies were erratic and unreliable— a problem
th a t they a ttrib u te d to the fact th a t the shares o f many small companies do n o t always trade over the
ex-dividend date period. A related problem is th a t in many cases the dividends (and the associated
fran king credits) on ordinary shares are small relative to the share price and those prices can be
quite volatile, which makes i t d iffic u lt to accurately q ua n tify the effect o f shares beginning to trade
ex-dividend. In other words, w ith relatively small dividends and high price v o la tility, the Signal-to-noise
ratio* is low in studies o f th is type. Feuerherdt, Gray and Hall (2010) address this problem by focusing
11 This result assumes that the tax rate on the grossed-up dividend is the same as the tax rate on capital gains.
12 At that time the company tax rate was 36 cents in the dollar, so a fully franked dividend of $2.50 would carry a tax credit of
approximately $1.41. The larger tax credit for ERAs dividend reflects the fact that some of its tax credits were based on the
company tax rate of 39 cents in the dollar, which applied previously. Other companies that paid similar special fully franked
dividends include Joe White Makings Ltd and George Weston Foods Ltd. The case of ERAs special dividend is discussed by
McDonald and Collibee (1996).
on hybrid securities— preference shares— which have high dividend yields and prices th a t are relatively
insensitive to m arket movements so the signal-to-noise ratio is much higher than fo r o rdinary shares.
D uring the period they studied, the company tax rate was 30 cents in the dollar, so a fu lly franked
$1 dividend carried a fran king credit o f 43 cents.13 Feuerherdt, Gray and Hall found th a t fo r all the
securities they examined, the package o f a $1 dividend and the associated fran king credit had a value o f
$1. Hence, i f cash dividends are fu lly valued by investors, they fin d th a t fran king credits do n o t affect
share prices— which is consistent w ith security prices being set by non-resident investors who place no
value on franking credits.
Another problem in research o f this type is th a t the cum-dividend and ex-dividend prices are n ot
simultaneous. The ex-dividend drop-off is typically measured from the close o f trading on the last day
o f cum-dividend trading to the close o f trading on the follow ing day. Over a 24-hour period the share
price may change significantly due to overall m arket movements or the arrival o f company or ind ustry
inform ation. Therefore, ex-dividend drop-off ratios typically exhibit extreme variation. Walker and
Partington (1999) overcame this problem by analysing data from 1 January 1995 to 1 March 1997,
a period when the ASX allowed trading in cum-dividend shares after the official ex-dividend date. By
observing essentially simultaneous trades in cum-dividend and ex-dividend shares they were able to
observe an ‘instantaneous drop-off ra tio ’. For a sample o f 1015 trades covering 93 ex-dividend events
they found th a t the average instantaneous drop-off ratio fo r fu lly franked dividends is 1.23. Therefore
they concluded that a dollar o f franked dividends is w o rth significantly more than $1.
Cannavan, Finn and Gray (2004) also id e n tify problems inherent in using the dividend drop-off
approach to estimate the value o f franking credits. One problem is th a t efforts to separate the values
o f cash dividends and the tax credits attached to them rely on the im p lic it assumption th a t the value of
dividends is independent o f the degree o f franking. I f there are ‘im p utatio n clienteles’ where resident
investors are attracted to companies paying fu lly franked dividends, this assumption may n o t be valid.
Another problem is th a t dividend drop-off studies typically assume th a t the value o f tax credits remains
the same over the sample period and is constant across companies in the sample.
Cannavan, Finn and Gray avoid these problems by in fe rrin g the value o f tax credits from the relative
prices o f individual share futures contracts and the prices o f the underlying shares. One advantage o f
this approach is th a t a larger num ber o f observations can be used because it is n o t necessary to restrict
the data to observations around the ex-dividend date. A nother advantage is th a t the value o f tax credits
can be estimated separately fo r different types o f shares. For example, tax-paying resident investors w ill
value all tax credits highly, b ut non-residents w ill value tax credits only i f they can in some way transfer
tax credits to residents. Some schemes have been developed fo r m aking such transfers, b u t they can
involve significant transaction costs, and the use o f such schemes may be w orthw hile only fo r high-
yielding shares w ith fu lly franked dividends. Hence, i f the m arginal investors in Australian shares are
non-residents, then the m arket value o f tax credits may be related to the dividend yield.
In an e ffo rt to restrict transfers o f tax credits between investors, the tax laws were amended in
1997 w ith the intro du ction o f a holding period rule, which provides th a t an investor can use a franking
credit only i f the shares in the company are held at risk fo r at least 45 days around the date o f dividend
entitlem ent. Cannavan, Finn and Gray found th a t p rio r to the 45-day rule, franking credits were valued
at up to 50 per cent o f face value fo r high-yielding companies. A fte r the intro du ction o f the 45-day rule,
they found no evidence o f franking credits having any value. These results are consistent w ith share prices
in the Australian m arket being set by non-resident investors who were able to extract some value from
franking credits distributed by large high-yielding companies p rio r to the intro du ction o f the 45-day rule.
A fte r the intro du ction o f the rule, franking credits appear to be worthless in the hands o f non-resident
investors.
Beggs and Skeels (2006) examined the effects o f dividend im p utatio n on the ex-dividend share
price drop from its inception to m id-2004. They addressed two more issues th a t complicate the use o f
dividend drop-off ratios to estimate the value o f franking credits. First, the m arket value o f a dollar o f
cash dividend may n o t be equal to the m arket value o f a dollar o f franking credit. Second, the values
o f both cash dividends and franking credits could change over tim e and any such changes may be related
to amendments to the tax regime such as the intro du ction o f the 45-day rule in 1997 and the refunding
o f excess franking credits from 1 July 2000. Beggs and Skeels found th a t gross drop-off ratios— th a t is,
the ex-dividend price drop divided by the cash dividend plus the franking credit— were significantly less
13 The franking credit is 43 cents because $1/(1 - 0.3) - $1 = $1.43 - $1 = 43 cents.

B usiness finance
than 1 over the whole period studied. W hen th e ir model was extended to provide separate estimates o f
the cash drop-off ratio and the franking credit drop-off ratio fo r each financial year, they found th a t the
cash drop-off ratio was generally close to 1 b ut the estimated value was significantly less than 1 in five
o f the 18 years. In the case o f the franking credit drop-off ratio, its value was n ot significantly different
from zero fo r much o f the period, which suggests th a t m arginal investors placed no value on franking
credits. Im portantly, Beggs and Skeels found th a t the value o f franking credits was positive in the 2001 to
2004 period. This finding suggests th a t the intro du ction o f refunds fo r excess franking credits from 2000
caused a significant increase in the value o f franking credits to m arginal investors.
As discussed in Chapter 14, the findings outlined above have im p o rta n t im plications fo r the debate
on the effects o f im p utatio n on the cost o f capital fo r Australian companies. However, i t is im p o rta n t to
note th a t the factor used to reflect the value o f franking credits when estim ating the cost o f capital under
the im p utatio n tax system w ill n o t necessarily be the same as the value o f a dollar o f franking credits as
discussed in this section. The studies discussed here provide estimates o f the value o f a dollar o f franking
credits, given th a t those credits have been distributed. In contrast, as discussed in Section 14.5.4 the
effective company tax rate used in estim ating the cost o f capital also depends on the extent to which
franking credits are used to reduce personal taxes.14 This depends on a company s payout policy and on
the a b ility o f shareholders to utilise franking credits. W hile a fu ll im putation tax system has the potential
to ‘elim inate company tax’，Handley and Maheswaran (2008) analysed Australian Taxation Office data
and found that, on average, only 67 per cent o f the franking credits distributed by Australian companies
were used to reduce personal taxes over the period 1990 to 2000. The average u tilis a tio n rate increased to
81 per cent over 2001 to 2004.
Under New Zealands im putation tax system, im putation credits are norm ally attached to cash dividends
b ut can also be distributed via taxable stock dividends (bonus issues). Thus, there are taxable stock
dividends w ith im putation credits attached and non-taxable stock dividends th a t do n ot carry im putation
credits. This provides another setting fo r examining whether investors value im putation credits.
Im putation credits cannot be used u n til they are distributed to shareholders. However, the value o f any
such credits being stored by a company should be reflected in its share price. This argum ent implies that
shareholders can realise the value o f undistributed im p utatio n credits at any tim e by sim ply selling th eir
shares. Anderson, Cahan and Rose (2001) argue th a t taxable stock dividends d istributed by New Zealand
companies have two advantages. First, shareholders can realise the tax benefits o f im p utatio n credits
w ith o u t selling th e ir shares. Second, the present value o f the tax benefits is greater, the sooner they
are distributed to investors. Therefore, i f im p utatio n credits are valuable to investors, the share price
should increase when a company announces a taxable stock dividend. Moreover, the size o f this increase
should exceed the size o f the reaction to the announcement o f a non-taxable stock dividend. Consistent
w ith this expectation, Anderson, Cahan and Rose found th a t taxable stock dividends were associated
w ith average abnormal returns o f 4.39 per cent over a 2-day announcement period, compared w ith
2.96 per cent fo r non-taxable stock dividends.
Information effects and signalling

to investors
L E A R N IN G
O BJEC TIVE 6
There is empirical evidence th a t share price changes around the tim e o f the announcement o f dividend
Understand the
argum ent that payout changes and share repurchases are positively related to the change in payout (see Finance in Action at the
decisions m ay have end o f th is section). For example, i t is clear th a t announcements o f large increases in dividends are often
a role in pro viding followed im m ediately by increases in share prices, and th a t reductions in dividends can result in decreases
signals to investors in share prices.15 M ille r and M odigliani (1961, pp. 415-21) claimed th a t these facts do n o t invalidate th eir
dividend irrelevance theorem. They m aintained th a t i t is n o t the dividend payments per se th a t determine
the value o f a company, b ut the present and future cash flows from the company s investments. Managers
w ill usually have better inform a tion about a company s prospects than outside shareholders and i f this
inform a tion affects th e ir decisions about current dividend payments, then changes in dividends w ill
14 This point is emphasised by Hathaway and Officer (2004), pp. 6-7.

15 Studies that formally document these effects include Healy and Palepu (1988) and Balachandran, Krishnamurti, Theobold and
Vidanapathirana (2012).
4^^
convey management’s ‘inside’ info rm a tio n about future cash flows to the market. Thus, the announcement
o f a change in dividends provides the occasion fo r a change in share price, b u t the change in dividends
is not itse lf the cause o f the price change. In summary, M ille r and M odiglianis response was th a t the
inform ation effect o f dividends can be consistent w ith th e ir irrelevance theorem.
De Angelo and De Angelo dispute this approach and argue th a t the m arkets response to payout
announcements can be explained w ith o u t invoking the idea th a t the m arket is really responding to
inform ation about future earnings. They argue th a t payout policy does m atter_ th a t is, th a t the share
market places a value on dividends— because investors value securities only fo r the payouts they are
expected to provide (2006, p. 309). Therefore, it is logical th a t higher (lower) share prices follow the
announcement o f higher (lower) payouts.
I f dividend announcements do convey inform ation, it is possible th a t management deliberately uses
dividend policy to signal inform a tion to investors.16 This argum ent relies on the existence o f inform ation
asymmetry, whereby management has valuable inside inform a tion about the company. For example,
management may be very confident about the success o f a new product it has launched. Could management
not simply release a media statem ent telling everyone the good news? Yes it could— b ut would it be
believed? A company m ig ht release such a statement even i f it were n o t true. How can management
release inform a tion in a manner th a t w ill be believed? Dividends may provide a credible signal about a
company’s ‘q uality’ because the payment o f dividends is evidence th a t the company generates sufficient
cash to be able to pay dividends, and also provides inform a tion on managements expectations as to the
company s future pro fitab ility. O ther companies, w ith less favourable prospects, th a t attem pt to im itate
higher quality companies by increasing th e ir payout cannot do so w ith o u t increasing the risk o f being
forced to cut th e ir dividend in the future.
As noted earlier, there is clear evidence th a t changes in dividends appear to convey new inform ation
about company value. Several US studies report th a t dividend increases (decreases) are associated w ith
positive (negative) share price changes. For example, Grullon, Michaely and Swaminathan (2002) studied
a large sample o f dividend changes o f at least 12.5 per cent over the period 1967 to 1993. They found
that the average abnormal retu rn over a 3-day announcement period was 1.34 per cent (median 0.95
per cent) fo r dividend increases and -3.71 per cent (median -2.05 per cent) fo r dividend decreases. N ot
surprisingly, dividend in itia tio n s (omissions) are associated w ith positive (negative) price changes that
are larger than those th a t accompany dividend increases and decreases. Michaely, Thaler and Womack
(1995) found average abnormal returns over a 3-day announcement period o f 3.4 per cent fo r dividend
initiations and -7.0 per cent fo r omissions. Using Australian data from 1995 to 2008, Balachandran,
Krishnam urti, Theobold and Vidanapathirana (2012) found th a t dividend reductions were associated
w ith mean (median) abnormal returns o f -1 .7 per cent (3.4 per cent) over a 3-day period.
Many studies focus on the relationship between current dividends and future earnings. For example,
Healy and Palepu (1988) studied the p ro fit performance o f companies th a t in itia te d dividends and
companies th a t om itted dividends. For th e ir sample o f companies th a t in itia te d dividends, earnings had
increased rapidly p rio r to the dividend and continued to increase fo r the next 2 years. For companies
that om itted dividends, earnings decreased in the year o f omission b ut then increased significantly in
subsequent years— which is the opposite o f the prediction made by signalling models.
Benartzi, Michaely and Thaler (1997) found th a t there is a strong correlation between increases in
dividends and recent increases in p ro fit— th a t is, when dividends are increased, profits have already
increased. However, they found little evidence th a t increases in dividends are followed by fu rth e r
increases in p ro fit. In the 2 years follow ing dividend increases, they found th a t p ro fit changes are
essentially unrelated to the dividend changes. In the case o f dividend decreases they found th a t profits
tend to increase over the next 2 years. Hence, th e ir findings support the perverse result reported by Healy
and Palepu.
De Angelo, De Angelo and Skinner (1996) examined the dividend decisions made by managers o f
145 companies whose p ro fit declined after at least 9 consecutive years o f grow th in profits. The dividend
decision in Year 0, the year th a t the record o f sustained p ro fit grow th was broken, could convey valuable
inform ation to outsiders to help them assess whether the dow nturn was likely to be transient or persistent.
The managers o f 99 o f the 145 companies increased dividends in Year 0, b u t De Angelo, De Angelo and
Skinner found no evidence th a t these dividend increases were associated w ith favourable p ro fit surprises
in the future. Also, the subsequent p ro fit performance o f the companies th a t increased dividends was
16 Signalling models are discussed by Miller (1987).

B usiness finance
no better than th a t o f the companies th a t did n o t change th e ir dividends. Essentially, the study found
virtu a lly no support fo r the n otio n th a t dividend decisions provide reliable signals about future p ro fit.
The findings o f Grullon, Michaely and Swaminathan (2002) confirm the results from earlier studies.
They examined the p ro fita b ility (measured by return on assets) o f companies 3 years before and 3 years
after a change in dividends o f at least 12.5 per cent. They found th a t dividend-increasing companies move
from a period o f increasing retu rn on assets before the dividend increase to a period o f declining return
on assets after the increase. Moreover, companies th a t increased th e ir dividends the m ost experienced
the greatest decline in p rofitability. Dividend decreases follow a period o f declining retu rn on assets, but
after the dividend decrease, company p ro fita b ility tends to recover rather than decline further.
A fte r reviewing the large body o f empirical evidence on the in fo rm a tio n signalling argument, Allen
and M ichaely (2003) conclude that: <rThe overall accumulated evidence does n o t support the assertion that
dividend changes convey inform a tion about future profit*. They also conclude th a t i f company managers
do use dividends to signal, 4the signal is n o t about future grow th in earnings or cash flows*.
W hile there is agreement th a t the tra d itio n a l view th a t managers use dividends to signal th e ir
expectations o f fu tu re profits is n o t supported by em pirical evidence, several authors have suggested
th a t payout p olicy may s till provide useful in fo rm a tio n to investors. For example, Allen, Bernardo and
Welch (2000) argue th a t paying dividends is an effective way o f a ttractin g in s titu tio n s as shareholders.
In s titu tio n s such as pension funds are either largely or fu lly exempt from taxes and therefore may
be happy to invest in dividend-paying shares. Also, because o f th e ir scale, in s titu tio n s have a greater
incentive than individuals to become well inform e d about a company s activities and to m o n ito r its
perform ance. Therefore, paying dividends increases the likeliho od th a t a company^ tru e q ua lity w ill be
detected by investors. It follows th a t companies th a t are successful and w ell managed have an incentive
to pay dividends, even i f this increases taxes fo r some investors— as is the case fo r m ost individual
investors under the classical tax system. Allen, Bernardo and Welch argue th a t having in s titu tio n s as
shareholders makes i t like ly th a t a company w ill rem ain w ell managed so the resultant benefit to all
shareholders can offset the tax disadvantage o f dividends fo r taxable investors. Companies th a t are
less successful or poorly managed have no incentive to im ita te the b e tte r companies because they w ill
prefer th a t th e ir shareholders rem ain uninform e d and inactive.
G rullon, Michaely and Swaminathan (GMS) (2002) take a different approach. They reason th a t if
the in fo rm a tio n conveyed by dividend changes is n o t about future pro fitab ility, then it may relate to
changes in risk and, therefore, discount rates. As noted earlier, they studied a large sample o f dividend
changes o f at least 12.5 per cent announced by US companies between 1967 and 1993. GMS found that
companies th a t increase (decrease) dividends experience a significant decrease (increase) in systematic
risk. Companies th a t increase dividends also experience a significant decline in retu rn on assets and
increases in th e ir payout ratio tend to be permanent.
GMS propose w hat they refer to as the ‘m a tu rity hypothesis’. As companies make the tran sition from
a higher gro w th phase in th e ir life cycle to a lower grow th (mature) phase, th e ir investm ent opportunities
decline, which shows up in a declining rate o f reinvestment, declining return on investm ent and declining
risk. The declining reinvestm ent rate gives rise to excess cash, which should be paid o ut to investors.
This m aturation process is likely to be a lengthy one, b ut GMS argue that larger cash payouts may be
im p o rta n t signs o f this lengthy process. W hy would the m arket react positively to higher cash payouts
i f they are associated w ith companies m aking the tran sition from a grow th phase to a m ature stage w ith
lower retu rn on assets and lower grow th prospects? GMS found th a t the decline in ris k experienced
by dividend-increasing companies results in an economically significant decline in th e ir cost o f capital.
They also show th a t this decline in the cost o f capital can account fo r the positive price reaction to the
dividend-increase announcement, even when the dividend change conveys in fo rm a tio n about a decline
in the company’s grow th prospects’ （2002, p. 421).
Skinner and Soltes (2011) test whether payout policy provides in fo rm a tio n about the quality* o f
a company s reported earnings.17 They fin d th a t the relationship between current earnings and future
earnings is stronger fo r companies th a t pay dividends than fo r those th a t do not. In other words, the
reported earnings o f dividend-paying companies are more persistent than those o f other companies and
they fin d th a t it is dividends per se th a t m atter rather than the magnitude o f those dividends. Given that
share repurchases are another im p o rta n t way o f paying out cash, Skinner and Soltes also test whether
17 There is no single definition of earnings quality' but the concept may be illustrated by noting that a high-quality reported
earnings number is one that accurately reflects a company's operating performance and is a useful measure for assessing the
value of the company. Skinner and Soltes use the persistence of earnings to measure earnings quality.
repurchase activity is inform ative about earnings quality. They find th a t it is, b u t repurchases provide
a less credible signal than dividends— which is to be expected, since dividends represent a stronger
com m itm ent to continue to d istribute cash to shareholders.
As noted earlier, Brav, Graham, Harvey and Michaely (2005) surveyed and interviewed financial
executives to determine the factors th a t are im p o rta n t in m aking payout decisions. They fin d th a t managers
agree that both dividends and repurchases can convey inform a tion to investors. However, th eir responses
to more detailed questions reveal little support fo r the signalling theories we have discussed. In particular,
it is rare th a t managers view either type o f payout as a to ol th a t can be used to reveal private inform ation
or to signal a company s q uality relative to competitors. Similarly, managers believe that dividends and
repurchases are equally attractive to most in s titu tio n a l investors. Consequently, even companies th a t
wish to attract in stitu tio n s as shareholders do n ot consciously use payout policy as an im p o rta n t tool to
convince institutio ns to hold th e ir shares. Managers do, however, see a connection between risk reduction
and dividend increases. M any hold views th a t are consistent w ith the ‘m a tu rity hypothesis’ proposed by
GMS— that is, companies typically increase dividends when they become more mature and less risky.
The next section discusses the role o f dividends in reducing agency costs. The signalling and agency
cost arguments are related, b u t the way they are viewed differs depending on the underlying model th a t is
adopted. I f the M ille r and M odigliani (M M ) dividend irrelevance theorem is used as the starting point, the
signalling argument says th a t dividend changes convey news. A lternatively, the De Angelo and De Angelo
(DD) fu ll payout model holds th a t dividends are im p orta nt, so it has no need to invoke the inform ation
and signalling concepts to explain why share prices react to dividend-related announcements. In the case
o f agency costs, there is no difference between the M M and DD approaches: in b oth cases the agency cost
argument says th a t dividends are good news.
A N Z BANK AN N O U N CES INCREASED DIVIDEND_____________ Finance

in ACTION
The signalling argument under the Miller and Modigliani (MM) analysis suggests that dividend
N ews
n
changes convey news while the De Angelo and De Angelo (DD) model provides that dividend
changes themselves affect company values. In the case of an individual announcement by a company
concerning its dividend payout, it is not possible to differentiate between these explanations.
AN Z Bank shares have surged to a record high after it vowed to give shareholders a bigger
slice of future profits, raising investor hopes of even stronger returns across the sector. In a
result that smashed market expectations, A N Z hiked the interim dividend by 1 1 per cent to
73 cents a share on Tuesday, and said it would lift the share of profits paid as dividends as
it continued to cut costs and target growth across Asia. The $2 billion dividend payout was
underpinned by a 10 per cent jump in half-year earnings to $3.1 8 billion, but is also a sign the
bank is accumulating excess capital due to slow lending growth. Investors cheered the result,
pushing A N Z shares up by 5.8 per cent, or $ 1 .74, to a new high of $31.84.
Although analysts say bank dividend growth may soon cool off, A N Z chief executive Mike
Smith signalled he expected further earnings growth, as its push to lift productivity still had
more 'gas in the tank7. Helped by this earnings growth, the bank said it would lift its dividend
payout ratio towards the upper end of its target range of 65 to 70 per cent.
S o u rc e : 7A N Z su rge s o n profits p a yo u t', C la n c y Yeates, S y d n e y M o r n in g H e r a ld , 3 0 A p ril 2 0 1 3 .
11.6 Agency costs and corporate governance

We saw in Chapter 1 that, given the separation o f ownership and control o f companies, there can be
conflicts o f interest between shareholders and managers resulting in agency costs. Shareholders are aware L E A R N IN G
O B JEC TIVE 7
that these costs exist and may therefore impose restrictions on managers and give them incentives to make
Exp lain the w a y s in
financing and investment decisions th a t are expected to increase shareholders’ wealth. Various authors w hich a g e n c y costs
have argued th a t paying higher dividends can reduce agency costs, b ut there is no single or generally agreed can be related to
model o f how dividends achieve this outcome. D ifferent authors have suggested different mechanisms. p ayout d ecisions
B usiness finance
One approach is based on the fact th a t higher dividends w ill force a company to raise capital externally
more frequently than would otherwise be the case (Easterbrook 1984). Capital raising is accompanied
by the provision o f in fo rm a tio n to investors, underw riters and other capital m arket agents, particularly
potential new investors. As a result, investors w ill have the o p p o rtu n ity to scrutinise the company closely
at a relatively low cost. The capital raising process provides an efficient mechanism fo r contributors o f
new capital to m o n ito r the performance o f the managers. Existing shareholders also benefit from this
process because managers who are subject to regular m o n itoring are more likely to act in shareholders’
interests than managers subject to less scrutiny.
A nother approach focuses on the agency costs th a t are likely to arise when a company generates free
cash flowSy which are defined as cash flows in excess o f those required to fund all available projects that
have positive NPVs. Managers have incentives to achieve grow th because i t is likely th a t the larger the
company, the greater w ill be th e ir power and remuneration. Therefore, managers o f companies w ith
free cash flows are likely to retain cash and invest it in new projects, even i f the projects have negative
NPVs. This problem is known as overinvestment. It follows th a t shareholders’ wealth w ill be increased
i f managers com m it themselves to paying out this cash as dividends rather than retaining it w ith in the
company (Jensen 1986).18 This argument provides another possible explanation fo r the positive m arket
response to announcements o f dividend increases: investors welcome the higher payout m ainly because
they believe th a t managers cannot be relied upon to invest retained funds profitably.
This argument should be particularly strong fo r cash-rich companies in mature industries w ith few
grow th opportunities. Lang and Litzenberger (1989) tested this hypothesis using a measure known as
Tobins Q, which is the ratio o f the m arket value o f a company s assets to the estimated replacement
cost o f those assets. I f a company is successful (unsuccessful) in ide ntifyin g investments w ith positive
NPVs, its Q ratio should be greater (less) than one. For announcements o f dividend increases, Lang
and Litzenberger found th a t low Q companies had larger share price increases than high Q companies.
They interpreted this fin ding as being consistent w ith the free cash flow hypothesis. However, this
interpretatio n was questioned by Denis, Denis and Sarin (1994) and Yoon and Starks (1995), who found
th a t after controlling fo r the effects o f dividend yield and change in dividend yield, the m arket reaction to
announcements o f dividend changes was n ot related to a company’s Q ratio.
Lie (2000) undertook a direct exam ination o f the relationship between excess cash and payout policy
in the context o f special dividends, increases in regular dividends and share repurchases. He found that
in all three cases, companies m aking these payouts had higher cash holdings p rio r to the payout than
others in the same industry. Lie also found th a t the m arket reaction to the announcement o f special
dividends and share repurchases was positively related to the level o f cash relative to ind ustry norms.
Moreover, this relationship was stronger fo r companies w ith poor investm ent o pportunities as indicated
by th e ir having a Q ratio o f less than one. Lie concluded th a t shareholders1 wealth could be enhanced
by d istrib u tin g cash and thereby restricting p otential overinvestment by managers. As discussed in the
previous section, the findings o f Grullon, Michaely and Swaminathan (2002) are also consistent w ith the
free cash flow hypothesis.
In summary, evidence on the significance o f the free cash flow hypothesis is mixed, b u t most o f it is
consistent w ith the argument th a t higher payouts can add value by reducing the p otential fo r management
to overinvest. Similarly, it is n ot hard to fin d cases where investors welcome increased payouts because the
higher payout indicates th a t management has changed its priorities. The response to an announcement
by the Chairman o f Telstra Corporation in June 2004 is a good example (see Finance in A ction at the end
o f this section).19
La Porta, Lopez-De-Silanes, Shleifer and Vishny (2000) outline and test two agency models o f dividends
using legal protection o f shareholders as a proxy fo r agency problems between corporate insiders and
outsiders. The ‘outcome model’ proposes th a t dividends are paid because effective legal protection allows
outside shareholders to pressure corporate insiders to pay o ut cash, thus lim itin g the extent to which
insiders can use company profits to benefit themselves.20
18 J e n s e n a r g u e s t h a t th e u s e o f d e b t fin a n c e w ill b e p a r t ic u la r ly e ffe c tiv e in r e d u c in g t h e s e a g e n c y c o s t s b e c a u s e se v e r e p e n a lt ie s

a re a s s o c i a t e d w ith fa ilu r e to m e e t o b lig a t io n s to le n d e r s . C o m m it m e n t s t o p a y r e g u la r d iv id e n d s m a y h a v e a sim ila r , b u t le s s
p r o n o u n c e d , e ffe c t b e c a u s e o f th e w e ll-k n o w n r e lu c ta n c e o f m a n a g e r s t o r e d u c e d iv id e n d s .
19 T h e e x a m p le o u t lin e d h e re is d is c u s s e d m o r e fu lly b y E a s t o n a n d H o w a r d ( 2 0 0 5 ).
20 T h is a r g u m e n t d o e s n o t re ly o n o u t s id e s h a r e h o ld e r s h a v in g a n y sp e c ific r ig h t to d iv id e n d s . R a th e r , th e a r g u m e n t is t h a t
s h a r e h o ld e r s w h o h a v e th e m o re g e n e r a l r ig h t s to v o t e fo r d ir e c t o r s a n d to r e s is t o p p r e s s i o n a n d w e a lth e x p r o p r ia t io n w ill b e
a b le to e x t r a c t d iv id e n d s fr o m c o m p a n ie s . F o r e x a m p le , s h a r e h o ld e r s m a y v o te fo r d ir e c t o r s w h o o ff e r b e t t e r d iv id e n d p o lic ie s
o r m a y s u e c o m p a n ie s t h a t u s e r e s o u r c e s in w a y s t h a t b e n e fit o n ly th e in s id e r s .
^^
4
Alternatively, dividends may be seen as a substitute fo r legal protection o f shareholders. This view
is based on the need fo r companies to approach the capital markets to raise funds externally, at least
occasionally. The substitute m oder proposes th a t insiders, who are interested in raising equity in the
future, pay dividends to establish a reputation fo r favourable treatm ent o f outside shareholders. A good
reputation w ill be o f greatest value in countries where legal protection o f m in o rity shareholders is weak
and such shareholders have little to rely on apart from a company s reputation.
La Porta, Lopez-De-Silanes, Shleifer and Vishny tested these models using a sample o f more than
4000 companies from 33 countries w ith different legal systems and different legal protection o f
shareholders. Investor protection is generally stronger in common law countries such as the US, UK
and Australia than i t is in civil law countries such as France, Spain and Japan. The outcome model has
two testable predictions. First, if dividends are an outcome o f an effective system o f legal protection
for investors, then dividends should be higher in countries where th a t protection is better. Second, fo r
companies in these countries i t predicts a relationship between investm ent opportunities and dividends.
High-growth companies should make lower payouts than low -grow th companies because shareholders
who feel well protected w ill accept low payouts from companies w ith good investm ent opportunities. The
alternative substitute model makes only one prediction: dividend payouts should be higher in countries
where legal protection o f investors is weak.
La Porta, Lopez-De-Silanes, Shleifer and Vishny found consistent support fo r the outcome model.
Companies operating in countries where legal protection o f investors is better, pay higher dividends. This
result is consistent w ith the outcome model and is the reverse o f the substitute models prediction. Also,
in countries where investors are well protected, there is a relationship between dividends and growth.
Companies th a t are growing more rapidly, as measured by grow th in sales, pay lower dividends than slow-
growth companies. This fin ding is consistent w ith the view th a t investors who are well protected legally
are prepared to w ait fo r dividends provided th a t a company has good investm ent opportunities.
Correia Da Silva, Goergen and Renneboog (2004) propose th a t dividend policy may be influenced
by corporate governance regimes that, like investor protection, d iffer between countries. They define a
corporate governance regime as *the amalgam o f mechanisms which ensure th a t the agent (the management
o f a corporation) runs the company fo r the benefit o f one or m ultiple principals (shareholders, creditors,
suppliers, clients, employees and other parties w ith whom the company conducts its business)1(p. 156).
Corporate governance regimes may be m arket based or blockholder based. The market-based regime
applies in countries such as the UK, the US and Australia and is characterised by diffuse ownership o f listed
companies, the one-share-one-vote rule, an active m arket fo r corporate control and strong shareholder
and creditor rights. In contrast, the blockholder system th a t is common in Europe involves the presence
o f large blockholders, complex ownership structures such as cross-ownership between companies,
frequent violations o f the one-share-one-vote rule and weak legal protection o f shareholders. Correia
Da Silva, Goergen and Renneboog suggest th a t dividend policy may have different roles under these two
regimes. For example, the greater concentration o f control th a t is inherent in the blockholder system may
mean th a t there is less pressure on managers to com m it to paying high dividends as a way o f avoiding
overinvestment. Also, dividends may be less im p o rta n t as a signal when control is more concentrated.
As well as involving differences in the concentration o f control, the tw o regimes differ in terms o f the
nature o f control. In market-based countries, m ost shares are held by financial in stitu tio n s b ut the holding
o f each in s titu tio n in a given company is usually small. In European countries the m ain shareholder
categories are families or individuals, corporations and, in the case o f Germany, banks. Banks are an
im portant source o f finance fo r German companies and often hold significant voting stakes as well as
being the main provider o f debt finance. Thus, the separation o f ownership and control th a t is the source
o f many agency problems under the market-based regime is n o t an issue fo r many German companies.
Correia Da Silva, Goergen and Renneboog examined the dividend policies o f German companies
and compared th e ir findings w ith those from the existing body o f empirical research, m ost o f which
has been conducted on companies operating under the market-based system. They found several
differences between the dividend practices o f German companies compared w ith UK and US companies.
First, German companies pay out a lower p roportion o f th e ir cash flows. Second, w hile the dividends
per share o f UK and US companies are relatively sm ooth over tim e w ith frequent small adjustments, the
dividends per share o f German companies exhibit less frequent b ut larger changes. In particular, German
companies frequently reduce or o m it dividends i f they incur a loss, b u t quickly revert to the payout p rio r
to the reduction or omission once p ro fita b ility is restored. These findings contrast w ith L in tn e rs (1956)
prediction th a t managers w ill only make dividend changes th a t they believe w ill n ot have to be reversed
B usiness finance
in the short run. In other words, the blockholder regime o f corporate governance appears to provide
companies w ith greater fle x ib ility in terms o f th e ir dividend policies. A nother im p o rta n t result is that
bank ownership o f the vo ting equity o f German companies is associated w ith a lower level o f dividends
and a greater propensity to o m it the dividend when p ro fit falls. Thus, direct control by a bank can be seen
as reducing agency costs.
In summary, the legal protection o f investors th a t was stressed by La Porta, Lopez-De-Silanes, Shleifer
and Vishny may n o t be the m ost im p o rta n t factor th a t explains differences in dividend policy between
countries. O ther differences between corporate governance regimes, such as the concentration and
nature o f control, are also im p o rta n t and the evidence from Correia Da Silva, Goergen and Renneboogs
study is consistent w ith the view th a t control is a substitute fo r dividends as a mechanism fo r m on itoring
management and reducing agency costs.
Finance AGENCY COSTS AT TELSTRA__________________________________

in ACTION
The market reaction to the announcement in June 2004 of a new capital management strategy
for Telstra Corporation provides an excellent illustration of the role that payout policy can play in
alleviating investors' concerns about the use of free cash flows.
Telstra, Australia's largest telecommunications company, had been strongly criticised in previous
years over its strategy of growth by acquisition. This strategy—regarded by critics as poorly
executed —led to investments in Asia and technology-related investments that resulted in write
downs of more than $2 billion. A failed attempt to merge its directories business with media
company John Fairfax Holdings also attracted criticism, split the Telstra board and contributed
to the resignation in April 2 0 0 4 of former chairman, Bob Mansfield. The Fairfax plan had been
put forward by Mansfield together with [then] Telstra CEO, Dr Ziggy Switkowski.
〇n 21 June 2 0 0 4 , the new chairman of Telstra released a statement on capital management
which included the following:
The Telstra Board o f Directors has undertaken with management its review o f the
Company's strategy os port o f the annual budget and planning process. The operating
strategy o f Telstra has been reaffirmed and new capital settings have been established.
The Company expects future cosh flows from operations to remain robust.
Accordingly, the Board has adopted the following capital management policies from
the 2 0 0 4 -0 5 year:
• The Board's policy w ill be to declare ordinary dividends o f around 80 per cent o f
normal profits offer tax.
• The Board expects to return $ 1 .5 billion to shareholders each year for the next three
years through special dividends o n d /o r shore buybacks, subject to maintaining the
Board’s target balance sheet ratios.
• The Board notes that offer appropriate capital expenditures and the proposed capital
returns to shareholders, the company w ill have sufficient balance sheet capacity to
support well targeted acquisitions o f moderate scale and which satisfy strict financial
criteria [emphasis added].
Analysts noted that the higher cash payout would result in higher financial leverage and the
announcement sparked a credit downgrade by rating agencies such as Standard & Poor's.
Telstra shares jumped by 4.6 per cent in response to the announcement to a nine-month high of
$5.02. Peter M organ, director of fund manager 4 52 Capital, said: 'This is a step in the right
direction. If they have excess capital, they should be returning it to shareholders. W hat the
market has been concerned about is that their acquisitions so far have been disappointing’ .
Other commentators pointed to the significance of the Board's commitment to an 80 per cent
payout ratio in comparison to the previous commitment to distribute at least 60 per cent of
profits.
S o u rc e : A d a p te d from Telstra M e d ia Release, 'Statem ent from M r John Ralph, C h a irm a n of the B oard , Telstra C o rp o ratio n
on the matter o f C a p ita l M a n a g e m e n t ’， O ffice of the C o m p a n y Secretary, 21 June 2 0 0 4 .
Behavioural factors and catering theory

As we discussed in Section 11.2.3, the M odigliani and M ille r analysis assumes th a t capital markets are
perfectly competitive. It also assumes th a t investors are rational and th a t they are equally satisfied w ith L E A R N IN G
O B JEC TIVE 8
a given increase in wealth, regardless o f whether it is in the form o f dividends or an increase in the value
Explain behavioural
of the shares they hold. Baker and W urgler (2004a, 2004b) present and test a theory th a t relaxes these factors that m ay affect
assumptions. payout policy
This theory has three foundations. First, it is assumed th a t n ot all investors are rational and th a t
sometimes investors prefer dividends to increases in the value o f th e ir shares and sometimes they prefer
increases in the value o f th e ir shares to dividends. Second, i t is assumed th a t i f investors are sometimes
w illing to pay more to invest in companies th a t pay higher dividends th a t the process o f arbitrage, as
discussed in Section 1.5.7, w ill fa il to prevent these companies having higher prices than those th a t do
not pay dividends. Third, managers cater to this investor demand by paying dividends when investors
place higher value on dividends, and not paying dividends when investors place higher value on increases
in the value o f th e ir shares. It is from these foundations th a t c a te rin g th e o ry is derived: the theory that CATERING THEORY
managers cater to changes over tim e in investor demand fo r dividends. theory that suggests
that m a n a g e rs cater to
To test this theory, Baker and W urgler (2004a) examine whether the market-wide rate o f companies
c h a n g e s ove r time in
in itia tin g or o m ittin g to pay dividends depends on the presence o f a so-called ‘dividend prem ium ’ in investor d e m an d for
share prices. A company’s dividend premium is measured as a ratio given by the m arket value o f its shares d ivid e nd s
divided by the book value o f its shares. The market-wide dividend premium is the difference between the
average o f this ratio fo r companies paying dividends and those n o t paying dividends. Baker and W urgler
argue that this m arket-wide dividend prem ium is due to investors being w illin g to pay more to hold payers
than non-payers. They also argue th a t i f a dividend prem ium is present it w ill lead to a difference between
the future share returns o f dividend-paying and non-dividend-paying companies. Specifically, they argue
that i f demand fo r dividends is high this w ill lead to the share prices o f dividend-paying companies being
overpriced, and hence th e ir future returns to be relatively low.
Using US data from 1963 to 2000 they fin d th a t m arket-wide dividend initia tion s are higher in years
following years in which the m arket-to-book ratio fo r dividend-paying companies is higher than fo r
non-dividend-paying companies. They also find th a t increases in market-wide dividend in itia tio n s are
followed by years in which shares in dividend-paying companies underperform shares in non-dividend
paying companies. Sim ilarly they find th a t market-wide dividend omissions are high in years follow ing
years in which the m arket-to-book ratio fo r dividend-paying companies is low relative to th a t fo r non
dividend-paying companies. Further, they fin d th a t increases in market-wide dividend omissions are
followed by years in which shares in dividend-paying companies outperform shares in non-dividend
paying companies. These results suggest th a t dividends are relevant to share prices, and th a t managers
cater to changes over tim e in investor demand in order to maximise the current share price.
However, Hoberg and Prabhala (2009) have cast doubt on these findings by showing th a t the
relationship between the so-called dividend prem ium and companies paying dividends may be due to
risk— a factor th a t Baker and W urgler ignored. Hoberg and Prabhala argue th a t riskier companies adopt
more conservative payout policies to avoid the potential o f needing to cut dividends. And as was discussed
in Section 7.7, some studies suggest th a t companies w ith lower m arket-to-book ratios may be riskier.
Therefore they argue th a t the difference between the m arket-to-book ratios o f dividend-paying and non
dividend-paying companies may be due to risk differences and th a t this in tu rn leads to differences in
future returns. As economy-wide risk varies over tim e so does this relationship between risk and return.
When Hoberg and Prabhala control fo r this risk factor they fin d no residual relationship between the
so-called dividend prem ium and companies1propensity to pay dividends.
L E A R N IN G
11.8 Share buybacks O B JEC T IV E 9
U nde rstand the nature
of share buybacks,
Most cash paid out to the shareholders o f Australian companies is distributed as dividends. As discussed d ivid e n d reinvestment
in Section 11.1.4, changes to the Corporations Act in 1989 and 1995 mean th a t companies can also pay p la ns a n d d ivide nd
cash to shareholders by repurchasing shares. This m ethod o f d istrib u tin g cash has grown rapidly since election schem es
4 ^^
B usiness finance
1995. In the 1995 financial year, share repurchases by listed companies totalled $770 m illio n (Renton
2000, p. 38) and, as noted in Section 11.1.4, the to ta l peaked at about $16 b illio n in 2010. Rapid growth
in share repurchases since the 1990s appears to be a global phenomenon. M any other countries that
previously prohibited share repurchases, such as Germany and Japan, also introduced provisions that
allow companies to repurchase shares. Share repurchases also grew dramatically in countries like the US,
Canada and the UK where repurchases had long been perm itted. For example, between 1985 and 1996,
the value o f open-market repurchase programs announced by US industrial companies increased by 750
per cent from $15.4 b illio n to $113 billion , while aggregate dividends increased by a factor o f ju s t over
two during the same period (Jagannathan, Stephens & Weisbach 2000, p. 356). In 1999, fo r the firs t tim e
in history, and again in 2000, US ind ustria l companies distributed more cash to investors through share
repurchases than through cash dividends (G rullon & Michaely 2004, p. 651).
I f there are no taxes or other imperfections, repurchasing shares is effectively the same as paying a cash
dividend. Accordingly, many o f the factors th a t may explain why companies repurchase shares are the
same as those th a t may explain why they pay dividends. For example, i f the agency costs o f free cash
flow can be reduced by paying dividends, they can also be reduced by repurchasing shares. In terms o f
a company s assets and operations, the end result o f taking surplus cash out o f the company should
be the same, regardless o f the m ethod used to pay out the cash. Indeed, G rullon and Michaely (2004)
report th a t th e ir analysis ‘indicates strong sim ilarities between companies th a t increase dividends and
those th a t use open-market share repurchases, (p. 653). In b oth cases, p ro fita b ility does n o t increase and
risk and the cost o f capital decline. They conclude th a t these and other sim ilarities suggest th a t Sim ilar
factors m otivate companies to repurchase shares in the open m arket and to increase dividends* (p. 654).
However, the m ethod o f payment can matter. For example, suppose th a t managers are more reluctant to
cut dividends than they are to cancel share repurchase programs. I t follows th a t dividends may be better
in controlling agency costs because they represent a stronger com m itm ent to continue paying out cash.
Similarly, dividends and share repurchases may both be used as signals o f a managers expectations b ut
the in fo rm a tio n conveyed to investors may be different. In particular, an increase in dividends is likely to
signal a more perm anent increase in cash flows than a one-off share repurchase.
In this section we discuss several factors th a t may influence the decision to retu rn cash to shareholders
by repurchasing shares and review empirical evidence on the effects o f share repurchases.
Improved perform ance measures

Company announcements o f share buybacks and reports in the financial press often m ention th a t the
buyback is expected to have a favourable effect on performance measures, particula rly earnings per share
(EPS) and net assets per share. Focusing on the effects on EPS may reflect an assumption th a t the m arket
w ill react mechanically to increases in EPS by increasing the share price. This 4EPS-based* rationale fo r
buybacks raises tw o m ain issues.
First, to repurchase shares a company m ust use cash th a t could have been invested elsewhere.
Therefore, unless the buyback is financed by borrowing, the company w ill have fewer assets after the
buyback. I f the assets were being used efficiently, earnings w ill also be lower so EPS w ill increase only if
the decrease in earnings is less, in percentage terms, than the decrease in the num ber o f shares on issue.
I f the company has surplus cash th a t i t cannot invest profitably, then using the cash to repurchase shares
should certainly increase EPS. However, the real source o f any gain to investors is the more efficient use
o f resources, n o t some magical reaction to the higher EPS.
Second, a share buyback reduces the company s equity and increases its financial leverage, particularly if
the buyback is financed by borrowing. Higher leverage means higher risk for shareholders and this w ill tend
to reduce the share price and hence lower the price-earnings (P/E) ratio. In summary, i f the only reason for
a share buyback is that it is expected to increase EPS, the probability that the share price w ill increase is low.
Signalling and undervaluation

As discussed in Section 11.5, managers are likely to have better in fo rm a tio n about a company s true value
than outside investors and may use changes in dividends to convey info rm a tio n to investors. Arguably,
share repurchases may serve a sim ilar purpose. In the case o f share repurchases, there are tw o versions
o f the signalling hypothesis. The firs t version is th a t the announcement o f a share repurchase could
provide new inform ation: managers expect th a t earnings and cash flows w ill be higher in the future. The
second version is th a t managers may use repurchases to indicate th a t they disagree w ith the m arkets
valuation o f the company based on existing public inform ation. Several studies, including Comment and
Jarrell (1991), fin d negative abnormal returns in the m onths p rio r to the announcement o f open-market
repurchase programs. This fin ding suggests th a t managers make repurchase announcements at times
when they believe th a t the shares are undervalued.
Early studies, such as Bartov (1991), found support fo r the firs t version o f the signalling hypothesis
in that there is some evidence o f earnings grow th follow ing repurchases. However, the findings o f a more
recent and comprehensive study (Grullon & Michaely 2004) are inconsistent w ith the hypothesis that
repurchases signal good news about future earnings. This study found a significant decline in operating
p ro fit as a percentage o f to ta l assets over the 3 years follow ing the announcement o f a repurchase
program. I t also found th a t analysts revise th e ir forecasts o f earnings per share downwards after these
announcements are made.
Managers who believe th a t th e ir company s shares are undervalued could tr y to signal th a t belief by
increasing dividends or repurchasing shares. Any share price increase follow ing an increase in dividends
accrues proportionately to all current shareholders. In contrast, i f the share price appreciates follow ing a
repurchase, then insiders and any other shareholders who do n o t sell w ill benefit disproportionately. This
difference suggests th a t perceived undervaluation may lead managers to favour repurchases rather than
dividend increases.
To examine the u ndervaluation version o f the signalling hypothesis, Ikenberry, Lakonishok and
Vermaelen (1995) analysed share returns fo r a period o f 4 years fo llo w in g repurchase announcements
by more th an 1200 US companies. For the whole sample they found excess returns o f more than
12 per cent over the 4-year period. Excess returns were measured relative to a benchm ark p o rtfo lio
form ed on the basis o f company size and book-to-m arket ratio. This overall result is consistent w ith
the p ossibility th a t companies are undervalued, on average, at the tim e repurchases are announced.
Ikenberry, Lakonishok and Vermaelen also found th a t excess returns over the 4-year period were
strongly related to the book-to-m arket ratio. For companies w ith the lowest book-to-m arket ratio
(gla m o u r1 stocks), the average excess re tu rn was slig h tly negative, w hile fo r those w ith the highest
book-to-m arket ratio (Value* stocks), the average excess re tu rn was extrem ely high. The sample
contained companies w ith a wide range o f book-to-m arket ratios and was n o t s ig n ifica n tly biased
towards value stocks.
In summary, the results suggest th a t some groups o f companies are fa irly priced at the tim e o f
repurchase announcements, b u t in other cases managers do appear to be indicating th a t th e ir company
is undervalued.
Resource allocation and agency costs

The share m arket plays an im p o rta n t role in allocating capital between competing investm ent
opportunities. Profitable companies w ith good investm ent opportunities should experience increases in
share price th a t make it easier to raise capital. Conversely, i f a company has run out o f positive NPV
investments, then any surplus capital should be returned to shareholders, who are then free to invest it
elsewhere. I f share repurchases are part o f this process o f resource allocation in the capital market, then
repurchases should be associated w ith reduced investm ent opportunities.
The empirical evidence is consistent w ith this suggestion. US companies th a t repurchase shares
via tender offers do, on average, have smaller asset bases after the repurchase transactions. Similarly,
US companies subsequently make lower capital expenditures after open m arket repurchases (Nohel &
Tarhan 1998). G rullon and Michaely (2004) found th a t any changes in p ro fita b ility in the years after
share repurchase are negative rather than positive. Like Nohel and Tarhan, they found th a t companies
that repurchase th e ir shares subsequently decrease th e ir investments. G rullon and Michaely conclude
that repurchase announcements are viewed positively by investors because they are related to a reduction
in the agency costs o f free cash flow.
In summary, there is evidence th a t share repurchases are im p o rta n t in allowing capital to be released
from declining sectors o f the economy and reallocated to sectors where the investm ent opportunities are
better.
B usiness finance
Financial flexibility
Jagannathan, Stephens and Weisbach (2000) propose th a t the choice between dividends and repurchases
is influenced by financial flexibility. As suggested by Lintner, managers prefer to increase dividends
regularly and tr y to avoid decreasing them. Therefore, dividends are effectively an ongoing comm itment,
whereas repurchases do n o t im p lic itly com m it the company to future payouts. In other words,
repurchases preserve financial fle x ib ility relative to dividends. Jagannathan, Stephens and Weisbach test
the hypothesis th a t repurchases are used to distribute cash flows th a t are likely to be temporary, while
dividends are used to distribute perm anent cash flows. The results o f th e ir tests support this hypothesis.
For example, they found th a t companies w ith higher operating cash flows are more likely to increase
dividends, while companies w ith higher non-operating cash flows are more likely to increase repurchases.
Guay and H arford (2000) address the same issue using a different m ethodology and reach the same
conclusion: the permanence* o f an increase in cash flows is an im p o rta n t factor th a t influences the choice
between paying out the extra cash by increasing dividends and m aking a share repurchase.
Employee share options

Another factor that can influence the choice between dividends and repurchases is the existence o f
employee share options. Employees, particularly senior managers, may receive p art o f th e ir remuneration
in the form o f call options on the company s shares. The existence o f these options is likely to favour
repurchases relative to dividends because dividends and share repurchases have different effects on
the prices o f options on shares. As discussed in Section 18.2.5, the value o f a call o ption is negatively
related to future dividends on the underlying share because the price o f a share is expected to fall on each
ex-dividend date. In contrast, repurchasing shares at the m arket price should n o t affect the share price
or the value o f call options held by managers. Fenn and Liang (2001) examined this issue and found that
option holdings by management are strongly related to the composition o f payouts. Management share
options induce a substitution o f repurchases fo r dividends.
Dividend substitution
The dividend substitution hypothesis proposes th a t share repurchases and payment o f dividends are
sim ply alternative ways o f d istrib u tin g company profits to shareholders. For example, i f a company
reports higher earnings and m aintains the same dividend b u t also announces a share repurchase, then
the repurchase may be seen as a substitute fo r dividends. One im p o rta n t difference between share
repurchases and dividends involves the tax treatm ent o f investors* income. Under m ost tax systems
(including Australia’s), long-term capital gains are taxed less heavily than ordinary income. Even i f the
m arginal tax rates applicable to capital gains and dividends are the same, investors are likely to prefer
capital gains because they are able to defer the realisation o f gains and the payment o f taxes. Therefore, the
rapid grow th o f share repurchases may reflect, at least in part, a tax-driven substitution o f repurchases fo r
dividends. Fama and French (2001) reported th a t the p ro po rtio n o f US companies paying cash dividends
fell fro m 67 per cent in 1978 to 21 per cent in 1999. Their analysis suggests th a t the decision to pay
dividends is influenced by three characteristics:
a p ro fita b ility
b investm ent o pportunities
c size.
Companies th a t are larger and more profitable are more likely to pay dividends, w hile dividends are
less likely fo r companies w ith more investm ent opportunities. The decline in the p ro p o rtio n o f companies
th a t pay dividends is due in p art to the listing o f very large numbers o f small growth* companies
th a t make large investm ent outlays and have yet to pay any dividends. However, after controlling fo r
company characteristics, Fama and French (2001) also found a significant decline in the likelihood that
a company pays dividends. In other words, the perceived benefits o f paying dividends appear to have
declined over tim e, leading to an increase in the relative p opularity o f share repurchase. They found that
m ost repurchases are made by companies th a t also pay dividends and conclude that: *the large share
repurchases o f 1993-98 are m ostly due to an increase in the desired payout ratios o f dividend payers,
which they are reluctant to satisfy w ith cash dividends* (p. 39).
Grullon and Michaely (2002) reported several findings which indicate th a t US companies have gradually
substituted share repurchases fo r dividends. The dividend-payout ratios o f US companies declined in the
1980s and 1990s b ut the to ta l payout ratio did not decline over th a t period. Also, companies th a t initia ted
cash payouts favoured repurchases over dividends. The pro po rtio n o f companies in itia tin g distributions
through repurchases rather than dividends increased from 27 per cent in 1973 to 81 per cent in 1998.
They also found that, since the mid-1980s, established dividend-paying companies rely more on share
repurchases than dividends to increase th e ir cash payouts. Finally, they found evidence th a t investors
view repurchases as a substitute fo r dividends. In particular, they found th a t the m arket reaction to
dividend decreases— which is generally negative— is not significantly different from zero i f the company
has repurchased shares in the recent past.
Grinstein and Michaely (2005) tested the argument presented by Brennan and Ih a k o r (1990) th a t
repurchases are likely to be higher fo r those companies w ith large in s titu tio n a l shareholdings. This
argument is based on the premise th a t less inform ed individual investors are likely to avoid companies
that repurchase shares because they have less knowledge than in s titu tio n a l investors as to when to
participate by selling shares back to the company. Grinstein and Michaely did fin d th a t repurchases are
higher fo r those companies w ith large in stitu tio n a l holdings and th a t in s titu tio n a l holdings increase
after repurchases. However, they found th a t increases in in s titu tio n a l holdings did n o t lead to higher
repurchases.
Skinner (2008) also finds strong evidence th a t since share repurchases firs t became significant in
the US in the early 1980s they have increasingly been substituted fo r dividends. For example, in the
case o f companies th a t pay annual dividends and make regular repurchases, the relationship between
earnings and dividends becomes weaker from 1980 to 2005, b u t repurchases adjust quickly to changes
in earnings, which is consistent w ith the greater fle x ib ility o f repurchases. Companies in this category
have generally been paying dividends fo r many years (or decades) and Skinner argues th a t they continue
to do so because o f th e ir h is to ry — given the w ell-known reluctance to cut dividends, these companies
are essentially forced to continue paying them. In the case o f companies w ith no significant dividend
history which make repurchases either regularly or occasionally, Skinner again finds th a t earnings are
increasingly im p o rta n t in explaining repurchases over the period o f his study. He argues th a t newer
companies w ith o u t a dividend h isto ry are unlikely to in itia te dividends once they are in a position to
commence payouts and th a t dividends may eventually disappear in the US.
1 1 .8 .2 1 Share repurchases in Australia

As in the US and other countries, the factors discussed in the previous section may be im p o rta n t in
m otivating the management o f an Australian company to repurchase some o f its shares. In addition, as
noted in Section 11.1.4, in Australia an off-m arket share buyback can be structured to include a franked
dividend and this feature can have significant tax advantages fo r resident investors, p articularly those
w ith a low m arginal tax rate such as superannuation funds (see Finance in Action).
Finance
W Q O LW O R TH ^ 2010 OFF-MARKET SHARE BUYBACK
in ACTION
The share buyback completed in October 2010 by Woolworths Ltd (W O W ) is typical of the
News
off-market buybacks conducted by several large Australian companies. Two important features of
such buybacks are that the buyback price includes a significant fully franked dividend component
as well as a capital component, and that the buyback price is determined by a tender process.
n=.
In August 2 010, W oolworths announced that it intended to buy back up to $7 0 0 million worth
of shares. Shareholders who chose to participate in the buyback were invited to select a tender
discount from seven discounts of 8 per cent to 14 per cent inclusive to the Market Price —
which was defined as the volume weighted average price of W O W shares traded on the ASX
over the five trading days up to and including the closing date for tenders (8 October). The
closing price of W O W shares on 25 August 2 0 1 0 (the last trading day before details of the
buyback were announced) was $ 26.90 . All shares bought through the buyback were bought
continued
B usiness finance
continued
at the same price, the buyback price, which was determined through the tender process.
Tenders were accepted only if the shareholder's tender discount was equal to or greater than
the buyback discount. Shareholders could also choose to make a 'Final Price Tender’，in
which case they would receive the buyback price but there was no assurance that successful
tenders would be accepted in full because the company had the right to apply a scale back
if the number of shares tendered exceeded the number it was prepared to buy. Therefore,
the success of each tender depended on the shareholder’s tender discount, the size and
discount of tenders lodged by other shareholders, and the total number of tenders the company
accepted. In summary, shareholders who decided to tender their shares faced uncertainty about
the number of their shares that might be bought back and about the price they would receive.
The buyback price had two components: a capital component of $ 3 .08 and a fully
franked dividend component, which made up the balance of the price. The capital gains tax
consequences of participating in the buyback are complicated by the fact that the Australian
Taxation Office determines a 'tax value7 for the shares. In the case of the W O W buyback,
the tax value was determined by adjusting the pre-announcement average price of $ 2 6 .3 6 to
reflect any change in the S&P/ASX 20 0 Index between 26 August and 8 October. In its advice
to shareholders, W oolworths assumed that the tax value would be $27. For capital gains tax
purposes, Australian resident individual and superannuation entity shareholders would be
deemed to have disposed of each share for the capital proceeds of $3.08 plus any amount by
which the tax value exceeded the buyback price.
The estimated effects of participating in the buyback for resident individuals are shown in
Table 1 1.4. The calculations assume a buyback price of $ 23.22 , so the fully franked dividend
component is $ 2 0 .1 4 with franking credits of $8.63, giving assessable income of $ 2 8 .7 7
per share.
TABLE 11.4 Estimated effects of W O W buyback for resident individuals

Marginal tax rate (i) 16.5% 31.5% 38.5% 46.5%
Dividend component
Dividend (ii) $20.14 $20.14 $20.14 $20.14
Franking credit (iii) $8.63 $8.63 $8.63 $8.63
Assessable income (ii) + (iii) = (iv) $28.77 $28.77 $28.77 $28.77
Tax on assessable income (i) x (iv) = (v) ($4.75) ($9.06) ($11.08) ($13.38)
Proceeds net of tax (iv) - (v) $24.02 $19.71 $17.69 $15.39
Capital component—proceeds net of tax ⑹ $3.75 $4.36 $4.65 $4.97
Total after-tax proceeds $27.77 $24.07 $22.34 $20.36

(°l The p ro ce e d s net of tax are equal to the capital com p one nt of the b u y b a c k price ($ 3 .0 8 ) plus tax sa v in g s ra n g in g
from 6 7 cents to $ 1 . 8 9 . Details of the capital g a in s tax calculations a re not sh o w n since the am ounts are small a n d the
capital g a in s tax co n se q u e n c e s of participating in the b u y b a c k d e p e n d o n the sh a re h o ld e r's cost b a se (assum ed to be
$ 1 5 ), the length of time the sh ares are held a n d the sh a re h o ld e rs' ability to utilise capital losses to offset capital g a in s
derived from other assets.
S o u rc e : W o o lw o rth s Limited, O ff-M a r k e t B u y -B a ck B o o k le t Se pte m ber 2 0 1 0 , p. 25 .
Table 1 1.4 shows that the value of the buyback was greater the lower the shareholder's
marginal tax rate. Moreover, for shareholders on low marginal tax rates, the total after-tax
proceeds could be greater than the buyback price—assumed to be $ 2 3 .2 2 . This comes about
because, for these shareholders, the franking credit attached to the dividend component is
greater than the personal tax on the dividend. It is clear that shareholders with low marginal
tax rates would determine pricing of the buyback. Since the market price of the shares was
about $27, high tax rate investors who wished to sell W O W shares were better off selling on
market rather than through the buyback.
On 1 1 October 2010, W O W announced that the buyback price was $25.62, reflecting a
buyback discount of 14 per cent. The buyback price consisted of a capital component of $3.08
and a fully franked dividend of $22.54 per share. The tax value of the shares bought back was
$28.54 ($2.92 more than the buyback price) so for capital gains tax purposes the deemed
disposal price of each share was $3.08 + $2.92 = $6. Woolworths returned $704 million to
shareholders through the buyback and successful tenders were scaled back by 88.2 per cent.
Research on share buybacks in Australia has focused on two issues: the m otivations fo r buybacks and the
market response when a buyback is announced. In both cases there are good reasons to expect that the results
may differ between buybacks o f different types. For example, managers m ight use an on-market buyback
to signal their belief that a company is undervalued. In the case o f off-market buybacks, the consideration
for the repurchased shares is often less than the current m arket price so a buyback o f that type is unlikely
to be effective as a way o f signalling undervaluation. A study o f the stated m otivations for 67 buybacks
over the period 1990 to 1995 found that the m otivations differed depending on the type o f buyback. The
main motivations for on-market buybacks were to signal managements perception o f the true value o f the
company and to improve financial performance. Selective buybacks were used m ainly to remove specific
shareholders from the share register, while equal access (off-market) buybacks were viewed prim arily as
an alternative to dividends (M itchell & Robinson 1999). Brown and Norman (2010) identified the largest
75 Australian industrial companies in 1997 and found that from 1997 to 2007, 36 o f these companies made
23 off-market and 86 on-market share buybacks. The off-market buybacks were typically larger than the
on-market buybacks. The average transaction size was $742.9 m illion (9.5 per cent o f the company s shares)
for off-market buybacks and $219.6 m illion (3.3 per cent o f the company s shares) fo r on-market buybacks.
In addition to being favoured fo r larger buybacks, Brown and Norman found that an off-market buyback
is more likely to be chosen when a company has accumulated excess franking credits and when a company
is generating larger free cash flows. They conclude that the incentive to distribute accumulated franking
credits ‘is a major m otivation fo r undertaking an off-market buyback in Australia’ （p. 780). Moreover,
their results support the view th a t franking credits are valuable to participating shareholders because they
are w illing to sell their shares at less than the market price to obtain the franking credits that are usually
distributed through an off-market buyback. Finally, Brown and Norman found that the market-to-book ratio
is significantly lower fo r companies making on-market buybacks, which suggests that they are favoured as
a way o f signalling undervaluation. This result is consistent w ith the findings o f M itchell and Dharmawan
(2007), whose comprehensive study o f on-market buybacks concluded that under the transparent buyback
regime in Australia, signalling o f undervaluation is one o f the strongest incentives fo r on-market buybacks.
Otchere and Ross (2002) note that ASX Listing Rules require that companies undertaking on-market
buybacks must give a reason for the transaction. They studied 132 Australian on-market buybacks announced
between January 1991 and July 1999 where the stated reason was ‘undervaluation, o f the company’s shares.
These announcements were associated w ith abnormal returns averaging in excess o f 4 per cent while industry
rivals recorded smaller but still significant abnormal returns. Thus, it appears that these announcements
conveyed value-relevant inform ation that was not just company-specific b ut related to the industry as a whole.
Balachandran and Faff (2004) found that during the period 1996 to 1999, announcements o f on-market
buybacks were associated w ith mean abnormal returns o f 2.72 per cent over a 3-day period.
Brown (2007) studied off-m arket share buybacks between January 1996 and December 2003 and
found that abnormal returns on the announcement date were small b u t significant, averaging around 1.2
per cent. She argues th a t signalling is unlikely to explain the positive m arket reaction which she suggests
is more likely to be a response to the d istrib u tio n o f franking credits. Brown also documents a ‘dram atic’
increase in trading volume on the announcement date and finds th a t trading volumes remain elevated, on
average, over the next 3 days. This tem porary increase in trading volume is a ttrib uted to demand fo r the
shares from superannuation funds and other low tax rate investors who value the franking credits th a t
are often distributed through off-m arket buybacks.21
21 T w e n ty o f th e 2 8 b u y b a c k s in B r o w n s s a m p le in c lu d e d a d iv id e n d c o m p o n e n t . T h e s a m p le s iz e is lim ite d b e c a u s e s h a r e
b u y b a c k s w ere rare in A u s t r a lia u n t il th e la w s g o v e r n in g t h e m w e re lib e r a lis e d in D e c e m b e r 1 9 9 5 , a n d th e s t u d y p e r io d
fin is h e s in D e c e m b e r 2 0 0 3 p r io r t o th e J a n u a r y 2 0 0 4 c h a n g e s in th e c a lc u la tio n o f t h e c a p it a l g a i n s t a x lia b ility fo r
sh a r e h o ld e r s p a r t ic ip a t in g in e q u a l a c c e s s s h a r e b u y b a c k s.
Dividend reinvestment plans and
dividend election schemes
As discussed in Section 11.4.3, most resident investors w ill prefer th a t Australian companies distribute
franking credits by paying the m axim um possible franked dividends. However, sim ply m axim ising the
payout o f franked dividends is unlikely to be an optim al dividend policy, because companies th a t pay
substantially increased dividends may be in danger o f run nin g short o f cash to finance new investments.
This problem has been addressed through dividend reinvestm ent plans. These plans and dividend election
schemes are discussed in this section.
DIVIDEND Dividend reinvestm ent plans (DRPs) were introduced by some Australian companies in the
REINVESTMENT early 1980s. They offer shareholders the option o f using all or p art o f th e ir dividends to buy additional
PLAN (DRP)
shares. W hile shareholders have always had this option, DRPs enable shareholders to purchase additional
arrangem ent m a d e b y
a co m p a n y that giv e s shares w ith o u t incu rring brokerage. In addition, the shares can sometimes be obtained at a discount. The
shareholders an option discount may be from 1.5 to 10 per cent o f the current m arket price, depending on the company, w ith
of reinvesting all or 2.5 per cent being a typical choice. However, many companies offer no discount at all. Where a discount
part of their d ivide nds
applies, i t benefits shareholders taking up the new shares at the expense o f those who do not. As a result,
in additional sh ares in
there is an incentive fo r shareholders to jo in dividend reinvestment plans th a t offer discounts.
the com pany, usually
at a small discount The incentive to increase payouts under the im p utatio n system has undoubtedly contributed to the
from market price popularity o f DRPs. In 2013, over 160 Australian listed companies used DRPs. Clearly, a company that
responds to the demand fo r franked dividends by increasing its payout may ru n short o f cash. Management
could respond by m aking additional rights issues or share placements to replace the extra cash paid out
as dividends. However, as discussed in Section 9.6, these measures can be slow and involve significant
transaction costs. The adoption o f a DRP can be a more attractive and less costly solution. A DRP does
n ot require a prospectus or other disclosure document provided the shares issued are fu lly paid. Where a
shareholder chooses to reinvest a franked dividend, the company pays out no cash, b ut franking credits
are s till transferred to the shareholder.
The evidence suggests th a t DRPs are well received by shareholders. Exam ination o f daily share returns
has shown that, p rio r to im putation, there was little m arket reaction when a company announced th a t
it was introducing a DRP. However, after the intro du ction o f im putation, such announcements were
associated w ith a significant positive m arket response, particularly in the period after 1 July 1988, when
im putation was extended to superannuation funds and other in s titu tio n a l investors (Chan, McColough
& Skully 1993).
Several companies have found th a t dividend reinvestm ent has been so popular w ith investors that
the company has accumulated surplus cash th a t it is unable to invest profitably. I f this occurs, a possible
response is to make dividend reinvestm ent less attractive by reducing or elim inating the discount at
which shares are offered under the DRP. Also, some companies have imposed lim its on participation
in DRPs. For example, each shareholder may be allowed to participate in the DRP fo r a m axim um o f
10000 shares. A nother response is to suspend the company s DRP u n til its investm ent opportunities
improve, b ut suspension o f a DRP may n o t be popular w ith shareholders. In May 1996, Lend Lease
Corporation announced an innovative solution which allowed shareholders to reinvest th e ir dividends
while avoiding the possibility o f the company accumulating surplus cash. The solution was simple: after
each dividend Lend Lease would buy back shares at the m arket price so th a t the net num ber o f issued
shares remains unchanged. O ther large companies have since adopted the same approach.
DRPs are the most popular o f the various dividend-related plans in the Australian market. Some
DIVIDEND ELECTION companies also operate a dividend election scheme, which offers shareholders the option o f receiving
SCHEME th e ir dividends in one or more o f a number o f forms. The popularity o f dividend election schemes increased
arrangem ent m ade
considerably following the introduction o f the im putation system, although subsequent legislative changes
by a co m p a n y that
gives shareh olde rs the
have reduced their tax effectiveness. As well as fu lly franked dividends, the options could include unfranked
option of receiving dividends (at a higher rate than the franked dividends), dividends paid by an overseas subsidiary, or bonus
their d ivid e n d s in one shares issued in lieu o f dividends. These schemes were designed to make a company s shares attractive to
or more of a num ber different classes o f shareholders and to enable franking credits to be streamed* to those shareholders who
of forms
could use them most effectively. For example, fu lly franked dividends appeal to superannuation funds and
resident individuals in low personal income tax brackets. Higher unfranked dividends appeal to non-residents
who cannot use franking credits. Bonus shares issued instead o f a dividend are not treated as a dividend for
tax purposes and cannot carry franking credits. But fo r capital gains tax purposes, they are deemed to be
acquired at the same tim e as the original holding. Further, if the original holding was purchased before the
introduction o f capital gains tax on 20 September 1985, they are not subject to capital gains tax and the
bonus shares inherit their tax-free status. Bonus shares may also be attractive to overseas and resident
investors who do not pay Australian income tax and are therefore unable to use franking credits.
The use o f dividend election schemes to stream, franking credits to particular classes o f investors has
now been restricted.22 Despite the restrictions, some companies have retained th e ir dividend election
scheme, b u t typically the choice o f dividend substitutes is now confined to bonus shares and dividends
paid by an overseas subsidiary. These choices are offered through separate plans, typically called bonus
share plans and overseas dividend plans. Overseas dividend plans can be attractive to non-resident
shareholders in Australian companies w ith overseas subsidiaries. For example, shareholders who reside
in the UK m ight elect to receive dividends paid by a UK subsidiary o f an Australian company instead
o f dividends from the Australian parent company. The dividends could then carry a tax credit th a t the
shareholders can use to offset th e ir tax liabilities in the UK.
Payout policy and com pany life cycle

In this section we draw on the theories and empirical evidence discussed earlier in the chapter to outline
a model th a t w ill help financial managers to develop payout policies fo r individual companies. Given that L E A R N IN G
O B JEC T IV E 10
payout decisions can be influenced by many factors, including a company’s investm ent opportunities,
Exp lain h o w payout
taxes, inform a tion effects, signalling, agency costs and transaction costs, i t is unrealistic to expect that p o lic y m ay c h a n g e
any single model can provide a complete explanation o f payout policy. However, i f a model is to be useful a s a c o m p a n y m oves
it should be able to explain im p o rta n t empirical findings, including the follow ing:23 through its life cycle
a Aggregate payouts (dividends plus share repurchases) are massive and have increased steadily in real
terms over the years.
b Dividends tend to be paid by mature companies whose retained earnings far exceed th e ir
contributed equity, and n o t by early-stage companies, which are largely financed by capital
infusions.
C Companies pay dividends on an ongoing basis and avoid accumulating large cash balances.
d Individuals in high tax brackets receive large amounts in cash dividends and pay substantial
amounts o f taxes on these dividends.
e The market reacts positively to announcements o f repurchase and dividend increases, and negatively
to announcements o f dividend decreases.
f Unexpected dividend changes are o f little help in forecasting future earnings surprises.
g Once they initia te regular dividends, managers are reluctant to cut or o m it them.
De Angelo and De Angelo (DD) (2007) argue th a t th e ir fu ll payout approach is a more prom ising
foundation fo r a model o f payout policy than the M ille r and M odigliani (M M ) dividend irrelevance
theorem. For example, authors who adopt the M M theorem find i t puzzling (see Black 1976) th a t
dividends are as common and large as they are in countries such as the US where the classical tax system
typically means th a t dividends are taxed more heavily than capital gains. A ttem pts to explain the empirical
findings using inform a tion asymmetry and signalling have m et w ith lim ite d success. As noted in Section
11.5, changes in dividends are o f little i f any help in forecasting future earnings. Moreover, signalling
theory predicts th a t a company w ill pay dividends when outside investors fin d it particularly d ifficu lt to
assess the company s prospects. This suggests th a t young, small companies w ith good grow th prospects
that are n ot fu lly recognised by investors would fin d signalling valuable. However, few such companies
22 T h e s c h e m e s a re s t ill a llo w e d , b u t t h e ir t a x e ffe c t iv e n e s s h a s g e n e r a lly b e e n e lim in a te d . F r o m 1 J u l y 1 9 9 0 , a c o m p a n y m u s t

d e b it it s fr a n k in g a c c o u n t i f a n u n fr a n k e d o r p a r t ly fr a n k e d d iv id e n d is p a i d t o a s h a r e h o ld e r a s a s u b s t it u t e f o r a fr a n k e d
d iv id e n d . S im ilarly , th e fr a n k in g a c c o u n t m u s t b e d e b ite d i f ta x - e x e m p t b o n u s s h a r e s a r e is s u e d a s a s u b s t it u t e fo r a fr a n k e d
d iv id e n d .
23 T h e se a re n o t th e o n ly e m p ir ic a l o b s e r v a t io n s o n p a y o u t p o lic ie s t h a t m a y b e r e g a r d e d a s im p o r t a n t . I t e m s (d ) a n d (e) o n o u r
lis t h a v e b e e n s e le c te d fr o m a t o t a l o f s ix o b s e r v a t io n s p r e s e n t e d b y A llen a n d M ic h a e ly ( 2 0 0 3 ) . T h e o t h e r fiv e it e m s a r e fr o m
a fu r t h e r 1 0 p r e s e n t e d b y D e A n g e lo a n d D e A n g e lo ( 2 0 0 7 ) .
pay dividends. In fact, dividends are m ostly paid by large, profitable, mature companies th a t have less
info rm a tio n asymm etry than smaller growth* companies.
DD argue th a t a theory o f payout policy should be based on the principle th a t shares have value only
fo r the payouts delivered to th e ir holders. Therefore, the cash flows generated by a company s assets m ust
be converted into cash distributions to make shareholders as well o ff as possible. W hile an optim al payout
policy w ill deliver the fu ll value o f a company s free cash flow to shareholders, the fu ll payout model is
silent on the tim in g o f the payments. DD suggest th a t the tim e profile o f a company s payouts w ill depend
on a trade-off between the advantages o f internal capital, such as savings in flo ta tio n costs, and the
disadvantages o f retaining cash. In th e ir view, the m ain disadvantage o f retention is the agency problems
th a t can develop w ith free cash flow. Further, the balance between the advantages o f interna l capital and
the disadvantages o f retaining cash w ill change as the investm ent o pportunities available to the company
change. In other words, the fu ll payout approach leads naturally to a life-cycle theory o f payout policy.
DD were n ot the firs t to suggest a life-cycle theory o f payout policy. Clearly, the life-cycle approach
is consistent w ith the concept, discussed in Section 11.5, th a t cash payouts w ill typicaQy increase as a
company matures and its investm ent opportunities shrink. Similarly, Lease et al. (2000) pointed out that
a company s payout policy may need to change as it moves through its life cycle. For example, when a new
business w ith good growth prospects is started, capital requirements w ill generally be large and access to
the capital markets w ill be restricted because outsiders know little about the company. Therefore, payment
o f dividends is usually not practical at this stage. Subsequently, the company may experience rapid growth
and begin to raise more external funds by borrow ing and by m aking share issues. Despite large investment
needs, the company may start to pay modest dividends to establish a track record o f payouts and to increase
its appeal to in stitu tio n a l investors, some o f which may be restricted to investing only in dividend-paying
shares. When the company reaches m aturity, positive NPV projects are harder to find, the ownership o f
the founders w ill have been diluted by successive capital raisings and agency problems are likely to arise.
A t this stage companies generate ample amounts o f cash, which should be paid out through dividends and
share buybacks unless it can be invested profitably by the company. For companies in mature stages o f
the life cycle, payouts to shareholders become more im p o rta n t because the agency costs o f free cash flow
would be large i f they allowed large amounts o f cash to accumulate w ith in the company.
Tests carried out by De Angelo, De Angelo and Stulz (DDS) (2006) supported a life-cycle theory o f
dividends, which, as they note, is essentially a theory o f how the trade-off between the benefits and costs
o f retention evolves as a company moves through its life cycle. W hile the benefits o f retention (such
as saving flo ta tio n costs and reducing personal taxes) are well accepted in the literature as being large
enough to influence payout decisions, there is less agreement about the significance o f factors th a t are
supposed to m otivate the managers o f mature companies to distribute cash. This difference has probably
arisen because factors such as the agency costs o f free cash flow are much harder to measure than the
costs o f issuing securities and the effects on share prices o f new issue announcements. To provide some,
adm ittedly indirect, evidence on the economic magnitude o f the effects o f excess retention, DDS selected
the 25 largest, long-standing dividend-paying industrial companies in the US as at 2002, and projected
how th e ir financial structures would appear at th a t tim e i f these companies had n o t paid any dividends
over the period 1950 to 2002, while keeping th e ir investm ent outlays unchanged.
Collectively, at the end o f 2002, the 25 companies held cash o f $157 b illion and had a long-term debt o f
$639 billion. Measured in 2002 dollars, these companies paid an estimated $1.6 trillio n in dividends over
the period 1950 to 2002. I f that cash had instead been retained, the cash holdings o f tdiese companies in
2002 would have totalled almost $1.8 trillio n and the median company s cash holding would have equalled
51 per cent o f total assets. Alternatively, these companies could have repaid all th eir long-term debt and
increased their cash balances by about $1 trillio n . DDS concluded that: *Most likely, the payouts we observe
reflect direct or indirect pressure to pay out cash from stockholders concerned that managers m ight use
the ample discretion provided by enormous cash balances and triv ia l debt obligations to make self-serving
decisions that h u rt stockholders’ （2006, p. 252). M ost o f the 25 companies that DDS examined are mature
companies in stable industries and th eir behaviour seems consistent w ith the life-cycle theory in which
companies pay dividends when the costs o f retaining free cash flow (mainly agency costs) exceed the benefits
o f retention. However, DDS p o in t out that the large payouts typically made by mature companies w ith ample
cash flows can also be explained w itho ut invoking the agency costs o f free cash flow as an im portant factor.
An alternative explanation is that the managers o f these 25 companies may have paid substantial dividends
simply because they wished to maximise stockholder wealth, and they recognised that shares have value
only to the extent that stockholders eventually receive distributions from the firm* (2006, p. 252).
CHAPTER ELEVEN REVIEW

SUMMARY
In this chapter we have discussed dividend and share dividends could leave the company short of cash
repurchase decisions with an emphasis on the central and may not suit all shareholders. These problems
issue of the effects of payout decisions on the wealth of are addressed by dividend reinvestment plans
shareholders. and dividend election schemes, respectively.
• When dividend policy is defined as the trade-off • Share repurchases are more flexible than
between: dividends, because once a company initiates
• retaining profit, and dividend payments, investors expect the
• paying dividends and making share issues to payments to be maintained and, preferably,
replace the cash paid out, increased over time.
it can be shown that dividend policy does not affect • A change in tax policy that favours capital gains
shareholders7wealth in a perfect capital market with relative to dividends occurred in Australia in 1999.
no taxes. This approach emphasises the importance Following this change, most resident investors will
of investment decisions in determining company prefer that dividends paid by Australian companies
value and shareholders' wealth. are franked. Where a company has profits that can
• The 'dividend irrelevance' theorem has been be distributed only as unfranked dividends, many
challenged as a basis for understanding payout investors are likely to prefer that these profits are
decisions and the alternative 'full payout’ approach retained rather than distributed.
is based on the principle that shares have value • There is evidence that dividends and share
only for the payouts delivered to shareholders. This repurchases have a valuable role in reducing
approach maintains that as well as making the right agency costs. In particular, the results of recent
investment decisions, managers should ensure that studies support the argument that distributing free
the full present value of a company's free cash flows cash flows to shareholders increases their wealth
is paid out to shareholders. by reducing the potential for managers to overinvest.
• Taxes, agency costs and information effects are the • Announcements of share repurchases and changes
main imperfections that may cause a relationship in dividends can have significant effects on share
to exist between payout policy and shareholders' prices. W hile there is no doubt that changes in
wealth. payouts often convey information to the market,
• While the payment of dividends is the most common the traditional argument that such changes act as
way of distributing cash to shareholders, companies signals of future cash flows is not supported by the
can also distribute cash by repurchasing shares. evidence. Rather, higher payouts are associated with
• A dividend will have tax effects for virtually all lower cash flows, shrinking investment opportunities
shareholders, but a share buyback will affect and lower risk. The characteristics of companies that
taxes paid by only the shareholders who sell. repurchase shares are similar to those of companies
In many countries share repurchases grew that increase dividends.
more rapidly than dividends during the 1990s • There is some evidence that companies cater to
and this trend has also occurred in Australia investors' changing preferences for dividends
since 1995. compared with increases in the value of the shares
• Dividend decisions are important under the they hold. However, there is also evidence that this
imputation tax system because franking credits, apparent finding may be due to changes in risk
which are valuable to Australian resident over time—changes in risk that result in changes in
taxpayers, can be distributed to shareholders payout policy.
only by payment of franked dividends. Many • The full payout approach leads to a life-cycle theory
listed companies have increased their dividend of payout policy, which proposes that payouts will
payouts substantially, while others have initiated be determined by a trade-off between the benefits
dividends since imputation was introduced. and costs of retaining cash. This trade-off will evolve
However, maximising the payout of franked as a company moves through its life cycle.
KEY TERMS
catering theory 339 dividend clientele 324
classical tax system 325 dividend drop-off ratio 330
cum-dividend period 317 dividend election scheme 346
349
dividend-payout ratio 319 full payout policy 323
dividend reinvestment plan (DRP) 346 imputation tax system 317
ex-dividend date 317 progressive dividend policy 320
franked dividend 317 treasury stock 318
franking credit 31 8 withholding tax 318
QUESTIONS
1 [LO 1] Define the following terms:
a) ex-dividend date
b) franked dividend
c) dividend reinvestment plan
d) dividend drop-off ratio
e) overseas dividend plan
f) franking account
g) free cash flow
h) full payout policy
i) progressive dividend policy.
2 [LO 3】It has been argued that company managers should adopt a 'full payout policy’ . W hy is the adoption
of this policy considered to be so important?
3 [LO 3 】Dividends and shore repurchases must be important because investors w ill value a share only for the
cosh payouts it is expected to provide. Do you agree? Explain your answer.
4 [LO 3] Distinguish between 'investment value7 and 'distribution value'. W hy is the distribution value concept
important?
5 [LO 4 】W hat reasons are there to suppose that there is a dividend-clientele effect? Does the empirical
evidence support the existence of such an effect? If such an effect exists, does this mean that a company can
influence its market value by changing its dividend policy? Why, or why not?
6 [LO 1, 2, 5] Are the following statements true or false?
a) A company can pay a dividend only if it is currently earning profits.
b) In Australia, dividends and capital gains are taxed at the same rate for individual investors.
c) The residual dividend policy is used by most companies.
d) The imputation system involves personal tax being collected at the company level.
e) To Australian resident investors, a dollar of franked dividends is worth more than a dollar of unfranked
dividends.
f) According to the Miller and Modigliani dividend irrelevance theorem, an unmanaged (residual) dividend
policy is no better or worse than a carefully designed, managed policy.
7 [LO 5 】Dividends are taxed at a lower rate than capital gains. This suggests that companies should have
high dividend-poyout ratios. Discuss this statement, giving special attention to its appropriateness in the
Australian tax environment.
8 [LO 4, 5] Explain the likely effects on dividend-payout ratios of each of the following:
a) The imputation tax system is modified to allow investors only partial (50 per cent) credit for company tax
b) Personal income (but not capital gains) tax rates are increased.
c) Capital gains tax is abolished.
d) Interest rates increase substantially.
e) Company profitability increases.
f) Prospectus requirements are tightened, increasing the costs of share issues.

9 [LO 5] Under the imputation tax system, there is on optim al dividend p olicy for a ll Australian companies:
always p ay the maximum possible franked dividend, given the balance in the franking account. Discuss this
statement.
10 [L0 4 ,6 ] Some companies have investment opportunities well in excess of the earnings available to finance
them but they still insist on paying dividends. Why?
11 [LO 4, 6 There is evidence to suggest that dividends have a more stable pattern than earnings. What
reasons can you suggest for management adopting a policy of paying a stable dividend in the face of
fluctuating earnings?
12 [1 0 4 ,6 】When dividends ore taxed more heavily than capital gains and there are transaction costs, a company
that pays dividends and subsequently makes a rights issue is behoving illogicolly. Discuss this statement.
13 [LO A, 6] Usually the Board of Directors increases dividend per share only slowly in response to rising
profits, and is even more reluctant to decrease dividend per share than to increase it. Give reasons for this
behaviour pattern. Is this behaviour more likely to be observed under an imputation tax system than under a
classical tax system? Why, or why not?
14 [LO 5, 6] Explain how the following circumstances could affect a company’s dividend policy:
a) The company issues cumulative preference shares carrying an entitlement to fully franked dividends.
b) The company receives a large unexpected fully franked dividend from another company.
c) Owing to continued losses, retained profits have been reduced to almost zero.
d) A large US investor recently acquired 40 per cent of the company’s shares.
e) The exploration division of the company has confirmed that several ore deposits are economically viable
and ready for development into mines.
15 [LO 6] Allen and M ichoely (2003) conclude that if company managers do use dividends to signal, %e
signal is not about future growth in earnings or cash flow s\ Outline evidence that supports this conclusion.
If Allen and Michaely are correct, how can the usual market responses to announcements of changes in
dividends be explained?
16 [LO 6】The 'maturity hypothesis' has been proposed as an explanation for the nature of the information
conveyed by dividend changes. Outline the key aspects of this hypothesis.
17 [LO 7】The payment of dividends is said to have a role in reducing agency costs. Outline the ways in which
the payment of dividends can limit the extent of agency problems.
18 [LO 7] Dividends and control moy be substitute mechanisms for monitoring management. Explain.
19 [LO 2, A, 6, 7 In an article titled 'BP should resist slashing dividend7 [W all Street Journal, 9 June 2010),
Liam Denning noted that UK-based oil company BP was under pressure to reduce or omit dividends on
its ordinary shares as a result of a major oil spill from one of its exploration wells in the Gulf of Mexico.
Subsequently, BP announced that it would omit some of its quarterly dividend payments. Carefully examine
why the reduction in, or omission of, BP's dividends may harm its shareholders.
20 [LO 8] Explain what is meant by catering theory and explain the importance of incorporating risk into tests
of this theory.
21 [LO 9] The imputation system encourages payment o f high dividends. Companies that do so may be left
short o f cosh. Comment on this statement.
22 [L0 7, 10] The nature o f the investment opportunities available to a company is likely to hove an important
influence on dividend decisions. Discuss.
23 [[〇 ]〇 ] A company's payout policy can be expected to change over time as the company moves through its
life cycle. Explain the life-cycle theory of payout policy.
PROBLEMS
1 Analysing dividend policy [LO 1]
As noted in Section 1 1.2.2, investors may attempt to infer a company’s dividend policy by observing its profits,
dividends and payout ratio over time. Data collected from the annual reports of the listed company Cabcharge
Australia Limited are shown in the following table.
351
B usiness finance
Year to 30 June Profit after tax ($m) Dividend per share (cents) Dividend payout ratio (%)
2002 16.1 10.0 68.9
2003 20.3 12.0 66.8
20 04 23.1 13.75 66.7
2005 27.8 17.0 68.7
2006 38.0 23.0 67.9
20 07 51.8 30.0 68.0
2 0 08 59.0 34.0 68.5
2009 61.4 34.0 66.7
2010 57.6 34.0 71.0
2011 46.1 30.0 70.5
2012 60.0 35.0 74.3
2013 60.6 30.0 71.6
a) Based on the dividend payout ratio data for the period 2002 to 2009, how would you describe
Cabcharge’s dividend policy?
b) When the figures for 2010 to 2013 are included, how might your inferences about the company's
dividend policy change? Give reasons.
2 Dividend payment policy [LO 4 】
The Dromana Dredging Company has asked your advice on its dividend policy. There has been only a small
change in earnings and dividends over the years and the company's share price has also been relatively stable
during the same period. It has been suggested that the company should expand its activities from dredging into
providing services for offshore oil exploration companies. To undertake the proposed expansion activity the
company intends to make a rights issue. As the expansion is expected to average approximately 25 per cent
return on investment each year, it is not expected that there will be any difficulty in convincing shareholders to
take up their rights. Below are data on earnings, dividends and share prices for the years 2011-14 and the
expected figures for 2015.
Dromana Dredging Company: data for 2011-14 and expected figures for 2015 ($)
2011 2013 2014 2015
2012
Earnings p e r share 0.40 0.42 0.44 0.43 0.44
Cash available p e r share 0.60 0.67 0.67 0.66 0.66
D iv id e n d per share 0.20 0.20 0.22 0.22 ?
Average m a rk e t price o f o rd in a ry shares 4.00 4.10 4.40 4.35 4.40
Make a recommendation on the dividend payment for 2015. Give reasons.

3 Ex-dividend share price drop [LO 5]
Dribnor Ltd has announced a fully franked dividend of $1 per share. The company tax rate is 30 per cent. By
how much should the share price fall on the ex-dividend date if:
a) franking credits are of no value
b) franking credits are fully valued?
352

Dividend payment policy [LO 4, 5, 6]
The Wrex Manufacturing Company has a history of rapid growth, with a rate of return on assets of about
20 per cent per annum. For the past 5 years its dividend-payout ratio has been approximately 60 per cent.
A high payout has been justified on the grounds that the company is operated in the shareholders7 interests
and dividends paid by the company have a beneficial effect on the company's share price. What factors
would you take into consideration when deciding on the appropriate dividend policy for the company? Is the
current dividend policy justified?
Information effects of dividends [LO 6]
Examine the daily share price behaviour of any company in the 4-week period before and after its most recent
change in cash dividends. What conclusions can you draw from the movements in the share price?
Share buybacks and earnings per share [LO 9]
Share buybacks are sometimes motivated by the desire to increase earnings per share. Falcon Ltd recorded an
operating profit of $2 million in the last financial year. It has 4 million shares on issue and the market price of
the shares is $5 each. Falcon announces that it will repurchase 10 per cent of each shareholder's shares at $5
per share.
a) Calculate Falcon's price-earnings ratio before the buyback.
b) An observer comments as follows: 'Falcon's buyback should boost its earnings per share from 50 cents to
55 cents, so with the price-earnings ratio remaining the same, the share price should increase'.
i) If the observer's argument is correct, what will Falcon's share price be after the buyback?
itically evaluate the observer's argument.
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355
CHAPTER CONTENTS
12.1 Introduction 3 57 112.6 The costs of financial distress 3 77
12.2 The effects of financial leverage 3 57 112.7 Agency costs 379
12.3 The M odigliani and M iller analysis | 12.8 Optimal capital structure: the static
(no tax case) 361 trade-off theory 381
12.4 The effects of taxes on capital structure 1 Capital structure with information
under a classical tax system 369 asymmetry 382
12.5 The effects of taxes on capital structure
under an imputation tax system 374
LEARNING OBJECTIVES
1 explain the effects o f financial leverage and distinguish between business risk and financial risk
2 understand the 'capital structure irrelevance' theory of M odigliani and M iller
3 explain how tax may influence capital structure decisions
4 explain how the costs of financial distress may influence capital structure decisions
5 explain how agency costs may influence capital structure decisions
6 understand the concept of an optimal capital structure based on a trade-off between the benefits and costs
of using debt
7 explain the 'pecking order' theory of capital structure.
4 ^^
C hapter twelve Principles of capital structure
Introduction
In C h ap te rs 9 an d 10 w e o u tlin e d th e sources o f fu n d s t h a t m a y be used to fin a n c e a co m p a n y s o p e ra tio n s .
The m ix o f sources o f fu n d s use d b y a c o m p a n y is called its c a p ita l s tru c tu re . The tw o basic sources are
d e b t1 an d e q u ity, so th a t, in p ra c tic e , a c o m p a n y s capital structu re ty p ic a lly re fe rs to th e m ix o f d e b t CAPITAL STRUCTURE
a n d e q u ity th a t i t uses to fin a n c e its a c tiv itie s . T w o m a jo r q u e s tio n s are c o n sid e re d in th is cha pter. The mix of debt and equity
finance used by a
f ir s t is: H o w does a c o m p a n y ’s c a p ita l s tru c tu re a ffe c t its ris k ? The s econd is: H o w does a c o m p a n y ’s c a p ita l
company
s tru c tu re a ffe c t its m a rk e t value?
The fu n d a m e n ta l source o f a c o m p a n y s value is th e s tre a m o f n e t cash flo w s g e n e ra te d b y its assets.
This stre a m is u s u a lly re fe rre d to as th e c o m p a n y s n e t o p e ra tin g cash flow s* o r e a rn in g s b e fo re in te re s t
and tax* (E B IT ).2 The c a p ita l s tru c tu re a d o p te d b y a c o m p a n y d iv id e s th is stre a m b e tw e e n d iffe re n t classes
o f in ve sto rs. I f a c o m p a n y is fin a n c e d e n tire ly b y e q u ity a n d th e re is n o c o m p a n y ta x , th e n a ll o f th is s tre a m
is available to p ro v id e in c o m e to sh a re h o ld e rs. I f a c o m p a n y also b o rro w s fu n d s , th e le n d e rs have f ir s t cla im
on th e n e t o p e ra tin g cash flo w s an d sh a re h o ld e rs are e n title d to th e re s id u a l cash flo w s t h a t re m a in a fte r
th e le nd ers have been pa id . T h ere fore, i f a co m p a n y has a g iv e n set o f assets, th e n a s k in g w h e th e r th e re is
an optim al capital structu re f o r th e co m p a n y a m o u n ts to a s k in g w h e th e r th e v a lu e o f th e s tre a m o f n e t OPTIM AL CAPITAL
o p e ra tin g cash flo w s depends o n h o w i t is d iv id e d b e tw e e n p a y m e n ts to le n d e rs a n d sha reh old ers. STRUCTURE

the capital structure
Does th e va lu e o f a c o m p a n y s s tre a m o f n e t o p e ra tin g cash flo w s d e p e n d o n h o w th is s tre a m is d iv id e d
that maximises a
be tw ee n le n d e rs a n d sh a re h o ld e rs? T his q u e s tio n so u n d s s im p le , b u t th e a n sw e r can be e ith e r s im p le o r company's value
com p le x, d e p e n d in g o n th e a p p ro a ch used to f in d th e answ er. The M o d ig lia n i a n d M ille r a n a lysis o f c a p ita l
s tru c tu re ( w ith o u t ta x ), w h ic h w e discuss in th is ch a p te r, p ro v id e s a s im p le a n sw e r— no. B u t th is a n sw e r
is reached u n d e r a set o f r e s tric tiv e a s s u m p tio n s . W h e n the se a s s u m p tio n s are relaxe d, th e a n sw e r is n o t
as s im p le — a c o m p a n y s c a p ita l s tru c tu re m a y a ffe c t its v a lu e f o r several reasons, in c lu d in g taxes, th e
costs o f fin a n c ia l d istre ss, agency costs a n d in fo r m a tio n a s y m m e trie s .
C a p ita l s tru c tu re in v o lv e s m a n y issues, an d, as a re s u lt, o u r d is c u s s io n o f i t is d iv id e d in to tw o c ha pters.
In th is c h a p te r w e discuss th e p rin c ip le s o f c a p ita l s tru c tu re . In C h a p te r 13 w e discuss e m p iric a l evidence
on th e v a lid ity o f th o s e p rin c ip le s a n d th e m a in fa c to rs t h a t m an ag ers s h o u ld c o n s id e r in m a k in g c a p ita l
s tru c tu re decisions.
12.2 The effects of financial leverage

A ll com p an ies are su b je c t to b u sin ess risk. W h e n th e m a n a g e m e n t o f a c o m p a n y decides to e n te r a
p a rtic u la r lin e o f bu sin ess, i t k n o w s t h a t th e re are ris k s in v o lv e d . F o r e xa m p le , n e w c o m p e tito rs m a y LEARNING
OBJECTIVE 1
em erge, te c h n o lo g y m a y change in u n e x p e c te d w ays, n e w g o v e rn m e n t re g u la tio n s m a y be in tro d u c e d o r
Explain the effects of
consum ers* ta ste s m a y change. These a n d o th e r fa c to rs c o n trib u te to a c o m p a n y s b u sin ess ris k , w h ic h financial leverage and
w ill be re fle c te d in changes in th e co m p a n y s n e t o p e ra tin g cash flo w s . distinguish between
I f a c o m p a n y is fin a n c e d e n tire ly b y shares— t h a t is, i t has n o d e b t— th e n bu sin ess r is k is th e sole cause business risk and
o f v a ria tio n s in th e r e tu r n to sh a re h o ld e rs. B u t i f a c o m p a n y is fin a n c e d p a r tly b y d e b t, th e sh a re h o ld e rs financial risk
are exposed to a second sou rce o f r is k called fin a n c ia l ris k . T h is ty p e o f r is k re s u lts fr o m th e fa c t t h a t
th e p a y m e n ts p ro m is e d to le n d e rs m u s t be m ade, even i f th e co m p a n y s u ffe rs a se rio u s d e c lin e in it s n e t BUSINESS RISK
variability of future
o p e ra tin g cash flo w s .3 T h e re fo re , th e m o re d e b t th e c o m p a n y has, th e g re a te r is th e fin a n c ia l r is k face d b y
net cash flows
its sha reh old ers.
attributed to the nature
of the company’s
operations. It is the
1 F o r e a s e o f e x p o s it io n , w e u s e t h e t e r m 'd e b t' to r e fe r to a ll f o r m s o f fin a n c e t h a t p r o d u c e a r a t e o f r e t u r n t h a t i s fix e d , o r
risk shareholders face
v a r ie s in a c c o rd a n c e w ith s p e c if ie d r u le s. H e n c e , ^ e b t ' in c lu d e s in t e r e s t - b e a r in g lo a n s , m a r k e ta b le fix e d a n d v a r ia b le in t e r e s t
r a te s e c u r it ie s , le a s e fin a n c e a n d s o m e t y p e s o f p r e fe r e n c e s h a r e s .
if the company has
2 C o m p a n y n e t o p e r a t in g c a sh flo w s a re a ls o o f t e n r e fe r r e d to a s n e t o p e r a t in g in c o m e *, b u t in g e n e r a l w e r e s e r v e t h e te r m
no debt
m c o m e * fo r c a sh flo w s to in v e s t o r s . In th e e x a m p le s in t h is c h a p te r , b e fo r e - t a x n e t o p e r a t in g c a sh flo w s a r e a s s u m e d to
r e m a in c o n s t a n t in p e rp e tu ity . T h is a s s u m p t io n im p lie s t h a t th e c o m p a n y k e e p s th e s a m e a s s e t s in p la c e a t all t im e s .
T h ere fo re, th e b e fo r e - t a x n e t o p e r a t in g c a s h flo w s m u s t b e n e t o f th e in v e s t m e n t r e q u ir e d e a c h y e a r to r e p la c e a s s e t s t h a t
d e te r io r a te t h r o u g h u s e o r o b s o le sc e n c e . D e d u c t in g t h is in v e s t m e n t is th e s a m e , in p r in c ip le , a s d e d u c t in g d e p r e c ia tio n to
d e te r m in e th e *e a r n in g s , o r p ro fit* t h a t c a n b e d is t r ib u t e d w h ile m a in t a in in g c a p it a l in ta c t. T h e r e fo r e , w e u s e th e t e r m s *n et
o p e r a t in g c a sh flo w s* a n d e a r n in g s b e fo r e in t e r e s t a n d t a x ' in te r c h a n g e a b ly .
3 I f a c o m p a n y is u n a b le to m e e t i t s o b lig a t io n s to le n d e r s , th e y c a n ta k e c o n tr o l o f th e c o m p a n y , a n d t h is a c tio n m a y r e s u lt in
i t s liq u id a tio n .
FINANCIAL LEVERAGE W h y , th e n , do co m p a n ie s b o rro w , i f b o rro w in g in v o lv e s e x tra ris k ? The rea son is t h a t b y b o rro w in g ,
( g e a r in g ) a c o m p a n y m a y be able to increase th e ra te o f r e tu r n e a rn e d b y its sh a re h o ld e rs. T his e ffe c t is k n o w n as
the effect of
financial leverage, or gearing. I f th e ra te o f r e tu r n o n a co m p a n y s assets is g re a te r th a n th e in te re s t
company debt on
ra te o n it s d e b t, b o rro w in g w ill increase th e ra te o f r e tu r n to sh a re h o ld e rs. B u t i f th e ra te o f r e tu r n o n a
the returns earned
by shareholders. c o m p a n y s assets is less th a n th e in te re s t ra te o n its d e b t, b o rro w in g w ill decrease th e ra te o f r e tu r n to
Financial leverage is sh a re h o ld e rs. Thus b o rro w in g increases th e v a r ia b ility in th e ra te o f r e tu r n e a rn e d b y s h a re h o ld e rs — th a t
measured by ratios is, fin a n c ia l leverage exposes sh a re h o ld e rs to fin a n c ia l ris k . A h ig h p r o p o r tio n o f d e b t m ea ns t h a t a sm a ll
such as the debt-
pe rce n ta g e change in th e r e tu r n o n a c o m p a n y s assets w ill g e n e ra te a la rg e p e rcen ta ge change in th e
equity ratio and the
ratio of debt to total p r o fit a va ila b le to sh a re h o ld e rs. M o s t d ire c to rs o f com p an ies are w e ll aw are o f th e re la tio n s h ip b e tw e e n
assets b o rro w in g a n d r e tu r n s — f o r exa m ple, a p a r tic u la r ly cle a r s ta te m e n t a p pe ared in th e 2 0 1 2 a n n u a l re p o rt
o f C abcharge A u s tra lia L td (see F ina nce in A c tio n ).
Finance CAPITAL MANAGEMENT AT CABCHARGE AUSTRALIA LTD

in ACTION
Many company annual reports provide statements about the company's approach to capital
N ews
management—that is, to issues such as the company's debt-equity ratio. The 2012 annual report
of Cabcharge Australia Ltd included the following statements of Board policy:
n =
The Board's policy is to maintain a strong capital base so as to maintain investor, creditor and
market confidence and to sustain future development of the business. The Board of Directors
monitors the return on capital, which the Group defines as net operating income divided
by total shareholders' equity. The Board of Directors also monitors the level of dividends to
ordinary shareholders.
The Board seeks to maintain a balance between the higher returns that might be possible
with higher levels of borrowings and the advantages and security afforded by a sound capital
position. The G roup’s target is to achieve a return exceeding its cost of capital; during the
year ended 3 0 June 201 2 the return was 4 3 .4 per cent (201 1: 33.3%). In comparison, the
weighted average interest expense on interest-bearing borrowings (excluding liabilities with
imputed interest) was 6.2 per cent (201 1: 5.7%).
Source: Cabcharge Australia Ltd, Annual Report 2012, p. 65.
Table 12 .1 p re se n ts tw o m easures o f leverage t h a t w e have ca lcu la te d fr o m p u b lic ly a va ila ble da ta

f o r 13 lis te d A u s tra lia n com p an ies. The n u m e ra to r o f each m ea sure is th e b o o k va lu e o f n e t d e b t d e fin e d
as in te re s t-b e a rin g lia b ilitie s (o r b o rro w in g s ) less cash a n d assets v e ry s im ila r to cash. Ide ally, w e w o u ld
have use d m a rk e t values ra th e r th a n b o o k values b u t c o rp o ra te d e b t is o fte n in th e f o r m o f lo a n s th a t
are n o t tra d e d , so w e w ere u n a b le to ca lcu la te th e m a rk e t v a lu e o f d e b t. The d e n o m in a to r o f th e f ir s t
r a tio is th e b o o k va lu e o f d e b t p lu s th e m a rk e t va lu e o f th e c o m p a n y s shares (also k n o w n as it s e q u ity ).
Because th e m a rk e t va lu e o f e q u ity re fle c ts th e co m p a n y s e xp ected f u tu r e cash flo w s , th is ra tio s h o u ld
be a g o o d in d ic a to r o f a c o m p a n y s a b ility to m e e t its in te re s t p a y m e n ts in th e future. The d e n o m in a to r
o f th e seco nd r a tio is th e b o o k v a lu e o f th e co m p a n y s assets. T his ra tio is u s u a lly n o t a p a r tic u la r ly g o od
m easure o f a c o m p a n y s a b ility to m e e t e ith e r c u rre n t o r fu tu r e in te re s t p a y m e n ts . R a th e r, i t re fle c ts th e
e x te n t to w h ic h a c o m p a n y has used d e b t in th e past to fin a n c e th e a c q u is itio n o f n e w assets.
Table 12 .1 sho w s t h a t leverage va rie s s ig n ific a n tly b e tw e e n c o m p a n ie s. D iffe re n c e s in leverage can be
re la te d to in d u s tr y m e m b e rs h ip a n d asset typ e . F o r exa m p le , D a v id Jon es, w h ic h is a re ta ile r, re lie s m u c h
less o n d e b t fin a n c e th a n A m c o r, a p a c k a g in g m a n u fa c tu re r, a n d Q an ta s, an a irlin e . In th is c h a p te r a n d
in C h a p te r 13 w e discuss th e fa c to rs t h a t m a y e x p la in w h y som e co m p a n ie s re ly m o re h e a v ily o n d e b t
fin a n c e th a n o th e rs .
To illu s tra te th e c a lc u la tio n a n d in te r p r e ta tio n o f d e b t- e q u ity ra tio s , sup po se W o o d la n d s L td has
e q u ity o f $ 10 m illio n , d e b t o f $8 m illio n a n d assets o f $ 1 8 m illio n . Its c a p ita l s tru c tu re can be s u m m a ris e d
b y its d e b t- e q u ity ra tio , w h ic h is 0.8. Suppose t h a t W o o d la n d s th e n b o rro w s $5 m illio n to b u y a n e w
fa c to ry . I t s t ill has e q u ity o f $ 1 0 m illio n , b u t its d e b t is n o w $ 1 3 m illio n a n d it s assets have g ro w n to
$ 2 3 m illio n . Its d e b t- e q u ity ra tio is n o w 1.3. N o te t h a t W o o d la n d s has s im u lta n e o u s ly cha ng ed b o th its
d e b t- e q u ity ra tio a n d its assets— t h a t is, i t has s im u lta n e o u s ly ch a ng ed b o th its c a p ita l s tru c tu re a n d
its in v e s tm e n t p o lic y . W h ile m a n y co m p a n ie s fr e q u e n tly m ake such s im u lta n e o u s d e cisio n s, w h e n we
e xa m in e th e effects o f a change in c a p ita l s tru c tu re w e ne ed to h o ld e v e ry th in g else c o n s ta n t. N a tu ra lly ,
‘e v e ry th in g else’ in c lu d e s th e c o m p a n y ’s in v e s tm e n t p o lic y . T his o u tc o m e c o u ld be a ch ie ve d b y a c o m p a n y
TABLE 12.1 Leverage ratios of Australian listed «companies

Company Debt/(debt + MVE) Debt/book value of assets %
A m cor 3 1 .9 2 4 .5
BH P B illiton 2 1 .1 2 3 .7
B lu eSco pe Stee l 2 .0 5 .4
C ab ch arge A u stra lia 2 6 .8 2 4 .1
D avid J o n e s 7 .0 5 .7
D ulu xG roup 3 2 .4 1 5 .9
F airfa x M edia 3 .5 8 .2
H ills H oldin gs 0 .8 1 .6
O rica 3 0 .2 2 0 .2
Q an tas 1 6 .1 5 1 .8
T elstra 3 2 .7 1 7 .5
T re asu ry W ine E s ta te s 5 .2 5 .4
W esfarm ers 1 0 .3 8 .8
l〇) MVE = market value of equity on the company's balance date. Debt is the book value of debt as at balance date.
Balance date is 3 0 June 2 0 1 3 , except for David Jones (27 July 2 0 1 3 ), DuluxGroup (30 September 20 1 2 ) and Orica
(30 September 2 012).
Source: Compiled from company annual reports and end-of-year share prices on the ASX.
b o rr o w in g m o n e y to f u n d th e r e p u r c h a s e o f s o m e o f i t s s h a r e s . W e u s e t h is a p p r o a c h in E x a m p le 1 2 .1 ,
w h ich i llu s t r a t e s th e e ffe c ts o f le v e r a g e o n s h a r e h o ld e r s .
E x a m p le 1 2 .1 i llu s t r a t e s tw o im p o r t a n t e f f e c t s o f fin a n c ia l le v e r a g e . F ir s t , it s h o w s t h a t w h e n a
c o m p a n y b o r r o w s , th e expected rate of return on equity is increased. I f th e e x p e c t e d e a r n in g s b e fo r e in t e r e s t
o f $ 3 0 0 0 0 0 p e r a n n u m a r e m a in t a in e d , th e p r o p o s e d c a p it a l s t r u c t u r e r e s u lt s in a n in c r e a s e in th e
e x p e c te d r a te o f r e t u r n o n e q u it y f r o m 1 5 p e r c e n t to 1 8 p e r c e n t p e r a n n u m . T h ere is a c o r r e s p o n d in g
c h a n g e in e x p e c t e d e a r n in g s p e r s h a r e (E P S ), w h ic h in c r e a s e s fr o m 3 0 c e n t s to 3 6 c e n t s . S e c o n d , w h e n
a c o m p a n y b o r r o w s , th e variability of returns to shareholders is increased. I f e a r n in g s b e fo r e in t e r e s t a re
increases th e r a te o f r e t u r n
$ 4 0 0 0 0 0 p e r a n n u m , th e p r o p o s e d s t r u c t u r e o n e q u it y f r o m 2 0 p e r c e n t
to 2 8 p e r c e n t p e r a n n u m , b u t i f e a r n in g s b e fo r e i n t e r e s t a r e o n ly $ 2 0 0 0 0 0 p e r a n n u m , th e p r o p o s e d
stru ctu re decreases th e r a te o f r e tu r n o n e q u it y fr o m 1 0 p e r c e n t to 8 p e r c e n t p e r a n n u m . Th e e f f e c t s o f
th e a lte r n a tiv e c a p it a l s t r u c t u r e s o n th e r e t u r n s to s h a r e h o ld e r s a r e s h o w n in F ig u r e 1 2 .1 .
W ith th e e x is tin g a ll- e q u ity c a p it a l s t r u c t u r e , th e r a te o f r e tu r n o n e q u it y is , b y d e fin itio n , a lw a y s
e q u a l to th e r a te o f r e t u r n o n D r i b n o r s a s s e t s . U n d e r th e p r o p o s e d s t r u c t u r e , t h is r e m a in s t r u e o n ly w h e n
th e r a te o f r e tu r n o n D r i b n o r s a s s e t s is e q u a l t o th e i n t e r e s t r a t e p a id o n i t s d e b t , w h ic h is 1 2 p e r c e n t.
I f th e r a te o f r e t u r n o n a s s e t s i s g r e a t e r th a n 1 2 p e r c e n t, th e le v e re d s t r u c t u r e r e s u lt s in a h ig h e r r a te o f
r e tu r n o n e q u ity t h a n th e a ll- e q u ity s t r u c t u r e . I f th e r a te o f r e tu r n o n a s s e t s is l e s s th a n 1 2 p e r c e n t, th e
le v e re d s t r u c t u r e r e s u lt s in a lo w e r r a te o f r e t u r n o n e q u ity . In o t h e r w o r d s , fr o m th e v ie w p o in t o f th e
s h a r e h o ld e r s , le v e r a g e a p p lie s in b o t h d ir e c tio n s : it t u r n s a g o o d y e a r in t o a n e v e n b e t t e r o n e b u t it t u r n s
a b a d y e a r in t o a n e v e n w o r se o n e . Th e e ffe c t o f le v e r a g e in c r e a t in g fin a n c ia l r i s k is s h o w n c le a r ly b y th e
d iffe r e n t s lo p e s o f th e tw o lin e s in F ig u r e 1 2 .1 .
In s u m m a r y , th e c h o ic e o f c a p it a l s t r u c t u r e fo r D r ib n o r in v o lv e s a t r a d e - o f f b e tw e e n r is k a n d e x p e c t e d
re tu rn . C learly , a n y v a lid a n a ly s is o f t h is c h o ic e m u s t c o n s id e r both f a c t o r s : th e fin a n c ia l m a n a g e r s h o u ld
n o t d e te r m in e a t a r g e t d e b t - e q u it y r a t io b a s e d o n ly o n th e e x p e c t e d le v e l o f E P S o r th e r a t e o f r e t u r n
o n e q u ity . P r o v id e d t h a t th e e x p e c t e d r a t e o f r e t u r n o n a s s e t s is g r e a t e r t h a n th e in t e r e s t r a te o n d e b t,
Exam ple 12.1
Dribnor Ltd is currently unlevered—that is; it has not borrowed—and has an issued capital of 1 million
shares that have a market price of $2 each. Dribnor's expected earnings are $300 0 0 0 per annum
and the market value of its assets is $2 million. There are no taxes and all earnings available to
ordinary shareholders are paid out as dividends. Ron Peacock, who is Dribnor's financial manager,
is considering whether the company should borrow $1 million at an interest rate of 1 2 per cent per
annum, and use the borrowed money to repurchase 5 0 0 0 0 0 shares at their market price of $2 each.
If this proposal is implemented, Dribnor's capital structure will be different—it will have some debt—
but its assets and earnings before interest will be the same. W hile Dribnor's expected earnings before
interest are $30 0 0 0 0 per annum, it is not certain that these earnings will be achieved, and Ron
wishes to analyse the effects if earnings increase to $ 4 000 00 per annum or decrease to $200000
per annum. Ron also wishes to analyse the effect if earnings are $240 0 0 0 per annum, because, in
that event, the rate of return on assets would be 12 per cent per annum, which is the same as the
interest rate on debt.
SOLUTION
The results of Ron’s calculations are shown in Table 12.2.
TABLE 12.2 Effect of leverage on returns to Dribnor shareholders

E a r n in g s b e fo re in te r e s t ($) 200000 240000 300000 400000
R ate o f re tu rn on a s s e t s (%) 10 12 15 20
E x is tin g c a p ita l stru c tu re (1 0 0 % eq uity )
N u m b e r o f sh a re s (m illion ) 1 .0 1.0 1 .0 1 .0
E a r n in g s p e r sh a re (c en ts) 20 24 30 40
R a te o f re tu rn o n e q u ity ( % ) ⑷ 10 12 15 20
P ro p o se d c a p ita l stru c tu re (5 0 % equity, 5 0 % d e b t)
N u m b e r o f sh a re s (m illion ) 0 .5 0 .5 0 .5 0 .5
In te r e st o n d e b t ($) 120000 120000 120000 120000
E a r n in g s availab le to o rd in ary 80000 120000 180000 280000

sh a re h o ld e rs ($)
E a r n in g s p e r sh a re (c en ts) 16 24 36 56
R a te o f re tu rn on eq u ity ( % ) ⑹ 8 12 18 28
Rate of return on equity = Earnings per share (cents)/Market price per share. The market price per share is $2.
in c r e a s in g th e d e b t - e q u it y r a tio w ill a lw a y s in c r e a s e b o t h e x p e c t e d E P S a n d th e e x p e c t e d r a te o f r e tu r n
o n e q u ity . B u t t h e s e e x p e c t e d b e n e f it s c o m e a t th e p ric e o f in c r e a s e d fin a n c ia l r isk .
W e h a v e s h o w n t h a t fin a n c ia l le v e r a g e in c r e a s e s b o t h e x p e c t e d r e t u r n a n d r i s k f o r s h a r e h o ld e r s .
H o w e v e r, w e h a v e n o t y e t c o n s id e r e d th e m o s t i m p o r t a n t q u e s t io n : Is th e in c r e a s e in e x p e c t e d r e tu r n
e n o u g h t o c o m p e n s a t e s h a r e h o ld e r s f o r th e in c r e a s e in r is k ? I f i t is j u s t e n o u g h to c o m p e n s a t e (b u t n o
m o r e ), th e n th e v a lu e o f th e c o m p a n y w ill b e u n c h a n g e d b y le v e r a g e . B u t i f i t m o r e (le s s ) t h a n c o m p e n s a t e s ,
th e n th e v a lu e o f th e c o m p a n y w ill b e h ig h e r (lo w e r). A r ig o r o u s a n a ly s is o f t h is q u e s t io n b y M o d ig lia n i
a n d M ille r (1 9 5 8 ) s h o w e d t h a t , in a p e r f e c t c a p it a l m a r k e t w ith n o t a x e s , th e h ig h e r e x p e c t e d r e tu r n is
j u s t e n o u g h to c o m p e n s a t e f o r t h e h ig h e r r is k — n o m o r e a n d n o l e s s . T h e r e fo re , th e v a lu e o f th e c o m p a n y
is n e ith e r in c r e a s e d n o r d e c r e a s e d b y le v e r a g e ; c a p it a l s t r u c t u r e is t h u s ir r e le v a n t to c o m p a n y v a lu e . T h eir
a n a ly s is i s c o n s id e r e d in th e n e x t s e c tio n .
Figure 12.1 The effect of leverage on returns
proposed structure
(50% equity, 50% debt) /
t
xllnb uo
a)
UJnJjoôa
Qj
10 12 20 30
Rate of return on assets [%)
12.3 The M o d ig lia n i and M ille r analysis

(no tax case)
LEARNING
OBJECTIVE 2
12.3.1 | M odigliani and Miller's Proposition 1 Understand the
'capital structure
M o d ig lia n i a n d M ille r (M M ) (1 9 5 8 ) a n a ly s e d th e e ffe c t o f c a p it a l s t r u c t u r e o n c o m p a n y v a lu e b a s e d o n a irrelevance7theory of
s e t o f r e s tr ic tiv e a s s u m p t i o n s . The m o s t i m p o r t a n t a s s u m p t i o n s a re : Modigliani and Miller
a S e c u r itie s is s u e d b y c o m p a n ie s a r e t r a d e d in a p erfect capital m arket; t h is is a f r ic t io n le s s m a r k e t PERFECT CAPITAL
in w h ic h th e re a r e n o t r a n s a c t io n c o s t s a n d n o b a r r ie r s to th e fr e e flo w o f in f o r m a t io n . MARKET
frictionless capital
丨 T h ere a re n o t a x e s .
market in which there
C C o m p a n ie s a n d in d iv id u a ls c a n b o r r o w a t th e s a m e in t e r e s t ra te . are no transaction
d T h ere a re n o c o s t s a s s o c i a t e d w ith th e liq u id a t io n o r r e o r g a n is a t io n o f a c o m p a n y in fin a n c ia l costs and no barriers
difficu lty . to the free flow of
e C o m p a n ie s h a v e a fix e d in v e s t m e n t p o lic y s o t h a t in v e s t m e n t d e c is io n s a r e n o t a f f e c t e d b y fin a n c in g information
d e c is io n s .
G iv e n th e s e a s s u m p t i o n s , M M p r o v e d t h a t th e v a lu e o f a c o m p a n y is i n d e p e n d e n t o f i t s c a p ita l
s tr u c tu r e . T h ey c o n c lu d e d t h a t i f a c o m p a n y h a s a g iv e n in v e s t m e n t p o lic y , t h e n c h a n g in g i t s r a t io o f
d e b t to e q u ity w ill c h a n g e th e w a y in w h ic h i t s n e t o p e r a t in g c a s h flo w s a r e d iv id e d b e tw e e n le n d e r s a n d
s h a r e h o ld e r s , b u t w ill n o t c h a n g e th e t o t a l v a lu e o f th e c a s h flo w s. T h e r e fo re , th e v a lu e o f th e c o m p a n y
w ill n o t c h a n g e . T h is i s th e ir n o w - f a m o u s P r o p o s it io n 1.
C learly , in m o s t c a s e s , t h e s e a s s u m p t i o n s a r e n o t r e a lis tic . F o r e x a m p le , M M s a s s u m p t i o n s e x c lu d e
ta x e s a n d d e f a u lt c o s t s . B u t t h i s d o e s n o t m e a n t h a t t h e ir a n a ly s is is u s e l e s s . O n e o f th e g r e a t v ir t u e s o f
M M s a n a ly s is is t h a t b y im p lic a t io n it p o in t s th e w a y fo r w a r d . I f c a p it a l s t r u c t u r e d o e s in f a c t m a t t e r
a t l e a s t a l it t le — a s m o s t p e o p le b e lie v e — th e n it m u s t m a t t e r f o r r e a s o n s t h a t M M e x c lu d e d fr o m th e ir
a n a ly s is . W e d is c u s s t h is is s u e f u r t h e r in S e c t io n 1 2 .3 .4 .
P r o p o s itio n 1 c a n b e p r o v e d in m a n y d iffe r e n t w a y s. Th e p r o o f p r o v id e d b y M M i s b a s e d o n th e id e a
t h a t in v e s t o r s c a n c r e a te h o m em ad e lev e rage a s a n a lte r n a tiv e to c o r p o r a t e le v e r a g e . S u p p o s e t h a t w e c o u ld
o b s e r v e tw o c o m p a n ie s , U a n d L , w h ic h a r e e q u iv a le n t, e x c e p t t h a t U h a s n o d e b t w h ile L h a s d e b t — t h a t
is , U is u n le v e r e d , w h ile L is le v e re d . S u p p o s e , c o n t r a r y t o P r o p o s it io n 1, t h a t th e m a r k e t v a lu e o f L (w h ich
w e d e n o t e VL) e x c e e d s th e m a r k e t v a lu e o f U (w h ich w e d e n o t e ). T h en a s h a r e h o ld e r in L s h o u ld se ll h is
s h a r e s in L a n d , b y b o r r o w in g m o n e y , w ill b e a b le t o s t r u c t u r e a n in v e s t m e n t in U t h a t p r o d u c e s :
1 a h ig h e r r e t u r n a t th e s a m e r is k
2 th e s a m e r e t u r n a t a lo w e r r is k
3 th e s a m e r e t u r n a t th e s a m e r i s k f o r a lo w e r in v e s t m e n t o u tla y .
T h a t is , i f VL > Vv t h e n all th r e e o f t h e s e s t r a t e g ie s a r e a v a ila b le t o a s h a r e h o ld e r in L .

T h is i s illu s t r a t e d in E x a m p le 1 2 .2 .
Exam ple 12.2

Suppose we observe two companies, U and L, which are equivalent except for their capital structure.
Both companies produce net operating cash flows (N C F ) of $11 000 a year. The market value of
the levered company, L, is VL = $105000, comprised of debt, DL, whose market value is $2500 0
and equity, EL, whose market value is $80000. The market value of the unlevered company, U, is
Vu = $1000 00, which by definition is comprised only of equity (that is, E j = $100000). The interest
rate for both companies (and all investors) is 4 per cent per annum. Consider an investor who owns
1 per cent of the shares in L. The market value of his shareholding is 0.01 x $ 8 000 0 = $800.
a) W hat is the investor's return and risk?
b) How could the investor achieve:
i) a higher return at the same risk?
ii) the same return at a lower risk?
iii) the same return at the same risk and also have money left over?
SOLUTION
a) The investor's return is:
Return = 0.01 x net income of L
= 0.01 x (NCF-interest expense)
= 0 .0 1 x ($ 11 0 0 0 - 0 .0 4 x $25 000)
= 0.01 x $ 1 0 0 0 0
=$100
The investor’s risk is measured by L’s debt-equity ratio:
Risk = L’ s debt- equity ratio
_ $25 0 0 0
_ $8 0 0 0 0
= 0 .3 1 2 5
b) Recognising that, according to MM, the shares in L are overvalued because VL > VUf the investor
first sells his shares in L for $800.
i) How to achieve a higher return at the same risk.
The investor borrows $250 at 4 per cent and invests the whole sum ($800 + $250 = $1050)
in shares of company U. Because the total market value of all shares in U is $ 100 000, he must
now own 1.05 per cent of the shares of U. Hence, the return on this shareholding is 1.05 per
cent of the net operating cash flows of U.
The return on this investment is:
Return = return on shares - interest on debt
= 0 .0 1 0 5 x $11 0 0 0 - 0 . 0 4 x $ 2 5 0
= $ 1 1 5 .5 0 - $ 1 0 .0 0
= $ 1 0 5 .5 0
> $100
The risk of this investment is:

Risk = investor’ s de bt-eq uity ratio
= $250
= $800
= 0.3125
Thus, the investor has achieved a higher return ($105.50) at the same risk (0.3125).
ii) How to achieve the same return at a lower risk.
The investor borrows $171.43 at 4 per cent and invests the whole sum ($800 + $171.43 =
$971.43) in shares of company U. Therefore he owns 0.971 43 per cent of the shares of U.
Return = return on shares —interest on debt
= 0.0097143 x $11 0 0 0 -0 .0 4 x $171.43

= $10 6.8 6 -$ 6.8 6
=$100
$171.43
~ $800
= 0.2143
<0.3125
Thus, the investor has achieved the same return ($100) at a lower risk (0.2143).
iii) How to achieve the same return at the same risk and also have money left over.
The investor retains $41.71 of the $800, leaving $758.29, then borrows $236.97 and invests
the whole sum ($758.29 + $236.97 = $995.26) in shares of company U. Therefore he owns
0.995 26 per cent of the shares of U.
Return = return on shares - interest on debt
=0.0099526 x $11 0 0 0 -0 .0 4 x $236.97

= $ 1 0 9 .4 8 -$ 9 .4 8
=$100
$236.97
—$758.29
= 0.3125
Thus, the investor has achieved the same return ($100) at the same risk (0.3125), and the
investor also has some money ($41.71) to spend or to invest elsewhere.
For a risk-averse investor all of these strategies produce a better outcome than if they continued
to hold the shares in company L.
It can be proved algebraically th a t the results in Example 12.2 hold in all cases where the value o f
the levered company is greater than the value o f the unlevered company. As an example, we provide the
algebraic p ro of fo r achieving a higher retu rn at the same risk.
Notation
E l = market value o f the equity (shares) o f company L
D l = market value o f the debt o f company L
VL = m arket value o f company L = + DL
Ev = m arket value o f the equity o f company U
Vu = m arket value o f company U = EV
r = interest rate on debt
NCF = net operating cash flow (the same fo r b oth companies)
p = the percentage o f the shares o f company L th a t the investor owns
The value o f the shares held by the investor is L = p x EL. The retu rn on these shares is the proportion,
p} o f the net income o f company L. That is,
Return = p (N C F - rD i) ^
The risk is measured by the debt-equity ratio o f company L, which is
The investor borrows an amount, A, such th a t his personal d ebt-equity ratio equals the debt-equity
ratio o f company L. That is, A is chosen such that:
PEl El
Therefore v4 = p x D i ，
The am ount to be invested in U shares is therefore:
pEL + pDL = p(EL + Dl ) = pVL
vVj
Therefore, the proportion o f U shares on issue owned by the investor is - — .
vu
Thus the return on this investm ent is:
New return = return on shares - interest on debt
pX l
x NCF- r x pDi
Hence, the difference between the new retu rn and the previous retu rn is:
Difference in return = new return - previous return
^ x NCF-prDL -p(N C F-rD L)

Vu J
p x NCF x
(竞 .
> 0 if VL >Vu
Investor’s deb t-e q uity ratio = -----
= pDl = 〇L
PEl PEl El
Therefore, the investor has achieved a higher retu rn at the same risk.
Example 12.2 shows th a t i f the value o f the levered company exceeds the value o f the unlevered
company, an investor in the levered company should sell her shares and instead borrow money and invest
in the shares o f the unlevered company. This action w ill be profitable fo r as long as the value o f the levered
company remains greater than the value o f the unlevered company. I f enough investors undertake sim ilar
transactions, there w ill be downward pressure on the price o f L shares (because there are many sellers) and
upward pressure on the price o f U shares (because there are many buyers). E quilibrium w ill be restored
when security prices have adjusted to the p o in t where the m arket values o f the tw o companies are equal.
W hat happens i f the opposite o f Example 12.2 arises— th a t is, i f the value o f the levered company
is less than the value o f the unlevered company? In th a t case, an investor in U shares should sell these
shares and buy shares in L. O f course, this action w ill increase the investors risk because L has borrowed
whereas U has not. However, this risk can be offset by the investor also lending money. In effect, the
investor can undo the effect o f corporate leverage.
The central mechanism in M M s p ro of is the substitu ta bility between corporate debt and personal
debt. I f a levered company is overvalued, an investor in th a t company s shares can replicate his risk and
return by investing instead in the shares o f an unlevered company and adjusting the d ebt-equity ratio
by borrow ing personally. Hence, leverage does n ot add value to a levered company because, by borrowing,
the levered company is n o t doing anything th a t its shareholders cannot do fo r themselves. Therefore,
there is no reason fo r investors to pay a prem ium fo r the shares o f levered companies. Similarly, i f an
unlevered company is overvalued, an investor in th a t company s shares can replicate his risk and return
by investing instead in the shares o f a levered company and adjusting his d ebt-equity ratio (to zero) by
lending personally. Leverage neither adds to, n o r subtracts from , the value o f a company.
Proposition 1 is a law o f conservation o f value. A company is a collection o f assets th a t generates a stream
o f net operating cash flows, which are then divided between different suppliers o f finance. Proposition 1
says that the value o f a set o f assets remains the same, regardless o f how the net operating cash flows
generated by the assets are divided between different classes o f investors. I f this law is breached then
investors can earn immediate profits w ith no risk. The process o f taking advantage o f such an o p p ortu nity
is called arbitrage, which should ensure th a t perfect substitutes w ill n ot sell at different prices in the ARBITRAGE
same m arket at the same tim e. In the context o f the M M analysis, tw o companies w ith the same assets, simultaneous
transactions in
but different capital structures, are perfect substitutes. I f th e ir m arket values are n o t the same, investors
different markets that
w ill enter the m arket to take advantage o f the arbitrage o p p o rtu n ity and, in doing so, w ill force the values result in an immediate
o f the two companies to be the same. risk-free profit
It is sometimes argued that the arbitrage process employed by M M is unrealistic because company
leverage and personal leverage are not perfect substitutes. For example, individual borrowers often pay
higher interest rates and higher transaction costs than companies. Although true, this observation has little
substance as a criticism because the particular arbitrage procedure used by M M is not the only way to prove
their proposition. Another way, which uses a different arbitrage procedure, is shown in Example 12.3.
Example 12.3
This example again compares Company L and Company U using the information provided in
Example 12.2. Recall that both companies have net operating cash flows of $1 1 000 a year. Company
U has no debt and the market value of its equity is $100000. Company L has borrowed $25000 at an
interest rate of 4 per cent per annum and the market value of its equity is $80000. Hence, contrary to
MM, the market value of L, which is $80000 + $25000 = $105000, exceeds the market value of U,
which is $100000. If an investor owns 1 per cent of L—that is, 1 per cent of its shares and 1 per cent
of its debt—what is the market value of the investment and what is the annual return on the investment?
SOLUTION
The market value of this investment is:
Equity: 1% x $ 8 000 0 = $ 800
Debt: l% x $ 2 5 0 0 0 = $ 250
Total market value: $1050
The annual return produced by this investment is:
Equity: 1% x ($ 1 1 000 - 0.04 x $25 000) = $100
Debt: 0.04 x $250 = $10
Total annual return: $110
The investor can arbitrage this situation by first selling his portfolio of the debt and equity of
company L for its market value of $1050. The investor then retains $50, and invests the remaining
$ 1000 in U's shares. This shareholding represents 1 per cent of the equity of company U and hence
entitles the investor to 1 per cent of the net operating cash flows generated by company U—that is,
the annual return on this investment is 0.01 x $11 000 = $110. Therefore, the investor's return is
$110 —the same as before—but the investor also has $50 left over to consume or to invest elsewhere.
Clearly, the difference between the values of the two companies could not persist and the actions
of investors selling L’s securities and buying U's shares would quickly establish an equilibrium in
which their values would be exactly the same.
In summary, M M s Proposition 1 states th a t a change in the company s capital structure sim ply changes
the way in which the net operating cash flows generated by the assets are divided between shareholders
and lenders. Regardless o f how they are divided, th e ir to ta l size remains the same. Therefore, the value o f
the company s assets remains the same. Because the company s securities represent claims against those
assets, the to ta l m arket value o f the securities also remains the same. To illustrate this w ith an everyday
analogy, we cannot change the size o f a cake sim ply by slicing it up in a different way!
12 .3 .2 1M odigliani and M iller’s Proposition 2

Proposition 1 focuses on dollar values— in particular, it states th a t the dollar value o f a company is
independent o f the company s capital structure. Proposition 2 focuses on a company s cost o f capital,
which is the required rate o f retu rn on the company s securities. Proposition 2 states th a t a company s
4^^
1 B usiness fikance
weighted average cost o f capital is independent o f the company s capital structure. In short, Proposition 2
is like retelling the story o f Proposition 1 b ut in a different language.
I f a company s net operating cash flows are constant in perpetuity, then the expected rate o f return on
the company s assets, k〇iis sim ply the expected net operating cash flows per annum divided by the m arket
value o f the company, V. That is:
annual net operating cash flows
念 o=
V ran
Consider an investor who owns all o f a company s shares and has also provided all o f its debt finance.
As discussed in Chapter 7, the expected rate o f retu rn on a p o rtfo lio is a weighted average o f the expected
rates o f re tu rn on the assets in the p ortfolio. Therefore, in this case, the investors expected rate o f return
is a weighted average o f the rates o f retu rn on the company s equity and the company s debt, where the
weights are the proportions o f equity and debt in the company s capital structure. Because this investor
has provided all o f the company s equity capital and all o f its debt capital, the investor is entitled to all
o f the net operating cash flows generated by the company s assets. Hence, the investors expected rate o f
retu rn is equal to k〇 . Therefore, the expected rate o f retu rn on the company s assets is:
*。= ( x i )
12.2
where
k 〇 = expected rate o f retu rn on assets (or weighted average cost o f capital)
ke = expected rate o f retu rn on equity (or cost o f equity capital)
kd = expected rate o f return on debt (or cost o f debt capital)
E = the m arket value o f the company s equity capital
D = the market value o f the company s debt capital
V = E + D = the to ta l m arket value o f the company
The alternative terms used to describe the variables ke and kd may need to be explained. Investors w ill
purchase a security only i f the expected rate o f retu rn on the security is at least equal to the m inim um
rate o f retu rn th a t the investor requires or demands. The rates o f retu rn received by investors m ust be
provided by the issuers o f securities, and, from the issuers view point, the rate o f retu rn required by
investors is effectively a cost— typically referred to as a cost o f capital. Similarly, the expected rate o f
return on a p o rtfo lio o f all the securities issued by a company, as calculated in Equation 12.2, is often
referred to as the weighted average cost o f capital. The weighted average cost o f capital is typically used
as the discount rate when estim ating the net present value (NPV) o f projects th a t are o f the same risk as
the company s existing assets. The weighted average cost o f capital is discussed in detail in Chapter 14.
Equation 12.2 can be rearranged to show how the cost o f equity capital, kei is affected by the use of
debt finance. This gives:
ke = k 〇 + (k 〇 - kd)
12.3
Equation 12.3 is M M s Proposition 2, which shows that fo r a levered company the cost o f equity capital
consists o f two components. The first component is /c〇. I f a company had no debt (D = 0), then Equation 12.3
tells us th a t fo r this company, ke = k〇
. That is, k 〇 is equal to the rate o f return required by shareholders on a
company th a t has no debt. I f a company has no debt, it has no financial risk, but i t w ill have business risk.
So, in Equation 12.2, k0 can be interpreted as the rate o f return required because o f the company s business
risk. The second component is an increment fo r financial risk and is proportional to the company s debt-
equity ratio, ~ and also depends on the difference between k〇 and kd一 which m ust be positive.
DEFAULT RISK I f a company can always borrow w ith no defau lt risk, the cost o f debt, kdi w ill rem ain constant as the
the chance that a company s d ebt-equity ratio increases, and the relationship between the cost o f equity capital and the
borrower will fail
deb t-e q uity ratio w ill be linear. Proposition 2 fo r the case o f default-free debt is shown in Figure 12.2.
to meet obligations
to pay interest and Propositions 1 and 2 may appear contradictory. Proposition 1 says th a t shareholders w ill be indifferent
principal as promised to borrow ing by a company. But Proposition 2 says th a t borrow ing by a company increases a shareholders
expected rate o f return. W hy would a shareholder be ind iffe re nt to getting a higher expected rate o f
return? The answer is th a t because o f the financial risk associated w ith borrow ing, the shareholders*
required rate o f return also increases exactly in line w ith the increase in th e ir expected rate o f return. The
extra expected rate o f retu rn is just enough— no more and no less— to compensate fo r the extra financial
risk. Therefore, borrow ing by a company has no effect on its shareholders’ wealth.
Figure 12.2 Modigliani and Miller's Proposition 2 with default-free debt
How can the weighted average cost stay the same when the cost o f one component (equity) has risen
and the cost o f the other component (debt) has stayed the same? W hy doesn^ the average increase? The
answer is th a t when a company changes its capital structure, the securities m arket reacts by also changing
the m arket value o f the company’s debt and the m arket value o f the company’s equity. Therefore, the
weights, which are market-value weights, also change. Here is a hypothetical num erical example where
the company s debt is default-free and the interest rate is always 4.5 per cent. The company is considering
three alternative capital structures.
Low leverage (80 per cent equity and 20 per cent debt)
The cost o f equity capital (ke) is 11.125 per cent.
So k0 = 0.8 x 11.125% + 0.2 x 4.5% = 9.8%
Medium leverage (60 per cent equity and 40 per cent debt)
So k0 = 0.6 x 13.33% + 0.4 x 4.5% = 9.8%
High leverage (20 per cent equity and 80 per cent debt)
The cost o f equity capital (ke) is 31 per cent.
So k0 = 0.2 x 31% + 0.8 x 4.5% = 9.8%
In each case, the cost o f debt remains at 4.5 per cent b ut the cost o f equity increases as more debt is
issued. As required, the weights always sum to 1, b ut the weighted average remains at 9.8 per cent.
This outcome is not the result o f assuming default-free debt. In practice, there is always some risk th a t
a corporate borrower w ill default. For many large companies this risk is very small b u t i t is never zero.
Therefore, as a company borrows more, i t w ill have to pay higher interest rates. But this does n o t mean
that the weighted average cost o f capital m ust increase as borrow ing increases. Here is a simple numerical
example o f what could happen:
Low leverage (80 per cent equity and 20 per cent debt)
The cost o f debt capital (kd) is 4.6 per cent.
So k 〇 = 0.8 x 11.1% + 0.2 x 4.6% = 9.8%
Medium leverage (60 per cent equity and 40 per cent debt)
The cost o f debt capital (kd) is 5 per cent.
So k0 = 0.6 x 13% + 0.4 x 5% = 9.8%
High leverage (20 per cent equity and 80 per cent debt)
The cost o f debt capital (kd) is 6 per cent.
So k0 = 0.2 x 25% + 0.8 x 6% = 9.8%
In each case, the cost o f debt and the cost o f equity increase as more debt is issued. As required, the
weights always sum to 1, b u t the weighted average remains at 9.8 per cent.
While Proposition 1 is a law o f conservation o f value, Proposition 2 is a law o f conservation o f risk. Assume
that a company is able to borrow w ith no risk o f default. When the company borrows, it transfers a risk-free
cash flow stream to lenders. The business risk associated w ith the company s assets, and therefore w ith its net
cash flows, remains the same regardless o f its capital structure. Under the assumption o f risk-free debt, this
risk w ill affect only shareholders. While increasing the amount o f debt does not change the total risk to which
shareholders are exposed, it concentrates that risk on a smaller amount o f equity capital. Therefore, borrowing
increases the risk per dollar o f equity. Because shareholders are assumed to be risk averse, they respond by
requiring a higher rate o f return. But perfect capital markets do not provide something for nothing: the
increased expected rate o f return is just enough— no more and no less— to compensate for the extra risk.
Because lenders rank ahead o f shareholders in the division o f net operating cash flows, the required
rate o f retu rn on a company s debt is always less than the required rate o f retu rn on its equity. This has led
some people to believe th a t debt is cheaper1than equity from the view point o f the company as a whole.
Proposition 2 highlights the error in this belief. Example 12.4 provides an illustration.
Example 12.4
Consider again Example 12.1, in which Dribnor Ltd is financed solely by equity and its shareholders
require a rate of return of 15 per cent per annum. This rate reflects the risk of Dribnor's assets. Dribnor
can borrow at an interest rate of 12 per cent per annum. Suppose that Dribnor borrows $1 million
and uses these funds to repurchase shares. W hat will happen to Dribnor's cost of equity capital? What
will happen to its weighted average cost of capital?
SOLUTION
We can answer the first question using Proposition 2 as shown in Equation 12.3:
k e = k 〇 + [k 〇 - k d )
= 0 .1 5 + ( 0 . 1 5 - 0 . 1 2 ) ⑴
= 0 .1 8 or 18% per annum
Dribnor's weighted average cost of capital can be calculated using Equation 12.2:
= 0 .1 8 x 0.5 + 0 .1 2 x 0.5
0 .1 5 or 15% per annum
The introduction of debt finance has not changed Dribnor's weighted average cost of capital of
15 per cent, despite the fact that the interest rate on debt is only 12 per cent. The reason is that the
borrowing causes the cost of equity capital to increase to a level that exactly offsets the effect of the
apparently cheaper debt. In other words, the interest cost of debt is only its explicit cos\. The financial
risk created by borrowing increases the cost of equity capital, and this increase is an im plicit cost
associated with the debt.
1 2 .3 . 3 !M odigliani and Miller's Proposition 3

M M s Proposition 3 states th a t the appropriate discount rate fo r a particular investm ent proposal is
independent o f how the proposal is to be financed. The appropriate discount rate depends on the features
o f the investm ent proposal— in particular, its riskiness. W hether the investing company obtains the
funds by borrowing, or by issuing shares, or both, has no effect on the appropriate discount rate. This
im plication is consistent w ith the irrelevance o f the financing decision as stated in Proposition 1.
Taken together, the M M propositions m aintain that in a perfect capital market w ith no taxes, it is only
the investment decision that is im portant in the pursuit o f wealth maximisation. The financing decision is
o f no consequence. Therefore, investment decisions can be completely separated from financing decisions.
1 2 .3 .4 1 W hy is the M M analysis important?

We have given considerable space to an explanation o f the M M analysis. This should n ot be taken to im ply
that we regard the M M analysis as providing a complete description o f the effects o f financing decisions.
Clearly, it cannot do so because im p o rta n t factors such as taxes have so far been ignored. So why is the
M M analysis so im portant? There are two reasons. The firs t is th a t it helps us to ask the rig h t questions
about financing decisions. In particular, as M ille r (1988) later observed, showing w hat doesn't m atter
can also show, by im plication, w hat does.4 By m aking the assumptions they did, M M excluded from th e ir
analysis a num ber o f factors th a t could be im p orta nt. These factors include company taxes, personal
taxes and default (and the associated costs o f liquidating a b ankrupt company). By im plication, i f capital
structure does in fact matter, then taxes and default risk could be good places to look fo r the reasons
why i t matters. The second reason, which is related to the first, is th a t an understanding o f the M M
propositions helps to distinguish between logical and illogical reasons fo r particular financing decisions.
For example, it may be suggested th a t companies should use at least some debt finance because debt is
cheaper* than equity. Using the M M analysis, we can state th a t i f this reason is based on the observation
that interest rates are lower than required rates o f retu rn on equity, then th a t reason is illogical. But a
logical reason might be th a t there is a tax advantage to using debt rather than equity.
The basic M M analysis th a t we have presented envisages only two sources o f finance: debt and equity.
In practice, there are many other sources o f finance, including preference shares, leases and hire-purchase
agreements. Furtherm ore, debt may be short term or long term , it can be denominated in different
currencies such as US dollars, euro or yen, and some types o f debt and preference shares can be convertible
into ordinary shares. But the fundam ental M M message is th a t any com bination o f finance sources is as
good as any other. No m atter how many sources o f finance are used, the resulting capital structure is just
another way o f dividing the net operating cash flows between the people who have contributed the capital
that sustains the company s operations.
We now tu rn to a discussion o f some o f the factors th a t M M o m itted from th e ir basic analysis.
The effects of taxes on capital structure

under a classical tax system
LEARNING
OBJECTIVE 3
M M excluded company tax and personal tax from th e ir basic analysis. However, they were well aware that
Explain how tax may
company tax m ight be an im p o rta n t factor and extended th e ir analysis to include company tax. There influence capital
are two main types o f company tax systems. Under the classical tax system, which applies in the US, and structure decisions
to foreign companies operating in Australia, companies and th e ir shareholders are taxed independently.
That is, fo r tax purposes, a company is an e n tity d istin ct from the shareholders who own it. Under an
imputation tax system, which is used in many countries, including Australia, Canada and New Zealand, the
taxation o f companies and shareholders is integrated. We begin by considering the effects o f company tax
under the classical tax system. The effects o f personal taxes are discussed in Sections 12.4.2 to 12.4.4. The
effects o f taxes under an im putation tax system are discussed in Section 12.5.
12.4.1 | Company income tax

M M extended th e ir original no-tax analysis to incorporate the effect o f company income tax under the
classical system.5 Company p ro fit is taxed after allowing a deduction fo r interest on debt, which means
that borrowing causes a significant reduction in company tax and a corresponding increase in the after
tax net cash flows to investors. The tax savings associated w ith debt are shown in Example 12.5, which is
based on the same data as Example 12.1.
4 In o th e r w o r d s, if fin a n c in g d e c is io n s a re im p o r t a n t , th e r e a s o n s f o r t h e ir im p o r t a n c e m u s t b e r e la t e d t o th e f a c t o r s t h a t M M
e x c lu d e d th r o u g h t h e ir a s s u m p t io n s . H o w e v e r, it d o e s n o t n e c e s sa r ily fo llo w t h a t a ll s u c h f a c t o r s w ill c a u s e a d e p a r t u r e fr o m
M M s c o n c lu s io n s . A s M y e r s ( 2 0 0 3 , p. 2 2 1 ) c o m m e n t e d , p e r h a p s M ille r s h o u ld h a v e s a i d *w h at m ay m a tte r ".
5 The o r ig in a l M o d ig lia n i a n d M ille r ( 1 9 5 8 ) a rtic le in c lu d e d th e e ffe c t o f t a x s a v in g s o n in t e r e s t , b u t v a lu e d th e s a v in g s
in c o rre c tly . T h e e rr o r w a s r e c tifie d in M o d ig lia n i a n d M ille r ( 1 9 6 3 ).
4^^
Example 12.5
Dribnor Ltd is subject to company income tax at the rate of 30 cents in the dollar and interest on debt
is tax deductible. W hat is the effect of borrowing $1 million at 12 per cent per annum on the after-tax
net cash flows to investors?
SOLUTION
The two capital structures proposed for Dribnor Ltd are compared in Table 12.3, assuming that
earnings before interest and tax are $3000 00 per annum.
Table 12.3 shows that by borrowing $1 million, Dribnor increases its after-tax cash flow by
$ 3 6 0 0 0 per annum. This increase is equal to the annual tax savings on interest, which is calculated
by multiplying the annual interest payment, I, by the company income tax rate, tc. That is:
A nn ua l tax savings on interest = fc x /
= 0 .3 0 x $ 1 2 0 0 0 0
= $ 3 6 0 0 0 per annum
TABLE 12.3 The effects of borrowing and company tax on cash flows
Capital structure 100% equity Equity and debt of $1 million
Earnings before interest and 300000 300000

tax ($)
Interest on debt ($) — 120000
Taxable income ($) 300000 180000
Company income tax ($) (tax 90000 54000

rate, tc = 0.30)
After-tax company income ($) 210000 126000
After-tax cash flow available 210000 246000

to investors (shareholders and
lenders) ($)⑷
Increase in after-tax cash flow — 36 000

available to investors ($)
(°l Earnings before interest and tax less company income tax
W hat is the effect o f these tax savings on the value o f the company? Since the annual after-tax cash
flow increases by an am ount equal to the annual tax savings on interest, i t follows th a t the m arket value
o f a levered company, VD m ust be equal to the value o f an equivalent unlevered company, VU} plus the
present value (PV) o f the tax savings on interest. That is:
VL = Vu (PVof tax saving on interest) 12.4
W hat is the appropriate risk-adjusted discount rate to apply to the tax savings? Assuming th a t the
tax savings are just as risky as the interest payments on debt, the appropriate discount rate is sim ply the
cost o f debt, kd.
I f the annual interest payment remains constant in perpetuity, Equation 12.4 becomes:
VL = VU + ^
kd 12.5
In th is case the annual interest payment, I, is equal to the cost o f debt, kdi m u ltip lie d by the value o f
debt, D. M aking these substitutions, Equation 12.5 can be rew ritten as follows:
VL = V u + t^ -
kd
= Vy + tcD 12.6
Equations 12.4 to 12.6 express M M s Proposition 1, m odified to incorporate the effects o f company tax.
Note th a t i f there is no company tax, then tc = 0, and Equation 12.6 becomes VL = VUf which is M M s no-tax
result. Equation 12.6 implies th a t a levered company is always w o rth more than an equivalent unlevered
company. Moreover, the more i t borrows, the greater is its debt, D, and the more its value increases. I f the
company tax rate is 30 per cent, then, according to Equation 12.6, company value increases by 30 cents
for every dollar o f debt in a company s capital structure.
In Section 12.3.1 we summarised Proposition 1 in the no-tax case using the analogy o f slicing a cake:
slicing a cake in a different way does n ot change the size o f the cake. Introducing company tax is analogous
to cutting the cake into three slices instead o f tw o— there is now a slice fo r the government as well as
slices fo r the shareholders and lenders. Saving company tax by borrow ing is equivalent to increasing the
size o f the shareholders’ slice by reducing the size o f the government’s slice.
The main im plication o f Proposition 1 w ith company tax is clear b ut extreme: a company should
borrow so much th a t its company tax b ill is reduced to zero. In practice, very few companies use such
extremely high levels o f debt. This fact indicates th a t while debt may have some advantages when there
is company tax to be paid, there m ust also be other factors th a t offset these advantages. One im p o rta n t
factor th a t can do so is income tax payable by individuals, which we refer to as personal taxes.6
1 2 .4 .2 1 Company tax and personal tax

In practice, the company tax system and the personal tax system interact in complex ways. A lthough we
cannot provide a complete analysis here, we can capture the m ain features by considering a simplified
case. This case is presented in Example 12.6.
Exam ple 12.6

In 2012-13, Nowra Ltd had earnings before interest and tax of $2500 00 and its interest expense
was $100000. All its lenders and shareholders are individuals. The company operates under a
classical tax system. All companies are taxed at the rate of 30 per cent on company income, while all
individuals are taxed at the rate of 40 per cent on interest income and 25 per cent on income from
shares. How much tax does the government collect?
SOLUTION
Table 12.4 sets out the calculations.
TABLE 12.4 Taxes collected from Nowra Ltd, its lenders and shareholders
Income and expenses Amount ($) Tax paid ($) Type of tax and tax rate
Earnings before interest 250000 — _

and tax (EBIT)
less Interest 100000 40 000 Personal tax (40%)
Earnings after interest, 150000 — _
before tax
less Company tax 45 000 45 000 Company tax (30%)
Earnings available to 105000 26250 Personal tax (25%)
shareholders
Total tax collected 111250
As shown in Table 12.4, the government collects tax of $11 1 250, of which $ 4500 0 is company
tax and $ 6 6 2 5 0 is personal tax.
Consider $100 o f Nowras earnings before interest and tax. I f this $100 is paid to one o f the lenders
as interest, then the government collects $40 in tax from the lender, and the lender keeps $60. I f this
6 Th e t e r m p e r s o n a l ta x e s* is w id e ly u s e d in th e fin a n c e lit e r a t u r e to r e fe r t o t a x e s p a id a t th e in v e s t o r le v e l. S u c h t a x e s in c lu d e
th e in c o m e t a x p a id b y s u p e r a n n u a t io n fu n d s a s w e ll a s t h a t p a id b y in d iv id u a l in v e s t o r s , b u t to b e c o n s is t e n t w ith th e
lite r a tu r e w e w ill u s e th e t e r m p e r s o n a l t a x e s.
4^^
$100 is n o t paid to a lender, then i t form s p art o f earnings after interest and w ill be subject to company
tax. The government w ill collect $30 in company tax, leaving $70 to be passed on to a shareholder. But
the shareholder m ust pay 25 per cent o f the $70 in personal tax, which is 0.25 x $70 = $17.50. The
shareholder therefore receives $70 - $17.50 = $52.50. This is summarised in Table 12.5. The table also
shows the general case in which the company tax rate is tc, the personal tax rate on interest income is tp
and the personal tax rate on income from shares is ts.
TABLE 12.5 Effect of taxes on the income of lenders and shareholders

Lenders Shareholders
Source of finance Nowra Ltd General case Nowra Ltd General case
Earnings before interest and tax 100 100 100 100

(EBIT) 衝
I
Company tax ($) N il 0 30 100 X tc
Earnings after company tax ($) 100 100 70 100(1 - tc)
Personal tax ($) 40 100 X tp 17.50 100(1- t c) x t s
Net income after all taxes ($) 60 100(1- t p) 52.50 100 (1 - g a - g

tc is the company income tax rate.
tp is the personal tax rate on interest income.
ts is the personal tax rate on income from shares.
Therefore, as shown in the b ottom line o f Table 12.5, the preferred source o f finance depends on a
comparison between (1 - t ) and (1 - tc) ( l - ts). W ith personal taxes and company tax, the effect o f debt
on company value becomes:
Vl = v u + D
(1-^) 12.7
where D = the m arket value o f debt
Equation 12.7 can be used to consider tw o special cases.
Special case No. 1: Suppose th a t the personal tax rate on interest income is equal to the personal tax
rate on income from shares— th a t is, = ts. In this case, Equation 12.7 simplifies to: =〜 + … ， which
is M M s result when they include company tax in th e ir analysis (Equation 12.6). In o ther words, personal
taxes do n o t affect the company tax savings associated w ith debt, provided th a t the personal tax rates on
income from debt and equity are the same.
Special case No. 2: Suppose th a t (1 - tp) is equal to (1 - tc) ( l - ts), which means th a t the overall tax
burdens on debt and equity are the same. In this case, Equation 12.7 simplifies to: VL = V。 — th a t is, the
effects o f company tax and personal taxes offset each other exactly, so changing a company s capital
structure w ill n o t affect its value. This result is the same as M M s no-tax case.
How likely are these special cases to arise in practice? In m ost classical tax systems Special case No. 1
is unlikely to arise because capital gains are often taxed at a lower rate than ordinary income. Typically,
interest income is regarded as ordinary income and hence is taxed at the fu ll personal tax rate, tp. Income
from shares w ill usually consist p a rtly o f dividends, which are taxed at the fu ll rate, and p artly o f capital
gains, which are taxed at a lower rate. So the overall tax rate on shareholders’ income, ts, is less than the
fu ll rate, tp. But Special case No. 2— or something very sim ilar— is quite likely to arise. Suppose th a t the
company tax rate, tc, is 0.30 and an investor has a personal tax rate o f 0.45 on interest and dividends but
the tax rate on capital gains is 0.10.7 Also assume th a t dividends make up one-third o f the return to equity
while capital gains make up tw o-thirds. For this investor, tp = 0.45 and ts = 0.45 x 1/3 + 0.1 x 2/3 = 0.217.
7 A c a p it a l g a in s t a x r a te o f 1 0 p e r c e n t m a y s e e m low . F o r e x a m p le , in A u st r a lia , c a p it a l g a i n s a r e fr e q u e n tly t a x e d a t h a lf th e rate

o n o r d in a r y in c o m e , w h ich in t h is e x a m p le w o u ld b e 2 2 .5 p e r c e n t. H o w e v e r, c a p ita l g a i n s t a x is u su a lly n o t p a y a b le u n til th e
s h a r e s a re s o ld , w h ich m a y n o t o c c u r u n til m a n y y e a r s a f t e r th e s h a r e s w ere b o u g h t. B e c a u se o f th e t im e v a lu e o f m o n e y , th is
d e fe r r a l o f t a x p a y a b le b e n e fits th e t a x p a y e r a n d m a y w ell im p ly t h a t th e e ffe c tiv e c a p ita l g a i n s t a x r a te is a s lo w a s 1 0 p e r ce n t.
The after-tax retu rn from debt w ill be $100 x (1 - 0.45) = $55 and from equity i t w ill be $100 x (1 - 0.3) x
(1 - 0.217) = $54.81. These returns are almost identical, which suggests th a t it is possible fo r the effect o f
personal taxes to offset the effect o f company tax, provided th a t the personal tax rate on equity returns
is significantly lower than the personal tax rate on interest. This outcome is possible i f capital gains are
tax-free or are taxed at a lower rate than ordinary income— a situation th a t frequently arises in practice.
One complication th a t we have n ot considered is the fact th a t personal tax rates d iffer between
investors. The effects o f taxes and th e ir im plications fo r capital structure decisions when different
investors have different personal tax rates were analysed form ally by M ille r (1977). This analysis is
presented in the next section.
To outline M ille r s analysis o f the effects o f debt and taxes under the classical tax system, we assume that
all the income received by shareholders is in the form o f unrealised capital gains, so the personal tax rate
on shareholders1 income, ts, is zero. Suppose th a t all companies were financed entirely by equity. That
situation cannot persist because there would be a strong incentive fo r companies to reduce company tax
by borrowing. This means th a t some investors w ill have to switch from holding shares to holding debt.
Tax-exempt investors should readily move from holding shares to holding debt because they would pay no
tax in either case. The in itia l impact o f the change from all-equity financing would be to reduce to ta l taxes,
because company tax is being reduced w ith o u t any increase in personal tax. When tax-exempt investors
have been satisfied, companies th a t wish to borrow w ill have to persuade taxable investors to purchase
debt. The interest rate offered to potential lenders m ust therefore increase, in order to attract investors
w ith higher and higher m arginal personal income tax rates, tp.
Companies can afford to persuade investors to switch from holding shares to holding debt, provided that
the company tax saved by issuing the additional debt is greater than the personal tax payable by the lender
(remember that ts = 0). Companies should be able to do this if the investors marginal tax rate is less than
the company tax rate. But it should not be tax effective for investors on marginal tax rates greater than the
company tax rate to become lenders: the personal tax paid on interest would be greater than the company tax
saved. Therefore, the migration of investors from equity to debt should stop when, for the marginal investor, t
is equal to If the tax rate o f the marginal investor is lower than the company tax rate, then there would be an
incentive for companies to reduce overall taxes by increased borrowing. However, companies cannot afford to
pay interest rates that are high enough to attract investors whose tax rate is higher than the company tax rate.
The logical result is an equilibrium in which there is no incentive for companies to borrow either more or less.
M ille rs analysis has three m ain im plications. Two are:
1 There is an optim al d ebt-equity ratio fo r the corporate sector as a whole, and this optim al d ebt-
equity ratio w ill depend on the company income tax rate and on the funds available to investors who
are subject to different tax rates.
2 The securities issued by different companies w ill appeal to different types o f investors. For example,
tax-exempt investors should invest only in debt securities, while investors subject to marginal
personal income tax rates greater than the company income tax rate should invest only in shares.
Therefore, companies w ith different capital structures w ill attract different investor clienteles, but,
according to M ille r (1977), one clientele is as good as the other'. Consequently, in equilibrium there
is no optim al debt-equity ratio for an individual company.
An analogy may help to explain these two im plications. Suppose th a t 20 per cent o f cars use diesel
fuel and 80 per cent use petrol. Cars o f both types are distributed evenly across a city. Then, i f the city
has 10 000 fuel bowsers, we would expect about 20 per cent (2000) would deliver diesel fuel and about
80 per cent (8000) would deliver petrol, because th a t is how to ta l fuel demand is organised. But there is
no reason fo r any individual service station to allocate its bowsers in those proportions. D ifferent service
stations could have different proportions o f diesel and petrol bowsers, w ith little or no effect on the
volume o f fuel they sell.
The th ird im plication is:
3 The shareholders o f levered companies end up receiving no benefit from the company tax savings on
debt because the saving is passed on to lenders in the form o f a higher interest rate on debt— th a t is,
companies are effectively required to compensate the lenders fo r the additional personal tax payable
on interest income. The compensation is paid in the form o f an interest rate th a t is higher than it
would be i f personal income taxes did n o t exist.
M ille rs analysis is valuable in explaining empirical observations such as the fact th a t the average
d ebt-equity ratio o f US companies did n o t increase substantially from the 1920s to the 1970s, despite an
almost five-fold increase in the company income tax rate during th a t period. M ille rs explanation is that
personal income tax rates increased in a sim ilar manner, thereby offsetting what would otherwise have
been a strong incentive fo r companies to issue more debt.
12 .4 .4 1The scope of M iller’s analysis

M ille r proposed th a t the effects o f personal and company taxes can exactly offset each other, im plying
th a t an individual company s value is independent o f its capital structure, even though there is an optim al
deb t-e q uity ratio fo r the corporate sector as a whole. His analysis is im p o rta n t in h ig hligh tin g the need to
consider personal tax as well as company tax when analysing the effects o f borrow ing on company value.
However, M ille rs analysis relied on some sim plifying assumptions.
An im p o rta n t assumption is th a t the effective company income tax rate is the same fo r all companies.
Suppose th a t the tax rate fo r all companies equals the sta tu tory rate, which is, say, 30 per cent. A profitable
company th a t has borrowed w ill save 30 cents o f company tax fo r every dollar o f interest paid. However,
n ot all companies make profits all the tim e. I f a company makes a loss, the am ount o f the loss is carried
forward as a deduction against later years’ taxable income. Therefore, fo r a loss-making company, the
present value o f the tax savings on an additional dollar o f interest w ill be less than 30 cents.
Moreover, as De Angelo and Masulis (1980) have pointed out, borrow ing is n ot the only way fo r
companies to save tax. For example, depreciation on many assets can be claimed as a tax deduction,
and the larger a company s deductions fo r depreciation and other non-debt items, the smaller is any
advantage associated w ith saving company tax by borrowing. In other words, non-debt tax deductions are
a substitute fo r interest as a tax deduction.
W ith uncertain future interest tax savings and non-debt tax deductions, debt may be more valuable
fo r some companies than it is fo r others. The companies whose shareholders w ill benefit most from
corporate borrow ing w ill be those best able to use the tax deductions generated by the interest paid on
debt. In other words, borrow ing by a company can add value i f the company tax saved by borrow ing is
greater than the additional personal tax paid; this is m ost likely fo r companies w ith profits that are large
and stable. Conversely, fo r companies w ith low profits and p articularly those w ith accumulated losses
being carried forward, borrow ing can reduce company value and shareholders1wealth because borrowing
increases the personal tax payable on interest received and hence increases to ta l taxes.
It should also be noted th a t in discussing the lim ita tio n s o f M ille rs analysis we have n ot yet allowed
fo r the fact that interest may n ot be the only cost incurred when a company borrows. O ther costs include
the costs o f financial distress and agency costs. M ille r recognised th a t in principle these costs are relevant
to capital structure decisions. However, he argued th a t in practice they are too small to have a significant
effect on company value. We discuss these costs in Sections 12.6 and 12.7. In summary, his analysis is
im p o rta n t in that i t shows th a t the effects o f personal and corporate taxes tend to be offsetting, and can
be exactly offsetting i f the personal tax rate on interest income is significantly greater than the personal
tax rate on income from shares.
12.5 The effects of taxes on capital structure

LEARNING
under an imputation tax system
OBJECTIVE 3
Explain how tax may 12.5.1 | W hat is an imputation tax system?
influence capital
structure decisions
In Chapter 11 we provided a detailed discussion o f the im putation tax system th a t operates in Australia.
In this section we therefore provide only a b rie f summary. Since 1987, Australian-owned companies
operating in Australia have been taxed under an im putation system. The hallm ark o f an im putation
system is th a t company taxes and personal taxes are integrated. Look again at Table 12.4, which sets out
the amount o f tax collected fro m Nowra Ltd under a classical tax system. Note that, although the highest
tax rate in this example is 40 per cent, Nowras earnings before interest and tax (EBIT) o f $250 000 has
generated tax collections o f $111 250— equivalent to a tax rate o f 44.5 per cent. This high im plied tax rate
arises because the classical system taxes company income in the hands o f the company and then taxes it
again when th a t income is passed on to the company s shareholders as a dividend. Critics o f the classical
system describe this outcome as ‘double taxation’. An im p utatio n system is designed to elim inate this
feature o f the classical tax system. Its operation is illustrated in Example 12.7.
Exam ple 12.7

In 2013-14, as in the previous year, Nowra Ltd had earnings before interest and tax (EBIT) of
$250000 and its interest expense was $1000 00. All its lenders and shareholders are individuals
resident in Australia. The company now operates under an imputation system. In this tax system, all
companies are taxed at the rate of 30 per cent on company income, while all individuals are taxed at
the rate of 40 per cent on interest income and 40 per cent on dividends. Nowra;s dividend policy is
to pay out all its after-tax income in dividends. How much tax does the government collect?
SOLUTION
Table 12.6 sets out the calculations.
TABLE 12.6 Taxes collected from Nowra Ltd, its lenders and shareholders
Income and expenses Amount ($) i Tax paid ($) Type of tax and tax rate
Earnings before interest and tax (EBIT) 250000
less Interest 100000 40000 Personal tax (40%)
Earnings after interest, before tax 150000
less Company tax 45 000 45000 Company tax (30%)
Earnings available to shareholders 105000
Franked dividend 105000
plus Franking credit1 45000
Shareholders’ taxable income 150000
Shareholders’ gross tax liability (at 40%) 60000
less Franking credit 45000
Shareholders’ net tax payable 15 000 15 000 Personal tax
Total tax collected 100000
1The calculation of the franking credit is:
franking credit = ~ ~ ~ x franked dividend
= 2 ^ 2 x $105000
0.70
=$45 000
Given Nowras dividend policy, the government has collected tax o f $100 000 from Nowras earnings
o f $250 000— equivalent to a tax rate o f 40 per cent. This tax rate is, o f course, equal to the personal tax
rate levied on interest and dividend income. The im p utatio n system is intended to produce this outcome.
4^^
B usiness finance
1 2 .5 .2 1The effects of tax on capital structure decisions under an

imputation tax system
To compare the effects o f taxes on debt and equity under an im putation tax system, consider a dollar
o f EBIT and th in k o f the company s capital structure as determ ining whether this dollar is paid out as
interest to lenders or used to provide a retu rn to shareholders. The return to shareholders could be in
the form o f either dividends or capital gains, depending on whether p ro fit is d istributed or retained by
the company. As discussed in Chapter 11, i f Australian company tax has been paid, then most resident
shareholders w ill benefit i f profits are distributed as franked dividends rather than retained. The after-tax
returns to lenders and shareholders from a dollar o f EBIT used to pay interest or franked dividends are
shown in Table 12.7.
TABLE 12.7 After-tax returns to investors under an imputation tax system

Lenders Shareholders
EBIT ($) 1 1
Company income tax ($) 0
Income after company tax ($) 1 (1 - tc) (franked dividend)
Franking credit ($) 0
Investors’ taxable income ($) 1 1 - tc + tc = 1 (grossed-up dividend)
Net personal tax ($) (tp - tc) (gross personal tax less tax credit)
fp
Income after all taxes ($) a - 〜） ( i - g - (tp- tc) = ( i - tp)
I f the dollar o f EBIT is used to pay interest to lenders, then company tax is zero because interest paid
is tax deductible fo r the company. Interest received is taxable in the hands o f lenders at the personal tax
rate, tpi so th a t the lender s net income after all taxes is $(1 - t ). Alternatively, i f the dollar o f EBIT is
used to provide a retu rn to shareholders, then the company w ill have to pay tax o f $tc w hich leaves after
tax p ro fit o f $(1 - tc). This p ro fit can be used to pay a franked dividend o f $(1 - tc) carrying a franking
credit o f $tc. The shareholder w ill then be taxed on the grossed-up dividend ($1), which means that, after
allowing fo r the franking credit, net personal tax w ill be $(tp - tc). Finally, the shareholders income after
all taxes w ill be the cash dividend, $(1 - tc), less net personal tax, $(tp - tc) — th a t is, the shareholder’s
after-tax income is $(1 - tc) - $(tp- tc) = $ ( l - t p). W hile the calculation o f shareholders, after-tax income
under im p utatio n may seem complex, the end result is simple: income distributed as franked dividends
to resident shareholders is effectively taxed only once, at the shareholders’ personal tax rate. As shown
in Table 12.6, interest paid to lenders is also taxed only once at the lenders* personal tax rate. Thus, the
im p o rta n t result is that, fo r any given investor, the overall tax burden is the same fo r both debt and
equity. In other words, in this case the im putation tax system is neutral between debt and equity.
I f n e u tra lity is achieved, we are back to M M s Proposition 1 in the original no-tax case: the choice
o f capital structure does n o t affect a company s value. In showing th a t the im p utatio n tax system can
be neutral we have assumed th a t all profits are distributed as franked dividends. O ther results may be
possible i f profits are retained.
In Australia in 2013-14 the income tax rate payable by companies was 30 per cent. A ll companies
face the same rate— — it does n o t vary w ith company income. However, the income tax rate payable by
individuals depends on the ind ivid ua ls taxable income. Thus different individuals pay different income
tax rates. In 2013-14 the top m arginal tax rate fo r personal income, excluding the Medicare levy, was 45
per cent. Consider an investor on this rate. This investors after-tax retu rn from a dollar o f EBIT paid out
as interest w ill be $(1 - 0.45) = $0.55. Alternatively, i f this investor receives a capital gain o f $1, the tax
law provides th a t at m ost only h a lf this am ount (50 cents) is subject to tax i f the gain is realised after a
period o f more than 12 m onths. Effectively, the income tax rate is halved; in this case, the rate would be
= 22.5 per cent. I f the same investor holds shares in a company th a t retains all profits and provides
returns only as capital gains, then the after-tax retu rn w ill be (1 - tc) (1 - tg) = (1 - 0.30) (1 - 0.225) = 0.5425.
The after-tax return from equity (0.5425) is only slightly lower than the after-tax retu rn from debt (0.55).
However, this analysis understates the attractiveness o f the investm ent in equity. W hile it is true th a t
this investor w ill pay a tax rate o f 22.5 per cent on a capital gain, this tax does not have to be paid until
the shares are sold. Therefore, i f the investor keeps the shares for, say, 10 years before selling them, the
payment o f the capital gains tax is deferred fo r 10 years. Taking in to account the tim e value o f money,
this is equivalent to a reduction in the capital gains tax rate. In this case, an investm ent in shares is
more attractive than an investm ent in debt. The im plication is th a t fo r this investor, the tax system is
not neutral, but the bias favours equity rather than debt as a source o f company finance. To state this in
another way, fo r a company to borrow from investors in the top tax bracket, the interest rate needed to
attract such investors would have to be so high th a t company value would be reduced.
In summary, the Australian im p utatio n tax system does n o t favour the use o f debt finance by
companies. The system is either neutral or biased towards equity, depending on the investors marginal
tax rate. Therefore, we arrive at essentially the same conclusion as M iller: borrow ing w ill n o t add value
because the interest rate paid w ill reflect personal tax rates on interest th a t are equal to or higher than
the overall tax rates on equity returns. W hile this conclusion is essentially the same as M ille rs , the reason
is different. M ille r s argument relied on m arket equilibrium , whereas in the case o f the Australian tax
system it is the structure o f the system th a t ensures th a t i t is either neutral o r biased towards equity.
The designers o f the im p utatio n tax system had as one o f th e ir m ain objectives the removal o f any tax-
related bias towards the use o f debt finance by companies. Our analysis indicates th a t this objective should
be achieved in the case o f companies th a t are w holly owned by Australian resident investors. However,
taxes can s till be an im p o rta n t influence on financing decisions fo r many companies. For example,
overseas investors in Australian companies are outside the im p utatio n tax system and are effectively s till
taxed under the classical system. Consequently, debt may have tax advantages fo r Australian companies
w ith a large overseas ownership.
fhe costs of financial distress

The costs o f financial distress may also cause a company s value to depend on its capital structure. We
first outline the nature o f financial distress. The effects o f direct bankruptcy costs are then discussed in LEARNING
OBJECTIVE 4
Section 12.6.1. Indirect costs o f financial distress are discussed in Section 12.6.2.
Explain how the costs
A company is said to be in a state o f financial d istress when it has d ifficu lty m eeting its comm itm ents of financial distress
to lenders. In serious cases, financial distress may lead to the liquidation o f the company. Alternatively, may influence capital
an adm inistrator or receiver-manager may be appointed by the lenders— this may lead either to eventual structure decisions
liquidation or to control reverting to shareholders i f the company trades out o f its difficulties. In less
FINAN C IAL DISTRESS
serious cases o f financial distress, a company may trade out o f its difficulties w ith o u t resorting to form al
situation where a
measures such as receivership. In other, even less serious cases, a company may meet all its comm itments
company’s financial
but the mere possibility o f financial difficulties can change peoples behaviour. For example, suppliers may obligations cannot be
demand cash on delivery i f the customer is rum oured to be facing financial difficulties. Therefore, we can met, or can be met
distinguish between costs associated w ith a form al transfer o f control to lenders, th a t is, bankruptcy only with difficulty
costs, and indirect costs o f financial distress, which can affect companies whose problems are less serious.8
BANKRUPTCY COSTS
direct and indirect
costs associated with
12.6.1 I Bankruptcy costs financial difficulty
that leads to control
In Section 12.2 we explained th a t any borrow ing by a company creates financial risk fo r its shareholders. of a company being
This is true even i f the d eb t-e q uity ratio is so low th a t there is no risk o f default. M M s analysis shows that transferred to lenders
financial risk increases the cost o f equity capital b ut has no effect on the weighted average cost o f capital
or on a company’s m arket value.
Increasing a company s deb t-e q uity ratio increases financial risk and also increases a separate but
related risk: the risk th a t the company w ill default on its debt. W hen there is some p robability o f default,
debt is described as ‘risky’. M M ’s Proposition 1 holds even i f debt is risky: a company’s m arket value is
8 S tr ic t ly s p e a k in g , th e te rm b a n k r u p t c y ' in A u s t r a lia a p p lie s o n ly t o th e in so lv e n c y o f in d iv id u a ls . W h e n a c o m p a n y fa ils

to m e e t it s fin a n c ia l o b lig a t io n s , it s c r e d it o r s h a v e a n u m b e r o f o p t io n s , s u c h a s s e e k in g th e a p p o in t m e n t o f a rec e iv e r,
a r e c e iv e r - m a n a g e r o r a liq u id a to r . W e u s e th e t e r m ‘b a n k r u p t c y ， to d e s c r ib e th e s t a t u s o f s u c h c o m p a n ie s b e c a u s e o f it s
w id e sp r e a d u s e in th e fin a n c e lit e r a t u r e .
B usiness finance
n ot affected by its d ebt-equity ratio. This conclusion also relies on the assumption that, while default is
possible, there are no costs associated w ith default— th a t is, bankruptcy costs are assumed to be zero.9
In practice, there are both direct costs o f bankruptcy and indirect costs o f financial distress, and these
costs w ill affect companies th a t issue risky debt. The direct costs are out-of-pocket costs associated w ith
receivership or liquidation and consist m ainly o f fees paid to parties such as lawyers, accountants and
liquidators. Indirect costs relate to factors such as the effects o f lost sales, reduced operating efficiency
and the cost o f managerial tim e devoted to attempts to avert failure.
When a company issues risky debt there is some probability th a t the company w ill subsequently
default, in which case direct bankruptcy costs w ill be incurred. Therefore, by issuing risky debt, a company
gives outsiders (lawyers, accountants, liquidators, and so on) a potential claim against its assets, which
m ust decrease the value o f the company to its shareholders and/or its lenders. Where debt finance offers
both benefits (such as tax savings) and the possibility o f bankruptcy costs, the value o f a company can be
w ritte n as follows:
Value of a company
= value of an equivalent all-equity financed company
+ present value of the benefits of debt
- present value of expected bankruptcy costs
The present value o f expected bankruptcy costs w ill be positively related to both the probability o f
bankruptcy and the present value o f costs incurred i f bankruptcy does occur.
The p robability o f bankruptcy w ill depend on the company s business risk and on its financial leverage,
b u t at any given level o f business risk, the higher the company s leverage, the higher w ill be the probability
o f bankruptcy. Therefore, the present value o f expected bankruptcy costs w ill increase as a company s
d ebt-equity ratio increases. Hence, on this view, the decision to borrow involves a trade-off between the
advantage o f tax savings and the disadvantage o f expected bankruptcy costs.
Bankruptcy costs would n o t concern shareholders i f they were borne entirely by other parties such as
lenders. When a company is liquidated, it is rare fo r shareholders to receive any return. In other words,
the company s equity is usually worthless and any proceeds from the sale o f assets w ill be distributed to
lenders. The costs incurred in adm inistering the liquidation, therefore, reduce the pool o f funds available
fo r distribu tio n to lenders. However, before they lend money, potential lenders should realise th a t they
w ill suffer in the event o f liquidation and respond by demanding a higher interest rate on th eir loans.
Consequently, while lenders w ill bear realised liquidation costs, the expected costs are likely to be borne by
shareholders. Therefore, expected bankruptcy costs decrease both company value and shareholders’ wealth.
As noted above, the indirect costs o f financial distress relate to factors such as the effects o f lost sales,
reduced operating efficiency and the cost o f managerial tim e devoted to attem pts to avert failure. The
basic problem is th a t the threat o f corporate bankruptcy provides incentives fo r managers and other
stakeholders such as customers, suppliers and employees to behave in ways th a t can disrup t a company s
operating activities and thus decrease its value. For example, i f a company is experiencing financial
difficulties, managers are likely to pay less a tte ntio n to issues such as product quality and employee safety.
Clearly, i f product quality falls and this fall is easily noticed by customers, sales and revenue w ill be
lost. I f product quality is im p orta nt, b ut d iffic u lt to assess, the mere perception th a t a company s product
quality is likely to suffer because o f financial difficulties can deter customers. For example, travellers are
likely to be w ary o f financially insecure airlines because o f fears th a t safety may be im paired by inadequate
maintenance. Therefore, it can be im p o rta n t fo r companies to m aintain an image o f low risk. Restricting
the level o f debt is one way o f restricting a company s overall risk.
Titm an (1984) points out th a t shareholders and lenders are n o t the only parties who can
suffer i f a company liquidates or w ithdraws vo lu n ta rily from a particular line o f business. Titm an
argues th a t expected future costs imposed on parties such as employees and customers w ill affect
9 T h e a s s u m p t io n o f n o c o s t s a s s o c ia t e d w ith d e f a u lt d o e s n o t m e a n t h a t t h e r e a r e n o lo s s e s in c u r r e d b y in v e s t o r s . T y p ically ,
b o t h le n d e r s a n d s h a r e h o ld e r s w ill in c u r lo s s e s b e c a u s e t h e v a lu e o f th e c o m p a n y s a s s e t s h a s d e c lin e d . T h is d e c lin e c a u s e s th e
c o m p a n y t o d e f a u lt b u t i f th e r e a r e n o c o s t s a s s o c ia t e d w ith d e f a u lt , th e t o t a l , a lb e it re d u c e d , v a lu e o f t h e a s s e t s is a v a ila b le
f o r d is t r ib u t io n to in v e s t o r s . T h e re fo r e , in v e s t o r s d o n o t s u ff e r a d d it io n a l lo s s e s a s a r e s u lt o f d e fa u lt .
shareholders* wealth. For example, suppose th a t a machinery m anufacturer is considered likely to

liquidate. Customers w ill expect problems in obtaining spare parts and service, so the price they are
prepared to pay fo r the company s products w ill fall. Sales, profits and share price would be greater if
the company could assure customers and other stakeholders th a t i t is very u nlikely to liquidate. Titm an
suggests th a t the choice o f capital structure can, in effect, help to provide this assurance. By borrow ing
less, a company decreases the p robability o f liquidation and hence improves the terms on which it trades
w ith customers and other parties. Conversely, fo r companies th a t borrow, the adverse effect on the
company’s current terms o f trade is p art o f the cost o f borrowing.
T itm ans model has the testable im plication th a t companies such as car manufacturers and computer
manufacturers, whose liquidation would impose large costs on customers and other associates, w ill adopt
capital structures th a t feature relatively low levels o f debt. Empirical evidence on this issue is presented
in Chapter 13. In addition to its adverse effects on sales, a company s risk o f financial distress can also
increase its operating costs and its financing costs. For example, a greater risk o f financial distress w ill
mean that it is harder to attract and retain skilled employees. Similarly, it can im pair a company s a bility
to borrow and to obtain trade credit.
12.7 A gency costs

Companies enter in to contractual relationships w ith various parties, including managers, shareholders,
lenders, customers and suppliers. These relationships may involve agency costs, which arise from the LEARNING
OBJECTIVE 5
potential fo r conflicts o f interest between the parties. In this section, we discuss the m ajor ways in which
Explain how agency
agency costs can affect financing decisions. The relevant costs include those associated w ith conflicts costs may influence
o f interest between lenders and shareholders, and the incentive effects o f debt. Equity finance also has capital structure
agency costs because there can be conflicts o f interest between shareholders and managers. decisions
12.7.1 I Conflicts of interest between lenders and shareholders

When a company borrows, the lenders may fear th a t managers w ill make decisions th a t w ill transfer
wealth from them to shareholders. This conflict o f interest is one type o f agency problem. The follow ing
examples illustrate the p otential fo r such conflicts o f interest (Myers 1977; Sm ith & Warner 1979).
• Claim dilution. A company may issue new debt th a t ranks equally w ith, or has a higher ranking than,
its existing debt. I f the proceeds from the issue are used to pay dividends, the to ta l assets o f the
company are m aintained and the only change is in the company s d ebt-equity ratio. However, the
holders o f the old debt now have a less secure claim on the company s assets and therefore th eir
investment has become riskier. Accordingly, the m arket value o f th e ir loans decreases. Unless the
value o f the company also decreases because o f the new debt, wealth is transferred from the holders
o f the old debt to shareholders.
• DzWend payout. I f a company significantly increases its dividend payout, it decreases the company’s
assets and therefore increases the riskiness o f its debt. Again, this results in a wealth transfer from
lenders to shareholders. Further, the incentives fo r managers to increase a company s dividends
become greater when the company is facing financial distress. In this case, the dividend payout
provides a means fo r the shareholders to receive returns th a t otherwise are likely to go to the lenders
on liquidation o f the company.
• Asset substitution. When a company borrows, it has a greater incentive to undertake risky
investments, especially i f the m arket value o f its shares is very low. In fact, this incentive can be so
strong th a t a company may undertake a high-risk investm ent even i f the investm ent has a negative
net present value. The reason is th a t i f the investm ent proves successful, m ost o f the benefits
w ill flow to shareholders, b ut if the investm ent fails, m ost o f the costs w ill be borne by lenders.
Therefore, at the tim e the investm ent is undertaken, the to ta l value o f the company w ill decrease
(because the investm ent has a negative net present value), b u t the value o f the shares w ill increase
and the value o f the debt w ill fall. Again there is a transfer o f wealth from lenders to shareholders.
• Underinvestment. A company may reject proposed low -risk investments that have a positive net present
value. If a company s debt is very risky, it may not be in the interest o f shareholders to contribute
additional capital to finance profitable new investments. While undertaking the investments would
B usiness finance
increase company value, shareholders can still lose because the risk o f the debt w ill fall and its value
w ill increase. The amount o f this increase can be greater than the net present value o f the investments.
Lenders should realise th a t th e ir wealth may be eroded by managers’ decisions made in the best
interests o f the company s shareholders. Lenders would be expected to attem pt to protect themselves
against such behaviour by managers. The more the company borrows, the greater is the need to seek such
protection. One response by lenders is to require a higher interest rate on debt than would otherwise be
the case, in order to compensate them fo r the losses they may suffer. This imposes costs on the company
th a t w ill be borne largely by shareholders.
Lenders may also protect themselves by requiring covenants to be included in loan agreements.
Examples o f covenants are restrictions on issuing additional debt, particularly debt th a t has a higher
ranking; restrictions on the disposal o f assets; a lim ita tio n on the payment o f dividends; lim ita tion s on
the types o f investments the company can undertake; and requirements th a t the company m aintain
specific financial ratios.10 The fact th a t these types o f covenants have been in existence fo r many years
suggests th a t lenders are well aware o f th e ir need fo r protection.
Covenants affect the value o f the company and shareholders’ wealth in tw o ways:
a M o n ito rin g w ill be required to ensure th a t the covenants are n ot breached,

b There may be o p p o rtu n ity costs in cases where the covenants are too restrictive and prevent
managers from im plem enting value-maximising decisions. For example, covenants designed to
prevent the company undertaking high-risk projects w ith negative net present values may also result
in some profitable, high-risk projects being forgone.
Conflicts of interest between shareholders and

company managers
The agency costs discussed in Section 12.7.1 relate only to debt b ut there can also be agency costs
associated w ith equity. These costs arise when a company's shares are owned by outside1investors rather
than by ‘insiders’ such as top-level managers. To see this, consider a company owned entirely by an
entrepreneur who also manages its operations. In this case, there are no agency costs o f equity because
one person both owns and controls the company. Many companies are clearly too large to be structured in
this way and equity capital is provided by shareholders who have little or no involvem ent in the company s
operations. Instead, managers are employed to control the day-to-day operations o f the company. W ith
this separation o f ownership and control there can be conflicts o f interest between shareholders and
managers. For example, managers are unlikely to be as m otivated as an entrepreneur to w ork hard, strive
fo r m axim um efficiency and search actively fo r profitable investm ent opportunities.
The agency costs o f equity can be reduced by measures th a t align the objectives o f managers w ith
those o f shareholders. These measures include employee share ownership schemes and the inclusion o f
options on the company s shares as p art o f the rem uneration o f top-level managers. I f these measures
are effective, this prom pts the question: Would it be efficient to elim inate the costs associated w ith the
separation o f ownership and control by having a company s equity capital provided only by its managers?
The answer is generally no, fo r two m ain reasons. First, while the owner-manager structure (rather than
the employee-manager structure) is preferred fo r many small businesses, there are few individuals who
have the combination o f wealth and skills to both own and manage a very large company. Second, while
having an owner-manager has advantages in terms o f agency costs, it has disadvantages in terms o f
risk bearing. As discussed in Chapter 7, investors can reduce risk by diversification and it is easy for
them to diversify by combining the shares o f many companies in a p ortfo lio . Diversification can eliminate
company-specific or unsystematic risk, and investors w ill require compensation only fo r bearing
systematic risk th a t cannot be removed by diversification. In other words, the existence o f a stock m arket
allows companies to raise equity capital on terms th a t reflect the benefits o f diversification. But where
a company s manager is also one o f its shareholders, the manager is u nlikely to reap the fu ll benefits o f
10 S m it h a n d W a r n e r ( 1 9 7 9 ) . In a d d it io n , th e la w m a y lim it t h e b e h a v io u r o f m a n a g e r s . F o r e x a m p le , u n d e r A u s t r a lia n law , a

c o m p a n y c a n p a y a d iv id e n d o n ly i f t h r e e c o n d it io n s a r e m e t . T h e se a r e : (i) th e c o m p a n y 's a s s e t s m u s t e x c e e d i t s lia b ilitie s
im m e d ia t e ly b e fo r e th e d iv id e n d is d e c la r e d a n d th e e x c e s s m u s t b e s u ffic ie n t t o p a y th e d iv id e n d ; (ii) i t m u s t b e fa ir a n d
r e a s o n a b le to th e s h a r e h o ld e r s ; a n d (iii) i t m u s t n o t m a t e r ia lly p r e ju d ic e th e c o m p a n y ’s a b ilit y to p a y i t s c r e d it o r s.
diversification. As an employee, the managers wealth is linked to some extent to the fortunes o f the
company. For example, managers generally develop skills and knowledge th a t are company-specific—
that is, they have skills and knowledge th a t are valuable in th e ir current employment, b ut are o f less value
elsewhere. Therefore, managers would require a higher rate o f retu rn on th e ir investm ent than outside,
investors. In other words, managers would charge* more fo r bearing risk than outside investors, who can
diversify. Consequently, the owner-manager structure is n o t efficient from the view point o f risk bearing.
Jensen (1986) outlines an im p o rta n t application o f agency theory to capital structure decisions. This
application is based on the concept o f *free cash flow*, which Jensen defines as the cash flow in excess FREE CASH FLOW
cash flow in excess of
o f that required to fund all projects that have positive net present values. Consider, fo r example, a highly
that required to fund
profitable company in a declining industry. Because the company is profitable, it w ill generate positive all projects that have
net operating cash flows, b u t because the in d u stry is declining, it w ill have few new investm ent projects positive net present
that have a positive net present value. Hence, it has large free cash flows. Managers have considerable values
discretion in deciding how to use free cash flows and Jensen argues th a t managers w ill be tempted to use
free cash flows in ways th a t benefit them rather than the shareholders. For example, managers may invest
in new projects or takeovers th a t increase th e ir command over resources, even though these investments
have negative net present values. Similarly, having free cash flows may allow managers to avoid making
hard decisions, such as retrenching surplus employees and adapting to rapidly changing technology. The
upshot is th a t the company becomes less efficient and the interests o f shareholders are damaged.
One way to reduce the agency costs o f free cash flows is through the paym ent o f dividends or by
buying back shares. Jensen argues th a t shareholders’ wealth should be increased i f managers com m it
to paying out this cash as dividends or to buying back shares rather than retaining the cash w ith in the
company. However, promises to continue to pay high dividends or to buy back shares are weak because
shareholders cannot enforce them. But i f a company borrows, i t is obliged to make agreed payments o f
interest and repayments o f principal to the lender. Thus, debt has a control effect* whereby managers
are forced to pay out cash because the penalties fo r default are severe. Jensen argues th a t the control
effect o f debt w ill be im p o rta n t in companies th a t generate large net operating cash flows b ut have low
growth prospects. Such companies can be expected to have higher financial leverage than others. He
acknowledges th a t high leverage can be dangerous b u t also believes th a t it can add value in cases where
companies generate large free cash flows.
O ptim al capital structure: the static

m
trade-off theory
LEARNING
Debt offers a company advantages, which include the tax d eductibility o f interest, b ut also disadvantages, OBJECTIVE 6
Understand the
which include increased costs o f financial distress. Therefore, there is the possibility o f a trade-off between
concept of an optimal
the advantages and the disadvantages o f debt, leading to an optim al capital structure.11 I f an all-equity capital structure based
company decides to issue a small am ount o f debt, it is likely th a t the probability o f financial distress w ill on a trade-off between
be increased only negligibly. Under a classical tax system, the resulting tax savings are therefore likely the benefits and costs
to outweigh the very small increase in expected costs o f financial distress. Consequently, the value o f of using debt
the company w ill increase. However, as the pro po rtio n o f debt is fu rth e r increased, the probability o f
financial distress also increases and hence the expected costs o f financial distress also increase. A t some
point, the higher costs w ill equal the higher tax savings. A t th a t point, the optim al d ebt-equity ratio
has been reached. I f the deb t-e q uity ratio is increased s till fu rthe r, the value o f the company starts to
decrease. This is illustrated in Figure 12.3. STATIC TRADE-OFF
The static trade-off th eory outlined here has been a popular way o f reconciling observed capital
THEORY
theory that proposes
structures w ith the M M analysis (w ith company income tax). There are several reasons fo r suggesting that that companies have
the static trade-off theory provides an over-sim plified view o f the relationship between capital structure an optimal capital
and company value. These reasons include the following: structure based on a
trade-off between the
• M ille r has argued th a t when both corporate and personal taxes are considered, the net effect o f taxes benefits and costs of
on company value can be zero.*1 3
7
9 using debt
11 S e v e r a l a u t h o r s h a v e d is c u s s e d o p t im a l c a p it a l s t r u c t u r e t h e o r ie s o f t h is ty p e . S e e , fo r e x a m p le , K r a u s a n d L itz e n b e r g e i
( 1 9 7 3 ) a n d S c o t t ( 1 9 7 6 ).
Rgure 12.3 The static trade-off theory of capital structure
• The im p u ta tio n tax system has the p otential to be neutral between debt and equity as sources o f
company finance. In cases where it is not neutral, the system is biased towards equity, n ot debt.
• There is evidence th a t the direct costs o f bankruptcy are small relative to company value (Warner
1977; Pham & Chow 1987, Weiss 1990; Andrade & Kaplan 1998).12
• Companies used debt finance long before there were income taxes, which suggests th a t there must
be advantages o f debt that are not related to income tax. The main such advantage probably involves
agency costs. As discussed in Section 12.7.2, debt can be valuable in reducing the agency costs o f equity.
W hile the static trade-off theory has significant lim ita tion s, its central message may s till be valid:
there are both advantages and disadvantages o f debt, which can give rise to an optim al capital structure
consisting o f a com bination o f different types o f finance. Therefore, despite its lim ita tion s, the static trade
o ff theory is useful in th a t it can help managers to focus on some o f the factors th a t can be im p o rta n t in
financing decisions.
12.9 C apital structure with inform ation

fk ：
LEARNING
asymmetry
OBJECTIVE 7
Explain the 'pecking 12.9.1 | Pecking order theory
order’ theory of
capital structure
In a landm ark study, Donaldson (1961) carried out an extensive survey to fin d out how the capital
structures o f US companies were actually established. His m ain findings can be summarised as follows:
a Managers prefer to use internal finance rather than raise funds externally by borrow ing or issuing
shares.
b D ividend-payout ratios are set based on companies, expected future cash flows and expected
investm ent opportunities. The aim is to ensure th a t there are sufficient internal funds to meet a
company’s capital expenditure needs under ‘norm al’ conditions, b ut managers are also reluctant to
make sudden changes in dividends— th a t is, dividend policy is ‘sticky’.
12 W a rn e r e s t im a t e d t h a t t h e d ir e c t b a n k r u p t c y c o s t s in c u r r e d b y a s a m p le o f b a ile d * U S r a ilr o a d c o m p a n ie s a v e r a g e d o n ly
5 .3 p e r c e n t o f th e m a r k e t v a lu e o f th e ir a s s e t s . T h is fig u re fa lls t o 1 p e r c e n t i f c o m p a n y v a lu e is m e a s u r e d 7 y e a r s b e fo r e
b a n k r u p tc y . W e iss e s t i m a t e s t h a t d ir e c t c o s t s fo r la r g e fin a n c ia lly d i s t r e s s e d fir m s a r e o n a v e r a g e 2 .8 p e r c e n t o f th e b o o k
v a lu e o f a s s e t s . P h a m a n d C h o w r e p o r t e d d ir e c t b a n k r u p t c y c o s t s a v e r a g in g 3 .6 p e r c e n t o f c o m p a n y v a lu e a t th e d a t e o f
b a n k r u p t c y fo r a s a m p le o f A u s t r a lia n c o m p a n ie s . W h e n th e p r o b a b ilit y o f fa ilu r e is a ls o t a k e n in t o a c c o u n t , it a p p e a r s t h a t
e x p e c te d d ire c t b a n k r u p t c y c o s t s w o u ld b e v e r y sm a ll.
c W ith a sticky dividend policy and unexpected changes in both cash flows and investm ent
opportunities, a company may or may n o t be able to finance all o f its capital expenditure internally.
In periods when the funds available interna lly are greater than the company s investm ent needs,
it may pay o ff debt, invest in marketable securities or increase dividends. Conversely, i f the funds
available interna lly are insufficient to meet the company s investm ent needs, i t may ru n down its
cash, sell marketable securities and, i f fu rth e r funds are needed, raise funds externally,
d If external funds are needed, borrow ing is preferred. A new issue o f ordinary shares is a last resort.
In summary, Donaldson observed th a t companies tend to follow a hierarchy or pecking order o f PECKING ORDER
financing sources. The pecking order is: THEORY

theory that proposes
a internal finance— in essence, retained earnings that companies
b external funds raised by borrow ing follow a hierarchy of
financing sources in
c external funds raised by issuing hybrid securities, such as convertible notes and preference shares
which internal funds
d external funds raised by issuing ordinary shares. are preferred and,
if external funds are
Donaldsons pecking order roughly corresponds to the transaction costs o f raising new capital. For
needed, borrowing
example, internal finance usually imposes lower transaction costs than external finance. Therefore, the is preferred to issuing
pecking order could perhaps be explained by a desire to m inim ise the transaction costs o f raising finance. riskier securities
According to Myers (1984), info rm a tio n asymm etry provides another explanation. In the follow ing
sections, we explain how in fo rm a tio n asymmetry may influence capital structure decisions.
1 2 .9 .2 1 Information asymmetry and the undervaluation

of a company’s assets
Inform ation asymmetry exists when company managers have more info rm a tio n about th e ir companies1
asset values and prospects than outside investors. I f managers have in fo rm a tio n th a t the share m arket
does not have, then the managers should have a more accurate idea than the share m arket o f the company s
*true value*. Sometimes the managers may know th a t the company is w o rth more than its m arket value,
while at other times the managers may know th a t the company is w o rth less than its m arket value. In
this section we consider the case where the managers know th a t the share m arket has undervalued a
company’s assets.
Suppose th a t Alpha Books Ltd has on issue 100 000 o rdinary shares w ith a m arket price o f $4.50
each, but the company’s managers know th a t the ‘tru e ’ value o f the company’s assets is greater than
the share m arket believes— the ‘tru e ’ value o f a share is $5. In the long term , perhaps when more
inform ation is publicly available, the share m arket w ill also value the shares at $5 each. But in the short
term, there is in fo rm a tio n asym m etry between the managers and the share m arket. Suppose fu rth e r
that Alpha Books also has an investm ent o p p o rtu n ity th a t requires an outlay o f $200 000, which w ill
have to be financed externally, and which has an NPV o f $17 000. The existence o f this investm ent
o p p ortu nity is n o t know n to outsiders and is n o t reflected in the current share price. Hence, there is
a second in fo rm a tio n asym m etry between the managers and the share m arket. But when the m arket
is inform ed o f the new investm ent, the share price w ill respond positively to th is inform a tion . Should
Alpha Books make the new investment? I f so, should the investm ent be made before or after the share
m arket learns the true value o f the company s existing assets? And should the investm ent be financed
by issuing new shares or by issuing new debt? To answer these questions, we consider the fo u r scenarios
TABLE 12.8 Alternative information and financing scenarios for Alpha Books Ltd
Time that the investment announcement Financing method
is made New share issue New debt issue
Before the share market learns the true Scenario 1 Scenario 3

value of the existing assets
After the share market learns the true Scenario 2 Scenario 4

value of the existing assets
B usiness finance
W e n o w analyse each o f the se scen arios. F o r ease o f e x p re ssio n w e use ‘s h o rt t e r m ’ to m e a n th e p e rio d

b e fo re th e share m a rk e t le a rn s th e tru e v a lu e o f th e e x is tin g assets. W e use ‘lo n g te r m ’ to m e a n th e p e rio d
a fte r th e share m a rk e t le a rn s th e tru e va lu e o f th e e x is tin g assets.
Scenario 1: Investment announcement made before the share

market learns the true value of the existing assets; new
shares are issued
In itia lly , th e share p ric e is $ 4 .5 0 , so th e n u m b e r o f n e w shares to be issu ed is $ 2 0 0 0 0 0 /$ 4 .5 0 = 4 4 4 4 4 .
A f te r th e n e w in v e s tm e n t is a n n o u n ce d , a n d th e n e w shares are issued, th e share p ric e in th e s h o rt te rm
w ill be:
n $450 0 0 0 + $200 0 0 0 + $17 000 ^
P q = -------------------------------------------- = $ 4 .b z
144 444
H a d th e n e w in v e s tm e n t n o t b e en m ade, th e share p ric e w o u ld have re m a in e d a t $ 4 .5 0 , so in th e s h o rt

te r m th e s h a re h o ld e rs g a in 12 cen ts p e r share.
In th e lo n g te rm th e share m a rk e t le a rn s th e tru e value o f th e e x is tin g assets a n d th e share p ric e
w ill be:
n $500 000 + $200 000 + $ 17 000 ^
Pi = ----------------------------------------------------------------------------------------------- = $4.96
144 444
H a d th e n e w in v e s tm e n t n o t been m ade, th e share p ric e w o u ld have been $ 5 .0 0 , so in th e lo n g te rm

th e s h a re h o ld e rs lose 4 cen ts p e r share.
T h e re fo re , th e ‘n e w ’ sh a re h o ld e rs — th o se w h o b o u g h t th e n e w shares a t $ 4 .5 0 each— w ill g a in b o th
in th e s h o rt te r m a n d th e lo n g te rm , because b o th $ 4 .6 2 a n d $ 4 .9 6 exceed $ 4 .5 0 . The <o ld , s h a re h o ld e rs
are b e tte r o f f in th e s h o rt te r m (because $ 4 .6 2 exceeds $ 4 .5 0 ), b u t in th e lo n g te r m w o u ld be b e tte r o f f
w ith o u t th e n e w in v e s tm e n t a n d th e n e w share issue (because $ 4 .9 6 is less th a n $ 5 .0 0 ).
Scenario 2: Investment announcement made after the share

shares are issued
In th e s h o rt te r m th e share p ric e re m a in s a t $ 4 .5 0 . In th e lo n g te rm , th e share m a rk e t le a rn s th e tru e
va lu e o f th e e x is tin g assets a n d th e share p ric e increases fr o m $ 4 .5 0 to $5 .00. T h ere fore, th e n u m b e r o f
n e w shares to be issu ed is $ 2 0 0 0 0 0 /$ 5 .0 0 = 4 0 0 0 0 . A f te r th e n e w in v e s tm e n t is a n n o u n c e d , a n d th e n e w
shares are issued, th e share p ric e w ill be:
$500 000 + $200 000 + $17 000
Pl = = $ 5 .1 2
140 000
In t h is scen ario, b o th th e n e w s h a re h o ld e rs a n d th e o ld s h a re h o ld e rs g a in in th e lo n g te r m b y 12 cents

p e r share.
Scenario 3: Investment announcement made before the share

debt is issued
I f th e c o m p a n y b o rro w s to fin a n c e th e p ro je c t, a ll th e b e n e fit o f th e p o s itiv e N P V w ill go to th e c u rre n t
sh a re h o ld e rs. A f te r th e n e w in v e s tm e n t is a n n o u n ce d , a n d th e n e w d e b t is issued, th e sha re p ric e w ill be:
$450 000 + $17 000
Ps $4.67
In th e s h o rt te r m th e sh a re h o ld e rs g a in b y 1 7 ce n ts p e r share. I n th e lo n g te r m th e share m a rk e t le arn s

th e tru e v a lu e o f th e e x is tin g assets, a n d th e share p ric e w ill be:
$500 000 + $17 000
Pl $5.17
100 000
4^ ^
C hapter twelve Principles 〇卩 capital structure
H ad th e n e w in v e s tm e n t n o t be en m ade, th e share p ric e w o u ld have b e en $ 5 .0 0 , so in th e lo n g te rm

th e sh a re h o ld e rs g a in b y 17 ce n ts p e r share.
Scenario 4: Investment announcement made after the share

debt is issued
In th e s h o rt te rm , th e share p ric e re m a in s a t $ 4 .5 0 . In th e lo n g te rm th e share m a rk e t le a rn s th e tru e
value o f th e e x is tin g assets a n d th e share p ric e increases fr o m $ 4 .5 0 to $ 5 .0 0 . A f te r th e n e w in v e s tm e n t
is a n no un ced, a n d th e n e w d e b t is issued, th e share p ric e w ill be:
D $500 0 0 0 + $17 000

Jr T — — IpO • L l
100 000
In th is scen ario th e sh a re h o ld e rs g a in in th e lo n g te rm b y 17 ce n ts p e r share.
In s u m m a ry, without the new investment, th e s h o r t- te rm o u tc o m e is a share p ric e o f $ 4 .5 0 w h ile th e
lo n g -te rm o u tc o m e is a share p ric e o f $ 5 .0 0 . With the new investment, th e s h o r t- te rm a n d lo n g -te rm
ou tcom es are th o se s h o w n in T able 12.9.
TABLE 12.9 Share price outcomes of alternative information and financing

scenarios for Alpha Books Ltd
F in a n c in g m e th o d
T im e th a t th e in v e s tm e n t a n n o u n c e m e n t N e w s h a re issue N e w d e b t issue
is m a d e
Before the share m a rk e t learns th e tru e Scenario 1 Scenario 3

value o f the e x is tin g assets
Share price in the s h o rt te rm : Share price in th e s h o rt te rm :

$4.62 $4.67
Share price in the lo n g te rm : Share price in th e lo n g te rm :

$4.96 $5.17
A fte r the share m a rk e t learns th e tru e Scenario 2 Scenario 4

value o f th e e xistin g assets
Share price in th e s h o rt te rm : Share price in th e s h o rt term :

$4.50 $4.50
Share price in th e lo n g te rm : Share price in th e lo n g term :

$5.12 $5.17
C o m p a rin g th e fo u r scenarios, th e cle ar w in n e r is S cen ario 3, in w h ic h th e n e w in v e s tm e n t p ro je c t

s h o u ld be accepted im m e d ia te ly , a n d s h o u ld be fin a n c e d b y d e b t. S cen ario 3 p ro d u ce s th e h ig h e s t share
p rice in th e s h o rt te r m ($ 4 .6 7 ) a n d th e e q u a l h ig h e s t share p ric e in th e lo n g te r m ($ 5 .1 7 ). The w o rs t
o u tco m e in th e lo n g te r m is c le a rly S cenario 1, in w h ic h th e n e w in v e s tm e n t is u n d e rta k e n im m e d ia te ly
a n d is fin a n c e d b y shares. In t h is exa m ple, S cenario 1 is so ba d t h a t in th e lo n g te r m th e s h a re h o ld e rs lose
as a re s u lt o f u n d e rta k in g an in v e s tm e n t w it h a p o s itiv e NPV.
1 2 .9 .3 1 Information asymmetry and the overvaluation of a

company's assets
N o w co n s id e r a d iffe re n t s itu a tio n . The c u rre n t share p ric e o f A lp h a B ooks is $ 4 .5 0 a n d th e re is n o ne w
in v e s tm e n t o p p o rtu n ity . M a n a g e m e n t has in fo r m a tio n t h a t im p lie s t h a t th e share p ric e s h o u ld be o n ly
$3 .50. In th e s h o rt te rm th e share m a rk e t does n o t have th is in fo r m a tio n b u t w ill le a rn o f i t in th e lo n g
te rm . M a n a g e m e n t decides to issue 50 0 0 0 n e w shares w h ile th e m a rk e t p ric e is s t ill $ 4 .5 0 a n d w ill use
th e cash raised ($ 2 2 5 0 0 0 ) to re p a y d e b t. In th e s h o rt te rm , th is changes th e c a p ita l s tru c tu re b u t n o t th e
4^ ^
B usiness finance
va lu e o f th e com p an y. In th e lo n g te rm , w h e n th e share m a rk e t le a rn s th e tru e va lu e o f th e c o m p a n y s

assets, th e share p ric e w ill be:
$350 000 + $225 000
Pl = = $ 3 .8 3
150 000
W h ile th is p ric e is less th a n th e p re v io u s p ric e o f $ 4 .5 0 , i t is more th a n $ 3 .5 0 , w h ic h th e share p rice

w o u ld have been h a d th e n e w share issue n o t be en m ade. H a v in g n e w s h a re h o ld e rs p a y m o re th a n th e
shares are w o r th c u s h io n s th e im p a c t o f th e bad ne w s o n th e o ld sh a re h o ld e rs.
I n fo r m a tio n a s y m m e try can cause th e share m a rk e t to u n d e rv a lu e o r to o v e rv a lu e a com p an y. I f a

c o m p a n y s m an ag ers b e lie ve t h a t its shares are u n d e rv a lu e d , th e y w ill p re fe r to b o rro w . I f th e y be lie ve
t h a t th e shares are o ve rv a lu e d , th e y w ill p re fe r to issue n e w shares. H o w e ve r, w h ile o u ts id e in v e s to rs are
n o t as w e ll in fo rm e d as m an ag ers, th e y u n d e rs ta n d m a n a g e rs’ m o tiv e s . T h ere fore, th e sha re m a rk e t m a y
see th e a n n o u n c e m e n t o f a n e w share issue as evidence t h a t th e co m p a n y s m a n a g e rs k n o w b a d new s
t h a t is n o t y e t k n o w n to o u ts id e rs . C o n se q u e n tly, th e share p ric e w ill decrease w h e n a n e w share issue is
a n n o u n c e d . T his p o s s ib ility p ro v id e s a n o th e r rea son w h y n e w share issues ra n k v e ry lo w in th e p e c k in g
o rd er.
The m a in im p lic a tio n f o r c o m p a n y m an ag ers is t h a t th e re are ad van ta ge s in r e s tr ic tin g fin a n c ia l
leverage so t h a t a c o m p a n y w ill be able to b o rro w a t s h o rt n o tic e i f a p ro fita b le in v e s tm e n t o p p o r tu n ity
arises. To see th is , suppose t h a t a c o m p a n y is so h ig h ly le v e re d t h a t a n y u n e x p e c te d ne ed f o r fu n d s
can be m e t o n ly b y is s u in g shares. The a n n o u n c e m e n t o f a share issue w ill cause th e c o m p a n y s share
p ric e to fa ll, u n le ss th e m a n a g e rs succeed in c o n v in c in g in v e s to rs t h a t th e y are n o t co n c e a lin g adverse
in fo r m a tio n . B u t f a ilin g to m ake an issue w i ll m e a n t h a t a p ro fita b le in v e s tm e n t o p p o r tu n it y m u s t
be fo rg o n e . This cho ice b e tw e e n tw o u n a ttra c tiv e a lte rn a tiv e s can be a vo id e d b y m a in ta in in g Reserve
b o r r o w in g c a p a c ity ’ o r ‘fin a n c ia l sla c k ’. In t u r n , th is can be a ch ie ve d b y r e s tr ic tin g d e b t to a m o d e ra te
le vel, h o ld in g m a rk e ta b le s e c u ritie s t h a t can be s o ld to p ro v id e cash a n d /o r a rra n g in g lin e s o f c re d it w ith
u n u s e d b o r r o w in g lim its .
A n im p o r t a n t d iffe re n c e b e tw e e n th e p e c k in g o rd e r th e o r y a n d th e s ta tic tra d e -o ff th e o ry is t h a t th e
p e c k in g o rd e r th e o ry does n o t re ly o n th e c o n ce p t o f a ta rg e t d e b t- e q u ity ra tio .13 In ste a d , a c o m p a n y s
o b se rve d c a p ita l s tru c tu re w ill s im p ly re fle c t th e h is to r y o f it s c a p ita l re q u ire m e n ts . F o r exa m ple, suppose
t h a t a co m p a n y en jo ys e x c e p tio n a l p r o fita b ility , w h ic h re s u lts in a s u b s ta n tia l increase in its share p rice .
T here fore, in m a rk e t va lu e te rm s , th e c o m p a n y s d e b t- e q u ity ra tio w ill have decreased. A c c o rd in g to th e
s ta tic tra d e -o ff th e o ry , i f a co m p a n y s o p tim a l c a p ita l s tru c tu re has n o t changed, th e n th e c o m p a n y s n e x t
c a p ita l ra is in g s h o u ld be d e b t, to m o ve b a ck to w a rd s th e ta rg e t d e b t- e q u ity ra tio . H o w e ve r, th e p e c k in g
o rd e r th e o r y suggests o th e rw is e . Ind e e d , because o f th e co m p a n y s e x c e p tio n a l p r o fita b ility , i t m a y n o t
ne ed to raise e x te rn a l fu n d s a t all. T h e re fo re , p ro fita b le co m p a n ie s w ill te n d to have lo w d e b t- e q u ity
ra tio s because o f th e a v a ila b ility o f in te r n a l fu n d s . Less p ro fita b le co m p a n ie s in th e sam e in d u s tr y w ill
have h ig h e r d e b t- e q u ity ra tio s because th e y g e n e ra te fe w e r fu n d s in te r n a lly a n d because d e b t is f ir s t on
th e p e c k in g o rd e r o f e x te rn a l sources o f fu n d s .
13 Note that internal equity and external equity are at opposite ends of the pecking order.
CHAPTER TWELVW REVIEW

SUMMARY
F in a n c ia l le v e r a g e in c re a s e s th e e x p e c te d ra te o f c la im a g a in s t its a sse ts, w h ic h re d u c e s th e v a lu e o f
re tu rn to s h a re h o ld e rs , b u t a ls o in c re a s e s th e ris k th e c o m p a n y to in v e s to rs . D ir e c t b a n k r u p tc y co sts
o f th e ir re tu rn s . T h e se e ffe c ts a r e o ffs e ttin g , a n d in a p p e a r to b e s m a ll a s a p r o p o r tio n o f com pany
a p e rfe c t c a p it a l m a rk e t w ith n o ta x e s , c h a n g in g v a lu e , b u t f in a n c ia l d is tre s s c a n a ls o in v o lv e v a r io u s
a c o m p a n y 's c a p it a l s tru c tu re does not change in d ir e c t costs.
c o m p a n y v a lu e o r s h a r e h o ld e r s 7 w e a lth . U n d e r th e se A g e n c y co sts m a y a ls o in flu e n c e c a p it a l s tru c tu re
c o n d itio n s , c a p it a l s tru c tu re is ir r e le v a n t b e c a u s e d e c is io n s . T h e se c o sts a r is e b e c a u s e th e re m a y b e
c h a n g in g it s im p ly c h a n g e s th e w a y in w h ic h th e c o n flic ts o f in te re s t b e tw e e n le n d e rs a n d s h a re h o ld e rs
s tre a m of net o p e r a tin g cash flo w s is d iv id e d a n d b e c a u s e th e re m a y a ls o b e c o n flic ts o f in te re s t
b e tw e e n d iffe r e n t c la s s e s o f in v e s to rs . In a p e r fe c t b e tw e e n s h a re h o ld e rs and com pany m a n a g e rs .
c a p ita l m a rk e t, d iv id in g th is c a s h f lo w s tre a m is T he la tte r c a s e m a y b e p a r tic u la r ly s e v e re w h e r e a
co stle ss a n d c a n n o t c h a n g e its to ta l v a lu e . c o m p a n y h a s a la r g e fre e c a s h flo w . Je n se n su g g e s ts
W h e n th e p e rfe c t c a p it a l m a rk e t a s s u m p tio n s a r e th a t, in th e s e c a s e s , d e b t m a y b e a u se fu l w a y to
re la x e d , s e v e ra l fa c to rs c o u ld m a k e c a p it a l s tru c tu re c o n tro l th e b e h a v io u r o f m a n a g e rs .
im p o rta n t. T hese fa c to rs in c lu d e c o m p a n y in c o m e • T he s ta tic tr a d e - o ff t h e o r y s u g g e s ts th a t d e b t
ta x , p e rs o n a l in c o m e ta x , th e co sts of fin a n c ia l s h o u ld be expanded u n til th e p o in t w h e re
d is tre s s , a g e n c y co sts a n d in fo r m a tio n a s y m m e try . th e a d v a n ta g e s of m o re debt ju s t e q u a l th e
• W h e n th e re a re in c o m e ta x e s , d e b t f in a n c e c a n d is a d v a n ta g e s o f m o re d e b t. T h is p o in t is th e
in c re a s e com pany v a lu e if th e com pany ta x o p tim a l c a p it a l s tru c tu re .
s a v e d b y b o r r o w in g is g r e a te r th a n th e e x tra • T he p e c k in g o rd e r th e o ry p ro p o s e s th a t, in
p e rs o n a l ta x p a id . W h ile th is is p o s s ib le fo r a t r a is in g fin a n c e , m a n a g e rs f o llo w a 'p e c k in g
le a s t s o m e c o m p a n ie s u n d e r th e c la s s ic a l ta x o rd e r’ in w h ic h in te rn a l fu n d s a re p r e fe r r e d ,
s yste m , th e im p u ta tio n ta x system is d e s ig n e d to fo llo w e d by d e b t, h y b r id s e c u ritie s a n d th e n ,
re m o v e a n y ta x a d v a n ta g e s o f d e b t. as a la s t re s o rt, a n e w issu e o f o r d in a r y s h a re s .
D e b t is s u e d b y c o m p a n ie s is ris k y in th a t th e re is In fo rm a tio n a s y m m e trie s b e tw e e n m anagem ent
so m e p r o b a b ilit y o f d e fa u lt, w h ic h can le a d to a n d in v e s to rs m a y h e lp to e x p la in th e p e c k in g
re c e iv e rs h ip o r liq u id a tio n . T h e se o u tc o m e s in v o lv e o rd e r. A c c o r d in g to th e p e c k in g o r d e r a p p r o a c h ,
d ir e c t b a n k r u p tc y co sts, la r g e ly in th e fo rm of a c o m p a n y 's d e b t - e q u it y r a t io w ill v a r y over
fee s p a id to in s o lv e n c y s p e c ia lis ts . T h e re fo re , a n y tim e , d e p e n d in g o n its n e e d s fo r e x te rn a l fin a n c e .
c o m p a n y th a t b o r r o w s is g iv in g o u ts id e rs a p o te n tia l
KEY TERMS
a r b itr a g e 365 fin a n c ia l le v e ra g e ( g e a rin g ) 358
b a n k ru p tc y costs 377 fre e ca sh f lo w 38 1
bu siness ris k 357 o p tim a l c a p ita l s tru c tu re 357
c a p ita l s tru c tu re 357 p e c k in g o r d e r th e o r y 383
d e fa u lt ris k 366 p e rfe c t c a p ita l m a rk e t 36 1
fin a n c ia l distre ss 377 s ta tic t r a d e - o ff th e o r y 381
SELF-TEST PROBLEMS
B a rry T o d d , a n e n tre p re n e u r, is p la n n in g to e s ta b lis h a n in la n d fis h fa rm . T he to ta l c o s t o f th e n e c e s s a ry
e a rth m o v in g , c o n s tru c tio n o f p o n d s a n d in s ta lla tio n o f p u m p s is e s tim a te d to b e $1 m illio n . T h re e
p o s s ib le fin a n c in g p la n s a r e b e in g c o n s id e r e d . T h e se a r e a s fo llo w s :
a) e q u ity o f $1 m illio n
b) e q u ity o f $ 7 5 0 0 0 0 a n d a b a n k lo a n o f $ 2 5 0 0 0 0
c) e q u ity o f $ 2 5 0 0 0 0 a n d a b a n k lo a n o f $ 7 5 0 0 0 0 .
387
T he in te re s t ra te o n th e lo a n s w ill b e 1 0 p e r c e n t p e r a n n u m . B a r r y is u n c e rta in a b o u t th e re tu rn s fro m fish
fa r m in g a n d w is h e s to a n a ly s e th e e ffe cts o f th e a lte rn a tiv e fin a n c in g p la n s o n th e ra te o f re tu rn o n his
in v e stm e n t.
P re p a re a ta b le s h o w in g th e ra te o f re tu rn o n B a rry 's in v e s tm e n t f o r e a c h fin a n c in g p la n if th e a n n u a l n e t

o p e r a tin g c a s h flo w s g e n e ra te d b y th e fish fa rm a re $ 0 , $ 1 0 0 0 0 0 a n d $ 2 0 0 0 0 0 . T he e ffe cts o f ta x e s
m a y b e ig n o r e d . C o m m e n t o n th e results.
2 Emu F a rm s Ltd h a s assets w ith a m a rk e t v a lu e o f $ 1 . 5 m illio n . Its c a p it a l s tru c tu re c o n s is ts o f e q u ity , p lus

a lo a n o f $ 5 0 0 0 0 0 a t a n in te re s t ra te o f 8 p e r c e n t p e r a n n u m . T h e c o m p a n y 's c o s t o f e q u ity h a s b e e n
e s tim a te d a t 2 1 . 5 p e r c e n t a n d its m a n a g e r is c o n s id e r in g a p r o p o s a l to b o r r o w a fu rth e r $ 2 5 0 0 0 0 ,
w h ic h w o u ld b e u se d to b u y b a c k s h a re s . T h e in te re s t ra te o n th e n e w lo a n is a ls o 8 p e r c e n t p e r a n n u m .
a) U se M M 's P ro p o s itio n 2 to c a lc u la te th e e ffe c t o f th e in c re a s e in le v e ra g e o n th e c o s t o f e q u ity .
b) C a lc u la te th e c o m p a n y 's w e ig h te d a v e r a g e c o s t o f c a p ita l b e fo re a n d a fte r th e in c re a s e in le v e ra g e .
3 C o s m ic Press Ltd is a ll- e q u ity fin a n c e d a n d is e x p e c te d to g e n e r a te n e t o p e r a tin g c a s h flo w s o f $ 6 0 0 0 0 0

p e r a n n u m . T h e c o m p a n y in c o m e ta x ra te is 3 0 p e r c e n t. C o s m ic 's s h a re h o ld e rs e x p e c t a 1 5 p e r c e n t
ra te o f re tu rn (a fte r c o m p a n y ta x ).
a) W h a t is C o s m ic 's v a lu e ?
b) If th e c o m p a n y b o r r o w s $1 m illio n a t a n in te re s t ra te o f 1 0 p e r ce n t:
i) W h a t is C o s m ic 's a fte r-ta x o p e r a tin g c a s h flo w ?
ii) W h a t is C o s m ic 's v a lu e a c c o r d in g to M M 's P ro p o s itio n 1 (w ith c o m p a n y ta x)?
tu
1
QUESTIONS
[L O 1] W h a t a r e th e p o te n tia l a d v a n ta g e s a n d d is a d v a n ta g e s to a c o m p a n y ’s s h a re h o ld e rs if th e c o m p a n y
in c re a s e s th e p r o p o r tio n o f d e b t in its c a p it a l stru c tu re ?
2 [L O 1] D is tin g u is h b e tw e e n b u s in e s s ris k , f in a n c ia l ris k a n d d e fa u lt risk.
3 [L O 2 】
a) O u tlin e th e M o d ig lia n i a n d M ille r v a lu a tio n p ro p o s itio n s . S p e c ify th e a s s u m p tio n s o n w h ic h th e ir p r o p

o s itio n s a re b a s e d .
b) M odigliani and Miller's Propositions 1 and 2 are contradictory. Shareholders cannot be indifferent to the
use o f debt when it increases the expected rate o f return on their investment. C o m m e n t o n th is s ta te m e n t.
4 [L O2] Alternative proofs o f the M M propositions show that it is not necessary to assume the operation o f
arbitrage involving personal borrow ing for the propositions to hold. D iscu ss th is s ta te m e n t.
5 [L O 3 ] O u tlin e M ille r 's a r g u m e n t th a t th e ta x a d v a n ta g e s o f d e b t a r e r e d u c e d o r c o m p le te ly o ffs e t o n c e
p e rs o n a l ta x e s a r e in c lu d e d in th e a n a ly s is . H o w a p p r o p r ia t e is M ille r 's a n a ly s is , g iv e n th e A u s tr a lia n ta x
system ?
6 [L O 3 】M ille r 's a n a ly s is a ss u m e s th a t a c o m p a n y c a n fu lly u tilis e th e ta x d e d u c tio n s g e n e r a te d b y in te re s t

p a y m e n ts o n d e b t. Is th is a s s u m p tio n lik e ly to b e tru e fo r a ll c o m p a n ie s ? G iv e re a s o n s .
7 [L O 3 ] A n investor w ill wish to invest in a company because o f its capital structure. D iscu ss th is s ta te m e n t.
8 [L O 4 】O u tlin e th e s ig n ific a n c e o f b a n k r u p tc y co sts in th e c a p it a l s tru c tu re d e b a te .
9 [L O 3 , 4 ] C o m m e n t o n th e f o llo w in g s ta te m e n ts :
a) The Australian imputation tax system is neutral in the sense that there is no bias towards the use o f either
debt or equity.
b) Costs o f financial distress w ill be borne entirely by lenders.
c) Evidence such os that provided by Warner, Weiss, and Pham and Chow indicates that the costs o f financial
distress ore too small to have any effect on capital structure decisions.
10 Managers, when pursuing the objective o f maximising the value o f the company to its shareholders,
[L O 5 ]
may moke decisions that ore not in the lenders' best interest. E x p la in w h y th is s ta te m e n t m a y b e tru e , a n d
g iv e e x a m p le s o f d e c is io n s th a t m a y le a d to a tr a n s fe r o f w e a lth fro m le n d e rs to s h a re h o ld e rs .
OHAPTEH TWELVE REVIEW

11 [LO 5 ] W h a t a r e a g e n c y co sts? O f w h a t s ig n ific a n c e a r e th e y in c a p it a l s tru c tu re d e c is io n s ?
12 [LO 6 ] C r itic a lly e v a lu a te th e f o llo w in g s ta te m e n ts:
a) It is obvious that companies should use os much debt as possible. It is cheaper than equity and the interest
is tax deductible os well.
b) The probability o f financial distress should be negligible for companies with a low proportion o f debt.
Therefore, a low proportion o f debt should not have any noticeable effect on the cost o f equity.
13 [LO 7 ] T he p e c k in g o r d e r t h e o r y p la c e s n e w s h a re issues a t th e b o tto m o f th e p e c k in g o rd e r. W h y ?
CA
1
PROBLEMS
E ffect o f le v e ra g e [L O 1 ]
A n e n tre p re n e u r is p la n n in g to e s ta b lis h a c o m p a n y w ith $ 5 0 m illio n in assets a n d is in v e s tig a tin g th re e
p o s s ib le c a p ita l structure s fo r th e c o m p a n y : (i) n o d e b t; (ii) 2 0 p e r c e n t d e b t; a n d (iii) 5 0 p e r c e n t d e b t.
T he in te re s t ra te o n th e d e b t is 1 0 p e r c e n t p e r a n n u m . T h e e n tre p re n e u r b e lie v e s th a t th e a n n u a l e a r n in g s
b e fo re in te re s t a n d ta x w ill b e $ 2 . 5 m illio n in a p o o r y e a r, $ 5 m illio n in a n a v e r a g e y e a r a n d $ 1 0 m illio n in
a g o o d y e a r.
a) C o m p le te th e ta b le b e lo w .
b) P lot th e results fo r th e th re e c a p ita l stru ctu re s to g e th e r o n th e o n e d ia g r a m , w ith re tu rn o n assets (RoA) on

th e h o r iz o n ta l a x is a n d re tu rn o n e q u ity (RoE) o n th e v e rtic a l a x is . C o m m e n t.
C a p ita l s tru c tu re (i) C a p ita l s tru c tu re (ii) C a p ita l s tru c tu re (iii)
Assets
D e b t/
Assets
D ebt ($)
E q u ity ($)
EBIT ($) $2.5m $5 .0m $10.0m $2.5m $5.0m $10.0m $2.5m $5.0m $1 0.0m
In te re st ($)
N et incom e
($)
RoA ( % ) ⑷
RoE (%)W
^R o A (Return on Assets) = EBIT/Assets (where EBIT means earnings before interest and tax).
^RoE (Return on Equity) = Net income/Equity.
2 E ffe ct o f le v e ra g e [LO 1 ]
a) C a lc u la te th e ra te o f re tu rn a v a ila b le to s h a re h o ld e rs f o r a c o m p a n y fin a n c in g $1 m illio n o f asse ts w ith th e
fo llo w in g th re e a rra n g e m e n ts :
i) a ll e q u ity
ii) 5 0 p e r c e n t e q u ity , a n d 5 0 p e r c e n t d e b t a t a n in te re s t ra te o f 1 2 p e r c e n t p e r a n n u m
iii) 2 5 p e r c e n t e q u ity , a n d 7 5 p e r c e n t d e b t a t a n in te re s t ra te o f 1 2 p e r c e n t p e r a n n u m .
T he assets a re e x p e c te d to g e n e ra te e a rn in g s b e fo re in te re s t o f $ 1 5 0 0 0 0 p e r a n n u m in p e rp e tu ity .
b) In te rp re t y o u r a n s w e r, a n d e x p la in w h a t e ffe c t a c h a n g e in th e p e rp e tu a l e a rn in g s stre a m m ig h t h a v e o n th e
ra te o f re tu rn a v a ila b le to s h a re h o ld e rs .
389
Debt^-equity ratio and arbitrage [LO 2]
R o c k m e lo n Pty Ltd a n d C a n ta lo u p e Pty Ltd a re tw o id e n tic a l c o m p a n ie s w ith e x p e c te d e a rn in g s b e fo re in te re st
o f $ 1 . 5 m illio n p e r a n n u m . T he o n ly d iffe re n c e b e tw e e n th e tw o c o m p a n ie s is th a t R o ck m e lo n h a s issu ed d e b t
s e c u ritie s to fin a n c e th e id e n tic a l a c tiv itie s th a t C a n ta lo u p e h a s fin a n c e d w ith e q u ity se c u ritie s a lo n e . T h e re a re
n o ta x e s. D e ta ils o f th e tw o c o m p a n ie s a re as fo llo w s :
Item R o ck m e lo n Pty Ltd C a n ta lo u p e Pty Ltd
M a rk e t value o f e q u ity ($) 6000000 8000000
M a rk e t value o f d e bt ($) 4000000 —
N u m b e r o f shares issued 6000000 5 000000
Cost o f de bt (kd) 0.08 —
C h e e W e n g o w n s 6 0 0 0 0 0 sh a re s in R o c k m e lo n Pty Ltd.
a) W h a t is th e c u rre n t m a rk e t v a lu e o f C h e e W e n g 's sh a re s, a n d w h a t is h is in c o m e fro m R o c k m e lo n Pty Ltd?
b) S h o w h o w C h e e W e n g c a n o b ta in a n id e n tic a l in c o m e w ith a lo w e r n e t o u tla y .
DebN-equity rafio and arbitrage [LO 2]

L a n c e lo t Ltd a n d U n iv e rs a l Ltd o p e ra te u n d e r th e c o n d itio n s a s s u m e d b y M o d ig lia n i a n d M ille r in th e ir a n a ly s is
w ith o u t ta x . T he tw o c o m p a n ie s a re id e n tic a l e x c e p t fo r th e ir c a p ita l stru ctu re s. B oth c o m p a n ie s h a v e a n n u a l
n e t o p e r a tin g c a s h flo w s o f $ 5 0 0 0 0 0 . T h e m a rk e t v a lu e o f L a n c e lo t's d e b t is $ 2 m illio n . T h e in te re s t ra te is 9
p e r c e n t p e r a n n u m . L a n c e lo t ha s 3 . 2 m illio n sh a re s o n issue; th e ir c u rre n t m a rk e t p r ic e is 5 9 ce n ts p e r s h a re .
U n iv e rs a l h a s n o d e b t. It h a s 1 .5 m illio n sh a re s o n issue; th e ir c u rre n t m a rk e t p r ic e is $ 2 . 4 5 p e r sh a re . H a ro ld
o w n s 2 0 0 0 0 0 sh a re s in L a n ce lo t.
a) W h a t is th e m a rk e t v a lu e o f H a ro ld 's in v e stm e n t? W h a t is th e c u rre n t re tu rn o n his in ve stm e n t? W h a t is th e

ris k o f his in ve stm e n t, as m e a s u re d b y th e d e b t - e q u it y ra tio ?
b) S h o w H a r o ld th a t e a c h o f th e fo llo w in g th re e s tra te g ie s is a n a r b itr a g e :
i) S ell th e 2 0 0 0 0 0 sh a re s in L a n c e lo t. B o r r o w $1 2 5 0 0 0 a n d in v e s t th e w h o le p ro c e e d s in
U n iv e rs a l sh a re s.
ii) Sell th e 2 0 0 0 0 0 sh a re s in L a n ce lo t. B o rro w $ 8 5 6 7 2 a n d in ve st th e w h o le p ro c e e d s in

U n iv e rs a l sh a re s.
iii) Sell th e 2 0 0 0 0 0 sh a re s in L a n ce lo t. S p e n d $ 9 7 9 8 . B o r r o w $1 1 4 6 1 9 , a d d th is to th e r e m a in in g c a s h ,
a n d in v e s t th e w h o le p ro c e e d s in U n iv e rs a l sh a re s.
Debl^-equity rafio and arbitrage (harder) [LO 2]

Le vity Ltd a n d U n ic o rn Ltd o p e ra te u n d e r th e c o n d itio n s a ss u m e d b y M o d ig lia n i a n d M ille r in th e ir a n a ly s is
w ith o u t ta x . T he tw o c o m p a n ie s a re id e n tic a l e x c e p t fo r th e ir c a p ita l structure s. B oth c o m p a n ie s h a v e a n n u a l
n e t o p e r a tin g c a s h flo w s o f $ 1 0 m illio n . T he m a rk e t v a lu e o f Le vity's d e b t is $ 3 0 m illio n . T he in te re s t ra te is 7 . 5
p e r c e n t p e r a n n u m . Le vity ha s 1 .2 5 m illio n sh a re s o n issu e; th e ir c u rre n t m a rk e t p ric e is $ 2 0 . 4 8 p e r sh a re .
U n ic o rn h a s n o d e b t. It ha s 4 0 m illio n sh a re s o n issu e; th e ir c u rre n t m a rk e t p ric e is $ 1 . 3 0 p e r s h a re . Je s s ic a
o w n s 1 0 0 0 0 sh a re s in Levity.
a) W h a t is th e m a rk e t v a lu e o f J e ssica 's in ve stm e n t? W h a t is th e c u rre n t re tu rn o n h e r in v e s tm e n t? W h a t is the

ris k o f h e r in v e s tm e n t, a s m e a s u re d b y th e d e b t - e q u it y ra tio ?
b) S h o w Je ssica th a t e a c h o f th e fo llo w in g s tra te g ie s is a n a r b itr a g e :
i) To a c h ie v e a h ig h e r re tu rn a t th e sa m e risk, firs t sell th e 1 0 0 0 0 sh a re s in Levity, th e n b o r r o w $ 2 4 0 0 0 0

a n d in v e s t th e w h o le p ro c e e d s in U n ic o rn sh a re s.
ii) To a c h ie v e th e sa m e re tu rn a t a lo w e r risk, firs t sell th e 1 0 0 0 0 sh a re s in Levity, th e n b o r r o w $ 1 9 2 7 8 7

a n d in v e s t th e w h o le p ro c e e d s in U n ic o rn sh a re s.
c) W h a t w o u ld Jessica n e e d to d o to a c h ie v e a n in v e s tm e n t in U n ic o rn th a t h a s th e s a m e re tu rn a n d risk as
h e r c u rre n t in v e s tm e n t b u t a ls o le a v e s c a sh le ft o v e r to s p e n d ?
CHAPTER TWELVmHEVIEW
6 Increasing income by arbitrage [LO 2 】
Q u a r r io n B o o k s Ltd a n d C o c k a tie l B o o ks Ltd a re id e n tic a l in e v e ry re s p e c t e x c e p t th a t Q u a r r io n h a s n o d e b t
w h ile C o c k a tie l h a s a $ 2 m illio n lo a n a t a n in te re s t ra te o f 8 p e r c e n t. T h e re a r e n o ta x e s . T h e v a lu a tio n o f th e
tw o c o m p a n ie s is as fo llo w s :
Item Q u a r r io n B oo ks C o c k a tie l B o o ks 1
Earnings be fore in te re s t ($) 700000 700000
less In te re s t on lo a n ($) 160000
equals Incom e available to o rd in a ry 700000 540000

shareholders ($)
divided by Cost o f e q u ity (ke) 0.14 0.16
equals M a rk e t value o f e q u ity ($) 5 000000 3375000
plus M a rk e t value o f debt ($) 2000000
equals T otal m a rke t value ($) 5 000000 5 375 000
J a n e o w n s $ 1 0 0 0 0 w o r th o f C o c k a tie l s h a re s. S h o w th e p ro c e s s a n d th e a m o u n t b y w h ic h J a n e c o u ld
in c re a s e h e r in c o m e b y th e use o f a r b itr a g e .
7 Increasing income without increasing risk [LO 2]

The f o llo w in g in fo rm a tio n re la te s to tw o c o m p a n ie s w ith th e s a m e b u sin e ss risk. T h e re a r e n o ta xe s.
Item P a rra m a tta Pet F o o d P e n rith Pet F o o d
Earnings before in te re s t ($) 10000 10000
M a rke t value o f debt ($) 50000 —
kd {%) 4 —
ke (%) 12 10
M a rke t value o f e q u ity ($) 66666 100000
T otal m a rke t value ($) 116666 100000
A c c o r d in g to M o d ig lia n i a n d M ille r , th e to ta l m a rk e t v a lu e o f th e tw o c o m p a n ie s s h o u ld b e th e sa m e ,
irre s p e c tiv e o f th e m e th o d s u se d to fin a n c e th e ir in ve stm e n ts.
S u p p o s e y o u h o ld 1 p e r c e n t o f th e sh a re s in P a rra m a tta Pet F o o d . S h o w th e p ro c e s s a n d th e a m o u n t b y w h ic h

y o u c o u ld in c re a s e y o u r in c o m e w ith o u t in c re a s in g y o u r risk.
8 Effect of company tax [LO 3]

T he f o llo w in g in fo rm a tio n re la te s to C e e l Ltd, a s s u m in g tw o d iffe re n t c a p ita l stru ctu re s. T he v a lu a tio n in th e
ta b le b e lo w a s su m e s th a t th e re is n o c o m p a n y ta x a n d n o p e rs o n a l ta x .
F in a n c e d b y
E q u ity a n d 10%
Item A ll e q u ity lo a n
Earnings be fore in te re s t ($) 600000 600000
less In te re s t o n lo a n ($) — 150000
equals Earnings available to o rd in a ry shareholders ($) 600000 450000
divided by Cost o f e q u ity (ke) 0.15 0.18
equals M a rk e t value o f e q u ity ($) 4000000 2 500000
plus M a rk e t value o f lo a n ($) — 1500000
equals T o ta l m a rke t value o f com pany ($) 4000000 4000000
‘ 391
B usiness finance
T he g o v e rn m e n t th e n in tro d u c e s c o m p a n y ta x a t th e ra te o f 3 0 cen ts in th e d o lla r. A s s u m in g th a t th e re a re still

n o p e rs o n a l ta x e s , c a lc u la te th e to ta l m a rk e t v a lu e o f th e c o m p a n y fo r b o th c a p ita l structures. C o m m e n t o n y o u r
fin d in g s .
9 Information asymmetry and capital structure [LO 7 】

S o p h ie P h a rm a c e u tic a ls Ltd h a s 9 . 6 m illio n o r d in a r y sh a re s o n issue. T he c u rre n t m a rk e t p ric e is $ 1 2 . 5 0 p e r
s h a re . H o w e v e r, th e c o m p a n y m a n a g e r k n o w s th a t th e results o f so m e re c e n t d ru g tests h a v e b e e n re m a r k a b ly
e n c o u r a g in g , so th a t th e 'tr u e 7 v a lu e o f th e sh a re s is $ 1 3 . U n fo rtu n a te ly , b e c a u s e o f c o n fid e n tia l p a te n t
issues, S o p h ie P h a rm a c e u tic a ls c a n n o t y e t a n n o u n c e the se test results. In a d d itio n , S o p h ie P h a rm a c e u tic a ls
ha s a p r o p e r ty in v e s tm e n t o p p o r tu n ity th a t re q u ire s a n o u tla y o f $ 1 5 m illio n a n d h a s a n e t p re s e n t v a lu e o f
$ 2 . 5 m illio n . A t p re s e n t, S o p h ie P h a rm a c e u tic a ls ha s little s p a re c a s h o r m a rk e ta b le assets, so if th is in v e s tm e n t
is to b e m a d e it w ill n e e d to b e fin a n c e d fro m e x te rn a l so u rce s. T he e x is te n c e o f th is o p p o r tu n ity is n o t k n o w n
to o u ts id e rs a n d is n o t re fle c te d in th e c u rre n t s h a re p ric e . S h o u ld S o p h ie P h a rm a c e u tic a ls m a k e th e n e w
in v e s tm e n t? If so , s h o u ld th e in v e s tm e n t b e m a d e b e fo re o r a fte r th e s h a re m a rk e t le a rn s th e tru e v a lu e o f the
c o m p a n y 's e x is tin g assets? S h o u ld th e in v e s tm e n t b e fin a n c e d b y is s u in g n e w sh a re s o r b y is s u in g n e w d e b t?
REFERENCES
Andrade, G. & Kaplan, S., 'How costly is financial (not ------, 'The capital structure puzzle', Journal of Finance, July
economic) distress? Evidence from highly leveraged 1984, pp. 575- 92.
transactions that became distressed', Journal of Finance, ------, 'Financing of corporations', in G. Constantinides,
October 1998, pp. 1443-93. M. Harris & R. Stulz (eds), Handbook of the Economics of
De Angelo, H. & Masulis, R., 'Optimal capital structure Finance, Elsevier North Holland, Amsterdam, 2003.
under corporate and personal taxation', Journal of Financial Myers, S. & Majluf, N w "Corporate financing and investment
Economics, March 1980, pp. 3-29. decisions when firms have information that investors do
Donaldson, G., Corporate Debt Capacity, Graduate School not have7, Journal of Financial Economics, June 1984,
of Business Administration, Harvard University, Boston, pp. 187-221.
1961. Pham, T. & Chow, D., 'Some estimates of direct and indirect
Jensen, M., 'Agency costs of free cash flow, corporate bankruptcy costs in Australia: September 1978-May 1983',
finance and takeovers', American Economic Review, May Australian Journal of Management, June 1987, pp. 75-95.
1986, pp. 323- 9. Scott, J., yA theory of optimal capital structure7, Bell Journal
Kraus, A. & Litzenberger, R., 'A state-preference model of of Economics, Spring 1976, pp. 33-54.
optimal financial leverage', Journal of Finance, September Smith, C. & Warner, J., 'On financial contracting: an analysis
1973, pp. 911-22. of bond covenants', Journal of Financial Economics, June
Miller, M .; 'Debt and taxes', Journal of Finance, May 1977, 1979, pp. 117-61.
pp. 261-75. Titman, S., The effect of capital structure on a firm's
------, 'The Modigliani-Miller propositions after thirty years7, liquidation decision7, Journal of Financial Economics, March
Journal of Economic Perspectives, Fall 1988, pp. 99-120. 1984, pp. 137-51.
Modigliani, F. & Miller, M., 'The cost of capital, corporation Warner, J., 'Bankruptcy costs: some evidence7, Journal of
finance and the theory of investment^ American Economic Finance, May 1977, pp. 337-47.
Review, June 1958, pp. 261-97. Weiss, l., 'Bankruptcy resolution: direct costs and violation of
------, ------ , 'Corporate income taxes and the cost of capital: priority of claims', Journal of Financial Economics, October
a correction,/ American Economic Review, June 1963, 1990, pp. 285-314.
pp. 433-43.
Myers, S., 'Determinants of corporate borrowing', Journal of
Finonciol Economics, November 1977, pp. 147-75.
392
▼
CHAPTER CONTENTS
ICT1 In tr o d u c t io n 394 13.4 F in a n c in g a s a m a r k e tin g p r o b le m 408
13.2 E v id e n c e o n c a p it a l s tru c tu re 395 13.5 D e te r m in in g a f in a n c in g s tr a te g y 409
13.3 A s s e s s in g th e t h e o r ie s o f c a p it a l s tru c tu re 406
LEARNING OBJECTIVES ^ (
1 o u t lin e e m p ir ic a l e v id e n c e f r o m r e c e n t s tu d ie s o f c a p it a l s tru c tu re
2 a s s e s s th e im p lic a t io n s o f th e e v id e n c e f o r th e s ta tic t r a d e - o f f a n d p e c k in g o r d e r th e o r ie s
3 e x p la in h o w f in a n c in g c a n b e v ie w e d a s a m a r k e tin g p r o b le m
4 o u t lin e th e m a in fa c t o r s t h a t f in a n c ia l m a n a g e r s s h o u ld c o n s id e r w h e n d e t e r m in in g a c o m p a n y ’s f in a n c in g
s tra te g y .
B usiness finance
Introduction
In Chapter 12 we outlined theories o f capital structure, beginning w ith the M odigliani and M ille r (MM )
analysis in the absence o f taxes. This analysis implies th a t in a perfect capital market, all capital structure
decisions are u nim portant. W hile th a t conclusion is valid under th e ir assumptions, one positive message
from the M M analysis is th a t i f capital structure is in fact im p orta nt, then the reasons fo r its importance
m ust relate to factors th a t M M excluded by th e ir assumptions. These factors include taxes, the costs of
financial distress, agency costs and differences in the inform a tion available to managers and investors.
These other factors have provided the foundation fo r alternative theories o f capital structure. The
static trade-off theoryy outlined in Section 12.8, proposes that there is an optim al capital structure that
maximises the value o f a company. Companies w ill borrow u n til the advantages o f additional debt are
exactly equal to the disadvantages o f additional debt. The advantages o f additional debt include the tax
savings th a t may be made because interest paid is tax deductible. The disadvantages o f additional debt
include the expected costs o f financial distress th a t w ill arise i f the company is unable to pay the interest
th a t it owes. In Section 12.7.2 we outlined Jensens analysis o f the agency costs o f free cash flows. We noted
th a t profitable companies in mature industries are likely to generate large free cash flows and managers
may invest these cash flows in ways th a t benefit them rather than the shareholders. Jensen pointed
out that debt can provide a solution to this overinvestment problem because it forces managers to pay
out cash. In Section 12.9, we outlined the pecking order theory, which is based on the effects o f financing
decisions under inform a tion asymmetry. I t suggests th a t capital structures are determined largely by
companies* past needs fo r external finance. In contrast to the static trade-off theory, the pecking order
theory is dynamic in th a t it attempts to explain financing decisions over time.
In this chapter we review empirical evidence on capital structure and we develop recommendations
fo r financial managers. The reader who examines the available evidence in search o f support fo r ^he
one correct* theory o f capital structure w ill inevitably be disappointed. There is no universal theory of
capital structure. Rather, each o f the theories highlights different aspects o f the choice between debt
and equity. The static trade-off theory emphasises taxes and financial distress; the pecking order theory
emphasises differences in inform ation. I t is also im p o rta n t to realise that, while capital structure theories
usually focus on the relatively simple generic issue o f debt-versus-equity, in practice, capital structure
decisions may involve many different types o f debt, including long-term debt, short-term debt, fixed-rate
debt, floating-rate debt, bank debt and marketable debt. In addition, financial managers may also need to
consider h ybrid securities such as the various form s o f preference shares.
13.1.1 | Company financing: some initial facts

US evidence provided by W righ t (2004) suggests that, fo r the non-financial corporate sector as a whole,
the ratio o f debt to equity stayed w ith in a narrow range during the tw e ntie th century. W right reports
th a t the ratio o f to ta l liabilities to to ta l m arket value o f assets typically fell w ith in the range 50% ± 10%.
This is a remarkable fin ding given th a t the tw entieth century saw huge changes in the size, structure and
activities o f the corporate sector. Evidence compiled by Frank and Goyal (2008) indicates that, across the
non-financial corporate sector as a whole, capital expenditure is approximately equal to the volume o f
internal funds generated— th a t is, the evidence suggests th a t m ost o f the investm ent by non-financial
companies is generally financed from internal cash flows. However, there is wide variation between
companies. Debt is used more heavily at both ends o f the size spectrum, w ith large listed companies and
private firm s showing a bias towards debt. But fo r small listed companies debt issues are fa irly m in or
and equity is the favoured method. As Frank and Goyal note, it is w o rth remembering th a t much o f the
research published on capital structure is lim ite d to listed companies.
A nother pervasive finding is th a t financial leverage differs across industries. For example, in the US,
industries w ith consistently high leverage include paper, steel and airlines, while those w ith low leverage
include pharmaceuticals and electronics (Harris & Raviv 1991). In fact, some companies effectively have
negative debt-equity ratios because th e ir holdings o f cash and marketable securities are greater than
th e ir debt so they are net lenders. Myers (2001, pp. 82-3) notes th a t large net lenders in the US at that
tim e included the m ajor pharmaceutical companies, Ford M oto r Company and M icrosoft. In Australia,
pharmaceutical and biotechnology company CSL is a net lender: at the end o f the 2012-13 financial year
C hapter thirteen C apital structure decisions
F in a n c e
PURSUING A NO-DEBT POLICY________________________________
in ACTION
S o m e c o m p a n ie s c h o o s e to k e e p d e b t a t e x tr e m e ly lo w le v e ls . O n e r e a s o n t h a t s o m e c o m p a n ie s
c h o o s e th is p o lic y is to s ig n a l to o t h e r p a r t ie s — s u c h a s its s u p p lie r s — t h a t th e c o m p a n y is
f in a n c ia lly s o u n d a n d h e n c e is s a fe to d o b u s in e s s w ith . T h e d e p a r tm e n t s to re H a r r is S c a r fe is a
c a s e in p o in t, a s a s to r y in th e A u s tra l io n F in a n cia l Review explains.
T h e p r iv a t e e q u ity o w n e r s o f b u d g e t d e p a r t m e n t s to r e c h a in H a r r is S c a r f e s a id a d e c is io n to
ru n th e c o m p a n y w it h o u t a n y d e b t h a d b e e n a g o d s e n d a s th e g lo b a l c r e d it c r u n c h s p ilt o v e r
in to w o r s e n in g e c o n o m ic c o n d it io n s . M o m e n t u m P r iv a te E q u ity b o u g h t H a r r is S c a r f e in A p r il
la s t y e a r , w it h d e p a r t m e n t s to r e o p e r a t o r M y e r t a k in g a 2 0 p e r c e n t s ta k e a s p a r t o f th e $ 8 0
m illio n d e a l. L ik e o t h e r r e t a ile r s , H a r r is S c a r f e is n o w f a c in g t o u g h e r c o n d it io n s a s th e b r o a d e r
r e ta il s e c to r s lo w s d o w n u n d e r th e w e ig h t o f r is in g in te r e s t ra te s a n d h ig h p e t r o l p r ic e s . T h e
m a n a g in g d ir e c t o r o f M o m e n t u m ’s c o r p o r a t e d iv is io n , K e v in J a c o b s o n , s a id H a r r is S c a r fe
w a s d e lib e r a t e ly s tru c tu re d to b e u n g e a r e d , w h ic h h a d t u r n e d o u t to b e fo r t u it o u s a s th e w o r ld
b a ttle d th e c r e d it c r u n c h .
M o m e n tu m w a s t a k in g a ' b u i ld a n d h o ld ' s tr a te g y w it h H a r r is S c a r fe , a n d th e d e c is io n to
h a v e th e b u s in e s s u n g e a r e d in it ia l ly h a d b e e n a b ig p lu s in its r e la t io n s h ip s w it h s u p p lie r s
to th e r e ta ile r . T h e r e t a ile r h a s n o w b e e n t r a d in g s u c c e s s fu lly f o r a lm o s t s e v e n y e a r s a f t e r a
f in a n c ia l c o lla p s e in e a r ly 2 0 0 1 .
Source: 'Harris Scarfe counts blessings of no-debt policy', Simon Evans, Australian Financial Review, 1 1 March 2008.
it held US$762 m illio n in cash and cash equivalents and had only US$6 m illio n in interest-bearing debt.
A t the same date, the online travel service company W otif.com Holdings held A$132 m illio n in cash and
cash equivalents and had only A$112 000 in interest-bearing debt. Similarly, the budget departm ent store
Harris Scarfe pursues a no-debt policy (see Finance in Action).
Leverage is generally low fo r grow th1companies and fo r companies w ith significant intangible assets.
In addition, high business risk tends to be associated w ith low financial leverage. International studies
by Rajan and Zingales (1995) and Wald (1999) find th a t differences in leverage between m ajor industrial
countries are moderate. They also fin d th a t the correlations between debt-asset ratios and factors such as
the ta ng ibility o f assets and p ro fita b ility are sim ilar across countries. Financial leverage is also associated
w ith the inten sity o f com petition in an industry. In a study o f US m anufacturing companies, MacKay
and Phillips (2005) report th a t financial leverage is higher in industries where a few large companies
dominate than in more com petitive industries.
If, as M M s Proposition 1 suggests, capital structure is irrelevant, we would not expect to see any
empirical patterns in capital structure. Hence, these empirical observations suggest th a t capital structure
decisions are regarded as im p o rta n t. The next section outlines the results o f empirical research on factors
that may influence capital structure decisions.
13.2 Evidence on capital structure

m
As noted earlier, the m ain theories o f capital structure attem pt to explain different aspects o f the choice
LEARNING
between debt and equity, and each theory emphasises different factors. Accordingly, our discussion of OBJECTIVE 1
the evidence is divided in to subsections th a t outline evidence on taxes, costs o f financial distress, agency Outline empirical
costs and inform ation costs. evidence from recent
studies of capital
structure
13.2.1 | Evidence on taxes
As discussed in Chapter 12, the effects o f taxes on capital structure decisions involve personal tax as
well as company tax, and the effects o f these tend to be offsetting— th a t is, while the tax deductibility
o f interest on debt reduces company tax, interest income is taxed more heavily than dividends and
B usiness finance
capital gains. As discussed in Section 12.4.3, lenders w ill effectively require companies th a t borrow to
pay the extra tax fo r them by paying a higher interest rate on debt relative to the returns to shareholders.
In other words, the argum ent is th a t companies w ill bear the fu ll effects o f the taxes generated by their
operations, regardless o f whether the tax is paid directly by the company or indirectly through higher
interest rates required by lenders.
W hile the effects o f company tax and personal tax tend to be offsetting, a company s tax position can
s till have im p o rta n t effects. For example, suppose th a t a company is profitable b ut its taxable income
is negative, either because it has large tax deductions fo r depreciation on assets th a t were purchased
recently o r because it has tax losses carried forw ard from previous years. For this company, borrow ing is
likely to have a tax disadvantage because lenders w ill have to pay personal tax on the interest, b ut there
w ill be no immediate reduction in company tax— the interest deductions w ill add to the tax losses being
NON-DEBT TAX carried forward. Therefore, in m aking financing decisions, managers can be expected to view non-debt
SHIELDS (N D TSs) ta x sh ields (NDTSs), such as depreciation deductions or tax losses carried forward, as substitutes for
ta x d e d u c tio n s
interest deductions. To reflect tax effects, many studies o f capital structure include measures o f NDTSs as
fo r item s such a s
d e p r e c ia tio n o n assets
an explanatory variable w ith the expectation th a t NDTSs w ill be negatively related to leverage.
a n d ta x losses c a rrie d The evidence on this issue is mixed. Studies th a t test fo r a relationship between leverage and NDTSs
fo r w a r d typically fin d that the effect is insignificant or th a t the NDTS variable has a positive coefficient一 the
opposite o f the theoretical prediction. The findings o f these studies are d iffic u lt to in te rp re t because a
company w ith large depreciation deductions is likely to have m ainly tangible assets. Companies w ith
m ainly tangible assets w ill fin d it less costly to borrow because tangible assets can be pledged as security
fo r debt. Similarly, a company th a t has tax losses being carried forw ard may be in financial distress. For a
company in distress, the m arket value o f equity w ill usually fall, causing leverage to increase. In summary,
NDTS may n ot be an adequate proxy fo r a company s tax position. Rather than indicating th a t the tax
benefits o f debt are low, high NDTSs may indicate high tangible assets or financial distress.
In the pre-1990 literature, evidence o f any significant relationship between leverage and taxes is
sparse. As MacKie-Mason (1990) notes, this is somewhat surprising because ‘nearly everyone believes’
th a t taxes m ust be im p o rta n t in financing decisions. He suggests th a t taxes are im p orta nt, b u t had failed
to show up in most previous studies because they were designed to test fo r average rather than marginal
effects. To see this point, consider the argument th a t the incentive to save tax by borrow ing is less when
a company has non-debt tax shields. The underlying logic is th a t higher non-debt tax shields w ill lower a
company s expected m arginal tax rate, thus reducing the expected tax savings on additional debt. While
this logic is sound, non-debt tax shields w ill lower a company s actual m arginal tax rate only i f they are
large enough to reduce its taxable income to zero— a condition know n as ‘tax exhaustion’.
MacKie-Mason argues th a t in m ost cases, non-debt tax shields w ill cause only a small change in the
probability o f tax exhaustion and a sim ilarly small change in a company s expected m arginal tax rate.
Therefore, differences in expected m arginal tax rates among companies w ill be small and d iffic u lt to
measure. A nother problem is th a t previous studies have typically measured the leverage o f companies
using accounting ratios, which reflect the cumulative results o f many separate financing decisions made
over several years. To overcome these problems i t is necessary to examine individual financing decisions
on a m arginal basis fo r companies th a t are at, or near, the p o in t o f tax exhaustion. Using this approach,
MacKie-Mason finds strong evidence th a t taxes do influence financing decisions.
The results o f MacKie-Mason are supported by those o f Graham (1996), who examined the incremental
use o f debt by more than 10 000 US companies fo r the years 1980 to 1992. When allowance is made
fo r the effects o f operating losses and investm ent tax credits, he finds th a t the m arginal tax rate varies
considerably across companies and th a t high tax-rate companies borrow more heavily than those w ith
low tax rates.
In a later study, Graham (2000) makes a detailed estimate o f the effects o f taxes on company value.
By examining the interest rate spread between taxable corporate bonds and tax-free m unicipal bonds he
estimates the personal tax rate o f m arginal investors in corporate debt. The estimated rate varies w ith
changes in statutory tax rates and is approximately 30 per cent from 1993 to 1994, the last year covered
by the study. Graham also estimates th a t the average tax rate on equity income is about 12 per cent. This
effective rate is much lower than the m arginal income tax rate o f 30 per cent because o f the benefits
associated w ith deferring the realisation o f capital gains. W hat do these tax rates im ply in terms o f the
net tax effects o f borrow ing under the US classical tax system w ith a company tax rate o f 35 per cent?
Assume th a t Company X borrows $1 m illio n at an interest rate o f 10 per cent and uses the funds
to repurchase shares w o rth $1 m illion . Company X w ill pay an extra $100000 in interest each year and
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reduce its company tax b ill by $35 000 per year. The m arginal lender w ill pay an extra $30000 per year
income tax. Equity income w ill fall by $65 000 per year— equal to the extra interest o f $100000 less the
company tax saving o f $35 000. Therefore, taxes paid by investors on equity income w ill fa ll by $65 000 x
0.12 = $7800 per year. The net tax saving is $35 000 - ($30 000 - $7800) = $12 800 per year. In this case
the extra tax paid by investors reduces the net tax saving to less than 40 per cent o f the company interest
tax saving. Despite this large reduction, the net tax saving is s till significant and should be very valuable.
Graham estimated th a t in 1994, the net tax benefits o f debt added 3.5 per cent to the value o f a typical
US company. Over the whole o f the 1980 to 1994 period covered by his study, Graham estimated that
on average the tax benefit o f debt added 9.7 per cent to company value (or 4.3 per cent, net o f personal
taxes).
The studies referred to above were all based on companies subject to the classical tax system. Many
countries, including Australia, Canada and New Zealand, have switched to the im p utatio n tax system.
As discussed in Section 12.5.2, the im putation tax system is designed to remove any tax-related bias
towards the use o f debt finance by companies. A t least three studies provide evidence th a t supports this
expectation. Schulman et al. (1996) examine the effects o f im p utatio n on corporate leverage in New
Zealand and Canada. New Zealand introduced a fu ll im putation tax system in 1988. Canada introduced
partial im putation in 1972 and simultaneously introduced a capital gains tax on the sale o f shares.
These two changes have opposing effects: the intro du ction o f im putation should reduce leverage while a
capital gains tax increases taxes on equity and favours the use o f debt finance. Accordingly, the sample o f
Canadian companies was divided in to four portfolios:
a companies th a t experienced a net operating loss during the study period (NOL sample)
b a high-dividend low -grow th sample
c a low-dividend high-grow th sample
d a fo u rth p o rtfo lio th a t contained all other companies.
The authors expected that the intro du ction o f im putation would have little effect on the leverage o f
companies in the NOL sample because those companies have a low m arginal tax rate. Similarly, the tax
changes should provide little benefit fo r low-dividend companies th a t deliver returns to investors m ainly
as capital gains. Conversely, companies in the <high-dividend, sample should experience a significant
reduction in leverage. The results fo r Canadian companies were consistent w ith these expectations. A fte r
the tax changes, the average deb t-e q uity ratio fell significantly fo r companies in the <high-dividend, and
all others* portfolios but did n o t change significantly fo r the NOL and <high-grow th, portfolios. In the
case o f New Zealand, there was a h ighly significant reduction in the average deb t-e q uity ratio o f sample
companies.
Richardson and Lanis (2001) examined the influence o f income taxes on the use o f debt by Australian
companies under the im p utatio n system. They used data fo r 1997 to study a sample o f 269 large, listed,
non-financial companies. Their m ain finding was that, under im putation, the tax advantage o f debt is
neutralised. In addition, they found th a t companies th a t do n ot pay dividends prefer internal equity to
debt. Richardson and Lanis also found a significant tax substitution effect— other things being equal,
companies th a t have high non-debt tax shields use less debt.
Pattenden (2006) studied 67 Australian companies th a t were listed on the Australian Securities
Exchange continuously from 1982 to 1993. Thus, every company existed both before and after the
introduction o f the im putation system in 1987. Pattenden tested the apparent effect o f the m arginal
tax rate on capital structure under the classical system (1982 to 1986) and under the im p utatio n system
(1989 to 1993). The result was very clear: taxes were very im p o rta n t under the classical system b ut were
o f considerably less importance under the im putation system. An extension o f the post-im putation tim e
period to 1998 saw the importance o f the tax rate decline even further.
In summary, the evidence from these studies supports theoretical arguments th a t the im p utatio n
system removes the tax advantage o f debt and results in lower corporate financial leverage than is typical
under the classical system.
1 3 .2 .2 1 Evidence on the costs of financial distress

The trade-off theory proposes th a t each company has an optim al capital structure based on a trade
o ff between the benefits o f debt on the one hand and the adverse effects o f financial distress costs on
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B usiness finance
the other. Costs o f financial distress refer to the costs o f liquidating or restructuring a company that has
failed, and also to the agency costs th a t can arise when there is doubt about a company s a b ility to meet its
obligations to lenders. The discussion in this section is confined to evidence on costs directly associated
w ith financial distress. The agency costs associated w ith high levels o f debt together w ith other agency
costs o f debt are discussed in the next section.
W hile few would dispute the argument th a t the costs associated w ith financial distress can reduce
company value, there is some dispute about whether these costs are large enough to have an economically
significant effect. First, there is evidence that suggests th a t the direct costs are too small to have a significant
effect on company value. For example, W arner (1977) estimated th a t the direct (out-of-pocket*) expenses
incurred in the adm inistration o f the bankruptcy process fo r ‘failed’ US railroad companies averaged only
5.3 per cent o f the m arket value o f th e ir assets at the date o f bankruptcy. This figure falls to 1 per cent i f
company value is measured 7 years before bankruptcy. Weiss (1990) investigated a sample o f bankrupt
listed US companies and found th a t the direct costs o f bankruptcy averaged 3.1 per cent o f the sum o f
the book value o f debt and the m arket value o f equity measured at the end o f the fiscal year p rio r to filing
fo r bankruptcy. This percentage falls to 2.8 per cent i f direct costs are measured as a p roportion o f the
book value o f to ta l assets. Similarly, Pham and Chow (1987) reported direct costs averaging 3.6 per cent
o f company value at the date o f failure fo r a sample o f Australian companies. The figures quoted in this
paragraph refer to the actual costs incurred by failed companies. For a company th a t is n o t in financial
distress, the expected costs would be far smaller because the actual costs have to be m u ltip lie d by the
probability o f failure. For m ost companies, it seems th a t expected direct costs o f financial distress would
be minuscule.
W hile expected direct costs o f financial distress appear to be very small, companies considered likely
to fa il may incur significant indirect costs. For example, Titm an and Wessels (1988) argue th a t these
indirect costs may be high fo r companies whose suppliers and customers may be harmed by th e ir financial
distress. Suppliers m ig ht refuse to supply products to companies th a t may default. Similarly, financial
distress may cause sales to be lost because customers change to more reliable suppliers who are less likely
to default and are more likely to be able to continue to service the product. Banerjee, Dasgupta and Kim
(2008) fin d support fo r this argument by showing th a t companies use less debt when they have a dedicated
supplier— th a t is, a supplier th a t provides much o f its purchases. Similarly, suppliers use less debt when
they have a dedicated customer— th a t is, a customer who purchases much o f th e ir product. They find that
these relationships are strongest in markets fo r durable goods where on-going relationships between
suppliers and customers are im p o rta n t (see earlier Finance in Action on ‘Pursuing a no-debt policy’).
F urther support fo r the significance o f the indirect costs o f financial distress is provided by Opler and
Titm an (1994), who examine the performance o f companies during in d u stry dow nturns. They found that
highly levered companies lost substantial m arket share to th e ir more conservatively financed competitors
during these periods o f economic distress. Opler and Titm an also found th a t the companies that suffered
the m ost were highly levered companies th a t engaged in research and development. This finding suggests
th a t companies w ith specialised or unique products are particularly vulnerable to financial distress.
A nother example o f an indirect cost is the risk o f employees becoming unemployed in the event o f
a company defaulting. Berk, Stanton and Zechner (2010) argue th a t this cost is u ltim ately borne by
companies in the form o f higher wages. Agrawal and Matsa (2013) found support fo r this argument in
th a t when states in the US increased benefits to the unemployed, which has the effect o f reducing the
expected costs o f being unemployed, companies increased th e ir use o f debt.
There is empirical evidence indicating th a t in aggregate these indirect costs can be a significant
pro po rtio n o f a company s value. A ltm an (1984) estimated both direct and indirect costs o f financial
distress fo r a sample o f 26 bankrupt US companies. He found th a t in many cases the aggregate costs
exceeded 20 per cent o f the value o f the company just before bankruptcy. Using a revised version o f
A ltm ans methodology, Pham and Chow (1987) found that, fo r a sample o f 14 failed Australian companies,
aggregate costs o f financial distress averaged 22.4 per cent o f company value just before failure. These
estimates are much greater than the reported levels o f direct costs.
Further evidence on the costs o f financial distress is provided by Andrade and Kaplan (1998), who
studied highly levered companies th a t encountered financial distress. They p o in t out th a t i t is d ifficu lt
to measure the costs o f financial distress. The source o f this d iffic u lty is *an in a b ility to distinguish
whether poor performance by a company in financial distress is caused by the financial distress its e lf or
is caused by the same factors th a t pushed the company in to financial distress in the firs t place* (Andrade
& Kaplan 1998, p. 1444). Suppose th a t a particular ind ustry suffers a significant unexpected fall in
sales. A ll companies in the ind ustry w ill experience lower profits (economic distress), b u t those th a t are
highly levered w ill be most likely to also experience d ifficu lty in meeting repayments to lenders (financial
distress). Therefore, the large indirect costs o f financial distress found by authors such as Altm an are
likely to reflect the effects o f economic distress as well as those o f financial distress.
A ll the companies studied by Andrade and Kaplan have operating margins th a t are positive, and
typically exceed the ind ustry median, in the years they are distressed. Therefore, the sample companies
appear to be largely financially distressed, n ot economically distressed. For the whole sample they
estimate that the net costs o f financial distress are between 10 and 20 per cent o f company value. As
they are unable to completely elim inate economic distress or the effects o f economic shocks, Andrade
and Kaplan regard th eir estimates as upper bounds on the costs o f financial distress fo r the sample
companies. They also divide th e ir sample in to two subsamples based on whether companies suffered an
adverse economic shock, such as a severe dow nturn in in d u stry sales. The costs o f financial distress are
found to be negligible fo r the subsample th a t did n o t experience an economic shock. I t is possible that
the results obtained by Andrade and Kaplan are influenced by a selection bias— i t may be th a t companies
w ith low costs o f financial distress are more likely to become highly leveraged. I f th a t is the case, th eir
estimates may understate the costs o f financial distress fo r a typical company. On the other hand, the
probability o f financial distress is very small fo r m ost public companies. Therefore, even i f the actual costs
o f financial distress are as high as 20 per cent o f company value, the expected costs o f financial distress
should be modest fo r m ost public companies.
In summary, the direct costs o f financial distress are small relative to company value. The indirect
costs appear to be considerably larger than the direct costs b u t are very d ifficu lt to distinguish from
the costs o f economic distress. Unless the probability o f financial distress is high, the expected costs of
financial distress appear to be modest.
As we explained in Section 12.7.1, there may be conflicts o f interest between shareholders and lenders,
which can lead to several problems, including the problem th a t the company may underinvest. I f a
company s value consists largely o f investm ent opportunities and the company is highly levered (and
hence at greater risk o f experiencing financial distress), the underinvestm ent problem is likely to be severe.
We also explained in Section 12.7.2 th a t because managers’ interests may diverge from shareholders’
interests, managers may overinvest on the company s behalf; the p rim ary m otive fo r m aking such
investments is to benefit the managers rather than the shareholders. In this section we consider empirical
evidence relevant to underinvestm ent and overinvestment. We also consider empirical evidence relating
to conflicts o f interest between companies and th e ir employees.
Debt and underinvestment

To illustrate the underinvestm ent problem, suppose th a t Zenacom Pty Ltd, a high-grow th technology
company w ith a new product ready to manufacture, persuades its bank to finance the necessary plant
and equipment w ith a high percentage o f debt.1 Also suppose th a t sales o f the product grow more slowly
than anticipated and management now faces a choice between tw o unattractive alternatives. I f i t is to
keep up the loan repayments i t w ill have to cut the research and development (R&D) budget, b u t its R&D
activities are expected to generate much o f the company s growth. I f it m aintains the R&D budget, there
is a high probability o f defaulting on the bank loan.
W hat Zenacom really needs in this case is an injection o f new equity. However, attracting new
shareholders is likely to be difficult. Because o f Zenacoms financial situation, much o f the value created
(or preserved) by injecting additional equity w ill serve largely to support the lenders position. To induce
new shareholders to invest, e ither the bank w ill have to w rite down its loan substantially— which it would
be reluctant to do— or the new equity w ill come at a very high price, in the form o f excessive d ilu tio n
o f ownership. Management w ill probably decide th a t the best alternative is to cut the R&D budget— in
which case its financing decision has caused Zenacom to pass up valuable investm ent opportunities.
As the Zenacom example illustrates, a company whose value consists m ostly o f intangible investm ent
opportunities is likely to find th a t debt is very costly fo r two reasons. First, the lack o f tangible assets to
1 For a more detailed discussion of this example and topic, see Barclay, Smith and Watts (1995, pp. 8-9).
B usiness finance
serve as security w ill mean th a t debt is both expensive and d iffic u lt to obtain. Second, i f such a company
does borrow, there are likely to be fu rth e r costs in the form o f investments forgone i f it gets into financial
difficulty. The clear im plication is th a t growth* companies should restrict th e ir financial leverage.
W hile the underinvestm ent problem can be severe fo r grow th companies, i t should n o t be significant
fo r mature companies w ith few profitable investm ent opportunities. The value o f such companies comes
m ostly from assets in place th a t can be used as security fo r debt. In summary, mature companies w ith
a high p ro po rtio n o f assets in place are expected to have higher leverage than growth companies. This
difference should be reflected in a negative relationship between leverage and investm ent opportunities.
Debt and overinvestment

In some cases, the use of high leverage can add value because o f the beneficial effects o f debt in controlling
the inclina tion o f managers to overinvest. Suppose th a t M am m oth Ltd generates large, stable cash flows
from its operations in a mature in d u stry where there are few profitable new investments. Nevertheless, its
managers may continue to invest in the same industry, m aking expensive attem pts to gain m arket share,
or they may attem pt to achieve grow th by acquiring companies in other industries. These diversifying
acquisitions are likely to destroy value fo r M am m oths shareholders, who can diversify th e ir own
portfolios by purchasing the shares o f companies in other industries w ith o u t paying any prem ium for
control. As noted earlier, Jensens (1986) free cash flow theory is applicable to companies like M am m oth
and i t suggests th a t fo r such companies a high p roportion o f debt may be beneficial. Increasing leverage
is an effective way o f forcing managers to pay out cash because o f the contractual obligations to make
payments to lenders.
In summary, debt finance can be beneficial fo r mature companies w ith few investm ent opportunities
by curbing managers* inclina tion to overinvest. The necessity o f servicing debt should mean that
managers w ill be more critical in evaluating capital expenditure proposals. The role o f debt in reducing
overinvestment is an additional factor th a t suggests th a t leverage w ill be negatively related to the extent
o f a company’s investm ent opportunities.
In empirical studies the extent o f a company s investm ent opportunities is typically measured
using the ratio o f the m arket value o f assets to the book value o f assets, which is usually referred to as
the m arket-to-book ratio. By definition, a growth* company is expected to have extensive investment
o pportunities in the future. The value o f these opportunities should be reflected in its share price, but
n ot in its statement o f financial position (or ‘balance sheet’). Assets appearing on a balance sheet are
assets in place*, n ot dreams o f the future. Therefore, the larger are a company s investm ent opportunities
relative to its assets in place, the higher its m arket-to-book ratio is expected to be. In contrast, mature
companies w ith few investm ent opportunities and a relatively high value o f assets in place are predicted
to have low m arket-to-book ratios.
Barclay, Sm ith and Watts (BSW) (1995, pp. 4-19) assessed the importance o f investm ent opportunities
when they studied a sample o f more than 6700 US industrial companies over the period 1963 to 1993.
Leverage was calculated as the ratio o f the book value o f debt to the m arket value o f the company (debt
plus equity). The authors expected leverage to be determined largely by the extent o f a company s
investm ent opportunities, which was measured using the ratio o f m arket value to book value. The results
provided strong support fo r the importance o f investm ent opportunities as a determ inant o f leverage.
As expected, companies w ith high m arket-to-book ratios had significantly lower leverage than those w ith
low m arket-to-book ratios. The relationship between leverage and the m arket-to-book ratio was highly
significant in a statistical sense and was also ‘economically’ significant. Economic significance refers to
the size o f the change in leverage ratio associated w ith changes in m arket-to-book ratios. BSW found that
m oving from the b ottom te nth percentile o f corporate m arket-to-book ratios to the n in e tie th percentile
corresponded to a fa ll in the predicted leverage ratio o f 14.3 percentage points— a large fraction o f the
average ratio o f 25 per cent.
BSW interpreted th e ir results as showing th a t the extent o f a company s investm ent opportunities
appears to be the m ost im p o rta n t systematic determ inant o f its leverage ratio. Their explanation fo r
this finding is th a t fo r companies whose value consists largely o f intangible investm ent opportunities,
the underinvestm ent problem associated w ith a high pro po rtio n o f debt finance makes high leverage
p ote ntia lly very costly. On the other hand, fo r mature companies w ith lim ite d investm ent opportunities,
high leverage has benefits in controlling the problem associated w ith free cash flow. As discussed above,
free cash flow tempts managers to overinvest in mature businesses or make diversifying acquisitions that
may n ot be in the interests o f shareholders.
BSW acknowledged th a t th e ir results are also consistent w ith an explanation th a t includes taxes.
Low-growth companies, w ith low costs o f financial distress and p otentially large benefits from using
debt because o f its role in controlling overinvestment, are also likely to have greater use fo r interest-tax
deductions than high-grow th companies. However, the results o f th e ir tests do n o t support the argument
that taxes have an im p o rta n t effect on corporate leverage decisions. Consequently, BSWs preferred
explanation fo r th e ir results does n ot include the effect o f taxes.
BSW also pointed out th a t th eir m ain findings are fundam entally inconsistent w ith the predictions
made by the pecking order theory. It would Suggest th a t companies w ith few investm ent opportunities
and substantial free cash flow w ill have low debt ratios— and th a t those high-grow th firm s w ith lower
operating cash flows w ill have high debt ratio s\ BSW (1995, p. 12) predicted, and found, results th a t are
the exact opposite o f those suggested by the pecking order theory. On the other hand, there is evidence
from other studies th a t provides support fo r the pecking order theory. In particular, one finding to
emerge clearly from all relevant studies is th a t leverage is negatively related to pro fitab ility. As noted
earlier, this finding is the opposite o f the static trade-off theory s prediction, and instead supports the
pecking order theory— th a t is, companies w ith high p ro fita b ility may use less debt than other companies,
simply because they have less need to raise funds externally and because debt is firs t on the pecking order
o f external fund sources.
Evidence o f a relationship between leverage and investm ent opportunities has been found in several
countries. Rajan and Zingales (1995) used 1987 to 1991 data to examine the capital structures o f
public companies in seven countries: the US, Japan, Germany, France, Italy, the UK and Canada. For
each country, they found th a t leverage was positively related to the ta n g ib ility o f assets (measured by the
ratio o f fixed assets to to ta l assets) and negatively related to the m arket-to-book ratio.
As we discussed in Section 12.7.2, Jensen (1986) pointed out th a t a high level o f debt forces companies
to pay interest, and hence prevents managers from wasting free cash flow on poor investments or
organisational inefficiencies. The most prom inent example o f this role o f debt can be found in leveraged
buyouts. Indeed, as we discuss in Chapter 19, th e ir p rim ary role is to provide a solution to the free cash
flow problem. W hile the role o f debt in restricting the use o f free cash flow may be very im p o rta n t fo r
large cash cow* companies, i t is probably o f lim ite d relevance in most other circumstances. I t appears
that listed companies do n o t generally overinvest because announcements o f capital investments are
associated w ith small b ut significant share price increases. Further, i f increased leverage generally adds
value by disciplining managers, then debt issues should be associated w ith share price increases. However,
there is no evidence o f such price increases, even fo r issues o f high-risk debt, where the pressure on
managers to pay out cash is high (Shyam-Sunder 1991).
Conflicts of interest between companies and their employees

While the studies discussed in Section 13.2.2 suggest th a t high debt levels may increase wage costs,
Brander and Lewis (1986) argue th a t management may use high debt levels as a negotiating device to
lower wage costs. They argue th a t high debt levels may be used to encourage employees to take a pay cut to
help avoid financial distress fo r the company. Consistent w ith this argument, Hennessy and Livdan (2009)
argue that there is a trade-off between the bargaining benefits o f debt and the debt-related disincentives
discussed in Section 13.2.2. They argue th a t companies whose employees have greater bargaining power
(such as through a highly unionised workforce) w ill have high debt levels, while those whose employees
are key in m aintaining relationships w ith suppliers and customers w ill have low debt levels. Matsa (2010)
provides support fo r the argument relating to the unionisation o f the workforce, fin ding th a t a 10 per
cent increase in the level o f unionisation is associated w ith a 1 per cent increase in debt levels.
1 3 .2 .4 1 Evidence on information costs and the pecking

order theory
The pecking order theory outlined in Section 12.9 is based on in fo rm a tio n asymmetry, w hich occurs
when managers know more than outside investors about the value o f th e ir company. When there
B usiness finance
are such in fo rm a tio n differences— which in practice is often the case— the company may incur large
‘in fo rm a tio n costs’ i f it issues (that is, sells) new shares to outside investors. Potential buyers o f
new shares w ill be aware th a t they are at an in fo rm a tio n disadvantage compared w ith the company s
managers. They are therefore like ly to take the sensible precaution o f assuming th a t the managers m ust
have some in fo rm a tio n th a t leads them to believe th a t the shares are overvalued: w hy else would they
be w illin g to sell new shares to outsiders? Therefore, potential investors w ill demand a price discount
on the shares they are offered. O f course, the managers are also aware th a t this w ill occur— even if
in fact they d on^ believe th a t the shares are overvalued. Therefore, managers w ill generally sell new
shares to outside investors only as a last resort. Myers (1984) suggests that, in tu itive ly, issuing risky
debt w ould rank between using in te rn a lly generated funds and issuing new shares. This conclusion is
the cornerstone o f the pecking order theory: managers* firs t choice is to use interna l funds, followed by
borrow ing and lastly by issuing new shares. The pecking order th eo ry is consistent w ith the observation
th a t in te rn a lly generated cash is the largest single source o f finance fo r companies and debt is the larger
o f the external sources. O f course, the fact th a t these observations are consistent w ith the pecking
order th eo ry does n o t prove th a t the theory is correct— there may be other explanations fo r the data.
The evidence we discuss concerns share price responses to announcements o f security issues and the
relationship between p ro fita b ility and leverage.
Share price response to new financing

An im p o rta n t prediction o f the pecking order theory is th a t the announcement o f a new share issue
w ill cause the company s share price to fall. W hen debt or hybrid security issues are announced, the
fall in share price should be smaller. The em pirical studies reviewed by Sm ith (1986) report findings
th a t are consistent w ith these predictions. Various proposed explanations were investigated, b ut the
only consistent result was th a t the price response was related to the type o f security issued. However,
it seems likely th a t the m arket response should also depend on the company s grow th prospects. For
example, Jensen (1986) argued th a t free cash flow is likely to be invested unprofitably, or wasted by
allowing inefficiencies to develop. W hen a company announces th a t it intends to raise new funds, the
m arket w ill assess the company s a b ility to invest the funds profitably. I f the company is mature, w ith
few investm ent opportunities, the m arket is likely to perceive th a t the new funds w ill create excess cash,
so the company s share price w ill fall. On the other hand, i f the company is growing rapidly, it is more
likely th a t the new funds w ill be invested in positive net present value (NPV) projects, so its share price
is likely to rise.
The effect o f investm ent o pportunities on the share price response to new security issues was studied
by Pilotte (1992). He found th a t fo r share issues, the average share price response was negative, b ut
the average price fa ll was much larger fo r mature companies than fo r grow th companies. For issues o f
debt, the share prices o f mature companies fell significantly, b u t fo r grow th companies, there was no
significant price change. Therefore, P ilottes results show th a t the share price response to new financing
depends on the company s investm ent o pportunities and is n o t related only to the type o f security being
issued.
Leverage and the pecking order theory

The pecking order theory does n o t have any role fo r an optim al capital structure or a target debt-equity
ratio. According to the theory there are tw o form s o f equity— interna l equity and external equity— and
they are at opposite ends o f the pecking order. The theory implies th a t a company s leverage w ill depend on
the difference between its operating cash flow and its investm ent needs over tim e. Therefore, the pecking
order theory predicts that, other things being equal, a company s leverage w ill be negatively related to its
pro fitab ility. Consider two companies th a t operate in the same ind ustry and are sim ilar except fo r th e ir
efficiency and, hence, th e ir profitability. Suppose th a t the two companies invest at sim ilar rates to keep
up w ith the average growth o f the industry. The less profitable company w ill have larger needs fo r external
finance and w ill end up w ith higher leverage because debt is firs t on the pecking order o f external sources
o f finance.
Consistent w ith the pecking order theory, several studies o f capital structure fin d th a t leverage is
negatively related to profitability. For example, studies by Bradley, Jarrell and Kim (1984), Titm an and
Wessels (1988), Rajan and Zingales (1995), Wald (1999), Graham (2000) and Graham and Harvey (2001)
all report this finding, which holds over different tim e periods and in different countries.
Testing the pecking order and the static trade-off theories

Suppose that each company has a target debt ratio as proposed by the static trade-off theory. In practice,
of course, a company s actual debt ratio w ill vary over tim e due to factors such as unexpected changes
in operating cash flows and changes in the m arket value o f its shares. To test the static trade-off theory
empirically, it is often assumed th a t actual debt ratios w ill be described by a *target-adjustment, model
where companies have a leverage target and make gradual adjustments towards it. In contrast, the pecking
order theory assumes th a t there is no target debt ratio and states th a t a company s debt ratio w ill vary
over tim e depending on the company’s cumulative needs fo r external finance.
Shyam-Sunder and Myers (1999) examined a panel o f 157 companies from 1971 to 1989 and tested
the time-series predictions o f both models. They found th a t i t is d iffic u lt to distinguish between the
models. For example, in one test they assumed th a t each company followed the pecking order exactly. The
researchers then calculated the corresponding annual debt ratios. They found th a t a target-adjustm ent
model fitte d this simulated data just as well as it fitte d the actual data. In other words, the statistical tests
indicated th a t the static trade-off theory was consistent w ith debt ratios generated by the pecking order
theory. This finding suggests th a t tests o f the static trade-off theory have low statistical power. Shyam-
Sunder and Myers concluded th a t the pecking order theory provided the best explanation o f the financing
behaviour o f the companies in th e ir sample.
Fama and French (2002) examined b oth the pecking order and the static trade-off theories by testing
whether the predictions o f these tw o models were consistent w ith the dividend and financing behaviour
o f a large sample o f US companies from 1965 to 1999. In th e ir tests, both models had considerable
success b ut also recorded some notable failures. Specifically, as in previous studies, the static trade-off
theory is unable to explain the strong negative relationship between p ro fita b ility and leverage. On the
other hand, in the case o f small grow th companies, those w ith the lowest leverage rely m ost heavily on
equity issues. Since these low-leverage companies appear to have the capacity to issue lo w -risk debt, this
finding is n ot consistent w ith the pecking order theory. Frank and Goyal (2003) also found weaknesses
in the pecking order theory when they tested i t on a large sample o f publicly traded US companies from
1971 to 1998. Small companies do n o t fo llo w the pecking order, which works best fo r large companies
in the earlier years. However, even fo r larger companies, support fo r the pecking order theory declines
over time.
In summary, support fo r the pecking order theory is mixed and the strongest evidence in its favour
is probably the negative relationship between leverage and p ro fita b ility th a t consistently emerges from
studies on broad samples o f companies. However, several authors have noted th a t this relationship could
also arise in other ways. Suppose th a t companies have target leverage ratios. When a company earns
profits, debt is often repaid so leverage can fa ll automatically. There maybe an incentive to borrow more in
order to capture the tax benefits o f leverage. However, i f companies face fixed costs in raising debt finance
and buying back shares, adjustments towards the leverage target may take place only periodically rather
than frequently. More generally, suppose th a t every company has a target debt-equity ratio. Between
^refinancing points*, such as when new securities are issued, many companies w ill n o t have achieved th eir
target. How can a researcher decide when a company is off-target because i t has no target and when a
company has a target but has n o t been able to achieve it?2
To overcome this problem some recent studies have used narrow samples o f companies selected so
that tim e series effects such as the <autom atic, repayment o f debt do n ot d is to rt the observed leverage.
These studies are discussed in the next section.
Hovakimian, Hovakimian and Tehranian (HHT) (2004) studied ‘dual issues’一 th a t is, cases where
companies raise both debt and equity in the same financial year. They reported th a t dual issues are typically
large and therefore have the potential to make substantial changes in a company s capital structure. In
the case o f dual issues, the post-issue structure should reflect each company s leverage target w ith o u t
2 A simulation study has suggested that in these circumstances cross-sectional statistical tests can be very misleading. If
companies in fact trade off the costs and benefits of leverage but change their debt-equity ratio only infrequently, then
a cross-section test could show a negative relation between expected profitability and leverage even though the ‘true’
relationship is known to be positive at refinancing points. See Strebulaev (2007).
B usiness finance
any distortions induced by accumulated profits or losses. Hence, dual issues provide a setting that should
make it easier to determine whether corporate financing behaviour is better explained by the static trade
o ff or pecking order theories.
The static trade-off theory predicts th a t high-grow th companies w ill have low leverage targets while
low -grow th companies w ill have high leverage targets. H H T found results consistent w ith this prediction:
companies w ith a high m arket-to-book ratio (indicating high grow th prospects) have a low target debt
ratio. However, there is an alternative explanation fo r this finding: perhaps companies tend to make
equity issues when th e ir m arket-to-book ratio is high. Baker and W urgler (2002) proposed th a t managers
w ill prefer to issue equity when they believe th a t the company s shares are overvalued, which w ill tend to
be at tim es when the m arket-to-book ratio w ill also be higher than usual. Moreover, they contend that
observed capital structures reflect the cumulative outcome o f these attem pts by managers to tim e the
equity m arket. H H T did find some evidence o f m arket tim in g in th a t recent increases in share price
increase the p robability o f an equity issue.
H H T also examined the effects o f p ro fita b ility and found th a t there is no relationship between
p ro fita b ility and leverage after a dual issue. Thus, th e ir results im p ly th a t the usual negative relationship
between p ro fita b ility and observed leverage is due to the cumulative effects o f profits and losses. An
im p o rta n t conclusion o f the study is th a t the evidence supports the hypothesis th a t firm s have target
capital structures’ （p. 539).
H istorical effects can also be avoided by examining the capital structure o f companies th a t emerge
from corporate spin-offs— th a t is, transactions in which a subsidiary is separated from its parent company
and each becomes a separate listed entity. In comparison to studies o f broad samples, this setting should
make it easier to detect relationships between leverage and company characteristics because the leverage
ratios o f the ‘new’ companies can be chosen deliberately. M ehrotra, M ikkelson and Partch (2003) studied
a sample o f 98 spin-offs from 1979 to 1997.3 They tested whether the difference in leverage o f the two
companies th a t emerge from a spin-off is explained by differences in:
• p ro fita b ility
• va ria b ility o f in d u stry operating income
• the nature o f assets
• tax status.
They found th a t higher leverage is related to higher pro fitab ility, lower va riab ility o f in d u s try operating
income and a greater proportion o f tangible assets. They also found no evidence o f a relationship between
leverage and tax status. Thus, in this setting, the relationship between leverage and p ro fita b ility is the
opposite o f the pervasive negative relationship th a t is regarded as providing strong evidence against the
static trade-off theory. Except fo r the lack o f support fo r a corporate tax effect, M ehrotra, M ikkelson and
Partchs results are consistent w ith the static trade-off theory.
13 .2 .6 1 Evidence on the choice of maturity and priority of debt

So far we have discussed the effects o f capital structure largely in term s o f financial leverage, which
im p lic itly assumes th a t all debt is the same. In practice, the debt used by companies can vary considerably
in terms o f features such as m aturity, covenant restrictions, p rio rity , security and w hether the debt is
in the fo rm o f marketable securities or non-marketable loans. Therefore, as well as deciding how much
debt to use, the financial manager has to make decisions about what type(s) o f debt to use and whether
debt should be secured or unsecured, short term or long term , and so on. Barclay and Sm ith (1996) suggest
th a t one factor th a t may be im p o rta n t in m aking such decisions is fle xib ility: private bank loans are
relatively easy to renegotiate i f circumstances change, whereas once marketable debt securities have been
issued it is much more d ifficu lt to vary the rights o f the holders. F lexibility is likely to be more im p orta nt
to grow th companies than it is to others, because they are more likely to get in to financial d ifficulty than
mature companies. Therefore, growth companies th a t borrow are likely to prefer private debt.
3 Dittmar (2004) also studied capital structure in corporate spin-offs. Since her results are consistent with those of Mehrotra,
Mikkelson and Partch, we discuss only one of the studies.
Barclay and Smith investigated the significance o f tw o features o f debt— m a tu rity and p rio rity — by
examining 6000 US companies over the period 1981 to 1993. They pointed out th a t it may be d ifficu lt
to assess the individual effects o f some features o f debt because many o f them are related. For example,
bank loans are typically shorter term , cheaper to arrange and contain tig h te r covenant restrictions than
publicly issued corporate bonds. Consistent w ith the findings o f Barclay, Sm ith and Watts (1995), they
argued that, because o f the higher risk th a t grow th companies pose fo r lenders, such companies w ill
find it prohibitively expensive to obtain long-term debt. Consequently, these companies are likely to use
shorter-term, private debt which, by its nature, provides greater financing fle x ib ility than long-term debt.
Similarly, the managers o f grow th companies m ig ht prefer to issue debt th a t is unsecured or subordinated
in order to retain financing flexibility. However, Barclay and Sm ith argued th a t prospective lenders w ill
require very high interest rates on such risky debt, so grow th companies are likely to be forced to issue
higher p rio rity secured debt instead.
The results o f th e ir analysis were consistent w ith these arguments. Companies w ith high ratios o f
m arket value to book value (‘grow th’ companies) tend to use debt o f shorter m a tu rity and higher p rio rity
than mature companies. Barclay and Sm ith found little evidence th a t m a tu rity and p rio rity choices were
determined by taxes or signalling effects.
Benmelech (2009) argues th a t companies w ith assets th a t are more easily sold— th a t is, assets sold in
liquid markets and assets that may be useful to p otential buyers— may be able to use longer-term debt.
He found support fo r this argum ent by exam ining nineteenth-century US railroad companies. He found
that those companies w ith trains designed to ru n on standard-gauge tracks used more long-term debt.
Benmelech, Garmaise and M oskowitz (2005) also found th a t real estate companies holding more liquid
properties used more long-term debt.
An alternative approach to em pirical testing is to ask chief financial officers (CFOs) w hat factors they
consider when they make capital structure decisions. This approach has the virtu e o f being direct and
simple but has two weaknesses. First, the survey respondents may be unrepresentative o f the population
of CFOs. Second, what a CFO believes, says and does may be three different things. Nevertheless, well-
conducted surveys provide a tim ely reality check.
The results o f an im p o rta n t survey o f 392 US CFOs were published in Graham and Harvey (2001).
The survey was repeated by Brounen, de Jong and Koedijk (2006) in a study o f 313 CFOs from France,
Germany, The Netherlands and the UK and repeated again by Coleman, Maheswaran and Pinder (2010)
in a survey o f 76 Australian CFOs. A ll three studies used the same questions on capital structure.
Unfortunately, the response rates were only 9 per cent in the US and just 5 per cent in Europe and
Australia. Survey respondents were provided w ith 14 factors th a t m ig ht explain th e ir capital structure
decisions and were asked to rank the importance o f each factor on a five-point scale. Table 13.1 lists the
top five factors in each country.
The results o f the studies are remarkably similar. O f the 14 factors, the m ost im p o rta n t was clearly
the desire to m aintain financial fle xib ility: this factor ranked second in Australia and firs t in the other
five countries. A t firs t sight, th is response appears to support the pecking order theory, b u t on fu rth e r
questioning i t did n ot appear that the m otivation fo r this desire was in fo rm a tio n asymm etry or grow th
options, as im plied by the theory. O f the 13 other factors, only six appeared in the top five responses
across the countries, suggesting th a t a sim ilar set o f factors is considered im p o rta n t in all countries. One
o f these is the tax advantage o f debt. There was some support fo r the static trade-off theory, w ith CFOs
reporting th a t company tax was o f moderate importance, while the importance accorded to earnings
vo la tility and the company's credit rating is consistent w ith a desire to avoid financial distress. This
sim ilarity in responses is perhaps surprising given th a t company tax rates in Europe are considerably
higher than in the US. Curiously, German CFOs were the least concerned about company tax despite
Germany having the highest tax rate. The importance o f company tax ranked lowest in Australia, which
is consistent w ith Australia’s use o f a pure form o f im putation. None o f the surveys found much evidence
that CFOs considered th a t asset substitution, asymmetric inform ation, free cash flows or personal tax
were im p orta nt factors.
A B usiness finance
TABLE 13.1 Top five responses of CFOs to the question: W hat factors affect how
you choose the appropriate amount of debt for your firm?
R ank A u s tr a lia F ra n c e G e rm a n y N e th e rla n d s UK USA
1 Volatility Flexibility Flexibility Flexibility Flexibility Flexibility
2 Flexibility Customers Credit rating Volatility Volatility Credit rating
3 Credit rating Credit rating Volatility Tax advantage Tax advantage Volatility
4 Transaction costs Tax advantage Transaction Credit rating Transaction Tax advantage
costs costs
5 Tax advantage Volatility Tax advantage Bankruptcy Customers Transaction

costs costs
Sources: Australia: Coleman, Maheswaran and Pinder (2010); France, Germany, Netherlands and UK: Brounen, de Jong
and Koedijk (2006); US: Graham and Harvey (2001).
The full statement of each factor was:
Volatility The volatility of our earnings and cash flows
Flexibility Financial flexibility (restrict debt so we have enough internal funds available to pursue new projects
when they come along)
Credit rating Our credit rating (as assigned by ratings agencies)
Transaction costs The transaction costs and fees for issuing debt
Tax advantage The tax advantage of interest deductibility
Customers We limit debt so our customers/suppliers are not worried about our firm going out of business
Bankruptcy costs The potential costs of bankruptcy, near-bankruptcy or financial distress
13.3 Assessing the theories o f capital

structure
LEARNING
OBJECTIVE 2
In Section 13.2 we reviewed empirical evidence on the effects o f several factors th a t may influence capital
Assess the implications
of the evidence for structure decisions: taxes, costs o f financial distress, agency costs and inform a tion costs. In this section
the static trade-off and we discuss the im plications o f th a t evidence fo r the two main contenders to explain capital structure: the
pecking order theories static trade-off theory and the pecking order theory.
13.3.1 | How useful is the static trade-off theory?

The static trade-off theory emphasises the effects o f taxes and also recognises th a t costs o f financial
distress act as a deterrent to high financial leverage. It proposes th a t companies should borrow u n til the
marginal tax advantage o f additional debt is exactly offset by the increase in the present value o f the
expected costs o f financial distress. The static trade-off theory is consistent w ith much o f the evidence
presented earlier. For example, i t is consistent w ith the fact th a t companies w ith tangible assets borrow
more than those w ith riskier, intangible assets in the fo rm o f valuable investm ent opportunities. Similarly,
it is consistent w ith the fact th a t companies w ith less volatile cash flows (low business risk) borrow more
than those w ith higher business risk.
W hile the static trade-off theory is consistent w ith some observations, Myers argues th a t *the trade
o ff theory is in immediate trouble on the tax fro n t1(2001, p. 89). Essentially Myers1argum ent is th a t the
static trade-off theory does n o t do a good job o f explaining capital structure decisions because there are
cases where corporate leverage is much lower than the theory suggests it should be. For example, many
large profitable companies such as M icrosoft and the m ajor pharmaceutical companies have operated for
years w ith low debt ratios. These companies have high credit ratings and could achieve significant interest
tax savings by increasing th e ir debt ratios w ith o u t the p robability o f financial distress becoming more
命
than remote. Graham (2000) found th a t conservative use o f debt finance was typical o f US companies.
About h alf the companies in his sample paid company tax at the fu ll sta tu tory rate. Graham noted that
the average company in this subsample could have doubled its interest payments and almost certainly
doubled its interest tax savings. How would such an increase in leverage affect company value? Graham
estimated that on average these companies could have added 7.5 per cent to company value by increasing
leverage to take advantage o f the net tax benefits o f debt. Graham s study did n ot ignore the fact that
increasing leverage w ill increase the likelihood o f financial distress. His estimates suggest that fo r most
companies the expected costs o f financial distress are sim ply too small to offset the net tax benefits
o f debt.
Historically, the static trade-off theory has been criticised because it appears to be inconsistent w ith
the evidence th a t p ro fita b ility is negatively related to financial leverage. For example, as Myers points
out, *if managers can exploit valuable interest tax shields as the trade-off theory predicts, we should
observe exactly the opposite relationship. High p ro fita b ility means th a t the firm has more taxable income
to shield, and that the firm can service more debt w ith o u t risking financial distress* (2003, p. 231). This
criticism was certainly valid based on the evidence available at the tim e, b ut the more recent evidence
outlined in Section 13.2.5 indicates th a t p ro fita b ility is positively related to target leverage.
While critical o f the static trade-off theory, Myers points out th a t there are many examples o f tactical
financing decisions that are tax-driven. For example, finance leases are largely tax-driven. As discussed
in Chapter 16, when the lessors effective tax rate is higher than the lessees tax rate, a lease can provide
an overall tax advantage th a t arises from deferring the payment o f tax. There are form al studies that
demonstrate th a t taxes have a m aterial effect on financing decisions. For example, MacKie-Mason (1990)
found that companies w ith low m arginal tax rates are more likely to issue equity than companies that
are paying tax at the fu ll sta tu tory rate. Similarly, Graham (1996) found th a t changes in long-term debt
are positively related to the company s effective m arginal tax rate. Both o f these studies show th a t taxes
affect financing decisions and th e ir results are consistent w ith the static trade-off theory. However, these
studies do n ot show th a t taxes give rise to a net benefit th a t increases company value.
Similar results would be expected under the im p utatio n system, which is designed to ensure th a t
corporate debt does not have a net tax advantage. For example, i f a company operating under im putation
is not in a tax-paying position, b u t needs to raise finance, i t should be better fo r it to issue equity rather
than debt. In comparison to issuing equity, borrow ing w ould involve an immediate increase in taxes fo r
investors w ith no immediate tax saving at the company level. Therefore, studies th a t show th a t taxes
affect marginal financing decisions only show th a t taxes are im p o rta n t at the tactical level. They do not
show that the present value o f interest tax savings is positive and influences the choice o f company debt
ratios. In other words, while i t is clear th a t taxes affect financing tactics, i t is much more d iffic u lt to find
evidence that taxes have a predictable effect on financing strategy. Indeed, Fama and French (1998), who
conducted an extensive statistical investigation o f relationships between company value, dividends and
debt, were unable to find any evidence th a t debt has net tax benefits.
The static trade-off theory can explain many o f the differences in capital structure th a t exist between
companies in different industries. In particular, it can explain why leverage is generally low when business
risk is high and when most o f a company s assets are intangible. I t can also explain the fact th a t the
companies th a t become private in leveraged buyouts (discussed in Chapter 19) are typically mature
companies w ith stable cash flows and tangible assets b ut few opportunities fo r growth.
While the static trade-off theory has commonsense appeal and can explain some aspects o f capital
structure, there are some facts th a t it struggles to explain. First, the static trade-off theory cannot explain
why companies are generally conservative in using debt finance. Second, i t is d iffic u lt to explain why
financial leverage is similar, on average, across many countries despite differences in th e ir tax systems.
If corporate borrow ing has a significant tax advantage, as proposed by the static trade-off theory, then
leverage should be higher in the US w ith its classical tax system than in other countries w ith im putation tax
systems. Third, there is the inconvenient historical fact th a t companies used debt long before companies
were required to pay income tax. Something caused them to use debt and i t certainly wasn’t tax.
1 3 .3 .2 1 How useful is the pecking order theory?

The pecking order theory, w hich we discussed in Section 12.9, can explain why interna l finance is so
popular and why debt is generally the firs t choice when external finance is needed. But, as is the case w ith
B usiness finance
the static trade-off theory, there are some observations th a t are d iffic u lt fo r the pecking order theory to
explain. Frank and Goyal (2003) found th a t some companies make extensive use o f external financing.
Barclay, Sm ith and Watts (1995) found th a t leverage is typically low in high-technology industries where
there are large grow th opportunities and large needs fo r external finance. They noted th a t th e ir finding
was the exact opposite o f w hat the pecking order theory predicts. However, th e ir finding may n ot be
d ifficu lt to explain. High-technology, high-grow th companies typically have m ostly intangible assets and
would therefore fin d debt very expensive. Further, heavy borrow ing by such companies should expose
them to the underinvestm ent problem. In other words, the empirical finding can be explained more easily
by considering costs o f financial distress and agency costs rather than relying on the pecking order theory.
Is this criticism o f the pecking order theory a fa ir one? Perhaps not. The pecking order theory does not
say th a t debt is always the best source o f external finance. I t does say th a t companies should raise external
equity only when they have exhausted th e ir debt capacity. For high-technology, high-grow th companies,
debt capacity may well be very low.
13.4 Financing as a marketing problem

Companies raise external finance by borrow ing, issuing preference shares and issuing ordinary shares.
LEARNING The differences between these three methods are significant in terms o f risk, required rate o f return, tax
OBJECTIVE 3
treatm ent, voting rights attached ( if any) and p rio rity fo r repayment in the event o f liquidation. Less
Explain how financing
can be viewed as a obvious perhaps are the differences th a t can exist w ith in these categories, particularly debt. For example,
marketing problem companies can borrow in different currencies, fo r different periods o f tim e, and the interest rate may
be fixed or variable. In addition, the repayment term s can differ, in th a t the principal may be repayable
in instalments or in a lum p sum. Also, the p rio rity o f the lenders claim can d iffer and some debt is
convertible to ordinary shares. The reason fo r o u tlin in g all these differences is to show th a t in choosing
a capital structure, a company is essentially choosing a particular package o f financial services th a t it
supplies to investors— th a t is, in raising different form s o f finance, a company provides financial assets
th a t offer investors different combinations o f risk, return, liq u id ity and vo ting power. Further, the return
can consist o f different proportions o f capital gains, compared w ith ordinary income, which in tu rn w ill
have taxation consequences fo r the investor.
Shapiro (1998) points out th a t to a person skilled in m arketing, the reason fo r these different
combinations is obvious.4 D ifferent securities coexist fo r the same reason th a t different makes and models
o f cars coexist: individuals have different tastes, preferences and levels o f wealth. The sales o f a given
model o f car w ill depend on the demand fo r the package o f features it offers, the cost o f m anufacturing
th a t package, and the com petition from suppliers o f sim ilar vehicles. Similarly, the capital structure
decisions o f companies w ill be influenced by the demand fo r different financial services, the costs o f
providing each package o f financial services, and the level o f com petition from financial in s titu tio n s that
provide sim ilar services.
The m arketing approach suggests another way in which M odigliani and M ille rs Proposition 1 can be
violated. Cars and other products w ill sell at a higher price i f they are well designed and have characteristics
tailored to the preferences o f potential buyers. The same principle can be applied to security issues. I f a
company^ financial manager can design a security th a t appeals to a particular clientele o f investors, such
th a t these investors are prepared to pay a higher price fo r it, the company can raise funds at a lower
cost than would otherwise be the case— th a t is, the required rate o f retu rn on the security is less than
the m arkets required rate o f return on other securities o f the same risk. In other words, the m arketing
approach focuses on the disequilibrium th a t can exist when there is some m ismatch between the demands
o f investors and the available supply o f securities.
In a com petitive market, a disequilibrium o f this type w ill generally be short lived b ut can certainly
occur. For example, a heightened fear o f in fla tio n could increase the demand fo r indexed bonds. W hen the
unsatisfied demand fo r a p articular type o f security becomes evident, innovative financial managers w ill
move to exploit the opportunity, and the supply o f suitable securities is likely to increase substantially.
Therefore, while there are rewards fo r financial innovation, the benefits are likely to go m ainly to the
4 Shapiro is not the only one to emphasise that the financing decision can be viewed as a marketing problem. See Brealey,
Myers and Allen (2013, p. 440).
companies whose financial managers are the genuine innovators. As the supply o f new securities
increases, the price investors are prepared to pay fo r them w ill decrease, and therefore the required rate
of return w ill increase. Once the clienteles needs have been met, there are no fu rth e r opportunities to
sell more securities at a premium.
13.5 Determining a financing strategy

The evidence discussed in this chapter shows th a t financing decisions are im p o rta n t and can be influenced
by many factors. There is no single model or theory that can be used to specify the best financing strategy LEARNING
OBJECTIVE 4
for any particular company. Such a strategy m ig ht include a long-term leverage target, b ut in m ost cases
Outline the main
such a target is unlikely to be adhered to precisely. Even where a target is chosen, it may be only one part factors that financial
o f an overall strategy. For example, suppose a company has decided to raise new funds by borrowing. managers should
There are then many more decisions to be made. Should the company borrow from banks or should it consider when
issue marketable debt securities direct to lenders? W hat should be the term o f the loan? Should the determining a
company's financing
interest rate be fixed or variable? Are there opportunities to add value by adding some new features to the
strategy
security? Clearly, there are no simple solutions th a t w ill always be the best, b ut by drawing on both theory
and evidence, it is possible to specify some general principles and guidelines th a t can be used by financial
managers to determine a company’s financing strategy.
An im p orta nt principle is th a t i t is usually harder to add value by m aking good financing decisions
than by making good investm ent decisions. W hile a company may be able to fin d investm ent projects
w ith positive net present values, the highly competitive nature o f financial markets means th a t it is
much more d ifficu lt to make financing decisions th a t have positive net present values. For example,
as discussed in Section 13.4, any m arketing advantage associated w ith issuing a security th a t is in high
demand w ill generally be short lived. Investm ent decisions are im p o rta n t because the p rim ary source
of a company s value is the cash flows generated by its assets. By comparison, the financing decision is
less im portant. Even so, the financing decision determines more than how the company s cash flows are
divided between different classes o f investors— there is evidence th a t financing decisions can also have
im portant effects on investm ent decisions. However, given the prim acy o f investm ent decisions, i t seems
sensible to suggest th a t a company s financing strategy should be designed to complement and support
its investment strategy. In particular, factors such as business risk and asset type, which are discussed
below, can have im p o rta n t effects.
A second im p o rta n t principle is th a t while it is n ot easy to add value by m aking good financing
decisions, it is certainly possible to reduce value by m aking poor financing decisions. For example, a
high proportion o f debt can reduce shareholders* wealth because the expected bankruptcy costs become
significant.
We now tu rn to some o f the more im p o rta n t factors to be taken in to account when m aking capital
structure decisions.
13.5.1 I Business risk

In Section 12.6 we pointed o ut th a t a company s expected bankruptcy costs reduce its m arket value.
The expected bankruptcy costs are positively related to the present value o f bankruptcy costs and the
probability o f bankruptcy occurring. The probability o f bankruptcy depends p a rtly on the company s
ability to meet its fixed financial comm itments. By issuing debt, the company increases these financial
commitments, and hence also increases its probability o f bankruptcy.
In order to gauge the bankruptcy cost implications o f issuing (more) debt, a financial manager has to
consider the variab ility o f the company s future net cash flows. The greater the variability, the greater is
the probability that, at some future tim e, the company w ill be unable to meet its financial comm itments.
The variability o f the net cash flows from a company s assets is typically taken as a measure o f its business
risk. Therefore, the greater a company s business risk, the less the company can borrow before its
probability o f bankruptcy is increased. As a result, the optim al capital structure fo r a company w ill be
affected by its business risk. Therefore, some sim ilarities may be expected between the capital structures
o f companies in the same industry, and the leverage used by sim ilar companies may be a useful guide fo r
the financial manager.
B usiness finance
M ost companies have both tangible assets and intangible assets. Also, some assets, referred to as
general purpose assets*, can easily be redeployed to alternative uses, w hile other assets, referred to
as company-specific assets1, are w o rth much more in th e ir current use than in any alternative uses.
For example, a m oto r vehicle is a general-purpose asset, while a specialised item o f equipm ent may
be company-specific. M any company-specific assets are also intangible. These asset characteristics are
im p o rta n t in determ ining how much a company can borrow. This is the case because a lenders risk is
lower i f the company s value is largely attributable to assets th a t can be sold w ith low transaction costs
and little or no loss o f value.
Tangible assets are usually easier to sell than intangible assets; indeed, many intangible assets cannot
be sold separately from the business as a whole. This suggests th a t companies w ith a high proportion o f
tangible assets would be able to borrow more than companies th a t have a high p roportion o f intangible
assets. For example, companies in many service industries, such as advertising agencies and consulting
companies, have a high pro po rtio n o f intangible assets and are largely financed by equity capital.
Similarly, general purpose assets can support more debt than company-specific assets. Lenders recognise
th a t company-specific assets w ill lose much o f th e ir value i f the borrow er defaults and is liquidated. In
other words, expected bankruptcy costs w ill be high and this w ill be reflected in the interest rate charged.
A related argum ent is th a t the agency costs o f debt are high fo r companies w ith a high p roportion of
intangible assets. For example, i f a company relies heavily on research and development (R&D) activities,
problems such as asset substitution w ill be d ifficu lt fo r lenders to detect. Therefore, borrow ing would
involve high m on itoring costs th a t would also be passed on to borrowers in the form o f higher interest
rates. Rather than incur the higher interest cost, such companies w ill tend to rely on equity capital and
hence w ill operate on relatively low d ebt-equity ratios.
The effects o f taxes on financing decisions w ill depend to a large extent on the nature o f the country s
tax system. However, under any tax system it should n ot be assumed th a t debt has a tax advantage just
because interest is tax deductible. Such an assumption is unwarranted because i t ignores personal taxes.
As discussed in Section 12.4.3, M ille r has shown that, under the classical system, the effects o f corporate
and personal taxes can offset each other exactly. I f there is, in practice, any net tax advantage o f corporate
borrow ing under the classical system, this advantage is likely to go only to companies w ith high and
stable earnings. For companies th a t are unable to make immediate use o f interest deductions (because,
fo r example, they have tax losses being carried forward), borrow ing w ill increase personal taxes, b ut there
w ill be no immediate reduction in company tax. Therefore, in this case, borrow ing is likely to have a net
tax disadvantage.
Under a fu ll im putation tax system, company income tax is, as discussed in Section 11.4.1, effectively
a w ith h o ld in g tax and can be recovered by resident shareholders. I f all company tax paid is effectively
recovered by shareholders through receipt o f franked dividends, any advantage from reducing company
tax would be due only to differences in the tim in g o f tax payments. However, in practice, many Australian
companies have both resident and non-resident shareholders. W hile Australian residents can use franking
credits, non-residents cannot use them and are therefore effectively s till taxed under the classical system.
In other words, i f a company pays franked dividends and some o f its shares are held by non-residents,
some tax credits w ill be 'wasted*. One way to reduce this waste is to issue a fu rth e r class o f shares th a t
allows a higher p ro po rtio n o f the tax credits to be transferred to resident investors. Some companies
have achieved this by issuing converting preference shares, which typically carry an e ntitlem ent to fu lly
franked dividends at a fixed rate. I f these shares are issued to ordinary shareholders via a renounceable
rights issue, non-resident shareholders can sell th e ir rights to residents. The price residents are prepared
to pay fo r the rights w ill reflect the value, to them, o f the tax credits. Therefore, reduction o f the wastage
o f tax credits means th a t all shareholders are able to benefit, either directly or indirectly.
As discussed in Section 12.5.2, the im putation tax system has the potential to be neutral between
debt and equity, but, in its Australian version, it tends to be biased towards equity. Thus the conclusion is
that, under the im p utatio n system, sim ply changing a company s d ebt-equity ratio is u nlikely to have any
significant tax-based effect on company value. However, the above discussion shows th a t changing the
type o f equity securities th a t a company issues can have im p o rta n t tax effects.
13.5.4 | M aintaining reserve borrowing capacity ('financial slack7)

As discussed in Section 12.9, when there is inform a tion asymmetry between managers and investors,
the announcement o f a new share issue is likely to cause the company s share price to fall. Therefore, if
a company needs to issue new shares to finance a new project, the overall effect can be a reduction in
shareholders* wealth, even though the project has a positive net present value. This problem does n ot
occur i f the project can be financed inte rn a lly or financed by borrowing. In other words, inform a tion
asymmetry can effectively force companies to follow a financing pecking order in which interna l funds are
the firs t choice and external equity is the last choice.
The problem o f being forced to choose between forgoing a positive NPV project and seeing the share
price fall because o f a share issue can be overcome by m aintaining reserve borrow ing capacity or 'financial
slack*. In this way additional finance can always be raised at short notice to take advantage o f profitable
investments. Clearly, the value o f m aintaining reserve borrow ing capacity w ill be greatest fo r companies
that operate in industries where there are significant investm ent opportunities.
A survey o f financial managers by Allen (1991) found th a t the m ajority o f Australian companies have a
policy o f m aintaining a substantial <cushion, o f reserve borrow ing capacity, typically in the form o f unused
credit facilities established w ith banks and other financial intermediaries. Allen (2000) investigated
the extent to which a sample o f listed Australian, B ritish and Japanese companies m aintained spare
borrowing capacity. He reported th a t 60 per cent o f Australian, 90 per cent o f B ritish and 32 per cent o f
the Japanese respondents to his survey m aintained spare borrow ing capacity.
While financial slack is valuable fo r some companies, i t is n ot valuable fo r all companies. Suppose th a t
a company is currently very profitable b u t operates in an ind ustry w ith few investm ent opportunities. I f
this company has a low d ebt-equity ratio, it w ill have considerable financial slack. However, i t w ill also
have a large free cash flow, so there is a danger th a t its managers may squander resources on takeovers
or diversification projects th a t benefit them b ut harm the shareholders. In other words, as discussed
in Section 12.7.2, the agency costs o f equity can be large when a company has large free cash flow. One
solution to this problem is to increase debt.
13 .5 .5 | Other factors
In discussing the effects o f business risk we referred to the va riab ility o f cash flows as a measure o f risk. A
company s cash flows can vary fo r many reasons, and financial managers should n o t assume th a t business
risk w ill be identical fo r all companies in a given industry. To illustrate some o f the many risk factors that
can influence financing decisions, we consider p olitical risk and in fla tio n risk.
Political risk
Many m ultinational companies have operations in countries th a t can be p olitically unstable. There is
the risk th a t a sudden change o f government may be followed by expropriation o f foreign-owned assets.
In addition, it is typically much more d ifficu lt to take dividends out o f such countries than i t is to move
investment capital in to them. M ultin a tio n a l companies w ill therefore structure the financing o f foreign
operations and projects to m inim ise the impact o f p olitical risk. For example, they may invest as little o f
their own funds as possible and raise most o f the finance w ith in the foreign country.
Inflation risk
Financial managers should consider the effects o f in fla tio n when deciding w hether to borrow at fixed or
floating interest rates. I f the rate o f in fla tio n increases, nom inal interest rates w ill increase, w ith the result
that floating-rate borrowers w ill incur higher loan repayments. This may n ot be a significant problem i f net
operating cash flows also increase in line w ith inflation. For example, companies th a t provide services are
generally able to increase th e ir prices in line w ith inflation, or they may have contracts w ith th eir customers
that provide fo r regular price reviews in accordance w ith a general price level index, such as the consumer
price index. On the other hand, capital-intensive industries are likely to suffer reductions in real cash flows
under inflationary conditions. One reason for this is th a t the cost o f replacing productive assets as they
wear out w ill increase, b ut fo r tax purposes companies can only claim depreciation based on the historical
cost o f their assets. For a company in this situation, borrow ing at a fixed interest rate may be preferred
because borrowing at a floating interest rate w ill tend to increase the variability o f its net cash flows.
SUMMARY
• E m p iric a l e v id e n c e in d ic a te s th a t c o r p o r a te c o r p o r a te s p in -o ffs is c o n s is te n t w ith th e p r e d ic tio n s
f in a n c ia l le v e r a g e h a s n o tic e a b le p a tte rn s , in c lu d in g o f th e s ta tic tr a d e - o ff th e o ry . In p a r tic u la r , th e se
s im ila r itie s w ith in in d u s trie s a n d d iffe re n c e s b e tw e e n s tu d ie s p r o v id e e v id e n c e th a t f in a n c ia l le v e r a g e is
in d u s trie s th a t te n d to p e rs is t o v e r tim e . A c ro s s p o s itiv e ly re la te d to p r o fita b ility .
th e US n o n - fin a n c ia l c o r p o r a te s e c to r a s a w h o le , • E v id e n c e fro m s u rv e y s o f C F O s g iv e s s o m e s u p p o rt
th e r a t io o f d e b t to e q u ity s ta y e d w ith in a n a r r o w to th e s ta tic tr a d e - o ff th e o ry , w ith b o th ta x b e n e fits
ra n g e d u r in g th e tw e n tie th c e n tu ry . T he p r in c ip le s a n d f in a n c ia l d is tre s s re c e iv in g a tte n tio n fro m C F O s .
d is c u s s e d in C h a p te r 12 suggest th a t c a p it a l O th e r th e o rie s re c e iv e d less s u p p o rt.
s tru c tu re d e c is io n s m ay be im p o r ta n t b e c a u s e o f • C o m p a n y f in a n c in g c a n b e v ie w e d as e s s e n tia lly a
th e e ffe c ts o f fa c to rs such as ta x e s , a s s e t ty p e , co sts m a rk e tin g p r o b le m . T h is a p p r o a c h uses th e fa c t th a t
o f f in a n c ia l d is tre s s a n d th e e x te n t o f a c o m p a n y ’s d iffe r e n t in v e s to rs h a v e d iffe r e n t ta ste s, p re fe re n c e s
in v e s tm e n t o p p o r tu n itie s . a n d le v e ls o f w e a lth to e x p la in th e c o e x is te n c e o f
• M any s tu d ie s fo c u s on d iffe re n c e s b e tw e e n s e c u ritie s th a t d iff e r in te rm s o f c h a r a c te ris tic s such
c o m p a n ie s and tr y to e x p la in th e ir o b s e rv e d a s ris k , re tu rn , ta x tr e a tm e n t a n d v o tin g rig h ts .
le v e ra g e in te rm s o f v a r ia b le s c h o s e n a s e m p ir ic a l • If th e s u p p ly o f e a c h ty p e o f s e c u rity e x a c tly
p ro x ie s f o r th e s e a n d o th e r fa c to rs . T h e re su lts o f m a tc h e s th e dem and fo r it, th e n a m a rk e t
th e se s tu d ie s suggest th a t c a p it a l s tru c tu re s a re e q u ilib r iu m w o u ld e x is t in w h ic h th e re w o u ld b e
c h o s e n s y s te m a tic a lly a n d th a t f in a n c ia l le v e r a g e is n o in c e n tiv e fo r a c o m p a n y to c h a n g e its c a p ita l
p o s itiv e ly r e la te d to th e p r o p o r tio n o f a sse ts th a t a r e stru c tu re .
ta n g ib le a n d n e g a tiv e ly re la te d to e a r n in g s v o la tility , • H o w e v e r, if th e re is d is e q u ilib r iu m su ch th a t th e re
n o n -d e b t t a x s h ie ld s a n d p r o fita b ility . is a c lie n te le o f in v e s to rs w h o s e n e e d s a r e n o t
• O ne fa c to r th a t a p p e a r s to be of p a r tic u la r s a tis fie d b y th e r a n g e o f s e c u ritie s a v a ila b le ,
im p o r ta n c e is in v e s tm e n t o p p o r tu n itie s : le v e r a g e th e n th e M o d ig lia n i a n d M ille r p r o p o s itio n s c a n
is n e g a tiv e ly re la te d to in v e s tm e n t o p p o r tu n itie s b e v io la te d .
a s m e a s u re d b y th e r a t io o f m a rk e t v a lu e to b o o k • To e x p lo it such a d is e q u ilib r iu m , a fin a n c ia l
v a lu e . C o m p a n ie s w ith h ig h ra tio s o f m a rk e t m a n a g e r n e e d s to d e s ig n a s e c u rity th a t m ee ts
v a lu e to b o o k v a lu e ( 'g r o w th c o m p a n ie s ’ ）a ls o th e re q u ire m e n ts o f th e u n s a tis fie d c lie n te le o f
te n d to use d e b t o f s h o rte r m a tu rity a n d h ig h e r in v e s to rs . In o th e r w o r d s , th e re c a n b e re w a r d s fo r
p r io r it y th a n m a tu re c o m p a n ie s . T he r e la tio n s h ip f in a n c ia l in n o v a tio n , b u t b e c a u s e c a p it a l m a rk e ts
b e tw e e n le v e r a g e a n d a c o m p a n y ’s ta x p o s itio n a r e h ig h ly c o m p e titiv e , a n y s u ch d is e q u ilib r iu m is
is r e la tiv e ly w e a k , b u t e x a m in a tio n o f fin a n c in g lik e ly to b e s h o rt liv e d a n d th e r e w a r d s a r e lik e ly
d e c is io n s o n a m a r g in a l b a s is s h o w s th a t ta x e s to g o o n ly to th e c o m p a n ie s w h o s e fin a n c ia l
d o in flu e n c e th e se d e c is io n s . m a n a g e rs a r e th e re a l in n o v a to rs , ra th e r th a n to
• Tests o f th e p e c k in g o r d e r t h e o r y fin d e v id e n c e th a t th o s e w h o m e re ly im ita te th e le a d e rs .
is c o n s is te n t w ith th e fin a n c in g p e c k in g o r d e r b e in g • B e c a u s e a c o m p a n y ’s v a lu e d e p e n d s p r im a r ily o n
c a u s e d b y in fo r m a tio n a s y m m e try b e tw e e n m a n a g e rs th e c a s h flo w s g e n e ra te d b y its assets, a c o m p a n y 's
a n d in v e s to rs . T h e re is a ls o e v id e n c e th a t, c o n s is te n t fin a n c in g s tra te g y s h o u ld b e d e s ig n e d to c o m p le m e n t
w ith th e p e c k in g o r d e r th e o ry , a n n o u n c e m e n t o f a n a n d s u p p o rt its in v e s tm e n t stra te g y . In a p p ly in g this
e x te rn a l c a p it a l r a is in g , p a r tic u la r ly a s h a re issu e, p r in c ip le th e fin a n c ia l m a n a g e r m a y n e e d to c o n s id e r
c a u s e s a c o m p a n y ’s s h a re p r ic e to fa ll. m a n y fa c to rs , th e m a in o n e s b e in g th e c o m p a n y 's
• E v id e n c e fro m c o m p a n ie s th a t m a k e 'd u a l issu e s' b u sin e ss risk, th e n a tu re o f its assets, its ta x p o s itio n
o f d e b t a n d e q u ity a n d fro m c a p it a l s tru c tu re s o f a n d th e n e e d fo r re s e rv e b o r r o w in g c a p a c ity .
KEY TERMS
n o n -d e b t ta x s h ie ld s (N D TS s) 396
CHAPTER THIRTEEN REVIEW

QUESTIONS
1 [LO 1 O u tlin e th e c h a r a c te r is tic s y o u w o u ld e x p e c t a c o m p a n y to h a v e if it h a d :
a) a v e r y lo w d e b t - e q u it y ra tio
b) a v e r y h ig h d e b t - e q u it y ra tio .
2 \ i 〇 1 \ E m pirical evidence suggests that m anagem ent takes account o f m arket conditions a n d recent security
prices when determ ining w hether to m ake a d e b t o r an e q u ity issue. D iscu ss th e re le v a n c e o f th e se fa c to rs
fo r m a n a g e m e n t's d e c is io n .
3 [ L O l ] W o u ld y o u n e c e s s a rily e x p e c t c o m p a n ie s in th e s a m e in d u s try to h a v e s im ila r d e b t - e q u it y ra tio s ?

G iv e re a s o n s fo r y o u r a n s w e r.
4 [LO 1 J S u p p o s e th a t th e g o v e r n m e n t s u b s ta n tia lly r e d u c e d th e c o m p a n y ta x ra te in a c la s s ic a l ta x syste m .
a) W h a t w o u ld th e M o d ig lia n i a n d M ille r (w ith c o m p a n y ta x) a p p r o a c h s u g g e s t a b o u t th e e ffe c t o f this

c h a n g e o n th e c a p ita l stru ctu re s o f c o m p a n ie s ?
b) W h a t w o u ld M ille r 's m o d e l p r e d ic t a b o u t th e e ffe c t o n :
i) th e q u a n tity o f d e b t fo r th e c o r p o r a te s e c to r a s a w h o le
ii) th e c a p ita l stru ctu re s o f in d iv id u a l c o m p a n ie s ?
5 [ L O l ] T he c o sts o f f in a n c ia l d is tre s s a r e lik e ly to b e h ig h fo r s o m e ty p e s o f c o m p a n ie s , a n d lo w fo r o th e rs .

O u tlin e th e ty p e s o f c o m p a n ie s f o r w h ic h th e s e co sts a r e lik e ly to b e :
a) h ig h
b) lo w .
6 [LO 1 A sample o f com panies that m ake 'd u a l issues' o f d e b t a n d e quity provides a better setting than a
b ro a d sample o f com panies fo r testing w hether com panies hove c a p ita l structure forgets. E x p la in w h y y o u
a g r e e o r d is a g r e e w ith th is s ta te m e n t.
7 [LO 1 1 The e m p irica l studies o f c a p ita l structure decisions are attempts to infer from the d ata the decision
m aking processes o f c o m p a n y managers. Such attempts ore heroic because they face numerous problem s
o f statistical design a n d interpretation. Surely there is a much sim pler a p p ro a ch : w h y not just ask c o m p a n y
managers w h o t factors they consider w hen they m ake c a p ita l structure decisions? D iscuss.
8 [LO 1 S tu d y th e c a p it a l s tru c tu re s o f a b a n k , a f in a n c e c o m p a n y , a r e ta ile r a n d a m a n u fa c tu re r. A r e th e re
d is c e r n ib le d iffe re n c e s in th e c a p it a l s tru c tu re s o f th e c o m p a n ie s c h o s e n ? G iv e re a s o n s fo r a n y d iffe re n c e s
y o u fin d .
9 [L O 1] C h o o s e a c o m p a n y a n d tr a c e th e m a jo r c h a n g e s in its c a p it a l s tru c tu re o v e r th e p a s t 1 0 y e a rs .
O u tlin e th e e c o n o m ic fa c to rs y o u c o n s id e r h a v e c o n trib u te d to th e m a jo r c h a n g e s in its fin a n c in g p o lic y
d u r in g th is p e r io d .
10 [LO 1] T h e p ro b le m is h o w to m o tiv a te m a n a g e rs to d is g o r g e th e c a s h ra th e r th a n in v e s tin g it b e lo w th e c o s t

o f c a p it a l o r w a s tin g it o n o r g a n is a t io n a l in e ffic ie n c ie s 7 (Jensen 1 9 8 6 , p . 3 2 3 ) . E x p la in h o w d e b t f in a n c e
c a n p r o v id e a s o lu tio n to th is p ro b le m .
11 [LO 1] T he M o d ig lia n i a n d M ille r (M M ) a n a ly s is o f c a p it a l s tru c tu re a ssu m e s th a t th e c o m p a n y 's n e t

o p e r a tin g c a s h flo w s a r e g iv e n . C a p it a l s tru c tu re is ir r e le v a n t u n d e r th e M M a s s u m p tio n s b e c a u s e , in a
p e rfe c t c a p it a l m a rk e t w ith n o ta x e s , th e v a lu e o f th is c a s h f lo w s tre a m is u n a ffe c te d b y c a p it a l s tru c tu re
d e c is io n s . O n e re a s o n w h y c a p it a l s tru c tu re d e c is io n s m a y b e im p o r ta n t in p r a c tic e is th a t c a s h flo w s a r e not
in d e p e n d e n t o f th e se d e c is io n s .
E x p la in h o w th is c o u ld o c c u r fo r:
a) a c o m p a n y th a t g e n e ra te s la r g e fre e c a s h f lo w
b) a c o m p a n y th a t is h ig h ly le v e re d .
12 [L O 2 ] The e m p iric a l observation that there is a negative relationship betw een p ro fita b ility a n d leverage is
em barrassing fo r the static tra d e o ff th e o ry o f c a p ita l structure. D o y o u a g r e e ? H o w r e lia b le is th e e v id e n c e
th a t th e re la tio n s h ip b e tw e e n p r o fita b ilit y a n d le v e r a g e is n e g a tiv e ra th e r th a n p o s itiv e ?
413
B usiness finance
13 [L 0 2]
a) T he s ta tic tra d e - o ff th e o r y o f c a p ita l s tru c tu re c a n e x p la in so m e o f th e d e b t - e q u it y r a tio d iffe re n c e s between

in d u s trie s , b u t c a n n o t e x p la in such d iffe re n c e s b e tw e e n c o m p a n ie s w ithin a g iv e n in d u s try . E x p la in w h y this
s ta te m e n t is c o rre c t o r in c o rre c t.
b) B rie fly o u tlin e a n o th e r th e o ry th a t c a n e x p la in d iffe re n c e s in c a p ita l stru ctu re s b e tw e e n c o m p a n ie s in th e

s a m e in d u s try .
14 [ L 0 4 ] A n e x e c u tiv e o f a m in in g c o m p a n y e x p la in s th a t it h a s a p o lic y o f m a in ta in in g a p o r tf o lio o f p ro je c ts

a t v a r io u s s ta g e s o f d e v e lo p m e n t. In th is w a y th e n e e d fo r e x te rn a l fin a n c e is m in im is e d b e c a u s e th e
c a s h f lo w g e n e r a te d b y o p e r a tin g m in e s c a n b e u se d to f in a n c e th e d e v e lo p m e n t o f n e w o n e s . A ls o th e
c o m p a n y 's n e t c a s h flo w s c a n b e s m o o th e d b y a d ju s tin g p r o d u c tio n p la n s to s u it th e tim in g o f n e w p ro je c ts .
F o r e x a m p le , if th e re a re d e la y s in b r in g in g a n e w m in e in to p r o d u c tio n , th e life o f a n o ld m in e m ig h t b e
e x te n d e d b y m in in g lo w - g r a d e o re th a t w o u ld n o t n o r m a lly b e c o n s id e r e d e c o n o m ic . C r it ic a lly e v a lu a te th e
c o m p a n y 's s tr a te g y fro m th e v ie w p o in t o f s h a re h o ld e rs .
15 [ L 0 4 ] T he c h ie f e x e c u tiv e o f P la n e ts Ltd, a y o u n g c o m p a n y th a t h a s ju st b e e n se t u p , sa ys: 'W e d e c id e d

to b o r r o w m o s t o f th e fu n d s n e e d e d to e s ta b lis h o u r o p e r a tio n s b e c a u s e h ig h le v e r a g e w o u ld s ig n a l to th e
m a rk e ts th a t w e w e r e c o n fid e n t a n d fu lly c o m m itte d to m a k in g th is b u s in e s s s u c c e e d / E v a lu a te th is s tra te g y ,
a s s u m in g th a t P la n e ts p ro d u c e s :
a) v o ic e -a c tiv a te d s o ftw a re system s
b) h o u s e h o ld d e te rg e n ts .
16 [L O 4 ] In A p r il 1 9 9 7 , T e lstra , th e n a te le c o m m u n ic a tio n s c o m p a n y w h o lly o w n e d b y th e A u s tr a lia n

G o v e rn m e n t, a n n o u n c e d a c a p it a l re s tru c tu rin g a h e a d o f its p r o p o s e d p a r tia l p r iv a tis a tio n th ro u g h a
s h a re m a rk e t f lo a t d u r in g th e s e c o n d h a lf o f 1 9 9 7 . T he c a p it a l re s tru c tu rin g in v o lv e d p a y m e n t o f a s p e c ia l
d iv id e n d o f $ 3 b illio n to th e g o v e r n m e n t a n d th e b o r r o w in g o f $ 3 b illio n b y T e lstra . Its f in a n c e d ir e c to r
r e p o r te d ly s a id th a t 'th e re s tru c tu rin g w o u ld lo w e r th e a v e r a g e c o s t o f c a p it a l a n d e n a b le g r e a t e r fin a n c ia l
f le x ib ilit y 7. S im ila rly , o n e jo u r n a lis t n o te d th a t 'd e b t fin a n c in g is c h e a p e r th a n e q u ity r a is in g '. H is a r tic le a ls o
s ta te d th a t 'd e b t in te re s t p a y m e n ts a r e a ls o ta x d e d u c tib le , w h ile d iv id e n d s a r e n o t7. C r it ic a lly e v a lu a te th e se
c o m m e n ts o n th e e ffe c ts o f, a n d re a s o n s fo r, th e re s tru c tu rin g .
17 [L O 4 ] T h e c a p it a l re s tru c tu rin g o f T e lstra o u tlin e d in Q u e s tio n 1 6 p r o m p te d r a tin g a g e n c ie s to d o w n g r a d e

T e lstra 's d e b t. F o r e x a m p le , S ta n d a r d & P o o r’s lo w e r e d T e ls tra ’s r a tin g fro m A A A to A A + . T h e re s tru c tu rin g
w a s th e s u b je c t o f m a n y c o m m e n ts b y f in a n c ia l jo u rn a lis ts , e c o n o m is ts a n d f in a n c ia l a n a ly s ts , s o m e o f w h o m
d iffe r e d w id e ly in th e ir p re d ic tio n s a b o u t its e ffe c ts . T he c o m m e n ts in c lu d e d :
a) A s p o k e s m a n fo r th e A u s tra lia n T e le c o m m u n ic a tio n s U sers G r o u p p r e d ic te d in c re a s e d c h a rg e s to p h o n e

users. C o n v e rs e ly , a n o th e r c o m m e n ta to r s ta te d th a t 'm o s t im p o rta n tly , it d o e s n o t m e a n h ig h e r c h a rg e s
to " g e t th e m o n e y b a c k " ’ . H e a d d e d th a t fu tu re te le p h o n y c h a rg e s w o u ld d e p e n d o n a m ix o f Telstra's
m o n o p o ly p o w e r ve rsu s th e e ffe c tiv e n e s s o f c o m p e titio n a n d th a t, 'p r o v id e d th e re g u la to rs d o th e ir jo b h a lf
w e ll, th e Telstra b a la n c e s h e e t is ir r e le v a n f .
b) S o m e c ritic s n o te d th a t th e ra tin g d o w n g r a d e w o u ld in c re a s e T e lstra ’s b o r r o w in g costs, w h ile o th e rs

s u g g e s te d th a t d e s p ite th e re d u c tio n o f $ 3 b illio n in n e t assets it w a s lik e ly th a t Telstra w o u ld fa ll in v a lu e b y
s o m e th in g less th a n $ 3 b illio n a n d m ig h t n o t lo se a n y v a lu e a t a ll. T he la tte r a rg u m e n t is s u p p o rte d b y the
c o m m e n t th a t th e p a y m e n t d id n o t p u t a n y fin a n c ia l p re s s u re o n Telstra a n d 'm ig h t c o n c e n tra te m in d s o n
h o w it s p e n d s its h u g e ca sh f lo w ’ . S im ila rly , a b ro k in g a n a ly s t c o m m e n te d th a t 'b y th e ir n a tu re , m o re h ig h ly
g e a r e d c o m p a n ie s e x e rc is e tig h te r c o s t d is c ip lin e s ’ .
C r itic a lly e v a lu a te th e a rg u m e n ts o u tlin e d in (a) a n d (b).
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CHAPTER CONTENTS
14.1 14.6
■
14.2
In tr o d u c t io n 418 P r o je c t a n d c o m p a n y c o s t o f c a p it a l 431
R isk, re tu rn a n d th e c o s t o f c a p it a l 418 IH H T h e w e ig h t e d a v e r a g e c o s t o f c a p it a l a n d
a lt e r n a t iv e p r o je c t e v a lu a t io n te c h n iq u e s 436
14.3 T a x e s a n d th e c o s t o f c a p it a l 419
■ 14.8 U s in g c e r t a in t y e q u iv a le n t s to a l lo w f o r r is k 437
14.4 A lt e r n a t iv e a p p r o a c h e s to e s t im a tio n o f
th e c o s t o f c a p it a l 421 A p p e n d ix 1 4 .1 T h e c o s t o f c a p it a l u n d e r
a lt e r n a t iv e t a x s y s te m s 447
14.5 E s tim a tio n o f th e c o s t o f c a p it a l:
a n e x t e n d e d e x a m p le 423
LEARNING OBJECTIVES
1 u n d e r s ta n d th e c o n c e p t o f th e c o s t o f c a p it a l
2 u n d e r s ta n d th e e ffe c t o f r is k o n th e c o s t o f c a p it a l
3 u n d e r s ta n d h o w th e c o s t o f c a p it a l c a n b e m e a s u r e d u n d e r th e im p u t a t io n t a x s y s te m
4 u n d e r s ta n d w h y th e c o s t o f c a p it a l f o r a c o m p a n y is e x p r e s s e d a s a w e ig h t e d a v e r a g e o f th e c o s ts o f a ll
o f th e c o m p a n y 's s o u rc e s o f c a p it a l
5 e s tim a te th e c o s t o f e a c h s o u r c e o f c a p it a l a n d c o m b in e th e s e c o s ts in to a w e ig h t e d a v e r a g e c o s t o f
c a p it a l f o r a c o m p a n y
6 e x p la in h o w to t r e a t is s u e c o s ts in p r o je c t e v a lu a t io n
7 u n d e r s ta n d th e d is t in c t io n b e t w e e n th e c o s t o f c a p it a l f o r a p r o je c t a n d a c o m p a n y 's w e ig h t e d a v e r a g e c o s t
o f c a p it a l
8 e s tim a te th e c o s t o f c a p it a l f o r a d iv is io n o f a d iv e r s if ie d c o m p a n y
9 u n d e r s ta n d th e a d v a n ta g e s a n d d is a d v a n t a g e s o f u s in g th e w e ig h t e d a v e r a g e c o s t o f c a p it a l in p r o je c t e v a lu a tio n
10 u n d e r s ta n d th e a p p l ic a t io n o f th e c e r t a in t y - e q u iv a le n t m e th o d o f in c o r p o r a t in g ris k in to p r o je c t e v a lu a t io n .
B usiness finance
14.1 Introduction
A s w e n o te d in C h a p te r 5, w h e n a p ro je c t is e va lu a te d u s in g th e n e t p re s e n t va lu e (N P V ) m e th o d , i t is
LEARNING necessary to have in fo r m a t io n o n th e p ro je c ts fo re c a s t net cash flows a n d it s required rate of return. U n d e r
OBJECTIVE 1
th e N P V m e th o d , th e fo re c a s t n e t cash flo w s are d is c o u n te d a t th e p ro je c ts re q u ire d ra te o f r e tu r n a n d
Understand the
concept of the cost of th e p ro je c t s h o u ld be u n d e rta k e n i f i t has a p o s itiv e NPV. In th is case, th e d e c is io n to u n d e rta k e th e n e w
capital p ro je c t s h o u ld increase s h a re h o ld e rs ’ w e a lth , because i t is e xp e cte d to g e ne rate n e t cash flo w s t h a t are
s u ffic ie n t to c o m p e n sa te th e s u p p lie rs o f c a p ita l f o r th e resources c o m m itte d to th e p ro je c t.
OPPORTUNITY COST
The ra te o f r e tu r n re q u ire d b y th e s u p p lie rs o f c a p ita l is also k n o w n as th e co st o f capital*. I t is an
highest price or
o p p o r tu n ity cost because c a p ita l s u p p lie rs w ill re q u ire t h a t a p ro je c t s h o u ld p ro d u c e a ra te o f r e tu r n
rate of return that
would be provided a t le a s t as g re a t as th e ra te o f r e tu r n th e y c o u ld o b ta in o n o th e r in v e s tm e n ts o f s im ila r ris k . In tu r n ,
by an alternative th is ra te o f r e tu r n is u s u a lly th o u g h t o f as c o n s is tin g o f tw o c o m p o n e n ts : th e ris k -fre e ra te o f r e tu r n to
course of action. The c o m p e n sa te f o r th e tim e va lu e o f m o n e y, p lu s a p re m iu m to co m p e n sa te f o r ris k .
opportunity cost of
The co st o f c a p ita l is a c ru c ia lly im p o r t a n t in p u t to th e in v e s tm e n t d e c is io n . O fte n th e d e c is io n to
capital is the rate of
accept o r re je c t a p ro p o s e d p ro je c t can change i f th e e s tim a te d cost o f c a p ita l is ch a n g e d b y as li t t le as a
return that could be
Gamed on another fe w pe rce n ta g e p o in ts . There are, h o w e ve r, d iffe re n t d e fin itio n s o f th e co s t o f c a p ita l t h a t can be a d op te d.
investment with the The co n sisten cy prin ciple re q u ire s t h a t th e d e fin itio n o f th e cash flo w s in th e n u m e ra to r o f an NPV
same risk c a lc u la tio n m u s t m a tc h th e d e fin itio n o f th e d is c o u n t ra te in th e d e n o m in a to r o f th e c a lc u la tio n . F o r
e xa m p le , in fla t io n m u s t be tre a te d c o n s is te n tly in th e cash flo w s a n d th e cost o f c a p ita l. T h ere fore, i f th e
CONSISTENCY
cash flo w s are n o m in a l— t h a t is, are based o n p rice s e xp e cte d in fu tu r e ye a rs— th e n th e d is c o u n t ra te
PRINCIPLE
in applying the NPV m u s t also be expressed in n o m in a l (ra th e r th a n real) te rm s . S im ila rly , taxes m u s t be tre a te d c o n s is te n tly
model, the net cash in th e cash flo w s a n d th e co st o f c a p ita l. T here fore, a fte r-c o m p a n y -ta x cash flo w s are d is c o u n te d u s in g
flows in the numerator an a fte r-ta x co st o f c a p ita l. In th is c h a p te r w e c o n s id e r th e d e fin itio n , e s tim a tio n a n d use o f th e cost
should be defined and
o f c a p ita l.
measured in a way
In p ra c tic e , r is k y p ro je c ts are u s u a lly e va lu a te d b y u s in g a co st o f c a p ita l t h a t re fle c ts th e r is k o f th e
that is consistent with
the definition of the p ro je c t. I n th is c h a p te r w e also c o n s id e r th e c e rta in ty -e q u iv a le n t ap p ro a ch . T his a p p ro a c h in c o rp o ra te s
discount rate r is k in to th e a n alysis b y a d ju s tin g th e cash flo w s ra th e r th a n th e d is c o u n t rate.
14.2 Risk, return and the cost of capital

In C h a p te r 7 w e discussed th e r e la tio n s h ip b e tw e e n r is k a n d r e t u r n f o r r is k y assets such as shares. In th a t
LEARNING d is c u s s io n w e use d th e te rm s ‘e xp e cte d r e t u r n ’ a n d ‘re q u ire d r e t u r n ’ to re fe r to th e re tu rn s d e m a n d e d
OBJECTIVE 2
b y in v e s to rs . The re tu rn s rece ive d b y in v e s to rs in s e c u ritie s m u s t be p ro v id e d b y th e issu ers o f th o se
Understand the effect
of risk on the cost of s e c u ritie s and, fr o m th e is s u e rs v ie w p o in t, th e r e tu r n d e m a n d e d b y in v e s to rs is e ffe c tiv e ly a co st—
capital ty p ic a lly re fe rre d to as th e cost o f c a p ita l. T h e re fo re , th e te rm s cost o f capital* a n d ^re qu ired re tu rn * c o u ld
COST OF CAPITAL be used in te rc h a n g e a b ly , an d, in assessing th e co st o f capital f o r a n y p ro je c t, w e fo cu s o n th e r e tu r n
minimum rate of return re q u ire d b y in v e s to rs to co m p e n sa te th e m f o r p ro v id in g c a p ita l.
needed to compensate S uppose t h a t a co m p a n y has tw o n e w p ro je c ts ava ila ble: one is r is k fre e a n d th e o th e r is ris k y . H o w
suppliers of capital for s h o u ld th e co m p a n y s fin a n c ia l m a n a g e r assess th e cost o f c a p ita l f o r each o f the se p ro je c ts ? E sse n tia lly,
committing resources
th e fin a n c ia l m a n a g e r s h o u ld ask: W h a t ra te o f r e tu r n w o u ld o u r shareholders re q u ire f r o m th e se p ro je cts?
to an investment
C learly, a d e cisio n to u n d e rta k e th e ris k -fre e p ro je c t w ill in crea se s h a re h o ld e rs ’ w e a lth o n ly i f th e p ro je c t’s
e xp e cte d ra te o f r e tu r n is a t le a s t as g re a t as th e ra te t h a t in v e s to rs can e a rn o n o th e r ris k -fre e in v e s tm e n ts ,
such as g o v e rn m e n t d e b t se c u ritie s . In o th e r w o rd s , th e co st o f c a p ita l f o r th e ris k -fre e p ro je c t is th e r is k
fre e ra te in th e s e c u ritie s m a rk e t. The co st o f c a p ita l f o r th e r is k y p ro je c t w ill be h ig h e r th a n th e ris k -fre e
ra te a n d w ill de p e n d o n th e ra te o f r e tu r n t h a t in v e s to rs re q u ire fr o m o th e r in v e s tm e n ts o f s im ila r ris k .
In s u m m a ry , th e co st o f c a p ita l f o r a p ro je c t de pe nd s o n th e r is k o f th e p ro je c t.
The re la tio n s h ip b e tw e e n r is k a n d r e tu r n is discusse d in C h a p te r 7 a n d o n e o f th e m a in c o n clu sio n s is
t h a t th e r e le v a n t m easure o f r is k f o r a n y asset is its s y s te m a tic o r n o n -d iv e rs ifia b le ris k , because in v e s to rs
w ill n o t be co m p e n sa te d f o r b e a rin g r is k t h a t can be e lim in a te d b y d iv e rs ific a tio n — t h a t is, th e y w ill n o t
be c o m p e n s a te d f o r u n s y s te m a tic o r d iv e rs ifia b le ris k . C o n s is te n t w it h th is c o n c lu s io n , th e c a p ita l asset
p r ic in g m o d e l (C A P M ) sta te s t h a t th e re q u ire d r e tu r n o n an in v e s tm e n t d e pe nd s o n th e in v e s tm e n ts
s y s te m a tic ris k . Hence, a c c o rd in g to th e C A P M , th e re le v a n t m ea sure o f r is k f o r a p ro je c t is th e systematic
risk of the project, m e a su re d b y its be ta.
C hapter fourteen T he c o s t o f capital
14.2.1 | Risk independence

I f th e cost o f c a p ita l f o r a p ro je c t depe nd s o n th e r is k o f th e p ro je c t th e n i t does not d e p e n d o n th e
c h a ra cte ristics o f th e c o m p a n y c o n s id e rin g th e p ro je c t. The d e c is io n r u le is to accept a ll p ro je c ts w h o se n e t
p re s e n t values are p o s itiv e w h e n th e e xp e cte d cash flo w s are d is c o u n te d a t th e p ro je c t-s p e c ific d is c o u n t
rate. Thus, th e v a lu e o f a p ro je c t depends o n w h a t th e p ro je c t is, n o t w h o th e in v e s to r is.
F u rth e r, p ro je c ts can be e va lu a te d as i f t h e ir r is k is in d e p e n d e n t o f th e r is k o f a ll o th e r p ro je c ts
u n d e rta k e n b y th e c om p an y. T his p rin c ip le o f r is k in d e p e n d e n ce can be e x p la in e d b y c o n s id e rin g co m p a n y
d iv e rs ific a tio n . I t is e x p la in e d in C h a p te r 7 t h a t a r a tio n a l risk-a ve rse in v e s to r w ill h o ld a w e ll-d iv e rs ifie d
p o r tfo lio a n d t h a t th e r is k o f an asset in a la rg e p o r tf o lio depends o n th e co va ria n ce o f th e re tu rn s o n th e
in d iv id u a l asset w it h th e re tu rn s o n th e p o r tfo lio . I t c o u ld be a rg u e d t h a t co m p a n ie s s h o u ld also d iv e rs ify .
I f so, th e n com p an ies w o u ld ta k e in to a cco u n t th e c o rre la tio n b e tw e e n re tu rn s o n th e p ro p o se d p ro je c t
and re tu rn s o n t h e ir e x is tin g p ro je c ts .
F o rtu n a te ly th is a rg u m e n t is in c o rre c t, because in v e s to rs can d iv e rs ify f o r th e m se lve s s im p ly b y
in v e s tin g in th e shares o f m a n y d iffe re n t co m p a n ie s. T h ere fore, d iv e rs ific a tio n b y a co m p a n y does n o t
p ro v id e a n y in v e s tm e n t o p p o r tu n it y t h a t is n o t a lre a d y a va ila b le to in v e s to rs .1 C o n se q u e n tly, each p ro je c t
s h o u ld be e va lu a te d u s in g th e co s t o f c a p ita l a p p ro p ria te f o r th a t p ro je c t. This depends o n th e r is k o f th e
p a rtic u la r p ro je c t. R isk in d e p e n d e n c e com es a b o u t because o f th e e ffe ctive n e ss o f th e c a p ita l m a rk e t in
p ro v id in g o p p o rtu n itie s f o r in v e s to rs to d iv e rs ify .
14.3 Taxes and the cost of capital

As m e n tio n e d in S e ctio n 14 .1, taxes m u s t be tre a te d c o n s is te n tly in th e n e t cash flo w s a n d in th e cost o f
cap ital. As d e m o n s tra te d in C h a p te r 6, p ro je c ts are n o rm a lly e va lu a te d o n an a fte r-c o m p a n y -ta x ba sis 一 LEARNING
OBJECTIVE 3
th a t is, a fte r-c o m p a n y -ta x cash flo w s are d is c o u n te d u s in g a n a fte r-c o m p a n y -ta x re q u ire d ra te o f r e tu rn .
Understand how the
W h ile th is p rin c ip le sou nd s s im p le , i t can be d iff ic u lt to a p p ly because th e re is m o re th a n one w a y to cost of capital can be
d e fin e ‘a fte r-c o m p a n y -ta x ’ cash flo w s . P a rtic u la r care is n e ed ed u n d e r th e im p u ta tio n ta x s yste m because, measured under the
as discussed in C h a p te r 11, som e o r a ll o f th e ta x c o lle c te d fr o m a co m p a n y is, in e ffe c t, p e rs o n a l ta x , imputation tax system
not (tYue co m p a n y ta x. O ffic e r (1 9 9 4 ) discussed several a lte rn a tiv e ways o f d e fin in g n e t cash flo w s a n d
th e cost o f c a p ita l u n d e r im p u ta tio n .2 O ne w a y to d e fin e a fte r-ta x cash flo w s is t h a t th e y are eq ua l to th e
b e fo re -ta x cash flo w s m u ltip lie d b y (1 - t e), w h e re teis th e effective c o m p a n y in c o m e ta x rate. The e ffe c tiv e
com p an y ta x ra te is te= tc( l - y), w h e re tcis th e s ta tu to r y c o m p a n y ta x ra te a n d y re p re se n ts th e p r o p o r tio n
o f th e ta x co lle cte d fr o m a c o m p a n y t h a t is p a id o u t to sh a re h o ld e rs a n d reco vere d th ro u g h ta x c re d its
associated w ith fra n k e d d iv id e n d s . N o te t h a t i f y is eq u a l to 1, th e n th e e ffe c tiv e c o m p a n y ta x ra te is zero,
w h ile i f y is eq ua l to zero, th e n th e e ffe c tiv e c o m p a n y in c o m e ta x ra te is th e sam e as th e s ta tu to r y rate.
The c o rre s p o n d in g d e fin itio n o f th e co st o f c a p ita l is discusse d in S e c tio n 14 .4.2.
O ffic e r also sho w e d th a t, u n d e r th e im p u ta tio n ta x system , a d ju s tm e n ts m a y be ne eded w h e re
observe d m a rk e t rates o f r e tu r n are used to e s tim a te th e co st o f e q u ity . C o n v e n tio n a lly , th e co st o f e q u ity ,
keJis d e fin e d a n d m e a su re d o n an a fte r-c o m p a n y -ta x , b u t b e fo re -p e rs o n a l-ta x , basis. U n d e r th e classical
ta x system th is a p p ro a ch is s tra ig h tfo rw a rd , because o b se rve d m a rk e t rates o f r e tu r n o n e q u ity are also
a fte r c o m p a n y ta x , b u t b e fo re p e rs o n a l ta x. H o w e ve r, u n d e r th e im p u ta tio n system , p a r t o f th e r e t u r n to
e q u ity con sists o f ta x c re d its . Because the se ta x c re d its are n o t in c lu d e d in c o n v e n tio n a l r a te -o f-re tu rn
m easures, a d ju s tm e n ts are re q u ire d to o b ta in tru e a fte r-c o m p a n y -ta x rates o f re tu rn .
The a d ju s tm e n t o f th e d iv id e n d y ie ld c o m p o n e n t o f th e r e tu r n to e q u ity to re fle c t th e in c lu s io n o f ta x
c re d its is illu s tra te d in E x a m p le 14.1.
E xam p le 14.1 show s t h a t w h e re d iv id e n d s are fra n k e d , o b se rve d rates o f r e t u r n o n shares need to
be a d ju s te d to o b ta in a fte r-c o m p a n y -ta x rates o f re tu rn . The a d ju s tm e n t is s im p le : add b a ck th e value o f
im p u ta tio n ta x f r a n k in g c re d its t h a t re p re s e n t p e rs o n a l ta x t h a t has a lre a d y been p a id . The va lu e o f these
1 Interestingly, in the context of companies acquiring other companies, Mukherjee, Kiymaz and Baker (2004) report that
diversification is the second-most popular reason for acquisitions cited by a sample of chief financial officers of acquiring
companies. This popularity exists despite shareholders being able to diversify their portfolios to match their risk appetite
and, in many cases, being able do so more cheaply than the acquiring company, which is forced to pay a control premium.
This point is discussed in greater depth in Section 19.2.1.
2 For a more detailed discussion of alternative definitions of the cost of capital and the derivation of equations for a company s
cost of capital on a before-tax and after-tax basis see Appendix 14.1.
T he s h a re s o f PXT Ltd h a v e a m a rk e t p r ic e o f $ 4 a n d a n a n n u a l d iv id e n d o f 1 7 . 5 c e n ts p e r s h a re , fu lly
fr a n k e d a t th e c o m p a n y ta x ra te o f 3 0 p e r c e n t. C a lc u la te :
a) th e d iv id e n d y ie ld o n th e s h a re s o f PXT th a t w o u ld b e r e p o r te d in th e f in a n c ia l p re ss
b) th e d iv id e n d y ie ld a fte r c o m p a n y ta x , b u t b e fo r e p e rs o n a l ta x
c) th e d iv id e n d y ie ld a fte r c o m p a n y t a x a n d a fte r p e rs o n a l ta x , f o r s h a re h o ld e rs w ith p e rs o n a l ta x

ra te s o f:
i) 3 0 p e r c e n t
ii) 4 5 p e r c e n t.
SOLUTION
a) D iv id e n d y ie ld s r e p o r te d in th e f in a n c ia l p re ss a r e b a s e d o n c a s h d iv id e n d s e x c lu d in g any
im p u ta tio n ta x f r a n k in g c re d its . T he r e p o r te d d iv id e n d y ie ld o n th e s h a re s is:
气〇.175 = 0.04375 or 4.375%

$4.00
b) T he d iv id e n d y ie ld a fte r c o m p a n y ta x , b u t b e fo r e p e rs o n a l ta x , is b a s e d o n th e c a s h d iv id e n d o f
$ 0 . 1 7 5 p e r s h a re , p lu s th e im p u ta tio n ta x f r a n k in g c r e d it, w h ic h re p re s e n ts p e rs o n a l ta x a lr e a d y
p a id . A s d is c u s s e d in S e c tio n 1 1 . 4 .1 , th e im p u ta tio n ta x f r a n k in g c r e d it is:
Dt x tc
1 - fc
= $ 0.17 5 X 0.03
0.07
=$0.075
T he d o lla r re tu rn to s h a re h o ld e rs a fte r c o m p a n y ta x is $ 0 . 1 7 5 + $ 0 .0 7 5 = $ 0 . 2 5 0 , so th e
d iv id e n d y ie ld a fte r c o m p a n y ta x is = 0 .0 6 2 5 o r 6 .2 5 % .
c) T h e s h a r e h o ld e r s ' p e r s o n a l t a x w ill b e c a lc u la te d a s fo llo w s :

T a x a b le d iv id e n d in c o m e = d iv id e n d + im p u ta tio n f r a n k in g c r e d it
= $ 0 . 1 7 5 + $ 0 .0 7 5
= $ 0 .2 5 0
G ro s s p e rs o n a l ta x = $ 0 . 2 5 0 x tp
N e t p e rs o n a l ta x = $ 0 . 2 5 0 x fp - $ 0 . 0 7 5
i) W h e n tp = 0 . 3 0
N e t p e rs o n a l ta x = $ 0 . 2 5 0 x 0 . 3 0 - $ 0 . 0 7 5 = 0
$0 175
In th is c a s e , th e d iv id e n d y ie ld a fte r a ll ta x e s is — ^------- = 4 .3 7 5 % , w h ic h is e x a c tly e q u a l to
the reported dividend yield. $4.00 i)
ii) W h e n tp = 0 . 4 5
N e t p e r s o n a l ta x = $ 0 . 2 5 0 x 0 . 4 5 - $ 0 . 0 7 5
= $ 0 .0 3 7 5
T h e d iv id e n d a fte r a ll ta x e s is $ ( 0 . 1 7 5 - 0 . 0 3 7 5 ) = $ 0 . 1 3 7 5 a n d th e c o r r e s p o n d in g d iv id e n d
丨0 1
yield is =0.034 375 or 3.4375%.
$4.00
3.4375%
A s a c h e c k , th is y ie ld c a n b e c o n v e r te d to a b e fo re -p e rs o n a l ta x y ie ld , w h ic h is - ：6.25%,
w h ic h is e x a c tly th e s a m e a s th e a n s w e r to p a r t (b ). 丨一 • J
ta x c re d its can be expressed as a ra te o f r e tu rn , X, b y d iv id in g th e ta x c re d its b y th e share p ric e . I t fo llo w s

t h a t a s im ila r a d ju s tm e n t is ne ed ed w h e n th e C A P M is used to e s tim a te th e co st o f c a p ita l. T h e re fo re , th e
C A P M w o u ld becom e:
A d d in g x, w h ic h can be c a lle d a f r a n k i n g p r e m iu m , a d ju s ts th e o b se rve d r e tu r n o n th e m a rk e t FR AN KIN G PREMIUM
p o r tfo lio to an a fte r-c o m p a n y -ta x ra te o f r e tu r n . The v a lu e o f X w ill d e p e n d o n th e average d iv id e n d that part of the return
on shares or a share
y ie ld o n th e shares in th e m a rk e t p o r tf o lio a n d th e e x te n t to w h ic h th e d iv id e n d s are fra n k e d . Suppose a
market index that
share m a rk e t in d e x re p re s e n ts th e m a rk e t p o r tfo lio , th e average d iv id e n d y ie ld o n shares in th e in d e x is is due to tax credits
3 p e r ce n t a n d d iv id e n d s are 8 0 p e r c e n t fra n k e d a t a co m p a n y ta x ra te o f 30 p e r c e n t. In th is case, th e ta x associated with
c re d its received o n an in v e s tm e n t o f $ 1 0 0 w o u ld be: franked dividends
$ 3 x 0 . 8 x Q.30=$1Q286
( 1 - 0 .0 3 )
T here fore, th e fr a n k in g p re m iu m , I , is a p p ro x im a te ly 1 p e r cen t.
14.4 Alternative approaches to estimation

of the cost of capital
I t is im p o r ta n t to reco gn ise t h a t th e co st o f c a p ita l re fle c ts rates o f r e t u r n t h a t in v e s to rs e xp e ct to receive
in th e fu tu re . Because in v e s to rs 1 e x p e c ta tio n s c a n n o t be o b se rve d , i t is u s u a lly n o t p o ssib le to m ea sure
th e cost o f c a p ita l pre cise ly. I t m u s t be estimated a n d th e p re fe rre d a p p ro a ch w ill be in flu e n c e d b y th e
a v a ila b ility o f d a ta a n d th e im p o rta n c e o f th e in v e s tm e n ts t h a t w ill be e va lu a te d u s in g th e e s tim a te d cost
o f c a p ita l. The fo llo w in g s e c tio n s discuss tw o approaches: th e d ire c t use o f th e C A P M a n d th e use o f th e
w e ig h te d average co st o f c a p ita l (W AC C ).
14.4.1 | Direct use of the CAPM

A c c o rd in g to th e C A P M , w h ic h is discusse d in S e ctio n 7.6 .2 , th e co st o f c a p ita l, /c;, f o r p r o je c t; is:
kj = Rf + 0j[E(RM) - R f] |Q I
T herefore, to use th e C A P M d ire c tly , i t is necessary to e s tim a te th e ris k -fre e in te re s t rate, R^yth e e xp e cte d
ra te o f r e tu r n o n th e m a rk e t p o r tf o lio , E(RM) a n d th e p ro je c ts s y s te m a tic ris k , J3y E s tim a tio n o f a n d
E(Rm) is discussed in S e ctio n 1 4 .5 .3 , b u t f o r n o w w e fo cu s o n th e p ro b le m o f e s tim a tin g th e s y s te m a tic
ris k o r b e ta o f a p ro je c t.
T echn iq ues f o r e s tim a tin g th e b e ta s o f s e c u ritie s , such as shares, u s in g n u m b e rs d e riv e d fr o m share
m a rk e t da ta, are e x p la in e d in S e c tio n 7.6. The necessary d a ta are re a d ily a va ila ble i f th e s e c u ritie s
con cern ed are tra d e d a c tiv e ly o n a s to c k exchange. P ro p o se d in v e s tm e n t p ro je c ts are, o f course, n o t
tra d e d o n a s to c k exchange, o r o n a n y o th e r m a rk e t, a n d th e re fo re th e d a ta re q u ire d to e s tim a te p ro je c t
betas d ire c tly are n o t a va ila b le . T his p ro b le m c o u ld e a sily be o ve rco m e i f a ll o f a c o m p a n y s p ro je c ts h a d
th e sam e b e ta , a n d i f th e c o m p a n y w e re fin a n c e d s o le ly b y e q u ity . S h a re h o ld e rs w o u ld b e ar a ll th e ris k
associated w ith th e c o m p a n y s n e t cash flo w s . A s the se cash flo w s are g e n e ra te d b y th e c o m p a n y s p ro je c ts
(o r assets) th e b e ta o f th e c o m p a n y s assets w o u ld be eq u a l to th e b e ta o f its shares.
In p ra c tic e , th e v a s t m a jo r it y o f c o m p a n ie s use d e b t fin a n c e as w e ll as e q u ity . T his increases th e b e ta
o f e q u ity because s h a re h o ld e rs o f le v e re d co m p a n ie s face fin a n c ia l r is k as w e ll as b u sin e ss ris k . I n th e
absence o f taxes, th e b e ta o f a c o m p a n y s assets w o u ld be e q u a l to th e w e ig h te d average o f th e b e ta s o f
its e q u ity a n d it s d e b t. W h ile e q u ity b e ta s are r o u tin e ly e s tim a te d u s in g d a ta o n share m a rk e t re tu rn s ,
th is is n o t th e case f o r d e b t. I n A u s tra lia , m o s t c o rp o ra te d e b t is e ith e r n o t lis te d o n a s to c k exchange
or, a t b e st, tra d e d irre g u la rly , a n d i t is th e re fo re v e ry d iff ic u lt to e s tim a te th e b e ta o f d e b t. M o re o v e r, in
p ra ctice , th e re la tio n s h ip b e tw e e n s e c u rity b e ta s a n d asset be ta s can be m o re c o m p lic a te d th a n i t is in
th e n o -ta x case.
In s u m m a ry , th e d ire c t use o f th e C A P M to e s tim a te th e co st o f c a p ita l in v o lv e s tw o m a in p ro b le m s .
F irs t, th e re is th e p ro b le m o f th e lim it e d a v a ila b ility o f d a ta to e s tim a te be tas o f d e b t. Second, care is
needed to e n sure t h a t ta x a n d leverage e ffe cts are h a n d le d c o rre c tly . These p ro b le m s m e a n t h a t th e
d ire c t use o f th e C A P M is g e n e ra lly n o t fea sible. H o w e ve r, th is does n o t m e a n t h a t th e m o d e l s h o u ld be
disreg arde d. The C A P M can be v e ry u s e fu l in e s tim a tin g som e c o m p o n e n ts o f th e w e ig h te d average cost
o f ca p ita l.
A B usiness finance
1 4 .4 .2 1 The weighted average cost of capital (WACC)

In S e c tio n 14 .2, w e em phasise th e p rin c ip le t h a t th e co st o f c a p ita l is p ro je c t-s p e c ific . In o th e r w o rd s,
e v a lu a tio n o f a p ro p o s e d p ro je c t s h o u ld be based o n th e p ro je c ts co st o f c a p ita l. H o w e ve r, i t can be v e ry
LEARNING
d iff ic u lt to m ea sure a p ro je c ts cost o f c a p ita l. T his is because w h e n a c o m p a n y raises c a p ita l, th e re is
OBJECTIVE 4
g e n e ra lly n o d ire c t lin k b e tw e e n th e re tu rn s to th e s u p p lie rs o f th e co m p a n y s c a p ita l a n d th e re tu rn s on
Understand why the
cost of capital for a in d iv id u a l p ro je c ts . F o r exa m ple, suppose t h a t a co m p a n y b o rro w s , u s in g an e x is tin g asset as s e c u rity , to
company is expressed p ro v id e th e cash f o r a n e w p ro je c t. The in te re s t ra te o n th e d e b t is not a v a lid m easure o f th e n e w p ro je c ts
as a weighted co st o f c a p ita l. The rea son is sim p le : th e in te re s t ra te o n th e d e b t depe nd s o n th e r is k o f th e co m p a n y
average of the costs of
a n d its e x is tin g assets, a n d does n o t d e p e n d s o le ly o n th e r is k o f th e n e w p ro je c t. The s itu a tio n is s im ila r
all of the company's
i f a c o m p a n y m akes a share issue to raise th e cash needed f o r a n e w p ro je c t. S h a re h o ld e rs are exposed
sources of capital
to th e r is k o f th e w h o le com pany. T h e re fo re , th e co st o f e q u ity w ill d e p e n d o n th e average r is k o f a ll
th e c o m p a n y s assets a n d o n its fin a n c ia l leverage, n o t ju s t o n th e c h a ra c te ris tic s o f th e n e w p ro je c t. In
s u m m a ry , th e rates o f r e tu r n to th e s u p p lie rs o f a c o m p a n y s c a p ita l do n o t n e ce ssa rily re fle c t th e cost o f
c a p ita l t h a t is a p p lica b le to a n y in d iv id u a l p ro je c t, even i f th e n e w c a p ita l is ra ise d a t th e tim e th e p ro je c t
is im p le m e n te d .
H o w e ve r, th e re is an im p o r t a n t s pe cia l case t h a t o fte n p ro v id e s a p ra c tic a l s o lu tio n to these p ro b le m s .
Suppose t h a t a c o m p a n y s assets are a ll o f s im ila r r is k a n d t h a t th e r is k o f th e p ro p o s e d p ro je c t is th e same
as th e r is k o f th e c o m p a n y s e x is tin g assets. T his s h o u ld be th e case i f th e p ro je c t is s im p ly an e x p a n s io n
o f th e c o m p a n y s e x is tin g o p e ra tio n s . Since th e re is n o change in ris k , th e co st o f c a p ita l f o r th e c o m p a n y
as a w h o le s h o u ld also be a v a lid m easure o f th e co st o f c a p ita l f o r th e n e w p ro je c t.
The company cost of capital is d e fin e d as th e d is c o u n t ra te t h a t equates th e p re s e n t v a lu e o f a co m p a n y s
e xp ected f u tu r e cash flo w s to th e c o m p a n y s value. To m a ke th is d e fin itio n u s e fu l i t is necessary to d e fin e
b o th cash flow s* a n d V a lu e 1. The value o f a co m p a n y is th e m a rk e t va lu e o f its e q u ity p lu s th e m a rk e t
va lu e o f it s d e b t. H o w e ve r, th is d e fin itio n o f va lu e can be c o m b in e d w it h several d e fin itio n s o f cash flow,
le a d in g to d iffe re n t v e rs io n s o f th e co st o f c a p ita l. F o r exa m p le , cash flo w s can be m e a su re d b e fo re ta x o r
a fte r ta x . W e use a fte r-ta x cash flo w s , d e fin e d as b e in g e q u a l to th e b e fo re -ta x cash flo w s m u ltip lie d b y
( l - t e), w h e re teis th e effective co m p a n y in c o m e ta x ra te . The e ffe c tiv e c o m p a n y in c o m e ta x ra te is t c( l - y ),
w h e re tc is th e s ta tu to r y co m p a n y in c o m e ta x ra te a n d y is th e p r o p o r tio n o f th e ta x c o lle c te d fr o m th e
co m p a n y t h a t is c la im e d as a c re d it b y s h a re h o ld e rs. F o r e xa m p le , i f th e b e fo re -ta x cash flo w is $1 m illio n ,
th e s ta tu to r y co m p a n y in c o m e ta x ra te is 3 0 cen ts in th e d o lla r, a n d 60 p e r c e n t o f th e ta x c o lle c te d fr o m
th e c o m p a n y is c la im e d as a c re d it b y sh a re h o ld e rs, th e n th e e ffe c tiv e c o m p a n y ta x ra te is 0 .3 0 (1 - 0 . 6 ) =
0 .1 2 a n d th e a fte r-c o m p a n y -ta x cash flo w is $ 1 0 0 0 0 0 0 x (1 - 0 .1 2 ) = $ 8 8 0 00 0.
WEIGHTED AVERAGE W h e n n e t cash flo w s are d e fin e d in th is way, a c o m p a n y s w e ig h ted a verage c o st o f capital (W ACC)
COST OF CAPITAL
can be fo u n d as fo llo w s . C o n s id e r a c o m p a n y t h a t has fin a n c e d its assets u s in g b o th d e b t a n d e q u ity
(WACC)
fin a n ce . The c o m p a n y s cost o f c a p ita l is th e m in im u m ra te o f r e tu r n t h a t i t needs to e a rn o n its assets in
the cost of capital
determined by the o rd e r to m e e t th e c ost o f d e b t fin a n c e a n d p ro v id e th e ra te o f r e t u r n t h a t s h a re h o ld e rs re q u ire . To s im p lify
weighted average m a tte rs , assum e t h a t th e c o m p a n y s n e t o p e ra tin g cash flo w s re m a in c o n s ta n t in p e rp e tu ity . In th is case,
cost of all sources of th e a n n u a l in te re s t cost o f th e c o m p a n y s d e b t is:
finance
In te re s t ra te (a fte r ta x ) x m a rk e t v a lu e o f d e b t
= A:f/(1 - g x D
w h e re kd = lenders* re q u ire d ra te o f r e t u r n — t h a t is, th e cost o f d e b t

te= th e e ffe c tiv e co m p a n y in c o m e ta x ra te
D = th e m a rk e t v a lu e o f th e co m p a n y s d e b t
If tc = 30 cen ts in th e d o lla r a n d y = 0.6 0, th e n te = 0 .1 2 . T hen i f kd = 10 p e r c e n t p e r a n n u m
and D = $ 1 0 m illio n , th e a n n u a l in te re s t cost o f th e c o m p a n y s d e b t is:
0.1 x ( 1 - 0 . 1 2 ) x $100 00 000
= $880000
S im ila rly , th e m in im u m n e t cash flo w re q u ire d b y s h a re h o ld e rs is:

R e q u ire d ra te o f r e tu r n o n e q u ity x m a rk e t v a lu e o f e q u ity
= kex E
w h e re /ce = s h a re h o ld e rs ’ re q u ire d ra te o f r e t u r n — t h a t is, th e co st o f e q u ity
E = th e m a rk e t v a lu e o f th e co m p a n y s e q u ity
F or exam ple, i f ke = 20 p e r c e n t p e r a n n u m a n d E = $10 m illio n , th e m in im u m cash flo w re q u ire d by

sha reh old ers is $2 m illio n p e r year.
To m e e t these re q u ire d ra te s o f re tu rn , th e c o m p a n y s m in im u m a n n u a l n e t o p e ra tin g cash flo w s
m u s t be:
k f i^ k d( \ - t e)D
Since w e assum e t h a t cash flo w s are c o n s ta n t in p e rp e tu ity , th e co m p a n y s co st o f c a p ita l kf is s im p ly th e
a n n u a l n e t o p e ra tin g cash flo w d iv id e d b y th e to t a l m a rk e t va lu e o f th e c o m p a n y — t h a t is:
_ a n n u a l n e t o p e ra tin g cash flo w

to ta l m a rk e t v a lu e o f c o m p a n y
keE + ^ ( 1 —te)D
E+D
E D
= ke + - te)
.e T d . .E+D .
'E D
ke + ^ (1 - te) 4.2
V. V.
w h ere V =E+D
= t h e t o ta l m a rk e t v a lu e o f th e c o m p a n y
F or exa m ple, i f kd = 10 p e r c e n t p e r a n n u m , tc = 30 ce n ts in th e d o lla r, y = 0 .6 0 , D = $ 1 0 m illio n ,
ke= 20 p e r ce n t p e r a n n u m a n d E = $1 0 m illio n , th e c o m p a n y s cost o f c a p ita l kr is:
10
kf = {0.2) ^ + ( 0 .1 0 ) ( 1 - 0 .1 2 )
20
= 0.10 + 0.044
= 0 . 1 4 4 o r 14.4% p e r a n n u m
E q u a tio n 14 .2 show s t h a t a co m p a n y s co st o f c a p ita l can be expressed as a w e ig h te d average o f th e

costs o f its e q u ity a n d d e b t. O u r d e riv a tio n o f E q u a tio n 1 4 .2 sho w s t h a t th e c o n ce p t u n d e rly in g th e
W ACC fo rm u la is th a t, to be acceptable, a n e w p ro je c t s h o u ld g e ne rate n e t cash flo w s t h a t are s u ffic ie n t to
m ee t th e a fte r-ta x co st o f d e b t used to fin a n c e th e p ro je c t, as w e ll as p ro v id e a t le a s t th e re q u ire d ra te o f
re tu rn o n th e e q u ity used to fin a n c e th e p ro je c t.
E q u a tio n 14.2, w h ic h w e use f o r th e v a lu a tio n o f co m p a n ie s a n d p ro je c ts u n d e r th e im p u ta tio n ta x
system , is also d e riv e d in A p p e n d ix 1 4 .1 , w h e re i t appears as E q u a tio n A 1 4 .7 . The v a lu a tio n ap p ro a ch
we a d o p t, w h ic h in v o lv e s u s in g an e ffe c tiv e c o m p a n y ta x ra te in th e c a lc u la tio n o f th e cash flo w s a n d th e
w e ig h te d average cost o f c a p ita l, is c o n s is te n t w it h th e m e th o d d e riv e d b y M o n k h o u s e (1 9 9 6 ).3
Estimation of the cost of capital:

an extended example LEARNING
OBJECTIVE 5
E q u a tio n 14 .2 sho w s t h a t a c o m p a n y s a fte r-ta x cost o f c a p ita l is eq u a l to th e w e ig h te d average o f th e Estimate the cost of
costs o f d e b t a n d e q u ity , w h e re th e cost o f each in d iv id u a l source o f c a p ita l is w e ig h te d a c c o rd in g to its each source of capital
p ro p o rtio n in th e c o m p a n y s c a p ita l s tru c tu re . W h ile th e W ACC has b e e n e x p la in e d a s s u m in g t h a t th e re and combine these
are o n ly tw o classes o f c a p ita l, n a m e ly e q u ity a n d d e b t, in re a lity a c o m p a n y m a y issue d iffe re n t classes o f costs into a weighted
average cost of capital
shares, as w e ll as d iffe re n t classes o f d e b t. These a d d itio n a l classes o f c a p ita l can be h a n d le d b y e x te n d in g
for a company
E q u a tio n 14 .2 to in c lu d e a ll sources o f fin a n c e used b y th e com p an y. C o n se q u e n tly, e s tim a tio n o f th e
W ACC re q u ire s th e e s tim a tio n o f each v a ria b le in E q u a tio n 1 4 .2 i f o n ly one class o f d e b t a n d e q u ity is
em p lo yed, o r an e x te n d e d v e rs io n o f i t i f m o re th a n one class o f d e b t a n d e q u ity is e m p lo ye d .
To e s tim a te th e cost o f c a p ita l i t is necessary to e s tim a te th e cost o f each source o f fin a n c e a n d th e
p r o p o r tio n o f each source o f fin a n c e in th e co m p a n y s c a p ita l s tru c tu re . Since we are e s tim a tin g a cost o f
c a p ita l based on in ve sto rs* e x p e c ta tio n s o f fu tu r e re tu rn s , i t is im p o r t a n t to use c u rre n t m a rk e t rates a n d
c u rre n t m a rk e t values, ra th e r th a n h is to ric a l rates a n d b o o k values.
3 Monkhouse showed that the approach he derived is applicable to non-uniform cash flow streams of finite duration.
B usiness finance
Fixed-interest debt may be used as an example to explain why current m arket rates, rather than
historical rates, m ust be used in estimating the cost o f capital. Suppose th a t a company has a loan
w ith a fixed interest rate o f 10 per cent per annum, b u t the current m arket rate on sim ilar loans is
15 per cent per annum. When estimating the company s cost o f capital, the current m arket rate o f
15 per cent should be used. This may appear to ignore the fact th a t the company is paying only 10 per
cent on its existing loan. Surely there m ust be some advantage in paying only 10 per cent instead o f
15 per cent? There is an advantage, but the company s shareholders have already received the benefit o f the
old, lower interest rate, and the current share price w ill take this into account. Investments to be made now
m ust be attractive in comparison w ith the current cost o f capital, and the old interest rate is irrelevant.
In the next fo ur sections, we discuss estim ation o f the individual components o f the WACC. Each
component is illustrated using the inform a tion on Tasman Industries Ltd (TIL). The discussion concludes
in Section 14.5.4 w ith an estimate o f the company s WACC as at 30 June 2015, using the components
calculated in the previous three sections. The sources o f finance used by T IL are shown in Table 14.1.
TABLE 14.1 Tasman Industries Ltd: selected balance sheet data as at

30 June 2015
S o u rce s o f fin a n c e B o o k v a lu e ($ m )
Commercial bills 20.000
Bank overdraft 7.368
Bonds 10.000
Preference shares, 8% 2.000
Ordinary shares: issued and paid up, 12 500 000 at 50 cents 6.250
TILs financial manager also has the follow ing inform ation:
a The commercial bills have a current interest rate (yield) o f 6.08 per cent per annum. The existing bills
mature on 31 August 2015 b u t w ill be replaced by a fu rth e r issue at th a t date,
b The interest rate on the bank overdraft is 9.5 per cent per annum, calculated daily and charged to
TIL’s account twice per year.
c There are 100 bonds, each w ith a face value o f $100 000 and a coupon interest rate o f 10 per cent per
annum, payable on 30 June and 31 December each year. The bonds w ill be redeemed at th e ir face
value on 30 June 2018. On 30 June 2015 the m arket value o f each bond was $102474.18.
d The preference shares are irredeemable, have a face value o f $2 and pay a dividend rate o f 8 per cent
per annum. Dividends are payable on 30 June and 31 December each year.4 On 30 June 2015, the
m arket price o f each preference share was $1.50.
e TIL pays dividends on its ordinary shares once per year on 30 June. The latest dividend was
17.5 cents, fu lly franked. On 30 June 2015, the m arket price o f each ordinary share was $4.20.
f The sta tu tory company income tax rate is 30 per cent.
14.5.1 | The cost of debt

Companies can raise debt from a variety o f sources. There are short-term and long-term sources o f debt,
and debt may be marketable or non-marketable. The overall cost o f debt fo r a company is a weighted
average o f the costs o f its individual sources o f debt. This weighted average cost w ill n ot be accurate i f the
individual costs are expressed inconsistently. For example, it would be inconsistent to average nom inal
interest rates th a t are based on different repayment frequencies. To ensure consistency, all costs o f debt
fo r T IL w ill be expressed as effective annual rates.
The after-tax cost o f debt is found by m u ltip lyin g the before-tax cost by (1 - te) t where te is the effective
company income tax rate. For example, i f the before-tax cost o f debt is 10 per cent per annum, the statutory
4 It is assumed for simplicity in this example that coupon interest payments are made on 30 June and 31 December, and that
preference dividends are also payable on 30 June and 31 December.
company income tax is 30 cents in the dollar, and the pro po rtio n o f tax collected from the company th a t is
claimed by shareholders is 0.60, then the effective company tax rate is 30(1 - 0.6) = 12 cents in the dollar
and the after-tax cost o f debt is 10(1 - 0.12) = 8.80 per cent per annum. This calculation assumes th a t the
company is operating p rofitably and th a t there is no tim e lag in the payment o f company income tax. The
calculation is the same fo r each item o f debt and is reflected in Equation 14.2. Therefore, in this example
the annual interest rates applicable to the individual sources o f debt finance w ill be stated as before-tax
rates and the conversion to an after-tax cost o f debt w ill be made in the final WACC calculation.
For convenience, debt may be classified as shown in Table 14.2.
TABLE 14.2 Types of debt

S h o rt-te rm d e b t ; L o n g -te rm d e b t
Marketable Commercial paper Bonds
Commercial bills Debentures
Unsecured notes
Floating-rate notes
Non-marketable Accounts payable Mortgage loans
Bank overdraft Finance leases
Money market loans Term loans
Cost of short-term debt

Short-term debt securities, such as commercial bills and commercial paper, are marketable, and current
interest rates are quoted in the financial press.5 From these quotations the current effective annual
interest rate on marketable debt can be calculated. In the case o f TILs commercial bills, the quoted
interest rate is 6.08 per cent per annum. The m arket conventions are to quote nom inal annual rates and
to use simple interest fo r short-term securities. In calculating the effective annual interest rate on the
bills, the firs t step is to convert the nom inal rate o f 6.08 per cent per annum to the effective rate z fo r the
62 days from 30 June to 31 August. Therefore:
on
i = 6.08 x —
365
= 1.032 767%
The second step is to convert this rate to an annual rate as follows:
= (1.010327 67)5-8871 - !
=0.062 355
Therefore, the rate applicable to bills issued by T IL is approxim ately 6.24 per cent per annum
before tax.
To calculate the WACC it is also necessary to know the m arket value o f debt, which can be found using
the nom inal interest rate. Therefore, fo r a commercial b ill or commercial paper:
14.3
where P = current m arket price o f the security

F = face value o f the security
; = nom inal interest rate per annum
t = the number o f days from the date o f price calculation to the m a tu rity date
5 Details of these securities are provided in Chapter 10.

B usiness finance
For TILs commercial bills, the m arket value at 30 June 2015 is:
$20 000 000

62
1 + 0.0608 x
365
$19 795 558
The cost o f non-marketable interest-bearing debt, such as a bank overdraft, w ill be its current interest
rate, converted i f necessary to an effective annual rate. The interest rate on TILs overdraft is 9.5 per cent
per annum or 4.75 per cent per half-year. Therefore, the effective annual rate is:
(1.0475)2 - 1
=0.097256
That is, the rate applicable to the bank overdraft is approximately 9.73 per cent per annum before tax.
O ther form s o f non-marketable short-term debt such as taxes payable, wages payable and accounts payable,
which do n ot have an explicit interest cost, should be excluded. The reason is not th a t these forms o f debt
are ‘free ’；rather, th e ir costs are accounted fo r in other ways. For example, the cost o f trade credit (the
difference between the price o f goods purchased w ith cash on delivery and the price when purchased on
credit) has already been deducted in calculating the cash flows. Therefore, accounts payable do n ot have to
be serviced out o f those cash flows; to include accounts payable as a source o f finance would be inconsistent.
Cost of long-term debt

Some form s o f long-term debt, such as debentures, unsecured notes and corporate bonds, are marketable.
We use the term 'bonds1to refer to these long-term debt securities. Given a current m arket price, P, the
effective interest rate on a company s bonds is equal to the discount rate th a t equates the m arket price of
the bond w ith the discounted value o f the cash flows promised under the terms o f the bond. M ost bonds
pay interest twice a year, and the price o f such a bond on a coupon payment date is given by:
'j 1 14.4
(1 + 0 " .
where P = current m arket price o f the bonds

z = the effective interest rate per half-year
. Fj
R = interest payments = —, where F = face value o f the bonds, and ; = nom inal interest rate per
annum
C = redem ption price o f the bonds
n = num ber o f future interest payments
Equation 14.4 can be used to calculate the effective interest rate per half-year and i t is then a simple
m atter to calculate the annual rate.
The logic o f Equation 14.4 can be explained using the bonds issued by T IL as an example. On 30
June 2015, a T IL bond was sold fo r $102474.18. The term s o f the bond were as follows: face value, F,
is $100000; nom inal interest r a t e , i s 10 per cent per annum payable on 30 June and 31 December
each year; redem ption price, C, is $100000; and m a tu rity date is 30 June 2018. Therefore, each interest
payment, R, is equal to ($100 000)(0.10/2) = $5000. There are six interest payments to be made, the firs t
on 31 December 2015, then tw o in each o f the years 2016 and 2017 and the last on 30 June 2018.6 The
redem ption price is a lum p sum payable in exactly 6 half-years’ tim e. A t a yield (or required rate o f return)
o f i per half-year, the value o f the bond calculated as at 30 June 2015 is given by:
(Present value o f the interest payments) + (present value o f the lum p sum)
$5000 r _____1 _ $100 000

i [ 一（
1 + /)6 (1 + i f
Therefore:
\ $5000 $100 000 ]
$102 474.18 [i 1
l (1 + /)6 ^ (1 + 0 6 1
6 These six payments comprise an ordinary annuity. See Section 3.6.2 for an explanation of the valuation of an ordinary annuity.
As noted in Section 4.2, equations o f this type cannot be solved directly fo r i b u t the required value for
z can be found by other methods. In this case, i equals 0.0452. This is shown as follows:
\ $5000 1 $100 000 ]
[0.0452 (1.0452)6 1 (1.0452)”
$100 000
= < ($5000)(5.154 546) +
1.303 756
= {$ 2 5 772.73 + $76 701.45}
=$102 474.18
The required rate o f retu rn on this bond is therefore 4.52 per cent per half-year. Converting this rate
to an effective annual rate gives a rate equal to:
(1.0452)2 - 1 = 0.092 443
Therefore, the rate applicable to TILs bonds is approximately 9.24 per cent per annum before tax.
Where a fixed-interest debt contract, such as a mortgage, is n ot marketable, the current cost o f the
debt cannot be measured in the way described fo r bonds. The best measure o f the current cost in this case
is an estimate o f the interest rate th a t the company would now have to pay to raise mortgage funds on
conditions th a t match those o f the existing mortgage.
1 4 .5 .2 1 The cost of preference shares

Preference shares have attributes o f b oth debt and equity. As explained in Section 10.8.3, i t is usual fo r
irredeemable preference shares to be cumulative and non-participating. Such preference shares pay a fixed
dividend per share, Dp, at regular tim e intervals. Although the payment o f a preference dividend is at the
discretion o f the Board o f Directors, it is unusual to o m it payment. As a result, preference dividends form
a perpetuity, and fo r a share th a t pays dividends twice a year, the share price on a preference dividend
payment date is given by:
p = \ ^ 14.5
• i
where P = current m arket price o f preference shares
i = effective yield per half-year
Dp = half-yearly preference dividend per share
For TILs preference shares the m arket price was $1.50 on 30 June 2015 and the next dividend o f 8
cents per share is due on 31 December. Therefore:
$ 1 .5 0 = ^ "
. i .
In this case, z = 0.053 33, so the effective annual cost o f the preference shares, k f is:
kp = (1.053 33)2 - l
=0.109511
Therefore, the rate applicable to TILs irredeemable preference shares is approximately 10.95 per cent
per annum after company tax.
I f the preference shares are redeemable on a predetermined date, the calculation o f the cost o f
preference shares is the same as the calculation o f the effective interest rate on debt. However, preference
dividends are generally a d istrib u tio n o f p ro fit rather than a tax-deductible expense. Thus, certain
preference shares may carry franked dividends, and th e ir cost can be calculated using the procedures
outlined fo r ordinary shares.
1 4 .5 .3 1 The cost of ordinary shares

In contrast to debt, ordinary shares issued by a company do n ot involve a contractual obligation to
provide any specific return. Therefore, i t is necessary to estimate the rate o f retu rn th a t investors expect
the shares to provide in the future. One approach is to focus on the company s expected future dividend
stream and estimate the discount rate im plied by the current share price. This approach was discussed in
Section 4.3.2 and is summarised in Equation 14.6:
r _ f - E(Pt) 14.6
(1 + ke)'
where P〇= current share price

E(Dt) = expected dividend per share to be paid at tim e t
ke = required rate o f re tu rn — th a t is, the cost o f ordinary shares
The cu rre n t share price w ill be know n and, given an estimate o f expected fu tu re dividends, an
estimate o f the cost o f o rd in a ry shares can be derived. In e stim ating a company s fu tu re dividend
stream it is usual to make sim p lify in g assum ptions. For example, i f i t is assumed th a t the dividend
per share w ill grow at a constant rate, g, ind efin itely, th en as shown in Section 4.3.2, Equation 14.6
becomes:
A)(l +g)
P〇
ke —g
where D 〇= the current period’s dividend per share
DIVIDEND GROWTH The m odel expressed by Equation 14.7 is usually referred to as the d iv id e n d g ro w th m od el. To find
MODEL ke} Equation 14.7 may be rew ritten as:
model expressing
the value of a share A )(i+ g )
+ g
as the sum of the P〇
present values of
future dividends where TILs share price at 30 June 2015 was $4.20 and the latest annual dividend was 17.5 cents per share,
the dividends are fu lly franked. Since the dividend is fu lly franked, the 17.5 cent dividend carries a tax franking credit of
assumed to grow at a tc _
constant「 ate $0,175 x ------- . W ith a sta tu tory company income tax rate o f 30 per cent, this tax fran king credit is
$0,175 x = $0,075. This tax franking credit represents personal tax th a t has been paid by T IL on
behalf o f its shareholders and m ust be added to the cash dividend to give the after-com pany-tax dividend
D q. Therefore, D q is $0,175 + $0,075 = $0,250. I f the dividend grow th rate is estimated to be 8 per cent
per annum, then TILs cost o f equity can be calculated as follows:
柳 +g)
ke :
Pi)
$0.250(1.08)
+ 0.08
$4.20
0.1443
Therefore, the after-com pany-tax cost o f equity applicable to TILs ordinary shares is 14.43 per cent.
I t was shown in Section 4.3.2 th a t estimates o f current share price based on the dividend growth
model are extremely sensitive to estimates o f the future grow th rate in dividend per share. The same
problem arises when the model is used to estimate the cost o f equity. Therefore, while the model is
theoretically correct given its assumptions, the practical problems involved in its application mean that
the CAPM may be preferred. The CAPM describes the equilibrium relationship between systematic risk
(beta) and expected returns on risky assets, and can therefore be used to estimate the cost o f equity.
The im plem entation o f the CAPM is discussed in Section 7.6.3 and requires estim ation o f the risk-free
interest rate, Rf , the expected rate o f retu rn on the m arket p ortfo lio , E(RM ), and the systematic risk o f
equ ity, 汊 .
A fte r estimates o f the three variables have been prepared, the cost o f equity can be calculated using
Equation 14.1. As noted in Section 14.3, i f the expected retu rn on the market, E(RM) y is based on rates
o f return observed under the im p utatio n system, the observed rates should be adjusted by adding back a
franking prem ium ,!. This adjustm ent is needed to express the return on the m arket on an after-company-
tax basis. Over the period since the intro du ction o f the im p utatio n tax system in Australia in 1987 u n til
2010, Brailsford, Handley and Maheswaran (2012) provide an estimate o f the franking prem ium in the
order o f 1 per cent per annum. Therefore, Equation 14.1 becomes:
ke = R f+ f3e \Ê(Rm + t ) -
C hapter fourteen T he c o s t 〇 f capital
I f TILs financial manager has the follow ing estimates:

Rf：= 5% or 0.05
E(Rm) = 10% or 0.10
X = 1% or 0.01
then: < = 0 .05 + 1.2(0.10 + 0 .1-0.05 )

= 0.122 or 12.2%
1 4 .5 .4 1 The company's cost of capital

A fter the explicit cost o f each source o f funds has been calculated, they should be checked fo r consistency.
For example, the estimated cost o f ordinary shares should exceed the estimated cost o f preference shares,
which in tu rn should exceed the estimated cost o f debt. The company s cost o f capital may then be
calculated by applying the appropriate weights to the cost o f each source o f funds. The appropriate weights
are the p roportion th a t each source represents o f the to ta l sources used to finance proposed projects. I f
the company s capital structure is expected to change, the weights should be the proportions o f debt and
equity in the target capital structure. However, unless there is reason to believe th a t im plem enting new
projects w ill alter the companys optim al capital structure, its current capital structure can be used to
calculate the weights. The weights should be calculated using m arket values.
Debt
Recall that T IL has three classes o f debt comprising commercial bills, bonds and bank overdraft.
a The m arket value at 30 June 2015 o f T IL s commercial b ills was calculated previously to be
$19 795 558.
b Each TIL bond had a m arket value o f $102 474.18, so w ith 100 bonds on issue, th e ir to ta l m arket
value w ill be $10 247 418.
Bank overdrafts carry a variable interest rate, which is adjusted in accordance w ith fluctuations in
m arket rates. Therefore, the m arket value o f a bank overdraft w ill always equal its book value, which,
in this case, is $7 368 000. The data fo r TILs debt are summarised in Table 14.3.
The average cost o f debt fo r T IL is approximately 7.75 per cent before tax.
TABLE 14.3 Calculation of the weighted average cost of debt for TIL
Type o f d e b t M a r k e t v a lu e ($ ) P ro p o rtio n C o s t (%) W e ig h te d co st
Commercial bills 19 795 558 0.52914 6.24 3.30182
Bank overdraft 7368000 0.19695 9.73 1.91630
Bonds 10247418 0.27391 9.24 2.53097
37410976 7.74909
Equity
TIL also has two classes o f equity comprising preference shares and ordinary shares.
a The $2 preference shares issued by T IL have a book value o f $2 m illion , so i t is clear th a t there are
1 m illion shares outstanding. Since the share price at 30 June 2015 was $1.50, the to ta l market
value is $1500 000.
b There were 12 500 000 ordinary shares issued by TIL and the share price was $4.20, giving a m arket
value o f $52 500 000. The data fo r TILs equity are summarised in Table 14.4.
The average cost o f equity fo r T IL is approximately 12.17 per cent.

These weighted average costs o f debt and equity can then be combined to form a weighted average cost
o f capital fo r TIL using Equation 14.2. The to ta l value o f the company is equal to the m arket value o f debt
plus the market value o f equity, which fo r TIL is $37 410 976 + $54 000 000 = $91410 976.
TABLE 14.4 Calculation of the weighted average cost of equity for TIL
T ype o f e q u ity M a r k e t v a lu e ($ ) P ro p o rtio n C o s t (%) W e ig h te d cost
Preference shares 1500000 0.0278 10.95 0.30441
Ordinary shares 52500000 0.9722 12.20 11.86084
54000000 12.165 25
I f Equation 14.2 is used, then the effective company tax rate, te>m ust also be estimated, and this means
th a t the p ro po rtio n o f the tax collected from the company th a t is claimed as tax credits by shareholders,
y, m ust be estimated. As explained in Section 11.4.4, the value o f y depends on the company s dividend
policy and on the tax dass(es) o f its shareholders. Even i f a company adopts a policy o f paying the
m axim um possible franked dividends, it w ill be d iffic u lt to determine the appropriate value o f y in cases
where some o f the company s shares are held by resident taxpayers (fo r whom theoretically y equals 1)
and other shares are held by tax-exempt or non-resident investors (for whom theoretically y equals 0).
The value o f y should reflect the value o f tax credits to the m arginal (as d istin ct from average)
shareholder. As Officer (1994, p. 4) points out, i f there is a m arket fo r tax credits, the m arket price could
be used to estimate the value o f y fo r the m arginal investor. However, any m arket in tax credits is hidden,
so the ‘m arket price’ o f tax credits is usually estimated through dividend drop-off ratios. As discussed
in Section 11.4.4, these estimates are unfortunately subject to a large degree o f error. W hile Hathaway
and Officer (2004) and Walker and Partington (1999) both provide positive estimates fo r y, Cannavan,
Finn and Gray (2004) and Feuerherdt, Gray and Hall (2010) find th a t y may be zero. Beggs and Skeels
(2006) report evidence consistent w ith a zero value fo r y p rio r to the year 2000, when changes in the tax
system allowed fo r the refund o f unused franking credits— and a positive value fo r y subsequent to this
legislative change. For TIL we w ill assume th a t y equals 0.60, which means th a t w ith a sta tu tory company
income tax rate o f 30 cents in the dollar, the effective company tax rate, is 0.12.
Using Equation 14.2, the weighted average cost o f capital fo r T IL is:
D
kf = ke - + k(i{ \ - te)
V] V.
$54 000 000 $37410976
= 0.1217 + 0.0775(1 -0.1 2)
.$91 410976 .$91410976
= 0.099 805
or approximately 10 per cent after effective company tax.
14.5.51 Issue costs and the cost of capital

So far we have discussed the cost o f capital w ith o u t recognising th a t i f a company undertakes a new
project, i t may incur issue costs involved in raising new capital. These costs include underwriters* fees as
LEARNING
well as legal and adm inistration costs.
OBJECTIVE 6
Explain how to treat When evaluating a project, such costs should not be included in the cost o f capital. As we emphasised
issue costs in project in Section 14.2, the cost o f capital is an o p p o rtu n ity cost th a t depends on the risk o f the project in
evaluation which the capital is invested. I t does n o t depend on the source o f the funds. However, issue costs w ill be
incurred i f a project is undertaken and cannot be ignored. They m ust therefore be included in the cash
ISSUE COSTS
flows associated w ith the project. The incorporation o f issue costs into project evaluation is illustrated in
costs of raising new
capital by issuing
Example 14.2.
securities, including Note th a t the weighted average issue cost is used in Example 14.2 rather than the issue cost fo r debt
underwriting fees and or the issue cost fo r equity. It is incorrect to assume th a t one project w ill be financed by debt and hence
legal, accounting and w ill incur the issue costs fo r debt, while another project w ill be financed by equity and hence w ill incur the
printing expenses
issue costs fo r equity. I f a company is to m aintain its optim al or target capital structure, both debt and
incurred in preparing
a prospectus or other equity m ust be raised over tim e. It follows th a t all o f a company s projects are effectively financed by a
offer documents. Also po 〇r o f funds consisting o f both debt and equity, and all projects m ust be assumed to incur the weighted
known as flotation costs average issue costs.
E xample 14.2
TIL is evaluating a project that w ill require an initial investment of $ 10 million and w ill generate an
6
annual after-tax cash flow o f $2 million in perpetuity. The net present value of this project, ignoring
issue costs, is:
NPV = -$ 1 0 000 000 + $2 000 Q〇Q

0.10
=$10000000
W hat is the net present value of the project, after allowing for issue costs, if issue costs for equity,
fe, are 8 per cent and issue costs for debt, fd, are 2 per cent?
SOLUTION
Using the market value weights of TIL's outstanding securities, the weighted average issue cost, f。，
will be:
fa = rd
\v .
= 0.08 ( $54 000 0 0 0 N 0.02 $37410976、
•
,$91 4 10 97 6, ,$91 4 10 9 7 6 ,
=0.055 44
Therefore, in order to raise a net $ 10 million, TIL w ill need to issue securities worth
$ 10J)00^)00^ = $ i 0 5 8 6 9 4 0 . The net present value of the project, including issue costs, is:
$2 000000
NPV = -$ 1 0 5 8 6 9 4 0 +
0.10
= $ 94 13 060
In this case the project should still be undertaken even after issue costs have been included in the
cash flows.
14.6 Project and company cost

of capital LEARNING
OBJECTIVE 7
A company s cost o f capital, as calculated in the previous section, should be used as an estimate o f the
Understand the
cost o f capital fo r a new project only when certain conditions are met. These conditions follow from the distinction between
fact th a t all the variables in the WACC form ula apply to the company as a whole. Therefore, a company s the cost of capital
WACC w ill reflect the risk o f its existing projects. It follows th a t a company s WACC should only be applied for a project and a
to projects that are identical, apart from th e ir size, to the company s existing projects. company’s weighted
average cost of capital
The consequences o f using single discount rate to evaluate all projects are illustrated in Figure 14.1.
The broken line represents the cost o f capital kf fo r the company and the solid line represents the security
market line, which is simply the graphical representation o f the trade-off between risk and expected
return im plied by the CAPM. Assume th a t Eastfarmers Ltd is a diversified company th a t has m ultiple
divisions operating in different industrial sectors. Each year the heads o f each o f the divisions meet w ith
the senior management team o f the company to apply fo r funding fo r new projects. The head o f the retail
division puts forw ard a proposal to open up a new retail outlet in a grow th suburb while the head o f the
exploration division asks fo r funding to open up a new coal mine in Western Australia. The risk-re tu rn
coordinates fo r the two projects are denoted by the titles o f the divisions th a t suggested the project.
I f the company applies the single discount rate V to all projects, then the project suggested by the
retail division w ill be rejected. Its expected rate o f retu rn is less than k \ even though it is greater than
the required rate o f return consistent w ith its systematic risk_ th a t is ，爲 etail. Conversely, the project
suggested by the exploration division w ill be accepted. Its expected rate o f retu rn exceeds k \ even though
it is less than the required rate o f retu rn consistent w ith its systematic risk— th a t is , 爲 xploration.
B usiness finance
Applying a single discount rate, k\ to all projects
Exploration
5jdD3j
oso
u
e
r Systematic risk [fi] ^ E x p lo
Therefore, a likely consequence fo r a diversified company th a t uses a single discount rate is th a t it

w ill make incorrect investm ent decisions. It w ill accept some projects th a t have a negative expected net
present value, and reject some projects th a t have a positive expected net present value. Moreover, high-
systematic-risk divisions w ill fin d it comparatively easy to have th e ir proposed projects accepted, while
low-system atic-risk divisions w ill fin d it d iffic u lt to have th e ir proposed projects accepted. As a result, the
systematic risk o f the company w ill d rift upward over time. The low-system atic-risk divisions are likely to
stagnate snd m 冱y even be dosed down.
The company s cost o f capital is also based on its existing capital structure. I f the debt capacity o f a
new project differs from th a t o f the existing projects, then this difference could affect the projects cost o f
capital. Therefore, another condition is th a t WACC should be used only i f the new project is n o t expected
to change the company s optim al or target capital structure.
In principle, each proposed project should be valued using a discount rate appropriate fo r the risk o f
th a t particular project. Where a company s operations are in more than one in d u stry and these industries
differ in risk, the company s cost o f capital is unlikely to be appropriate fo r evaluating a new project in
any o f the individual industries, o r in another ind ustry that the company may plan to enter. However, the
company s cost o f capital should be appropriate fo r evaluating an expansion by a company th a t operates
in only one industry. Where a company has divisions in different industries b u t the assets w ith in each
division are reasonably u nifo rm in terms o f risk, i t is reasonable fo r management to calculate a cost o f
capital fo r each o f the company s divisions.
There are tw o approaches th a t are used to calculate the cost o f equity fo r divisions o f a company. These
approaches are the pure play* approach and the direct estim ation approach.
LEARNING
OBJECTIVE 8
14.6.1 I Calculating the cost of capital for divisions using the
Estimate the cost of 'pure play, approach
capital for a division
of a diversified The approach th a t is m ost commonly recommended fo r calculating the cost o f capital fo r a project or
company division relies on id e n tifyin g other companies th a t operate only in the same ind ustry as the proposed
PURE PLAY project or division (Fuller & Kerr 1981). Such companies are known as p u re plays. The steps fo r estim ating
company that operates the cost o f capital fo r a project or division using data fo r a pure-play company are as follows:
almost entirely in only
one industry or line of a Id e n tify a pure-play company w ith operations sim ilar to the proposed project,
business b Estimate the beta o f the pure-play company s equity.
Adjust the equity beta fo r financial leverage to obtain an estimate o f the pure-play company s asset
beta, which is the beta th a t the pure-play company would have i f i t were all-equity financed— th a t is,
the beta o f equity has been ‘unlevered’.
d ‘Relever’ the asset beta, based on the financial leverage o f the company th a t is considering the
project, to obtain an estimate o f the beta o f equity fo r the project,
e Use the CAPM to estimate the cost o f equity fo r the project.
Calculate the WACC o f the project using the target debt-equity ratio o f the company th a t is
considering the project.
As discussed in Section 14.4.1, in the absence o f taxes, the beta o f a company s assets is simply a
veighted average o f the betas o f its equity and its debt— th a t is:
E D
Pa = Pe + Pci
ID + E] VD + E.
where fia - the beta o f the company s assets
Pe = the beta o f the company s equity
Pd = the beta o f the company s debt
D = the m arket value o f debt
E = the m arket value o f equity
I f the company’s debt is assumed to be risk-free— th a t is, J3d = 0— then Equation 14.8 can be sim plified
and rearranged to give:7
D'
Pe = Pa
E_
This equation can be rearranged to give:
0e 14.10
Pa
i +l
This use o f the pure-play procedure is illustrated in Example 14.3.
The pure-play approach is used by some companies b ut i t involves conceptual and practical problems.
The conceptual problems concern the issue o f how best to adjust betas fo r financial leverage. The
adjustments used in Example 14.3 are only approximate because they are based on the sim plifying
E xample 14.3
P e rc o Parts Ltd h a s tw o d iv is io n s : o n e m a n u fa c tu re s c a r p a rts a n d th e o th e r d is trib u te s a g r ic u ltu r a l
6
m a c h in e ry . T he a g r ic u ltu r a l m a c h in e r y d iv is io n is c o n s id e r in g a n e x p a n s io n p ro je c t. P e rc o h a s a
ta r g e t d e b t - e q u it y r a t io o f 1 :3 th a t w ill n o t b e c h a n g e d b y th e n e w p ro je c t. P e rc o 's f in a n c ia l m a n a g e r
ha s id e n tifie d S ty le F a rm E q u ip m e n t Ltd a s a c o m p a n y w ith th e s a m e b u s in e s s ris k a s th e n e w p ro je c t.
S tyle F arm E q u ip m e n t h a s a d e b t - e q u it y r a tio o f 1 : 1 ; a n d its e q u ity h a s a b e ta o f 1 . 2 5 . T he ris k -fre e
in te re s t ra te is 9 p e r c e n t p e r a n n u m a n d th e ris k p re m iu m fo r th e m a rk e t p o r tf o lio is e s tim a te d to b e
8 p e r c e n t p e r a n n u m . It is a ls o a s s u m e d th a t P e rc o c a n b o r r o w a t th e ris k -fre e in te re s t ra te o f 9 p e r
c e n t, th a t th e s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 p e r c e n t a n d th a t th e p r o p o r tio n o f th e ta x
c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 , g iv in g a n e ffe c tiv e c o m p a n y ta x
ra te o f 1 2 p e r c e n t.
T he p ro c e d u re o u tlin e d a b o v e re q u ire s a r e la tio n s h ip b e tw e e n e q u ity b e ta s a n d a s s e t b e ta s .
E q u a tio n s 1 4 . 9 a n d 1 4 .1 0 m a y b e u se d to e s tim a te a n a s s e t b e ta a n d th e c o s t o f c a p it a l f o r P e rc o ’s
a g r ic u ltu r a l e q u ip m e n t p r o je c t. T h e firs t s te p is to use E q u a tio n 1 4 . 1 0 to c a lc u la te th e b e ta o f S tyle
F arm E q u ip m e n t’s assets:
=0.625
continued
7 The conditions under which various relationships between the betas of a company's equity and its assets apply are discussed
by Taggart (1991).
continued
N e x t, E q u a tio n 1 4 . 9 is u se d to c a lc u la te th e b e ta o f e q u ity fo r th e p ro je c t:
p e = 0.625 h + 1
L 3J
= 0.8333
T h a t is, th e b e ta f o r th e e q u ity p r o p o r tio n o f P e rc o 's p r o p o s e d in v e s tm e n t is e s tim a te d to b e
a p p r o x im a t e ly 0 . 8 3 3 . T he c o s t o f e q u ity fo r th e p r o je c t c a n n o w b e e s tim a te d u s in g th e C A P M . The
c o s t o f e q u ity is c a lc u la te d a s fo llo w s :
ke = R f+ P e [E[Rm + t) - /?^]
= 0.09 + 0.833(0.08)
= 0.15667
T h e p r o je c t's W A C C c a n n o w b e c a lc u la te d a s:
E
k’ = ke M 1- ^ )
LVJ
0.15667 -0.09(1 -0.12)
0.137303
T h e re fo re , b a s e d o n th e p u r e - p la y a p p r o a c h , th e a p p r o p r ia te d is c o u n t ra te fo r P e rc o P a rts' fin a n c ia l
m a n a g e r to use w h e n e v a lu a tin g th e p r o p o s e d p r o je c t is 1 3 . 7 3 p e r c e n t.
assumption th a t corporate debt is risk-free. Other, more complex, models have been suggested, but
such models are generally based on a specific theory o f capital structure. Also, the appropriate leverage
adjustm ent depends on the company s capital structure policy.8 The m ain practical problem is th a t pure-
play companies are rare. Even i f some pure-play companies are available, relying only on data from such
companies means th a t a great deal o f inform a tion from diversified companies is ignored.
1 4 .6 .2 1 Calculating the cost of capital for divisions using

the direct estimation approach
An alternative approach th a t overcomes the problems associated w ith the pure-play approach is the direct
estim ation approach outlined by Harris, O’Brien and Wakeman (1989). This approach involves estimating,
directly, divisional weighted average costs o f capital. I t is assumed th a t a diversified company s WACC is
itse lf a weighted average o f the WACCs o f its divisions, where the weights are the values o f the divisions
as proportions o f the to ta l value o f the company— th a t is:
14.11
k' = w i k 'j
7=1
where V = the company cost o f capital
k '. = the cost o f capital fo r th e jth division
w- = the ratio o f the value o f the ;th division to the to ta l value o f the company
Equation 14.11 can be used to estimate divisional costs o f capital. The procedure is illustrated in
Example 14.4.
Example 14.4 shows th a t it is possible to in fe r divisional costs o f capital from inform a tion on
diversified companies, provided th a t the follow ing in fo rm a tio n is available:
a the WACC o f each company

b the ratio o f the value o f each division to to ta l company value fo r each company.*1
9
8 For example, the relationship between asset betas and equity betas depends on whether the debt associated with the project
is assumed to be constant, or whether the debt is adjusted to maintain a constant debt-value ratio over time. See Taggart
(1991) and Conine and Tamarkin (1985). The taxation of capital gains is discussed in Section 11.4.2.
E xample 14.4
T h re e c o m p a n ie s — A , B a n d C — o p e r a te in t w o in d u s trie s , 1 a n d 2 . C o m p a n y A h a s 4 0 p e r c e n t o f its
assets in v e s te d in In d u s try 1 a n d 6 0 p e r c e n t in In d u s try 2 . F o r c o m p a n ie s B a n d C , th e p r o p o r tio n s a re
3 0 : 7 0 a n d 8 0 : 2 0 , re s p e c tiv e ly . T he co sts o f c a p it a l f o r c o m p a n ie s A , B a n d C h a v e b e e n e s tim a te d
to b e 1 5 .3 p e r c e n t, 1 5 . 8 5 p e r c e n t a n d 1 3 .1 p e r c e n t, re s p e c tiv e ly . U se th is in fo r m a tio n to e s tim a te
th e c o s t o f c a p it a l fo r d iv is io n s th a t o p e r a te in in d u s trie s 1 a n d 2 .
SOLUTION
It is a s s u m e d th a t th e risks, a n d th e re fo re th e c o sts o f c a p it a l, in a g iv e n in d u s try a r e th e sa m e fo r e a c h
c o m p a n y . E q u a tio n 1 4 .1 1 h o ld s fo r e a c h c o m p a n y , so it c a n b e w r itte n a s fo llo w s :
C om pany A: 0 . 1 5 3 = 0 .4 k "] + 0 . 6 / ^ 2
C o m p a n y B: 0 . 1 5 8 5 = 0 . 3 ^ ! + 0 .7 k /2
C om pany C: 0 • 13 1 = 0 .8 /c ^ + 0 . 2 / ^
A n y tw o o f th e s e e q u a tio n s c a n b e s o lv e d s im u lta n e o u s ly to g iv e ^ = 12% a n d 6 = 1 7 .5 % .
In practice, these variables w ill have to be estimated, which means th a t the estimates w ill involve
some degree o f error. Consequently, it w ill n ot be possible to fin d an exact analytical solution fo r the
divisional costs o f capital. This problem can be overcome by using regression to estimate these costs. For
this purpose Equation 14.11 is w ritte n as:
V = a 1w 1 + a2w2 + ... + anwn + e
where e = an error term w ith a mean o f zero
In this regression, each company s cost o f capital is one observation o f the dependent variable and
each company s division weights are the corresponding measures o f the independent variables to wn.
The regression coefficients al to an are estimates o f the costs o f capital fo r industries 1 to n. The estimate
for a given industry can be used as a measure o f the divisional cost o f capital fo r all companies th a t operate
in that industry, w ith o u t any adjustm ent fo r financial leverage. This does n ot mean th a t differences in
leverage are ignored. Rather, i f different industries have different debt capacities and these differences
affect the cost o f capital, then such effects should automatically be reflected in the cost o f capital
estimates. This is one significant advantage compared w ith the pure-play approach. Another advantage is
flexibility. For example, to estimate the company WACCs there is no need to employ any particular model
such as the CAPM. O ther models such as the dividend grow th model can be used to estimate the cost o f
equity as a component o f the WACC. On the other hand, the divisional weights w- m ust be estimated fo r
each company. In theory, these weights should be based on m arket values, which are typically unknown.
Therefore, in practice, the weights may be based on book values or, perhaps, divisional sales.
F in a n c e
INSIGHTS INTO W ACC ESTIMATION FROM THE
in A C T IO N
ENERGY INDUSTRY____________________________________________
In s ig h ts in to th e p r a c t ic a l is s u e s a s s o c ia te d w it h e s t im a tin g a c o m p a n y 's w e ig h t e d a v e r a g e
c o s t o f c a p it a l ( W A C C ) a r e p r o v id e d b y c o n s id e r in g w h a t h a p p e n s in th e h ig h ly r e g u la t e d
e n e r g y in d u s tr y . R e g u la rly , th e p e a k r e g u la t o r y b o d y f o r th is s e c to r, th e A u s t r a lia n E n e r g y
R e g u la to r (A E R ), m a k e s a d e t e r m in a t io n o f th e r a te o f r e tu r n t h a t e le c t r ic it y d is tr ib u to r s c a n
g e n e r a t e fr o m t h e ir a s s e ts , w h ic h in tu rn u ltim a t e ly d e te r m in e s th e p r ic e t h a t th e s e c o m p a n ie s
c a n c h a r g e f o r t h e ir s e r v ic e s . In th e p a s t, th is w a s a m u lti- s ta g e p r o c e s s t h a t in v o lv e d n u m e ro u s
s u b m is s io n s fr o m p o w e r d is tr ib u to r s — in e v it a b ly a r g u in g f o r h ig h e r re tu r n s b a s e d u p o n c u r r e n t
m a r k e t c o n d it io n s — a n d o t h e r in te r e s te d p a r tie s s u c h a s c o n s u m e r a d v o c a c y b o d ie s a r g u in g
th e o p p o s it e c a s e . A g r e a t d e a l o f tim e a n d re s o u rc e s w e r e s p e n t b y th e d if f e r e n t p a r tie s
a r g u in g o v e r fa c t o r s s u c h a s th e a p p r o p r ia t e m a r k e t ris k p r e m iu m o r th e v a lu e o f im p u t a t io n
c r e d its d e r iv e d b y th e s h a r e h o ld e r s o f th e p o w e r d is t r ib u t io n c o m p a n ie s (a s m e a s u r e d b y y a n d
d is c u s s e d in S e c tio n 1 4 . 3 ) . T h e s e d e c is io n s a r e e x t r e m e ly im p o r t a n t , a s a d if f e r e n c e in re tu rn s
continued
B usiness finance
continued
o f a s little a s o n e b a s is p o in t r e p r e s e n ts s ig n if ic a n t a m o u n ts o f m o n e y w h e n a p p l ie d to b illio n s
o f d o lla r s o f a s s e ts . In D e c e m b e r 2 0 1 3 , in a n e f f o r t t o s t r e a m lin e th e p r o c e s s w h ile p r o v id in g
e n h a n c e d 'r e g u la t o r y s t a b ilit y ' a n d ’ in c r e a s e d c e r t a in t y t h r o u g h g r e a t e r t r a n s p a r e n c y ’ ，th e A E R
is s u e d its R a te o f R e tu rn G u id e lin e t h a t sets o u t th e p r o c e s s t h a t it w i ll a p p l y in d e t e r m in in g th e
r a te o f r e tu r n t h a t e le c t r ic it y a n d g a s p r o v id e r s m a y e a r n fr o m t h e ir a s s e ts . F ig u r e 1 4 . 2 sets o u t
th e w a y in w h ic h th e W A C C f o r th e s e fir m s w i l l n o w b e c a lc u la t e d b y th e A E R .
Source: Australian Energy Regulator, Better Regulation: Rate of Return Guideline, 2013. Available at www.aer.gov.au.
14.7 The weighted average cost of capital

and alternative project evaluation
LEARNING
OBJECTIVE 9
Understand the
techniques
advantages and
I t has been emphasised th a t the weighted average cost o f capital (WACC) has im p o rta n t lim ita tion s. In
disadvantages of
using the weighted particular, it can only be estimated directly fo r a whole company, and a company s cost o f capital should
average cost of capital only be used to evaluate new projects th a t are identical to the company s existing operations. A nother
in project evaluation problem is th a t the WACC lends its e lf to m isinterpretation because i t makes debt appear to be cheaper
than equity. For example, in the T IL case discussed in Section 14.5, the cost o f equity was more than 11
per cent, b u t the cost o f debt was less than 8 per cent. An observer could easily jum p to the conclusion
th a t a company s cost o f capital could be reduced by increasing the p ro po rtio n o f debt in its capital
structure. That conclusion is likely to be incorrect because it ignores some im p o rta n t effects o f financial
leverage. First, i f leverage is increased, the risk o f the borrower defaulting w ill increase, and lenders w ill
demand higher interest rates. Second, as discussed in Section 12.3.2, the risk faced by shareholders w ill
also increase and the cost o f equity w ill increase. As a result o f these changes, the WACC could increase
rather than decrease. The WACC is designed as a tool to be used in evaluating investm ent decisions. I t can
give misleading results i f attem pts are made to use it to analyse financing decisions.
The adjusted present value (APV) m ethod is an alternative technique th a t calculates separately
the value created by a project and the value created by the financing decision. This technique involves
forecasting a projects after-tax cash flows assuming th a t the project is financed entirely by equity. The net
present value o f these cash flows is found by using the rate o f retu rn th a t w ould be required by investors
i f the project were financed entirely by equity. Any value created by taxation effects associated w ith debt
financing may then be added to obtain the to ta l value created by undertaking the project. Similarly, the
value o f any government subsidies th a t may be offered to the company to undertake the project may be
added to the total value.9
Another lim ita tio n o f the WACC approach to project evaluation is th a t it only includes cash flows
directly associated w ith the project. I t does n ot include strategic options th a t may be associated w ith
the project. These options include the possibility o f reducing or expanding the scale o f the project,
or abandoning the project entirely. A nother option m ight be to w ait before investing. Section 18.8.6
discusses how option pricing models may be used to incorporate these options into project evaluation.
Despite its lim itations, the WACC also has considerable strengths, including fle x ib ility and relative
simplicity. It is flexible in th a t there are different versions o f the WACC, each o f which is correct provided
that it is used in conjunction w ith the appropriate defin itio n o f net cash flows. It is also conceptually
easier to understand than alternative project evaluation techniques and is the m ost widely used.
14.8 Using certainty equivalents to allow

for risk LEARNING
OBJECTIVE 10
In most cases, risky projects are evaluated by using a cost o f capital th a t reflects the risk o f the project—
Understand the
that is, the projects expected cash flows are discounted using a risk-adjusted discount rate. Using this application of
approach, the net present value, NPV, is calculated as follows: the certainty-
equivalent method of
A E(Ct) 14.12 incorporating risk into
NPV-- - C 〇 + Z ^ 77—Tv
t= \ I1+ project evaluation
where E(Ct) = the expected net cash flow in year t

k = the cost o f capital, appropriate to the risky expected cash flows £(Ct)
C〇= the in itia l cash outlay
77 = the life o f the project, in years
The c e rta in ty -e q u iv a le n t approach is an alternative m ethod o f incorporating risk into project CERTAINTY-EQUIVALENT
evaluation. This approach incorporates risk into the analysis by adjusting the cash flows rather than the approach that
incorporates risk by
discount rate— th a t is, each years expected net cash flow is converted to a certainty equivalent. The
adjusting the cash
certainty-equivalent net cash flow in year t, C*t i is the smallest certain cash flow th a t the decision maker flows rather than the
would be prepared to accept in exchange fo r the expected risky cash flow, E(Ct ). For example, assume discount rate
that a projects risky net cash flow is $10 000 at the end o f the firs t year. I f the decision maker is prepared
to exchange the claim to th is risky cash flow fo r a claim to receive, w ith certainty, $8000 at the end
o f the firs t year, then $8000 is the certainty equivalent o f the risky $10000. In this example, =
$10 000 and CTt = $8000 = $8000. Therefore, the expected net cash flow fo r any year can be converted to
its certainty equivalent as follows:
Ct = a tE(Ct)
14.13
where a t = the certainty-equivalent factor in year t
The certainty-equivalent factor in this example can be calculated as follows:
C； _ $8000
C^t 0.8
E(Ct) $10 000
Using the certainty-equivalent approach, the net present value is calculated by discounting the
certainty-equivalent net cash flow fo r each period at the appropriate risk-free interest rate:
NPv=c〇 + y t
14.14
9 The adjusted present value method was developed by Myers (1974). A detailed treatment is provided in Berk and DeMarzo
(2007, pp. 581-5). Details of how to adapt the technique for the dividend imputation system are provided in Monkhouse
(1997).
I f all variables are properly specified, the present value o f any future cash flow m ust be identical in
both the risk-adjusted discount-rate m ethod and the certainty-equivalent method. Therefore:
E(Q) = atE(Ct)
(1 + k)r _ (l+R f)'
/. Qt = -------- —
Jr 14.15
(1 + 冰
In Examples 14.5 and 14.6 we illustrate both methods. We then discuss th e ir relative m erits.
Example 14.5
C a s s ilis Ltd is c o n s id e r in g a n in v e s tm e n t in a n e w m a c h in e . T he m a c h in e w ill re q u ire a n in it ia l o u tla y
o f $ 1 0 0 0 0 0 a n d is e x p e c te d to g e n e r a te c a s h flo w s o f $ 5 0 0 0 0 , $ 4 0 0 0 0 a n d $ 5 0 0 0 0 a t th e e n d
o f Y e a rs 1, 2 a n d 3 , re s p e c tiv e ly . T he ris k -a d ju s te d d is c o u n t ra te is 1 2 p e r c e n t p e r a n n u m a n d th e
ris k -fre e in te re s t ra te is 8 p e r c e n t p e r a n n u m .
The net p re s e n t v a lu e u s in g th e ris k - a d ju s te d d is c o u n t r a te m e th o d is c a lc u la t e d u s in g
E q u a tio n 1 4 .1 2 :
N P V = $100000+ $50 000 + $4000° + $5000°

1.12 ( 1. 12)2 ( 1. 12)3
= -$100 000+ $44 643+ $31 888 + $35 589
=$12 120
F rom E q u a tio n 1 4 . 1 5 , th e c e r ta in ty - e q u iv a le n t f a c to r fo r e a c h y e a r is c a lc u la te d a s fo llo w s :
1.08
al = 0.964 28
U2
2
(1 0 8 )
a2 可 =0.929 85
( 1.121
(1.08)3
a3 = 0 .8 96 64
( 1. 12)3
U s in g th e se c e r ta in ty - e q u iv a le n t fa c to rs , th e n e t p re s e n t v a lu e c a n b e c a lc u la te d u s in g E q u a tio n
1 4 .1 4 :
N p y _ $1〇〇〇〇〇 ( 0.964 28($50 000) + 0.929 85($40000) + 0.896 64($50000)

1.08 (1.08)2 (1.08)3
= -$100 000 + $44 643 + $31888 + $35 589
= $12 120
T he n e t p re s e n t v a lu e s a re th e s a m e a n d , o n th e fa c e o f it, th e re see m s to b e n o re a s o n fo r
p r e fe r r in g o n e m e th o d to th e o th e r.
However, remember th a t in discounting a future cash flow to a present value there are tw o factors to
be taken in to account: tim e and risk. These factors are logically separate but the risk-adjusted discount
rate approach requires the effect o f both to be incorporated in to the discount rate. In particular, use o f
a constant risk-adjusted discount rate implies th a t the risk associated w ith the project increases over
tim e at a constant rate. This was illustrated in Example 14.5, which showed th a t a constant risk-adjusted
discount rate results in the certainty-equivalent factors decreasing at a constant rate in each successive
year. In Example 14.5, the rate o f decrease is approximately 3.6 per cent per year. The fact that the
certainty-equivalent factors decrease at a constant rate over tim e is shown by Equation 14.15, which can
be rew ritten as:
l+ R f
Off = = (^\Y
. l + k
The decrease o f certainty-equivalent factors at a constant rate indicates th a t the cumulative risk
associated w ith each successive cash flow increases steadily as we look fu rth e r in to the future. In cases
where this risk pattern does n o t apply, a constant risk-adjusted discount rate should n o t be used, and the
certainty-equivalent approach offers practical advantages. This is illustrated in Example 14.6.
E xample 14.6
J a m e s o n Ltd h a s re c e n tly in v e n te d a n e w m e th o d o f s e p a r a tin g p re c io u s m e ta ls . F u rth e r d e v e lo p m e n t
6
w o r k is r e q u ire d o v e r th e n e x t 2 y e a rs a n d m a n a g e m e n t b e lie v e s th e re is a 6 0 p e r c e n t p r o b a b ilit y o f
th e n p r o c e e d in g to c o m m e r c ia l p r o d u c tio n u s in g p la n t c o s tin g $ 2 m illio n . E x p e c te d c a s h in flo w s a re
$ 5 0 0 0 0 0 p e r y e a r fo r 2 0 y e a rs . T h e re is a 4 0 p e r c e n t p r o b a b ilit y th a t th e d e v e lo p m e n t w o r k w ill
fa il, in w h ic h c a s e th e re w ill b e n o c a s h flo w s a fte r th e firs t 2 y e a rs . T he d e v e lo p m e n t w o r k w ill b e
u n d e rta k e n b y a lo c a l u n iv e rs ity re s e a rc h c o m p a n y in re tu rn f o r a n im m e d ia te p a y m e n t o f $ 2 5 0 0 0 0 .
S u p p o s e th a t, b e c a u s e o f th e h ig h ris k , m a n a g e m e n t e v a lu a te s th e p r o je c t u s in g a d is c o u n t ra te o f
3 0 p e r c e n t p e r a n n u m , c o m p a r e d w ith its n o rm a l ra te o f 1 5 p e r c e n t p e r a n n u m . T he e x p e c te d c a s h
flo w s a re :
Year 0 : PV o f o u tla y s o n d e v e lo p m e n t w o r k = - $ 2 5 0 0 0 0
Year 2 : C o n s tru c tio n o f p la n t: ( 0 .6 ) x ( - $ 2 0 0 0 0 0 0 ) + 0 . 4 x $ 0 = - $ 1 2 0 0 0 0 0
Y ea rs 3 - 2 2 : C a s h in flo w s : 0 . 6 x $ 5 0 0 0 0 0 + 0 . 4 x $ 0 = $ 3 0 0 0 0 0
(1.3)20
NPV= - $250 0 0 0 - ~ 0 + $300000
0.3 (1.3)2
= -$371 457
B a s e d o n th is re s u lt th e p r o je c t w o u ld b e r e je c te d n o w w ith o u t u n d e r ta k in g th e d e v e lo p m e n t w o r k .
H o w e v e r, m u c h o f th e ris k a s s o c ia te d w ith th e p r o je c t w ill b e re s o lv e d a fte r th e firs t 2 y e a rs . If th e
d e v e lo p m e n t w o r k is su c c e s s fu l, th e p r o je c t m a y b e o f n o rm a l ris k , in w h ic h c a s e th e fu tu re c a s h flo w s
w o u ld b e d is c o u n te d a t J a m e s o n 's n o r m a l ra te o f 1 5 p e r c e n t p e r a n n u m . A s s u m in g t h a t th e ris k -fre e
in te re s t ra te is 8 p e r c e n t p e r a n n u m , th e p r o je c t's N P V c a n b e r e c a lc u la te d u s in g a c o m b in a tio n o f
th e tw o a p p r o a c h e s .
If th e p r o je c t g o e s a h e a d a fte r th e 2 y e a r s 7 d e v e lo p m e n t w o r k , th e N P V a t th e e n d o f Y e a r 2 w ill b e :
(1.15)20
NPV[2) = -$2 000 000 + $500 000
0.15
=$1 129666
But th e re is o n ly a 6 0 p e r c e n t p r o b a b ilit y o f th is o u tc o m e . A s s u m in g a c e r ta in ty - e q u iv a le n t fa c to r
o f 0 . 6 , th e p r o je c t N P V is:
NPV= $250000+ 0 6 x $1 129666

(1.08)2
=$331104
T h e re fo re , th e p r o je c t s h o u ld p r o c e e d , w h ic h is th e o p p o s ite o f th e d e c is io n o r ig in a lly in d ic a te d b y
th e c o n s ta n t ris k -a d ju s te d d is c o u n t ra te .
To summarise, discounting risky future cash flows to present values requires adjustments fo r the
effects o f two factors: tim e and risk. In the risk-adjusted discount-rate approach the effects o f both
factors are included in the discount rate. The tw o factors are logically separate and are treated separately
in the certainty-equivalent approach, which is easier to use in cases where the risk per u n it o f tim e is not
constant.
B usiness finance
SUMMARY
• T his c h a p te r fo c u s e d o n th e e s tim a tio n a n d use o f • A ll th e v a r ia b le s in th e W A C C fo r m u la a p p ly to a
th e c o s t o f c a p it a l, w h ic h is im p o r ta n t in p r o je c t c o m p a n y a s a w h o le , so it fo llo w s th a t a c o m p a n y ’s
e v a lu a tio n . In v e s tin g in a p r o je c t w ill in c re a s e W A C C s h o u ld b e u se d as a n e s tim a te o f th e c o s t o f
c o m p a n y v a lu e o n ly if th e p r o je c t p ro m is e s a t le a s t c a p it a l o n ly f o r p ro je c ts th a t a r e id e n tic a l, e x c e p t
th e ra te o f re tu rn th a t in v e s to rs c a n e a rn o n o th e r fo r s c a le , to th e e x is tin g c o m p a n y . In p a r tic u la r , th is
in v e s tm e n ts o f th e s a m e ris k a s th e p ro je c t. T h e re fo re , m e a n s th a t:
th e r e q u ire d r a te o f re tu rn , o r c o s t o f c a p it a l, fo r a • th e p r o p o s e d p r o je c t ’s ris k s h o u ld b e th e s a m e
p r o je c t is a n o p p o r tu n it y c o s t th a t d e p e n d s o n th e a s th e a v e r a g e ris k o f th e c o m p a n y ’s e x is tin g
ris k o f th e p r o je c t in w h ic h th e c a p it a l is in v e s te d . p ro je c ts
T h e C A P M c a n b e u s e d a s a fr a m e w o r k f o r m a k in g • a c c e p ta n c e o f th e p r o je c t w ill n o t c h a n g e th e
ris k a d ju s tm e n ts , and, a c c o r d in g to th is m o d e l, c o m p a n y 's o p tim a l c a p it a l s tru c tu re .
th e re le v a n t m e a s u re o f ris k fo r a n y p r o je c t is its • F o r a d iv e r s ifie d c o m p a n y , use o f a s in g le d is c o u n t
s y s te m a tic ris k (b e ta ). ra te f o r a ll p ro je c ts is lik e ly to re s u lt in in c o r r e c t
• T he c o s t o f c a p it a l c o u ld , in p r in c ip le , b e e s tim a te d in v e s tm e n t d e c is io n s . The cost of c a p it a l fo r a
b y d ir e c t use o f th e C A P M , b u t th is in v o lv e s p r a c tic a l d iv is io n o r a n in d iv id u a l p r o je c t c a n b e e s tim a te d
d iffic u ltie s r e la te d m a in ly to e s tim a tio n o f th e b e ta s if th e re a r e o th e r lis te d c o m p a n ie s ( 'p u r e p la y s ’ }
o f p ro je c ts . A lte r n a tiv e ly , th e c o s t o f c a p it a l f o r a w h o s e s o le o p e r a tio n s a r e o f th e s a m e s y s te m a tic
c o m p a n y c a n b e e x p re s s e d a s a w e ig h te d a v e r a g e ris k a s th e d iv is io n o r p ro je c t. If su ch a s u b s titu te
o f th e costs o f th e v a r io u s s o u rc e s o f c a p it a l u se d b y c o m p a n y c a n b e fo u n d , its W A C C c a n b e e s tim a te d
th e c o m p a n y . T h e w e ig h te d a v e r a g e c o s t o f c a p it a l a n d u s e d , p o s s ib ly w ith a n a d ju s tm e n t fo r fin a n c ia l
(W A C C ) a p p ro a c h is g e n e r a lly u se d in p ra c tic e . le v e ra g e , a s th e c o s t o f c a p it a l f o r th e d iv is io n o r
E s tim a tio n o f th e a fte r-ta x W A C C in v o lv e s e s tim a tio n p ro je c t.
o f e a c h te rm in th e e q u a tio n : • A lte r n a tiv e ly , d iv is io n a l c o sts of c a p it a l can be
e s tim a te d u s in g in fo r m a tio n o n d iv e r s ifie d c o m p a n ie s
= ke -h k^(l - te) ^ b y v ie w in g th e W A C C o f e a c h d iv e r s ifie d c o m p a n y
a s a w e ig h t e d a v e r a g e o f th e W A C C s o f its d iv is io n s .
T h e se e s tim a te s s h o u ld b e b a s e d o n c u rre n t m a rk e t T h is a p p r o a c h h a s s ig n ific a n t a d v a n ta g e s o v e r th e
ra te s a n d m a r k e t v a lu e s , n o t h is to ric a l ra te s a n d use o f p u r e - p la y c o m p a n ie s .
b o o k v a lu e s . • W e c o n c lu d e th a t w h ile th e W A C C h a s im p o r ta n t
The im p u ta tio n ta x system h a s im p lic a tio n s fo r th e a d v a n ta g e s , su ch a s f le x ib ility , it a ls o has som e
w a y th a t c a sh flo w s a n d th e c o s t o f c a p ita l sh o u ld im p o r ta n t lim ita tio n s th a t s h o u ld b e u n d e rs to o d b y
be d e fin e d and m e a s u re d , because o n ly p a rt its users.
o f th e ta x c o lle c te d fro m c o m p a n ie s is /tru e / c o m p a n y • We a ls o c o n c lu d e th a t th e c e r ta in ty - e q u iv a le n t
ta x . T his fe a tu re o f th e system can be re fle c te d a p p ro a c h , w h ic h in c o r p o r a te s ris k by a d ju s tin g
in p r o je c t e v a lu a tio n b y u s in g a n e ffe c tiv e c o m p a n y th e c a s h flo w s ra th e r th a n th e d is c o u n t ra te , m a y
ta x ra te in c a lc u la tin g b o th a fte r-ta x c a sh flo w s b e e a s ie r to use w h e r e ris k p e r u n it o f tim e is n o t
and th e c o s t o f c a p ita l. Rates o f re tu rn o b s e rv e d c o n s ta n t.
u n d e r th e im p u ta tio n ta x system a ls o re q u ire a d ju s tm e n t
if th e y a r e u se d to e s tim a te th e c o s t o f e q u ity .
KEY TERMS
c e rta in ty -e q u iv a le n t 437 issue costs 430
c o n s is te n c y p r in c ip le 418 o p p o r tu n ity co st 418
co s t o f c a p ita l 418 p u re p la y 432
d iv id e n d g ro w th m o d e l 428 w e ig h te d a v e r a g e co st o f c a p ita l (W A C C ) 422
fr a n k in g p re m iu m 421
CHAPTER FOURTEEN REVIEW

o SELF-TEST PROBLEMS
1 T he C a n b e r r a C o r p o r a t io n is c o n s id e r in g a n in v e s tm e n t in a n e w p r o je c t; it w ill in v o lv e a n in itia l
in v e s tm e n t o f $ 2 0 0 0 0 0 a n d is e x p e c te d to g e n e r a te a n e t c a s h in flo w o f $ 2 3 5 0 0 0 in 1 y e a r ’s tim e . T he
ris k -fre e in te re s t ra te is 1 2 p e r c e n t a n d th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio ( in c lu d in g th e f r a n k in g
p re m iu m ) is 1 8 p e r c e n t.
a) S h o u ld th e p r o je c t b e a c c e p te d if its s y s te m a tic ris k is e x p e c te d to b e 0 . 7 5 ?
b) W o u ld y o u r a n s w e r to (a) c h a n g e if th e p ro je c t's s y s te m a tic risk is e x p e c te d to b e 1 .0 ?
2 The E x p a n d o C o m p a n y h a s th re e n e w p ro je c ts th a t a r e b e in g e v a lu a te d . T he c o m p a n y 's W A C C is
e s tim a te d a t 1 4 . 6 p e r c e n t a fte r e ffe c tiv e c o m p a n y ta x . T he e x p e c te d a fte r-ta x re tu rn s a n d b e ta s o f th e
th re e p ro je c ts a r e a s fo llo w s :
I P ro je c t E x p e c te d re tu rn (%) B eta 1
M a rs 14.5 0.70
Pluto 15.0 0.85
Neptune 20.0 1.20
T he ris k -fre e in te re s t ra te is 9 p e r c e n t a n d th e e x p e c te d re tu rn o n th e m a rk e t p o r tf o lio ( in c lu d in g th e fr a n k in g

p re m iu m ) is 1 6 .5 p e r c e n t.
a) W h ic h o f th e p ro je c ts s h o u ld b e a c c e p te d ?
b) W o u ld a n y o f th e a c c e p t / r e je c t d e c is io n s c h a n g e if th e p ro je c ts w e re e v a lu a te d u s in g th e c o m p a n y c o s t
o f c a p ita l?
3 A c o m p a n y is c o n s id e r in g th e p u rc h a s e o f e q u ip m e n t c o s tin g $ 8 4 0 0 0 , w h ic h w ill p e r m it it to re d u c e its

e x is tin g la b o u r co sts b y $ 2 0 0 0 0 a y e a r fo r 1 2 y e a rs . T h e c o m p a n y e s tim a te s th a t it w ill h a v e to s p e n d
$ 2 0 0 0 e v e r y 2 y e a rs o v e r h a u lin g th e e q u ip m e n t. T he e q u ip m e n t m a y b e d e p r e c ia te d fo r ta x p u rp o s e s
b y th e s tra ig h t-lin e m e th o d , o v e r a 1 2 - y e a r p e r io d . T h e c o m p a n y ta x ra te is 3 0 c e n ts in th e d o lla r , th e
p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 7 5 , a n d th e a fte r
ta x c o s t o f c a p it a l is 1 0 p e r c e n t p e r a n n u m . A s s u m in g a ll c a s h flo w s , in c lu d in g ta x p a y m e n ts , a r e m a d e
a t th e e n d o f e a c h y e a r, s h o u ld th e c o m p a n y p u rc h a s e th e e q u ip m e n t?
QUESTIONS
1 [LO 1 ] E x p la in w h a t is m e a n t b y th e consistency p rin c ip le in th e c o n te x t o f e s tim a tin g a c o m p a n y 's c o s t o f
c a p ita l.
2 [LO 2 ] E x p la in th e im p o r ta n c e o f th e ris k -in d e p e n d e n c e a s s u m p tio n fo r p r o je c t a p p r a is a l.
3 [LO 2 ] T he c o s t o f c a p it a l f o r a p r o je c t c a n b e d e te r m in e d u s in g th e f o llo w in g e q u a tio n :
kj = i?y + (3y [E(Rm + l ) - Rf]

a) Ju s tify th is sta te m e n t, a n d in d ic a te th e c o n d itio n s n e c e s s a ry fo r it to b e c o rre c t.
b) D iscuss th e p ro b le m s a s s o c ia te d w ith e s tim a tin g
i?/ ? P7and£(/?M + T).

4 [L O 2 ] The errors associated w ith estim ating a com pany's beta are so g re a t that you m a y as w e ll assume
that o il betas equ a l one. D o y o u a g re e ? G iv e y o u r re a s o n s .
5 [LO 2 ] A n a lu m in iu m p r o d u c e r is p la n n in g to e x p a n d b y c o n s tru c tin g a n e w r o llin g m ill to p r o d u c e
a lu m in iu m she ets u se d in b e v e r a g e c a n s a n d th e b u ild in g in d u s try . T he p r o je c t's c o s t o f c a p it a l h a s b e e n
e s tim a te d a t 1 2 p e r c e n t p e r a n n u m , b a s e d o n a b e ta o f 0 . 5 . E x p la in th e e ffe c ts , if a n y , th a t th e f o llo w in g
w o u ld h a v e o n th e p r o je c t's c o s t o f c a p it a l:
a) th e c o rre la tio n b e tw e e n th e re tu rn s fro m a lu m in iu m p ro d u c e rs , a n d th e m a rk e t p o r tfo lio , d e c re a s e s
b) th e c o m p a n y re d u c e s its fin a n c ia l le v e ra g e
B usiness finance
c) th e risk-fre e in te re s t ra te in c re a s e s
d) o w in g to a te c h n o lo g ic a l b re a k th ro u g h , th e c o s t o f p r o d u c in g sh e e t steel is re d u c e d . A n a ly s ts fo re c a s t lo w e r
g r o w th in sa le s o f sh e e t a lu m in iu m .
6 [LO 3 ] W h e n e s tim a tin g a c o m p a n y 's c o s t o f c a p it a l, w h y is it im p o r ta n t to d is tin g u is h b e tw e e n th e effective

c o m p a n y ta x ra te a n d th e statutory com pany in c o m e t a x ra te ? U n d e r w h a t c irc u m s ta n c e s m ig h t y o u e x p e c t
th e s e tw o ra te s to b e v e r y d iffe re n t?
7 [LO 41 The weights used to estimate a com pany's W A C C reflect pa st decisions a b o u t the m ix o f financing
choices a n d hence w e should utilise the historical cost o f funds in the W A C C formula. C o m m e n t o n this
s ta te m e n t.
8 [L O 5 ] Trade c re d it is a free source o f finance. Therefore, w hen estim ating a com pany's cost o f ca p ital, trade
cre d it con be ignored. C o m m e n t o n th is s ta te m e n t.
9 [LO 6 E x p la in w h y th e costs a s s o c ia te d w ith r a is in g n e w c a p it a l, su ch as u n d e r w r it in g , le g a l a n d
a c c o u n tin g fe e s , a r e n o t s im p ly in c lu d e d in th e p r o je c t ’s c o s t o f c a p it a l, b u t in s te a d a r e a llo w e d fo r in th e n e t
c a s h flo w s a s s o c ia te d w ith th e p r o je c t itse lf.
10 [L 〇7 ] D iscu ss e a c h o f th e f o llo w in g s ta te m e n ts:
a) A project's cost o f c a p ita l reflects the return investors require to finance the project.
b) The cost o f c a p ita l is project-specific.
11 [ L 0 7 ] W hen evaluating a n ew project, m anagem ent requires an estimate o f the project's ow n cost o f
capital. The W A C C form ula o n ly gives a cost o f c a p ita l a p p lic a b le to the c o m p a n y as a w hole a n d is
therefore in a p p ro p ria te fo r this purpose. C o m m e n t o n th is s ta te m e n t.
12 [ L 0 7 ] In a c o m p a n y that has separate divisions, m anagem ent should a p p ly d iffe re n t discount rates to
projects p ro p o se d b y its various divisions. D iscu ss th is s ta te m e n t.
13 [ L 0 7 ] D iscuss th e re la tiv e m e rits o f th e a lte r n a tiv e m e th o d s o f c a lc u la tin g th e c o s t o f c a p it a l f o r a d iv is io n o f
a com pany.
14 [ L 0 8 ] T h e A c e C lo th in g C o m p a n y h a s d e c id e d to d iv e r s ify its o p e r a tio n s b y m a n u fa c tu r in g a n d m a rk e tin g

fo o tw e a r . M a n a g e m e n t n o te s th a t th e s y s te m a tic ris k o f th e sh a re s o f a lis te d f o o tw e a r c o m p a n y is 0 . 8 .
W h e n w o u ld it b e a p p r o p r ia t e to use 0 . 8 a s th e e s tim a te o f th e s y s te m a tic ris k o f th e e q u ity f o r th e
c o m p a n y 's n e w in v e s tm e n t?
15 [LO 9 , A n im p o rta n t im p lica tio n o f using the W A C C to evaluate projects is that it suggests that com panies
should m axim ise the use o f d e b t—as kd is a lw ays less than ke. C o m m e n t o n th is s ta te m e n t.
16 [L O 1 0 ] W h e n d is c o u n tin g a fu tu re c a s h f lo w to its p re s e n t v a lu e , w h a t a r e th e t w o fa c to rs t h a t n e e d to b e
a c c o u n te d fo r? U n d e r w h a t c irc u m s ta n c e s d o e s th e certainty-equivalent m e th o d p r o v id e a b e tte r a p p r o a c h to
CA
d is c o u n tin g c a s h flo w s re la tiv e to th e s ta n d a r d use o f a ris k -a d ju s te d d is c o u n t ra te ?
PROBLEMS
1 Calculating cost of capital [LO 1]
B a y -o f-ls la n d s D a irie s Ltd h a s a n in te re s t ra te o n its d e b t o f 6 p e r c e n t p e r a n n u m . T h e s y s te m a tic risk o f its
e q u ity is 1 .2 a n d th e e ffe c tiv e c o m p a n y ta x ra te is 0 . 1 2 . F o rty p e r c e n t o f its fu n d in g is p r o v id e d b y d e b t,
w h ile 6 0 p e r c e n t is p r o v id e d b y e q u ity . T h e risk-fre e in te re s t ra te is 5 p e r c e n t p e r a n n u m . In c a lc u la tin g its
c o s t o f c a p ita l, B a y-o f-lsla n d s h a s o b ta in e d tw o e x p e rt o p in io n s a s to th e m a rk e t risk p re m iu m (in c lu d in g th e
fr a n k in g p re m iu m ). O n e e x p e rt su g g e sts th a t th e m a rk e t risk p re m iu m is 1 p e r c e n t p e r a n n u m , w h ile th e o th e r
s u g g e sts th a t th e m a rk e t risk p re m iu m is 5 p e r c e n t p e r a n n u m . W h a t is B a y -o f-ls la n d s 7 c o s t o f c a p ita l b a s e d o n
the se e x p e rts 7 o p in io n s o f th e m a rk e t ris k p re m iu m ?
2 N P V analysis [LO 2]
S p a re s Ltd m a n u fa c tu re s c a r p a rts a n d m a n a g e m e n t is c o n s id e rin g a n e x p a n s io n o f its e x is tin g o p e ra tio n s a t
a c o s t o f $ 6 0 0 0 0 0 . It e x p e c ts th is e x p a n s io n to g e n e ra te a d d itio n a l n e t c a s h in flo w s fo r th e n e x t 1 0 y e a rs as
fo llo w s : $ 1 0 0 0 0 0 p e r a n n u m in Y ea rs 1 - 5 a n d $1 3 0 0 0 0 p e r a n n u m in Y ea rs 6 - 1 0 . T he c o m p a n y 's a n a ly s t
h a s m a d e th e fo llo w in g e s tim a te s:
a) th e s y s te m a tic risk o f th e c o m p a n y 's e x is tin g assets is 0 . 7 5

b) th e risk-fre e in te re s t ra te is 1 1 p e r c e n t p e r a n n u m
c) th e e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tf o lio is 1 5 p e r c e n t p e r a n n u m .
A s s u m in g th a t th e re is n o c o m p a n y in c o m e ta x , s h o u ld th e c o m p a n y u n d e rta k e th e e x p a n s io n ?
442

A b c o D is trib u to rs Ltd w is h e s to e v a lu a te a n in v e s tm e n t in a n e w a r e a o f a c t iv ity — m a n u fa c tu rin g p a in t. B ath
Paints (BP) ha s b e e n id e n tifie d a s a c o m p a n y w h o s e s o le a c tiv ity is to p ro d u c e p a in t. T he s y s te m a tic risk o f
BP’s e q u ity is 1 .2 . H o w e v e r, BP is fin a n c e d b y o n e p a r t d e b t to o n e p a r t e q u ity , w h e re a s A b c o D is trib u to rs
is fin a n c e d b y tw o p a rts d e b t to th re e p a rts e q u ity . F urthe r, A b c o 's m a n a g e m e n t ha s e s tim a te d th e risk-fre e
in te re s t ra te to b e 1 2 p e r c e n t a n d th e e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tfo lio (in c lu d in g th e fr a n k in g
p re m iu m ) to b e 1 7 p e r c e n t. T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r . T he p r o p o r tio n o f
th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 , a n d th e b e fo re -ta x c o s t o f A b c o 's
d e b t is 1 4 p e r c e n t p e r a n n u m . C a lc u la te th e c o s t o f c a p ita l o f th e p ro p o s e d n e w p ro je c t, s p e c ify in g th e
a s s u m p tio n s o n w h ic h y o u r c a lc u la tio n s a r e b a s e d .

R ylstone Ltd h a s c o m m e n c e d o p e r a tio n s w ith th e f o llo w in g c a p ita l stru ctu re :
Rylstone Ltd: statement of financial position as at date of incorporation

($)
Assets
Sundry assets 1000000
Liabilities and shareholders’ funds
Debentures, 8% (10 years) 300000
Preference shares, 9% 200000
Ordinary shares, issued and paid-up, 500 000 at $1 500000
1000000
The c o m p a n y 's p ro s p e c tu s c o n ta in s e s tim a te s th a t it w ill e a rn $ 1 0 0 0 0 0 in th e firs t y e a r a n d p a y d iv id e n d s

o f 1 0 cen ts p e r s h a re . B ro k e rs a n tic ip a te th a t d iv id e n d s w ill g r o w a t 5 p e r c e n t p e r a n n u m . T he sh a re s a re
c u rre n tly s e llin g a t $ 1 . T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 cen ts in th e d o lla r a n d th e p r o p o r tio n o f
th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 . C a lc u la te th e c o s t o f c a p ita l fo r
R ylstone Ltd.

The f o llo w in g fin a n c ia l in fo rm a tio n re la te s to th e o p e r a tio n s o f W o o d T im b e r Ltd:
A d d itio n a l in fo rm a tio n :
a) The n o m in a l in te re s t ra te o n th e b a n k o v e r d r a ft is 1 0 p e r c e n t p e r a n n u m a n d in te re s t is c a lc u la te d
h a lf-y e a rly .
b) The d e b e n tu re s a r e c u rre n tly s e llin g a t $ 9 7 e a c h a n d m a tu re in 6 y e a r s ' tim e .
Wood Timber Ltd: abstract from the statement of profit and retained
earnings for the year ended 31 December 2014
($)
Net profit after taxes 200000
Retained earnings 1.1.2014 150000
Total available for appropriation 350000
less Dividends on ordinary shares 120000
less Dividends on preference shares 28000
Retained earnings 31.12.2014 202000

4 43
B usiness finance
Summary statement of financial position as at 31 December 2014
Assets
Inventory 120000
Accounts receivable 82 000
Land and buildings 1200000
Plant and equipment 900000
2 302000
Liabilities
Accounts payable 100000
Bank overdraft 200000
12% debentures, $100 face value 600000 900000
Shareholders’ funds
14% preference shares, $10 face 200000

value
Ordinary shares, $1 face value 1000000
Retained earnings 202000 1402000
2302 000
c) The p re fe re n c e sh a re s a re c u rre n tly s e llin g a t $ 9 . 5 0 e a c h .
d) The o r d in a r y sh a re s a re c u rre n tly s e llin g a t $ 1 . 1 0 e a c h .
e) T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r.
f) The p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 .
C a lc u la te th e c o s t o f c a p ita l fo r W o o d T im b e r Ltd, u s in g th e d iv id e n d g r o w th m e th o d to c a lc u la te th e c o s t o f
e q u ity . N o te a n y a s s u m p tio n s y o u m a k e .
6 Cost of debt capital [LO 5]
If the appropriate cost o f debt capital is greater than the coupon rate o f a debt security, its price w ill
usually be less than its face value. C o m m e n t o n th e v a lid it y o r o th e r w is e o f th is s ta te m e n t w ith th e a id o f
th e f o llo w in g e x a m p le : a 5 - y e a r d e b t s e c u rity h a s a fa c e v a lu e o f $ 1 0 0 a n d a c o u p o n ra te o f 1 0 p e r c e n t
p e r a n n u m , w ith in te re s t p a id s e m i-a n n u a lly . T h e a p p r o p r ia te c o s t o f d e b t c a p it a l is 1 3 p e r c e n t p e r a n n u m
(e ffe c tiv e ).
The m a n a g e m e n t o f H e a v y C la y Ltd w a n ts to k n o w th e c o s t o f c a p ita l a s s o c ia te d w ith e x p a n d in g its bu sin ess.
You h a v e b e e n to ld th a t fu n d s w ill b e ra is e d fo r th is p u rp o s e a c c o r d in g to a ta r g e t c a p it a l s tru c tu re re fle c te d
in th e m a rk e t v a lu e o f its s e c u ritie s . Y o u r ta s k is to c a lc u la te th e c o s t o f c a p ita l f o r th e c o m p a n y . The fo llo w in g
in fo rm a tio n m a y a ssist y o u in y o u r task:
a) T he 1 3 p e r c e n t d e b e n tu re s h a v e just b e e n issu e d a n d in te re s t ra te s h a v e re m a in e d s ta b le s in c e th e issue.

T his ra te w a s 1 p e r c e n t p e r a n n u m a b o v e th e in te re s t ra te o n g o v e rn m e n t s e c u ritie s .
b) T h e la s t o b s e r v e d m a r k e t p r ic e o f th e p r e fe r e n c e s h a re s w a s $ 1 , w h e r e a s it w a s $ 3 f o r th e
o r d in a r y s h a re s .
c) T h e b e ta o f e q u ity o f H e a v y C la y w a s r e c e n tly e s tim a te d a t 0 . 5 , w h ile th e c o n s e n s u s v ie w is t h a t th e

e x p e c te d r a te o f re tu rn f o r th e m a r k e t is 1 8 p e r c e n t p e r a n n u m , w h ic h in c lu d e s a f r a n k in g p re m iu m
o f 2 p e r c e n t.
444
C hapter fourteen The c o s t o f capital

d) A n e x tra c t o f th e m o st re c e n t s ta te m e n t o f fin a n c ia l p o s itio n s h o w s :
Debentures 2500
7% preference shares ($2 face value) 1000
Paid-up capital ($1 face value) 3000
Reserves 500
7000
e) T h e s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r.
f) T he d iv id e n d s o n H e a v y C la y ’s o r d in a r y sh a re s w ill b e fu lly fra n k e d a n d a ll th e sh a re s a r e h e ld b y

A u s tra lia n re s id e n ts.
8 Company versus project cost of capital [LO 7 】

D o rs e t Ltd is a ll-e q u ity fin a n c e d a n d h a s a c o s t o f c a p ita l o f 1 6 p e r c e n t p e r a n n u m . O b s e rv e rs s u g g e s t th a t
D o rs e t c o u ld e a s ily b o r r o w u p to 4 0 p e r c e n t o f th e v a lu e o f its assets a t a n in te re s t ra te o f 1 0 p e r c e n t p e r
a n n u m a n d a c h ie v e a r a tin g fo r its d e b t o f A + o r b e tte r. T h e y a rg u e th a t ra is in g n e w c a p ita l b y b o r r o w in g
w o u ld lo w e r th e c o m p a n y 's c o s t o f c a p ita l, a n d in c re a s e th e n e t p re s e n t v a lu e o f so m e p ro je c ts th a t w e re
re c e n tly re je c te d . U se a n u m e ric a l e x a m p le to illu s tra te th e o b s e rv e r's a rg u m e n t. Is th e ir a rg u m e n t c o rre c t? G iv e
re a s o n s fo r y o u r a n s v /e r.

a) Use th e f o llo w in g in fo r m a tio n to c a lc u la te th e c o s t o f c a p ita l fo r S A M Ltd, a s s u m in g th a t in v e s to rs c a n
re m o v e a ll u n s y s te m a tic risk b y d iv e rs ific a tio n .
i) The s y s te m a tic risk o f S A M Ltd's e q u ity is 0 . 8 .
ii) T he ris k -fre e in te re s t ra te is 1 0 p e r c e n t p e r a n n u m .
iii) T he e x p e c te d ra te o f re tu rn o n th e m a rk e t p o r tfo lio ( in c lu d in g th e fr a n k in g p re m iu m ) is 1 5 p e r c e n t

p6「annum .
iv) The v a rio u s s o u rc e s o f fu n d s u se d b y S A M Ltd a n d th e ir re s p e c tiv e m a rk e t v a lu e s a re a s fo llo w s :
S o u rc e o f fu n d s M a r k e t v a lu e ($ m )
Debt (face value $100) 1
Equity 3
v) T he in te re s t ra te o n th e d e b t is 1 1 p e r c e n t p a id a n n u a lly . T h e d e b t, w h ic h is d u e to m a tu re in 8 y e a r s '
tim e , h a s a c u rre n t m a rk e t p ric e o f $1 1 1.
vi) T he s ta tu to ry c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r.
v ii) The p r o p o r tio n o f th e ta x c o lle c te d fro m th e c o m p a n y th a t is c la im e d b y s h a re h o ld e rs is 0 . 6 0 .
b) U n d e r w h a t a s s u m p tio n s is th e c o s t o f c a p ita l y o u h a v e c a lc u la te d fo r S A M Ltd in (a) a p p r o p r ia te fo r a

p ro p o s e d p ro je c t?
10 Estimating divisional cost of capital [LO 8]

T h re e c o m p a n ie s — X, Y a n d Z — o p e r a te in in d u s trie s 1 a n d 2 . T he c o m p a n ie s , costs o f c a p ita l a n d in v e s tm e n t
in e a c h in d u s try a re as fo llo w s :
X 14.0 0.5 0.5
Y 12.8 0.7 0.3
Z 14.6 0.4 0.6

a) E stim a te th e d iv is io n a l c o s t o f c a p ita l fo r e a c h c o m p a n y .
b) O u tlin e th e m a in a s s u m p tio n s th a t u n d e rlie y o u r m o d e l.
c) D iscuss th e a d v a n ta g e s a n d d is a d v a n ta g e s o f th e m e th o d y o u use d in (a) c o m p a r e d w ith th e /p u re -p la y ,

a p p ro a c h .
11 Understanding the advantages and disadvantages of using W A C C for project evaluation [LO 9 】
V e rity C o tto n Ltd (VCL) o p e ra te s a la r g e c o tto n fa rm n e a r B u lla m a k a n k a . Its w a te r s u p p ly c o m e s fro m tw o
so u rce s: r a in fa ll a n d a n a n n u a l a llo c a tio n fro m th e B u lla m a k a n k a W a t e r S u p p ly A u th o rity . In re c e n t y e a rs it
ha s b e e n d iffic u lt to o b ta in s u ffic ie n t w a te r to p ro d u c e a g o o d c r o p . G e o ff S in g h , th e m a n a g in g d ir e c to r o f
V C L, h a s re c e n tly re c e iv e d a r e p o r t fro m th e B u lla m a k a n k a Tourism B o a rd s u g g e s tin g th a t V C L s h o u ld c o n s id e r
o p e n in g a c a m p in g g ro u n d to s e rv e v is ito rs to th e re c e n tly -o p e n e d B u lla m a k a n k a N a tio n a l P a rk a n d H e rita g e
S ite , w h ic h is lo c a te d n e a r th e fa rm . S uch a d e v e lo p m e n t w o u ld ta k e a b o u t 1 0 p e r c e n t o f V C L 's la n d o u t o f
c o tto n p r o d u c tio n . G e o ff p r e p a r e d a n N P V a n a ly s is o f th e p r o p o s a l, w h ic h he p re s e n te d to a re c e n t m e e tin g o f
th e V C L b o a r d o f d ire c to rs . A t th e m e e tin g , th e re w a s s o m e d is a g re e m e n t o v e r tw o a s p e c ts o f G e o ff's a n a ly s is .
T hese a s p e c ts w e r e :
a) G e o ff ig n o r e d th e fa c t th a t 1 0 p e r c e n t o f th e la n d w o u ld n o lo n g e r b e u se d fo r c o tto n p r o d u c tio n . S o m e
d ire c to rs fe lt th a t b e c a u s e 1 0 p e r c e n t o f th e la n d w o u ld n o lo n g e r b e use d to p r o d u c e c o tto n , th e a n a ly s is
s h o u ld in c lu d e a 1 0 p e r c e n t re d u c tio n in th e n e t c a s h f lo w e x p e c te d fro m c o tto n p r o d u c tio n .
b) In his a n a ly s is , G e o ff h a d use d a n e s tim a te o f V C L 's c o s t o f c a p ita l to d is c o u n t th e fo re c a s t n e t ca s h flo w s o f

th e c a m p in g g r o u n d p ro je c t. H o w e v e r, G e o ff n o te d in his a n a ly s is th a t a ll o f th e costs o f th e p r o je c t w o u ld
b e fin a n c e d b y a b a n k lo a n . S o m e d ire c to rs a r g u e d th a t, in v ie w o f th is fa c t, th e a p p r o p r ia te d is c o u n t ra te
to use is th e in te re s t ra te th a t th e b a n k w o u ld c h a rg e . A s H a n k , o n e o f th e d ire c to rs , e x p la in e d , 'S in c e n o n e
o f th e s h a re h o ld e rs ' m o n e y w ill b e use d in th e p ro je c t, w e d o n 't n e e d to re w a r d th e s h a re h o ld e rs ; w e o n ly
n e e d to e n s u re th a t th e c a s h flo w s a r e s u ffic ie n t to m e e t th e b a n k 's re q u ire m e n ts '.
P ro v id e th e b o a r d w ith y o u r a d v ic e o n e a c h o f th e tw o m a tte rs ra is e d in (a) a n d (b).
REFERENCES
Beggs, DJ. & Skeels, C., 'M arket arbitrage of cash dividends 2 0 0 4 . Available at w w w .capitalresearch.com .au/
and franking credits', The Economic Record, September dow nloads/lm putationU pdate2004.pdf.
2 0 0 6 , pp. 2 3 9 -5 2 . Monkhouse, P.H.L., The valuation o f projects under the
Berk, J. & DeMarzo, P., Corporate Finance, Pearson dividend imputation tax system7, Accounting and Finance,
Education, Boston, 20 07 . November 1996, pp. 1 8 5 -2 1 2 .
Brailsford, T., Handley, J. & Maheswaran, K., The historical ------ , 'A dapting the APV valuation methodology and the
equity risk premium in Australia: post-GFC and 128 years of beta gearing formula to the dividend imputation tax system',
data7, Accounting and Finance, March 2 0 1 2 , pp. 2 3 7 -4 7 . Accounting and Finance, M ay 1997, pp. 6 9 -8 8 .
Brown, P. & Clarke, A ., The ex-dividend day behaviour Mukherjee, T.K., Kiymaz, H. & Baker, H., 'M erger motives
o f Australian share prices before and after dividend and target valuation: a survey of evidence from CFOs',
imputation', Australian Journal of Management, June 1993, Journal of Applied Finance, W inter 2 0 0 4 , pp. 7 -2 4 .
pp. 1-4 0. Myers, S.C., 'Interactions of corporate financing and
Cannavan, D.; Finn, F. & Gray, S., 'The value o f imputation investment decisions: implications for capital budgeting ’，
credits in Australia', Journal of Financial Economics, April Journal of Finance, M arch 1974, pp. 1 -2 5 .
2 0 0 4 , pp. 167-97. ------, & Turnbull, S., 'C apital budgeting and the capital
Conine, T. & Tamarkin, M ., 'Divisional cost of capital asset pricing model: good news and bad news', Journal of
estimation: adjusting for leverage', Financial Management, Finance, M ay 1977, pp. 3 2 1 -3 3 .
Spring 1985, pp. 5 4 -8 . Officer, R.R., 'The measurement o f a firm ’s cost of c a p ita l:
Feuerherdt, C., G ray, S. & Hall, J., 'The value of imputation Accounting and Finance, Novem ber 1981, pp. 3 1 -6 3 .
tax credits on Australian hybrid securities', International ------, 'The cost of capital of a company under an imputation
Review of Finance, September 2 0 1 0 ; pp. 3 6 5 -4 0 1 . tax system,/ Accounting and Finance, M a y 1994, pp. 1 -1 7 .
Fuller, RJ. & Kerr, H.S., 'Estimating the divisional cost of Taggart, R., 'Consistent valuation and cost-of-capital
capital: an analysis o f the pure-play technique,, Journal of expressions with corporate and personal taxes7, Finonciol
Finance, December 19 81 , pp. 9 9 7 -1 0 0 9 . Management, Autumn 1991, pp. 8 -2 0 .
Harris, R.S., CXBrien, TJ. & Wakeman, D., 'Divisional W alker, S. & Partington, G ., The value o f dividends:
cost-of-capital estimation for multi-industry firms', Financial evidence from cum-dividend trading in the ex-dividend
Management, Spring 1989, pp. 7 4 -8 4 . period,/ Accounting and Finance, Novem ber 1999,
Hathaway, N. & Officer, R.R.; The Value of Imputation Tax pp. 2 7 5 -9 6 .
Credits: Update 2004, Capital Research Pty Ltd, November
A pp en d ix 1 4 .1 T he c o s t o f capital under alternative tax systems
A p p e n d ix ♦ The cost of capital under

alternative tax systems10
Introduction
In this appendix we discuss alternative definitions o f the cost o f capital and derive equations fo r a
company s cost o f capital on both a before-tax and an after-tax basis. We show th a t under the im p utatio n
tax system there is more than one way to define an after-tax cost o f capital.
Under an im putation system the d istin ction between company tax and personal tax becomes blurred
because resident shareholders can use im p utatio n credits to offset th e ir personal tax liabilities. There
are at least three ways in which this issue can be handled. The firs t is to adjust the after-tax cash flows
generated by a company or project. A second approach involves adjusting the d efin itio n o f the cost o f
capital, while a th ird approach involves adjusting both the cash flows and the cost o f capital.
One principle that must be stressed is that, whichever approach is adopted, it m ust be used consistently:
that is, the definition o f the cost o f capital m ust be consistent w ith the definition o f the cash flows that are
discounted using that cost o f capital. I f consistency is maintained, the three approaches are equivalent. But if
consistency is not maintained, a biased valuation w ill result and incorrect investment decisions may be made.
Deriving cost of capital form ulae11

To define the cost o f capital, we assume th a t all o f a company s cash flows are expected to remain constant
in perpetuity. This assumption is necessary fo r algebraic convenience. The value o f a company depends on
the net operating cash flows generated by the company s assets and the cost o f capital applicable to those
cash flows. For cash flows th a t remain constant in perpetuity:
y= ^ A14.1
^0
where V = value o f the company (value o f equity plus debt)
X 〇= annual net operating cash flow before tax
k 〇 = before-tax cost o f capital
From Equation A14.1, the general d efinition o f the before-tax cost o f capital is:
A14.2
V
Equation A14.2 form s the basis fo r all the cost-of-capital form ulae th a t we derive.
To derive formulae fo r the cost o f capital it is necessary to consider only company tax, because we work
on a before-company-tax or after-company-tax, b ut always before-personal-tax, basis. A company s net
operating cash flow before tax, X〇 , is the net cash flow th a t remains after m eeting the costs o f all factors
o f production other than payment o f company income tax to the government and providing returns to
suppliers o f capital. Therefore X 〇 can be divided in to three components:
A14.3
where X = net cash flow to the government
= net cash flow to debtholders
X a = net cash flow to shareholders
The am ount o f tax collected from a company w ill be equal to tc(X〇 - X ^ ) , where t c is the statutory
company tax rate. This is because interest paid is a tax-deductible expense o f the company. But a proportion
y o f the tax collected from the company w ill be claimed by shareholders as a consequence o f receiving
franking credits. Therefore, the tax collected from the company can be divided into tw o components:
im p licit personal tax and ^true* or effective company tax.
10 The discussion in this appendix is largely a simplified version of that provided by Officer (1994).
11 The general approach used in this section follows that adopted by Officer (1981, pp. 31-61).
This c o n ce p t m a y re q u ire e x p la n a tio n . Suppose t h a t a b u sin ess is u n in c o rp o ra te d . F o r exa m ple, i t
m a y be s tru c tu re d as a p a rtn e rs h ip ra th e r th a n as a com pany. A p a rtn e rs h ip is n o t ta x e d as a separate
e n tity ; ra th e r its p r o fits are ta xe d in th e h a n d s o f th e p a rtn e rs . T h e re fo re , a ll th e ta x o n its p ro fits is
p e rs o n a l ta x. O n th e o th e r h a n d , i f a c o m p a n y s tru c tu re is used, p r o fits p a id o u t as fra n k e d d iv id e n d s are
also s u b je c t to p e rs o n a l ta x , b u t som e o r a ll o f th e ta x has a lre a d y b e en co lle cte d fr o m th e com pany. I t is
e x tre m e ly im p o r t a n t to u n d e rs ta n d th is p o in t: u n d e r th e im p u ta tio n syste m , m o s t o f th e in c o m e ta x p a id
o n c o m p a n y p r o fits is im p lic itly p e rs o n a l ta x . C o n se q u e n tly, e ffe c tiv e co m p a n y ta x is a n y e x tra in c o m e ta x
in c u rre d due to a bu sin ess b e in g s tru c tu re d as a com p an y, ra th e r th a n b e in g u n in c o rp o ra te d .
F ro m th is d is c u s s io n w e can see t h a t th e n e t cash flo w to th e g o v e rn m e n t is:
Xg= t c(X0-X cl) ( l - 7) A14.4

E q u a tio n A 1 4 .4 illu s tra te s th e s ig n ific a n c e o f th e v a ria b le y. I f n o ta x c re d its can be used, th e n
y = 0 and = tc(X - Xd)— t h a t
〇 is, a ll o f th e ta x c o lle c te d f r o m a co m p a n y is tru e c o m p a n y ta x a n d th e ta x
s yste m is e ffe c tiv e ly a classical system . I f a ll o f th e ta x c re d its can be used, th e n y = 1 a n d Xg = 0 — t h a t is,
a ll th e ta x c o lle c te d fr o m a co m p a n y is re a lly n o th in g m o re th a n a w ith h o ld in g o f p e rs o n a l ta x.
S u b s titu tin g E q u a tio n A 1 4 .4 in to E q u a tio n A 1 4 .3 , m u ltip ly in g o u t th e b ra cke ts a n d c o lle c tin g te rm s ,
gives:
X〇 [l - fc(l - 7)] = ^ + Xf/[1 - ft.(l - 7)]

Xe
+ Xc/
-^ (1 -7 )
F ro m E q u a tio n A 1 4 .2 :
= Kv
S im ila rly ,
Xe= keE a n d Xd = kdD

w h e re ke= co st o f e q u ity (a fte r e ffe c tiv e c o m p a n y ta x )
E = m a rk e t v a lu e o f e q u ity
kd = cost o f d e b t (b e fo re co m p a n y ta x )
D = m a rk e t v a lu e o f d e b t
S u b s titu tin g f o r th e cash flo w te rm s in E q u a tio n A 1 4 .3 gives:
^ = ^ / [ l - r c( l - 7)] + ^ D
a n d d iv id in g b y V, th is becom es:
E D A14.5
k 〇= f e / [ l - fc (l - 7 )]
V. V.
E q u a tio n A 1 4 .5 show s t h a t a c o m p a n y s co st o f c a p ita l is e q u a l to a w e ig h te d average o f th e costs

o f e q u ity a n d d e b t, w h e re th e w e ig h ts are th e p ro p o rtio n s o f e q u ity a n d d e b t in th e c o m p a n y s c a p ita l
s tru c tu re . H o w e ve r, th is cost o f c a p ita l is o f lim ite d use because i t is a b e fo re -ta x co st o f c a p ita l, w hereas
re tu rn s to in v e s to rs in a co m p a n y d e p e n d o n its a fte r-ta x cash flo w s. The s im p le s t d e f in itio n o f a fte r-ta x
cash flo w s is a fte r-e ffe c tiv e -c o m p a n y -ta x cash flo w s:
- 7)]
a n d i t fo llo w s t h a t th e c o rre s p o n d in g a fte r-ta x cost o f c a p ita l is o b ta in e d b y m u ltip ly in g E q u a tio n A 1 4 .5

by [(1 - t f( l - 7 )], w h ic h gives:
kf = ke A14.6
V.
w h e re kr = an a fte r-e ffe c tiv e -c o m p a n y -ta x cost o f c a p ita l
A second d e fin itio n o f a fte r-ta x cash flo w s is:
X 〇 ( l - fc)
a n d th e c o rre s p o n d in g a fte r-ta x co st o f c a p ita l is o b ta in e d b y m u ltip ly in g E q u a tio n A 1 4 .5 b y (1 - tc)}

w h ic h gives:
A pp en d ix 1 4 .1 T he c o s t o f capital under alternative tax systems
k，
f = k e ( l- t c ) / [ l- t c ( l- j) ]
E
H- kd{ \ - tc) A] 4.7
[V i
This ap p ro a ch uses th e t r a d itio n a l d e fin itio n o f n e t cash flo w s a n d a ll th e a d ju s tm e n ts needed f o r th e
im p u ta tio n system are m ade to th e W ACC. A t h ir d d e fin itio n o f a fte r-ta x cash flo w s is:
X〇 - - fc( X0-X ")(l - *y)

This d e fin itio n o f a fte r-ta x cash flo w s is n e t o p e ra tin g cash flo w b e fo re ta x less th e n e t cash flo w to th e
g o v e rn m e n t. F ro m E q u a tio n A 1 4 .3 , X〇- Xg = Xe + a n d th e c o rre s p o n d in g a fte r-ta x co s t o f c a p ita l is:
kf,/ = ke \-} + k d \ - A14.8

[v\ [v\
A fo u r th d e fin itio n o f a fte r-ta x cash flo w s is:
^ 〇 ( 1 - 0 + fc ( ^ 〇 _ y
This d e fin itio n o f a fte r-ta x cash flo w adds th e va lu e o f im p u ta tio n ta x fr a n k in g c re d its to th e t r a d itio n a l
d e fin itio n o f n e t cash flo w s . S u b s titu tin g th is d e fin itio n o f a fte r-ta x cash flo w in E q u a tio n A 1 4 .3 p ro v id e s
th e fo llo w in g c o rre s p o n d in g a fte r-ta x cost o f c a p ita l:
E A14.9
k，
m = ke + k^(l - tc)
V.
Summary
I t is im p o r ta n t th a t p ro je c ts are e va lu a te d u s in g a cost o f c a p ita l t h a t is c o n s is te n t w it h th e pro je cts* cash
flow s. T ra d itio n a lly , in p ro je c t e v a lu a tio n , b o th cash flo w s a n d th e co st o f c a p ita l have b e en expressed o n
an a fte r-c o m p a n y -ta x basis. T h a t a p p ro a ch is easy to use u n d e r th e classical ta x s yste m w h e re th e re is a
d e a r d is tin c tio n b e tw e e n c o m p a n y ta x a n d p e rs o n a l ta x . H o w e ve r, u n d e r th e im p u ta tio n syste m , som e o r
a ll o f th e ta x co lle cte d fr o m co m p a n ie s is re a lly p e rs o n a l ta x . T h e re fo re , to express cash flo w s o n an a fte r-
c o m p a n y -ta x basis, a d ju s tm e n ts are needed.
A
CHAPTER FIFTEEN
Leasing and
other equipment
finance
CHAPTER CONTENTS
I n t r o d u c t io n 451 E v a lu a tio n o f f in a n c e le a s e s
IB H T y p e s o f le a s e c o n tr a c ts 451 E v a lu a tio n o f o p e r a t in g le a s e s
15.3 A c c o u n t in g a n d t a x a t io n t r e a tm e n t 15.7 A d v a n t a g e s a n d d is a d v a n t a g e s
o f le a s e s 455 o f le a s in g
15.4 S e ttin g le a s e r e n ta ls 456 15.8 C h a t t e l m o r t g a g e s a n d h ir e - p u r c h a s
LEARNING OBJECTIVES
1 e x p la in th e m a in fe a tu r e s o f f in a n c e le a s e s a n d o p e r a t in g le a s e s
2 u n d e r s ta n d th e r e a s o n s f o r le v e r a g e d le a s e s a n d c r o s s - b o r d e r le a s e s
3 o u t lin e th e a c c o u n t in g a n d t a x t r e a t m e n t o f le a s e s in A u s t r a lia
4 c a lc u la t e r e n ta ls f o r a f in a n c e le a s e
5 e v a lu a t e a f in a n c e le a s e fr o m th e le s s e e 's v ie w p o in t
6 e v a lu a t e a n o p e r a t in g le a s e fr o m th e le s s e e ’s v ie w p o in t
7 c r it ic a lly e v a lu a t e th e s u g g e s te d a d v a n t a g e s o f le a s in g
8 e x p la in th e fa c t o r s t h a t c a n in flu e n c e le a s in g p o lic y
9 o u t lin e th e m a in f e a tu r e s o f c h a tte l m o r t g a g e s a n d h ir e - p u r c h a s e a g r e e m e n ts .
C hapter fifteen Le a s in g a n d other e q u ip m e n t fin a n c e
Introduction
W h en m o s t p e o p le th in k o f le a s in g , th e y p r o b a b ly th in k o f s o m e t h in g lik e h ir in g a c a r f o r th e w e e k e n d o r
le a s in g a n a p a r t m e n t f o r 6 m o n t h s . W h ile su c h c o n t r a c t s a r e in d e e d l e a s e s , th e r e is a n o t h e r f o r m o f le a s e ,
k n o w n a s a fin a n c e le a s e , w h ic h u s e s th e le g a l f o r m o f le a s in g in su c h a w a y t h a t it b e c o m e s a n a lte r n a tiv e
to b o r r o w in g f u n d s t o p u r c h a s e n e w a s s e t s . In t h is c h a p te r , w e c o n s id e r th e v a r io u s f o r m s o f le a s e s a n d
e x p la in h o w a p r o p o s e d le a s e m a y b e e v a lu a te d . W e a ls o c o n s id e r c h a tte l m o r t g a g e s a n d h ir e - p u r c h a s e ,
w h ich , t o g e th e r w ith le a s in g , a r e k n o w n a s e q u ip m e n t fin a n c e *.
L e a s in g is d is t i n g u i s h e d fr o m m o s t o t h e r f o r m s o f fin a n c e b y th e f a c t t h a t th e fin a n c ie r (th e le sso r) is LESSOR
th e le g a l o w n e r o f th e le a s e d a s s e t . The a s s e t u s e r (th e le sse e ) o b t a i n s th e r ig h t to u s e th e a s s e t in r e tu r n in a lease contract, the

party that owns the
fo r p e r io d ic p a y m e n ts (le a s e r e n t a ls ) to th e le s s o r . In o t h e r w o r d s , l e a s in g a llo w s a c o m p a n y to o b t a in th e
asset
use o f a n a s s e t , w ith o u t a ls o o b t a in in g ow n ersh ip o f th e a s s e t . Th e r a n g e o f a s s e t s t h a t c a n b e le a s e d is
LESSEE
v ir tu a lly u n lim ite d . M a n y m o t o r v e h ic le s , a ir c r a ft , c o m p u t e r s , p h o t o c o p ie r s , m a c h in e r y a n d o t h e r i t e m s
in a lease contract, the
o f p r o d u c tio n e q u ip m e n t a r e le a s e d . U n u s u a l a s s e t s to b e le a s e d in c lu d e o il r ig s , s e w a g e t r e a t m e n t p la n t s
party using the asset
a n d c o m m u n ic a tio n s s a t e llit e s (V a r d ig a n s 1 9 9 0 ).
The A u s tr a lia n E q u ip m e n t L e s s o r s A s s o c ia t io n (w w w .a e l a .a s n .a u ) e s t im a t e s t h a t l e a s in g a n d o t h e r
e q u ip m e n t fin a n c e a c c o u n t s f o r a r o u n d 4 0 p e r c e n t o f a ll c a p it a l e x p e n d it u r e o n e q u ip m e n t in A u s tr a lia . ^w w ^J
The le a s e c o m p o n e n t, w h ic h m a d e u p 6 0 p e r c e n t o f t o t a l e q u ip m e n t fin a n c e in 2 0 0 0 , d e c lin e d to a r o u n d

2 6 p e r c e n t o f th e t o t a l in 2 0 1 2 , w h ile o v e r th e s a m e p e r io d h ir e - p u r c h a s e d e c lin e d fr o m 4 0 t o 1 8 p e r c e n t
a n d c h a tte l m o r t g a g e s g re w c o n s id e r a b ly to m a k e u p 5 6 p e r c e n t o f th e t o t a l .1
The sig n ific a n c e o f le a s in g in A u s tr a lia is c o m p a r a b le w ith i t s p r e v a le n c e in o t h e r m a r k e ts . F o r e x a m p le ,
L e a se u r o p e r e p o r t s t h a t , in 2 0 0 9 , e q u ip m e n t l e a s in g in E u r o p e a c c o u n te d fo r a r o u n d 2 0 p e r c e n t o f th e
t o ta l in v e s t m e n t in e q u ip m e n t (w w w .l e a s e u r o p e .o r g ). The J a p a n L e a s in g A s s o c ia t io n r e p o r t s s u r v e y
r e s u lts sh o w in g t h a t in 2 0 1 2 l e a s in g a c c o u n t e d fo r a b o u t 7 p e r c e n t o f p r iv a te c a p it a l in v e s t m e n t (w w w . 卜， |
l e a s in g .o r .jp ) .
L e a s e fin a n c e is p r o v id e d o n a la r g e s c a le b y b a n k s a n d fin a n c e c o m p a n ie s a s a n a lte r n a tiv e to lo a n s .
O th e r s o u r c e s o f le a s e fin a n c e in c lu d e in v e s t m e n t b a n k s , s p e c ia lis t l e a s in g c o m p a n ie s , a n d v e n d o r le a s in g
c o m p a n ie s a s s o c i a t e d w ith e q u ip m e n t s u p p lie r s . L e a s e fin a n c e c o m m it m e n t s f o r fin a n c e l e a s e s m a d e b y
s ig n ific a n t le n d e r s a r e s h o w n in T a b le 1 5 .1 .
TABLE 15.1 The value of new lease finance commitments for finance leases by
type of lessor, $ million___________________________________________________
Year to June Banks General financiers Other㈣ Total
2009 2144 1658 1885 5687
2010 1417 1614 1611 4642
2011 1251 1764 1900 4915
2012 1301 2351 2111 5763
2013 1363 2545 2264 6172
Includes finance companies and money market corporations.
Source: Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5671.0, Table 3. ABS data used with permission
from the Australian Bureau of Statistics, www.abs.gov.au.
15.2 Types of lease contracts m

LEARNING
L e a s e s ca n b e b r o a d ly c la s s if ie d a s e it h e r fin an ce le a s e s o r o p e ra tin g le a se s. W ith in t h e s e b r o a d c la s s e s , OBJECTIVE 1
se v e r a l t y p e s o f le a s e c o n t r a c t s c a n a ls o b e id e n tifie d . F o r o u r p u r p o s e s , th e r e a s o n fo r d is tin g u is h in g Explain the main
b e tw e e n fin a n c e le a s e s a n d o p e r a t in g l e a s e s is t h a t th e y h a v e d iffe r e n t fin a n c ia l im p lic a t io n s f o r b o t h th e features of finance
leases and operating
leases
1 The features of hire-purchase and chattel mortgages are outlined in Section 15.8.
B usiness finance
le sso r a n d th e lessee. T h ere fore, d iffe re n t fa c to rs can be im p o r t a n t in th e e v a lu a tio n o f each ty p e o f lease.

The m a jo r lease typ e s are discussed in th e fo llo w in g se ctio n s a n d d e ta ils o f th e typ e s o f assets t h a t are
leased are s h o w n in Table 15.2.
TABLE 15.2 The value of new lease finance commitments, by type of lease and
type of goods leased, $ million
Y e a r to Ju n e
2010 2011 | 2012 2013

1
F in a n c e l e a s e s / t y p e o f g o o d s
M o to r vehicles and o th e r tra n s p o rt e q u ip m e n t 2517 3 0 34 3230 3603
C o n s tru c tio n and e a rth m o v in g e q u ip m e n t 61 196 401 704
M a n u fa c tu rin g e q u ip m e n t 63 35 29 59
A g ric u ltu ra l m a ch in e ry and e q u ip m e n t 57 61 57 81
O ffice e q u ip m e n t 1433 12 0 1 1311 1203
O th e r goods 512 387 735 520
T o ta l n o n -o p e ra tin g lease finance 4642 4915 5763 6172
O p e r a t in g l e a s e s / t y p e o f g o o d s
M o to r vehicles 1172 1289 1391 1547
O ffice e q u ip m e n t 652 662 760 578
A g ric u ltu ra l, c o n s tru c tio n and m a n u fa c tu rin g e q u ip m e n t 77 48 69 134
O th e r 195 380 368 257
T o ta l o p e ra tin g lease finance 2096 2379 2 5 88 2516
T o ta l l e a s e fin a n c e 6738 7294 8351 8688

Source: Australian Bureau of Statistics, Lending Finance, Australia, cat. no. 5671.0, Tables 28 and 39. ABS data used with
permission from the Australian Bureau of Statistics, www.abs.gov.au.
15.2.1 | Finance leases

FINANCE LEASE A fin an ce le a se is a lo n g -te rm a g re e m e n t t h a t g e n e ra lly covers m o s t o f th e e c o n o m ic life o f an asset.
long-term lease that The a g re e m e n t w i ll e ith e r be n o n -c a n c e lla b le o r can cellab le o n ly i f th e lessee pays a s u b s ta n tia l p e n a lty
effectively transfers the
to th e lessor. T h e re fo re , a fin a n c e lease is e ffe c tiv e ly n o n -c a n c e lla b le a n d th e lessee has an o b lig a tio n to
risks and benefits of
m a ke a ll th e agreed lease p a y m e n ts . T his o b lig a tio n is e s s e n tia lly th e sam e as a b o rro w e rs o b lig a tio n to
ownership of an asset
from the lessor to the re p a y a lo a n . F in a n ce lease a g re e m e n ts n o rm a lly c o n ta in re s tric tiv e co ve n a n ts a n a lo g o u s to th o s e in lo a n
lessee a g re e m e n ts a n d th e le sso r w ill be co n ce rn e d to e n sure t h a t a p ro s p e c tiv e lessee is c re d it-w o rth y . In th is
case th e ro le o f th e le s s o r is to p ro v id e fin a n ce , a n d fr o m th e le s s o rs v ie w p o in t a fin a n c e lease is, in e ffe ct,
a secured lo a n . W h ile th e le s s o r is th e le g a l o w n e r o f th e asset, i t has n o g re a t in te re s t in m a tte rs such
as th e d a y -to -d a y use o f th e asset, a n d th e lessee is re s p o n s ib le f o r re p a irs, m a in te n a n c e a n d in su ra n ce .
Because o f the se c h a ra c te ris tic s , th e re is an e ffe c tiv e tra n s fe r fr o m th e le sso r to th e lessee o f m o s t o f th e
ris k s a n d b e n e fits o f o w n e rs h ip o f th e leased asset. In o th e r w o rd s , w h e n a c o m p a n y s ig n s a fin a n c e lease
i t is, in e ffe c t, e n te rin g in to an a g re e m e n t to p u rcha se th e asset u s in g fu n d s b o rro w e d f r o m th e lessor.
The ro le o f th e b a n ks a n d o th e r in s titu t io n s t h a t a ct as lessors in fin a n c e leases is to p ro v id e fin a n ce
ra th e r th a n to r e n t assets a n d th e y p re fe r th a t th e lessee s h o u ld p u rch a se th e asset a t th e e n d o f th e lease
te rm . To be tre a te d as a g e n u in e lease* f o r ta x p u rp o se s, a lease a g re e m e n t c a n n o t e x p lic itly p ro v id e th e
lessee w it h an o p tio n to p u rcha se th e asset. H o w e ve r, u n d e r a fin a n c e lease th e lessee w i ll g u a ra n te e th a t
C hapter fifteen Le a s in g a n d other e q u ip m e nt f in a n c e
th e le ssor receives a sp e cifie d re s id u a l v a lu e fr o m th e sale o f th e asset a t th e e n d o f th e lease te rm . The

a im o f th is p ro v is io n is to e n su re t h a t th e lessee p ro p e rly m a in ta in s th e asset. In p ra ctice , th e lessee o fte n
purchases th e asset f o r th e re s id u a l v a lu e a t th e e n d o f th e lease te rm .
1 5 .2 .2 1 O perating leases
An o p e ra tin g le a se is e s s e n tia lly a re n ta l a g re e m e n t a n d has a te r m t h a t is s h o rt re la tiv e to th e e co n o m ic OPERATING LEASE
life o f th e leased asset. F o r exa m ple, a tr u c k w it h an e xp ected life o f 15 years m ig h t be leased u n d e r an lease under which
the risks and benefits
o p e ra tin g lease f o r 3 years. Because an o p e ra tin g lease covers o n ly p a r t o f th e life o f th e leased asset, i t
of ownership of the
fo llo w s t h a t th e le s s o r re ta in s a ll o r m o s t o f th e ris k s a n d b e n e fits o f o w n e rs h ip o f th e asset. T his is th e
leased asset remain
e sse ntia l d iffe re n c e b e tw e e n an o p e ra tin g lease a n d a fin a n c e lease w h e re , as discussed above, th e ris k s with the lessor
and b e n e fits o f o w n e rs h ip are s u b s ta n tia lly tra n s fe rre d to th e lessee. Lessors are w illin g to re ta in th e ris k s
o f o w n e rs h ip o n ly i f th e y are c o n fid e n t t h a t th e asset, w h e n re tu rn e d b y th e lessee, w ill achieve a resale
p rice th a t is p re d ic ta b le . A c c o rd in g ly , o p e ra tin g leases are m o re a ttra c tiv e to lessors i f th e re is an a ctive
seco nd -han d m a rk e t f o r th e leased asset.
D e ta ils o f th e type s o f go od s leased u n d e r th e m a in typ e s o f leases are s h o w n in Table 1 5 .2 . The
d e ta ile d fig u re s f o r le a sin g s h o w n in th is ta b le are c o n s is te n t w it h b ro a d e r fig u re s o n th e e q u ip m e n t
fin a n ce m a rk e t. The A u s tra lia n E q u ip m e n t Lessors A s s o c ia tio n (w w w .a b s .g o v .a u ) re p o rts t h a t as a t
D ecem ber 2 0 1 2 m o to r v e h icle s a cco u n te d f o r 38 p e r c e n t o f to t a l e q u ip m e n t fin a n c e a n d o th e r tr a n s p o r t
e q u ip m e n t f o r 16 p e r ce n t. The re m a in in g 4 6 p e r c e n t is cla s s ifie d as ge n e ra l e q u ip m e n t. A b re a k d o w n o f
|ww^|
these b ro a d asset classes is p ro v id e d b y th e A u s tra lia n B ure au o f S ta tis tic s o n ly f o r le a s in g an d, as s h o w n
in Table 15 .2, n o n -m o to r le a s in g was d o m in a te d b y o ffic e e q u ip m e n t.
In A u s tra lia , o p e ra tin g leases have be en lim it e d m a in ly to m o to r veh icle s, c o m p u te rs a n d m u ltip u rp o s e
in d u s tria l e q u ip m e n t such as fo r k lift s . O p e ra tin g leases are n o r m a lly o ffe re d b y th e s u p p lie rs o f th o se
assets, such as c o m p u te r co m p a n ie s, a n d b y s p e c ia lis t re n ta l co m p a n ie s, such as m o to r v e h ic le re n ta l
com panies. The fig u re s in Table 1 5 .2 sh o w t h a t in 2 0 1 2 -1 3 , m o to r v e h icle s a c c o u n te d f o r 62 p e r c e n t o f
th e value o f o p e ra tin g leases e n te re d in to , fo llo w e d b y o ffic e e q u ip m e n t (m a in ly c o m p u te rs ) a t 2 3 p e r cen t.
In th e 2 0 1 2 -1 3 year, o p e ra tin g lease c o m m itm e n ts a cco u n te d f o r 29 p e r c e n t o f th e v a lu e o f n e w leases
e n te re d in to .
A n o p e ra tin g lease a g re e m e n t is n o r m a lly f o r a s h o rt p e rio d a n d th e asset m a y be leased to a series
o f users. T h ere fore, an o p e ra tin g lease enables a b u sin ess to o b ta in th e use o f an asset t h a t is re q u ire d
f o r o n ly a s h o rt p e rio d . F o r e xa m p le , suppose t h a t a M e lb o u rn e -b a s e d c o m p a n y needs a car f o r use b y an
exe cutive v is itin g its A d e la id e b ra n c h f o r a m o n th . The co m p a n y c o u ld b u y a car a n d th e n se ll i t a m o n th
la te r b u t t h a t is lik e ly to be b o th in c o n v e n ie n t a n d expensive. As w e ll as n e g o tia tin g th e p u rch a se an d
resale prices, th e c o m p a n y w o u ld have to re g is te r a n d in s u re th e car a n d th e n tra n s fe r th e re g is tra tio n
and cancel th e in s u ra n c e a m o n th la te r. C learly, in th is case i t m akes sense to r e n t o r lease th e car ra th e r
th a n b u y it .
O p e ra tin g leases m a y also be m ain te n an ce le a se s, w h ic h m ea ns t h a t th e le s s o r is re s p o n s ib le f o r M AINTENANCE LEASE
in s u rin g th e asset, m a in ta in in g i t a n d f o r p a y m e n t o f a n y g o v e rn m e n t charges. A n o p e ra tin g lease enables operating lease

where the lessor is
a lessee to use th e asset w ith o u t d ire c tly in c u r r in g th e ris k s o f o w n e rs h ip such as th e r is k o f obsolescence.
responsible for all
The lease re n ta ls w ill re fle c t th e costs in c u rre d b y th e le s s o r in c lu d in g th e fa c t t h a t th e le sso r re ta in s th e
mai门te门anc6 a 门d
ris k s o f o w n e rs h ip . F o r th e le ssor, o p e ra tin g leases are ch a ra c te ris e d b y re n tin g o u t assets a n d e xp osu re service of the leased
to th e ris k s o f o w n e rs h ip , ra th e r th a n b y th e p ro v is io n o f fin a n ce . O p e ra tin g leases are discussed f u r t h e r asset
in S ection 15.6.
15.2.3|S ale and lease-back agreements

U n d e r a sale an d lea se -b ac k a g re e m e n t th e o w n e r o f an asset sells th e asset to a fin a n c ia l in s t it u t io n f o r SALE A N D LEASE-BACK
an a m o u n t u s u a lly eq ua l to it s c u rre n t m a rk e t v a lu e a n d im m e d ia te ly leases i t b a ck fr o m th e in s titu t io n . AGREEMENT

agreement in which
The o w n e r re lin q u is h e s th e t it le to th e asset in r e tu r n f o r cash a n d agrees to m ake p e rio d ic lease p a y m e n ts
a company sells an
to th e lessor. A sale a n d lease-back tra n s a c tio n is an a lte rn a tiv e to ra is in g cash b y b o rro w in g , u s in g th e asset and then leases
asset as s e cu rity. The le sso r m a y be an in s u ra n c e com p an y, a lth o u g h som e s u p e ra n n u a tio n fu n d s , b a n ks it back
and s p e c ia lis t le a sin g co m p a n ie s also o ffe r th is fo r m o f fin a n ce . C o m m e rc ia l re a l esta te is o fte n th e
su b je ct o f such tra n s a c tio n s . O ffic e b u ild in g s , re ta il stores, h o te ls , m o te ls , re g io n a l s h o p p in g cen tre s,
B usiness finance
ra ilw a y r o llin g sto c k , ve h icle fle e ts , w a reh ouse s a n d fa c to rie s have a ll b e en th e su b je c t o f sale a n d lease
back ag re e m e n ts.
The te r m o f a sale a n d lease-back a g re e m e n t w ill d e p e n d o n th e ty p e o f asset c o n ce rn e d b u t in th e
case o f c o m m e rc ia l p ro p e rty is u s u a lly less th a n 15 years. The lessee agrees to m ake th e lease p a y m e n ts
f o r th is p e rio d and, in a d d itio n , is n o rm a lly re s p o n s ib le f o r p a y m e n t o f m a in te n a n c e costs, in su ra n ce ,
g o v e rn m e n t charges a n d a n y o th e r costs o f o cc u p a tio n .
15.2.41 Leveraged leasing

¥ LEARNING
Le vera ged le a sin g , w h ic h is a fo r m o f fin a n c e lease, was in tro d u c e d in to th e A u s tra lia n c a p ita l m a rk e t
in th e m id -1 9 7 0 s , a n d since th e n m a n y la rge a n d e xp en sive assets have b e en leased in th is w ay .2 The
s tru c tu re o f a le vera ged lease is s h o w n d ia g ra m m a tic a lly in F ig u re 15.1.
OBJECTIVE 2
A le v e r a g e d le a s e d iffe rs fr o m an o rd in a ry fin a n c e lease in t h a t i t in v o lv e s a t le a s t th re e p a rtie s
Understand the
in s te a d o f tw o . The a d d itio n a l p a r ty is a le n d e r a n d is n o rm a lly re fe rre d to as a *debt p a rtic ip a n t*. In
reasons for leveraged
leases and cross- p ra ctice th e re m a y be m o re th a n th re e p a rtie s in v o lv e d because th e le s s o r is u s u a lly a p a rtn e rs h ip o f tw o
border leases o r m o re e q u ity p a rtic ip a n ts , an d th e re m a y be tw o o r m o re d e b t p a rtic ip a n ts .
LEVERAGED LEASE The d e b t p a rtic ip a n ts le n d to th e le sso r a h ig h p r o p o r tio n o f th e co st o f th e asset. U n d e r th e p ro v is io n s
finance lease where o f T a x a tio n R u lin g IT 2 0 5 1 , th e d e b t p a rtic ip a n ts are e xp ected to c o n trib u te n o m o re th a n 8 0 p e r ce n t
the lessor borrows o f th e cost o f th e asset. A d e b t p a r tic ip a n t is u s u a lly a life in s u ra n c e co m p a n y, s u p e ra n n u a tio n fu n d ,
most of the funds to
in v e s tm e n t b a n k o r b a n k . T y p ic a lly th e lo a n is a n o n - r e c o u r s e lo a n , w h ic h m ea ns t h a t th e le sso r is n o t
acquire the asset
re s p o n s ib le f o r its re p a y m e n t. T h e re fo re , i t is im p o r t a n t t h a t th e r is k o f d e fa u lt b y th e lessee is v e ry low .
NON-RECOURSE LOAN S e c u rity f o r th e d e b t p a rtic ip a n t(s ) is p ro v id e d b y an a s s ig n m e n t o f th e lease p a y m e n ts , a n d in som e cases
type of loan used
a m o rtg a g e o v e r th e leased asset.
in leveraged leases
where the lender has The e q u ity p a rtic ip a n ts are g e n e ra lly b a n ks, in v e s tm e n t b a n ks o r fin a n c e co m p a n ie s t h a t have
no recourse to the s u ffic ie n t p r o fits to ta ke ad va n ta g e o f th e ta x d e d u c tio n s associated w ith o w n e rs h ip o f th e asset a n d th e
lessor in the event of
default by the lessee
2 For more details of leveraged leasing, its legal documentation and taxation requirements, see Bennett, Hardaker and Worrall
(1997, pp. 283-89, 292-303).
C hapter fifteen Le a s in g a n d other e q u ip m e n t f in a n c e
in te re s t p a y m e n ts o n th e lo a n . The e q u ity p a rtic ip a n ts p ro v id e th e fu n d s n o t a lre a d y p ro v id e d b y th e

le n d e r a n d f o r m a p a rtn e rs h ip t h a t pu rcha ses th e asset. A s th e m a jo r ity o r, in som e cases, a ll o f each lease
p a y m e n t is p a id o u t as in te re s t a n d p rin c ip a l to th e d e b t p a rtic ip a n t(s ), th e e q u ity p a rtic ip a n ts receive
litt le , i f any, cash in flo w fr o m th e lease p a y m e n ts . T h e ir in v e s tm e n t is le ve re d in t h a t th e y p ro v id e o n ly
part o f th e asse ts purcha se p ric e , b u t th e y receive all th e ta x b e n e fits fr o m o w n in g a n d fin a n c in g th e
asset. The e q u ity p a rtic ip a n ts ’ re tu rn s are ach ie ved m a in ly b y d e fe rra l o f ta x p a y m e n ts because th e le sso r
p a rtn e rs h ip in c u rs ta x losses d u r in g th e e a rly years o f th e lease. W h ile a le vera ged lease is co m p le x f o r th e
lessor, fro m th e lessees v ie w p o in t i t is e s s e n tia lly th e sam e as a n y o th e r fin a n c e lease. The lessee e n te rs
in to a n o rm a l lease c o n tra c t, a g re e in g to lease th e asset f o r a sp e cifie d p e rio d a n d to m a ke sp e cifie d lease
p a ym en ts.
1 5 .2 .5 1 Cross-border leasing
In g e ne ral te rm s , a c r o s s - b o r d e r le a s e (C B L ) is a lease w h e re th e lessee a n d le sso r are lo c a te d in CROSS-BORDER
d iffe re n t c o u n trie s . Such tra n s a c tio n s are u s u a lly le vera ged a n d are m o tiv a te d b y diffe re n ce s b e tw e e n LEASE (CBL)
finance lease, usually
th e ta x re g u la tio n s o f d iffe re n t c o u n trie s . A s c o u n trie s assess tra n s a c tio n s d iffe re n tly , a llo w d e p re c ia tio n
leveraged, where the
to be cla im e d a t d iffe re n t rates, a n d a p p ly d iffe re n t co m p a n y in c o m e ta x rates, i t is po ssib le to s tru c tu re
lessor and lessee are
tra n s a c tio n s to ta ke ad va n ta g e o f the se d iffe re n ce s. G en erally, th e lease w ill be s tru c tu re d so t h a t th e located in different
lessor a n d lessee can b o th c la im d e p re c ia tio n d e d u c tio n s o n th e sam e asset. Because o f th e costs in v o lv e d countries
in e s ta b lis h in g a CBL, o n ly v e ry exp en sive assets are fin a n c e d in th is way.
Several c o u n trie s a llo w CBLs because th e y g e n e ra te b e n e fits such as in cre a se d e x p o rts , b u t som e
g o v e rn m e n ts , in c lu d in g th e A u s tra lia n G o v e rn m e n t, have m o v e d to discou rage t h e ir use. In p a rtic u la r,
re s tric tio n s c o n ta in e d in s e c tio n 5 1 A D a n d D iv is io n 1 6 D o f th e Income Tax Assessment Act m e a n th a t it
is v ir tu a lly im p o s s ib le f o r a n A u s tra lia n le sso r to p a rtic ip a te in a c ro s s -b o rd e r lease in v o lv in g a n o ffs h o re
asset. H o w eve r, a CBL can be s tru c tu re d so t h a t a fo re ig n le sso r a n d an A u s tra lia n lessee can b o th c la im
d e p re c ia tio n d e d u c tio n s , p ro v id e d t h a t th e lease c o n ta in s a pu rcha se o p tio n so t h a t i t is tre a te d as a h ire -
purchase a g re e m e n t in A u s tra lia .
The CBL m a rk e t has b e en d o m in a te d b y tra n s a c tio n s in v o lv in g c o m m e rc ia l a irc ra ft, b u t o th e r assets
fin a n ce d in th is w a y in c lu d e p r in t in g presses, tru c k s , r o llin g sto c k , cargo sh ip s a n d s h ip p in g c o n ta in e rs .
A CBL can in v o lv e p a rtie s in several d iffe re n t c o u n trie s a n d th e a rra n g e m e n ts are ty p ic a lly v e ry co m p le x.
A lso, th e c o n tra c tu a l a rra n g e m e n ts used in th e CBL m a rk e t can change fre q u e n tly in resp on se to fa c to rs
such as changes in re g u la tio n s . T here fore, a n y b u sin ess t h a t c o n te m p la te s th e use o f a CBL w ill re q u ire
specialised le ga l a n d ta x a tio n advice.
Accounting and taxation treatment

of leases
LEARNING
OBJECTIVE 3
15.3.1 | Accounting for leases3 Outline the accounting
and tax treatment of
T ra d itio n a lly , lease re n ta ls w e re re co g n ise d as an expense f o r th e lessee a n d th e re was n o re c o g n itio n b y leases in Australia
th e lessee o f a n y lease assets o r lia b ilitie s . This a p p ro a ch was c ritic is e d f o r tw o reasons. F irs t, som e leases
p ro v id e v a lu a b le rig h ts a n d o b lig a tio n s t h a t c a n n o t be a v o id e d a n d s h o u ld be in c lu d e d in th e lessees
s ta te m e n t o f fin a n c ia l p o s itio n (balance she et). Second, i t was a rg u e d t h a t th e a c c o u n tin g tre a tm e n t
o f tra n s a c tio n s s h o u ld be based o n t h e ir e c o n o m ic sub stance ra th e r th a n t h e ir le g a l fo rm . Since a
fin a n ce lease is e c o n o m ic a lly e q u iv a le n t to b o rro w in g a n d b u y in g an asset, i t fo llo w s t h a t th e rig h ts a n d
o b lig a tio n s in v o lv e d in a fin a n c e lease s h o u ld be s h o w n o n th e lessees s ta te m e n t o f fin a n c ia l p o s itio n .
In A u s tra lia , A c c o u n tin g S ta n d a rd A ASB 11 7, Xeases*, p ro v id e s t h a t th e a c c o u n tin g tr e a tm e n t o f a lease
depends o n w h e th e r i t is cla ssifie d as an o p e ra tin g lease o r a fin a n c e lease. O p e ra tin g leases are tre a te d
in th e tra d itio n a l w a y b u t fin a n c e leases m u s t be re co g n ise d as assets a n d lia b ilitie s . AASB 1 1 7 p ro v id e s
3 For a full discussion of this topic, see Henderson, Peirson and Herbohn (2013).
th a t a lease w o u ld n o rm a lly be cla s s ifie d as a fin a n c e lease i f s u b s ta n tia lly a ll o f th e ris k s a n d rew ards
a sso cia te d w it h o w n e rs h ip o f th e leased asset are e ffe c tiv e ly tra n s fe rre d to th e lessee (para. 8 ). W h e re th e
lease is a fin a n c e lease, a lease asset a n d lia b ilit y e q u a l to th e f a ir v a lu e o f th e leased p ro p e rty or, i f lo w e r,
th e p re s e n t va lu e o f th e m in im u m lease p a y m e n ts m u s t be reco gn ised . H o w e ve r, som e lessees be lie ve
t h a t i t is ad van ta g e o u s to a v o id re c o g n is in g fin a n c e leases as assets a n d lia b ilitie s . C o n se q u e n tly, lessors
have re s p o n d e d b y d e s ig n in g leases t h a t are, in s ubstance, fin a n c e leases b u t can be cla ssifie d as o p e ra tin g
leases u n d e r A ASB 117. T his a c tiv ity c o n tin u e d , d e sp ite e ffo rts b y th e s ta n d a rd se tte rs to em phasise th a t
th e c la s s ific a tio n o f a lease s h o u ld d e p e n d o n it s e co n o m ic sub stance ra th e r th a n its legal fo rm . In response
to s u s ta in e d c ritic is m b y users o f fin a n c ia l s ta te m e n ts t h a t th e a c c o u n tin g tr e a tm e n t o f leases was le a d in g
to w id e s p re a d u n d e rs ta te m e n t o f d e b t le vels, in M a y 2 0 1 3 th e I n te r n a tio n a l A c c o u n tin g S ta n d a rd s B oa rd
(IA S B ) a n d th e F in a n c ia l A c c o u n tin g S ta n d a rd s B o a rd (FASB) jo in t ly released f o r c o m m e n t a p ro p o se d
a c c o u n tin g s ta n d a rd f o r leases th a t, i f a d o p te d , w o u ld replace th e e x is tin g A u s tra lia n s ta n d a rd A ASB 117.
The k e y change suggested in th e p ro p o s e d s ta n d a rd was t h a t a ll n o n -re a l esta te leases o f g re a te r th a n
12 m o n th s ’ d u ra tio n w o u ld n e ed to be c a p ita lis e d in th e lessee’s s ta te m e n t o f fin a n c ia l p o s itio n —
re s u ltin g in th e re c o g n itio n o f b o th a lease asset a n d c o rre s p o n d in g lia b ility . As a t F e b ru a ry 20 14 ,
fo llo w in g a le n g th y p e rio d o f c o n s u lta tio n a n d n u m e ro u s s u b m is s io n s b y in te re s te d p a rtie s , th e Boards
are 're d e lib e ra tin g * th e p ro p o sa ls, w h ic h u ltim a te ly w ill r e s u lt in a f u r t h e r d r a ft o f th e p ro p o s e d sta n d a rd .
1 5 .3 .2 1 Taxation treatment of leases

The ta x a tio n tr e a tm e n t o f leases in A u s tra lia can be co m p le x a n d has been su b je c t to m a n y changes th ro u g h
b o th le g is la tio n a n d ta x a tio n r u lin g s .4 O n ly a b ro a d o u tlin e o f th e m a in p rin c ip le s is p ro v id e d here. I f a
leased asset is used to g e n e ra te ta x a b le in co m e , th e lease re n ta ls p a id b y th e lessee are an a llo w a b le ta x
d e d u c tio n , p ro v id e d t h a t th e lease is cla s s ifie d as a g e n u in e lease 1 ra th e r th a n an In s t a lm e n t purchase
arra n g e m e n t*. The p u rp o s e o f th is d is tin c tio n is to p re v e n t ta xp a ye rs u s in g le a sin g as a w a y o f o b ta in in g
accelerated ta x d e d u c tio n s b y c la im in g , as d e d u c tio n s , o u tla y s t h a t are o f a c a p ita l n a tu re . C o nse que ntly,
a d e d u c tio n m a y n o t be a llo w e d f o r lease re n ta ls i f th e lease a g re e m e n t gives th e lessee an o p tio n to
p u rcha se th e leased asset a t th e e n d o f th e lease t e r m .5 S im ila rly , th e C o m m is s io n e r o f T a x a tio n has
sp e cifie d ru le s c o n c e rn in g acceptable re s id u a l values a n d m a y d is a llo w a d e d u c tio n f o r lease re n ta ls th a t
have b e en in crea sed b y th e use o f an u n re a lis tic a lly lo w re s id u a l value.
W h ile lease re n ta ls are d e d u c tib le , th e lessee c a n n o t d e d u c t, f o r ta x p u rp o se s, d e p re c ia tio n o n th e
leased asset. D e p re c ia tio n is d e d u c tib le b y th e le sso r as th e le g a l o w n e r o f th e asset, a n d lease re n ta ls
rece ive d b y th e le sso r are, o f course, ta xa b le . Lessors m a y a tte m p t to d e fe r ta x p a y m e n ts b y v a ry in g th e
size o r fre q u e n c y o f th e re n ta ls d u rin g th e te r m o f a lease. The A u s tra lia n T a x a tio n O ffic e m a y s c ru tin is e
such a rra n g e m e n ts a n d is p a r tic u la r ly sce p tica l o f lease s tru c tu re s t h a t in v o lv e in cre a se d re n ta ls o ve r
tim e (S zekely 1 9 9 1 , p. 49 ).
The ta x a tio n ru le s o fte n have an im p o r t a n t e ffe c t o n th e choice b e tw e e n le a sin g a n d o th e r s im ila r
fo rm s o f fin a n ce . F o r exa m ple, i f i t is a d va n ta g e o u s f o r d e p re c ia tio n d e d u c tio n s to be c la im e d b y th e
asset user, a c h a tte l m o rtg a g e o r a h ire -p u rc h a s e a g re e m e n t m a y be used, ra th e r th a n a lease. C h a tte l
m o rtg a g e s a n d h ire -p u rc h a s e are discussed in S e c tio n 15.8.
Setting lease rentals

W h ile th e m a in em p ha sis in th is b o o k is o n th e v ie w p o in t o f th e lessee, i t is u s e fu l to c o n s id e r th e
LEARNING a p p ro a ch use d b y lessors in s e ttin g lease re n ta ls . P ro sp e ctive lessees w h o u n d e rs ta n d th e fa c to rs th a t
OBJECTIVE 4
in flu e n c e lease re n ta ls s h o u ld be in a s tro n g e r n e g o tia tin g p o s itio n th a n th o s e w h o do n o t. The s e ttin g o f
Calculate rentals for a
finance lease lease re n ta ls is illu s tra te d in E xa m p le 15.1.
For a more detailed coverage of the taxation effects of leasing in Australia, see Australian Equipment Lessors Association
(www.ae
/.aela.asn.au).
5 Although the requirements of the Commissioner of Taxation, set out in Taxation Ruling IT28, prevent the lessor from
providing the lessee with an option to buy the asset, it is usual for such an option to be implicit in finance lease agreements.
In the vast majority of cases, the lessee buys the asset by payment of the specified residual value at the end of the initial lease
period. In most other cases the lessee renews the lease for an additional period.
E xample 15.1
M o n le a s e h a s b e e n a s k e d b y a g r o u p o f d o c to rs to q u o te o n a 4 - y e a r le a s e o f a n ite m o f m e d ic a l
6
e q u ip m e n t th a t c o sts $ 6 0 0 0 0 0 . T h e e q u ip m e n t c a n b e d e p r e c ia t e d f o r t a x p u rp o s e s o n a s tra ig h t-lin e
b a s is o v e r 3 y e a rs . M o n le a s e h a s a ta x ra te o f 3 0 p e r c e n t a n d re q u ire s a ra te o f re tu rn o f 8 p e r c e n t
p e r a n n u m a fte r ta x fro m le a s e s . T h e re a r e to b e fo u r e q u a l le a s e p a y m e n ts , p a y a b le a n n u a lly in
a d v a n c e . T he a g r e e d r e s id u a l v a lu e is $ 1 2 0 0 0 0 . W h a t is th e m in im u m a n n u a l le a s e p a y m e n t th a t
M o n le a s e s h o u ld q u o te ?
SOLUTION
The m a n a g e r o f M o n le a s e c a lc u la te s th e le a s e p a y m e n ts u s in g th e f o llo w in g step s,
a) Calculate the present value o f cosh flows from asset ownership. T h e se c a s h flo w s a r e th e ta x
s a v in g s o n d e p r e c ia tio n a n d th e a fte r-ta x c a s h in flo w fro m th e s a le o f th e a s s e t (a t th e re s id u a l
v a lu e ) a t th e e n d o f th e le a s e te rm . T h e p re s e n t v a lu e o f th e d e p r e c ia t io n ta x s a v in g s is c a lc u la te d
a s s h o w n in T a b le 1 5 . 3 .
TABLE 15.3
Year D e p re c ia tio n (D) T ax s a v in g s (D x ta x ra te ) PV fa c to r @ 8 % p .a . P rese nt v a lu e
1 $200000 $60000 0.9259 $55556
2 $200000 $60000 0.8573 $51440
3 $200000 $60000 0.7938 $47630
Total $154626
M o n le a s e w ill a ls o re c e iv e th e re s id u a l v a lu e o f $ 1 2 0 0 0 0 b u t w ill h a v e to p a y ta x o n th e
re s u ltin g p r o fit o n th e s a le o f th e e q u ip m e n t, w h ic h is a ls o $ 1 2 0 0 0 0 b e c a u s e th e e q u ip m e n t
ha s a w r itte n - d o w n v a lu e fo r ta x p u rp o s e s o f z e r o . T h e re fo re , th e a fte r-ta x c a s h in flo w w ill b e
$ 1 2 0 0 0 0 (1 - 0 . 3 ) = $ 8 4 0 0 0 , w h ic h h a s a p re s e n t v a lu e o f $ 8 4 0 0 0 / 1 . 0 8 4 = $ 8 4 0 0 0 x
0 . 7 3 5 0 o r $ 6 1 7 4 3 . T h e to ta l c a s h flo w s a s s o c ia te d w ith o w n e r s h ip o f th e e q u ip m e n t h a v e a
p re s e n t v a lu e o f $ 1 5 4 6 2 6 + $ 6 1 7 4 3 = $ 2 1 6 3 6 9 .
b) Calculate the required present value o f the lease payments. T h e a s s e t c o sts $ 6 0 0 0 0 0 , o f w h ic h

M o n le a s e w ill re c o v e r $ 2 1 6 3 6 9 fro m its o w n e r s h ip . T h e re fo re , th e r e q u ire d p re s e n t v a lu e o f th e
le a s e p a y m e n ts is $ 6 0 0 0 0 0 - $ 2 1 6 3 6 9 = $ 3 8 3 6 3 1 .
c) Calculate the minimum ofter-tox lease payment. W it h a n n u a l le a s e p a y m e n ts , L, p a y a b le in

advance:
$383 631 = 1+ —
\ 0.08 (1.08)3
二【
(1 +2.5771)
L_ $383 631
~ 3.5771
= $107246
d) Calculate the minimum before-tox lease payment, L\ given the tax rote tc.
= $107246 =$1532〇9
1- t c 1 -0 .3
To a c h ie v e its r e q u ire d ra te o f re tu rn o f 8 p e r c e n t a fte r ta x , M o n le a s e s h o u ld q u o te a n n u a l

le a s e p a y m e n ts o f $ 1 5 3 2 0 9 .
F ro m th e s e c a lc u la tio n s it s h o u ld b e c le a r th a t M o n le a s e w o u ld b e a b le to q u o te lo w e r le a s e
re n ta l p a y m e n ts if:
i) th e d e p r e c ia tio n r a te f o r ta x p u rp o s e s is higher
ii) th e re s id u a l v a lu e o f th e e q u ip m e n t is higher
iii) th e le s s o r's r e q u ire d ra te o f re tu rn is lower.
B usiness finance
In p ra c tic e , o th e r fa c to rs w i ll also a ffe c t lease re n ta l p a y m e n ts . F o r exa m ple, le ssors w i ll a d ju s t lease

re n ta ls to re fle c t a n y tra n s a c tio n costs in v o lv e d in e s ta b lis h in g th e lease a n d a n y g o v e rn m e n t charges,
such as s ta m p d u ty a n d th e go od s a n d services ta x (G ST). T hey are also lik e ly to a d ju s t th e re q u ire d rate
o f r e t u r n to re fle c t d iffe re n ce s in c re d it r is k b e tw e e n d iffe re n t lessees, a n d th e y m a y ta k e in to acco un t
th e e xa ct tim in g o f ta x effects. T h e re fo re , f o r som e leases, p a r tic u la r ly la rg e ones, th e c a lc u la tio n o f lease
re n ta ls is m o re co m p le x th a n th e p ro c e d u re illu s tra te d in E xa m p le 15.1. O n th e o th e r h a n d , th e p ro ce d u re
m a y be less co m p le x. F o r s m a ll leases, a le sso r m a y ca lcu la te th e re q u ire d lease p a y m e n ts u s in g b e fo re -ta x
cash flo w s a n d a b e fo re -ta x ra te o f re tu rn .
15.5 Evaluation of finance leases

m M a n y m e th o d s have been suggested f o r e v a lu a tin g fin a n c e leases. O ne rea son f o r th is is th a t th e re has
LEARNING been c o n tro v e rs y o v e r th e q u e s tio n o f h o w to s tru c tu re th e e v a lu a tio n o f leases; som e a u th o rs suggest
OBJECTIVE 5
t h a t th e a p p ro p ria te c o m p a ris o n is ‘le a sin g versu s b o r r o w in g ’，w h ile o th e rs suggest t h a t ‘le a sin g versus
Evaluate a finance
lease from the lessee’s b u yin g * is th e c o rre c t ap pro ach.
viewpoint The a p p ro a ch w e discuss was p re s e n te d b y M y e rs , D ill an d B a u tis ta (M D B ) (1 9 7 6 ). E sse n tia lly, th e
m ech an ics o f th e M D B m e th o d o f a n a ly s in g a fin a n c e lease are id e n tic a l to th o s e p ro p o s e d e a rlie r b y o th e r
a u th o rs .6 H o w eve r, th e m a in c o n tr ib u tio n m ade b y M D B lie s in a n a ly s in g a fin a n c e lease in th e c o n te x t
o f its e ffe c t o n th e lessees c a p ita l s tru c tu re . In p a rtic u la r, M D B e m p h a sise d t h a t e n te rin g in to a fin a n ce
lease uses som e o f th e lessees d e b t capacity. T here fore, i t fo llo w s t h a t a fin a n c e lease s h o u ld be analysed
b y c o m p a rin g i t w it h d e b t.
M D B sho w e d t h a t th is c o n c lu s io n fo llo w s even i f th e c o m p a ris o n is in it ia lly v ie w e d as lease versus buy.
T hey p o in te d o u t t h a t th e p h rase le a s e versus b u y 1 is v ir t u a lly m e a n in g le ss u n le ss th e m ea ns o f fin a n c in g
th e p u rch a se are sp e cifie d . S uppose t h a t th e c o m p a ris o n is s p e c ifie d as le a s in g ve rsu s b u y in g , u s in g
n o r m a l fin a n c in g — t h a t is, th e m ix tu r e o f d e b t a n d e q u ity in th e co m p a n y s n o rm a l c a p ita l s tru c tu re . I t is
th e n necessary to a llo w f o r th e fa c t t h a t lease fin a n c e w ill use som e o f th e co m p a n y s d e b t capacity. W h e n
th is is d o n e i t can be seen th a t, in e ffe c t, lease fin a n c e m u s t be co m p a re d w it h d e b t. The e ffe c t o f lease
fin a n c e in u s in g d e b t c a p a city is illu s tra te d in E xa m p le 15.2.
E xa m p le 15 .2 show s t h a t le a sin g uses a c o m p a n y s d e b t cap acity, w h ic h suggests t h a t a fin a n c e lease
s h o u ld be e va lu a te d b y c o m p a rin g i t w it h o th e r d e b t fin a n ce . H o w e ve r, th is does n o t m e a n t h a t th e
a lte rn a tiv e to le a s in g an asset is to b o rro w an a m o u n t e q u a l to th e p u rcha se p ric e o f th e asset. R a th e r i t
m eans t h a t fin a n c e lease e v a lu a tio n m u s t a llo w f o r th e fa c t t h a t a c o m p a n y e n te rin g in to a fin a n c e lease
reduces it s a b ility to b o rro w in o th e r w a ys— t h a t is, th e o b lig a tio n to m a ke re n ta l p a y m e n ts u n d e r a
lease uses u p som e o f th e d e b t ca p a city p ro v id e d b y th e co m p a n y s assets. F o r le a s in g to be e c o n o m ic a lly
E xample 15.2
H e a v y H a u la g e Ltd h a s asse ts w ith a m a rk e t v a lu e o f $ 5 0 0 0 0 0 , fin a n c e d b y a c a p it a l s tru c tu re
of $ 2 5 0 0 0 0 e q u ity a n d $ 2 5 0 0 0 0 d e b t. T h e c o m p a n y n e e d s a n e w tru c k , w h ic h c a n e ith e r b e
p u rc h a s e d fo r $ 1 0 0 0 0 0 o r le a s e d . W h a t e ffe c t w ill le a s in g th e tru c k h a v e o n th e c o m p a n y 's d e b t
c a p a c ity ?
SOLUTION
If th e tru c k is p u rc h a s e d u s in g th e c o m p a n y ’s n o r m a l c o m b in a t io n o f d e b t a n d e q u ity , th e s ta te m e n t o f
f in a n c ia l p o s itio n w ill b e a s fo llo w s :
S ta te m e n t o f fin a n c ia l p o s itio n
Assets $500000 Debt $300000
Truck $100000 Equity $300000
$600000 $600000
6 For an analysis of the origins of the MDB method, see Burrows (1988).
A lte rn a tiv e ly , if th e tru c k is le a s e d , th e s ta te m e n t o f f in a n c ia l p o s itio n w ill b e :
S ta te m e n t o f fin a n c ia l p o s itio n 2
Assets $500000 Debt $250000
Truck $10 0 0 0 0 Lease liability $10 0 0 0 0

Equity $250000
$600000 $600000
L e a s in g h a s in c r e a s e d th e c o m p a n y 's d e b t - e q u it y r a t io b e c a u s e th e le a s e lia b ilit y is a n a d d itio n a l

ty p e o f d e b t in th e c o m p a n y 's c a p it a l s tru c tu re . To re s to re th e o r ig in a l d e b t - e q u it y r a tio , th e c o m p a n y
s h o u ld ra is e a n o th e r $ 5 0 0 0 0 o f e q u ity a n d r e p a y th e d e b t o f $ 5 0 0 0 0 . A fte r th e se c h a n g e s , th e
s ta te m e n t o f fin a n c ia l p o s itio n w ill c o n ta in e q u ity o f $ 3 0 0 0 0 0 , d e b t o f $ 2 0 0 0 0 0 a n d th e le a s e
lia b ilit y o f $ 1 0 0 0 0 0 . A c o m p a r is o n w ith S ta te m e n t o f f in a n c ia l p o s itio n 1 s h o w s th a t th e le a s e use d
$ 1 0 0 0 0 0 o f th e c o m p a n y 's d e b t c a p a c ity .
advantageous to a lessee, th e fin a n c e p ro v id e d b y le a sin g m u s t be g re a te r th a n th e lia b ilit y in c u rre d b y

leasing. The M D B m e th o d focuses o n m a k in g t h a t c o m p a ris o n b y c a lc u la tin g th e lia b ilit y in c u rre d b y
leasing. E xa m p le 15 .3 illu s tra te s th e M D B m e th o d .
Example 15.3
S h a re m a rk e t R e s e a rch Ltd (SRL) n e e d s a n e w c o m p u te r, w h ic h c a n b e p u rc h a s e d fo r $ 6 0 0 0 0 0 .
6
T he c o m p a n y 's f in a n c ia l m a n a g e r, E llio tt W a v e , is c o n s id e r in g th e a lte r n a tiv e o f le a s in g th e c o m p u te r
fro m E ffic ie n t F in a n c e , w h ic h re q u ire s s ix le a s e re n ta ls o f $ 1 2 6 0 0 0 e a c h , p a y a b le a n n u a lly in
a d v a n c e . T he c o m p u te r c a n b e d e p r e c ia te d fo r ta x p u rp o s e s o v e r 3 y e a rs o n a s tra ig h t-lin e b a s is
a n d its d is p o s a l v a lu e is e x p e c te d to b e z e r o a t th e e n d o f th e le a s e . T h e c o m p a n y in c o m e ta x ra te is
3 0 p e r c e n t. Is th e p r o p o s e d le a s e a ttr a c tiv e to SRL?
SOLUTION
The in c re m e n ta l c a s h flo w s f o r le a s in g th e c o m p u te r, ra th e r th a n b u y in g it, a r e s h o w n in T a b le 1 5 .4 .
TABLE 15.4 Cash flows: lease versus purchase

C a s h flo w s ($)
Item Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Cost o f com p uter 600000 — — — — —
2. Lease rentals -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0
3. Tax savings on lease 37800 37800 37800 37800 37800 37800

rentals
4. D epreciation tax 一 -6 0 0 0 0 -6 0 0 0 0 -6 0 0 0 0 _ 一
savings lo s t
Total 511800 -1 4 8 2 0 0 -1 4 8 2 0 0 -1 4 8 2 0 0 -8 8 2 0 0 -8 8 2 0 0
R e m e m b e rin g th a t th e ta b le s h o w s th e increm ental c a s h flo w s fo r le a s in g ve rsu s b u y in g , th e

e x p la n a tio n f o r e a c h ite m is s tr a ig h tfo r w a r d . F irst, b y le a s in g th e c o m p u te r, SRL d o e s n o t n e e d to p a y
th e p u rc h a s e p r ic e o f $ 6 0 0 0 0 0 . T h e re fo re , th e re is a n e ffe c tiv e c a s h in flo w o f th is a m o u n t. S e c o n d ,
th e le a s e re n ta ls a r e a c a s h p a y m e n t e a c h y e a r, b u t th e se p a y m e n ts a r e ta x d e d u c tib le , g e n e r a tin g
a n n u a l ta x s a v in g s o f $ 3 7 8 0 0 , w h ic h a r e a c a s h in flo w . F in a lly , b y le a s in g ra th e r th a n b u y in g , SRL
continued
B usiness finance
continued
is u n a b le to c la im d e p r e c ia tio n d e d u c tio n s o f $ 2 0 0 0 0 0 p e r a n n u m in Y e a rs 1 , 2 a n d 3 . T h e re fo re , it
fo r g o e s t a x s a v in g s o f $ 6 0 0 0 0 in e a c h o f th e se y e a rs . T h e b o tto m r o w o f T a b le 1 5 . 4 s h o w s th a t th e
le a s e p r o v id e s f in a n c e o f $ 5 1 1 8 0 0 to SRL a n d re q u ire s n e t c a s h o u tflo w s b y SRL in Y e a rs 1 to 5 .
To d e te r m in e w h e th e r th e le a s e is a ttr a c tiv e to SRL, th e c a s h o u tflo w s in Y e a rs 1 to 5 c a n b e
r e g a r d e d as a fte r-ta x re p a y m e n ts o f a lo a n th a t is e q u iv a le n t to th e le a s e — th a t is, w e a s k : if SRL
h a d o ffe r e d th is set o f re p a y m e n ts to a n a lte r n a tiv e le n d e r, h o w m u c h c o u ld SRL h a v e b o r r o w e d ? If
th e a m o u n t is less th a n $ 5 1 1 8 0 0 , SRL s h o u ld a c c e p t th e le a s e . T h e a m o u n t th a t c o u ld b e b o r r o w e d
fro m a n a lte r n a tiv e le n d e r w ill d e p e n d o n th e in te re s t r a te o n th e h y p o th e tic a l e q u iv a le n t lo a n . T he
in te re s t r a te w ill, in tu rn , d e p e n d o n th e s e c u rity o ffe r e d to th e le n d e r. F o r th e lo a n to b e e q u iv a le n t
to th e le a s e , th e s e c u rity s h o u ld b e th e s a m e a s th a t h e ld b y th e le sso r. If th e le s s o r's o n ly s e c u rity is
o w n e r s h ip o f th e c o m p u te r, th e in te re s t ra te o n a lo a n s e c u re d b y a m o r t g a g e o r o th e r c h a r g e o v e r th e
c o m p u te r c o u ld b e a p p r o p r ia t e . 7 A s s u m e th a t E llio tt W a v e h a s b e e n q u o te d a ra te o f 1 0 . 8 p e r c e n t
p e r a n n u m o n such a lo a n . B e c a u s e th e c a s h flo w s to b e d is c o u n te d a r e a fte r ta x , th e d is c o u n t ra te
m u st a ls o b e a fte r t a x — th a t is, 1 0 . 8 x (1 - 0 . 3 ) = 7 . 5 6 p e r c e n t p e r a n n u m .
T h e p re s e n t v a lu e o f th e n e t c a s h o u tflo w s is:
$148200 $88200 $88200

0 .0 7 5 6 (1 .0 7 5 6 )3 . (1.07 56 )4 (1.07 56 )5
$512141
T he le a s e p r o v id e s fin a n c e o f $ 5 1 1 8 0 0 a n d th e p re s e n t v a lu e o f th e lia b ilit y in c u r r e d b y le a s in g is

$ 5 1 2 1 4 1 , so th e n e t p re s e n t v a lu e (N P V ) o f th e le a s e re la tiv e to th e e q u iv a le n t lo a n is:
N P V = $ 5 1 1 8 0 0 - $ 5 1 2 141 = - $ 3 4 1
B a s e d o n th is a n a ly s is th e le a s e is m a r g in a lly u n a ttra c tiv e a n d s h o u ld n o t b e a c c e p te d b y SRL.
15.5.1 | Leasing decisions and investment decisions

To in te r p r e t c o rre c tly th e re s u lt o f a lease e v a lu a tio n such as t h a t in E xa m p le 15 .3, i t is necessary to
given
u n d e rs ta n d t h a t th is e v a lu a tio n relates o n ly to th e q u e s tio n o f w h e th e r i t is b e tte r to lease o r buy,
that the services provided by the asset are to be acquired. I n o th e r w o rd s , th e lease e v a lu a tio n gives an N P V fo r
le a s in g th e asset relative to b u y in g it . Suppose t h a t in E xa m p le 1 5 .3 th e N P V o f th e lease w as $ 1 0 0 0 . This
p o s itiv e N P V does n o t ne ce ssa rily m e a n t h a t SRL s h o u ld lease th e c o m p u te r. I f b u y in g th e c o m p u te r has
a n e g a tiv e NPV, say - $ 5 0 0 0 , th e n le a sin g i t w o u ld n o t be a ttra c tiv e because th e to t a l N P V f o r a c q u irin g
th e c o m p u te r b y le a sin g is:
N P V i f p u rch a se d -$ 5 0 0 0
N P V o f lease re la tiv e to purcha se $1000
N P V o f le a s in g c o m p u te r -$ 4 0 0 0
Since th e to t a l N P V is n e g a tive , th e c o m p u te r s h o u ld n o t be leased: le a s in g is b e tte r t h a n p u rch a sin g ,

b u t b o th a lte rn a tiv e s are u n p ro fita b le .
In p ra c tic e , th e in v e s tm e n t d e c is io n w o u ld n o r m a lly be c o n sid e re d f ir s t and, i f th e p ro je c t were
p ro fita b le , th e a lte rn a tiv e o f le a sin g th e re q u ire d assets w o u ld th e n be e va lu a te d . H o w e ve r, th e fin a n c ia l
m a n a g e r s h o u ld n o t ne ce ssa rily d isca rd a p ro je c t i f e v a lu a tio n o f th e in v e s tm e n t d e c is io n reveals a
n e g a tive NPV. In som e cases, th e N P V o f a lease can be la rg e e n o u g h to Vescue 1 an o th e rw is e m a rg in a lly
u n p ro fita b le p ro je c t.
7 The lessors formal security is generally, but not always, restricted to ownership of the leased asset. A case in which additional
security was required is cited by Burrows (1998, p. 117). For evidence on factors that affect the cost of lease finance, see
Schallheim et al. (1987).
15.5.2|The value of leasing in competitive capital markets

L a te r sectio ns, in c lu d in g S e c tio n 1 5 .5 .3 , discuss som e o f th e c o n d itio n s t h a t can re s u lt in a lease h a v in g
a p o s itiv e N P V f o r th e lessee. Lease fin a n c e is p ro v id e d in m a rk e ts t h a t are h ig h ly c o m p e titiv e , w h ic h has
im p o r ta n t im p lic a tio n s f o r th e value o f leasing. To e x a m in e the se im p lic a tio n s , suppose t h a t a ll fin a n c ie rs
an d asset users o p e ra te in a p e rfe c t c a p ita l m a rk e t w h e re th e fo llo w in g c o n d itio n s a p p ly:
a le asin g in v o lv e s n o tra n s a c tio n costs

b in fo r m a tio n is costless a n d fre e ly a va ila ble
C a ll p a rtie s are su b je c t to th e sam e ta x la w s a n d ta x rates.
U n d e r these c o n d itio n s , th e cost o f le a s in g an asset s h o u ld be e x a c tly th e sam e as th e cost o f b u y in g

i t — t h a t is, th e le a se -o r-b u y d e c is io n s h o u ld be a m a tte r o f in d iffe re n c e . The a rg u m e n t t h a t leads to th is
co n clu sio n w ill be e x p la in e d u s in g , f o r illu s tr a tiv e p u rp o se s, th e d a ta a n d re s u lts o f E xa m p le 15 .3. In th a t
exam ple, th e N P V f o r th e lessee o f le a sin g th e n e w c o m p u te r ra th e r th a n p u rc h a s in g i t w as -$ 3 4 1 .
N o w c o n s id e r th e p o s itio n o f th e lessor, E ffic ie n t Finance. F ro m th e le s s o rs v ie w p o in t th e d e cisio n
is w h e th e r to lease th e c o m p u te r to SRL o r to le n d SRL fu n d s to b u y i t . I f E ffic ie n t F in a n ce is to lease th e
c o m p u te r to SRL, i t m u s t f ir s t b u y th e c o m p u te r f o r $ 6 0 0 00 0. E ffic ie n t F in a n ce w ill receive th e lease
re n ta ls, be ta xe d on th e m a n d can c la im ta x d e d u c tio n s f o r d e p re c ia tio n o f th e c o m p u te r. T here fore,
p ro v id e d th a t b o th p a rtie s are ta xe d a t th e sam e rate, th e lessee s a fte r-ta x cash o u tflo w s are th e le s s o rs
a fte r-ta x cash in flo w s . In o th e r w o rd s, E ffic ie n t F in a n c e s n e t cash flo w s w ill be th o s e s h o w n in th e b o tto m
ro w o f Table 15.4, w it h th e sig n s reversed. Because th e a p p ro p ria te d is c o u n t ra te w ill re m a in u n c h a n g e d
a t 7.5 6 p e r ce n t p e r a n n u m , th e N P V o f th is lease f o r th e le s s o r m u s t be + $ 3 4 1 .
U n d e r the se circu m sta n ce s, th e lease a lte rn a tiv e is a ttra c tiv e to th e le sso r b u t n o t to th e lessee.
R educing th e lease re n ta ls w o u ld increase th e v a lu e o f th e lease to SRL b u t m u s t also cause a n eq ua l
re d u c tio n in th e v a lu e o f th e lease to E ffic ie n t F ina nce . Because o f th e s y m m e try b e tw e e n th e p o s itio n s o f
th e tw o p a rtie s , i t is im p o s s ib le to d e sig n a lease t h a t w ill be m o re a ttra c tiv e to th e lessee th a n b o rro w in g ,
w ith o u t s im u lta n e o u s ly m a k in g th e lease less a ttra c tiv e to th e lessor.
F u rth e r, in a p e rfe c t c a p ita l m a rk e t, lessors s h o u ld e a rn o n ly a n o rm a l ra te o f r e tu r n o n t h e ir a c tiv itie s .
Therefore, in e q u ilib riu m , th e N P V o f p r o v id in g lease fin a n c e s h o u ld be zero. A g a in , because o f th e
s y m m e tric a l p o s itio n s o f th e tw o p a rtie s , th e N P V o f le a s in g f o r th e lessee m u s t also be zero. T here fore,
in a p e rfe c t c a p ita l m a rk e t a ll asset users s h o u ld be in d iffe r e n t b e tw e e n th e a lte rn a tiv e s o f le a sin g a n d
b u yin g . This c o n c lu s io n s h o u ld n o t be s u rp ris in g . The le a s e -o r-b u y d e c is io n is a fin a n c in g d e cisio n , and,
as discussed in C h a p te r 12, M o d ig lia n i a n d M ille r sh o w e d th a t, in a p e rfe c t c a p ita l m a rk e t, fin a n c in g
de cisions have no e ffe c t o n s h a re h o ld e rs ’ w e a lth . In o th e r w o rd s, ju s t as th e re is n o m a g ic in fin a n c ia l
leverage in a p e rfe c t c a p ita l m a rk e t, so th e re is n o m a g ic in leasing.
C a lc u la tio n o f th e e q u ilib r iu m lease re n ta ls t h a t s h o u ld m a ke an asset u se r in d iffe r e n t b e tw e e n le a sin g
and b u y in g is s h o w n in E x a m p le 15.4.
Example 15.4
W e s te rn C o m p u te r S e rv ic e s Ltd (W C S ) is c o n s id e r in g th e a c q u is itio n o f a c o m p u te r th a t c a n b e
p u rc h a s e d fo r $ 5 0 0 0 0 0 o r le a s e d . T h e le a s e is to in v o lv e fiv e e q u a l re n ta l p a y m e n ts , p a y a b le
a n n u a lly in a d v a n c e , w ith a re s id u a l v a lu e o f $ 5 0 0 0 0 a fte r 5 y e a rs . W C S e x p e c ts to b e p a y in g ta x
a t th e ra te o f 3 0 p e r c e n t d u r in g th e te rm o f th e le a s e . W h a t a r e th e m a x im u m le a s e re n ta ls th a t s h o u ld
b e p a id , g iv e n th a t th e in te re s t ra te o n a n e q u iv a le n t lo a n is 1 0 p e r c e n t p e r a n n u m ?
SOLUTION
A s in E x a m p le 1 5 . 3 , th e firs t ste p is to d e te r m in e th e in c re m e n ta l c a s h flo w s fo r le a s in g ve rs u s b u y in g .
T he a d d itio n a l fa c to r to b e c o n s id e r e d is th e tre a tm e n t o f th e re s id u a l v a lu e , w h ic h in th is c a s e is
$ 5 0 0 0 0 . To p u t th e le a s e a n d p u rc h a s e a lte rn a tiv e s o n th e s a m e b a s is it m ust b e a s s u m e d th a t
W C S p a y s th e r e s id u a l v a lu e a n d t h e re b y p u rc h a s e s th e c o m p u te r fro m th e le sso r. T h is ra is e s o n e
fu rth e r c o m p lic a tio n : if W C S le a se s th e c o m p u te r a n d th e n p u rc h a s e s it, th e c o m p a n y c a n c la im ta x
d e d u c tio n s , b e g in n in g in Y e a r 6 , fo r d e p r e c ia tio n b a s e d o n th e p u rc h a s e p r ic e o f $ 5 0 0 0 0 . If W C S
h a d p u rc h a s e d th e c o m p u te r w h e n it w a s n e w , a ll d e p r e c ia t io n d e d u c tio n s w o u ld h a v e b e e n c la im e d
continued
continued
d u r in g th e firs t 3 y e a rs . T h e re fo re , th e t w o a lte rn a tiv e s in v o lv e a d iffe re n c e in a llo w a b le ta x d e d u c tio n s

a fte r th e le a s e te rm .
To m a k e a n u n b ia s e d c o m p a r is o n , it w ill b e a s s u m e d th a t in e a c h a lte r n a tiv e th e c o m p u te r is s o ld a t
th e e n d o f Y e a r 5 — th a t is, a t th e e n d o f th e le a s e te rm , W C S b u y s th e c o m p u te r b y p a y in g th e re s id u a l
v a lu e o f $ 5 0 0 0 0 a n d im m e d ia te ly sells it fo r its m a rk e t v a lu e , a ls o a s s u m e d to b e $ 5 0 0 0 0 . T h e re fo re ,
th e s a le p r o c e e d s w ill b e th e s a m e in e a c h c a s e a n d d o n o t h a v e to b e in c lu d e d , s in c e in c re m e n ta l
c a s h flo w s a r e b e in g c o n s id e r e d . H o w e v e r, th e le a s e ’s re s id u a l v a lu e m ust b e in c lu d e d , as m ust a n y
ta x e ffe c ts r e la te d to th e s a le o f th e c o m p u te r. In th is c a s e , th e le a s e a lte r n a tiv e d o e s n o t in v o lv e
a n y ta x e ffe c t, s in c e W C S is a s s u m e d to sell th e c o m p u te r f o r $ 5 0 0 0 0 , w h ic h is th e s a m e a s th e
p r ic e it p a id . T he a lte r n a tiv e o f b u y in g th e a s s e t in v o lv e s a p r o fit o f $ 5 0 0 0 0 (s in c e in th a t c a s e , th e
w r itte n - d o w n v a lu e is z e ro ) o n w h ic h th e in c o m e ta x w ill b e $ 5 0 0 0 0 x 0 . 3 = $ 1 5 0 0 0 .
T h e in c re m e n ta l c a s h flo w s f o r le a s in g ve rs u s b u y in g a re s h o w n in T a b le 1 5 . 5 , w h e r e L re p re s e n ts
th e a n n u a l le a s e re n ta l.

C a sh flo w s ($)
Item Year 0 Year 1 Year 2 Year 3 丨 Year 4 Y ear 5
1. Cost o f co m p u te r 500000 — — — — —
2. Lease ren ta ls -L -L -L -L -L —
3. Tax savings on lease ren ta ls 0.3L 0.3L 0.3L 0.3L 0.3L —
4. D e pre ciatio n ta x savings lo s t — -5 0 0 0 0 -5 0 0 0 0 -5 0 0 0 0 — —
5. Lease residual value — — — — — -5 0 0 0 0
6 . Tax saved o n p ro fit on sale — — — 15 000
T h e a fte r-ta x in te re s t ra te o n a n e q u iv a le n t lo a n is 10 (1 - 0 . 3 ) = 7 p e r c e n t p e r a n n u m , a n d th e
e q u ilib r iu m le a s e re n ta ls c a n b e fo u n d b y s o lv in g a s f o llo w s : 8
| $50000 $35 000

N PV =0 = $ 5 0 0 0 0 0 -0 .7 [ [i 1 [i 1
1 0.07 . (1-07)4 . J 0.0 7 L (i- 〇 7)3 J (10.7)5
3.071 〇 [ = $500 000 - $ 131216 - $24 955
and U $111958
T h e re fo re , th e m a x im u m le a s e re n ta ls th a t W C S s h o u ld be p re p a re d to p a y a re $111 95 8
p e r a n n u m . T h e se re n ta ls w ill a ls o p r o v id e a n o r m a l r a te o f re tu rn to th e le ssor.
Does th e p e rfe c t c a p ita l m a rk e t re s u lt o f in d iffe re n c e b e tw e e n le asin g an d b u y in g a p p ly in re a l-w o rld

c a p ita l m arke ts? The p o p u la rity o f leasing has va rie d o ve r tim e a n d i t is p a rtic u la rly p o p u la r fo r som e types
o f assets. These o b se rva tio n s suggest th a t th e re are cases w h e re asset users have a syste m a tic preference fo r
leasing o r b u yin g . Clearly, f o r th is to be th e case, th e re m u s t be ta x differences o r im p e rfe c tio n s th a t can m ake
leasing advantageous. Some c o n d itio n s th a t m a y give rise to a n o ve ra ll advantage f o r leasing are discussed in
th e n e x t section. The advantages an d disadvantages o f le asin g are also discussed in S ection 15.7.
1 5 .5 .3 1 Establishing an advantage for leasing

To m ake le a s in g a ttra c tiv e to th e u s e r o f an asset, w ith o u t s im u lta n e o u s ly m a k in g le a s in g u n a ttra c tiv e to
th e lessor, re q u ire s som e d e p a rtu re fr o m th e p e rfe c t-m a rk e t c o n d itio n s o u tlin e d in th e p re v io u s sectio n.
In p a rtic u la r, i t is necessary to b re a k th e s y m m e try b e tw e e n th e p o s itio n s o f th e tw o p a rtie s . There are
8 Since the residual value of $50 000 is specified in the lease agreement, it is of similar risk to the lease rentals and can be
discounted at the after-tax cost of debt. However, the tax savings ($15 000) depend in part on the disposal (market) value of
the computer and are therefore riskier. Discounting this cash flow at the after-tax cost of debt is an approximation.
ways in w h ic h th is can be do ne . F o r exa m ple, th e le sso r m a y be e n title d to receive q u a n tity d is c o u n ts

th a t are n o t ava ila ble to th e b u y e r o f a s in g le ite m . Such d is c o u n ts m a y be a va ila b le to s p e c ia lis t lessors o f
m ass-p rod uced assets, such as cars, b u t are u n lik e ly to a p p ly w h e re th e asset is u n iq u e o r w h e re th e le sso r
is a general fin a n c ie r. Le a sin g m a y also be ad va n ta g e o u s w h e re th e re is som e d iffe re n c e b e tw e e n th e ta x
p o s itio n s o f th e le sso r a n d th e asset user. T his is illu s tra te d in E xa m p le 15 .5, w h ic h uses th e sam e basic
in fo r m a tio n as E xa m p le 15.3.
E xample 15.5
S h a re m a rk e t R e s e a rch Ltd (SRL) is a g a in c o n s id e r in g th e a c q u is itio n o f a $ 6 0 0 0 0 0 c o m p u te r, b u t
E llio tt W a v e h a s n o w e s ta b lis h e d th a t b e c a u s e o f p a s t lo sses th a t a r e b e in g c a r r ie d f o r w a r d , SRL is
u n lik e ly to p a y c o m p a n y in c o m e ta x d u r in g th e n e x t 5 y e a rs . Is th e le a s e a ttra c tiv e ?
SOLUTION
The re v is e d c a s h flo w s fo r le a s in g th e c o m p u te r, ra th e r th a n p u rc h a s in g it, a r e s h o w n in T a b le 1 5 . 6 .
The o n ly re le v a n t c a s h flo w s a r e th e c o s t o f th e c o m p u te r a n d th e le a s e re n ta ls .

C a s h flo w s ($)
Item Year 0 Year 2 Year 3 Year 4 Year 5

Year1
1. Cost o f com p uter 600000
2. Lease rentals -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0
T otal 474000 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0 -1 2 6 0 0 0
B e c a u s e SRL is u n lik e ly to p a y c o m p a n y in c o m e ta x d u r in g th e te rm o f th e le a s e , th e se n e t c a s h flo w s

s h o u ld b e d is c o u n te d a t th e b e fo re -ta x b o r r o w in g ra te o f 1 0 . 8 p e r c e n t. T he N P V o f th e le a s e to SRL is:
N P V = +$474 0 0 0 - $ 126000
0 .1 0 8 (1.10 8)5
=$5965
T h e re fo re , b e c a u s e SRL w ill n o t b e p a y in g c o m p a n y in c o m e ta x d u r in g th e te rm o f th e le a s e , th e
N P V o f th e le a s e h a s in c r e a s e d fro m - $ 3 4 1 to $ 5 9 6 5 . A s s u m in g th a t E ffic ie n t F in a n c e w ill b e in a
t a x p a y in g p o s itio n e a c h y e a r , th e N P V to it w ill still b e $ 3 4 1 . T h e re fo re , th e le a s e a lte r n a tiv e n o w h a s
a p o s itiv e N P V fo r b o th p a r tie s a n d th e re is a n o v e r a ll g a in fro m le a s in g :
G a in fro m le a s in g = $ 5 9 6 5 + $ 3 4 1 = $6306
T h is g a in is r e a lis e d a t th e e x p e n s e o f th e g o v e r n m e n t a n d is a c h ie v e d b e c a u s e th e le s s o r is u tilis in g
ta x d e d u c tio n s a s s o c ia te d w ith o w n e r s h ip a n d fin a n c in g o f th e le a s e d a s s e t (in th is c a s e , d e d u c tio n s
fo r d e p r e c ia tio n a n d in te re s t o n b o r r o w in g s ) a s s o o n a s th e y a r e a v a ila b le . If SRL p u rc h a s e d th e
c o m p u te r u s in g b o r r o w e d m o n e y , th e s e d e d u c tio n s w o u ld b e o f n o im m e d ia te v a lu e to th e c o m p a n y
b e c a u s e th e y w o u ld o n ly a d d to th e ta x loss b e in g c a r r ie d f o r w a r d .
T he m a n n e r in w h ic h th e g a in o f $ 6 3 0 6 is s h a re d b e tw e e n th e le s s o r a n d le sse e w ill d e p e n d , in
p a rt, o n th e le v e l o f c o m p e titio n in th e le a s in g in d u s try . If th e re is p e r fe c t c o m p e titio n in th e in d u s try ,
th e a n n u a l le a s e re n ta ls w ill b e re d u c e d to a le v e l such th a t th e N P V to E ffic ie n t F in a n c e is z e r o a n d
th e w h o le g a in w ill th e n a c c ru e to SRL.
1 5 .5 .4 1 Taxes and the size of leasing gains

E xam ples 15 .3 a n d 15 .5 s h o w t h a t le a sin g can be less c o s tly th a n p u rc h a s in g w h e re th e le s s o r has
advantages n o t a va ila ble to th e p o te n tia l lessee a n d w h e re som e o f th e se advan ta ge s are passed o n to
th e lessee b y w ay o f lo w e r lease p a y m e n ts . H o w e ve r, the se exa m ples assum e an e x tre m e case in w h ic h
th e lessees ta x ra te is zero a n d th e le s s o rs ta x ra te is th e f u ll s ta tu to r y ra te , assu m ed to be 30 p e r cen t.
k B usiness finance
In m a n y cases, th e d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates o f th e tw o p a rtie s m a y be m u c h s m a lle r a n d

i t m a y v a ry o ve r tim e . F o r exa m ple, th e lessee m a y in it ia lly have a ta x ra te o f zero b u t b e g in to p a y ta x
d u rin g th e lease te rm . T h e re fo re , fa c to rs such as th e t im in g o f th e lease r e n ta l p a y m e n ts c an a ffe c t th e size
o f th e g a in a sso cia te d w it h leasing. To id e n tify th e fa c to rs t h a t can be im p o r t a n t a n d to illu s tra te th e ir
effects, c o n s id e r th e e ffe cts t h a t a lease can have o n th e p re s e n t v a lu e o f th e g o v e rn m e n ts ta x rece ip ts.
In E xam p le s 1 5 .3 a n d 15 .5, th e N P V o f th e lease in v o lv e s c a lc u la tin g th e p re s e n t value s o f th re e type s
o f cash flo w s : th e cost o f th e asset, th e a fte r-ta x lease re n ta ls a n d th e ta x savings o n d e p re c ia tio n . The
N P V o f a lease to th e lessee (N P V LES) can be expressed as:
NPVles = C-PV(L) - P \/(D e p )
w h e re C = cost o f th e leased asset

PV(L) = p re s e n t va lu e o f lease re n ta ls
P V (D e p ) = p re s e n t value o f d e p re c ia tio n ta x savings
S im ila rly , th e NPV to th e le sso r (N P V L〇R) w ill be:
NPVlor = -C + PV(L)* + PV{Dep)* 15.2

The a s te ris k s (*) have be en adde d because th e p re s e n t values o f th e lease re n ta ls a n d th e d e p re c ia tio n
ta x saving s can d iffe r, g iv e n t h a t th e le sso r a n d lessee have d iffe re n t ta x rates. The o v e ra ll g a in fr o m th e
lease can be fo u n d b y a d d in g E q u a tio n s 15 .1 a n d 15.2. The co st o f th e asset, C, w ill cancel o u t, le a v in g
o n ly te rm s in v o lv in g th e lease re n ta ls a n d th e d e p re c ia tio n ta x savings. T h ere fore, th e lease a ffe cts th e
p re s e n t v a lu e o f th e g o v e rn m e n ts ta x re c e ip ts in tw o ways. F irs t, th e g o v e rn m e n t ga in s, in t h a t i t can ta x
th e lease re n ta ls rece ive d b y th e lessor. Second, th e g o v e rn m e n t loses, in t h a t th e le s s o r is able to c la im
d e d u c tio n s f o r d e p re c ia tio n o n th e leased asset. The n e t re s u lt is t h a t th e g o v e rn m e n t can lose th ro u g h
d e fe rra l o f ta x re ce ip ts a n d i t fo llo w s th a t, o th e r th in g s b e in g equal, th e g o v e rn m e n ts n e t loss w ill be
la rg e r in p re s e n t va lu e te rm s if:
a th e d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates o f th e le sso r a n d lessee is large

b th e d e p re c ia tio n ra te a p p lica b le f o r ta x p u rp o s e s is h ig h , so t h a t d e p re c ia tio n ta x savings are
rece ive d e a rly
C th e te r m o f th e lease is lo n g a n d th e lease re n ta ls are c o n c e n tra te d d u r in g th e la te r p a r t o f th e lease
te rm , so t h a t ta x p a y m e n ts b y th e le s s o r are d e fe rre d
d in te re s t rates a n d hence th e d is c o u n t ra te a p p lic a b le to th e cash flo w s are h ig h ( i f th e d is c o u n t ra te
is zero , c h a n g in g th e t im in g o f ta x p a y m e n ts does n o t change t h e ir p re s e n t value).
Thus, le a sin g is m o re lik e ly to be used i f th e re are h ig h c o m p a n y ta x rates, h ig h d e p re c ia tio n rates an d

h ig h in te re s t rates. I t is n o t s u rp ris in g t h a t le a s in g has g ro w n ra p id ly a t tim e s w h e n th e se fa c to rs have
been p re s e n t. E xa m p le 15 .5 sh o w e d t h a t th e re can be a ta x-b a se d g a in fr o m le a sin g w h e n th e le s s o r has a
h ig h e r ta x ra te th a n th e lessee b u t i t s h o u ld be n o te d t h a t any d iffe re n c e b e tw e e n th e ta x rates o f th e tw o
p a rtie s is lik e ly to re s u lt in a n e t g a in o r loss fr o m le asin g. Le w e lle n , L o n g a n d M c C o n n e ll (1 9 7 6 ) sho w e d
t h a t a n e t g a in can arise w h e n th e le s s o rs ta x ra te is lower th a n th e lessees ra te a n d th e m a g n itu d e o f
th e g a in de pe nd s o n th e sp e cific fe a tu re s o f each case, in c lu d in g th e te rm o f th e lease, th e d e p re c ia tio n
m e th o d a n d ra te a n d th e d is c o u n t rates a p p lie d to fu tu r e cash flo w s.
1 5 .5 .5 1 Leasing and the imputation tax system

The d is c u s s io n in S ectio n 1 5 .5 .4 e x p la in e d t h a t a n y ta x advantages associated w it h a lease arise fro m
d e fe rra l o f taxes, u s u a lly in th e f o r m o f c o m p a n y in c o m e ta x . I t was also e x p la in e d t h a t th e p o te n tia l ta x
b e n e fits are la rge r, o th e r th in g s b e in g equal, w h e n th e re is a la rge d iffe re n c e b e tw e e n th e e ffe c tiv e ta x rates
o f th e le sso r a n d th e lessee. The p o te n tia l f o r th e re to be la rge d iffe re n ce s b e tw e e n e ffe c tiv e ta x rates w ill
be g re a te r w h e n ta x rates are h ig h . H o w e ve r, as discussed in S e ctio n 1 1 .4 .1 , u n d e r th e A u s tra lia n system o f
f u ll im p u ta tio n , co m p a n y in c o m e ta x is, fr o m th e v ie w p o in t o f re s id e n t sh a re h o ld e rs, o n ly a w ith h o ld in g
ta x . In o th e r w o rd s, f o r m a n y com p an ies th e e ffe c tiv e ra te o f company in c o m e ta x (as d is tin c t fr o m ta x
collected a t th e co m p a n y le ve l) is v e ry lo w . I t fo llo w s t h a t f o r such co m p a n ie s a n y ad van ta ge associated
w ith d e fe rrin g a c o m p a n y s ta x p a y m e n ts w ill also be v e ry s m a ll a n d a n y ta x a d va n ta g e fr o m le a sin g m u s t
also be sm a ll. O f course, in d iv id u a ls w h o op e ra te businesses as sole tra d e rs a n d p a rtn e rs h ip s are o fte n
ta xe d a t m u c h h ig h e r rates th a n com p an ies, so le a sin g m a y have s ig n ific a n t ta x advantages in the se cases.
Evaluation of operating leases

In S ectio n 1 5 .2 .2 w e e x p la in e d t h a t an o p e ra tin g lease a llo w s a lessee to o b ta in th e services p ro v id e d b y
an asset w ith o u t d ire c tly b e a rin g th e ris k s o f asset o w n e rs h ip . The ris k s o f o w n e rs h ip re m a in w it h th e LEARNING
OBJECTIVE 6
le ssor because an o p e ra tin g lease has a te rm t h a t is s h o rt re la tiv e to th e life o f th e asset. These leases
Evaluate an operating
are m o re co m p le x th a n fin a n c e leases f o r several reasons. F irs t, th e lessee m a y have th e r ig h t b u t n o t lease from the lessee's
th e o b lig a tio n to re n e w th e lease a t th e e n d o f an in it ia l te rm . Second, th e lessee m a y have th e r ig h t to viewpoint
cancel th e lease, e ith e r a t a n y tim e a fte r i t has co m m e n ce d o r a t a n y tim e a fte r a n agreed date. T here fore,
cancellable o p e ra tin g leases e n ab le a lessee to o b ta in in s u ra n c e a g a in s t an u n e x p e c te d ly la rg e d e clin e in
th e value o f an asse t .9 The r is k o f an u n e x p e c te d d e clin e in va lu e can be p a r tic u la r ly h ig h f o r assets such
as c o m p u te rs , w h ic h can becom e o b so le te v e ry q u ic k ly , because o f changes in te c h n o lo g y . T h ird , th e lease
re n ta l m a y be c o n tin g e n t o n a n o th e r v a ria b le such as th e lessees v o lu m e o f sales. F o r exa m ple, re ta il
te n a n ts in s h o p p in g cen tre s u s u a lly lease t h e ir p re m ise s u n d e r an a g re e m e n t w h e re th e re n t co n sists o f
a fix e d base re n t p lu s a p e rcen ta ge o f a n y m o n th ly sales in excess o f a sp e cifie d th re s h o ld le vel. A u th o rs
w h o have e x a m in e d th e v a lu a tio n o f th e se c o m p o n e n ts o f o p e ra tin g leases in c lu d e C o p e la n d a n d W e s to n
(1 9 8 2 ) a n d G re n a d ie r (1 9 9 5 ).
The d e cisio n o n w h e th e r to b u y an asset o r lease i t th ro u g h an o p e ra tin g lease o fte n ce n tre s o n th e
tra n s a c tio n costs o f b u y in g a n d s e llin g th e asset. As n o te d in S e ctio n 1 5 .2 .2 , w h e re an asset such as a
car is needed f o r a s h o rt p e rio d o f, say, a m o n th o r less, i t is u s u a lly cle ar t h a t an o p e ra tin g lease w i ll be
cheaper th a n b u y in g th e car a n d th e n s e llin g it . O n th e o th e r h a n d , i f th e car is ne ed ed f o r a ye a r o r m o re ,
m o s t users w ill fin d i t che ap er to b u y ra th e r th a n lease. F o r in te rm e d ia te tim e p e rio d s th e p re fe rre d
choice m a y n o t be o b v io u s a n d fin a n c ia l a n a lysis m a y be ne eded to d e te rm in e w h e th e r an o p e ra tin g lease
is a ttra c tiv e . W h ile o p tio n -p ric in g m o d e ls such as th o se discussed in S e ctio n 1 8 .8 .6 can, in p rin c ip le , be
used to v alue th e o p tio n s in h e re n t in an o p e ra tin g lease, such m o d e ls are c o m p le x. F o rtu n a te ly , th e re is a
s im p le r m o d e l t h a t can be used in ste a d .
In S e ctio n 6.4 th e e q u iv a le n t a n n u a l v a lu e m o d e l was used to co m p a re p ro je c ts w it h d iffe re n t
eco no m ic lives. A v a r ia n t o f t h is m o d e l, e q u iv a le n t a n n u a l cost, can be used to eva lu ate o p e ra tin g leases.
an operating lease is attractive to the lessee if the annual rental is less than
The p rin c ip le in v o lv e d is sim p le :
the equivalent annual cost of buying and operating the asset. In a p p ly in g th is p rin c ip le , care is n e ed ed to
ensure t h a t th e lease a n d b u y a lte rn a tiv e s are tre a te d c o n s is te n tly . F o r exa m p le , i f th e o p e ra tin g lease
is a m a in te n a n c e lease, th e n th e costs o f in s u rin g a n d m a in ta in in g th e asset s h o u ld be in c lu d e d in th e
e q u iv a le n t a n n u a l co st c a lc u la tio n , as w e ll as th e costs o f o w n in g th e asset.
As n o te d in S e ctio n 1 5 .2 .2 , th e re n ta ls f o r an o p e ra tin g lease w ill re fle c t th e costs in c u rre d b y th e
le ssor in a c q u irin g a n d m a in ta in in g th e asset. M o re precisely, in a c o m p e titiv e le a s in g m a rk e t th e a n n u a l
re n ta l f o r an o p e ra tin g lease s h o u ld be eq ua l to th e e q u iv a le n t a n n u a l cost o f th e asset to th e lessor. W h e n
th e u se r re q u ire s th e asset f o r a lo n g p e rio d such as 5 years, i t w ill g e n e ra lly be che ap er to b u y th e asset
ra th e r th a n to lease it . In o th e r w o rd s , th e cost o f a ‘d o -it-y o u rs e lf lease’ o b ta in e d b y b u y in g th e asset is
lik e ly to be lo w e r th a n th e re n ta ls cha rge d b y an e x te rn a l lessor. T his is so because, w h e n s e ttin g th e lease
re n ta ls , an e x te rn a l le sso r w i ll n e ed to c o n s id e r th e costs o f n e g o tia tin g m u ltip le leases o v e r th e life o f th e
asset a n d ta ke in to a cco u n t th e e x p e c ta tio n t h a t th e asset w i ll be id le f o r p a r t o f th e tim e . These costs can
be avo id ed i f th e u se r b u ys th e asset.
W h ile an o p e ra tin g lease w ill g e n e ra lly be m o re c o s tly th a n b u y in g a n asset t h a t is n e ed ed f o r an
e xte n d e d p e rio d , th e re are c irc u m sta n ce s w h e re an o p e ra tin g lease can be less c o s tly th a n b u y in g . F irs t,
an o p e ra tin g lease can be che ap er th a n b u y in g i f th e le sso r can ta k e ad va n ta g e o f co s t savings t h a t are
n o t ava ila ble to th e lessee. F o r exa m ple, car re n ta l co m p a n ie s b u y th o u s a n d s o f cars each ye a r a n d can
n e g o tia te v o lu m e d is c o u n ts t h a t are n o t a va ila ble to s m a lle r cu sto m e rs. S im ila rly , car re n ta l com p an ies
p ro b a b ly face lo w e r costs in m a in ta in in g , s e rv ic in g a n d in s u r in g cars th a n m o s t o th e r o w n e rs. A b u sin ess
th a t uses o n ly a fe w v e h icle s c a n n o t ta ke ad van ta ge o f th e se eco no m ies o f scale a n d w ill p ro b a b ly f in d i t
cheaper to lease cars ra th e r th a n b u y th e m . Second, o p e ra tin g leases p ro v id e o p tio n s t h a t are va lu a b le to
th e lessee a n d in som e cases th e o p tio n to cancel a lease can be th e m o s t cost e ffe c tiv e w a y o f o b ta in in g a
b e n e fit such as in s u ra n c e a g a in s t th e r is k o f p re m a tu re obsolescence o r th e r is k t h a t an asset is n o lo n g e r
needed o w in g to a d e clin e in d e m a n d .
9 The right to renew a lease provides a call option over the leased asset, while the right to cancel the lease provides a put option.
A detailed coverage of options is provided in Chapter 18.
The a irlin e in d u s tr y is a g o o d e xa m p le o f an in d u s tr y t h a t faces flu c tu a tin g d e m a n d a n d changes in
th e m ix o f a irc ra ft t h a t are n e ed ed a n d th is has im p o r t a n t im p lic a tio n s f o r th e d e c is io n to o w n o r lease
a irc ra ft. Suppose t h a t a t e r r o r is t a tta c k a t a m a jo r a ir p o r t causes a d e clin e in d e m a n d f o r a ir tra v e l and
a s u rp lu s o f a irc ra ft. In th is case, an a irlin e t h a t o w n s a ll o f its a irc ra ft can e xp e rie n ce m a jo r fin a n c ia l
d iffic u ltie s , p a r tic u la r ly i f th e d e clin e in d e m a n d is w id e s p re a d a n d p e rs is ts f o r an e x te n d e d p e rio d so
t h a t th e c o m p a n y has several a irc ra ft ly in g id le ra th e r th a n e a rn in g reve nu e. U n d e r the se circu m sta nce s,
e ffo rts to se ll th e s u rp lu s a irc ra ft are lik e ly to be u n su cce ssfu l un le ss th e s e lle r is p re p a re d to d is c o u n t th e
p ric e s ig n ific a n tly . A c c o rd in g ly , m o s t a irlin e s lease a p r o p o r tio n o f t h e ir fle e t u n d e r can cellab le o p e ra tin g
leases a n d are p re p a re d to p a y a p re m iu m f o r th e le sso r to accept th e r is k o f c a n c e lla tio n . O n e s tu d y fo u n d
t h a t leased a irc ra ft are tra d e d m o re fre q u e n tly a n d p ro d u ce h ig h e r o u tp u t th a n a irc ra ft t h a t are o w n e d b y
th e user. The m a in rea son f o r th e h ig h e r o u tp u t is t h a t leased a irc ra ft spe nd m o re tim e in th e a ir a n d less
tim e p a rk e d o n th e g ro u n d th a n o w n e d a ir c r a ft .10
15.7 Advantages and disadvantages

LEARNING
of leasing
OBJECTIVE 7
The p o p u la r ity o f le a s in g in d ic a te s t h a t th e re are m a n y cases w h e re users p re fe r to lease assets ra th e r th a n
Critically evaluate the
suggested advantages to p u rch a se th e m . I t is s h o w n in S e ctio n 15 .5 .3 t h a t le a sin g m a y be p re fe rre d w h e re : (a) th e le sso r has an
of leasing a d va n ta g e (o r advantages) n o t a va ila ble to th e p o te n tia l lessee; a n d (b) th e le s s o r passes o n a t le a s t som e
o f th e a d va n ta g e (s) to th e lessee b y w a y o f red uce d lease p a y m e n ts .
A lte rn a tiv e ly , le a sin g m a y have advantages such as lo w e r tra n s a c tio n costs a n d i t m a y have in c e n tiv e
effects t h a t m a ke i t m o re e ffe c tiv e th a n o th e r fo rm s o f fin a n c e in c o n tro llin g agency costs. Several o f th e
alleged advan ta ge s o f le a s in g are discussed in th e fo llo w in g se ctio n s. F irs t, w e discuss p o ssib le advantages
o f le a sin g in ge ne ral. Second, w e discuss fa c to rs t h a t m a y be im p o r t a n t in d e te rm in in g w h ic h p a rtic u la r
assets s h o u ld be leased, ra th e r th a n p u rcha sed, b y a com pany.
15.7.1 I Possible advantages of leasing

P ro p o n e n ts o f le a s in g o fte n stress ta x a tio n ad van ta ge s, c o n s e rv a tio n o f c a p ita l, in cre a se d c re d it
a v a ila b ility a n d th e p o s s ib ility t h a t le a sin g m a y p ro v id e c a p ita l a t a lo w e r cost th a n o th e r fo rm s o f fina nce .
The p re va le n ce o f such cla im s was n o te d b y S carm a n (1 9 8 2 ), w h o e x a m in e d p r o m o tio n a l lite ra tu re used
b y fin a n c e c o m p a n ie s in t h e ir m a rk e tin g o f leases. H e fo u n d a h ig h in c id e n c e o f e rro rs a n d o v e rs ta te m e n ts
w h ic h , n o t s u rp ris in g ly , w ere b iase d in fa v o u r o f le asin g. Several p o ssib le a d van ta ge s o f le a sin g are
discussed in tu r n .
C om pany taxation
The ta x d e d u c tio n s asso cia te d w it h o w n e rs h ip o f a n asset are g e n e ra lly th e sam e, regardless o f w h e th e r
th e asset is o w n e d o r leased b y th e user. I f, as assum ed in E xam p le s 15 .2 a n d 1 5 .3 , th e p o te n tia l lessee
an d le s s o r are ta x e d a t th e sam e rate, th e re s h o u ld be n o ta x a tio n a d va n ta g e a sso cia te d w ith leasing.
I f th is a s s u m p tio n does n o t h o ld th e n , as discusse d in S e c tio n 1 5 .5 .3 , le a s in g m a y p ro v id e a ta x a tio n
ad van ta ge . A n y such ad va n ta g e arises fr o m th e d e fe rra l o f taxes a n d can be la rg e in p re s e n t value te rm s
w h e re a c o m p a n y re q u ire s an exp en sive asset b u t is n o t able to u tilis e f u lly th e d e p re c ia tio n d e d u c tio n s
i f th e asset is p u rch a se d . This p ro b le m m a y be ove rco m e i f th e asset is a c q u ire d b y a le s s o r w h o can use
a ll th e a llo w a b le d e d u c tio n s as soo n as th e y are ava ila ble. In th is case, th e le s s o r has a n ad van ta ge o ve r
th e p o te n tia l lessee a n d i t w o u ld be p re fe ra b le to lease th e asset i f th e le s s o r shares som e (o r a ll) o f th is
ad van ta ge w it h th e lessee. E s s e n tia lly th is ad van ta ge arises because th e le s s o rs e ffe c tiv e ta x ra te is h ig h e r
th a n th e lessees e ffe c tiv e ta x rate. E xa m p le 15 .5 illu s tra te s th is a d va n ta g e in an e x tre m e case w h e re th e
lessees e ffe c tiv e ta x ra te is zero.
The in a b ilit y o f som e asset users to use im m e d ia te ly a ll th e a llo w a b le d e d u c tio n s asso cia te d w it h th e
a c q u is itio n o f v e ry e xp en sive assets was a m a jo r fa c to r in th e g ro w th o f le vera ged le a s in g d u rin g th e
10 Gavazza (2011) found that for the US airline industry, the output of leased aircraft, as measured by flying hours, was
6.5 per cent higher than the output of owned aircraft.
1970s a n d th e e a rly p a r t o f th e 1980s. Such leases are in v a ria b ly s tru c tu re d so as to e x p lo it s itu a tio n s
w h ere th e le ssor has a h ig h e r e ffe c tiv e ta x ra te th a n th e lessee. T here is evide nce t h a t th is rea son f o r th e
g ro w th in leveraged le a s in g is g e n e ra lisa b le to o th e r fo rm s o f le asin g. Thus, in th e US i t has been fo u n d
th a t c om p an ies w ith lo w m a rg in a l ta x rates use le a sin g m o re th a n co m p a n ie s w it h h ig h m a rg in a l ta x rates
(G raham , L e m m o n & S c h a llh e im 1 9 9 8 ). T his fin d in g is c o n s is te n t w it h th e v ie w t h a t h ig h ta x ra te lessors
can b e n e fit m o re fr o m th e ta x d e d u c tib ility o f d e p re c ia tio n th a n lo w ta x ra te lessees.
T a x a tio n advantages are also th e m o tiv e f o r cro s s -b o rd e r leases w h ic h , as discussed in S e ctio n 1 5 .2 .5 ,
are s tru c tu re d so as to ta ke ad van ta ge o f d iffe re n ce s b e tw e e n th e ta x e n v iro n m e n ts o f d iffe re n t c o u n trie s .
I f th e re w ere n o d iffe re n ce s in ta x re g u la tio n s a n d ta x rates b e tw e e n c o u n trie s , cro s s -b o rd e r leases w o u ld
p ro b a b ly n o t exist.
Transaction costs
There is a d iffe re n ce b e tw e e n le a s in g a n d b o rro w in g t h a t can be im p o r t a n t in th e e v e n t o f d e fa u lt. I f a lessee
d e fa u lts, th e lessor, as th e o w n e r o f th e asset, can repossess th e asset m o re e a sily th a n a secured le n d e r,
w h o is lik e ly to face co n sid e ra b le delay, a n d g re a te r costs, because i t m a y be necessary f o r a d e fa u ltin g
b o rro w e r to be liq u id a te d . In th is case, a liq u id a to r has to be a p p o in te d to se ll th e assets a n d d is tr ib u te
th e proceeds to le n d e rs an d o th e r c re d ito rs . T h ere fore, th e re m a y w e ll be a d iffe re n c e in tra n s a c tio n costs
th a t fa vo u rs leasing. S im ila rly , because lessors have th e s e c u rity o f o w n e rs h ip o f th e leased asset, th e y
m ay be p re p a re d to p ro v id e fin a n c e w ith o u t c a rry in g o u t a f u ll check o n th e c re d it s ta n d in g o f th e lessee.
A lso, th e le sso r m a y be able to use a re la tiv e ly s im p le , s ta n d a rd c o n tra c t f o r each lease, p a r tic u la r ly i f th e
leased assets are s im ila r ite m s such as cars o r o th e r m o to r veh icle s. A s a re s u lt, le a s in g can be a ttra c tiv e
to sm a ll c om p an ies t h a t do n o t have g o o d access to o th e r sources o f fin a n ce . F o r la rg e r co m p a n ie s, le a sin g
m ay also be m o re a ttra c tiv e th a n o th e r sources o f fin a n c e because th e tra n s a c tio n costs are lo w e r th a n th e
cost o f is s u in g s e c u ritie s o r n e g o tia tin g a lo a n .
Conservation of capital
I t is o fte n suggested th a t, b y le a sin g , a c o m p a n y can con serve its c a p ita l f o r in v e s tm e n t elsew here.
A lte rn a tiv e ly , th e sam e a rg u m e n t m a y be based o n th e su g g e s tio n t h a t le a s in g p ro v id e s 41 0 0 p e r ce n t
fin a n c in g ’. In o th e r w o rd s, i t is a rg u e d t h a t th e re is som e fu n d a m e n ta l d iffe re n c e b e tw e e n le a sin g and
o th e r fo rm s o f fin a n ce , w h ic h a llo w s a lessee to ‘b o r r o w ’ 10 0 p e r c e n t o f th e p u rch a se p ric e o f an asset,
com pared w ith pe rh a p s 8 0 p e r c e n t in th e case o f a secured lo a n . T his a rg u m e n t is c o n tro v e rs ia l. M a n y
academ ics have a rg u e d t h a t th e ‘10 0 p e r c e n t fin a n c in g ’ c la im is a fallacy. F o r e xa m p le , th e y p o in t o u t t h a t
w h ere lease re n ta ls are payable in advance, w h ic h is usu al, th e fin a n c e e ffe c tiv e ly p ro v id e d b y le a s in g can
be m u ch less th a n th e pu rcha se p ric e o f th e a sse t .11 A lso , th e fo r m a l s e c u rity p ro v id e d to th e le s s o r is n o t
ne cessarily re s tric te d to o w n e rs h ip o f th e leased asse t .12 In o th e r w o rd s , to o b ta in a fin a n c e lease, i t is
necessary to have som e e q u ity c a p ita l, a n d th e lease w ill use u p som e o f th e d e b t ca p a c ity p ro v id e d b y th e
co m p a n y s e q u ity in th e sam e w a y as o th e r d e b t. T h ere fore, w h e n o n ly th e im m e d ia te cash consequences are
considered, le a sin g m a y g ive th e appearance o f 10 0 p e r c e n t fin a n c in g , b u t th is appearance is m is le a d in g .
There is n o such th in g as *100 p e r c e n t lease fin a n c e 1, ju s t as th e re is n o such t h in g as *100 p e r c e n t d e b t
finance*. O n th e o th e r h a n d , p ra c titio n e rs , p a rtic u la rly th o s e in v o lv e d in p r o m o tin g le a sin g , arg ue th a t
le asin g is not th e sam e as o th e r d e b t a n d t h a t a d o lla r o f lease fin a n c e w i ll use less o f a c o m p a n y s d e b t
ca p a city th a n a d o lla r o f ‘o r d in a r y ’ d e b t.
This v ie w is s u p p o rte d b y E is fe ld t a n d R a m p in i (ER) (2 0 0 9 ), w h o arg ue t h a t th e a b ility o f a le ssor
to repossess an asset m o re e a s ily th a n a secured le n d e r p ro v id e s b e n e fits f o r le a s in g t h a t go b e yo n d
th e tra n s a c tio n cost savings discusse d above. In t h e ir w o rd s: 'This a b ility to repossess a llo w s a le sso r to
im p lic itly e x te n d m o re c re d it th a n a le n d e r w h ose c la im is secured b y th e sam e asset. The d e b t cap acity
o f le asin g th u s exceeds th e d e b t c a p a c ity o f secured le n d in g 1 (p. 1 6 2 1 ). A f te r c o n s id e rin g th e tre a tm e n t
u n d e r US b a n k ru p tc y law s o f secured le n d e rs a n d lessors in d iffe re n t typ e s o f leases, ER con clu de th a t
th e ad van ta ge th e y id e n tify a p p lie s p r im a r ily to o p e ra tin g leases b u t m a y be a p p lica b le to som e fin a n ce
leases. This d iffe re n c e arises because, u n d e r US law, an o p e ra tin g lease w i ll g e n e ra lly be c la ssifie d as a *true
lease*, w h ic h a llo w s th e easiest rep osse ssion b y th e lessor. In th e case o f a fin a n c e lease, th e le sso r is lik e ly
11 This factor is illustrated by Example 15.3 where the lease provides finance of $511800, which is much less than the asset cost
of $600000.
12 See Footnote 7.
to be re g a rd e d as h a v in g o n ly a ‘s e c u rity in te re s t’ in th e leased asset, w h ic h m eans t h a t th e p o s itio n o f th e
le sso r is e s s e n tia lly th e sam e as t h a t o f a secured le n d e r.
I f i t is tr u e t h a t le a s in g conserves c a p ita l, w h a t are th e m a in im p lic a tio n s f o r le a s in g de cisio ns?
A c c o rd in g to ER, le a s in g , p a r tic u la r ly th r o u g h o p e ra tin g leases, w i ll be v a lu a b le to co m p a n ie s t h a t are
fin a n c ia lly c o n s tra in e d — t h a t is, c o m p a n ie s t h a t have a s h o rta g e o f in te r n a l fu n d s a n d need to raise
fu n d s e x te rn a lly . H o w e ve r, agency costs a ris in g f r o m th e s e p a ra tio n o f o w n e rs h ip a n d c o n tro l t h a t is
in h e r e n t in le a s in g m e a n t h a t co m p a n ie s w it h s u ffic ie n t in te r n a l fu n d s w ill p re fe r to b u y assets. Tests
u s in g d a ta o n US co m p a n ie s p ro v id e s tro n g s u p p o rt f o r th e p r e d ic tio n t h a t le a s in g is va lu a b le f o r
c o m p a n ie s t h a t are s m a ll o r fin a n c ia lly c o n s tra in e d . L e a s in g is n e g a tiv e ly re la te d to c o m p a n y size— s m a ll
c o m p a n ie s r e n t o r lease a h ig h e r p r o p o r tio n o f th e assets th e y use th a n la rg e c o m p a n ie s. ER also fo u n d
a ro b u s t n e g a tiv e re la tio n s h ip b e tw e e n le a s in g a n d th e ra tio o f d iv id e n d s to assets. S im ila rly , th e ra tio
o f cash flo w to assets— t h e ir m o s t d ire c t m ea sure o f a va ila b le in te r n a l fu n d s — is n e g a tiv e ly re la te d to
le a sin g . The p r o p o r tio n o f c a p ita l leased is c o n s id e ra b ly h ig h e r f o r b u ild in g s th a n f o r e q u ip m e n t, an d
th e re la tio n s h ip s b e tw e e n le a s in g a n d th e ra tio s use d as m ea sure s o f fin a n c ia l c o n s tra in ts w e re s tro n g e r
f o r b u ild in g s . In s u m m a ry , ER fo u n d s tro n g e m p iric a l s u p p o rt f o r th e a rg u m e n t t h a t le a s in g conserves
c a p ita l’ 一 a t le a s t in th e case o f o p e ra tin g leases— b u t th e y a c k n o w le d g e t h a t even o p e ra tin g leases do
n o t p ro v id e *100 p e r c e n t fin a n c in g ,. T hey co n clu d e t h a t th e h ig h e r d e b t c a p a c ity o f le a s in g m a y m a ke i t
p a r tic u la r ly a ttra c tiv e f o r s m a ll c o m p a n ie s a n d f o r n e w v e n tu re s , b o th o f w h ic h are lik e ly to have lim ite d
in te r n a l fu n d s .
Leasing can provide 'off-balance-sheet’ finance

A n a rg u m e n t re la te d to th e p re v io u s one is t h a t because lessees in th e p a s t have n o t been re q u ire d to
re p o r t t h e ir lease o b lig a tio n s in th e s ta te m e n t o f fin a n c ia l p o s itio n , th e y can use le a s in g to increase th e ir
access to d e b t. E ven i f th is w ere tru e , i t is o n ly a n ad van ta ge i f b o rro w in g re s tric tio n s im p o s e d b y le n d e rs
have p re v e n te d th e p o te n tia l lessee fr o m a tta in in g th e o p tim a l d e b t- e q u ity ra tio . F u rth e r, e m p iric a l
evide nce suggests t h a t lease fin a n c e is a s u b s titu te f o r d e b t, w it h th e re s u lt t h a t co m p a n ie s m a y n o t have
been able to use le a sin g to in crea se t h e ir access to o th e r typ e s o f d e b t (B o w m a n 1 9 8 0 ). In a n y e ve n t,
A c c o u n tin g S ta n d a rd AASB 1 1 7 re q u ire s th e c a p ita lis a tio n o f fin a n c e lease o b lig a tio n s , w h ic h m ea ns th a t
a n y p o te n tia l *ofF-balance-sheet fin a n c in g * ad van ta ge f o r le a s in g s h o u ld n o lo n g e r be a v a ila b le .13 This
sug ge ste d ad van ta ge is f u r t h e r d im in is h e d w h e n one c o n sid e rs th e c u rre n t p ro p o s a ls b y th e a c c o u n tin g
s ta n d a rd s e tte rs to m o d ify A ASB 1 1 7 to e n sure t h a t a ll n o n -re a l esta te leases, w it h a te r m lo n g e r th a n
12 m o n th s , are re co g n ise d in co m p a n ie s’ fin a n c ia l s ta te m e n ts .
Cost of capital
The a n a lysis o u tlin e d e a rlie r is c o n s is te n t w ith th e p rin c ip le th a t, in lease e v a lu a tio n , th e d is c o u n t ra te
a p p lic a b le to a g iv e n c o m p o n e n t o f th e cash flo w s m u s t be th e sam e f o r b o th th e lessee a n d th e lessor. In
o th e r w o rd s , f o r a g iv e n cash flo w , th e re q u ire d ra te o f r e t u r n s h o u ld d e p e n d o n th e r is k o f th e cash flo w ,
n o t th e id e n t it y o f th e re c ip ie n t.
H o w e ve r, i f th e le s s o rs co st o f c a p ita l is lo w e r (h ig h e r) th a n t h a t o f th e p o te n tia l lessee, th e existe nce
o f c o m p e titiv e c a p ita l m a rk e ts w i ll re s u lt in le a s in g (b u y in g ) b e in g p re fe rre d to b u y in g (le asin g). W h a t
c irc u m sta n ce s w ill cause th e cost o f c a p ita l o f th e le s s o r a n d th e lessee to d iffe r? The an sw e r to th is
q u e s tio n w ill d e p e n d o n th e ris k s a sso cia te d w it h u s in g th e asset. M ille r a n d U p to n (1 9 7 6 ) id e n tifie d
tw o ty p e s o f re le v a n t ris k . O ne is a sso cia te d w it h u n c e r ta in ty a b o u t th e a sse ts e c o n o m ic d e p re c ia tio n ,
w h ile th e o th e r is associated w ith u n c e rta in ty a b o u t th e n e t cash flo w s fr o m u s in g th e asset. In th e case
o f a fin a n c e lease w it h a sp e cifie d re s id u a l value , b o th th e se ris k s are b o rn e b y th e lessee. In th e case o f
an o p e ra tin g lease, b o th the se ris k s are b o rn e b y th e lessor. There m a y be o th e r cases w h e re th e ris k s
are sh a re d b e tw e e n th e tw o p a rtie s . A lth o u g h th e ris k s b o rn e b y th e tw o p a rtie s can d iffe r, c o m p e titiv e
c a p ita l m a rk e ts w i ll e n sure th a t th e d is c o u n t ra te im p lic it in th e lease a g re e m e n t w ill re fle c t th e a llo c a tio n
o f r is k b e tw e e n th e tw o p a rtie s .
Suppose, h o w e ve r, t h a t th e lessee can raise c a p ita l a t a lo w e r co st f o r a g iv e n le v e l o f r is k th a n th e
lessor. I f th is is so, th e p ro s p e c tiv e lessee s h o u ld fin d t h a t i t is m o re p ro fita b le to b u y th a n to lease.
13 There is conflicting evidence on whether the ofF-balance-sheet aspect of leasing ever provided borrowing opportunities
that had a favourable effect on a company's share price. A number of these studies are summarised in Lev and Ohlson
(1982, pp. 280-1).
H o w eve r, as M ille r a n d U p to n (1 9 7 6 ) p o in te d o u t, th e lessee ‘w o u ld fin d i t even m o re p ro fita b le u n d e r

th o se circu m sta n ce s to e n te r th e le a sin g business*. A n y d is e q u ilib riu m b e tw e e n th e costs o f c a p ita l f o r
le asin g a n d b u y in g w o u ld th e n be e lim in a te d . In o th e r w o rd s, th e costs o f c a p ita l f o r le a sin g a n d b u y in g
m u s t be th e same, because i f th e y w ere n o t, th e n one o f tw o re s u lts w o u ld occu r: le a s in g w o u ld e ith e r be
d o m in a n t— t h a t is, a ll assets w o u ld be leased— o r le a sin g w o u ld disap pea r.
Leasing and agency costs

As n o te d above, a leased asset is u n d e r th e c o n tro l o f a u se r w h o is n o t th e o w n e r, a n d th e s e p a ra tio n
o f o w n e rs h ip a n d c o n tro l can g ive ris e to c o s tly agency p ro b le m s . F o r exa m ple, as discussed in S e ctio n
15 .7.2, i t w ill be d iff ic u lt a n d e xp en sive to lease assets t h a t are e a sily d a m ag ed b y carelessness o r n e glect.
Leasing can also have in c e n tiv e e ffe cts t h a t c o n trib u te to agency costs. S m ith a n d W a ke m a n (1 9 8 5 )
p o in te d o u t t h a t m a n a g e m e n t c o m p e n s a tio n p la n s can create in c e n tiv e s to lease assets ra th e r th a n
purchase th e m . F o r exa m ple, a m a n a g e r w h o se b o n u s depends o n th e ra te o f r e tu r n o n in v e s te d c a p ita l
w ill fa v o u r th e le a sin g o f assets un le ss th e p re s e n t value o f fu tu r e lease p a y m e n ts is in c lu d e d as p a r t o f
in ve ste d c a p ita l. Thus, a c o m p e n s a tio n p la n t h a t is n o t w e ll d e sig n e d can m o tiv a te m an ag ers to lease
assets w h e n p u rc h a s in g w o u ld be b e tte r f o r sh a re h o ld e rs.
The o w n e rs h ip s tru c tu re o f a b u sin ess m a y also in flu e n c e le a s in g de cisio n s. F o r e xa m p le , a m a n a g e r
w h o has a la rge o w n e rs h ip sta ke in th e b u sin e ss m a y p re fe r to lease b u sin ess assets in o rd e r to reduce
p e rso n a l e xp osu re to asse t-sp e cific ris k s such as th e r is k o f obsolescence. C o n s is te n t w it h th is a rg u m e n t,
a s tu d y b y M e h ra n , T a g g a rt a n d Y e rm a ck (1 9 9 9 ) o f US m a n u fa c tu rin g fir m s fo u n d t h a t CEO share
o w n e rs h ip has a s ig n ific a n t p o s itiv e e ffe c t o n b o th d e b t fin a n c in g a n d leasing.
In s u m m a ry , th e m a jo r reasons f o r le a s in g ap p e a r to in v o lv e savings in taxes a n d tra n s a c tio n costs
an d m in im is in g th e e ffe cts o f fin a n c ia l c o n s tra in ts . There can be s ig n ific a n t ta x advan ta ge s f o r le a sin g
w h e n th e re is a la rge d iffe re n c e b e tw e e n th e e ffe c tiv e in c o m e ta x rates o f th e le s s o r a n d lessee. H o w e ve r,
u n d e r th e im p u ta tio n ta x syste m , a n y ta x ad van ta ge s o f le a s in g a p p e a r to be s m a ll w h e n b o th th e le ssor
an d lessee are A u s tra lia n -o w n e d co m p a n ie s. There is evide nce t h a t le a sin g does co n se rve capital*, a t le a st
f o r o p e ra tin g leases, w h ic h can m a ke le a s in g a ttra c tiv e f o r s m a ll co m p a n ie s a n d n e w v e n tu re s t h a t lack
in te rn a l fu n d s . W h ile som e o f th e c la im e d advan ta ge s o f le a s in g a p p e a r to be o f d u b io u s v a lid ity , i t seems
th a t, in pra ctice , m a n y p e op le do p e rceive t h a t th e re are a d van ta ge s in k e e p in g leases o f f balance sheet*.
Leasing in v o lv e s a s e p a ra tio n o f o w n e rs h ip a n d c o n tro l, so th e agency costs a ris in g fr o m th is s e p a ra tio n
te n d to o ffs e t th e a d van ta ge s o f leasing.
A lth o u g h o p p o r tu n itie s to reduce taxes a n d tra n s a c tio n costs, a n d to m in im is e th e e ffe cts o f fin a n c ia l
c o n s tra in ts , p ro v id e th e m a in m o tiv e s f o r le a sin g , th e re are som e a d d itio n a l fa c to rs t h a t can g ive ris e to
advantages f o r leasing. These are discussed in th e n e x t se ctio n .
S m ith a n d W a ke m a n (1 9 8 5 ) p o in te d o u t t h a t ta x -re la te d fa c to rs a n d in c e n tiv e s a ris in g fr o m fa c to rs such

as c o m p e n s a tio n c o n tra c ts a n d o w n e rs h ip s tru c tu re p ro v id e an im p o r ta n t, b u t in c o m p le te , e x p la n a tio n o f
m
LEARNING
som e aspects o f leasing. D iffe re n c e s in e ffe c tiv e ta x rates a n d o w n e rs h ip s tru c tu re are u s e fu l in id e n tify in g
OBJECTIVE 8
p o te n tia l lessors a n d lessees, b u t p ro v id e l i t t le e x p la n a tio n o f w h y som e assets are leased, w h ile o th e r
Explain the factors that
s im ila r assets are ow n e d . F o r exa m ple, w h y is i t t h a t le a s in g o f o ffic e b u ild in g s is m o re c o m m o n th a n can influence leasing
le asin g o f research la b o ra to rie s ? Som e o f th e in c e n tiv e s f o r le a s in g t h a t v a ry across d iffe re n t assets are policy
n o w discussed.
Sensitivity to use and maintenance decisions

As discussed in S e ctio n 1 5 .7 .1 , le a sin g m ea ns t h a t an asset is u n d e r th e c o n tro l o f a u se r w h o is n o t th e
ow ner. A lessee does n o t have a r ig h t to th e d isp o sa l va lu e o f an asset a t th e e n d o f th e lease, so th e re is
less in c e n tiv e to care f o r a n d m a in ta in assets t h a t are leased ra th e r th a n ow n e d . Lessors w ill recognise
th is a n d w ill set lease re n ta ls o n th e basis o f e xp e cte d le vels o f abuse. T h e re fo re , th e m o re s e n s itiv e th e
value o f th e asset to th e le vels o f use a n d m a in te n a n c e i t receives, th e m o re c o s tly i t w ill be t o lease ra th e r
th a n purchase th e asset. T h e re fo re , i t is a rg u e d t h a t assets t h a t are v e ry s e n s itiv e to use a n d m a in te n a n c e
de cisio ns w ill te n d to be p u rch a se d b y th e u s e r ra th e r th a n leased. T his a rg u m e n t appears to be m o re
re le v a n t to o p e ra tin g leases th a n to fin a n c e leases.
i B usiness finance
Specialised assets
S m ith a n d W a k e m a n (1 9 8 5 ) suggested t h a t th e re is an in c e n tiv e to buy, ra th e r th a n lease, specialised
(o r co m p a n y -s p e c ific ) assets. Such assets are m o re h ig h ly v a lu e d w it h in th e co m p a n y th a n in t h e ir best
a lte rn a tiv e use. They a rg u e d t h a t le a sin g c o m p a n y -s p e c ific assets in v o lv e s n e g o tia tio n costs a n d o th e r
agency costs t h a t can be s ig n ific a n t because o f c o n flic ts b e tw e e n th e le sso r a n d lessee a b o u t th e d iv is io n
b e tw e e n th e m o f t h a t p a r t o f th e va lu e o f th e asset t h a t exceeds its va lu e in a lte rn a tiv e uses. F o r exam ple,
th e le sso r w ill w a n t to calcula te th e lease p a y m e n ts u s in g a c o n s e rv a tiv e re s id u a l va lu e based on th e lik e ly
d isp o sa l v a lu e o f th e asset. T his va lu e is lik e ly to be u n c e rta in , a n d th e le sso r s e s tim a te w ill p ro b a b ly be
m u c h less th a n th e va lu e placed o n th e asset b y th e user. T h e re fo re , th e lease p a y m e n ts re q u ire d b y th e
le sso r are u n lik e ly to be acceptable to th e user.
In c o n tra s t, f o r g e n e ra l use* assets, such as tru c k s a n d f o r k lift s , s u b s titu te s are re a d ily ava ila ble, and
th e d iffe re n c e b e tw e e n th e v a lu e -in -u s e a n d th e v a lu e -in -e x c h a n g e is lik e ly to be sm a ll. M o re o v e r, th e re
is an a c tiv e se co n d -h a n d m a rk e t in th e se assets, so i t is re la tiv e ly easy to fo re c a s t lik e ly d isp o sa l values
a n d to agree o n th e te rm s o f a lease. T his a rg u m e n t, a n d th e asso cia te d e m p iric a l evide nce, is c o n s is te n t
w ith th e o b s e rv a tio n t h a t le a sin g o f cars a n d o th e r m o to r veh icle s is re la tiv e ly c o m m o n . Gavazza (2 0 1 0 )
in v e s tig a te s th is issue in th e c o n te x t o f a irc ra ft le a sin g b y e x p lo rin g th e re la tio n s h ip b e tw e e n h o w liq u id
th e m a rk e t is f o r a p a rtic u la r ty p e o f a irc ra ft a n d th e lik e lih o o d t h a t th e a irc ra ft w ill be leased, ra th e r th a n
pu rch a se d , as w e ll as th e co st o f le asin g. H e re p o rts th a t a irc ra ft w it h m o re a c tiv e se c o n d a ry m a rk e ts are
m o re lik e ly to be leased a n d a t a b e tte r ra te re la tiv e to less a c tiv e ly tra d e d a irc ra ft.
Flexibility and transaction costs

As d iscusse d in S ectio ns 1 5 .2 .2 a n d 15 .6, an o p e ra tin g lease can have w o r th w h ile a d van ta ge s w h e n an
asset is re q u ire d f o r o n ly a s h o rt p e rio d . A n o p e ra tin g lease is lik e ly to in v o lv e lo w e r costs th a n p u rc h a s in g
an asset a n d th e n s e llin g it , p a r tic u la r ly i f th e costs o f o w n e rs h ip tra n s fe r are s ig n ific a n t. Le asing ra th e r
th a n b u y in g can also in v o lv e d iffe re n ce s in search costs a n d costs o f assessing q u a lity .14 F o r e xa m p le , a
co m p a n y th a t leases a tr u c k w ill be less co n ce rn e d a b o u t th e c o n d itio n o f its e n g in e , tra n s m is s io n a n d
o th e r m e c h a n ic a l p a rts th a n a p o te n tia l b u y e r o f th e sam e ve h icle . T h e re fo re , a less c o s tly in s p e c tio n w ill
s u ffice i f th e tr u c k is to be leased.
T his a d va n ta g e f o r le a sin g w ill be o ffs e t b y th e fa c t t h a t, as discussed above, lessees w i ll te n d to be less
c a re fu l in t h e ir use o f assets th a n o w n e rs are lik e ly to be. Lessors w i ll reco gn ise th is p ro b le m a n d base th e
re n ta ls o n th e e xp ected re s id u a l v a lu e o f th e asset, g iv e n th e n o rm a l tre a tm e n t to w h ic h leased assets are
sub je cte d. H o w e ve r, th e re can be an o v e ra ll a d va n ta g e f o r le a sin g , p ro v id e d t h a t th e c o s t sa vin g th ro u g h
a v o id in g fre q u e n t o w n e rs h ip tra n s fe rs is g re a te r th a n th e a d d itio n a l costs a sso cia te d w it h d e te rio ra tio n
o f leased assets.
I f th e le s s o r has a c o m p a ra tiv e ad va n ta g e in d is p o s in g o f an asset, th is m a y cause le a s in g to be p re fe rre d .

F o r e xa m p le , a le sso r m a y be able to se ll an asset a t th e e n d o f th e lease te rm a t a h ig h e r p ric e th a n c o u ld
a c o m p a n y t h a t ha d p u rch a se d th e asset. S m ith a n d W a ke m a n (1 9 8 5 , p. 9 0 2 ) id e n tifie d th re e p o te n tia l
sources o f such a c o m p a ra tiv e advantage.
a There is th e p o te n tia l f o r lo w e r search, in fo r m a tio n a n d tra n s a c tio n costs asso cia te d w it h th e le ssor
p ro v id in g a sp e cia lise d m a rk e t f o r used assets. Such m a rk e ts m a ke i t ea sie r a n d che ap er f o r bu yers
se e kin g a p a r tic u la r asset to lo ca te p o te n tia l sellers.
b There m a y be red uce d re p a ir a n d m a in te n a n c e costs f o r e x is tin g assets fr o m re u s in g c o m p o n e n ts o f
p re v io u s ly leased assets.
c R educed p ro d u c tio n costs re s u lt fr o m re u s in g c o m p o n e n ts o f p re v io u s ly leased assets in th e
p ro d u c tio n o f n e w assets.
These advantages are lik e ly to e x is t o n ly w h e re th e le sso r is also th e m a n u fa c tu re r a n d /o r d is tr ib u to r

o f th e asset. H o w e ve r, S m ith a n d W a k e m a n a rg u e d t h a t m a n u fa c tu re rs w h o accept used assets as tra d e -
in s o ffe r th e sam e c o m p a ra tiv e advantages to asset b u ye rs. T h e re fo re , w h ile th e cost re d u c tio n s can be
real, th e y are n o t p e c u lia r to leasing.
14 For a discussion of these and other factors relevant to short-term leasing, see Flath (1980).
Chattel mortgages and hire-purchase

C h a tte l m o rtg a g e s a n d h ire -p u rc h a s e a g re e m e n ts are s im ila r to fin a n c e leases a n d are p ro v id e d b y th e
same fin a n c ia l in te rm e d ia rie s , m a in ly b a n ks a n d fin a n c e com p an ies. The d iffe re n ce s b e tw e e n these LEARNING
OBJECTIVE 9
v a rio u s fo rm s o f e q u ip m e n t fin a n c e are ‘te c h n ic a l’ b u t th e d iffe re n ce s can have im p o r t a n t legal a n d ta x
Outline the main
im p lic a tio n s . In th e case o f a c h a tte l m o rtg a g e , th e u se r b u ys th e goods d ire c tly fr o m th e s u p p lie r a n d features of chattel
th e fin a n c ie r re g is te rs a charge o v e r th e goods as se c u rity . Thus, a c h a tte l m o rtg a g e is a lo a n secured b y mortgages and hire-
a m o rtg a g e o v e r m o va b le p ro p e rty ra th e r th a n re a l estate. I n c o n tra s t, w it h h ire -p u rc h a s e th e fin a n c ie r purchase agreements
purchases th e asset a n d h ire s i t to th e u s e r f o r an agreed p e rio d . CHATTEL MORTGAGE
W h e re an asset is su b je c t to a c h a tte l m o rtg a g e o r a h ire-p u rch ase a g re e m e n t, th e u se r w ill be a loan secured by
re q u ire d to m ake a series o f p a y m e n ts o r in s ta lm e n ts to th e fin a n c ie r f o r an agreed p e rio d . As f o r a a mortgage over
movable property
fin a n ce lease, th e te rm u s u a lly ranges fr o m 2 to 5 years a n d th e in te re s t ra te is u s u a lly fix e d f o r th e w h o le
o f th e te rm . The p a y m e n ts m a y be e q u a l o r th e y can be ta ilo re d to s u it th e u s e rs cash flo w p a tte rn . F o r HIRE-PURCHASE
AGREEMENT
exam ple, th e p a y m e n ts m a y in c lu d e an in it ia l d e p o s it a n d /o r a fin a l 'b a llo o n p a y m e n t.
agreement under
O ne e sse n tia l fe a tu re o f a h ire -p u rc h a s e a g re e m e n t is t h a t i t w ill e ith e r c o m m it th e u se r to b u y in g
which an asset owned
th e asset o r g ive th e u s e r a n o p tio n to b u y it . A lease c a n n o t c o m m it th e lessee to b u y in g th e asset o r by a financier is hired
e x p lic itly g ive th e lessee an o p tio n to do so. This d iffe re n c e is im p o r ta n t f o r ta x p u rp o se s because i t m eans by a user who has the
th a t in th e case o f h ire -p u rc h a s e a g re e m e n ts th e user, ra th e r th a n th e fin a n c ie r, w ill be e n title d to c la im right or an obligation
to purchase the asset
d e d u c tio n s f o r d e p re c ia tio n . The u se r w ill also be able to c la im d e d u c tio n s f o r th e in te re s t c o m p o n e n t o f
when the agreement
th e h ire -p u rch a se p a y m e n ts . In A u s tra lia , th e p o p u la r ity o f c h a tte l m o rtg a g e s has in cre a se d m a rk e d ly
expires
since th e goods a n d services ta x was in tro d u c e d in 2 0 0 0 an d, as n o te d in S e ctio n 15.1, d u rin g 2 0 1 2
c h a tte l m o rtg a g e s m ade u p a p p ro x im a te ly 4 0 p e r c e n t o f th e v a lu e o f n e w e q u ip m e n t fin a n c e ag re e m e n ts
e n te re d in to .
15.8.1 I Equipment finance and the goods and services tax

C h a tte l m o rtg a g e s, h ire -p u rc h a s e a n d le a sin g are n o t tre a te d in e x a c tly th e sam e w a y u n d e r th e goods
and services ta x (G ST). C h a tte l m o rtg a g e s are tre a te d in th e sam e w a y as o th e r lo a n s in t h a t th e y are
classed as a fin a n c ia l su p p ly. A c c o rd in g ly , n o GST is payable o n th e p ro v is io n o f th e lo a n o r o n th e lo a n
re p a ym e n ts. The p u rcha se p ric e o f th e e q u ip m e n t it s e lf w ill u s u a lly in c lu d e a GST c o m p o n e n t b u t th e
p u rch a se r m a y be able to re co ve r th is o u tla y b y c la im in g an in p u t ta x c re d it. In c o n tra s t, le a s in g is n o t
classed as a fin a n c ia l s u p p ly so lease re n ta ls are w h o lly su b je c t to GST. In o th e r w o rd s , f o r a lease, GST
applies to b o th th e co st o f th e asset a n d th e c re d it charge in c lu d e d in th e lease re n ta ls . In th e case o f
a c h a tte l m o rtg a g e , GST a p p lie s o n ly to th e co st o f th e asset. W h e re th e u s e r o f th e asset is a business
th a t can c la im an in p u t c re d it f o r th e GST, th e h ig h e r GST o n a lease s h o u ld n o t m a tte r. H o w e ve r, i f th e
asset use r is u n a b le to c la im in p u t ta x c re d its , le a s in g m a y be less a ttra c tiv e th a n a c h a tte l m o rtg a g e .
H ire -p u rch a se ag re e m e n ts e n te re d in to a fte r 1 J u ly 2 0 1 2 are e ffe c tiv e ly tre a te d in th e sam e w a y as lease
agree m ents f o r ta x p u rp o s e s .15
16
In s u m m a ry , w h ile c h a tte l m o rtg a g e s, h ire -p u rc h a s e a n d fin a n c e leases have m a n y s im ila ritie s , th e re
are im p o r ta n t d iffe re n ce s b e tw e e n th e m in te rm s o f le ga l o w n e rs h ip a n d ta x a tio n tre a tm e n t. In th e case
o f GST, c h a tte l m o rtg a g e s are e ffe c tiv e ly a t th e o p p o s ite e n d o f th e ta x S p e c tru m * to leases a n d h ire -
purchase ag ree m ents.
15 Prior to July 2012, the tax treatment of hire-purchase agreements depended upon whether a separate credit charge was
disclosed to the asset purchaser. If such disclosure was made then the asset purchaser was only liable for GST on the cost of
the asset, with no tax liability arising from the financial supply component of the agreement.
B usiness finance
SUMMARY
• T he re a s o n s fo r le a s in g d iff e r b e tw e e n th e v a rio u s c a p a c ity in th e c a s e o f o p e r a tin g le a s e s . L e a s in g a n d
ty p e s o f le a se s. T h e t w o b a s ic ty p e s a r e o p e r a tin g o th e r ty p e s o f e q u ip m e n t f in a n c e c a n b e a ttra c tiv e
le a s e s a n d f in a n c e le a se s. f o r b u s in e s s e s th a t a r e s m a ll o r n e w a n d , th e re fo re ,
• O p e r a t in g le a s e s s e p a ra te th e risks o f o w n e r s h ip fa c e r e la tiv e ly h ig h tra n s a c tio n c o sts in o b ta in in g
fro m th e use o f th e le a s e d a sse t a n d c a n p r o v id e f in a n c e in o th e r w a y s .
a d v a n ta g e s su ch as lo w e r tra n s a c tio n costs, • L e a s in g in v o lv e s a s e p a r a tio n o f o w n e r s h ip a n d
c o n v e n ie n c e a n d fle x ib ility , a s w e ll a s in s u ra n c e c o n tr o l th a t re s u lts in a g e n c y c o s ts . U n le s s a le a s e
a g a in s t th e ris k o f o b s o le s c e n c e . h a s s ig n if ic a n t b e n e fits s u ch a s la r g e ta x s a v in g s ,
• In th e case of fin a n c e le a s e s , th e risks of a s s e t u se rs w ith g o o d a c c e s s to in te r n a l fu n d s w ill
o w n e r s h ip a r e b o r n e b y th e u s e r o f th e a sse t g e n e r a lly p r e fe r to p u r c h a s e r a t h e r th a n le a s e .
a n d le a s in g is a n a lte r n a tiv e to o th e r fo rm s o f • T h e le a s in g m a rk e t is h ig h ly c o m p e titiv e a n d v e r y
d e b t fin a n c e . L e a s in g o f v e r y e x p e n s iv e assets f le x ib le . T h e re fo re , fa c to rs su ch a s c h a n g e s in ta x
is d r iv e n b y ta x -re la te d fa c to rs . E xcep t w h e re ru le s and th e le v e l of g o v e r n m e n t c h a rg e s and
th e re a re s ig n if ic a n t ta x a d v a n ta g e s , le a s in g o f d iffe re n c e s in G S T tr e a tm e n t c a n have im p o r ta n t
s p e c ia lis e d a sse ts is m u c h less c o m m o n th a n e ffe c ts o n th e p o p u la r ity o f le a s in g c o m p a r e d w ith
le a s in g o f g e n e r a l use o r m a r k e ta b le a sse ts, such s im ila r fo rm s o f fin a n c e , n a m e ly c h a tte l m o rtg a g e s
a s m o to r v e h ic le s a n d c o m p u te rs . a n d h ire -p u rc h a s e .
• T he a b ilit y o f a le s s o r to re p o sse ss a n a s s e t m o re
e a s ily th a n a s e c u re d le n d e r p r o v id e s g r e a te r d e b t
KEY TERMS
c h a tte l m o rtg a g e 471 le v e ra g e d le a se 454
c ro s s -b o rd e r le a se 455 m a in te n a n c e le a se 453
fin a n c e le a se 452 n o n -re c o u rs e lo a n 454
h ire -p u rc h a s e a g re e m e n t 471 o p e r a tin g le a se 453
lessee 451 sa le a n d le a s e -b a c k a g re e m e n t 453
le ssor 45 1
SELF-TEST PROBLEMS
1 D o n a s h Pty Ltd n e e d s a n e w c o m p u te r, w h ic h it c a n b u y f o r $ 4 4 0 0 0 0 o r it c a n le a s e fro m C o m le a s e .
T he le a s e r e q u ire s s ix a n n u a l p a y m e n ts o f $ 1 0 0 0 0 0 e a c h , in a d v a n c e . D o n a s h h a s la r g e ta x losses a n d
d o e s n o t e x p e c t to p a y ta x f o r a t le a s t 5 y e a rs . C o m le a s e p a y s ta x a t 3 0 p e r c e n t a n d c a n d e p r e c ia te
th e c o m p u te r o n a s tra ig h t-lin e b a s is o v e r 3 y e a rs . T he c o m p u te r w i ll h a v e n o r e s id u a l v a lu e a t th e e n d o f
5 y e a rs , a n d th e b e fo re -ta x in te re s t r a te o n a n e q u iv a le n t lo a n w o u ld b e 1 5 p e r c e n t p e r a n n u m .
a) W h a t is th e N P V o f th e le a s e fo r D o n a s h ?
b) W h a t is th e N P V fo r C o m le a s e ?
c) W h a t is th e o v e ra ll g a in to le a s in g in th is tra n s a c tio n ?
Solutions to self-test problem s are a va ila b le in A p p e n d ix B.
47 2
C H A P T E R FIFTEEN R E V I W W
QUESTIONS
1 [L O 1] D is tin g u is h b e tw e e n a 'fin a n c e le a s e 7 a n d a n 'o p e r a t in g le a s e 7. W h y is it im p o r ta n t to m a k e th is
d is tin c tio n ?
2 [L O U W h a t a r e th e im p o r ta n t c h a ra c te ris tic s o f a f in a n c e le a se ?
3 [L O 1] W h a t a r e th e e s s e n tia l c h a ra c te ris tic s o f a s a le a n d le a s e -b a c k a g re e m e n t? O u tlin e th e a d v a n ta g e s

a n d d is a d v a n ta g e s o f su ch a n a g re e m e n t.
4 [LO 2 ] W h a t d is tin g u is h e s a le v e r a g e d le a s e fro m o th e r ty p e s o f fin a n c e le a se s? W h a t a r e th e ro le s o f th e

v a rio u s p a rtie s to a le v e r a g e d le a se ?
5 [L O 2 ] C o m p a re a n d c o n tra s t a le v e r a g e d le a s e 7 a n d a 'c ro s s -b o rd e r le a s e '.
6 [L O 3 ] Leasing is a form o f tax a vo id an ce that should be o u tla w e d b y legislation. D iscu ss th is s ta te m e n t,

in d ic a tin g w h y y o u a g r e e o r d is a g r e e w ith it.
7 [L O 7 ] Leasing increases a com pany's access to debt. D iscu ss c r itic a lly .
8 [LO 7 ] D iscuss c r it ic a lly th e a lle g e d a d v a n ta g e s o f le a s in g .

9 [LO 7 ] W h ic h , if a n y , o f th e f o llo w in g a r e g e n u in e a d v a n ta g e s o f le a s in g ?
a) L e asing c o n s e rv e s th e lessee's c a p ita l.
b) L e asing e n a b le s n e e d e d assets to b e a c q u ir e d e ve n w h e n th e B o a rd o f D ire c to rs w ill n o t a p p r o v e a n y

c a p ita l e x p e n d itu re re q u e sts.
c) By le a s in g a c o m p u te r, th e risk o f o b s o le s c e n c e c a n b e tra n s fe rre d to th e lessor.
d) Le a sin g p ro v id e s 1 0 0 p e r c e n t fin a n c in g .
10 [L 0 7 ] It is c o m m o n f o r a ir lin e s to o w n s o m e a ir c r a f t w h ile le a s in g o th e rs u n d e r o p e r a tin g le a se s. W h a t a re

th e a d v a n ta g e s a n d d is a d v a n ta g e s o f th is a p p r o a c h ?
11 [L O 7 ] If le a s in g d o e s c o n s e rv e c a p it a l in th e se n se th a t th e d e b t c a p a c it y o f le a s in g e x c e e d s th e d e b t
c a p a c ity o f le n d in g , w h a t a r e th e m a in im p lic a tio n s fo r le a s e ve rsu s p u rc h a s e d e c is io n s ?
12 [LO 7 ] Leasing means that an asset is under the control o f o user w h o is not the o w n e r a n d this separation
gives rise to agen cy costs. W h a t a r e th e m a in im p lic a tio n s o f th e s e co sts f o r le a s e ve rs u s p u rc h a s e
d e c is io n s ?
13 [L O 8 ]C r itic a lly e v a lu a te th e f o llo w in g s ta te m e n t: M a n y ro o d transport com panies ore risky businesses
w hich are unable to b o rro w enough to buy o il the trucks they need. For them, leasing makes a lo t o f sense.
Trucks are attractive to lessors because they are d u ra b le a n d there is an active second-hand market.
14 [L 0 8 ] It is common to lease assets such os cars a n d trucks, w hereas specialised assets ore usually o w n e d
b y the user. E x p la in .
15 [L 0 8 ] In Australia, o p e ra tin g leases have been lim ite d m a in ly to m otor vehicles, computers a n d
m ultipurpose industrial equipm ent such as forklifts. W h a t c h a ra c te ris tic s o f th e se assets m a k e th e m s u ita b le
fo r o p e r a tin g le a se s?
16 [L O 9 ] O u tlin e th e m a in fa c to rs th a t a r e lik e ly to in flu e n c e th e c h o ic e b e tw e e n a c q u ir in g a n a s s e t th r o u g h a

fin a n c e le a s e o r b y h ire -p u rc h a s e .
17 [L O 9 ] D is tin g u is h b e tw e e n :
a) a fin a n c e le a s e a n d a h ire -p u rc h a s e a g re e m e n t
b) c h a tte l m o r tg a g e a n d h ire -p u rc h a s e .
18 [LO 9 ] Leases a n d c h a tte l m o rtg a g e s a r e tre a te d d iffe r e n tly u n d e r th e g o o d s a n d s e rv ic e s ta x (G S T). O u t lin e

th e G S T tre a tm e n t o f le a s e s a n d c h a tte l m o rtg a g e s . F o r a b u s in e s s , is th e o v e r a ll c o s t o f a le a s e lik e ly to b e
g re a te r th a n th e c o s t o f a c h a tte l m o rtg a g e ?
473
B usiness finance
CA PROBLEMS
1 Calculating lease rentals [LO 4]
T he V is io n C o m p a n y is e v a lu a tin g th e a c q u is itio n o f a n a sse t th a t it re q u ire s fo r a p e r io d o f 6 y e a rs . The
fo llo w in g in fo r m a tio n re la te s to th e p u rc h a s e o f th e asse t:
a) The p u rc h a s e p ric e is $1 m illio n .
b) It c a n b e d e p r e c ia te d a t a ra te o f 1 0 p e r c e n t p e r a n n u m , s tra ig h t-lin e .
c) The e s tim a te d d is p o s a l v a lu e in 6 y e a r s 7 tim e is $ 3 0 0 0 0 0 .
d) T h e c o m p a n y in c o m e t a x ra te is 3 0 ce n ts in th e d o lla r.
e) T h e re q u ire d ra te o f re tu rn o n th e in v e s tm e n t is 1 5 p e r c e n t p e r a n n u m a fte r ta x .
A s s u m e th a t th e c o m p a n y h a s th e a lte rn a tiv e o f le a s in g th e a sse t fro m th e A ja x Le a sin g C o m p a n y . A ss u m e a ls o

th a t th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 9 p e r c e n t p e r a n n u m .
A s s u m in g th a t th e a n n u a l le a s e p a y m e n ts a re m a d e a t th e b e g in n in g o f e a c h y e a r a n d th a t th e le a se s p e c ifie s
a re s id u a l v a lu e o f $ 3 0 0 0 0 0 , w h a t le a s e p a y m e n ts w o u ld m a k e V is io n in d iffe r e n t b e tw e e n b u y in g o r le a s in g
th e asset?

A s s u m e th a t A ja x Le a sin g C o m p a n y c o u ld a c q u ir e th e a sse t re q u ire d b y V is io n (see P ro b le m 2 ) fo r $ 9 0 0 0 0 0
a n d d e p r e c ia te it a t a ra te o f 1 5 p e r c e n t p e r a n n u m , s tra ig h t-lin e . T he o th e r in fo r m a tio n is th e s a m e a s th a t
p re s e n te d in P ro b le m 2 .
a) C a lc u la te th e m in im u m a n n u a l le a s e p a y m e n t th a t A ja x Le a sin g C o m p a n y w o u ld c h a rg e .
b) D o e s y o u r a n s w e r to (a) n e c e s s a rily im p ly th a t V is io n s h o u ld le a s e th e asset? W h y o r w h y not?

C o n n e ll F in a n c e is d e te rm in in g p a y m e n ts fo r a 4 -y e a r fin a n c e le a se w ith a 2 0 p e r c e n t re s id u a l o n a n a sse t
th a t costs $ 8 0 0 0 0 0 a n d c a n b e d e p r e c ia te d o n a s tra ig h t-lin e b a s is o v e r 3 y e a rs . T he ta x ra te fo r C o n n e ll
is 3 0 p e r c e n t, a n d it re q u ire s a b e fo re -ta x ra te o f re tu rn fro m le ase s o f 1 2 p e r c e n t. D e te rm in e th e le a s e
p a y m e n ts w h e n th e le a se p a y m e n ts a r e m a d e :
a) a n n u a lly in a d v a n c e
b) q u a r te r ly in a d v a n c e .
S u p p o s e th a t th e le a se re n ta ls a re p a y a b le a n n u a lly in a d v a n c e a n d th e te rm s o f th e le a s e a re c h a n g e d so
th a t it is a n o p e r a tin g le a se . W ill th e re n ta ls b e h ig h e r o r lo w e r th a n y o u r a n s w e r to (a)? G iv e re a s o n s fo r y o u r
a n s w e r.
4 Evaluating investments: lease versus purchase [LO 5]

The H y b e e C o m p a n y is e v a lu a tin g a n in v e s tm e n t to p ro d u c e a n e w p r o d u c t w ith a n e x p e c te d m a rk e ta b le life
o f 5 y e a rs . T he e x p e c te d a n n u a l n e t c a s h f lo w b e fo re ta x is $1 2 0 0 0 0 . To p ro d u c e th is p r o d u c t th e c o m p a n y
w ill h a v e to a c q u ir e n e w p la n t. The c o m p a n y c a n e ith e r p u rc h a s e this p la n t o r le a se it. D e ta ils o f these
a lte rn a tiv e s a re as fo llo w s :
Purchase
T he p u rc h a s e p ric e o f th e p la n t is $ 2 5 0 0 0 0 a n d it is e x p e c te d th a t it w ill h a v e a z e r o re s id u a l v a lu e a fte r
5 y e a rs . T h e a llo w a b le a n n u a l d e p r e c ia tio n c h a r g e o n th e p la n t is 2 0 p e r c e n t p e r a n n u m , s tra ig h t-lin e .
Lease
T he le a se re q u ire s fiv e a n n u a l p a y m e n ts , e a c h o f $ 6 0 0 0 0 , p a y a b le a t th e b e g in n in g o f e a c h y e a r. T he
c o m p a n y ta x ra te is 3 0 ce n ts in th e d o lla r . T he r e q u ire d ra te o f re tu rn o n th e in v e s tm e n t is 1 5 p e r c e n t p e r
a n n u m a fte r ta x a n d th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 8 p e r c e n t p e r a n n u m .
S h o u ld th e c o m p a n y u n d e rta k e th e in ve stm e n t? If so, s h o u ld it p u rc h a s e o r le a s e th e p la n t?
5 Lease versus purchase [LO 5]

C a r r y Ltd is e v a lu a tin g th e p o s s ib ility o f te n d e rin g fo r th e lic e n c e to o p e r a te in te r n a tio n a l flig h ts fro m C a n b e r r a
to Q u e e n s to w n (N Z ) fo r a 5 -y e a r p e r io d . If its b id is su cce ssfu l, th e lic e n c e fe e h a s to b e p a id im m e d ia te ly a n d
is n o t ta x d e d u c tib le .
474
C H A P T E R FIFTEEN R E V I m w
T he c o m p a n y h a s e s tim a te d th a t th e b e fo re -ta x a n n u a l n e t c a s h in flo w fro m o p e r a tin g th e s e rv ic e w o u ld b e
$ 2 0 m illio n , a n d th a t it w o u ld re q u ire a n a fte r-ta x ra te o f re tu rn o f 1 5 p e r c e n t p e r a n n u m o n its in ve stm e n t.
The c o m p a n y in c o m e ta x ra te is 3 0 ce n ts in th e d o lla r . C a r r y Ltd h a s th e o p tio n o f e ith e r b u y in g o r le a s in g a n
a ir c r a ft. T he f o llo w in g in fo r m a tio n is re le v a n t to th e se o p tio n s :
Purchase
T he p u rc h a s e p r ic e o f th e a ir c r a f t is $ 6 0 m illio n . \\ c o u ld b e d e p r e c ia te d a t a ra te o f 1 5 p e r c e n t p e r
a n n u m , s tra ig h t-lin e . T h e e s tim a te d d is p o s a l v a lu e in 5 y e a r s ' tim e is $ 2 0 m illio n .
Lease
T he a n n u a l le a s e p a y m e n ts w o u ld b e $ 1 5 m illio n , p a y a b le a t th e b e g in n in g o f e a c h y e a r, w ith a le a s e
re s id u a l o f $ 2 0 m illio n . T he a fte r-ta x in te re s t ra te o n a n e q u iv a le n t lo a n is 1 1 p e r c e n t p e r a n n u m .
W h a t is th e m a x im u m lic e n c e fe e th a t C a r r y Ltd s h o u ld te n d e r?
6 E v a lu a tio n o f a n o p e r a tin g le a se [LO 6 ]

Ibus Ltd is c o n s id e rin g th e in s ta lla tio n o f a n e w c o m p u te r. B e c a u s e o f u n c e rta in ty a s to its fu tu re c o m p u tin g
re q u ire m e n ts a n d th e p ro s p e c t o f a d v a n c e m e n ts in c o m p u tin g te c h n o lo g y , it is e v a lu a tin g th e a c q u is itio n o f the
c o m p u te r b y e ith e r p u rc h a s in g it, o r le a s in g it u n d e r a c o n tra c t th a t in c lu d e s a c a n c e lla tio n o p tio n . In fo rm a tio n
re le v a n t to th e c o m p a n y ’s e v a lu a tio n is as fo llo w s :
Purchase
T he p u rc h a s e p ric e o f th e c o m p u te r is $ 3 0 0 0 0 0 a n d it c a n b e d e p r e c ia te d a t a ra te o f 1 5 p e r c e n t p e r
a n n u m , s tra ig h t-lin e . Ib u s Ltd p la n s to o p e r a te th e c o m p u te r fo r a m a x im u m o f 5 y e a rs . T he c o m p u te r's
d is p o s a l v a lu e a t th e e n d o f 5 y e a rs is e s tim a te d to b e $ 5 0 0 0 0 .
Lease
T he a n n u a l le a se p a y m e n ts o n th e o p e r a tin g le a s e w o u ld b e $ 9 0 0 0 0 , p a y a b le a t th e b e g in n in g o f e a c h
y e a r. T he le a se c a n b e c a n c e lle d b y Ibu s Ltd a t a n y tim e w ith o u t in c u rrin g a n y p e n a lty p a y m e n t.
The c o m p a n y in c o m e ta x ra te is 3 0 c e n ts in th e d o lla r, th e r e q u ire d re tu rn o n th e in v e s tm e n t is 2 0 p e r c e n t p e r

a n n u m a n d th e a fte r-ta x c o s t o f a n e q u iv a le n t lo a n is 1 0 p e r c e n t p e r a n n u m . S h o u ld th e c o m p a n y p u rc h a s e o r
le a se th e asset?
REFERENCES
Australian Bureau of Statistics, Lending Finance, Australia, Graham, J.R., Lemmon, M.L. & Schallheim, J.S., 'Debt,
cat. no. 5 6 7 1 .0 , February 20 1 4 . leases, taxes and the endogeneity of corporate tax status’，
Bennett, J., Hardaker, R. & W orrall, M ., 'Equipment: leasing Journal of Finance, February 1998, pp. 1 3 1 -6 2 .
and financing7, in R. Bruce, B. McKern, I. Pollard & M. Skully Grenadier, S.R., 'Valuing lease contracts: a real options
(eds), Handbook of Australian Corporate Finance, 5th edn, approach', Journal of Financial Economics, July 1995,
Butterworths, Sydney, 1997, pp. 2 7 4 -3 0 3 . pp. 2 9 7 -3 3 1 .
Bowman, R., 'The debt equivalence of leases: an empirical Henderson, S.f Peirson, G. & Herbohn, K.; Issues in Financial
investigation7, The Accounting Review, April 1980, Accounting, 15th edn, Pearson Education, Sydney, 2 0 1 3 ,
pp. 2 3 7 -5 3 . Chapter 12.
Burrows, G .H .; 'Evolution of a lease solution', Abacus, Lev, B. & Ohlson, J., 'Market-based em pirical research
September 1988, pp. 1 0 7 -1 9 . in accounting: a review, interpretation and extension', in
Copeland, T. & Weston, J., 'A note on the evaluation of 'Studies on current research methodologies in accounting:
cancellable operating leases7, Financial Management, a critical evaluation,/ Journal of Accounting Research,
Summer 1982, pp. 6 0 -7 . Supplement, 1982.
Eisfeldt, A. & Rampini, A ./Leasing, ab ility to repossess, and Lewellen, W ., Long, M . & McConnell, J.,'A sset leasing in
debt capacity', /?ewevv o f/^n a n c/a / A pril 20 09 , competitive capital markets7, Journal of Finance, June 1976,
pp. 1 6 2 1 -5 7 . pp. 7 8 7 -9 8 .
Flath, D., 'The economics of short-term leasing7, Economic M ehran, H., Taggart, R.A. & Yermack, D., 'CEO ownership,
Inquiry, April 1980, pp. 2 4 7 -5 9 . leasing and debt financing,/ Financial Management, Summer
Gavazza, A., 'Asset liquidity and financial contracts: 19 99, pp. 5 -1 4 .
evidence from aircraft leases', Journal of Financial Miller, M . & Upton C., le a s in g , buying and the cost
Economics, January 2 0 1 0 , pp. 6 2 -8 4 . of capital services', Journal of Finance, June 1976,
------ , 'Leasing and secondary markets: theory and evidence pp. 7 6 1 -8 6 .
from commercial aircraft', Journal of Political Economy, April Myers, S., Dill, D. & Bautista, A., 'Valuation of financial lease
2 0 1 1 , pp. 3 2 5 - 7 7 . contracts7, Journal of Finance, June 19 7 6 , pp. 7 9 9 -8 1 9 .
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B usiness finance
Scarman, l.; 'Lease evaluation: a survey of Australian finance Sharpe, S.A. & Nguyen, H.H., 'C apital market imperfections
company approaches', Accounting and Finance, November and the incentive to lease', Journal of Financial Economics,
1 9 8 2 , pp. 3 3 - 5 1 . O cto be r/N ovem b er 1995, pp. 2 7 1 -9 4 .
Schallheim, J.S., Lease or Buy?, Harvard Business School Smith, C.W . Jr. & W akeman, L.M, 'Determinants of corporate
Press, Boston, 1994. leasing policy7, Journal of Finance, July 1985, pp. 8 9 5 -9 0 8 .
Schallheim, J., Johnson, R., Lease, R. & McConnell, J., 'The Vardigans, P., 'The benefits of leasing7, Banking World,
determinants o f yields on financial leasing contracts,/ Journal August 1990, pp. 2 6 -7 .
of Financial Economics, September 1987, pp. 4 5 -6 7 .
476
CHAPTER CONTENTS
16.1 I n t r o d u c t io n 478 M a r k e t e f f ic ie n c y a t th e m a c r o le v e l 495
16.2 T h e e f f ic ie n t m a r k e t h y p o th e s is 478 ^ ^ 3 B e h a v io u r a l f in a n c e a n d m a r k e t e f f ic ie n c y 495
16.3 Tests o f re tu r n p r e d i c t a b il it y 481 I m p lic a t io n s o f th e e v id e n c e w it h r e s p e c t to

m a r k e t e f f ic ie n c y 497
16.4 E v e n t s tu d ie s 487
16.5 Tests f o r p r iv a t e in f o r m a t io n 493
LEARNING OBJECTIVES
Z
1 u n d e r s ta n d th e c o n c e p t o f m a r k e t e f f ic ie n c y
2 u n d e r s ta n d th e m e th o d s u s e d to te s t f o r m a r k e t e f f ic ie n c y
3 u n d e r s ta n d th e e v id e n c e p r o v id e d b y te sts o f m a r k e t e f f ic ie n c y a n d th e e x t e n t to w h ic h t h a t e v id e n c e
s u p p o r ts o r d o e s n o t s u p p o r t m a r k e t e f f ic ie n c y
4 u n d e r s ta n d th e d if f e r e n c e b e t w e e n m ic r o a n d m a c r o m a r k e t e f f ic ie n c y
5 u n d e r s ta n d th e r e le v a n c e o f b e h a v io u r a l f in a n c e t o m a r k e t e f f ic ie n c y
6 u n d e r s ta n d th e im p lic a t io n s o f th e e v id e n c e o n m a r k e t e f f ic ie n c y f o r in v e s to r s a n d f in a n c ia l m a n a g e r s .
B usiness finance
16.1 Introduction
In C h a p te r 1, w e assu m ed t h a t th e o b je c tiv e o f a co m p a n y was to m a x im is e th e m a rk e t v a lu e o f its shares.
In th e c h a p te rs t h a t fo llo w e d , w e discussed th e in v e s tm e n t, fin a n c in g a n d p a y o u t d e cisio n s c o n s is te n t
w ith t h a t o b je c tiv e . T h ro u g h o u t th o se ch a p te rs i t was im p lic it ly assu m ed t h a t in v e s to rs w o u ld rea ct
q u ic k ly to such de cisio n s, a n d a c c o rd in g ly t h a t th e m a rk e t p ric e o f th e co m p a n y s shares w o u ld a d ju s t
q u ic k ly to re fle c t th e im p a c t o f each d e c is io n o n th e c o m p a n y s value. I n o th e r w o rd s , i t w as assum ed th a t
th e shares w e re tra d e d in a m a rk e t t h a t was e fficie n t*, in th e sense t h a t share p rice s a ccu ra te ly re fle c t
a va ila b le in fo r m a tio n .
The e x te n t to w h ic h asset p rice s a ccu ra te ly re fle c t a va ila ble in fo r m a tio n has be en w id e ly tested . These
EFFICIENT MARKET te sts e x a m in e th e efficien t m a rk e t h y p o th esis (EM H) — th e h y p o th e s is t h a t th e p ric e o f a s e c u rity
HYPOTHESIS (EM H ) (such as a share) a ccu ra te ly re fle c ts a va ila b le in fo r m a tio n . M o s t o f these te s ts have use d share prices, b u t
that the price of a
o th e r m a rk e ts such as d e b t m a rk e ts a n d d e riv a tiv e s e c u ritie s m a rk e ts have also b e en e x te n s iv e ly tested.
security (such as a
In re v ie w in g th e evide nce o n m a rk e t e ffic ie n c y i t is necessary to m a ke a d is tin c tio n b e tw e e n m ic ro
share) accurately
reflects available e ffic ie n c y an d m a c ro -e fficie n cy. A t th e m ic ro le vel, m a rk e t e ffic ie n c y con cern s th e e x te n t to w h ic h th e
information p ric e o f a s e c u rity re fle c ts in fo r m a tio n re la tiv e to o th e r s e c u ritie s in th e sam e asset class: f o r exam ple,
w h e th e r B H P B illit o n shares are c o rre c tly p ric e d w h e n c o m p a re d w ith R io T in to shares. A t th e m a cro level,
th e issue is w h e th e r c a p ita l m a rk e ts as a w h o le re fle c t a ll a va ila b le in fo r m a tio n — w h e th e r, f o r exa m ple,
th e share m a rk e t is c o rre c tly p ric e d co m p a re d w it h a less r is k y asset class such as g o v e rn m e n t de bt.
M ic ro -e ffic ie n c y does n o t n e ce ssa rily im p ly m a c ro -e ffic ie n c y . F o r exa m ple, shares in C o m p a n y X m a y
be c o rre c tly p ric e d re la tiv e to shares in C o m p a n y Y, b u t th e share m a rk e t as a w h o le m a y be o v e rv a lu e d
due to ‘ir r a tio n a l exu b e ra n ce ’. M o re o v e r, i t is p o ssib le t h a t som e in v e s to rs w ill k n o w t h a t th e share m a rk e t
is o ve rv a lu e d , b u t i f th o se in v e s to rs c a n n o t p re d ic t w h e n th e 'bubble* w ill b u rs t, th e y m a y s t ill b u y shares
t h a t th e y t h in k are re la tiv e ly cheap a n d sell shares t h a t th e y t h in k are re la tiv e ly expensive. W h ile th is
tra d in g a c tiv ity m a y m a in ta in h ig h m ic ro -e ffic ie n c y , i t m a y n o t e lim in a te m a c ro -in e ffic ie n c y .
This c h a p te r p ro v id e s a re v ie w o f th e evide nce o n m ic ro a n d m a cro m a rk e t e ffic ie n c y an d th e
im p lic a tio n s o f t h a t evidence f o r fin a n c ia l d e c is io n m a k in g . O n th e basis o f th is e vide nce m o s t academ ics
a n d p ra c titio n e rs b e lie ve t h a t m a rk e ts are n e ith e r c o m p le te ly e ffic ie n t n o r c o m p le te ly in e ffic ie n t.
T h e re fo re , in re v ie w in g th is evidence, ra th e r th a n a s k in g w h e th e r m a rk e ts are e ffic ie n t o r in e ffic ie n t—
one e x tre m e o r th e o th e r— th e m o re h e lp fu l q u e s tio n is to ask: To w h a t e x te n t are m a rk e ts e ffic ie n t?
(D o u ka s e t al. 2 0 0 2 ).
T his is n o t m e re s e m a n tics. I f y o u w is h to k n o w s o m e th in g a b o u t th e te m p e ra tu re , th e q u e s tio n : W h a t
is th e te m p e ra tu re ? is lik e ly to le a d to m o re in s ig h ts th a n d e b a tin g w h e th e r i t is either 'h o t* or cold* w ith o u t
a llo w in g f o r a ran ge o f answ ers. The sam e a p p lie s to th e q u e s tio n o f m a rk e t e ffic ie n c y . To u n d e rsco re
th e im p o rta n c e o f th is p o in t, i t m a y be n o te d t h a t Eugene Fam a a n d R o b e rt S h ille r w e re each aw arded
th e 2 0 1 3 N o b e l M e m o ria l P rize in E co n o m ic Sciences f o r t h e ir w o rk e x a m in in g m a rk e t e fficie n cy. B o th
have m ad e a fu n d a m e n ta l c o n tr ib u tio n to o u r u n d e rs ta n d in g o f m a rk e t e ffic ie n c y y e t th e y have d iffe re n t
vie w s as to th e e x te n t t h a t m a rk e ts are e ffic ie n t.1 Fam a is one o f th e s tro n g e s t a d h e re n ts to th e v ie w th a t
m a rk e ts are v e ry e ffic ie n t, w h ile S h ille r argues t h a t m a rk e ts are m ic ro -e ffic ie n t b u t m a c ro -in e ffic ie n t. See
J u n g a n d S h ille r (2 0 0 5 ).
16.2 The efficient market hypothesis

Fam a (1 9 7 0 ) d e fin e d an e ffic ie n t c a p ita l m a rk e t as one in w h ic h s e c u rity p rice s ^ u lly refle ct* a ll ava ila ble
LEARNING in fo r m a tio n . S e c u rity p rice s change w h e n n e w in fo r m a tio n becom es ava ila ble. I f th e m a rk e t processes
OBJECTIVE 1
n e w in fo r m a t io n e ffic ie n tly , th e re a c tio n o f m a rk e t p rice s to n e w in fo r m a tio n w ill be instantaneous a n d
Understand the
concept of market unbiased (Fam a 1 9 7 0 ).2 To g a in an in tu it iv e u n d e rs ta n d in g o f the se re q u ire m e n ts i t is u s e fu l to exa m in e
efficiency
1 The prize was jointly awarded to Eugene Fama, Lars Hansen and Robert Shiller. A thorough analysis of their work that led to
the Nobel Prize is provided in U n d e rsta n d in g A s s e t P rice s compiled by the Economic Sciences Prize Committee of the Royal
Swedish Academy of Sciences (2013).
2 This definition focuses on 'the market', rather than on individuals responding to information, and is readily testable. For a
discussion of alternative definitions, see Ball (1994), pp. 10-13.
C hapter sixteen C apital m arket efficiency
a h y p o th e tic a l e xa m ple o f a n o n -in s ta n ta n e o u s p ric e re a c tio n a n d a h y p o th e tic a l e xa m p le o f a biased

p rice re a ctio n .
E ffic ie n c y re q u ire s t h a t th e p ric e reacts in s ta n ta n e o u s ly . In p ra c tic e , th is m eans t h a t a fte r n e w in fo r m a tio n

becom es ava ila ble i t s h o u ld be f u lly re fle c te d in th e n e x t p ric e e s ta b lis h e d in th e m a rk e t. Suppose t h a t
th e m a rk e t in C o pp eram a L td shares opens f o r tra d in g a t 1 0 :1 0 am . O n a p a rtic u la r day, th e f ir s t tra d e in
C opperam a shares occurs a t 1 0 :4 5 a m a n d th e p ric e e s ta b lis h e d in th e m a rk e t is $1 p e r share. A t 1 1 :0 0 am ,
C opperam a m akes a c o m p le te ly u n e x p e c te d a n n o u n c e m e n t: a la rg e d e p o s it o f g o ld has be en d isco ve re d
in one o f its co p p e r m in e s. N a tu ra lly th is is g o o d new s. Suppose t h a t th is new s w a rra n ts an increase
in C o pp eram a s share p ric e fr o m $1 to $ 1 .5 0 . A t 1 1 :1 5 am , a s h a re h o ld e r in C o pp eram a w ishes to sell
his shares. H o w eve r, he has n o t h e a rd th e ne w s o f th e g o ld d is c o v e ry a n d asks o n ly $1 p e r share f o r h is
shares. The sale is m ade a t $1. A t 1 1 :3 0 am , a C o p p e ra m a s h a re h o ld e r w h o has h e a rd th e new s w ishes to
sell h e r shares. H e r a s k in g p ric e is $ 1 .5 0 p e r share a n d th e sale is m ad e a t $1 .50.
This m a rk e t is in e ffic ie n t. The p ric e e s ta b lis h e d a t 1 1 :1 5 a m d id n o t re fle c t th e in fo r m a tio n ava ila ble
a t 11 :00 am . E ve n tu a lly, a t 1 1 :3 0 am th e m a rk e t p ric e rea cte d to th e new s. H o w e ve r, th is re a c tio n was
n o t in s ta n ta n e o u s because i t s h o u ld have o c c u rre d a t th e 11 :1 5 am tra d e . C o m p e titio n b e tw e e n in fo rm e d
p o te n tia l b u yers s h o u ld have s e t th e 1 1 :1 5 am p ric e a t $ 1 .5 0 , n o tw ith s ta n d in g th e fa c t t h a t th e s e lle r was
u n in fo rm e d .
This s im p le e xa m ple also illu s tra te s th e im p o rta n c e o f excess* o r a b n o rm a l* p r o fits in e ffic ie n c y tests.
The buyer a t 1 1 :1 5 am has m ad e an excess p r o f it o f 50 cents p e r share because he has o b ta in e d h is shares
a t a p rice 50 cen ts b e lo w th e p ric e t h a t s h o u ld have been e sta b lish e d , g iv e n th e in fo r m a tio n a va ila ble
to th e m a rk e t a t 1 1 :1 5 am . N o te , h o w e ve r, t h a t a lth o u g h th e b u y e r a t 1 0 :4 5 a m has also m ad e a p r o fit
o f 50 cents o n th e day, h is p r o f it cannot be d e scrib e d as excess. G ive n th e in fo r m a t io n a va ila b le to th e
m a rk e t a t 1 0 :4 5 am , th e p ric e he p a id was corre ct* a t t h a t tim e .
This exa m ple also illu s tra te s th e ro le o f tra d in g stra te g ie s. I f th e m a rk e t o fte n fa ils to react
in s ta n ta n e o u s ly , share tra d e rs can de ve lo p s im p le ru le s to g e n e ra te excess p ro fits . In th is case, th e ru le
w o u ld be: purchase shares im m e d ia te ly a c o m p a n y m akes an u n a n tic ip a te d a n n o u n c e m e n t o f g o o d news.
The m a rk e t w ill n o t re a ct in s ta n ta n e o u s ly a n d th e shares w ill increase in p ric e w h e n th e re a c tio n does
e v e n tu a lly occur.
Suppose th e m a rk e t in th e shares o f M o rtla k e L td op en s f o r tra d in g a t 1 0 :1 0 am . O n a p a r tic u la r day,

th e fir s t tra d e in M o r tla k e s shares occurs a t 1 0 :4 5 am a n d th e p ric e e s ta b lis h e d is $1. A t 1 1 :0 0 am , th e
co m p a n y m akes a c o m p le te ly u n e x p e c te d a n n o u n c e m e n t: an u n c o n tro lla b le fire has d e s tro y e d its m a jo r
fa c to ry , an d M o rtla k e s m a n a g e m e n t has d isco ve re d th a t, o w in g to an e rro r b y a ju n io r e m p lo yee, th e
co m p a n y is n o t in s u re d a g a in s t fire . In v e s to rs p a n ic a n d th e n e x t sale o f M o rtla k e s shares a t 1 1 :1 5 a m is
a t 5 cents p e r share. S h o rtly a fte r, h o w e ve r, c o o le r heads p re v a il a n d i t is re m e m b e re d t h a t M o rtla k e also
has a n u m b e r o f s m a lle r fa c to rie s a n d s u b s ta n tia l in v e s tm e n ts in se c u ritie s . A t 1 1 :3 0 a m th e m a rk e t p ric e
o f M o rtla k e s shares is 35 cents.
The m a rk e t is in e ffic ie n t. The p ric e e s ta b lis h e d a t 1 1 :1 5 a m was an ov er re a c tio n to th e new s, and, OVERREACTION
g iv e n th e in fo r m a tio n a va ila b le to th e m a rk e t a t 1 1 :1 5 am , i t s h o u ld have b e en re co g n ise d a t t h a t tim e as biased response of a

price to information
an o v e rre a c tio n . C o m p e titio n b e tw e e n in fo rm e d p o te n tia l b u ye rs s h o u ld have p re v e n te d such a lo w p ric e
in which the initial
o c c u rrin g , n o tw ith s ta n d in g th e fa c t t h a t p o o rly in fo rm e d sellers h a d p a n icke d . price movement can
As in th e p re v io u s e xa m p le , th is e xa m p le can be in te rp re te d in te rm s o f excess p r o fits a n d tra d in g be expected to be
strateg ies. The b u y e r a t 11 :1 5 a m has m ad e an excess p r o f it o f 30 ce n ts p e r share. The b u y e r a t 10 :4 5 am reversed
has m ade a loss o n th e day o f 65 cen ts p e r share, b u t th is loss c a n n o t be ca lle d excess. I f th e m a rk e t
o fte n ove rrea cts to b a d new s, th e fo llo w in g tra d in g ru le w ill be successful: p u rcha se shares im m e d ia te ly a UNDERREACTION
biased response of a
co m p a n y m akes an u n a n tic ip a te d a n n o u n c e m e n t o f b a d new s. The m a rk e t w ill a t f ir s t o ve rre a ct, a n d th e
price to information in
shares w ill rise in p ric e w h e n th e m a rk e t rea pp raise s th e in fo r m a tio n in a m o re ra tio n a l fa s h io n . which the initial price
A second k in d o f biase d re a c tio n is an u n d e rrea ctio n . In th is case th e m a rk e t re sp o n d s g ra d u a lly to movement can be
a piece o f ne w in fo r m a tio n , m o v in g to w a rd s th e n e w e q u ilib r iu m p ric e in a p re d ic ta b le series o f steps. expected to continue
This w ill create observable price trends. The trading strategy in this case would be to buy immediately,
if the news is good, and to sell im m ediately i f the news is bad.
I
1 6 .2 .3 1 Categories of capital market efficiency
As suggested earlier, the EMH implies th a t investors cannot earn abnormal returns by using inform ation
th a t is already available. This im plication has been the basis fo r most empirical tests o f the hypothesis.
LEARNING
The concept o f efficiency inherent in this defin itio n may be described as in form ation efficiency, as
OBJECTIVE 2
Understand the
it relates to the im pounding o f inform a tion in to m arket prices. I t does n o t directly address questions
methods used to test concerning the allocative or operational efficiency o f capital markets.
for market efficiency Fama (1970) suggested a m ethod o f characterising the efficiency o f a m arket on the basis o f the type
o f in fo rm a tio n incorporated in to the prices o f assets traded on the market. Assets traded on a m arket
INFORMATION
th a t was weak-form efficient were traded at prices th a t incorporated all inform a tion contained in the
EFFICIENCY
situation in which past record o f asset prices. I f a m arket was sem i-strong-form efficient, then prices reflected n o t only all
prices accurately info rm a tio n contained in past price series b ut also all other publicly available inform ation. When asset
reflect available prices reflected all privately held inform ation, in addition to th a t which was publicly available, then the
information m arket was said to be strong-form efficient.
The inform a tion content o f each successive classification is cumulative. Therefore the second
classification includes all previous price inform ation, as well as all other publicly available inform ation,
while the th ird classification includes all publicly available info rm a tio n and all privately held inform ation.
TESTS OF RETURN The im plication o f strong-form efficiency is th a t an investor cannot earn abnormal returns from having
PREDICTABILITY inside inform ation.
research method In a later review o f the literature, Fama (1991) proposed an alternative categorisation o f capital
designed to detect
m arket efficiency. Instead o f classifying a m arkets efficiency on the basis o f the type o f inform ation
systematic patterns in
asset prices impounded into the prices o f assets traded in the market, Fama suggested th a t categories could be formed
on the basis o f the research methodology used to assess the efficiency o f the m arket. The three research
EVENT STUDY
research method that methodologies he identified were:
analyses the behaviour
a te sts o f return predictability, which are employed to ascertain whether future returns can be
of a security’s price
around the time of predictedonthebasisofpastinform ationsuchaspastreturns,tim e-of-the-yearorbook-to-m arket ratios
a significant event b event studies, which involve the analysis o f the behaviour o f a security s returns around the tim e
such as the public o f a significant event such as the public announcement o f the company s p ro fit, dividend details or
announcement of the in te n tio n to acquire another company
company’s profit
c te sts fo r private inform ation, which are designed to test w hether investors can trade profitably
TESTS FOR PRIVATE by m aking investm ent decisions on the basis o f inform a tion th a t is n ot publicly available.
INFORMATION
research method In Sections 16.3 to 16.5 we consider the way in which these three methodologies have been used to test
that tests whether the efficiency o f various markets, particularly w ith respect to the Australian capital m arket. In Section
systematic profits 16.6 we examine the evidence w ith respect to macro-efficiency and in Section 16.7 consider the evidence
can be generated by
from behavioural finance. Im plications fo r investors and financial managers o f the evidence o f the extent
making investment
decisions on the basis to which markets are efficient are then considered in Section 16.8. Before we move on, however, we make
of private information it clear in the next section th a t tests o f m arket efficiency are also tests o f the model used in those tests.
1 6 .2 .4 1 M arket efficiency and the joint test problem

I f a security m arket is inefficient, then opportunities may exist fo r investors aware o f the inefficiency to
ABNORM AL RETURNS earn systematic abnorm al returns. Abnorm al returns can be defined as returns in excess o f the return
returns in excess of the one could norm ally expect from investm ent in the asset. In Chapter 7 we discussed how an assets expected
return expected from a
return can be estimated by employing an asset p ricing model th a t links the assets characteristics to the
security
investors required return from the asset. For instance, the capital asset p ricing model (CAPM) links an
assets expected return to its systematic risk as measured by beta. Therefore, the CAPM is one way that
JOINT TEST PROBLEM we can estimate the fo rm a l* retu rn on a security.
problem that any test
The jo in t te st problem arises because any test fo r the presence o f systematic abnormal returns is
of market efficiency
is simultaneously a
simultaneously a test o f both the efficiency o f the m arket and the v a lid ity o f the asset pricing model
test of some model of used to estimate expected (or ‘norm al’）returns. Hence, any apparent evidence o f m arket inefficiency may
’normal’ asset pricing instead be the result o f an incorrectly specified asset pricing model.
C hapter sixteen C apital market efficiency
Tests of return predictability

m
In an efficient market, investors should be unable to generate positive abnormal returns systematically
through an ability to forecast future price movements accurately. Researchers who have examined this LEARNING
OBJECTIVE 3
aspect o f m arket efficiency have been p rim a rily concerned w ith the follow ing three issues:
Understand the
a The relationship between p a s t an d future returns. I f investors can systematically generate positive evidence provided
by tests of market
abnormal returns from a security merely by n otin g the returns generated by th a t security in the
efficiency and the
past, then this is an indication o f m arket inefficiency, because the inform a tion contained in the past extent to which that
return series is n o t fu lly reflected in current prices, evidence supports
b The presence o f seaso n al effects in returns. Testing fo r the presence o f seasonal effects in returns or does not support
involves an analysis o f w hether future returns are related to the period in tim e over which the return market efficiency
is generated.
c Predicting future returns on the b asis o f other forecast variables. In an efficient market, asset prices
reflect all inform a tion currently available. There have been numerous studies th a t have tested for
a systematic relationship between returns and asset characteristics such as the company s size,
book-to-market ratio or dividend yield.
16.3.1 | The relationship between past and future returns

Short-term patterns
A common way o f testing fo r short-term patterns in returns is to test fo r the presence o f serial correlation.
Serial correlation tests measure the correlation between successive price changes or, more frequently, the
correlation between returns in one period and returns in a p rio r period. Positive correlation indicates that
there are trends in price movements, while negative correlation indicates a tendency towards reversals
in price movements. Either result would indicate the possible existence o f potentially profitable trading
strategies.
Both Conrad and Kaul (1988) and Lo and MacKinlay (1988) found evidence o f positive serial correlation
in weekly returns o f US shares. However, both studies also found th a t the level o f serial correlation was
small— probably too small to generate profitable trading opportunities. Furtherm ore, Lo and MacKinlay
(1999) found less evidence o f positive serial correlation over later periods. In Australia, Brailsford and
Faff (1993) examined the daily returns from an index consisting o f shares from 50 o f the m ost actively
traded companies listed on the Australian Stock Exchange. They also reported evidence o f small positive
serial correlation in returns.
Long-term patterns
While there is only weak evidence o f serial correlation in daily or weekly returns, in the medium term
there is strong evidence th a t shares w ith the best recent performance outperform shares w ith the worst
recent performance. Using US data from 1963 to 1989, Jegadeesh and Titm an (1993) identified better
perform ing shares (the winners) and poorer-perform ing shares (the losers) over a period o f 6 months.
They then tracked the performance o f these shares over the follow ing 6 months. On average, the biggest
winners outperform ed the biggest losers by 10 per cent per annum. Sim ilar evidence o f this m o m e n tu m M O M EN TU M EFFECT
effect have also been reported by Brock, Lakonishok and LeBaron (1992), M oskowitz and G rinblatt effect in which good
or bad performance of
(1999), Lo, Mamaysky and Wang (2000) and George and Hwang (2004). In particular, George and Hwang
shares continues over
show that shares th a t are close to or at th e ir 52-week high outperform shares th a t are far from th eir time
52-week high. Given th a t 52-week-high prices are readily available in newspapers and from websites,
this study suggests th a t abnormal returns may be earned using simple strategies and readily available
inform ation.
Evidence o f m om entum is widespread, w ith G riffin, J i and M a rtin (2003) finding it in m ost
international markets, and Hameed and Kusnadi (2002) and Brown, Yan Du, Rhee and Zhang (2008)
finding it in Asian markets. In Australia, evidence o f m om entum has been found in a range o f studies,
including Brailsford and O’Brien (2008) ，Bettman, Maher and Sault (2009), and Docherty, Chan and
Easton (2013). I t is also pervasive across a num ber o f asset classes, w ith M oskowitz, Ooi and Pedersen
B usiness finance
(2012) reporting evidence o f m om entum n ot only in equities markets b ut also in bond, currency and
commodities markets.
W hile m om entum is pervasive, there is disagreement as to its cause. Conrad and Kaul (1998) suggest
th a t winners are riskier than losers, so winners earn higher returns simply because they are riskier.
But this argum ent is refuted by Grundy and M a rtin (2001). A nother argument, presented by Barberis,
Shleifer and Vishny (1998) and Hong and Stein (1999), is th a t investors underreact to inform a tion and
place too much emphasis on recent share price performance. G rinblatt, Titm an and Wermers (1995)
suggest th a t fund managers are more likely to buy past winners and dump past losers, and they tend to
do this at the same time, thus generating mom entum. W hile there is disagreement as to its cause, even
Eugene Fama has accepted th a t o f all the potential embarrassments to m arket efficiency, m om entum is
the prim ary one’ （ Fama and Litterm an, 2012).
W hile there is evidence o f a m om entum effect in the m edium term , there is also evidence that this
effect is reversed over long periods. DeBondt and Thaler (1985 and 1987), Chopra, Lakonishok and R itter
(1992), Lee and Swaminathan (2000) and Jegadeesh and Titm an (2001) have documented long-term
reversals in share prices. These studies identified better-perform ing and poorer-perform ing shares over
several years. On average, the winners turned in to losers and the losers became winners.
Seasonal patterns in returns give rise to the possibility o f predicting returns based on those patterns.
M any studies have tested whether there are daily or m onthly patterns in share returns.
Daily return patterns

French (1980) reported th a t a daily index o f US share prices over the period 1953 to 1977 showed that, on
average, returns on Mondays were negative, while returns on Fridays were positive. I f this were true, why
would anyone buy shares on a Friday afternoon? W hy n o t w ait u n til late Monday when, on average, the
price would be lower? The result was puzzling b ut was replicated in later studies. For example, Lakonishok
and Sm idt (1988) studied 90 years o f US data (from 1897 to 1987) and found negative average Monday
returns over the period as a whole, and in all 10 subperiods th a t they studied.
W hat could explain these findings? One suggested possible explanation is th a t companies tend
to release bad news over the weekend (see, fo r example, Damodaran 1989). However, if this is the
explanation, then it suggests th a t markets are n o t perfectly efficient because prices do n ot adjust to
reflect the fact th a t companies have this tendency to release bad news over the weekend.3
N or is the phenomenon purely American. Ball and Bowers (1988) reported evidence o f a ^negative
Tuesday* over the period 1974 to 1984. Is i t coincidence th a t when it is Tuesday in Australia, i t is Monday
in America? O ther international comparisons tu rn up fu rth e r results: Canadas pattern is very like that
o f the US; the UK has a negative Monday, b u t its Friday is only m arginally positive; France, Japan and
Singapore have negative Tuesdays.4A common thread is th a t every country has some kind o f daily pattern,
but n ot necessarily the same pattern as th a t found in other countries and, im p orta ntly, n ot necessarily
the same pattern is observed over long periods o f time. For example, Rubinstein (2001) reports the
disappearance o f the Monday effect from the US m arket over the period 1988 to 1998. Indeed, over the
same period, he reports th a t M onday is actually the best-perform ing day o f the week, while Thursday has
become the worst. Similarly, over the period 1985 to 2013 the average retu rn on the Australian m arket
on a Tuesday was positive, b ut it was s till the w orst-perform ing day o f the week.5
M onthly return patterns

Rozeff and Kinney (1976) reported th a t the average retu rn on US shares in January was more than five
times larger than the average o f returns in the other 11 m onths. W hy didn’t a lo t o f investors buy in
3 Other possible explanations include: settlement procedures (see Lakonishok & Levi 1982); that there are patterns in trades
occurring at the asking price; and that there are patterns in the trading activity of individual (as against institutional)
shareholders. Except for small firms, the size of the Monday effect seems to have declined in recent years. See Aitken et al.
(1995) and Chan, Leung and Wang (2004).
4 Condoyanni, O'Hanlon and Ward (1988). See also Jaffe and Westerfield (1985).
5 Over the period 1985 to 2013, the average per cent returns on the Australian market, categorised by day of the week, were
Monday (0.039), Tuesdays (0.028), Wednesday (0.082), Thursday (0.063) and Friday (0.042).
December to benefit from this so-called Jan uary e ffect? Their actions would be expected to increase the JANUARY EFFECT
December price level and eventually elim inate the high January return. observation that, on
average, share prices
This effect has also been found in other countries. One study o f stock markets in 17 countries (including
increase more in
the US) found th a t January was the highest return m onth in 14 countries (Gultekin & Gultekin 1983). January than in other
In Australia over the period 1958 to 1981 the strongest m on thly effects fo r the m arket as a whole were months
for December and January. Together, these 2 m onths contributed, on average, 6.6 percentage points,
while the other 10 m onths contributed a to ta l o f only 6.3 percentage points. In other words, 2 m onths
contributed more than half o f the to ta l retu rn fo r the year fo r the m arket as a whole.6 Over the period
1982 to 2013 there was a different pattern: the highest average returns were in A p ril, July and December.7
I t is not clear why any particular m onth should be different from other months. One possible
explanation investigated thoroughly is ta x lo ss sellin g. The end o f a tax year could induce heavy selling TAX LOSS SELLING
pressure in the last m onth, causing lower prices, followed by a rebound in prices in the firs t m onth o f investment strategy
in which the tax rules
the new tax year. As the US has a tax year ending in December, this m ight explain the US January effect.
make it attractive for
In Australia, tax loss selling by domestic investors would produce high returns in July, while in the UK, an investor to sell
high returns would occur in A p ril. A lthough high returns are indeed observed at these times, Australia certain shares just
and the UK have at various tim es had strong January effects, which are n ot predicted by the tax loss before the end of the
selling hypothesis. Therefore, tax effects provide, at best, a partial explanation.8 The January effect is also tax year
closely related to the ‘size’ effect discussed in Section 16.3.3.
1 6 .3 .3 1 Predicting future returns on the basis of other

forecast variables
A range o f studies has reported that a number o f variables may be used to predict future returns. These
variables include a company s dividend yield, its price-earnings ratio, whether i t has repurchased or
issued shares, the level o f its accounting accruals, its asset growth, its size, and the ratio o f the book value
o f its equity to the m arket value o f its equity. For sim plicity this last factor is often called the company s
book-to-market ratio. Studies th a t have examined these variables w ill be discussed in tu rn . We w ill then
provide a discussion o f the interrelationship between these factors.
Dividend yield
A share s dividend yield is the value o f the dividend (per share) divided by the share price. A number o f DIVIDEND YIELD
US studies have found th a t dividend yield helps to explain returns, even after adjustm ent fo r systematic dividend per share
divided by the share
risk.9 Typically, these studies fin d th a t beta-adjusted returns are higher, the higher the dividend yield—
price
that is, there is a relationship between returns and dividend yields th a t cannot be explained by the capital
asset pricing model. Sim ilar results have been found using Australian data fo r the period 1960 to 1969
(Ball et al. 1979) and fo r the period 1975 to 1998 (Boudry & Gray 2003).
Price-earnings ratio
The share price divided by earnings per share is usually called the p r ic e -e a r n in g s ra tio , or the *P/E PRICE-EARNINGS
ratio’，and is used in decision making by investm ent analysts. In 1977 Basu reported th a t the P/E ratio RATIO
share price divided by
helps to explain returns even after adjustm ent fo r systematic risk. Specifically, risk-adjusted returns were
earnings per share
higher, the lower the P/E ratio. Basus results were supported in a larger and more detailed study o f US
shares by Reinganum (1983). There is now a considerable literature suggesting th a t shares w ith low P/E
ratios earn higher returns. In Australia, this relationship has been documented by Anderson, Lynch and
M athiou (1990).
6 See Brown, Keim, Kleidon and Marsh (1983). The high January return also occurred in Australia in the earlier period of 1936
to 1957; see Brailsford and Easton (1991).
7 Over the period 1982 to 2013, the average monthly rates of return were 3.4 per cent, 2.4 per cent and 2.3 per cent in
April, July and December respectively. The next highest average monthly rate of return was 1.7 per cent in November.
8 For a detailed and entertaining review, see Haugen and Lakonishok (1988).
9 For a brief survey of these studies, see Keim (1988, p. 19).
Net share issues
A num ber o f US studies have found th a t returns after adjustm ent fo r systematic risk are higher for
companies th a t have repurchased or bought back th e ir shares (see, fo r example, Ikenberry, Lakonishok &
Vermaelen 1995). O ther studies have found th a t returns are lower fo r companies that have issued shares
(see, fo r example, Loughran & R itter 1995, Daniel & Titm an 2006 and P ontiff & Woodgate 2008).
In aggregate, these studies document a negative relationship between net share issues and returns.
Accounting accruals
Under accrual accounting, companies record revenues and expenses when they are incurred, regardless o f
when cash is exchanged. In an im p o rta n t study Sloan (1996) found th a t companies w ith high net positive
accruals, th a t is, where non-cash revenues exceeded non-cash expenses, earned lower risk-adjusted
returns. Since the original Sloan study, this finding has been confirmed many times in the accounting
literature. Pincus, Rajgopal and Venkatachalam (2005) confirm its existence in Australia, Canada and the
UK as well as in the US. Some fu rth e r evidence o f this negative relationship between accounting accruals
and risk-adjusted returns has also been found in Australia by Anderson et al. (2009), Gray, Koh and Tong
(2009) and Clinch et al. (2012).
Asset growth
Cooper, Gulen and Shill (2008) report a very strong negative association between grow th in net assets
and risk-adjusted returns fo r US shares. This association has been confirmed in Australia by Bettman,
Kosev and Sault (2011) and Gray and Johnson (2011).
Size
One o f the m ost intensively studied o f all the variables th a t have been used to forecast returns is size,
where size is measured by the total m arket value o f a company s shares. Future returns are predictable in
th a t returns on the shares o f small companies exceed the returns on the shares o f larger companies both
before and after adjusting fo r systematic risk. Put simply, returns on small-company shares are *too high*.
This relationship was firs t documented fo r US companies and it has since been observed in the share
prices o f Australian, Canadian, Japanese and UK companies.10
Figure 16.1 shows the performance o f portfolios form ed by dividing Australian shares into quintiles
based on company size each year from 1975 to 2010. The p o rtfo lio form ed from shares in the smallest
companies earned a m on thly average return o f 3.2 per cent while the p o rtfo lio formed from shares in the
largest companies earned a m on thly average return o f only 0.6 per cent.
Many studies, including th a t by Brown et al. (1983), have shown th a t this relationship remains after
adjusting fo r systematic risk. This relationship has also been investigated in Australia by Beedles, Dodd
and Officer (1988), who found th a t it remains present in the data, even when different measurement
techniques are used. However, they identified several factors th a t may p a rtly explain it. In particular, they
reported th a t shares in small companies trade less frequently than shares in larger companies. This finding
is consistent w ith shareholders in small companies requiring a higher expected retu rn to compensate for
the lower liq u id ity o f th e ir investm ent.
W hile the cause o f the relationship is unclear, it is well documented th a t the size effect is linked to the
January effect. In the US, this relationship is strong, w ith approximately h a lf the difference in the returns
on the shares o f small and large companies being due to the higher reported returns to small companies
in January (Keim 1983).11 Loosely speaking, i f just 1 m onth (January) is ignored, h a lf o f the size effect
disappears. In Australia, the relationship appears to have changed quite significantly over the years.
Gaunt, Gray and M clvor (2000) report th a t the higher retu rn on small companies was prevalent across
each calendar m onth when tested using a sample period from 1974 to 1985. However, their analysis o f
the period from 1986 to 1997 showed th a t while the size effect was s till present in returns generally, there
was no evidence o f a relationship between size and retu rn in January.
10 Among the earliest US studies are Banz (1981) and Reinganum (1981); for a survey, see Keim (1988).
11 See also Reinganum (1983).
Average monthly return for five size-based portfolios: 1975-2010
Source: Compiled using the database from Australian Research Council/Acorn Capital Linkage Project Grant LP0560381
(Chief Investigators Howard Chan, Robert Faff and Paul Kofman). We thank the Chief Investigators for data access and Paul
Docherty for the analysis.
Book-to-market ratio
The book value o f a company s equity is the value o f the shareholders1stake in the company, as measured
by accounting data. I t appears in a company s financial statements and thus is readily available. The
market value o f equity is sim ply the m arket’s valuation o f the shareholders’ stake in the company: i t is
the share price m ultiplie d by the num ber o f shares on issue. Security analysts frequently calculate the
ratio o f the book value o f a company s equity to the m arket value o f its equity. For sim plicity, this ratio is
often called the company s book-to-m arket ratio. B O O K 'TO -M A R K E T
What m ight explain why a company has a low or high book-to-m arket ratio? One possible explanation RATIO
book value of a
is that a company w ith a low book-to-m arket ratio may be a company th a t the m arket judges to have
company’s equity
good prospects (hence its ‘high’ m arket value) while a company w ith a high book-to-m arket ratio may be divided by market
a company that has had good years in the past (hence its ‘h igh’ book value) b ut which the m arket now value of the
judges to have poor prospects. Because a company s book-to-m arket ratio is p ublicly available at low cost, company’s equity
this inform ation should be reflected in its current share price, i f the m arket is efficient.
Fama and French (1992) documented th a t in the US, over the period 1963 to 1990, there was a
relationship between the book-to-m arket ratio and future share returns. Specifically, companies w ith
low book-to-market ratios tended to earn low returns, while companies w ith high book-to-m arket
ratios tended to earn high returns. Significantly, Fama and French showed th a t this difference was not
attributable to differences in systematic risk. W hile some subsequent w ork has suggested th a t some o f
Fama and Frenchs results may have been due to a survivorship bias in th e ir data (Kothari, Shanken &
Sloan 1995), other w ork has cast doubt on the significance o f any such bias (Chan, Jegadeesh & Lakonishok
1995; Fama & French 1996b).
Figure 16.2 shows the perform ance o f p o rtfo lio s form ed by d iv id in g A ustralian shares in to
quintiles based on th e ir book-to-m arket ratio each year fro m 1975 to 2010. The p o rtfo lio form ed
from the companies w ith the highest book-to-m arket ratios earned a m o n th ly re tu rn o f 1.5 per cent,
while the p o rtfo lio form ed fro m companies w ith the lowest book-to-m arket ratios earned a m o n th ly
retu rn o f only 1.1 per cent. As fo r the size factor, m any studies, inclu ding those by H alliw ell, Heaney
and Sawicki (1999) and Gaunt (2004), have shown th a t th is relationship remains a fte r a djusting fo r
systematic risk.
0 . 2 ----- ---------------- - ：
•■----------沐丨，.----------- . --------------'
0 .0 -I---------^ ---------1---------^ ---------1---------^ ---------1--------- ^

1 2 3 4 5
Book-to-market quintile: 1 = high, 5 = low
Source: Compiled using the database from Australian Research Council/Acorn Capital Linkage Project Grant LP0560381
(Chief Investigators Howard Chan, Robert Faff and Paul Kofman). We thank the Chief Investigators for data access and Paul
Docherty for the analysis.
Interrelationship between factors used to predict future returns

Given the number o f variables th a t have been found to be able to predict returns, i t is im p o rta n t to
examine possible interrelationships between these factors. As discussed in Section 7.7, in an im p o rta n t
study, Fama and French (1992) showed th a t many o f these factors are dominated by the size and book-
to-m arket factors. Specifically, dividend yield and price-earnings ratio are n o t useful in predicting
future returns after allowing fo r the more dom inant effects o f the size and book-to-m arket factors. The
dominance o f both size and book-to-m arket factors in Australia over the period 1982 to 2006 has been
supported by Brailsford, Gaunt and O’Brien (2012). However, n o t all factors are dom inated by the size and
book-to-m arket factors. For example, Fama and French (2008) reported th a t net share issues, accounting
accruals and asset grow th remain im p o rta n t in predicting future returns even after allowing fo r the size
and book-to-m arket factors.
W hile there is a high level o f agreement th a t various factors may be used to predict future returns, there
is much less agreement on the im plications o f th a t evidence fo r m arket efficiency. The reason is the jo in t
test problem discussed in Section 16.2.4. For example, as discussed in Section 7.7, some studies suggest
th a t small companies and those w ith high book-to-m arket ratios may be riskier than large companies
and those w ith low book-to-m arket ratios. Fama and French (1996a) argue th a t smaller companies are
more likely to default than larger companies. Further, they argue th a t this risk is likely to be systematic
in th a t small companies as a group are more exposed to default during economic downturns. As a result,
investors in small companies w ill require a risk premium. Similarly, Zhang (2005) argues th a t companies
w ith high book-to-m arket ratios w ill on average have higher levels o f physical capacity. Much o f this
physical capacity w ill represent excess capacity during economic dow nturns and therefore expose such
companies to increased risk.
However, La Porta et al. (1997) note th a t when companies w ith low book-to-m arket ratios announce
th e ir earnings, th e ir share prices on average fall. Conversely, when companies w ith high book-to-market
ratios announce th eir earnings, th e ir share prices on average rise. They in te rp re t th is result as being
due to m arket inefficiency. Specifically, they suggest th a t the share m arket overestimates the growth
potential o f companies w ith low book-to-m arket ratios. This overestim ation results in an increase
in th e ir share price relative to th e ir book value. W hen earnings are released, the m arket is on average
disappointed and hence share prices fall. The opposite is true fo r companies w ith high book-to-market
ratios.
Event studies
The efficient m arket hypothesis requires th a t security prices adjust instantaneously and w ith o u t bias
to an event, such as the public announcement o f new inform a tion relevant to the security s value.
It follows that abnormal returns should n ot be expected to be earned from a subsequent analysis o f such
inform ation.
Voluminous research has been conducted w ith a view to testing whether there are any post-event
abnormal returns associated w ith the public release o f inform ation. These same studies are frequently used
to evaluate the inform a tion content o f particular types o f inform ation, such as p ro fit announcements and
dividend announcements.12 The inform a tion content is measured by the presence o f abnormal returns
both p rio r to, at the tim e of, and subsequent to, the announcement. Such a test is generally called an event
study. I f markets are efficient, the price change measures as accurately as possible the *true value* o f the
inform ation to investors. M any people believe th a t event studies are among the clearest and most reliable
tests o f m arket efficiency. An inform a tion release (events is identified and the share price response is
then studied to test its consistency w ith the hypothesis o f m arket efficiency.13
There are many variants o f event study methodology. Rather than provide details o f each variant,
we illustrate the m ajor issues involved by using the announcement o f annual p ro fit as an example o f an
event*. For each announcement the follow ing three questions need to be answered:
a W hat is the (new) inform ation?

b When was it announced?
c Were there abnormal returns associated w ith its announcement?
We now consider each question.
a An annual p ro fit figure provides inform a tion only i f the announced or reported p ro fit differs from
the p ro fit expected by investors. This is because, in an efficient m arket, the effects o f the expected
p ro fit w ill already be reflected in the share price before the announcement. Only the unexpected part
o f the reported p ro fit should cause the share price to react. I t is therefore necessary to estimate
the expected annual p ro fit so th a t we can derive an estimate o f the unexpected component. For
example, it could be assumed th a t the expected annual p ro fit is equal to the previous years p ro fit. I f
the reported p ro fit is greater than expected, then the unexpected component is positive, the event is
classified as good news, and the m arket s response should also be positive. The reverse applies i f the
reported p ro fit is less than expected (see Finance in Action on ‘Dividend surprise’),
b It is im p orta nt to id e n tify the tim e o f the event accurately, ideally in this case the exact m om ent at
which the annual p ro fit became public knowledge. This is im p o rta n t because the m arket may react
in anticipation o f the announcement as investors revise th e ir expectations. The m arket should also
react at the tim e o f the announcement to any unanticipated inform ation. However, the m arket
should n ot continue to react after the announcement because its response should be instantaneous
and unbiased.
c It is necessary to calculate the response o f the m arket to the announcement. In essence, this
response is the percentage change in share price in excess o f (or below) the percentage change
that would norm ally be expected. Therefore, some model o f ^normal* security price movement
is needed. As highlighted in Section 16.2.4, the jo in t test problem inevitably arises because event
studies are simultaneously tests o f m arket efficiency and the pricing model used to estimate what
is ‘norm al’.
12 For an extensive discussion of accounting-related issues, see Brown (1994).

13 See Fama (1991, especially pp. 1601-2) for further discussion.
j B usiness finance
Finance DIVIDEND SURPRISE__________________________________________

in A C T IO N
In e x a m in in g th e s h a r e m a r k e t r e a c tio n t o e a r n in g s a n d d iv id e n d a n n o u n c e m e n ts , it is im p o r t a n t
N ew s k
to c o m p a r e th e a n n o u n c e m e n t w it h th e e x p e c ta tio n s t h a t p e r ta in e d b e f o r e th e a n n o u n c e m e n t, a s
th e f o llo w in g e x c e r p t f r o m a n a r t ic le b y M a lc o lm M a id e n e x p la in s .
n =
F o rte s c u e M e t a ls lift e d n e t p r o f it b y 1 2 p e r c e n t to U S $ 1 . 7 5 b illio n in th e y e a r to J u n e , b u t
it w a s its d e c is io n to d e c la r e a 10<t a s h a r e d iv id e n d t h a t p r o p e lle d its s h a re s 4 . 2 p e r c e n t
h ig h e r o n T h u r s d a y in a m a r k e t t h a t fe ll b y a h a lf a p e r c e n t.
F o rte s c u e p a id in te r im a n d f in a l d iv id e n d s o f a s h a r e in 2 0 1 1 - 2 0 1 2 b u t s u s p e n d e d
p a y m e n ts in th e D e c e m b e r h a lf a f t e r a p lu n g e in th e ir o n o r e p r ic e f o r c e d it in to d e b t
r e n e g o t ia t io n s . It re s e t its d e b t a n d th e ir o n o r e p r ic e b o u n c e d , b u t th e r e w e r e s till b r o k e r s
p r e d ic t in g n o d iv id e n d a t a ll f o r th e J u n e h a lf.
D iv id e n d s u r p r is e is o n e o f th e e m e r g in g th e m e s o f th e p r o f it s e a s o n . G o ld m a n S a c h s
n o te d a t th e s ta r t o f th is w e e k t h a t th e r a t io o f p o s it iv e d iv id e n d s u r p r is e s to n e g a tiv e d iv id e n d
s u r p r is e s w a s 2 . 6 to 1, th e h ig h e s t s in c e 2 0 0 9 w h e n it b e g a n t r a c k in g th e d a t a .
Source: 'Dividend surprise7, Malcolm Maiden, Sydney Morning Herald, 23 August 2013.
The problem associated w ith measuring 'normal* returns can be neatly sidestepped i f we examine price
behaviour on an intraday basis. This is because the expected retu rn o f a security over a very short tim e
interval, such as a half-hour, is effectively zero. For example, A itken et al. (1995) studied the share return
behaviour fo r a sample o f Australian companies during the 23 half-hourly trading intervals preceding,
and the 25 half-hourly intervals subsequent to, the announcement o f p ro fit. They separated th e ir sample
into separate ‘good news’ and ‘bad news’ subsamples on the basis o f whether or not the p ro fit announced
exceeded analysts1forecasts. The results relating to announcements made by 78 o f the largest companies
listed on the Australian Stock Exchange are illustrated in Figure 16.3.
I t is im m ediately apparent from Figure 16.3 th a t the m ajority o f the m arkets reaction to the release
o f either good, or *bad, news occurs in the firs t half-hour follow ing the release o f the inform a tion to the
market. This contention is fu rth e r supported by the finding th a t the only half-hourly mean return th a t is
statistically d ifferent from zero is the retu rn occurring im m ediately after the in fo rm a tio n release.
W hile some event studies use intraday data, others examine returns over much longer periods. As a
result, these studies need a systematic approach to measuring the expected retu rn o f a security. A simple
way o f measuring expected returns is to use some variant o f the m arket model.14 The standard m arket
model— which we discussed in Section 7.6.3— is specified as follows:
Rjt = a t- + PjRMt+ uit
where Rjr = rate o f retu rn on security z in period t

RMt = rate o f retu rn on the m arket index in period t
Qj = constant in regression equation
/3j = slope o f regression equation— th a t is, beta value o f security z
uit = disturbance term
Factors th a t affect the whole m arket— such as war, drought, m onetary policy and exchange rate
changes— are captured by the term RMt. The rem aining— th a t is, abnormal— return is therefore attributed
to company-specific factors, such as the public release o f inform a tion relating to the company.
Suppose th a t Equation 16.1 is estimated using m on thly data and the follow ing estimate is obtained:
/?" = 0.005 + 1.25/?ay/ +

Abnorm al returns, AR} on security z in a later m onth t are measured by:
ARjt = Rjt —0.005 —1.25RMl
14 While the market model is used here for simplicity, expected returns are often calculated by adjusting not only for the market
return but also the dominant factors that were discussed in Section 16.3.3 as being able to predict returns, namely firm size
and the book-to-market ratio.
|ure 16.3 Mean abnormal intraday returns associated with profit announcements of
'good news' and (b) 'bad news'*i
Source: Intraday Price Response and Order Imbalance Surrounding Earnings Releases, A S X Perspective 1, 1995, pp. 31-5.
Suppose that, in the m onth o f the p ro fit announcement fo r company z, the return on the shares o f
i was 8 per cent and the retu rn on the m arket index th a t m onth was 2 per cent. Then the abnormal return
in m onth zero, the announcement m onth, is:
AR0 = 0.08 - 0.005 - (1.25)(0.02) = 0.05
This may be interpreted as follows: during the m onth, this security returned 8 per cent to investors,
o f which 5 percentage points were due to company-specific events, such as the p ro fit announcement.
However, as m entioned earlier, p art o f the test involves estim ating and examining abnormal returns
before and after the announcement, as well as the abnormal returns at the tim e o f the announcement.
Typically, this involves estim ating and examining abnormal returns for, say, each o f the 12 m onths before
the event, and fo r each o f the 6 m onths after the event.
This completes the procedure fo r one company s announcement date. The to ta l sample w ill consist
o f a large number o f companies and announcement dates. For each announcement date the procedure
is repeated fo r the company announcing on th a t date. Each announcement date in the sample is labelled
Time zero; points in tim e before the announcement are labelled -1 , -2 , - 3 , - 1 2 , and points in tim e after
the announcement are labelled +1, +2, +6. This is known as event time*. A t each p o in t in event time,
the abnormal returns are calculated. For example, at Time zero a large positive abnormal retu rn would
be expected fo r companies announcing p rofits classified as good news*. A t each p o in t in event tim e the
average abnormal retu rn across companies is calculated. The average abnormal returns are then summed
over event tim e. The procedures are illustrated in the sim plified case shown in Example 16.1.
E xample 16.1
C o m p a n ie s A , B a n d C a n n o u n c e d , a t d iffe r e n t d a te s , p ro fits th a t w e r e h ig h e r th a n e x p e c te d (see
T a b le 1 6 .1 ) . 15
TABLE 16.1
Abnormal returns
Month relative to A(% ) B(%) C(%) Average (%) Cumulative averaqe
announcement date (%)
-12 1.0 -1.4 2.1 0.57 0.57
-11 4.2 0.9 -1.2 1.30 1.87
-10 -0.2 -3.6 0.4 -1.13 0.74
-9 1.2 -2.2 4.4 1.13 1.87
-8 0.6 -2.2 2.1 0.17 2.04
-7 -1.8 1.1 3.1 0.80 2.84
-6 0.0 1.9 0.4 0.77 3.61
-5 0.4 -0.4 -0.9 -0.30 3.31
-4 1.0 7.6 -1.2 2.47 5.78
-3 -0.2 2.6 3.1 1.83 7.61
-2 -0.3 -0.7 1.1 0.03 7.64
-1 0.9 2.1 -0.6 0.80 8.44
0 5.1 7.9 4.2 5.73 14.17
+1 -0.2 1.4 -0.6 0.20 14.37
+2 0.6 -3.2 1.9 -0.23 14.14
+3 1.2 0.1 -0.5 0.27 14.41
+4 -0.8 0.4 -0.9 -0.43 13.98
+5 0.0 -1.2 1.1 -0.03 13.95
+6 0.5 -1.9 3.0 0.53 14.48
T his e x p la in s th e h ig h a b n o r m a l re tu rn s fo r e a c h c o m p a n y a t T im e z e r o . F o r A , B a n d C , th e a b n o r m a l
re tu rn s a v e r a g e d 5 . 7 3 p e r c e n t a t T im e z e ro . It is lik e ly th a t th e m a rk e t w a s a n tic ip a t in g g o o d n e w s .
T h e e v id e n c e o f th is a n tic ip a t io n is th e p r e d o m in a n c e o f p o s itiv e a v e r a g e a b n o r m a l re tu rn s in th e
1 2 m o n th s b e fo r e th e a n n o u n c e m e n t. H o w e v e r, f o llo w in g th e a n n o u n c e m e n t, th e a v e r a g e a b n o r m a l
re tu rn s a re c lo s e to z e r o , b u t d o n o t h a v e a d e te c ta b le tre n d . T h is p a tte rn is ty p ic a l o f a n e ffic ie n t
m a rk e t in th a t th e re is a n in s ta n ta n e o u s r e a c tio n a t th e a n n o u n c e m e n t d a te to th e u n a n tic ip a te d
c o m p o n e n t o f th e in fo r m a tio n a n d n o s u b s e q u e n t d r if t in th e a v e r a g e a b n o r m a l re tu rn s . T h e fin a l c o lu m n
in T a b le 1 6 .1 s h o w s th e c u m u la tiv e a v e r a g e a b n o r m a l re tu rn s , w h ic h a r e p lo tte d in F ig u re 1 6 .4 .
15 This hypothetical example is very simple in that with a sample size of only three companies, the results, in reality, are
unlikely to be so well behaved.
Figure 16.4 Cumulative average abnormal returns
I% S
) En J oEJOU D a DJa>0a> 0 nEnu
aj
l
-Q
05
l l
0 _ 1 2 - 1 1 -1 0 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6
Month relative to announcement date (event time)
1 6 .4 .2 1 Evide nee: profit and dividend announcements in Australia

To illustrate the empirical evidence found in event studies we consider some o f the evidence on the
reaction o f share prices in Australia to p ro fit and dividend announcements. In Australia, announcements
of p ro fit are nearly always accompanied by simultaneous announcements o f dividends. Thus, it is useful
to examine both the p ro fit and the dividend inform a tion in an empirical test. Brown, Finn and Hancock
(1977) conducted a study o f dividend announcements by Australian companies fo r the period January
1963 to December 1969. In the firs t part o f th e ir study they examined the abnormal returns calculated
on a m onthly basis fo r the 12 m onths on each side o f an annual dividend announcement. A fte r adjusting
for rights issues, bonus issues and other changes in capital, three groups were formed: one comprising
shares in companies th a t had announced an increase in dividend per share (DPS), one comprising shares
in companies that had announced a decrease in DPS and one comprising shares in companies whose DPS
had remained constant. The cumulative average abnormal returns fo r each o f these groups are shown in
Figure 16.5.
The results suggest th a t an increase (decrease) in DPS results in an increase (decrease) in abnormal
returns. In particular, the results suggest th a t a decrease in DPS had significant inform a tion content
and that, on average, investors expected an increase in DPS. The results also indicate th a t much o f the
inform ation content o f dividend announcements had been obtained earlier from other sources. Overall,
these results are consistent w ith m arket efficiency.
Recognising th a t dividend and p ro fit announcements usually occur simultaneously, Brown, Finn and
Hancock divided each o f the three groups in to tw o subgroups, depending on whether profits increased
or decreased. The cumulative average abnormal returns (CAR) associated w ith each subgroup are shown
in Figure 16.6.
B usiness finance
Figure 16.5 Cumulative average abnormal returns
Figure 16.6 Cumulative average abnormal returns for each of the six subgroups
CAR (%)
------------- profit increase 20

profit decrease DPS increase (N = 209)
/ — — ’
DPS constant ( N = 199)
___________________________________
^ ^ --------------;---------- Month relative to announcement
0 3 6 9 12
一
DPS decrease [ N = 19)
\ 、
、'
、
、' - 20- DPS constant ( N = 16 6 )
DPS decrease (N = 50)
-30-
The evidence suggests th a t the inform a tion content o f the tw o sources o f in fo rm a tio n is increased
when they are in agreement. The highest positive abnormal returns are associated w ith the simultaneous
announcement o f p ro fit and DPS increases. Similarly, the lowest (most negative) abnormal returns
are associated w ith the simultaneous announcement o f p ro fit and DPS decreases. Where the signals
are m ixed— fo r example, p ro fit increase w ith DPS decrease— abnormal returns fall between these two
extremes. In general, these results support m arket efficiency.
The share price reaction to simultaneous p ro fit and dividend announcements was investigated fu rth e r
by Easton and Sinclair (1989). Using nearly 900 half-yearly announcements by Australian companies in
the period 1978 to 1980, they applied a technique that, in a statistical sense, can isolate the m arkets
reaction to the p ro fit announcement from the m arkets reaction to the dividend announcement. They
found th a t both types o f announcement caused a reaction, b ut th a t the reaction to dividends was weaker
than the reaction to profits. In a subsequent study using the same sample, Easton (1991) conducted a
more form al examination o f the reaction to dividend and p ro fit announcements and found th a t the share
price response depends n ot only on the separate dividend and p ro fit signals b u t also on the interaction
between the signals. In other words, the m arket appears to take account o f the interrelation o f the p ro fit
and dividend inform ation.
Many other types o f events have been studied in Australia, and a voluminous set o f events has been studied
in the US and other markets. In Australia, the events th a t have been studied range from capitalisation
changes (bonus issues, rights issues and share splits) and takeovers, to the impact o f large trades by
institutio na l investors.16 W hile many event studies are undertaken fo r reasons other than to test m arket
efficiency, often some inference concerning m arket efficiency can be drawn. Usually, the inference is that
prices have responded rapidly to the event studied. For example, Fama (1991, pp. 1601-2) argued that
this ‘result is so common th a t this w ork now devotes little space to m arket efficiency. The fact th a t quick
adjustment is consistent w ith efficiency is noted, and then the studies move on to other issues1.
Over the past 20 years there has been much evidence presented which suggests th a t there is some
underreaction to new in fo rm a tio n — in particular, the new inform a tion provided in p ro fit announcements.
For example, studies by Bartov, Radhakrishnan and K rinsky (2000), M ikhail, W alther and W illis (2003)
and Battalio and Mendenhall (2005) show th a t share prices continue to d rift upwards after good p ro fit
news has been released, while they d rift downwards follow ing bad p ro fit news.
Tests for private inform ation

A strict view o f the EMH requires th a t abnormal returns are n o t available even to investors who have
private (inside) inform a tion about a company. However, by definition, it is usually d iffic u lt to id e n tify the
date on which private info rm a tio n becomes available, and therefore the event study m ethodology often
cannot be applied directly to studies concerned w ith the im pact o f private inform ation. An alternative
methodology is to examine the trading o f those who m ig ht have access to private in fo rm a tio n — such
as company directors, fu nd managers and investm ent analysts— and determine i f they are able to earn
positive abnormal returns.
An early study by Seyhun (1986) o f management and director trades reported th a t while small
abnormal returns were possible from selling shares after these insiders disclosed th a t they had sold
shares, abnormal returns were insufficient to offset transaction costs. However, subsequent studies
suggest greater evidence o f inefficiency. Bettis, Vickery and Vickrey (1997) found th a t investors who
focused only on large trades made by top executives, rather than all directors, were able to earn abnormal
returns. Further, over the period 1975 to 1995, Lakonishok and Lee (2001) found th a t companies w ith
substantial selling by directors had share returns o f 14.4 per cent over the subsequent 12 m onths, which
was significantly lower than the 22.2 per cent earned by companies w ith substantial buying by directors.
However, they found th a t the lin k between insiders* trading and subsequent returns was greatest fo r
small companies and th a t there was almost no relationship fo r larger companies.
In Australia the Corporations Act 2001, which governs the behaviour o f company directors, provides
researchers w ith an o p p o rtu n ity to test the EMH w ith respect to private inform ation. The Act imposes
an obligation on company directors to disclose to the Australian Securities Exchange changes in th e ir
interests in th e ir own companies w ith in 14 days o f the change occurring. I f the Australian share m arket
were inefficient, then we would expect th a t company directors, who can be assumed to have access to
private inform a tion about th e ir company s prospects, would be able to tim e the purchase (sale) o f th e ir
shares before a future increase (decrease) in the share price.
16 S tu d ie s t h a t h a v e e x a m in e d r ig h t s is s u e s in c lu d e t h o s e b y B a la c h a n d r a n , F a f f a n d T h e o b a ld ( 2 0 0 8 ) a n d B a la c h a n d r a n e t al.
( 2 0 1 2 ); s t u d ie s e x a m in in g t a k e o v e r s in c lu d e t h o s e b y B ro w n a n d D a S ilv a R o s a ( 1 9 8 8 ) a n d D a S ilv a R o s a a n d W a lte r ( 2 0 0 4 ) ;
w h ile s t u d ie s e x a m in in g b lo c k t r a d e s in c lu d e t h o s e b y F rin o , J a r n e c ic a n d L e p o n e ( 2 0 0 7 a n d 2 0 0 9 ) .
B usiness finance
Uylangco, Easton and Faff (2010) tested the relationship between directors1 trades and share price
performance in Australia, and found th a t while directors* purchases were on average followed by abnormal
gains o f only 0.2 per cent, directors’ sales avoided a future abnormal loss o f 1.1 per cent. They also found
th a t w hile small abnormal returns were possible from selling shares after directors disclosed th a t they
had sold shares, these abnormal returns were insufficient to offset transaction costs.
A nother strand o f the literature has evaluated the performance o f fund managers and other
professional investors* on the principle th a t i f they have access to in fo rm a tio n th a t is n o t reflected
in prices, they should display superior investm ent performance. The US evidence presents a mixed
picture, w ith some studies suggesting th a t professional investors are able to show superior investment
performance and others finding th a t they are unable to do so. Elton et al. (1993) concluded that, after
co ntrolling fo r the size o f the companies th a t managers invested in (as detailed in Section 16.3.3,
companies w ith small m arket capitalisation on average provide greater returns than companies w ith
large m arket capitalisation), and after controlling fo r the m ix o f shares and bonds in the p ortfolio, fund
managers were n o t able to generate superior performance. However, Kosowski et al. (2006) found th a t a
m in o rity o f fund managers were able to generate superior returns.
A num ber o f Australian studies have also examined the performance o f m utual funds, u n it trusts
and superannuation funds.17 None o f these studies concluded th a t funds in general were able to earn
abnormal returns. Similarly, Ferreira et al. (2011) examined m utual funds in 27 countries and found
th a t on average they underperform m arket indexes by 0.20 per cent per annum. These studies can be
interpreted as supporting m arket efficiency i f it is assumed th a t the fu nd managers have access to private
info rm a tio n b u t cannot use i t to earn abnormal returns. However, in the lig h t o f other evidence, an
alternative interpretatio n is th a t this evidence has little bearing on m arket efficiency. This interpretation
would deny th a t fund managers have access to private inform ation, or, i f they do have such access, they
do n o t use i t to advantage.
US studies have also evaluated the performance o f investm ent analysts. Womack (1996) examined
changes in analysts* recommendations and found that positive changes were associated w ith increased
share prices o f approximately 5 per cent, while negative changes were associated w ith share price
decreases o f approximately 11 per cent. Jegadeesh et al. (2004) also found th a t changes in the consensus
o f analysts* recommendations were associated w ith permanent share price changes. The fact th a t these
changes were permanent suggests th a t the price changes were due to in fo rm a tio n revealed by the analysts*
recommendations and n ot sim ply due to buying and selling pressure caused by the recommendations.
Barber et al. (2001) examined the level o f the consensus o f analysts* recommendations. They found that
companies fo r which the consensus o f analysts’ recommendations was a ‘buy’ outperform ed companies for
which the consensus o f analysts* recommendations was a sell*. However, they noted th a t the transaction
costs o f buying and selling shares th a t would be required to act on these recommendations would be high
and likely to prevent the earning o f abnormal returns.
A num ber o f Australian studies have also evaluated the performance o f investm ent analysts.
Brown and W alter (1982) analysed confidential buy and sell recommendations made by analysts. On
a risk-adjusted basis, these recommendations outperform ed the market. I f the analysts employed
private inform a tion when m aking th e ir recommendations, then these results are contrary to m arket
efficiency. Finn (1984) evaluated the performance o f recommendations made by analysts employed by
a large in s titu tio n a l investor. He found that, i f acted on, these recommendations would have resulted
in abnormal returns. This result is consistent w ith th a t o f Brown and Walter. Both studies found that
the analysts* ability to id e n tify shares th a t should be sold exceeded th e ir a b ility to id e n tify shares that
should be purchased. Interestingly, the in s titu tio n a l investor studied by Finn earned negative abnormal
returns, w hich is consistent w ith much o f the previous evidence on the performance o f fund managers.
Finns results suggest that analysts employed by the in s titu tio n a l investor may have had access to private
inform ation, b ut th a t the in s titu tio n failed to act quickly enough to benefit from the inform a tion . Chan,
Brown and Ho (2006) support the lin k between share price performance and broker recommendations in
th e ir exam ination o f a sample o f 5000 recommendations made in relation to Australian-listed companies.
The evidence relating to Australian and US share markets supports the conclusion th a t neither m arket
is efficient w ith respect to asset prices reflecting all privately held inform ation. This is n ot surprising.
Inside info rm a tio n w ill be costly (and often impossible) fo r an outsider to obtain and, because o f legal
implications, may prove costly fo r an insider to use. W hile we would n o t expect an efficient market to
17 See, fo r example, Hallahan and Faff (1999), Sawicki and Ong (2000), Gallagher (2001) and Frino and Gallagher (2002).
reward the use o f zero-cost in fo rm a tio n — such as inform a tion th a t is already publicly available— it may
reward the use o f costly inform ation.
16.6 M arket efficiency at the macro level1 8

The evidence presented in the previous sections o f this chapter has all related to m arket micro-efficiency.
That evidence suggests, on balance, th a t markets are highly m icro efficient. However, as noted earlier, LEARNING
OBJECTIVE 4
this does n ot mean th a t markets are necessarily macro efficient. Unfortunately, much less evidence exists
Understand the
as to whether the m arket as a whole reflects all available in fo rm a tio n — whether, fo r example, the share difference between
market is fa irly priced compared w ith a less risky asset class such as bonds. However, several studies have micro and macro
examined whether it is possible to predict market-wide returns. Seminal studies are those by Keim and market efficiency
Stambaugh (1986) and Campbell and Shiller (1988a, 1988b). Keim and Stambaugh calculated a d efa u lt
spread*, which is the yield on riskie r corporate bonds minus the yield on relatively safe corporate bonds.
They found that m arket-wide share returns were higher follow ing periods when the default spread was
high. Campbell and Shiller found th a t future market-wide returns were positively related to the current
market-wide average earnings yield (where earnings yield is equal to earnings per share divided by price
per share). However, the key d ifficu lty is in the interpretatio n o f the results. When m arket-wide risk
is higher, investors in bonds w ill demand compensation fo r this risk and the default spread w ill also
be higher. Similarly, fo r a given earnings per share, price per share w ill be lower in periods when risk
is higher. Therefore, lower prices per share and the resultant higher earnings yields may be positively
related to future returns because o f the basic ris k -re tu rn relationship— th a t is, higher risk needs to be
compensated w ith higher expected returns.
Is the claimed p redictability o f market-wide returns due to m arket inefficiency or is it due to changes
over tim e in market-wide risk? A ttem p ting to answer this question runs headlong in to the jo in t test
problem discussed in Section 16.2.4. It is, therefore, a question th a t may never have a definitive answer.
Behavioural finance and market

efficiency LEARNING
OBJECTIVE 5
Shleifer (2000) has defined behavioural finance as the ‘study o f human fa llib ility in competitive m arkets’.
Understand the
Behavioural finance suggests th a t once we account properly fo r the impact o f investor sentim ent on m arket relevance of
prices, we w ill find th a t markets are n ot only inefficient b u t should never be expected to be otherwise. To behavioural finance to
illustrate how behavioural finance has challenged trad ition al perceptions o f market behaviour, Shleifer market efficiency
summarises, and then responds to, the three arguments th a t provide the theoretical foundations o f
the EMH.
a I f all participants in a m arket are rational, then all assets w ill be priced rationally,
b I f there are investors who behave irrationally, then th e ir trades w ill be random and u ltim ately cancel
each other out, leaving prices unaffected.
C I f irrational investors, as a group, exhibit a bias in the way in which they price assets, then any
pricing bias w ill u ltim ately be elim inated by rational arbitrageurs who enter the m arket to take
advantage o f deviations o f m arket prices from fundam ental values. Furtherm ore, com petition
between arbitrageurs w ill ensure th a t this adjustm ent occurs quickly.
Behavioural finance has suggested, by reference to existing psychological theory and evidence, a
number o f models th a t explain why investors may n ot behave in a rational manner and, furtherm ore,
why there may be lim its to arbitrage th a t may prevent rational investors from entering the m arket to
eliminate the impact th a t these irra tion al investors have on prices.19
18 Th e m a t e r ia l c o v e re d in S e c t io n 1 6 .6 a n d s o m e o f th e m a t e r ia l in S e c t io n 1 6 .7 is d is c u s s e d in E a s t o n a n d K e r in ( 2 0 1 0 ) .
19 F o r a s u r v e y t h a t d is c u s s e s th e p s y c h o lo g ic a l t h e o r y a n d e v id e n c e , s e e B a r b e r is a n d T h a le r ( 2 0 0 3 ) . F o r d i s c u s s io n s o f th e
lim its to a r b itr a g e , s e e D e lo n g e t al. ( 1 9 9 0 ) a n d S h le ife r a n d V ish n y ( 1 9 9 7 ).
B usiness finance
Some o f these models have been used to seek to explain why market-wide share prices (and the prices
BUBBLE in other asset classes) m ig ht display bubbles. Various definitions o f a ‘bubble’ have been proposed, but
period in which prices it is usually suggested th a t the follow ing two features constitute a bubble (see Flood and Garber 1980;
rise strongly, departing
Blanchard 1979). First, prices show a strong tendency to rise fo r a period, possibly followed by a decrease,
from their ’true value’,
frequently followed by
which may be quite sudden. Second, as a result, the price departs from the true, fundam ental value o f
a sudden decrease in the asset. W hile the firs t o f these features seems to be readily observable in stock markets— fo r example,
prices in the crashes o f October 1929 and October 1987— the mere presence o f the firs t does not, o f course,
im ply the presence o f the second. Prices changing random ly w ill occasionally produce, purely by chance,
episodes displaying the firs t feature. These episodes would probably appear to be bubbles, but they may
n ot in reality be bubbles in the sense th a t we have suggested because the assets values have n ot departed
from th e ir fundam ental value.
A situation often cited as an example o f such a bubble was the sharply rising m arket fo r shares in
internet-based companies th a t occurred in the late 1990s— the so-called ‘dotcom bubble’. D uring this
tim e there were numerous examples o f rapidly increasing prices fo r shares in companies th a t had never
recorded a p ro fit and, perhaps more im portantly, did n ot look like generating a p ro fit in the near future.
There are at least two plausible explanations fo r this bubble-type price behaviour. Proponents o f
behavioural finance may suggest th a t a bubble is an example o f positive feedback trading*, where investors
are keen to buy after a series o f price rises and to sell follow ing price falls. Hence, price rises occur not
because o f any change in the m arkets expectation o f future returns b ut sim ply because the price has
recently risen. Far from dampening the impact o f this irra tion al trading behaviour, i t can be fu rth e r
argued th a t arbitrageurs actually contribute to the bubble by seeking to p ro fit n o t from any departure in
prices from fundam ental values b ut instead in anticipation o f the prices continuing to increase.
An alternative explanation suggests th a t bubbles may in fact be consistent w ith an efficient market.
To illustrate this concept o f a rational bubble, suppose th a t a share price depends in p a rt on its expected
rate o f change. Therefore, it has a îgh * price because it is expected to go higher still. In the presence o f
such se lf-fulfilling prophecy, prices may increase, even though there is no change in the ‘fundam entals’.
However, even these prices may be ‘rational’ in the sense th a t m arket participants fo rm unbiased
expectations.
I t may also be noted th a t a large m arket-wide price change per se does n o t constitute a bubble, nor
does it prove m arket inefficiency. An example using the global financial crisis may be used to illustrate this
point. The S&P/ASX 200 Index fell by 54 per cent between its all-tim e high o f 6828.7 on 1 November 2007
and its subsequent (to date) low o f 3145.5 on 6 March 2009. W hile a fa ll o f 54 per cent may at firs t view
appear im plausibly large, such a fa ll may be consistent w ith reasonable estimates o f changes in investors’
required rate o f retu rn and in expected dividend grow th rates. For example, using the simple dividend
grow th model from Section 4.3.2 (see Equation 4.8), the present value o f $1 o f annual dividend income
w ith an annual cost o f equity capital o f 10 per cent and an expected annual grow th rate in dividends o f
5 per cent is $21. By comparison, the present value o f $1 o f annual dividend income w ith an annual cost
o f equity capital o f 13 per cent and an expected annual grow th rate in dividends o f 2 per cent is $9.27— a
fall o f 56 per cent. In essence, it may be argued th a t the global financial crisis was a period o f great
uncertainty th a t caused investors to revise upwards the rate o f return they required to compensate them
fo r the increased risk they perceived and to revise downwards th e ir estimates o f future dividend growth.
In addition to seeking to explain bubbles, behavioural finance has also been used to tr y to provide
explanations fo r other apparent inefficiencies. We discussed in Section 16.3.1 the findings o f DeBondt
and Thaler (1985 and 1987) th a t indicated th a t shares th a t have historically perform ed well (poorly)
w ill subsequently p erform poorly (well). One interpretatio n o f these findings is th a t investors overvalue
companies th a t have exhibited superior performance in the past and undervalue companies th a t have a
history o f in fe rio r performance. Such irra tion al behaviour may be explained by w hat is referred to in the
psychological literature as the ‘representativeness heuristic’. This concept suggests th a t in form ing their
beliefs, individuals may be too quick in ide ntifyin g a company as an ‘excellent’ or a ‘te rrib le ’ investm ent
w ith o u t properly accounting fo r the probability o f the company belonging to th a t extreme group o f
investments. Hence, an investor assessing the uncertain future o f a company w ith a h isto ry o f superior
performance may tend to overweight the importance o f th a t immediate past performance in achieving
future superior returns, w hile failing to properly recognise the relatively small pro ba bility o f any company
achieving such superior performance in the future. W hy m ig ht overreaction persist in the long term
instead o f being offset by the arbitrage activity o f rational investors? One reason is th a t when prices
are, at least in part, determ ined by investors behaving irrationally, arbitrage is inherently risky, as the
unpredictable nature o f irra tion al investors may mean th a t prices w ill n o t revert to th e ir fundam ental
value in the short term.
There is now a range o f studies th a t have provided results th a t are consistent w ith behavioural finance
models. For example, Chopra, Lakonishok and R itte r (1992) found th a t shares th a t have perform ed the
best tend to fall in price when earnings are announced, suggesting th a t investors are affected by the
representativeness heuristic and th a t earnings announcements cause them to revise th e ir over-optim istic
beliefs. Also, La Porta et al. (1997) show th a t the lower returns to companies w ith lower book-to-m arket
ratios m ight in part be explicable by irra tion al investor behaviour. One reason fo r shares having a low
book-to-market ratio is th a t investors believe th a t the shares have higher potential fo r growth, therefore
justifying a higher m arket price compared w ith book value. But La Porta et al. show th a t companies w ith
high book-to-market ratios outperform those w ith low book-to-m arket ratios in the days surrounding
earnings announcements. They argue that this result is consistent w ith investors being overly optim istic
about the growth prospects o f companies w ith low book-to-m arket ratios. Investors then revise these
beliefs when earnings are announced.
The extent to which the combined effects o f investor irra tio n a lity and lim its to arbitrage result in
markets being less than fu lly efficient remains a key focus o f research in finance. Survey articles supporting
the behavioural finance position include those by Shleifer (2000), H irshleifer (2001), Shiller (2002) and
Barberis and Thaler (2003), while survey articles th a t conclude th a t markets are highly efficient include
those by Fama (1998), Rubinstein (2001) and M alkiel (2003).
16.8 Implications of the evidence with

respect to market efficiency
LEARNING
OBJECTIVE 6
The evidence on m arket efficiency is complex and subject to many qualifications. Nevertheless, there
Understand the
is considerable evidence to suggest th a t markets often perform well in reflecting available inform a tion implications of
and respond quickly to new inform ation. This evidence provides im p o rta n t im plications fo r investors in the evidence on
securities and fo r financial managers. market efficiency for
investors and financial
managers
16.8.1 I Implications for investors in securities

There are a number o f techniques th a t are used to evaluate investm ents in securities. The veracity o f these
techniques given the evidence on m arket efficiency is discussed under the follow ing headings:
• charting, or technical analysis

• fundam ental analysis
• random selection o f securities
• buy-and-hold policies.
We then offer some comments on try in g to beat the m arket.
Charting, or technical analysis

Some security analysts p lo t a share s historical price record on a chart. On the basis o f such a chart,
predictions are made as to the likely future short-term course o f prices. For example, a rising trend may
be detected, or perhaps a presumed cycle o f peaks and troughs may be predicted to continue. The evidence
from tests o f serial correlation suggests th a t simple short-term repetitive patterns are unlikely to be
present. I t is possible th a t more complex patterns are present, b u t attem pts to detect these patterns by
judgm ent and visual inspection are prone to self-delusion. Thus, Batten and Ellis (1996), using Australian
data, found, after allowing fo r transaction costs, th a t technical trading rules did n o t yield abnormal
profits. However, Lo, Mamaysky and Wang (2000), using sophisticated statistical techniques th a t can
recognise patterns, found_ using US data— th a t certain patterns had modest predictive power. Further,
persuasive and persistent evidence o f m om entum in returns over longer periods suggests th a t charting
over longer tim e periods may yield abnormal profits.
Fundamental analysis
O ther security analysts believe th a t the m arket either ignores some publicly available inform ation or
systematically m isinterprets th a t inform ation. These analysts m aintain that sometimes the market is
shortsighted and a share price cannot be justified on the basis o f the company s ûndam entar features,
such as its earnings record, or its net asset backing, which determine the share’s ‘true value’. Consequently,
they believe th a t a careful analysis o f available info rm a tio n may reveal mispriced securities, and therefore
abnormal returns may be made by the skilled fundam ental analyst.
In a m arket th a t is efficient, all publicly available inform a tion is reflected in the market price.
Fundamental inform a tion is publicly available at a cost o f approximately zero. In a competitive market,
the retu rn to using zero-cost inform a tion is expected to be zero. On its own, therefore, the analysis o f
such info rm a tio n should n o t yield abnormal returns in an efficient market.
The em pirical evidence presented in this chapter suggests th a t while markets are n o t fu lly efficient
they are nevertheless very efficient. The analysis presented in Section 16.3.3 in particular, however, does
suggest th a t fundam ental inform a tion about a company, such as its dividend yield, earnings, size, book
value relative to m arket value, asset grow th and level o f accounting accruals, may be o f some value in
predicting returns. However, the security analyst ind ustry is nevertheless a very com petitive industry
and it is only those analysts who have the skills to use this inform a tion better than th e ir peers who are
likely to be able to generate abnormal returns.
A t its simplest level i t needs to be stressed th a t fundam ental analysis needs to do more than
id e n tify good companies th a t w ill be good investments. It is about id e n tifyin g companies th a t are better
investments than the m arket consensus considers them to be. Achieving this outcome using publicly
available fundam ental inform a tion w ill always be difficult.
The evidence th a t markets may be macro inefficient may be used to support the so-called top-down
approach to fundam ental investm ent analysis. This approach begins w ith a broad allocation o f investment
funds between asset classes including shares, bonds and real estate. There is much evidence to suggest that
the asset allocation decision is o f considerable importance. For example, Brinson, Singer and Geebower
(1991) rep ort th a t 91.5 per cent o f the difference in returns achieved by investm ent funds is due to this
decision. This approach is consistent w ith a claim that, fo r example, the stock m arket as a whole may be
overpriced compared w ith its longer-term value, even though the m arket may be micro efficient and that
individual shares w ith in th a t m arket may be properly priced relative to each other.
Random selection of securities

I t is sometimes suggested th a t i f markets are fu lly efficient and all securities are therefore correctly* priced,
investors m ig ht as well choose th e ir investments randomly. However, this is n o t correct advice even if
markets are fu lly efficient. First, returns on a large p o rtfo lio o f randomly selected securities w ill be highly
correlated w ith returns on the m arket p ortfolio; th a t is, a p o rtfo lio o f all risky assets. Therefore, the risk
o f such a p o rtfo lio w ill be close to the risk o f the m arket p ortfolio. This may n o t suit the risk preferences
o f the investor. Second, investors should consider th e ir tax position when selecting investments, which is
unlikely to be the case i f investments were selected randomly.
Buy-and-hold policies
B U Y -A N D -H O LD In a sim ilar vein, it is sometimes suggested th a t i f markets are fu lly efficient then a buy-and-hold policy
POLICY is the best investm ent strategy. It is true that, fo r many investors, the evidence th a t markets are efficient
investment strategy
suggests th a t try in g to beat the m arket is inadvisable, because such an attem pt cannot be expected to
in which shares
are bought and succeed, and w ill generate higher transaction costs. _Abuy-and-hold strategy is supported by the results
then retained in the o f research by Barber and Odean (2000). Using a sample o f more than 60000 households from a large US
investor’s portfolio for discount brokerage firm , Barber and Odean found th a t fo r the period February 1991 to December 1996
a long period the 20 per cent o f households th a t traded the m ost earned a net return after transaction costs o f 10 per
cent per annum, compared w ith the average fo r all households o f 18 per cent per annum. In a later study,
Barber and Odean (2001) found that men traded 45 per cent more than women and earned a return net
o f transaction costs th a t was 1.4 per cent per annum less than th a t earned by women.
However, this evidence does n o t mean th a t a buy-and-hold policy is always optim al fo r all investors.
First, as share prices change over tim e, there w ill be changes in the p ro po rtio n o f the p o rtfo lio th a t a
given shareholding represents. Thus, the risk o f the p o rtfo lio is also likely to have changed. There w ill
be fu rth e r changes in the p o rtfo lio s risk i f the risks o f individual securities change over tim e. The result
may well be th a t the p o rtfo lio ’s risk w ill diverge from the investor’s desired risk level. The solution is
to rebalance the portfolio, and this w ill usually require the sale o f some securities and the purchase
o f others. An inflexible buy-and-hold policy is n ot optim al. Second, some investors may occasionally
come upon private info rm a tio n about a company. It has already been stated th a t there is evidence
suggesting th a t the m arket is n o t efficient w ith respect to selected pieces o f inform ation. Thus, there
w ill be private inform ation th a t is n o t reflected in prices, and trading on the basis o f such inform a tion
may therefore yield excess returns. The possibility th a t an investor may discover private inform a tion
provides a justification fo r studying public inform ation, such as th a t found in company annual reports.
How can private in fo rm a tio n be identified and evaluated, w ith o u t some knowledge o f the company s
characteristics?
Beating the market

The evidence on the extent to which markets are efficient is increasingly complex and mixed. Nevertheless,
w ith most evidence suggesting th a t at best a m in o rity o f fund managers are able to generate abnormal
returns, it is n ot sensible fo r the average investor to tr y to beat the m arket. Obviously, i f an investor has
private inform ation th a t is n o t yet reflected in the share price, then beating the m arket becomes a d istinct
possibility. But average investors do n ot often have such inform ation. This suggests th a t m ost investors,
most o f the time, would do well to follow a passive investm ent approach. By this we mean th a t most
investors should adopt a long-term view, hold a diversified p o rtfo lio and trade infrequently.
As noted by the Economic Sciences Prize Committee when awarding the 2013 Prize jo in tly to Eugene
Fama, one o f the outcomes o f the efficient markets literature is the rise o f passive investm ent funds that
hold diversified portfolios and attem pt to match market-wide index returns. The firs t such passive funds
Iw w w l
started to emerge in the 1970s and today account fo r 41 per cent o f funds invested in to m utual funds.20
Vanguard Investments* site www.vanguard.com.au contains detailed in fo rm a tio n on p o rtfo lio indexing.
The evidence concerning m arket efficiency also provides strong im plications fo r financial managers. Some
o f those im plications are considered under the follow ing headings:
• project selection
• communicating w ith the stock m arket
• using share price as a measure o f company performance
• repurchasing existing securities or issuing new securities.
Project selection
Evidence suggests th a t markets respond quickly to new inform ation, including inform a tion th a t is
released by company management. I f investing in a project really does increase the company’s ‘true value’,
the company s share price w ill reflect this fact when the in fo rm a tio n becomes available to the market.
Communicating with the stock market

As mentioned above, markets respond quickly to inform ation. However, the m arkets reactions w ill not
be unthinking, mechanical responses, since such responses would be identifiable as underreactions or
overreactions. Managers m ust therefore expect th a t announcements o f factors such as p ro fit, dividends,
takeovers, new security issues and capital reconstructions w ill elicit a price response th a t represents the
m arkets collective view o f the true situation.21
20 S e e U n d e rsta n d in g A s s e t P rices, c o m p ile d b y th e E c o n o m ic S c ie n c e s P riz e , C o m m it te e o f th e R o y a l S w e d is h A c a d e m y o f

S c ie n c e s ( 2 0 1 3 , p . 4 3 ).
21 F o r fu r t h e r d is c u s s io n , s e e S te w a r d a n d G la s s m a n ( 1 9 8 4 ) a n d H e a ly a n d P a le p u ( 1 9 9 2 ).
Using share price as a measure of com pany performance
The evidence concerning m arket efficiency suggests th a t the current share price is, i f n ot the best available
estimate o f a company’s ‘true value’，then certainly a good estimate. The historical share price record
(taking in to account the effects o f dividends and changes in capital) w ill be an accurate statement o f
the record o f the company s performance. This is n ot to say th a t the company s management is entirely
responsible fo r this record, b ut presumably i t m ust bear significant responsibility fo r it.
Repurchasing existing securities or issuing new securities

As discussed in Section 16.3.3, there is evidence th a t m arkets are n ot fu lly efficient w ith respect to
the tim in g o f repurchases and new share issues, and th a t shares tend to perform well follow ing share
repurchases and poorly follow ing new share issues. This result may be due to managers having private
inform a tion th a t enables them to repurchase shares when prices are low and to issue new shares when
prices are high. I f so, then investors who sell th e ir shares back to the company via share repurchases tend
to lose when compared w ith those shareholders who retain th e ir shares. Similarly, those shareholders
who invest in new shares tend to lose when compared w ith existing shareholders.
O f course, investors tend to be aware o f these incentives, so announcements o f share repurchases
tend to cause prices to rise (see Ikenberry, Lakonishok & Vermaelen 1995 fo r US evidence and Otchere &
Ross 2002 fo r Australian evidence), while announcements o f new share issues tend to cause prices to fall
(see Manuel, Brooks & Schadler 1993 fo r US evidence and Denhert 1993 fo r Australian evidence).
The financial m anager and evidence with respect to market

efficiency
Given the complex nature o f the evidence concerning m arket efficiency, how should financial managers
react? In particular, w hat are the im plications o f apparent m arket inefficiencies fo r the financial manager?
We consider th a t the general body o f evidence supporting m arket efficiency s till provides a useful guide
to financial managers.
• Managers should be aware th a t there are reasons to expect that, unless people are fa m ilia r w ith the
research literature, they w ill systematically tend to underestimate the level o f m arket efficiency.
There are many reasons fo r this tendency, including:
- the d ifficu lty in distinguishing a b ility from luck
- the presence o f vested interests in denying th a t markets are efficient
- the fact th a t people tend to forget losses and embellish th e ir w ins.22
• M arkets can be expected to respond positively to good news and negatively to bad news. Therefore,
news o f successful operations and o f wise decisions by management is expected to increase share
prices, while news o f losses, mistakes and failure w ill decrease share prices. The perfom iarice o f
companies and, im p licitly, the performance o f management, may ultim ately be judged by the stock
market.
• On the question o f evidence th a t suggests th a t markets are n o t perfectly efficient, there may often
be few alternatives to behaving as if the stock m arket is highly efficient. For example, i f the financial
manager o f a small company interprets the evidence on the size effect to mean th a t the company
may be undervalued, i t is d iffic u lt to see exactly how this should guide his or her actions unless there
is also some knowledge o f what causes the underpricing and when the underpricing may be expected
to cease. I f the manager decides n o t to raise new capital by way o f a share issue, is a debt issue
necessarily a superior choice? W hat i f debt issued by small companies is even more underpriced than
shares issued by small companies?
• It should always be remembered th a t efficiency tests are jo in t tests o f the assumed asset pricing
m odel and o f the efficiency o f the market. M ost o f the asset pricing models th a t have been used
are quite simple and it would n o t be surprising to learn th a t they do n ot w ork well when applied
to extreme* cases, such as the smallest companies.
22 F o r a lo n g e r c a ta lo g u e o f r e a s o n s a n d a d e t a ile d d is c u s s io n , s e e B o w m a n a n d B u c h a n a n ( 1 9 9 5 ) .
CHAPTER SIXTEEN REVIEW

SUMMARY
An efficient capital market has been defined as Each of these testing methodologies has provided
one in which the prices of securities ’fully reflect' evidence with respect to market efficiency that is
all available information. This requires that the complex and mixed.
reaction of market prices to new information should In reviewing the evidence on market efficiency it is
be instantaneous and unbiased. If such conditions also necessary to make a distinction between micro
exist, it will not be possible (except by chance) to efficiency and macro-efficiency.
employ either past information or a mechanical There are a number of implications of the theory and
trading strategy to generate returns in excess of the evidence on capital market efficiency.
returns warranted by the level of risk involved. In • In an efficient market, charting and fundamental
short, consistent excess profits will not be made. analysis will not succeed since both involve
Market efficiency may be classified according to the the analysis of only past information, which
three research methodologies employed to assess should already be reflected in the market price.
the efficiency of a market: However, this does not mean that securities
• tests of return predictability are undertaken to should be selected randomly or that a buy-and-
ascertain whether future returns can be predicted hold policy is always best for all investors. It
on the basis of factors such as past returns, the does, however, suggest that investors should not
time of the year or the company's book-to-market try to 'beat the market' unless they possess inside
ratio information that is not yet reflected in the price.
• event studies are employed to analyse the • Likewise, an efficient market is not easily misled
behaviour of a security's returns around the and company managers can expect the share
time of a significant event such as the public price to respond to news of their successes and
announcementof a company’s profit, its dividends failures.
or its intention to acquire another company • While the evidence with respect to market effi
• tests for private information are designed to ciency is complex and mixed it is suggested that, in
assess whether investors can trade profitably by normal circumstances, market efficiency is a useful
making their investment decisions on the basis of way to approach the study of price behaviour, and
information that is not publicly available. to organise our knowledge of capital markets.
KEY TERMS
abnormal returns 480 joint test problem 480
book-to-market ratio 485 momentum effect 481
bubble 496 overreaction 479
buy-and-hold policy 498 price-earnings ratio 483
dividend yield 483 tax loss selling 483
efficient market hypothesis (EMH) 478 tests for private information 480
event study 480 tests of return predictability 480
information efficiency 480 underreaction 479
January effect 483
QUESTIONS
[L O I] What is an 'efficient capital market7? Illustrate your answer with an example.
[LO 1] The EMH implies that o il financial assets are always correctly priced. Is this statement correct? Give
reasons.
3 [L O I] W hat would cause a capital market to be efficient?
4 [LO 2] W hat are the objectives of tests of return predictability? Outline the empirical evidence from
these tests.
501
B usiness finance
5 [L O 2 】D e s ig n a n e m p ir ic a l te st o f th e e ffe c t o f c o m p a n ie s ' d iv id e n d a n n o u n c e m e n ts o n s e c u rity p ric e s .

W h a t a r e s o m e o f th e p ro b le m s in c o n s tru c tin g a v a lid test?
6 [L O 2 ] B rie fly o u tlin e th e e m p ir ic a l e v id e n c e fro m e v e n t stu d ie s .
7 [L O 2 ] As it is im possible to determ ine when p riva te inform ation becomes a vailable, it is im possible to test
w hether a m arket is efficient w ith respect to this inform ation. D iscuss.
8 [L O 3 ] In te rp re t th e f o llo w in g sta te m e n ts in te rm s o f th e ir im p lic a tio n s fo r m a rk e t e ffic ie n c y .
a) Shores in risky companies g ive higher returns than shores in safe companies.
b) The shares in a com pany increase in p rice in the p e rio d before that in w hich a takeover b id is announced
for the company.
c) Tax-exempt governm ent bonds are issued a t lo w e r interest rates than taxable governm ent bonds.
d) C om pany directors tend to moke profits from investments in the shores o f companies with w hich they are
associated.
e) There is evidence that share prices fo llo w a trend.
9 [L O 3 ] S u p p o s e th a t M e g a n M c D o n a ld h a s u n d e rta k e n a s tu d y o f th e e ffic ie n c y o f th e s to c k m a rk e t's
re a c tio n to th e a n n o u n c e m e n t o f c h a n g e s in steel p ric e s . S p e c ific a lly , she fin d s th a t s h a re p ric e s a p p e a r to
c o n tin u e re a c tin g fo r s o m e m o n th s a fte r th e a n n o u n c e m e n t. A d v is e M e g a n o n th e a lte r n a tiv e in te rp re ta tio n s
h e r s tu d y m ig h t b e g iv e n .
10 [ L 0 3 ] D iscu ss th e e x te n t to w h ic h th e g lo b a l f in a n c ia l c ris is m a y h a v e a d d e d to o u r u n d e r s ta n d in g o f th e
e v id e n c e o n m a rk e t e ffic ie n c y .
11 [L O 3 ] P u lb a h Is la n d R e so u rce s ju st a n n o u n c e d a fa ll in its a n n u a l e a r n in g s , y e t its s h a re p r ic e ro s e . Is th is

r e a c tio n c o n s is te n t w ith th e m a rk e t b e in g e ffic ie n t? B rie fly e x p la in y o u r a n s w e r.
12 [L〇3 ] Y ou k n o w th a t th e c o m p a n y Lake M a c q u a r ie Life style s Ltd is v e r y w e ll ru n . O n a s c a le o f 1 (w o rs t) to

1 0 (b e st), y o u w o u ld g iv e it a s c o re o f 8 . T he m a rk e t c o n s e n s u s e v a lu a tio n is th a t th e m a n a g e m e n t s c o re is
9 . If y o u c o n s id e r th a t m a rk e ts a r e e ffic ie n t w ith re s p e c t to such c o n s e n s u s in fo r m a tio n , w o u ld y o u b u y o r sell
s h a re s in th is c o m p a n y ? B rie fly e x p la in y o u r a n s w e r.
13 [L O 3 ] E x p la in w h a t is m e a n t b y th e te rm 'm o m e n tu m ' as it is u se d in th e fin a n c e lite ra tu re .
14 [L O 4 ] D iscu ss w h a t is m e a n t b y m ic ro m a rk e t e ffic ie n c y a n d m a c r o m a rk e t e ffic ie n c y .
15 [L O 5 ] B e h a v io u r a l f in a n c e rests o n th e p r o p o s itio n s th a t s o m e in v e s to rs s o m e tim e s a c t ir r a tio n a lly a n d th a t

th e re a r e lim its to a r b it r a g e . W h y a r e b o th p r o p o s itio n s n e e d e d ?
16 [L O 6 ] E m pirical evidence suggests that professional investment m anagers d o not earn positive a b n orm al
returns. Is th is tru e ? D iscu ss th e im p lic a tio n s o f th is e v id e n c e .
17 [ L 0 6 ] In a n a r tic le in th e M e lb o u r n e A g e n e w s p a p e r o n 9 S e p te m b e r 2 0 0 3 e n title d 'W r it e - o f f o r rip -o ff
as $ 5 5 b n g o e s w e s t7, A la n K o h le r s ta te d th a t 'th e A u s tr a lia n e c o n o m y m ig h t b e d o in g w e ll a n d th e s h a re
m a rk e t r e c o v e r in g , b u t a w ild e p id e m ic o f w rite -o ffs a m o n g lis te d c o m p a n ie s is c o s tin g s h a re h o ld e rs p le n ty 7.
To w h a t e x te n t is th is s ta te m e n t lik e ly to b e tru e in a n e ffic ie n t m a rk e t?
18 [L O 6 ] W h a t a r e th e im p lic a tio n s o f th e e m p ir ic a l e v id e n c e o n m a rk e t e f fic ie n c y fo r:
a) te c h n ic a l a n a ly s is
b) fu n d a m e n ta l a n a ly s is ?
19 [L O 6 ] A s s u m in g th a t y o u h a v e $1 m illio n to in v e s t, h o w w o u ld y o u s tru c tu re y o u r in v e s tm e n t? W h y ?
20 [L O 6 ] O u t lin e th e im p o r ta n c e o f m a rk e t e ffic ie n c y f o r th e a s s u m e d o b je c tiv e o f m a x im is in g th e m a rk e t

v a lu e o f a c o m p a n y ’s e q u ity .
21 [L O 6 ] If c a p ita l markets are efficient, it mokes no difference w hich securities a c o m p a n y issues. D iscu ss th is
s ta te m e n t.
22 [L O 6 ] W h a t a r e th e im p lic a tio n s o f th e e v id e n c e o n m a rk e t e f fic ie n c y fo r th o s e w h o s u p p o r t g r e a te r

re g u la tio n o f c o r p o r a te d is c lo s u re ?
23 [L O 6 ]The significance o f calendar-based patterns in returns lies not so much in their size as in the fact that
they exist a t a ll. D iscu ss th is s ta te m e n t.

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CHAPTER CONTENTS
17.1 Introduction 508 I 17.8 Financial futures on the Australian
Securities Exchange: the 30-day
IHH W h a t is a futures contract? 509 interbank cash rate futures contract 535
The Australian Securities Exchange 512 17.9 Financial futures on the Australian
17.4 Securities Exchange: the share price index
Determinants of futures prices 513
S&P/ASX 2 0 0 (SPI 200) futures contract 536
17.5 Futures m arket strategies: speculating
and hedging 515 Valuation o f fin an cia l futures contracts 540
17.6 Financial futures on the Australian | 17.11 Forward-rate agreements 542

Securities Exchange: the 9 0-day
bank-accepted bill futures contract 525 17.12 Swaps 544
17.7 Financial futures on the Australian Securities 17.13 Currency swaps 551
Exchange: the 10-year Treasury bond
futures contract 532
LEARNING OBJECTIVES
1 understand w ha t a futures contract is and how futures markets are organised
2 understand the system o f deposits, m argins and marking-to-market used by futures exchanges
3 have a basic understanding o f the determinants o f futures prices
4 understand and explain speculation and hedging strategies using futures contracts
5 understand and explain the reasons w h y hedging w ith futures contracts may be im perfect
6 understand and explain the features o f the m ajor fin an cia l futures contracts traded on the Australian
Securities Exchange
7 explain speculation and hedging strategies using the m ajor financial futures contracts traded on the
Australian Securities Exchange
8 understand the valuation o f 90-day bank-accepted bill futures contracts and share price index futures contracts
9 understand and explain the uses o f forw ard-rate agreements
10 identify the characteristics and uses o f interest rate swaps and currency swaps.
B usiness finance
Introduction
In this chapter we discuss futures contracts and swaps. They are sim ilar in th a t b oth are agreements
between tw o parties which require each p arty to com m it to future transaction(s) on term s and conditions
determ ined at the start o f the contract. However, there are differences between them; fo r example, a
futures contract requires the parties to agree to one future transaction, whereas a swap requires the
parties to agree to more than one future transaction.
FUTURES CONTRACT A fu tu res contract is an agreement which provides th a t something w ill be bought or sold in the
an agreement to future at a fixed price. In short, the price is decided today, b u t the transaction is to occur later. Such
trade in an asset in
contracts are traded on various futures exchanges around the world. The largest and m ost famous futures
the future that can be
itself traded on an
exchanges are in Chicago but there are also exchanges in many other cities, including New York, London,
exchange Paris, Hong Kong, Singapore, Tokyo, Osaka and Sydney. Much o f the m aterial in this chapter relates to
futures contracts traded on the Australian Securities Exchange, although the principles discussed also
have application to contracts traded on other futures exchanges.
Trading in futures contracts on a fo rm a lly organised exchange can be traced to the middle o f last
| WWW j century, when the Chicago Board o f Trade (now p a rt o f CME Group, w w w .cm egroup.com ) introduced
a futures contract on corn. Such a contract enables farmers to sell th e ir corn *in advance* and a farm er
therefore knows the price he or she w ill receive fo r the crop before it is harvested and sold. In Australia,
the firs t futures contract was on greasy wool and was introduced in 1960. U n til the early 1970s, v irtu a lly
all futures contracts traded on the various exchanges around the w orld were futures contracts on
commodities. In 1972 the w o rld s firs t futures contract on a foreign currency was traded, followed in
1975 by the firs t futures contract on a debt instru m e nt. In 1982 trading began in a futures contract on an
index o f stock m arket prices. Australia d id n o t lag far behind, introducing futures on a debt instru m e nt
in 1979, on foreign currency in 1980 and on a share price index in 1983. These financial futures, as
they are called, have grown very rapidly in im portance and nearly all futures trading on the Australian
Securities Exchange is now in financial futures rather than com m odity futures. In this chapter, we
focus on financial futures and, in particular, on the opportunities they provide fo r financial managers.
However, because they are often more readily understood, we use com m odity futures to illustrate some
o f the principles.
HEDGERS Futures contracts can be used fo r hedging purposes and speculative purposes. H edgers wish to lock
individuals and in, today, the price o f the com m odity, in w hich they w ill need to deal in the future, so th a t they are not
companies who enter
affected by any fu tu re changes in the m arket price o f the comm odity. For example, a fa rm e r (or a flo u r
into contracts in order
to reduce risk
m iller) could wish to fix, in advance, the price to be received (or paid) fo r wheat. Sim ilarly, a company
planning to lend (or borrow ) could wish to fix, in advance, the interest rate to be received (or paid).
The goal o f the hedger is to co ntrol ris k and this goal can be at least p a rtly achieved by appropriate
SPECULATORS trading in a relevant futures contract. Sp ecu lato rs have no wish to deal in the 'co m m o dity1itself, but
individuals and are w illin g to trade in futures contracts in the hope o f p ro fitin g from correctly a n ticip a tin g movements
companies who enter
in the futures price. The m otive o f the speculator is to p ro fit through bearing risks th a t others do not
into contracts in order
to profit from correctly wish to bear. Successful speculation can be extrem ely profitable. O f course, unsuccessful speculation
anticipating price can be extrem ely expensive.
movements A swap is an agreement between tw o counterparties to exchange sets o f future cash flows. There are
two m ain types o f swaps: interest rate swaps and currency swaps. For example, an interest rate swap may
require Party A to pay Party B amounts calculated using a long-term fixed interest rate and also require
Party B to pay Party A amounts calculated using a sequence o f sh ort-term (boating*) interest rates. A
currency swap has a sim ilar structure, b u t a m ajor difference is th a t the payments between the parties are
in different currencies. For example, a currency swap may require Party A to pay Party B amounts in US
dollars calculated using a US dollar fixed interest rate, and also require Party B to pay Party A amounts in
Australian dollars calculated using an Australian dollar fixed interest rate. Swaps are o f much more recent
origin than futures contracts. The firs t swap contracts were designed in the early 1980s and the volume
o f trading has grown very rapidly in the ensuing years.
C hapter seventeen Futures contracts a n d swaps
17.2 W h a t is a futures contract?

LEARNING
17.2.1 I Forward contracts and futures contracts OBJECTIVE 1
Understand what a
Forward contracts p re d a te futures contracts b y c e n tu rie s , b u t are s t ill c o m m o n , p a r tic u la r ly in fo re ig n futures contract is and
how futures markets
exchange. F u tu re s c o n tra c ts d e ve lo p e d o u t o f fo rw a rd c o n tra c ts , so w e b e g in b y c o n s id e rin g a fo rw a rd
are organised
c o n tra c t o n a c o m m o d ity .
A f o r w a r d c o n t r a c t is an a g re e m e n t b e tw e e n tw o p a rtie s th a t, o n a s ta te d fu tu r e da te, one o f th e FORWARD CONTRACT
p a rtie s w ill b u y a n d th e o th e r p a r ty w ill sell, an u n d e rly in g asset a t a p ric e de cid e d tod ay. agreement between
two parties that, on a
F o r e x a m p le , su p p o se t h a t I o w n a n o u n c e o f g o ld , w h ic h to d a y (1 M a rc h ) is w o r th $ 1 4 0 0 . H o w e v e r,
stated future date, one
I p la n to s e ll m y g o ld s o m e tim e in th e n e a r fu tu r e . S up po se f u r t h e r t h a t y o u k n o w (to d a y ) t h a t o n of the parties will buy
1 A p r il y o u w i ll n e ed to b u y a n o u n c e o f g o ld to use in y o u r je w e lle r y -m a k in g b u s in e s s . W e m ig h t and the other party
th e re fo re agree to d a y to th e f o llo w in g c o n tra c t: o n 1 A p r il, I w i ll d e liv e r o n e o u n c e o f g o ld to y o u a t will sell an underlying
y o u r p re m is e s a n d y o u w i ll p a y m e, o n t h a t d a te , $ 1 4 1 0 . T h is is a 1 - m o n th fo r w a r d c o n tra c t o n g o ld . asset at a price
decided today
I t has th e f o llo w in g fe a tu re s :
a The fo rw a rd p ric e ($ 1 4 1 0 ) is de cid ed n o w (1 M a rc h ) b u t th e tra n s a c tio n is to o c c u r o n a n o m in a te d

fu tu re da te (1 A p ril).
b The d e ta ils o f th e c o m m o d ity , w h ic h is th e su b je c t o f th e c o n tra c t, are s p e lt o u t ( in th is case,
one ounce o f g o ld to be d e liv e re d to y o u r p re m ise s),
c The c o n tra c t is a p riv a te c o n tra c t b e tw e e n y o u a n d m e. I c a n n o t pass o n to a n yo n e else m y
re s p o n s ib ility to d e liv e r a n ou nce o f g o ld in 1 m o n th s tim e a n d lik e w is e y o u c a n n o t pass o n to
anyone else y o u r re s p o n s ib ility to accept d e liv e ry o f th e g o ld a n d to p a y $ 1 4 1 0 f o r it .
A futures contract o n g o ld w i ll also have fe a tu re s (a) a n d (b) in t h is li s t — t h a t is, th e p ric e w i ll be

de cid ed n o w f o r a tra n s a c tio n to o c c u r a t a la te r d a te in a c o m m o d ity (o r o th e r ite m ) w h ic h has b e en
c a re fu lly d e fin e d . H o w e ve r, fe a tu re (c) is n o t tr u e o f a fu tu re s c o n tra c t. A fu tu re s c o n tra c t is n o t a
p e rs o n a lis e d a g re e m e n t. F u tu re s c o n tra c ts are alw ays a g ree d to th r o u g h a n exch an ge a n d , m o s t
im p o r ta n tly , can be d is c o n tin u e d (c lo s e d o u t* o r Reversed*) a t a n y tim e th r o u g h a f u r t h e r tra n s a c tio n
o n th e exchange. E x a c tly h o w t h is is d o n e is e x p la in e d la te r. A t t h is stage, th e im p o r t a n t p o in t to n o te
is th a t a fu tu re s c o n tra c t is lik e a fo r w a r d c o n tra c t t h a t can be tra d e d o n a n e xch a n g e .1
1 7 .2 .2 1 How a futures market is organised

B efore t u r n in g to a d e s c rip tio n o f h o w fu tu re s tr a d in g o n th e A u s tra lia n S e c u ritie s E xcha ng e is
o rg a n ise d , th e im p o r t a n t p o in ts are e x p la in e d in th e m y th ic a l e x a m p le o f th e D e a k in F u tu re s E xcha ng e
d e scrib e d here. In o th e r w o rd s , th e fo llo w in g is a s im p lifie d d is c u s s io n o f h o w fu tu re s m a rk e ts o p e ra te .
Suppose t h a t th e D e a k in F u tu re s E xchange is o ffe rin g , f o r th e f ir s t tim e , fu tu re s c o n tra c ts o n go ld .
The c o n tra c t d o c u m e n t d e fin e s th e a m o u n t a n d p u r it y o f th e g o ld , w h o is q u a lifie d to c e r tify its p u r ity ,
w h e n i t is to be d e live re d , th e place w h e re i t is to be d e liv e re d a n d o th e r such d e ta ils . There m a y be several
d iffe re n t c o n tra c ts , each s p e c ify in g a d iffe re n t m a t u r ity da te. O f course, th e one im p o r t a n t fe a tu re n o t
spe cifie d b y th e exchange is th e fu tu re s p rice . T his is d e te rm in e d b y m a rk e t forces. C o n s id e r th e D e a k in
g o ld fu tu re s c o n tra c t, w h ic h re q u ire s t h a t o ne o u n ce o f g o ld be d e liv e re d o n 1 A p r il (to d a y b e in g 1 M a rc h ).
O n 1 M a rc h , a p e rs o n n a m e d B1 e n te rs th e exchange a n d o ffe rs to b u y one ou n ce o f g o ld f o r $ 1 4 1 0 o n
1 A p ril. In o th e r w o rd s , B1 has o ffe re d to e n te r in to on e D e a k in A p r il g o ld fu tu re s c o n tra c t to b u y a t a
p rice o f $ 1 4 1 0 . A n o th e r p e rso n , n a m e d S I, is a t th e exchange a n d is w illin g to e n te r in to on e A p r il g o ld
fu tu re s c o n tra c t to se ll a t a p ric e o f $ 1 4 1 0 . T h e re fo re , B1 a n d S I agree, a n d th e A p r il g o ld fu tu re s p ric e a t
th e D e a k in F u tu re s Exchange is c u rre n tly $ 1 4 1 0 .
1 For a detailed comparison, and for empirical evidence on price differences between futures and forwards, see Cox, Ingersoll
and Ross (1981), Cornell and Reinganum (1981) and French (1983).
4 ^ ^
i B usiness finance
The next step in the procedure is crucial to an understanding o f futures markets. A company,
Deakin Clearing House Ltd, which is a subsidiary o f the Deakin Futures Exchange, now interposes its e lf
between B1 and S I: the agreement between B1 and S I becomes tw o contracts, which, fo r convenience,
we w ill call Contract la and Contract l b . 2 These contracts are as follows.
• Contract la is between B1 and the clearing house. Under this contract, B1 agrees to pay the clearing
house $1410 on 1 A p ril and the clearing house agrees to deliver one ounce o f gold to B1 on 1 April.
In short, the clearing house plays the role o f seller in B is contract to buy.
• Contract l b is a contract between S I and the clearing house. Under this contract, the clearing house
agrees to pay S I $1410 on 1 A p ril and S I agrees to deliver one ounce o f gold to the clearing house on
1 A p ril. In short, the clearing house plays the role o f buyer in S is contract to sell.
There is no longer any agreement or contract between B1 and S I. Indeed, B1 and S I need n ot even
know each o the rs identity. Instead, B1 looks to the clearing house to deliver the gold and S I looks to the
clearing house to pay the agreed price. Note that, provided the clearing house has fa ith in the financial
strength and honesty o f B1 and SI, it is in a riskless position. I t owes* $1410 to S I, b u t is owed, $1410
by B l. It owes* one ounce o f gold to B1 b u t is owed5one ounce o f gold by S I. The n et position o f the
clearing house is therefore zero in b oth money and gold.
A few m inutes after B l and S I agree on a futures price o f $1410, a new buyer, B2, and a new seller, S2,
meet in the exchange and a new price of, say, $1411 is established. The clearing house follows the same
procedure, creating tw o new contracts, 2a and 2b. It becomes the seller to B2 (Contract 2a) and the buyer
fo r S2 (Contract 2b). The net position o f the clearing house is s till zero.
New buyers and sellers come and go all day at the Deakin Futures Exchange. If, at the close o f
business on 1 March, 37 A p ril gold futures contracts have been bought and sold, Deakin Clearing House
has 74 obligations: 37 to buy and 37 to sell, w ith , as always, a net position o f zero. D u rin g the day, prices
have responded to m arket forces and have ranged between, say, $1408 and $1415, closing at $1414.
As tim e passes, more contracts are bought and sold. Now suppose that, on 8 March, B l observes th a t
the then current price fo r A p ril gold futures is $1420. Recall th a t under the terms o f Contract la , B l
w ill be e ntitle d to buy gold at $1410 per ounce. Sellers are at present entering futures contracts to sell
at $1420. Therefore, on current indications, B l has a paper* p ro fit o f $10. W ith a futures contract, B l is
able to realise this p ro fit, and, having done so, w ill be free o f all fu rth e r obligations. The mechanism by
which this is achieved is as follows. On 8 March, B l enters the futures exchange as a seller. For example,
B l may become S200, the seller in the 200th A p ril contract traded. In the exchange, S200 and B200 agree
on a price of, say, $1420. The clearing house becomes a seller to B200 (Contract 200a) and a buyer fo r S200
(Contract 200b). Therefore, on 8 March, B is financial position may be summarised as follows:
B l owes the clearing house: $1410 (Contract la )

B l (who is also S200) is owed by the clearing house: $1420 (Contract 200b)
Therefore, the clearing house owes B l $10
In effect, B l is able to offset his original contract as a buyer by entering another contract as a seller,
taking the p ro fit (or loss) which results. I t is this offsetting procedure th a t perm its futures traders to
‘close o u t’ （
or ‘reverse’）th e ir contracts before the m a tu rity date. The ‘closing o ut’ procedure is feasible
only because the two contracts are identical (except fo r the price) and both are w ith the same party,
namely the clearing house. For example, the firs t A p ril gold contract is the same as the tw o-hundredth
A p ril gold contract, except fo r the price. There would be little p o in t in the clearing house delivering the
gold to B l to fu lfil the term s o f Contract la , only to have B l (in his role as S200) redeliver the same
gold to the clearing house a m om ent later to fu lfil the terms o f Contract 200b. Instead, B l is released o f
all obligations and keeps the $10 pro fit.
Note the follow ing five points about this procedure:
a Because the clearing house becomes the counterparty in every contract, it is n ot necessary fo r buyers
and sellers to know the id e n tity or credit-worthiness o f the other buyers and sellers. For example, it
is n o t necessary fo r B200 to know th a t S200 is, in fact, an existing buyer (that is, th a t S200 is also
B l) who wants to sell in order to reverse his existing bought position. Similarly, as B200s contract is
w ith the clearing house, it is n ot necessary fo r B200 to know the id e n tity o f S200.
b However, it is necessary fo r S200 to in fo rm the clearing house th a t he (S200) is in fact the same
person as B l. Otherwise, instead o f the offsetting procedure described earlier, B l w ill find that he
2 This is the easiest way to visualise what occurs. For a detailed description of the strict legal position, see Markovic (1989).
has two ongoing contracts: as the buyer in Contract la and as the seller in Contract 200b. I f he does
not n o tify the clearing house, both contracts w ill run through to 1 A p ril and then be settled,
c Even though the contract was n ot due to be settled u n til 1 A p ril, B1 has in fact ended his
involvement on 8 March. Moreover, no gold was ever delivered to, or by, B l. No gold changed hands.
This is usual in futures markets. Generally speaking, only about 2 per cent o f contracts end in
delivery o f the com m odity1, the other 98 per cent being closed out by the offsetting procedure
(Howard & Jameson 1997).
d Persons who have already agreed to sell can also reverse out o f th e ir positions. For example, B200
could in fact be a person who has already agreed to sell (S57, say) and is seeking to offset her
existing sold position w ith a bought position. In this way, a person can firs t enter in to a contract
to sell and subsequently enter in to a contract to buy and at no tim e is it necessary fo r the person
who has agreed to sell to own the item th a t is the subject o f the futures contract. First entering into
a contract to sell and later entering in to a contract to buy is referred to as s h o r t s e llin g and the SHORT SELLING
ability to short sell is essential fo r the smooth functioning o f futures markets, process of first
entering into a
e The websites o f securities markets that trade futures contracts report the Volume* o f futures
contract to sell and
contracts traded the previous day, as well as the number o f ‘open positions’. These terms are often later entering into a
misunderstood, so i t is w o rth explaining th e ir meanings. The Volume traded* refers to the number contract to buy
o f contracts that have been agreed to over a particular period, such as during the previous day.
Therefore, volume is a ‘flow ’ concept; it is something measured over an interval o f tim e. The number
o f ‘open positions’ is the num ber o f contracts s till in force (that is, which are yet to be closed out) at
a certain time, such as at the close o f business on the previous day. The num ber o f open positions is
a stock* concept; it is something measured at a particular p o in t in time. Both measures indicate the
level o f interest in the contract and the ease w ith which a trading partner can be found.
The foregoing description o f how a futures m arket functions is much simpler than the reality. For
example, in real futures exchanges, ordinary traders are perm itted to trade only through brokers. However,
this is n ot central to an understanding o f how futures exchanges operate. O f the many other differences
between real futures exchanges and the m ythical Deakin Futures Exchange, two in particular stand out:
a Deakin has no system o f deposits and margins,

b Deakin has no m ark-to-m arket rule.
In reality, futures exchanges always have feature (a) and usually have feature (b). These two features
are explained in the next section.
In the example in Section 17.2.2, the futures trader B l made a p ro fit o f $10 because the futures price
rose by $10 between 1 March and 8 March. Where does the $10 come from? The answer lies in the
kC
LEARNING
system o f deposits, margins and the m ark-to-m arket rule.
OBJECTIVE 2
The clearing house requires all traders to deposit a certain sum o f money w ith the clearing house Understand the system
before they enter in to th e ir firs t contract. Each intending trader is required to have an account and the of deposits, margins
first entry in the account is the deposit paid by the intending trader. A t the close o f each trading day, the and marking-to-market
clearing house calculates whether the trader has gained or lost since the close o f the previous trading day. used by futures
exchanges
I f a gain has been made, the clearing house adds the gain to the traders account balance. I f a loss has
been made, the clearing house subtracts the loss from the traders account balance. This process is called
m a rk in g -to -m a rk e t because each day the trader’s financial position is ‘m arked’_ th a t is, adjusted— M A R K IN G -TO -M A R K E T
according to the change in the ‘m arket’一 th a t is, the movement in the m arket price o f th a t futures process of adjusting
traders' account
contract since the previous m arking date.3
balances to reflect
The deposit system just described does n ot protect the clearing house i f the follow ing situation arises. changes in market
Suppose th a t a trader has entered in to a futures contract as a seller and subsequently the futures price prices
has increased steadily. Each day, the traders account is marked to m arket. Because the trader is steadily
making losses, the deposit is being steadily eroded. I f this continues long enough the deposit w ill vanish
and the clearing house w ill be in the unhappy position o f having to tru s t the trader to make good any
3 There is an obvious exception. Logically, a newly opened position should be adjusted by the difference between the agreed
price and the price at the close of trading. Thereafter, the daily adjustment is as described in the text.
B usiness finance
f u r t h e r losses. The sam e s itu a tio n c o u ld also a rise i f a tra d e r e n te re d in to a fu tu re s c o n tra c t as a b u y e r a n d

th e p ric e s u b s e q u e n tly fe ll s ig n ific a n tly .
To p r o te c t it s e lf a g a in s t th is s itu a tio n , a c le a rin g h o u s e w i ll ha ve a s y s te m o f ‘m a rg in c a lls ’.
F o r e x a m p le , th e D e a k in C le a rin g H o u s e c o u ld re q u ire t h a t f u r t h e r fu n d s be d e p o s ite d w h e n e v e r a
t r a d e r s a c c o u n t b a la n ce is e ro d e d by, say, 25 p e r c e n t. T h a t is, i f th e b a la n ce o f th e a c c o u n t fa lls b e lo w
an a m o u n t e q u a l to 75 p e r c e n t o f th e re q u ire d in i t i a l d e p o s it, th e tra d e r is re q u ire d to re s to re th e
a c c o u n t b a la n ce to th e a m o u n t o f th e in i t i a l d e p o s it. The d e m a n d t h a t e x tra fu n d s be d e p o s ite d is
M AR G IN CALL k n o w n as a m argin call. I f a tr a d e r does n o t re s p o n d to a m a r g in c a ll w it h in , say, 2 d a ys, th e c le a rin g
demand for extra h o u s e w i l l close o u t th e tr a d e r s p o s itio n . The c le a rin g h o u s e faces a s lig h t r is k in t h is case. I f th e
funds to be deposited
fu tu re s p ric e s h o u ld m o v e v e r y q u ic k ly d u r in g th e 2 -d a y re s p o n s e p e rio d , th e lo ss s u s ta in e d b y th e
into a trader's account
tr a d e r c o u ld exceed th e r e m a in in g fu n d s in th e tr a d e r s a c c o u n t. The c le a rin g h o u s e is th e n ju s t an
u n s e c u re d c r e d ito r o f th e tra d e r.
A fu tu re s c o n tra c t does n o t re q u ire a p a y m e n t o n in it ia t io n so i t is cle a r t h a t th e p re s e n t va lu e o f a

fu tu re s c o n tra c t m u s t be z e ro .4 In o th e r w o rd s , th e fu tu re s p ric e is th e p ric e a t w h ic h b o th b u y e r and
s e lle r are w illin g to agree to th e te rm s o f th e c o n tra c t, w it h n e ith e r p a r ty s e e k in g a n y im m e d ia te p a y m e n t
fr o m th e o th e r. F o r exa m p le , i f th e c u r r e n t fu tu re s p ric e w ere th o u g h t to be to o lo w , a p ro s p e c tiv e b u y e r
w o u ld , i f necessary, be w illin g to p a y a p o te n tia l s e lle r to agree to th e fu tu re s c o n tra c t a t th e c u rre n t
fu tu re s p ric e . The p re s e n t va lu e o f such a c o n tra c t w o u ld n o t be zero. H o w e ve r, t h is is n o t th e w a y a
fu tu re s m a rk e t behaves w h e n th e c u rre n t fu tu re s p ric e is th o u g h t to be to o lo w . In s te a d o f p a y in g m o n e y
today, b u y e rs b id u p th e futures p ric e u n t il a s e lle r is in d u c e d ( fo r zero p a y m e n t to d a y ) to agree to th e
fu tu re s c o n tra c t a t th e h ig h e r p ric e . T h e re fo re , th e p re s e n t v a lu e o f th e fu tu re s c o n tra c t w o u ld a g a in be
zero. A c c o rd in g ly , i t is, in a sense, im p o s s ib le to ca lcu la te a ra te o f r e tu r n o n a fu tu re s c o n tra c t. I f th e
o u tla y is zero, a n y su b s e q u e n t g a in is a n in f in it e percentage g a in a n d a n y su b s e q u e n t loss is an in fin it e
percentage loss. In p ra c tic e , som e tra d e rs ca lcu la te pe rce n ta g e r e tu rn s re la tiv e to th e d e p o s it re q u ire d ,
b u t th e re is n o p a r tic u la r ly c o m p e llin g re a so n to do so.
The Australian Securities Exchange

F u tu re s t r a d in g in A u s tr a lia n b e g a n in 1 9 6 0 w it h th e o p e n in g o f th e S y d n e y G reasy W o o l F u tu re s
E xcha ng e, w it h th e n a m e b e in g ch a n g e d to th e S yd n e y F u tu re s E xch a n g e in 1 9 7 2 .5 Since 1 9 9 9 ,
a ll t r a d in g has b e e n c o n d u c te d u s in g an e le c tro n ic t r a d in g s y s te m . I n 2 0 0 6 th e S yd n e y F u tu re s
E xch a n g e m e rg e d w it h th e A u s tr a lia n S to c k E xch a n g e to f o r m th e A u s tr a lia n S e c u ritie s E xchange
(A S X ). I n 2 0 1 0 i t a d o p te d th e n a m e A S X G ro u p .
The exchange o ffe re d o n ly w o o l fu tu re s c o n tra c ts u n t il 1 9 7 5 , w h e n a c o n tra c t o n c a ttle was in tro d u c e d .
Since th e n c o n tra c ts o n a ran ge o f c o m m o d itie s have b e e n tra d e d , w it h th e exchange n o w o ffe rin g
c o n tra c ts o n e le c tric ity , n a tu ra l gas a n d w o o l. H o w e ve r, the se c o n tra c ts m a ke u p o n ly a s m a ll p ro p o rtio n
o f th o se tra d e d o n th e exch an ge .6
V ir t u a lly a ll fu tu re s t r a d in g o n th e A S X is in c o n tra c ts o n ‘fin a n c ia l c o m m o d itie s ’. The f ir s t such
c o n tra c t to be tra d e d o n th e A S X w as t h a t o n 9 0 -d a y b a n k -a c c e p te d b ills in tr o d u c e d in 1 9 7 9 . U sers
o f th is c o n tra c t in c lu d e b a n k s , m e rc h a n t b a n k s , b u ild in g s o c ie tie s , fin a n c e c o m p a n ie s a n d in d u s tr ia l
co m p a n ie s . In fa c t, a n y p a r t y p la n n in g to b o r r o w o r le n d s ig n ific a n t su m s o f m o n e y f o r r e la tiv e ly
s h o r t p e rio d s c o u ld f in d a b a n k b i ll fu tu re s c o n tra c t u s e fu l. The in tr o d u c tio n o f th e b a n k b i ll c o n tra c t
was th e f ir s t s te p a lo n g th e p a th t h a t le d to th e exch an ge b e in g tr a n s fo r m e d f r o m a m a rk e t s e rv in g
m a in ly r u r a l in te re s ts to a m a r k e t t h a t p la ys a s u b s ta n tia l ro le in th e fin a n c e in d u s tr y . O th e r fin a n c ia l
fu tu re s t h a t have p ro v e d su cce ssfu l are th e sh a re p ric e in d e x c o n tra c t (th e ‘SPI 2 0 0 c o n tra c t’ f o r s h o rt)
in tro d u c e d in 1 9 8 3 , th e 1 0 -y e a r T re a s u ry b o n d c o n tra c t in tr o d u c e d in 1 9 8 4 , th e 3 -y e a r T re a s u ry
4 Recall that the deposit is not the value of the contract; it simply provides a guarantee that the traders obligations will be met.
5 For a detailed history, see Carew (1993). For a comprehensive treatment of the futures contracts traded on the Australian
Securities Exchange, see Frino and Jarnecic (2005).
6 In the 2012-13 financial year trading in these contracts accounted for less than half of one per cent of the total volume of
trading in futures contracts on the ASX.
b o n d c o n tra c t in tro d u c e d in 1 9 8 8 , a n d th e 3 0 -d a y in te r b a n k cash ra te c o n tra c t in tr o d u c e d in 2 0 0 3 .

The v o lu m e o f t r a d in g in th e se f o u r c o n tra c ts , to g e th e r w it h t r a d in g in th e 9 0 -d a y b a n k -a c c e p te d b ills
c o n tra c t, t o ta lle d m o re th a n 1 1 1 m illio n in th e 2 0 1 2 - 1 3 fin a n c ia l year. These fin a n c ia l fu tu r e s are
discussed in d e ta il la te r in th e c h a p te r.
A u s tra lia ’s f ir s t o p tio n -o n -fu tu re s c o n tra c t was in tro d u c e d in 1 9 8 2 . A call option on a fu tu res CALL OPTION O N
contract gives th e o p tio n b u y e r th e r ig h t (b u t n o t th e o b lig a tio n ) to e n te r in to th e fu tu re s c o n tra c t as a A FUTURES CONTRACT

option that gives the
b u ye r at a p re d e te rm in e d p rice . S im ila rly , a put option on a fu tu res contract gives th e o p tio n b u y e r
buyer the right to
th e r ig h t (b u t n o t th e o b lig a tio n ) to e n te r in to th e fu tu re s c o n tra c t as a s e lle r a t a p re d e te rm in e d p rice .
enter into the futures
O p tio n s have p ro v e d p o p u la r w it h tra d e rs .7 contract as a buyer at
The A SX operates its o w n c le a rin g house f o r fu tu re s tra n s a c tio n s . The m a jo r fu n c tio n s o f th is c le a rin g a predetermined price
house are to : PUT OPTION O N
A FUTURES CONTRACT
• e sta b lish a n d c o lle c t d e p o s its option that gives the
• call in m a rg in s as re q u ire d buyer the right to
• a p p o rtio n th e ga in s a n d losses (m a rk -to -m a rk e t ru le ). enter into the futures
contract as a seller at
The c le a rin g ho use v a rie s m in im u m c o n tra c t d e p o s its , d e p e n d in g o n m a rk e t c o n d itio n s . F o r e xa m ple, a predetermined price
th e g re a te r th e p ric e v o la tility , th e g re a te r th e ris k , a n d th e re fo re th e g re a te r th e d e p o s it re q u ire d .
To give an in d ic a tio n o f th e ty p ic a l sum s in v o lv e d , som e o f th e s ta n d a rd d e p o s its re q u ire d o f m e m b e rs as
a t M a rch 2 0 1 4 w ere as s h o w n in Table 1 7 .1 .8
TABLE 17.1 Major Australian securities exchange contracts: March 2014

Contract type Deposit per contract ($) Approxim ate value underlying one
contract ($)
90-day ba nk b ills 600 993 000
3-year Treasury bonds 750 109 000
10-year T reasury bonds 2 400 115 000
30-day in te rb a n k cash rate 225 2 500
Share price in de x 5 500 135 000
Determinants of futures prices

m
So fa r we have n o t tr ie d to e x p la in (o r m o d e l) fu tu re s prices. I t has s im p ly been s ta te d t h a t m a rk e t forces
d e te rm in e th e fu tu re s p rice . F ro m a m a n a g e m e n t v ie w p o in t, th e re is m u c h to re c o m m e n d th is ap pro ach. LEARNING
OBJECTIVE 3
M anagers tra d e in fu tu re s c o n tra c ts in o rd e r to c o n tro l ris k , a n d th e o n ly w a y to u n d e rta k e th e necessary
Have a basic
tra n s a c tio n s is to agree to b u y (o r sell) a t th e fu tu re s p ric e d e te rm in e d b y th e m a rk e t. W h e th e r th is understanding of the
m a rk e t p ric e accords w ith som e m o d e l o f fu tu re s p r ic in g is, o n th is vie w , la rg e ly irre le v a n t. determinants of futures
N e verthe less, i t is b e n e fic ia l to have som e u n d e rs ta n d in g o f th e d e te rm in a n ts o f fu tu re s prices. prices
A u s e fu l in s ig h t in to som e o f th e forces u n d e rly in g fu tu re s p r ic in g is p ro v id e d b y th e fo llo w in g th e o re m :
The futures price for a late-delivery contract must be less than (or equal to) the futures price for an
equivalent early-delivery contract, plus the carrying cost.
The carrying cost is th e c o s t o f h o ld in g a c o m m o d ity fr o m one tim e p e rio d to a n o th e r. I t in c lu d e s an CARRYING COST
in te re s t fa c to r (th e o p p o r tu n ity co st o f fu n d s used to fin a n c e th e h o ld in g o f th e c o m m o d ity ) and, in th e cost of holding a

commodity for a
case o f p h ysica l c o m m o d itie s , th e costs o f in s u ra n c e a n d storage. The lo g ic u n d e rly in g th e th e o re m can
specified period
re a d ily be seen in E xa m p le 17.1. of time
7 In the 2012-13 financial year over 4 million futures option contracts were traded on the ASX. These contracts are in fact
option contracts, rather than futures contracts. These and other option contracts are discussed in Chapter 18.
8 The members, in turn, require their clients to lodge deposits.
6e E xample 17.1
T h e g o ld fu tu re s p r ic e f o r m a tu r ity in J a n u a r y is $ 1 4 5 0 p e r o u n c e a n d th e g o ld fu tu re s p r ic e fo r
m a t u r ity in F e b r u a r y is $ 1 4 6 0 p e r o u n c e . A s s u m e t h a t th e c a r r y in g c o s t f o r g o ld is $ 7 p e r o u n c e
p e r m o n th , p a y a b le a t th e e n d o f th e m o n th . A t r a d e r c o u ld e x p lo it th e s e p r ic e s b y e n te r in g in to
a c o n t r a c t to b u y in J a n u a r y a n d e n te r in g in to a c o n t r a c t to s e ll in F e b r u a r y . W h e n th e J a n u a r y
m a t u r ity d a te a r r iv e s , th e t r a d e r a c c e p ts d e liv e r y o f th e g o ld a n d p a y s th e a g r e e d p r ic e o f $1 4 5 0 .
T h e t r a d e r th e n s to re s th e g o ld f o r 1 m o n th . In F e b r u a r y , th e tr a d e r d e liv e r s (sells) th e g o ld a t th e
a g r e e d p r ic e o f $ 1 4 6 0 a n d p a y s th e c a r r y in g c o s t o f $ 7 , g iv in g a n e t c a s h in f lo w o f $ 1 4 5 3 in
F e b r u a r y . T h e re s u ltin g p r o fit o f $ 3 is a 'p u r e 7 p r o f i t — t h a t is, in e x c e s s o f th e o p p o r t u n it y c o s t —
s in c e th e $ 7 c a r r y in g c o s t c o v e rs th e o p p o r t u n it y c o s t o f h o ld in g th e g o ld . O f c o u rs e , o th e r tr a d e r s
w i ll u n d e r ta k e s im ila r a c tiv itie s a n d w i ll c o n tin u e to d o so u n til th e g a p b e tw e e n th e J a n u a r y a n d
F e b r u a r y fu tu re s p r ic e s is $ 7 o r le ss. F o r e x a m p le , th e m a r k e t m a y se t a J a n u a r y fu tu re s p r ic e o f
$ 1 4 5 1 a n d a F e b r u a r y fu tu re s p r ic e o f $ 1 4 5 7 . A t th is p o in t, th e p r ic e o f th e la te - d e liv e r y c o n tr a c t
($ 1 4 5 7 ) is less th a n o r e q u a l to th e p r ic e o f th e e a r ly - d e liv e r y c o n t r a c t ( $ 1 4 5 1 ) , p lu s th e c a r r y in g
c o s t ( $ 7 ) . T h is is th e re s u lt s ta te d in th e th e o r e m .
A li m it in g case o f t h is th e o re m is o f sp e cia l s ig n ific a n c e . In th e lim it , th e e a rly -d e liv e ry c o n tra c t

SPOT PRICE c o u ld be f o r im m e d ia te d e liv e ry ; in o th e r w o rd s , its te r m to m a t u r ity c o u ld be zero. The sp o t price is
price of the commodity th e p ric e p a id in a s ta n d a rd c o m m o d ity p u rc h a s e — t h a t is, i t is th e p ric e o f th e c o m m o d ity w h e n th e
when the buyer pays
b u y e r pays im m e d ia te ly a n d th e s e lle r d e liv e rs im m e d ia te ly . T h e re fo re , to p re v e n t a rb itra g e , th e s p o t
immediately and
p ric e s h o u ld be v e ry close to th e p ric e o f a fu tu re s c o n tra c t w it h a te r m to m a t u r it y o f zero . S u b s titu tin g
the seller delivers
immediately ‘th e s p o t p ric e ’ f o r ‘th e fu tu re s p ric e f o r an e q u iv a le n t e a rly -d e liv e ry c o n tra c t’，th e th e o re m becom es:
A futures price must be less than (or equal to) the current spot price, plus the carrying cost.
In th is way, th e th e o re m p ro v id e s a m a x im u m p ric e f o r th e fu tu re s c o n tra c t, g iv e n th e c u rre n t s p o t
p ric e a n d th e c a rry in g cost. A lg e b ra ica lly, i t can be w r it t e n as:
F<S + C
w h e re F = fu tu re s p ric e
5 = c u rre n t s p o t p ric e
C = c a rry in g cost
W e n o w set fu tu re s c o n tra c ts b r ie fly to one side a n d d ire c t o u r a tte n tio n to th e m a rk e t in th e
c o m m o d ity its e lf. S uppose t h a t th e c u rre n t s p o t p ric e o f g o ld is $ 1 4 5 0 p e r ounce a n d th a t, ta k in g in to
a cco u n t th e e xp ected o u tp u t o f g o ld m in e s , th e fo re c a s t d e m a n d f o r je w e lle ry , th e p o litic a l s itu a tio n in
S o u th A fric a (a g o ld -p ro d u c in g c o u n try ) an d, in p rin c ip le , a n y o th e r fa c to r th o u g h t to be re le v a n t, a tra d e r
fo re ca sts t h a t in 1 m o n th s tim e , th e s p o t p ric e o f g o ld w ill be a t le a s t eq ua l to to d a y s s p o t p ric e ($ 1 4 5 0 )
a n d p o s s ib ly m u c h m o re . In o th e r w o rd s , i t is fo re c a s t t h a t th e s p o t p ric e o f g o ld w i ll increase. A ssum e,
f o r e xa m ple, t h a t th e p ric e is fo re c a s t to be $ 1 4 8 0 p e r ounce in 1 m o n th s tim e . In th is case, i t is p re d ic te d
t h a t a tra d e r c o u ld b u y g o ld , h o ld i t f o r 1 m o n th a n d th e n se ll i t f o r $ 1 4 8 0 . N e t o f th e c a rry in g co st o f
$7, th e p re d ic te d p r o f it is $23. Is th is la rg e e n o u g h to in d u c e a tra d e r to a d o p t th is s tra te g y? Perhaps
so, p e rh a p s n o t. U n lik e th e in v e s tm e n t s tra te g y u n d e rly in g th e th e o re m , th is is a r is k y p ro p o s itio n and
p e rh a p s $2 3 is n o t e n o u g h to co m p e n sa te f o r th e r is k in v o lv e d . H o w e ve r, th e re w ill c le a rly be som e le vel
o f p re d ic te d p r o f it fro m h o ld in g g o ld , w h ic h w ill in d u c e g o ld p u rcha ses— t h a t is, g o ld w ill be p u rch a se d if:
S + C + risk factor < E(S) 17.2

w h e re S = c u rre n t s p o t p ric e
C = c a rry in g c ost
E(S ) = e xp ected fu tu r e s p o t p ric e
G o ld w ill be b o u g h t, a n d th e s p o t p ric e w ill increase, u n t il E q u a tio n 17 .2 n o lo n g e r h o ld s — th a t
is, u n til:
E(S) < S -I- C + riskfactor 17.3

E q u a tio n 1 7 .3 th e re fo re p ro v id e s th e m a x im u m v a lu e t h a t th e e x p e c te d s p o t p ric e , E(S)f can

be, g iv e n th e c u r r e n t s p o t p ric e , th e c a r r y in g c o s t a n d a r is k fa c to r. S im ila rly , E q u a tio n 17 .1
p ro v id e s th e m a x im u m v a lu e t h a t th e fu tu re s p ric e F can be, g iv e n th e c u r r e n t s p o t p ric e a n d th e
c a rry in g cost.
F in a lly , can i 7 a n d E ⑸ be lin k e d ? S up po se, f o r e x a m p le , t h a t F w as $ 1 4 5 1 a n d £ ⑸ w as $ 1 4 8 0 .
I t is lik e ly th a t, in th e h o p e o f p r o f it , so m e o n e w o u ld be w illin g to b u y a fu tu r e s c o n tra c t, p o s s ib ly
w it h th e in t e n t io n o f a c c e p tin g d e liv e ry o n th e m a t u r it y d a te a n d th e n im m e d ia te ly re s e llin g th e g o ld .
A g a in , t h is is a r is k y s tra te g y , b u t a fo re c a s t p r o f it o f $ 2 9 m a y be e n o u g h to in d u c e so m e o n e to t r y it .
In fa c t, th e re is a g ro u p o f a n a ly s ts w h o b e lie v e t h a t fu tu re s p ric e s a n d e x p e c te d s p o t p ric e s are v e ry
c lo se ly re la te d .
This t r a d itio n a l th e o r y can be a d a p te d to fin a n c ia l fu tu re s . O ne w a y in w h ic h th is m ig h t be do ne
is discussed b r ie fly in S e ctio n 17 .9. A s b o th a p re lu d e to th is d iscu ssio n , a n d as a to p ic o f co n sid e ra b le
im p o rta n c e in its o w n r ig h t, w e f ir s t discuss in som e d e ta il h o w fu tu re s c o n tra c ts (e sp e cia lly fin a n c ia l
fu tu re s c o n tra c ts ) can be used.
17.5 Futures market strategies: speculating

m
and hedging
LEARNING
OBJECTIVE 4
17.5.1 | Introduction Understand and
explain speculation
and hedging strategies
T ra d itio n a lly , p a r tic ip a n ts in fu tu re s m a rk e ts h a ve b e e n d iv id e d in t o tw o g ro u p s : s p e c u la to rs a n d
using futures contracts
h e d g e rs .9 A speculator in t h is c o n te x t is so m e o n e w h o has tra d e d in a fu tu r e s c o n tra c t b u t w h o has n o
d ire c t in te r e s t in th e ‘c o m m o d ity ’ u n d e r ly in g th e fu tu re s c o n tra c t. F o r e x a m p le , i f so m e o n e tra d e s a
g o ld fu tu re s c o n tra c t b u t o w n s n o g o ld a n d does n o t in te n d to b u y any, th e fu tu re s m a rk e t tra n s a c tio n
is p u re ly s p e c u la tiv e . A hedger is so m e o n e w h o has tra d e d in a fu tu re s c o n tra c t a n d ha s a g e n u in e *
in te re s t in th e C o m m o d ity * u n d e r ly in g th e fu tu re s c o n tra c t. F o r e x a m p le , i f a je w e lle ry m a n u fa c tu re r
tra d e s a fu tu re s c o n tra c t o n g o ld , th e fu tu re s m a rk e t tra n s a c tio n p ro v id e s a h e d g e a g a in s t changes in
g o ld prices.
In s h o rt, th e d is tin c t io n b e tw e e n a s p e c u la to r a n d a h e d g e r in fu tu re s c o n tra c ts is s im p ly th is :
a s p e c u la to r is a ffe c te d b y th e fu tu re s p ric e ( b u t n o t th e s p o t p ric e ) o f th e ‘c o m m o d ity ’，w h e re a s
a h e d g e r is a ffe c te d b y both th e fu tu re s p ric e a n d th e s p o t p ric e o f th e c o m m o d ity ,. By t r a d in g in
fu tu re s c o n tra c ts th e s p e c u la to r is e xp o se d to th e ris k s o f changes in th e fu tu re s p ric e ; th is is a r is k to
w h ic h he o r she w o u ld n o t o th e rw is e ha ve b e e n e xp o se d . B y t r a d in g in fu tu re s c o n tra c ts , th e he d g e r,
to o , is e xp o se d to th e sam e ris k s o f cha ng es in th e fu tu r e s p ric e b u t o n ly in an a t t e m p t to offset th e
p re -e x is tin g r is k o f changes in th e <c o m m o d ity , p ric e its e lf. The s p e c u la to r uses fu tu re s c o n tra c ts to
in crea se h is o r h e r e x p o s u re to ris k , w h e re a s th e h e d g e r uses fu tu re s c o n tra c ts to decrease h is o r h e r
e xp o su re to ris k .
There is a la rg e b o d y o f th e o r y (a n d evide nce) re la tin g to s p e c u la to rs a n d hedgers, a n d to th e v a rio u s
in flu e n ce s t h a t have a b e a rin g o n s p o t p rice s a n d fu tu re s prices. M u c h o f th is th e o ry was d e ve lo p e d
in th e c o n te x t o f fu tu re s c o n tra c ts o n p h y s ic a l c o m m o d itie s an d, as a re s u lt, n o t a ll o f i t is re le v a n t to
fin a n c ia l fu tu re s . In p a rtic u la r, th e re is a s u b s ta n tia l lite ra tu re t h a t focuses o n such issues as in v e n to rie s ,
in sura nce, storag e costs a n d p ro d u c tio n se a so n a litie s, b u t as the se issues are o f lim it e d releva nce to
fin a n c ia l fu tu re s , th is m a te ria l w ill n o t be p re s e n te d .10 H o w e ve r, th e basic fe a tu re s o f s p e c u la tin g an d
h e d g in g are a p p lica b le to b o th typ e s o f fu tu re s c o n tra c ts . F o r ease o f e x p o s itio n we c o n tin u e to use
fu tu re s o n p h y s ic a l c o m m o d itie s to e s ta b lis h th e p rin c ip le s . D e ta ile d a p p lic a tio n s to fin a n c ia l fu tu re s are
p ro v id e d in S ectio ns 1 7 .6 ,1 7 .7 ,1 7 .8 a n d 17.9.
9 A third group, arbitrageurs, can also be distinguished. As discussed in Section 1.5.7, an arbitrage is a set of simultaneous
transactions in different markets that guarantees a risk-free profit. The transactions in Example 17.1 were an arbitrage
involving futures prices, spot prices and carrying costs. Arbitrage is discussed further in Sections 17.6.3 and 17.10.
10 For a survey, see Kolb and Overdahl (2006).
17 .5 .2 1 Speculating
In th e s im p le s t case, a s p e c u la to r ho pe s to :
a ta k e a lo n g p o s itio n — t h a t is, b u y — w h e n th e fu tu re s p ric e is ‘lo w ’，re v e rs in g o u t— t h a t is, s e llin g

la te r— w h e n th e fu tu re s p ric e has in crea sed; and/or
b ta k e a s h o rt p o s itio n — t h a t is, s e ll— w h e n th e fu tu re s p ric e is ‘h ig h ’, re v e rs in g o u t— t h a t is, b u y in g
la te r— w h e n th e fu tu re s p ric e has decreased.
In e ith e r case, th e s p e c u la to r ga in s. O f course, i f th e o p p o s ite occurs, th e s p e c u la to r loses. This is

s h o w n in Table 17.2.
TABLE 17.2 Basics Deculation outcomes

If futures contract is held If futures prices subsequently
Increase Decrease
Long G ain Loss
S h o rt Loss G ain
The tim e p e rio d o v e r w h ic h a s p e c u la to r hopes to g a in w ill v a ry d e p e n d in g o n th e ty p e o f s p e c u la tio n .

I t is c o m m o n to d is tin g u is h fiv e ty p e s o f s p e c u la tio n .
Scalping
The tim e p e rio d d u r in g w h ic h a scalper h o ld s a fu tu r e s c o n tra c t is e x tre m e ly s h o r t a n d is u s u a lly
m e a s u re d in m in u te s o r seconds. F o r t h is re a so n , o n ly tra d e rs w h o h a ve d ire c t access to th e e le c tro n ic
t r a d in g s y s te m a n d are p e r m it te d to tra d e o n t h e ir o w n a c c o u n t can be sca lp e rs. I n e ffe c t, scalpers
t r y to d e v e lo p a c o n tin u o u s ly u p d a te d *fe e r f o r th e m a rk e t, a n t ic ip a t in g a n d e x p lo it in g p e rc e iv e d
s h o r t- t e r m excesses o f s u p p ly o r d e m a n d . S calpers p e r fo r m th e u s e fu l f u n c t io n o f p r o v id in g liq u id it y
to th e m a rk e t.
Spreading
SPREAD A sp read is a lo n g (b o u g h t) p o s itio n in o n e m a t u r it y d a te , p a ire d w it h a s h o r t (s o ld ) p o s it io n in
long (bought) position a n o th e r m a t u r it y d a te . A n e x a m p le is a b o u g h t M a rc h b a n k b i ll fu tu re s c o n tra c t a n d a s o ld J u n e b a n k
in one maturity date,
b i ll fu tu r e s c o n tra c t. S p e c u la to rs w i ll a d o p t t h is s p re a d i f th e y b e lie v e t h a t th e c u r r e n t d iffe re n c e
paired with a short
(sold) position in b e tw e e n th e tw o fu tu r e s p ric e s is to o w id e . S p e c u la to rs w i ll g a in i f th e d iffe re n c e (o r ‘s p re a d ’ ） n a rro w s .
another maturity date I t is a s im p le m a t t e r to s h o w th is . L e t th e c u r r e n t— t h a t is, T im e 0 — fu tu r e s p ric e o f th e M a rc h
c o n tra c t be F (0 , M ). S im ila rly , le t th e c u r r e n t — t h a t is, T im e 0 — fu tu r e s p ric e o f th e J u n e c o n tra c t be
F (0 , J ). The s p re a d a t T im e 0 is:
F ( 0 ,J ) - F ( 0 ,M )
S im ila rly , th e spre ad a t T im e 1 is:
F (1 ,J )-F (1 .M )
B e tw e e n T im e 0 a n d T im e 1, th e b o u g h t p o s itio n in th e M a rc h c o n tra c t w i ll p ro d u c e a g a in of:
F (1 ,M )-F (0 ,M ) 17.4
S im ila rly , o v e r th e sam e tim e p e rio d , th e s o ld p o s itio n in th e J u n e c o n tra c t w ill p ro d u c e a g a in of:
F ( 0 , J ) - F ( 1 .J ) 17.5
N o te t h a t th e 0 a n d th e 1 in E q u a tio n 1 7 .5 are re v e rs e d c o m p a re d w it h E q u a tio n 1 7 .4 . T his is
because E q u a tio n 1 7 .4 give s th e g a in f r o m a b o u g h t p o s itio n , w h ile E q u a tio n 1 7 .5 g iv e s th e g a in fr o m
a s o ld p o s itio n .
A s old p o s itio n ge ne rates a g a in i f th e fu tu re s p ric e fa lls — t h a t is, if:
F(1,J)<F(0,J)
The spread s p e c u la to rs t o t a l g a in G is g iv e n b y th e s u m o f E q u a tio n s 1 7 .4 a n d 17.5:

G = F (l, M) - F(0, M) + F(0,1) - F (l, J)
= [F (0 ,J)-F (0 ,M )]-[F (1 ,J)- F (1 ,M )]
= [spread at T im e 0] less [spread a t T im e 1]
> 0 i f [spread at T im e 0] exceeds [spread at T im e 1]
In th is case, th e n , th e spre ad s p e c u la to r w ill g a in i f th e spre ad a t T im e 1 is n a rro w e r th a n th e spread

a t T im e 0. The spre ad s p e c u la to r p e rfo rm s th e u s e fu l fu n c tio n o f k e e p in g in lin e th e p rice s o f d iffe re n t
fu tu re s c o n tra c ts o n th e sam e c o m m o d ity . The spre ad s p e c u la to r m a y h o ld a fu tu re s p o s itio n f o r any
p e rio d , b u t w ill o fte n do so f o r o n ly a m a tte r o f h o u rs , o r p e rh a p s days.
Straddling
A straddle is s im ila r in co n c e p t to a spre ad b u t re fe rs to p o s itio n s in fu tu re s c o n tra c ts o n d iffe re n t
c o m m o d itie s , ra th e r th a n fu tu re s c o n tra c ts o n th e sam e c o m m o d ity f o r d iffe re n t m o n th s . F o r exa m ple,
a tra d e r m ig h t b u y a M a rc h b a n k b ill c o n tra c t a n d se ll a M a rc h b o n d c o n tra c t. The reasons f o r s tra d d lin g
are s im ila r to th o s e f o r sp re a d in g .
Day trading
Day traders are p re p a re d to tra d e as th e y see f i t d u rin g a tra d in g day, b u t re g a rd an o v e rn ig h t p o s itio n as
to o risky. Q u ite s im p ly , to o m u c h can h a p p e n w h ile th e exchange is closed.
Long-term/overnight position taking

This is b o th th e s im p le s t a n d th e ris k ie s t ty p e o f s p e c u la tio n . S p e cu la to rs fo r m a v ie w t h a t th e c u rre n t
fu tu re s p ric e is to o lo w (o r to o h ig h ), tra d e a cco rd in g ly, a n d w a it f o r e ve n ts to p ro v e th e m r ig h t. I t can be
a q u ic k w a y to ric h e s — o r rags.
1 7 .5 .3 1 Hedging
The essence o f h e d g in g is e a sily e x p la in e d . C o n sid e r, f o r exa m ple, a g ra z ie r w h o in te n d s to se ll h is c a ttle
in several m o n th s * tim e . He is a ffe cte d b y m o v e m e n ts in th e s p o t p ric e o f c a ttle , g a in in g i f i t increases
(since h is c a ttle becom e m o re v a lu a b le ) a n d lo s in g i f i t decreases (since h is c a ttle becom e less v a lu a b le ).
I f he w ishes to be p ro te c te d a g a in s t th e se changes, he can sell c a ttle fu tu re s — t h a t is, he becom es w h a t is
k n o w n as a s h o rt hedger. The p o s itio n o f th e s h o r t h e d g e r is s h o w n in Table 17 .3. SHORT HEDGER
hedger who hedges
by means of selling
TABLE 17.3 Short hedging outcomes futures contracts today
If prices rise If prices fall
S h o rt fu tu re s co n tra ct Loss G ain
C attle— lo n g in spot G ain Loss
N et re su lt A p p ro x im a te ly zero A p p ro x im a te ly zero
The n e t re s u lt is a p p ro x im a te ly zero. T h e re fo re , th e h e d g e r achieves h is o b je c tiv e , in t h a t w h e th e r

prices ris e o r fa ll, th e re is l i t t le o r n o e ffe c t o n th e hedger. N o te , th o u g h , t h a t th e re s u lt is s h o w n as
o n ly a p p ro x im a te ly zero. W h y n o t p re c is e ly zero? There are m a n y reasons w h y a p e rfe c t hedge is m o s t
u n lik e ly b u t b e fo re lo o k in g a t som e o f th e reasons, w e need to c o n s id e r hedges ach ie ved b y b u y in g fu tu re s
co n tra c ts . Such a hedge is ca lle d a lo n g he dg e— a n d i f th e p o s itio n o f a lo n g h e d g e r is s im p ly th e exa ct LONG HEDGER
reverse o f th e p o s itio n o f th e s h o rt hedger, th e o u tco m e s f o r th e lo n g h e d g e r are as s h o w n in Table 17 .4. hedger who hedges
by means of buying
H o w eve r, o n clo se r in s p e c tio n , i t s h o u ld be cle a r t h a t th e lo n g h e d g e rs p o s itio n is n o t n e ce ssa rily
futures contracts today
s im p ly th e reverse o f th e s h o rt h e d g e rs p o s itio n . F o r exa m p le , co m p a re th e p o s itio n o f a lo n g hedger,
such as a m a n u fa c tu re r o f b e e f sausages, w ith t h a t o f a s h o rt hedger, such as a g ra zie r. There can be no
4^^
B usiness finance
TABLE 17.4 Long hedging outcomes

If prices rise If prices fall
Long fu tu re s co n tra ct G ain Loss
C a ttle — s h o rt in spot Loss Gain
N e t re su lt A p p ro x im a te ly zero A p p ro x im a te ly zero
d o u b t t h a t a g ra z ie r ga in s i f s p o t c a ttle p rice s rise . F o r e xa m p le , i f s p o t c a ttle p rice s ris e fr o m $ 1 0 /k g to

$ 1 2 /k g , a g ra z ie r b e n e fits b y $ 2 /k g m u ltip lie d b y th e n u m b e r o f k ilo g ra m s o f c a ttle o w n e d . The g ra z ie rs
w e a lth has ris e n b y th a t a m o u n t. Is a sausage m a n u fa c tu re r $ 2 /k g p o o re r? I t is n o t cle ar t h a t th e an sw e r
to th is q u e s tio n is ‘yes’. To a g ra zie r, c a ttle are o b v io u s ly assets a n d hence i t is c o rre c t to t h in k o f th e
g ra z ie r as h a v in g a lo n g p o s itio n in th e s p o t m a rk e t f o r c a ttle ; b u t to a sausage m a n u fa c tu re r, c a ttle are
n o t lik e ly to be lia b ilitie s . I f a sausage m a n u fa c tu re r has s h o rt s o ld c a ttle , th e n c a ttle m ig h t be lia b ilitie s ,
b u t in p ra c tic e i t is im p o s s ib le (o r a t le a s t v e ry d iffic u lt) to s e ll c o m m o d itie s s h o rt. H o w e ve r, f o r s im p lic ity ,
we w ill tre a t lo n g h e d g in g as s im p ly th e reverse o f s h o rt h e d g in g .11
¥ LEARNING
1 7 .5 .4 1 Some reasons w hy hedging with futures is imperfect
In th is s e c tio n w e discuss th re e reasons w h y h e d g in g w it h fu tu re s c o n tra c ts m a y be im p e rfe c t. These are
im p e rfe c t convergence, basis r is k a n d s p e c ific a tio n diffe re nce s.
OBJECTIVE 5
Understand and
Imperfect convergence
explain the reasons S up po se t h a t a je w e lle ry m a n u fa c tu re r is c o m m itte d to b u y in g a n o u n ce o f g o ld o n 2 7 M a rc h a n d
why hedging with
i t so h a p p e n s t h a t th e re is a fu tu re s c o n tra c t t h a t p re c is e ly m a tc h e s t h is ne ed . T h a t is , th e re is a
futures contracts may
fu tu r e s c o n tra c t t h a t sp e c ifie s an o u n ce o f g o ld o f th e sam e q u a lit y a n d a t th e sam e lo c a tio n as th e
be imperfect
m a n u fa c tu r e r re q u ire s , a n d th e m a t u r it y d a te o f th e fu tu r e s c o n tra c t is 2 7 M a rc h . E ven in t h is case
a p e rfe c t hedge m a y n o t be p o s s ib le because o f th e p ro b le m o f im p e r fe c t c o n v e rg e n c e b e tw e e n s p o t
a n d fu tu r e s p rice s.
L o g ic a lly , th e p ric e o f a fu tu r e s c o n tra c t w i t h ze ro t im e to m a t u r it y o u g h t to be e q u a l to th e s p o t
p ric e . I f t h is w e re n o t so, th e n in p r in c ip le a n in s ta n ta n e o u s p r o f it c o u ld be m ad e. F o r e x a m p le , i f
th e s p o t p ric e w e re th e lo w e r on e, a tr a d e r c o u ld s im u lta n e o u s ly b u y in th e s p o t m a rk e t a n d se ll
in th e fu tu r e s m a rk e t, d e liv e r in g th e c o m m o d ity p u rc h a s e d in s a tis fa c tio n o f th e fu tu re s m a rk e t
c o m m itm e n t. H o w e v e r, in r e a lity th e fu tu r e s p ric e a t m a t u r it y can be s lig h t ly d iff e r e n t f r o m th e
s p o t p ric e o n th e m a t u r it y d a te . I n s h o r t, th e c o n v e rg e n c e b e tw e e n th e s p o t p ric e a n d th e fu tu re s
p ric e as th e m a t u r it y d a te a p p ro a ch e s can be im p e r fe c t. Y e t i t m a y n o t be p o s s ib le to p r o f it f r o m
th is d iffe re n c e . F o r e x a m p le , tra n s a c tio n co sts c o u ld p re v e n t th e o p p o r t u n it y f r o m b e in g e x p lo ite d .
T his w i ll a ffe c t th e q u a lity o f a h e dg e, b u t ty p ic a lly th e p ro b le m s h o u ld n o t be v e r y s e rio u s because
co n ve rg e n ce is g e n e ra lly close, e ve n th o u g h n o t p e rfe c t.
C o n s id e r ag a in th e je w e lle ry m a n u fa c tu re r w h o has b o u g h t g o ld fu tu re s . Suppose t h a t she faces th e
fo llo w in g s itu a tio n a n d has closed o u t h e r c o n tra c t:
F u tu re s p ric e (w h e n b o u g h t): $1400

F u tu re s p ric e (a t m a tu r ity ) : $1460
S p o t p ric e (o n fu tu re s m a t u r ity da te ): $ 1 4 6 2
The je w e lle r y m a n u fa c tu re r w i ll ha ve a fu tu r e s p r o f it o f $ 6 0 to a d d to th e p ric e o f $ 1 4 0 0 she k n e w

she w o u ld ha ve to pay, b u t w i ll be $2 s h o r t o f th e $ 1 4 6 2 n e e d e d to b u y g o ld (s p o t). In o t h e r w o rd s ,
th e g o ld e n d s u p c o s tin g h e r $ 1 4 0 2 in s te a d o f $ 1 4 0 0 as w as p la n n e d . T h is, a d m itte d ly , is im p e rfe c t,
b u t th e p ro b le m is n o t s e rio u s . C e r ta in ly i t is b e tte r to h a ve to f in d $ 2 u n e x p e c te d ly , th a n to have to
fin d $ 6 2 u n e x p e c te d ly .
11 A slightly different approach to long hedging is to think of the long hedger as gaining or losing on the spot, relative to the
forward price of the commodity. Of course, forward prices may be unobservable.
Basis risk
By d e fin itio n , a h e d g e r is p la n n in g to tra n s a c t in th e s p o t m a rk e t a t som e f u tu r e tim e . H o w e ve r, i t is
u n u s u a l f o r th e date o f th e p la n n e d s p o t tra n s a c tio n to co in c id e w ith th e m a t u r ity da te o f a fu tu re s
c o n tra c t. A t an y g iv e n tim e , a fu tu re s exchange w ill o ffe r o n ly a re s tric te d n u m b e r o f m a t u r ity da te s—
so m e tim e s o n ly fo u r o r five. A s a re s u lt, th e re is o n ly a s m a ll chance t h a t th e d a te o f th e p la n n e d s p o t
tra n s a c tio n w ill co in cid e w ith a fu tu re s c o n tra c t m a t u r ity da te. W h e n th e dates do n o t co in cid e , th e he d g e r
m u s t reverse o u t o f th e fu tu re s c o n tra c t b e fo re i t m a tu re s , an d, w h e n th is a c tio n is re q u ire d , hedgers face
a ris k k n o w n as ‘basis r is k ’. W e d e fin e th e b a s is a t a n y g iv e n tim e as th e s p o t p ric e S a t t h a t tim e o f a BASIS
c o m m o d ity t h a t m atche s e x a c tly th e c o m m o d ity d e fin e d in th e fu tu re s c o n tra c t, m in u s th e fu tu re s p ric e spot price at a point in
time minus the futures
F a t th a t tim e ( fo r d e liv e ry o f th e c o m m o d ity a t som e la te r t im e ).12 T h ere fore, th e basis B a t T im e 0 is:
price (for delivery at
5(0) = S (0 )-F (0 ) some later date) at
that point in time
S im ila rly , th e basis a t som e la te r tim e , say, T im e 1, is:
B(l) = S (l)-F (l)
N o w co n s id e r a s h o rt h e d g e r a n d assum e t h a t th e ‘c o m m o d ity ’ h e ld b y th e s h o rt h e d g e r can be
sto re d costlessly. A s h o rt h e d g e r m akes a g a in (loss) o n th e fu tu re s c o n tra c t i f th e fu tu re s p ric e decreases
(increases) a n d a g a in (loss) o n h o ld in g th e c o m m o d ity i f th e s p o t p ric e increases (decreases). T here fore,
in th e in te rv a l b e tw e e n T im e 0 a n d T im e 1:
T o ta l g a in to s h o rt h e d g e r = g a in m ad e o n fu tu re s + g a in m a d e o n spo t
= [ F ( 0 ) - F ( 1 ) ] + [S (1 ) - S ( 0 ) ]
= [S (l)-F(l)]-[S(0)-F(0)}
= B(l)-B(0)
= ch a n g e in basis b e tw e e n T im e 0 a n d T im e 1
The p o in t is sim p le : th e change in th e b asis o v e r a g iv e n tim e p e rio d is n o t, in ge ne ral, p re c is e ly zero.

Yet a p e rfe c t hedge is one in w h ic h th e w e a lth o f th e h e d g e r is im m u n e to th e m o v e m e n t o f prices.
I t fo llo w s th a t a h e dg er does n o t, in fa c t, e lim in a te a ll ris k . There re m a in s basis ris k .
I t is im p o r ta n t to u n d e rs ta n d th is p o in t. H o w e ve r, i t is also im p o r t a n t to place basis r is k in c o n te x t.
In general, fu tu re s p ric e s a n d s p o t p ric e s te n d to m o v e to g e th e r. O f course, th is te n d e n c y is n o t p e rfe c t
a n d f o r som e a g ric u ltu ra l c o m m o d itie s i t m a y n o t even be close to p e rfe c t. F o r exa m p le , i f a b u m p e r
h a rv e s t is e xp e cte d n e x t season b u t, s im u lta n e o u s ly , u n e x p e c te d s h o rta g e s in th e s p o t m a rk e t de ve lo p
tod ay, th e n fu tu re s p ric e s m ig h t fa ll a t th e sam e tim e as s p o t p rice s rise . B u t th is ty p e o f s itu a tio n is th e
e xce p tio n . In g e ne ral, w h a te v e r causes s p o t p rice s to in crea se (o r decrease) w ill also te n d to cause fu tu re s
p rice s to increase (o r decrease). E x a m p le 17 .2 illu s tra te s basis ris k .
Exam ple 17.2

S u p p o s e th a t s o m e d r a m a t ic e v e n t c a u s e s a la r g e fa ll in s p o t p ric e s , a n d s u p p o s e th a t th is s a m e
e v e n t c a u s e s a s im ila r, b u t s lig h tly s m a lle r, fa ll in fu tu re s p ric e s , a s s h o w n in T a b le 1 7 . 5 . G iv e n th e
d a ta in T a b le 1 7 . 5 , w h a t is th e g a in o r lo ss fo r a s h o rt h e d g e r?
TABLE 17.5 Example of basis risk

Prices ($)
L
A t Time 0 A t Time 1 Gain (+) or loss (-)
Spot (long) 1026 806 -2 2 0

Futures (sh o rt) 1040 825 +215
G ain (+) o r loss ( - ) made b y s h o rt hedger -5
continued
12 Conventions vary. Basis is usually defined as *spot minus futures*, but sometimes it is defined as 'futures minus spot',
particularly when the futures contract is on a financial asset.
4 ^ ^
continued
SOLUTION
In th e ta b le , T im e 0 is th e d a te o n w h ic h th e h e d g e is set u p a n d T im e 1 is th e d a te o n w h ic h th e s p o t
tr a n s a c tio n is m a d e a n d th e h e d g e is lifte d . A s s h o w n in th e ta b le , th e h e d g e is n o t p e rfe c t, a s th e re
is a n e t loss o f $ 5 , w h ic h is e q u a l to th e c h a n g e in th e b a s is :
Change in basis = 8 (1 )-8 (0 )
= [S (1 )-F (1 )]-[S (0 )-F (0 )]

= [$ 8 0 6 - $ 8 25 ] - [$ 1026 - $ 1040]
= _ $ 1 9 _ [_ $ 1 4 ]
= -$ 5
H o w e v e r, a loss o f $ 5 is t r iv ia l w h e n c o m p a r e d w ith th e loss o f $ 2 2 0 th a t w o u ld h a v e b e e n

in c u r r e d h a d n o fu tu re s c o n tra c t b e e n e n te re d in to . B a sis ris k is m u ch less th a n p r ic e risk. In th is
e x a m p le a s h o rt h e d g e r fa c e d a n in it ia l b a s is o f - $ 1 4 th a t la te r fe ll to - $ 1 9 a n d th e o u tc o m e w a s a
loss o f $ 5 . T a b le 1 7 . 6 sets o u t th e fu ll r a n g e o f p o s s ib ilitie s .
TABLE 17.6 Hedging outcomes and basis changes

O u tc o m e if ba sis(a)
D e s c rip tio n P o sitio n s In cre a se s D e cre a se s

1
S h o rt hedger F utures (s h o rt)
C o m m o d ity (long) Gain Loss
Long hedger F utures (long)
C o m m o d ity (s h o rt) Loss G ain
(a) Basis is defined as spot price less futures price.
Specification differences
‘S p e c ific a tio n d iffe re n c e s ’ re fe rs to th e fa c t t h a t th e s p e c ific a tio n o f th e ‘c o m m o d ity ’ t h a t is th e su b je ct
o f th e fu tu re s c o n tra c t m a y n o t p re c is e ly c o rre s p o n d to th e s p e c ific a tio n o f th e ‘c o m m o d ity ’ t h a t is o f
in te re s t to a hedger. F o r exa m ple, a h e d g e r m a y be in te re s te d in a p a rtic u la r grade o f w o o l t h a t is s lig h tly
d iffe re n t fr o m th e grade o f w o o l sp e cifie d in th e fu tu re s c o n tra c t. A lte rn a tiv e ly , a h e d g e r m a y be in te re s te d
in b u y in g w o o l to be d e liv e re d to a c e rta in lo c a tio n . H o w e ve r, th is lo c a tio n m a y be o n ly one o f a n u m b e r
o f lo c a tio n s acceptable f o r d e liv e ry u n d e r a fu tu re s c o n tra c t, o r i t m a y n o t even be one o f th e acceptable
lo c a tio n s . S im ila r o b s e rv a tio n s are re le v a n t to fin a n c ia l fu tu re s . Som e exa m ples are as fo llo w s :
• A b o rro w e r m a y in te n d to issue 1 2 0 -d a y b a n k b ills , b u t th e fu tu re s c o n tra c t specifies 9 0 -d a y b a n k b ills .

• A n in v e s to r m a y o w n a d iv e rs ifie d p o r tfo lio , w h ic h is s im ila r, b u t n o t id e n tic a l, to th e shares in th e
share p ric e in d e x t h a t th e fu tu re s c o n tra c t specifies.
• A le n d e r m a y in te n d to in v e s t in 5 -y e a r co m p a n y d e b e n tu re s , b u t th e fu tu re s c o n tra c t specifies
3 -y e a r g o v e rn m e n t b o n d s.
In fa c t, o n ly ra re ly is a h e d g e r able to fin d a fu tu re s c o n tra c t w h ose s p e c ific a tio n is precisely th e same

as th e c o m m o d ity t h a t is o f in te re s t to th e hedger. S p e c ific a tio n d iffe re n ce s in tro d u c e a f u r t h e r e le m e n t
o f im p e rfe c tio n in th e h e d g in g process. This is illu s tra te d in E xa m p le 17.3.
Exam ple 17.3

A s s u m e th a t a je w e lle r y m a n u fa c tu r e r in te n d s to b u y o n e o u n c e o f h ig h - g r a d e g o ld b u t th e fu tu re s
c o n t r a c t s p e c ifie s o n e o u n c e o f p r e m iu m - g r a d e g o ld . N e v e r th e le s s , a s a h e d g e , h e e n te rs in to
o n e fu tu re s c o n t r a c t to b u y p r e m iu m - g r a d e g o ld . S u p p o s e t h a t th e f o llo w in g p r ic e s , s h o w n in
T a b le 1 7 . 7 , o c c u r.
W h a t is th e g a in o r loss f o r th e je w e lle r y m a n u fa c tu re r?
TABLE 17.7 Prices for Example 17.3

P rices ($ )
G o ld A t T im e 0 A t T im e
H igh grade— spot 1450 1493
P rem ium grade— spot 1480 1520
Prem ium grade— fu tu re s 1490 1528
SOLUTION
'L o s s ' o n s p o t = $ 1 4 9 3 - $ 1 4 5 0 = $ 4 3 (loss)
G a in o n fu tu re s = $ 1 5 2 8 - $ 1 4 9 0 = $ 3 8 (g a in )
N e t re s u lt: $ 5 (loss)
B e c a u s e a s m a ll loss h a s re s u lte d , th e h e d g e is im p e rfe c t. T w o c o m p o n e n ts o f th e loss c a n b e

id e n tifie d :
a) Basis risk, w h ic h c a u s e d a lo ss o f $ 2 . A t T im e 0 , th e b a s is , m e a s u re d a s th e s p o t p r ic e m in u s th e
fu tu re s p ric e , w a s - $ 1 0 . A t T im e 1, it w a s - $ 8 . In o th e r w o r d s , w h e r e a s th e s p o t p r ic e in c re a s e d
b y $ 4 0 , th e fu tu re s p r ic e in c re a s e d b y o n ly $ 3 8 .
b) Specification differences, w h ic h c a u s e d a fu rth e r loss o f $ 3 . A t T im e 0 , th e p r ic e g a p b e tw e e n th e

tw o g r a d e s o f g o ld w a s $ 3 0 , b u t a t T im e 1, it w a s o n ly $ 2 7 . In o th e r w o r d s , th e g r a d e s o u g h t
b y th e h e d g e r h a s b e c o m e m o re e x p e n s iv e re la tiv e to th e g r a d e o f g o ld u n d e r ly in g th e fu tu re s
c o n tra c t.
A g a in , h o w e v e r, c o m p a r e d w ith n o h e d g e (in w h ic h c a s e a loss o f $ 4 3 w o u ld h a v e b e e n in c u rre d ),
th e re s u lt is q u ite g o o d , e v e n th o u g h th e h e d g e is im p e rfe c t.
1 7 .5 .5 1 Hedging and regretting

The p re v io u s exa m ples have be en c o n s tru c te d to s h o w h o w h e d g in g can reduce losses t h a t w o u ld o th e rw is e
have been in c u rre d . H o w eve r, b y its v e ry n a tu re , h e d g in g also reduces p r o fits w h ic h w o u ld o th e rw is e have
been m ade. C o n sid e r th e e xa m p le o f M eg an , a c o rp o ra te tre a s u re r, w h o ta ke s o u t a s h o rt hedge to p ro te c t
a g a in st p ric e fa lls. Prices in fa c t ris e as d isp la ye d in Table 17.8.
TABLE 17.8 A short hedge

P rices ($ )
C o m m o d ity A t T im e 0 A t T im e 1
Spot price (long) 430 500
Futures price (sh o rt) 440 510
In th is case, th e re is a g a in o n th e s p o t o f $ 7 0 a n d an o f f s e t t in g lo ss o n th e fu tu re s o f $ 7 0 . The
hedge has p e rfo rm e d p e rfe c tly ; i t p ro d u c e d im m u n it y to p ric e m o v e m e n ts . O f co u rse , i t is o b v io u s
th a t, in retrospect, M e g a n s c o m p a n y w o u ld ha ve b e e n b e t te r o f f b y $ 7 0 i f she h a d n o t ta k e n o u t th e
hedge. She m a y n e e d to e x p la in to h e r boss th e s im p le m essage o f h e d g in g w it h fu tu re s c o n tra c ts : to
have p r o te c tio n a g a in s t losses a fu tu r e s h e d g e r m u s t be w illin g to fo rg o p r o fits t h a t w o u ld o th e rw is e
have be en m ade.
4^^
B usiness finance
1 7 .5 .6 1 Selecting the number of futures contracts

In th e exa m ples w e have discussed, th e n u m b e r o f fu tu re s c o n tra c ts to be used in th e hedge was ob vio us.
H o w e ve r, in p ra c tic e th is is n o t alw ays th e case a n d he dg ers n e ed to a d o p t a s y s te m a tic a p pro ach in
d e c id in g h o w m a n y fu tu re s c o n tra c ts th e y s h o u ld b u y o r sell. I f a h e d g e r e n te rs in to to o fe w (o r to o m a n y)
fu tu re s c o n tra c ts , th e p o s itio n is ris k ie r th a n d e s ire d .13
Suppose t h a t a h e d g e r has an in te re s t in Ns u n its o f a c o m m o d ity 1. I f th is in te re s t is a lo n g (s h o rt)
p o s itio n , th e n Ns is p o s itiv e (n e g a tive ). Suppose f u r t h e r t h a t /"fu tu re s c o n tra c ts have b e e n e n te re d in to ,
each o f w h ic h covers NF u n its o f th e c o m m o d ity . I f a lo n g (s h o rt) p o s itio n is h e ld in fu tu re s c o n tra c ts ,
th e nfis p o s itiv e (n e g a tive ). The g a in G to th e h e d g e r is:
G = Ns x (cha ng e in sp o t p ric e p e r u n it) -\-fNp x (ch a n g e in fu tu re s p ric e p e r u n it)
= ^ s (5 i - 5 〇) -\-fNF(Fi -F 〇)
w h e re S〇 = s p o t p ric e p e r u n it w h e n th e hedge is e n te re d (‘to d a y ’）

F 〇 = fu tu re s p ric e p e r u n it w h e n th e hedge is e n te re d (ôdayO
^1 = s p o t p ric e p e r u n it w h e n th e hedge is lift e d
= fu tu re s p ric e p e r u n it w h e n th e hedge is lift e d
The tild e (〜）is used to e m p ha sise t h a t th e s u b se q u e n t p rice s are ra n d o m v a ria b le s — t h a t is, t h e ir value
is u n c e rta in .
O b v io u s ly , w h e n th e hedge is lif t e d a n d th e s p o t tra n s a c tio n is m ade, th e o u tco m e s 5 X a n d F1w ill be
k n o w n w it h c e rta in ty . T h ere fore, w ith h in d s ig h t, th e id e a l n u m b e r o f fu tu re s c o n tra c ts fr o m a h e d g in g
v ie w p o in t w ill be o b v io u s a n d can be fo u n d b y s e ttin g G eq ua l to zero a n d re a rra n g in g E q u a tio n 17.6. This
gives:
^ ( 5 ! -S o )
■ Nf(F] -F ) 〇
H o w e ve r, in p ra ctice , th is e q u a tio n c a n n o t be used because Sr a n d F1 are n o t k n o w n a t th e tim e th e

hedge is se t up. In e v ita b ly , th e re fo re , d e c id in g h o w m a n y fu tu re s c o n tra c ts s h o u ld be e n te re d in to re q u ire s
som e a s s u m p tio n o r fo re ca st t h a t relates changes in th e fu tu re s p ric e to changes in th e s p o t p rice . This
w ill u s u a lly in v o lv e som e e rro r.
U s in g E q u a tio n 17.6, th e g a in p e r u n it o f c o m m o d ity is g, w h ere :
Ns Ns
N o w d e fin e h = fN F/N Si w h e re h is th e *hedge ratio *, w h ic h is th e n u m b e r o f u n its cove red b y fu tu re s
c o n tra c ts p e r u n it o f s p o t c o m m o d ity . T here fore:
g= (S i - S 〇 ) + h(F\ -F 〇)
The c o m p o n e n ts oig rese m ble a tw o -a s s e t p o r tfo lio , a n d th e va ria n c e (ris k ) is g iv e n b y :14
V a r(g ) = V ar(S ! - S〇 ) + V a r [h ( f , - F 〇 ) ] + 2C ov [ ( § ! - S〇 ) , h ( f , - F 〇 ) ]
= V a r^ S ,) + h2Var(P^ + 2hCov(su F ^
W e a ssu m e t h a t th e h e d g e r w i l l cho ose th e h e d g e r a t io h so as to m in im is e th e v a ria n c e o f g .15 To
f in d h o w to ach ie ve t h is g o a l w e d iffe r e n tia te V a r( g) w it h re s p e c t to h, a n d s e t th e d e riv a tiv e e q u a l
to zero :
13 N o te t h a t s im p ly in c r e a sin g th e n u m b e r o f fu t u r e s c o n tr a c t s in a n a t t e m p t 4to m a k e s u r e e n o u g h a r e h eld * d o e s n o t so lv e

t h is p r o b le m . F o r e x a m p le , i f b u y in g n in e fu t u r e s c o n t r a c t s w o u ld p r o d u c e a p e r f e c t h e d g e , b u t 1 0 c o n tr a c t s a r e b o u g h t , th e
h e d g e r is o n e f u t u r e s c o n tr a c t lo n g o n a n e t b a s i s . T h a t is , th e h e d g e r is in fa c t a lo n g s p e c u l a t o r in r e la t io n t o o n e c o n tr a c t,
a n d h e n c e w ill m a k e a lo s s i f fu t u r e s p r ic e s fa ll.
14 C a lc u la t in g th e r is k o f a p o r t fo lio is e x p la in e d in d e t a il in C h a p t e r 7.
15 A s w e h a v e s t a t e d , t h is is m e r e ly a n a s s u m p t io n . In g e n e r a l, it is e x p e c te d t h a t fin a n c ia l m a r k e t s w ill p r ic e a s s e t s s o t h a t th e r e
is a t r a d e - o ff b e tw e e n r isk a n d e x p e c te d r e t u r n . D e p e n d in g o n th e d e c is io n m a k e r s p r e f e r e n c e s a s b e tw e e n r isk a n d e x p e c te d
r e tu rn , a r isk - m in im isin g s t r a t e g y m a y o r m a y n o t b e o p t im a l.
令
W a r逆 = 2hVar{Fi) + 2 C o v (S ], F 〇 = 0
dh
The ris k -m in im is in g va lu e o f h is th u s h* w h ere :
h* = _ C o v (S i 1 F i)
V a r(F 〇
17.7
A n e stim a te o f h* can be fo u n d fr o m re g re ssin g s p o t p rice s a g a in s t fu tu re s prices. U s in g th e d e fin itio n
o f th e hedge ra tio ht th e o p tim u m n u m b e r o f fu tu re s c o n tra c ts to e n te r in to is f* w here:
r = ~
Nf
S u b s titu tin g fr o m E q u a tio n 1 7 .7 gives:
NsCovCs^F,)
1 ~ Nf V a r(F 〇 17.8
E q u a tio n 17.8 suggests t h a t th e n u m b e r o f fu tu re s c o n tra c ts to e n te r in to depends o n fo u r
factors:
a N s, th e n u m b e r o f u n its o f th e c o m m o d ity a t r is k in th e s p o t m a rk e t
b NFf th e n u m b e r o f u n its o f th e c o m m o d ity u n d e rly in g one fu tu re s c o n tra c t
C C o v ( S i,F i) , w h ic h de scrib es th e re la tio n s h ip b e tw e e n s p o t a n d fu tu re s p rice s
d V a r(F i), w h ic h describes th e v a r ia b ility o f fu tu re s prices.
A n in te re s tin g spe cia l case arises i f i t is assu m ed t h a t s p o t a n d fu tu re s p rice s m o ve e q u i-

p ro p o rtio n a te ly — t h a t is, an x per c e n t change in th e s p o t p ric e w ill alw ays be m a tc h e d b y an x per cent
change in th e fu tu re s p rice . Then:
( 5 !- S 〇) = (F x-F p)
S〇 F〇
w h ic h on re a rra n g e m e n t gives:
an d th e re fo re :
Cov(Si,F1) = C o v ^ F i ,F ,^
= 吾 C o v (内，朽）
= ^ V a r(F ,)
户
0
S u b s titu tin g in E q u a tio n 1 7 .8 , th e o p tim u m n u m b e r o f fu tu re s c o n tra c ts f* is:
NsS /F Var(Fi)
〇〇
Nf V a r(F 〇
Ns S 〇
Nf Fq 17.9
The a p p lic a tio n o f E q u a tio n 17 .9 is illu s tra te d in E xa m p le 17.4.
Exam ple 17.4

G o s s G o ld o w n s 1 1 9 o u n c e s o f g o ld a n d is c o m m itte d to s e llin g th e g o ld in 3 w e e k s ' tim e . T he s p o t p ric e
(to d a y ) is $ 1 3 0 7 p e r o u n c e a n d th e fu tu re s p ric e fo r d e liv e r y in 7 w e e k s ' tim e is $ 1 3 1 6 p e r o u n c e . O n e
futures c o n tra c t c o v e rs 3 o u n c e s o f g o ld . G o s s G o ld w a n ts to h e d g e u s in g future s a n d n e e d s to d e c id e
o n the n u m b e r o f future s c o n tra c ts it s h o u ld enter.
continued
continued
SOLUTION
A s a firs t p a ss a t th e p r o b le m , G o s s G o ld is w illin g to a s s u m e th a t a 1 p e r c e n t c h a n g e in th e s p o t
p r ic e w ill b e m a tc h e d b y a 1 p e r c e n t c h a n g e in th e fu tu re s p ric e .
U s in g E q u a tio n 1 7 . 9 , th e n u m b e r o f fu tu re s c o n tra c ts is:
p = _N sS g
NF Fo
119 $ 1 3 0 7
$1316
= -3 9 .4 0
T hus, G o s s G o ld s h o u ld sell 3 9 fu tu re s c o n tra c ts .
A v a r ia tio n o n th is s im p le a p p ro a c h w h e n a p p lie d to b o n d fu tu re s is illu s tr a te d in E x a m p le 1 7 .1 1 .
F in a n c e
METALLGESELLSCHAFT________________________________________
in ACTION
T h e G e r m a n c o m p a n y M e ta llg e s e lls c h a ft A G p r o v id e s a c a s e o f a n a p p a r e n t h e d g in g s tra te g y
t h a t w e n t t e r r ib ly w r o n g . 16
In 1 9 9 3 th is 1 0 0 - y e a r - o ld c o m p a n y w a s th e fo u r t e e n t h - la r g e s t c o r p o r a t io n in G e r m a n y , w ith
5 8 0 0 0 e m p lo y e e s a n d 2 5 1 s u b s id ia r ie s w o r ld w id e . It w a s in v o lv e d in a r a n g e o f b u s in e s s e s
b u t p r i m a r il y in m in in g , m e ta ls a n d e n e r g y p r o d u c ts . In la te 1 9 9 3 a n d e a r ly 1 9 9 4 , it in c u r r e d
lo s s e s in fu tu re s t r a d in g o f a p p r o x im a t e ly U S $ 1 .3 b illio n . T h is w a s e q u a l to a b o u t h a lf o f its
v a lu e a t t h a t tim e .
T h e s e lo s s e s w e r e in c u r r e d b y a U S s u b s id ia r y o f th e c o m p a n y c a lle d M G R e fin in g a n d
M a r k e t in g ( M G R M ) . In 1 9 9 2 M G R M d e v e lo p e d a m a r k e tin g s tr a te g y in w h ic h it o f f e r e d U S firm s
lo n g -te rm fix e d - p r ic e c o n tra c ts o n g a s o lin e , h e a tin g o il a n d d ie s e l fu e l. M G R M 's c u s to m e rs w e r e
a b le to lo c k in t h e ir p u r c h a s e p r ic e f o r u p t o 1 0 y e a r s p r o v id e d th e y a g r e e d to b u y fr o m M G R M .
To h e d g e a g a in s t th e ris k o f o il p r ic e ris e s , M G R M e n te r e d in to b o u g h t p o s it io n s in fu tu re s
c o n t r a c t s t r a d e d o n th e N e w Y o rk M e r c a n t ile E x c h a n g e . H o w e v e r , a s th e s e fu tu r e s c o n tr a c ts
h a d r e la t iv e ly s h o r t te rm s to m a tu r ity , th e y h a d to b e r o lle d o v e r a s e a c h c o n t r a c t e x p ir e d .
M G R M s e ttle d e x p ir in g c o n tr a c ts a n d p u r c h a s e d th e n e x t s h o r te s t m a t u r ity c o n t r a c t . T h is
s t r a t e g y w o r k s s u c c e s s fu lly p r o v id e d th e m o r e d is t a n t fu tu re s p r ic e s a r e lo w e r t h a n th e s p o t
p r ic e o r n e a r b y fu tu r e s p r ic e .
U n fo r tu n a te ly , in la t e - 1 9 9 3 o il p r ic e s b e g a n f a llin g . D u r in g 1 9 9 3 p r ic e s o f o il f e ll b y a lm o s t
o n e - th ir d . M G R M 's b o u g h t p o s it io n s in th e fu tu r e s m a r k e t in c u r r e d lo s s e s , r e s u lt in g in la r g e
m a r g in c a lls . A s th e p r ic e o f o il w a s f a llin g , th e f ir m w a s g a in in g o n its f ix e d - p r ic e s u p p ly
c o n tr a c ts , b u t u n f o r t u n a t e ly th o s e g a in s c o u ld n o t b e r e a lis e d u n til th e o il w a s d e liv e r e d . A s
n o te d a b o v e , in s o m e c a s e s th is w a s u p to 1 0 y e a r s in th e fu tu re .
F a c e d w it h u n r e a lis e d g a in s in its f ix e d - p r ic e s u p p ly c o n tr a c ts a n d m a s s iv e lo s s e s in th e
fu tu re s m a r k e t, th e p a r e n t c o m p a n y c h o s e to liq u id a t e its fu tu re s p o s it io n s . U n fo r tu n a te ly , d u r in g
th e n e x t 6 m o n th s o il p r ic e s r e c o v e r e d a ll o f t h e ir lo s t g r o u n d . T h is m e a n t t h a t M R G M 's f ix e d -
p r ic e s u p p ly c o n t r a c t s t h a t w e r e n o w u n h e d g e d in c u r r e d fu r t h e r lo s s e s f o r th e c o m p a n y .
S o m e e x p e r ts c o n s id e r t h a t M G R M w a s in f a c t s p e c u la t in g . O th e r s a r g u e t h a t it h a d a n
e f f e c t iv e h e d g e in p la c e a n d c o u ld h a v e r a is e d th e c a s h to m e e t its m a r g in c a lls w it h o u t
liq u id a t in g its p o s it io n s . W h e t h e r t h r o u g h s p e c u la t io n o r a n u n s u c c e s s fu l h e d g in g s tra te g y ,
th e p a r e n t c o m p a n y r e p o r t e d a lo s s o f m o r e th a n U S $ 1 . 7 b i lli o n f o r th e f in a n c ia l y e a r e n d in g
S e p te m b e r 1 9 9 4 .
16 For details of the losses incurred by Metallgesellschaft, see Chance and Brooks (2010, p. 576) and Sheedy and McCracken
(1997, pp. 42-7).
4^^
17.6 Financial futures on the Australian

bank-accepted bill futures contract
As m e n tio n e d in S e ctio n 1 7 .3 , m o s t fu tu re s c o n tra c ts tra d e d on th e A S X are fin a n c ia l fu tu re s , ra th e r
th a n c o m m o d ity fu tu re s . In th is a n d th e fo llo w in g tw o se ctio n s, p rin c ip le s t h a t w e have d e ve lo p e d an d
e xp la in e d in te rm s o f c o m m o d ity fu tu re s are a p p lie d to A S X fin a n c ia l fu tu re s . M o re space is d e v o te d to
bank-a ccepte d b ill fu tu re s th a n to th e o th e rs , because th e re is s im p ly m o re m a te ria l to c o ve r a n d because
b a n k b ill fu tu re s are used to e x p la in th e m a jo r p rin c ip le s .
17.6.1 | A brief review of bank bills17

A bank bill is a s h o r t- te rm d e b t in s tr u m e n t t h a t is re a d ily tra d e a b le . B a n k b ills are g e n e ra lly issu ed
fo r s ta n d a rd fix e d te rm s (such as 9 0 days o r 18 0 days) a n d a t s ta n d a rd face values (such as $ 1 0 0 0 0 0 ,
$ 5 0 0 0 0 0 o r $ 1 0 0 0 0 0 0 ). The face va lu e is re p a id a t m a tu rity . P rio r to m a t u r ity a b ill is p ric e d a cco rd in g
to th e p rin c ip le s o f s im p le in te re s t. E q u a tio n 1 7 .1 0 show s th e b ill p r ic in g fo rm u la used in th is ch a p te r.
P: V R R V 9
1 + (/)(r/3 6 5 )
w h ere P = b ill p rice

V = face value
z = n o m in a l a n n u a l y ie ld (also k n o w n as th e b ill ra te )
t = te rm (in days) re m a in in g to b ills m a t u r ity date
This is illu s tra te d in E xa m p le 17.5.
Exam ple 17.5

A b ill w ith 9 0 d a y s r e m a in in g to m a tu rity , p r ic e d to y ie ld 6 . 8 8 p e r c e n t p e r a n n u m a n d w ith a fa c e
v a lu e o f $1 m illio n re q u ire s a p r ic e o f:
6^
p $1000000
_ 1 + (0 .0 6 8 8 1 (9 0 /3 6 5 )
= $ 9 8 3 3 1 8 .6 1
If th e y ie ld w e r e to in c re a s e by, say, 0 . 2 5 p e r c e n t p e r a n n u m to 7 .1 3 p e r c e n t p e r a n n u m , th e n th e
p ric e d e c re a s e s a s fo llo w s :
n $1000000
1 + (0 .0 7 1 3 1 (9 0 /3 6 5 )
$ 9 8 2 7 2 2 .9 2
This re p re s e n ts a c a p it a l loss o f $ 5 9 5 . 6 9 to th e in v e s to r (le n d e r). S im ila rly , if y ie ld s d e c re a s e ,

p ric e s in c re a s e . A n 'e q u iv a le n t ’ fa ll in y ie ld o f 0 . 2 5 p e r c e n t p e r a n n u m , to 6 . 6 3 p e r c e n t p e r a n n u m ,
w ill p r o d u c e a p r ic e in c re a s e a s fo llo w s :
n $1000000
1 + (0 .0 6 6 3 1 (9 0 /3 6 5 )
$ 9 8 3 9 1 5 .0 1
T his re p re s e n ts a c a p it a l g a in o f $ 5 9 6 . 4 0 to th e in v e s to r (le n d e r). N o te th a t b e c a u s e o f th e n o n

lin e a r re la tio n s h ip b e tw e e n y ie ld s a n d b o n d p ric e s , th e c a p it a l g a in is a little la r g e r th a n th e c a p it a l
loss fo r th e s a m e s h ift in y ie ld .
17 For further details, see Section 10.5.3.
4^^
B usiness finance
F o r m a n y p u rp o s e s ，a b a n k b ill is th e sam e as a n y o th e r ‘c o m m o d ity ’. I t has a m a rk e t p ric e a n d th is

p ric e changes fr o m d a y to day a cco rd in g to m a rk e t forces. There is, th e re fo re , n o reason w h y th e re c a n n o t
be a fu tu re s c o n tra c t o n 9 0 -d a y b a n k b ills .
17.6.1 | Specification of the bank-accepted bill futures contract

The b a n k-a cce p te d b ill fu tu re s c o n tra c t has th e fo llo w in g m a jo r fea tu res.
LEARNING Contract unit

OBJECTIVE 6
Understand and The c o n tra c t u n it is a 9 0 -d a y b a n k b ill w it h a face va lu e o f $1 m illio n , o r n e g o tia b le c e rtific a te s o f d e p o s it
explain the features w it h a face va lu e o f $1 m illio n issu ed b y an a p p ro v e d b a n k.
of the major financial
futures contracts Settlement
traded on the
Australian Securities The c o n tra c t is d e liv e ra b le — t h a t is, sellers can d e liv e r b a n k b ills in s a tis fa c tio n o f t h e ir fu tu re s c o n tra c t
Exchange re s p o n s ib ilitie s . T echn ica lly, b ills t h a t have a te r m as s h o rt as 85 days o r as lo n g as 95 days are acceptable.
H o w e ve r, b ills s h o rte r th a n 90 days are w o r th m o re th a n 9 0 -d a y b ills because th e y are d is c o u n te d w ith
resp ect to a s h o rte r tim e p e rio d . T h ere fore, b u ye rs m u s t pa y a li t t le m o re th a n th e s ta te d fu tu re s p ric e
in t h a t case. S im ila rly , i f sellers d e liv e r a b ill lo n g e r th a n 90 days, th e n b u ye rs p a y a l i t t le less th a n th e y
w o u ld f o r a 9 0 -d a y b ill. A ls o , b a n k n e g o tia b le c e rtific a te s o f d e p o s it can be s u b s titu te d f o r b a n k b ills .
The s e ttle m e n t da te is th e second F rid a y o f th e m a t u r ity (d e liv e ry ) m o n th .
Quotations
O n e h u n d re d m in u s th e a n n u a l p e rcen ta ge y ie ld to tw o d e c im a l places.
Termination of trading
T ra d in g ceases a t 12 n o o n o n th e bu sin ess day im m e d ia te ly p r io r to th e s e ttle m e n t date.
I t is im p o r t a n t to rea lise t h a t a b a n k b ill fu tu re s c o n tra c t is n o t a c o n tra c t o n a n y p re s e n tly e x is tin g
9 0 -d a y b a n k b ill because to m o r r o w an e x is tin g 9 0 -d a y b a n k b ill w ill be an 8 9 -d a y b a n k b ill a n d th e n e x t
day a n 88 -d a y b a n k b ill, a n d so on.
To illu s tra te th e n a tu re o f th e b a n k b ill fu tu re s c o n tra c t, c o n s id e r th e p ric e o f 9 7 .4 5 f o r th e
D e cem b er (2 0 1 3 ) b a n k b ill fu tu re s c o n tra c t p ro v id e d o n th e A u s tra lia n S e cu ritie s E xchange w e b s ite a fte r
th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 (see F ig u re 17 .1 ). The re p o rte d p ric e o f 9 7 .4 5 re fe rs to th e p ric e
in th e la s t tra d e o n t h a t day a n d re p re se n ts 1 0 0 m in u s th e a n n u a l pe rce n ta g e y ie ld . In o th e r w o rd s, th e
a n n u a l y ie ld is:
1 0 0 -9 7 .4 5
= 2 .5 5 %
= 0.0255
U s in g E q u a tio n 1 7 .1 0 , th e d o lla r p ric e im p lic it in th is fu tu re s c o n tra c t is th e re fo re :

$ 1 0 0 0 000*2013
1 + (0 .0 2 5 5 )(9 0 /3 6 5 )
= $ 9 9 3 7 5 1 .6 2
The s e ttle m e n t da te is th e second F rid a y o f D e ce m b e r 2 0 1 3 — t h a t is, 13 D e ce m b e r 2 0 1 3 . The b a n k b ill

in v o lv e d has 90 days to ru n ; th is 9 0 -d a y p e rio d is to begin on 13 December 2 0 1 3 . T h e re fo re , th e b a n k b ill
in v o lv e d is one t h a t m a tu re s o n 13 M a rc h 2 0 1 4 . The te rm o f th e fu tu re s c o n tra c t e xp ire s o n 13 D ecem ber
2 0 1 3 , w h ic h is 70 days a fte r i t was e n te re d in to o n 4 O c to b e r 2 0 1 3 .
To c la r ify th is , suppose t h a t a tra d e r b o u g h t one such c o n tra c t o n 4 O cto b e r, h e ld i t to s e ttle m e n t
day (1 3 D e cem b er), accepted d e liv e ry o f th e b ill o n t h a t d a y a n d th e n h e ld th e b ill to it s m a t u r ity date.
Ig n o rin g cash flo w s due to d e p o sits, m a rg in s a n d th e m a rk -to -m a rk e t ru le , th e cash flo w s in v o lv e d are as
s h o w n in F igu re 17.1.
The y ie ld e a rn e d o v e r th e 9 0 -d a y p e rio d fr o m 13 D e ce m b e r 2 0 1 3 to 13 M a rc h 2 0 1 4 is, as i t m u s t be,
2.5 5 p e r c e n t p e r a n n u m . By e n te rin g th e fu tu re s c o n tra c t, a p a r tic u la r y ie ld (2 .5 5 p e r c e n t p e r a n n u m )
Major cash flows in a bank-accepted bill futures contract

70 160
4 October 201 3 13 December 2013 13 March 2014
Enter futures contract Accept delivery Bill matures

at price of $97.45 pay $993 751.62 collect $ 1 0 0 0 0 0 0
has b e en lo c k e d in o n 4 O c to b e r 2 0 1 3 f o r th e 9 0 -d a y p e rio d t h a t b e g in s o n 13 D e cem b er 2 0 1 3 a n d ends

o n 13 M a rc h 20 14 .
O f course m o s t tra d e rs d o n o t h o ld a fu tu re s c o n tra c t u n t il s e ttle m e n t. T y p ic a lly th e b u y e r
in th is e xa m ple w o u ld so o n reverse o u t b y a sale. I f, f o r exa m ple, th e re v e rs in g sale w e re m ade a t
th e c lo sin g p ric e on 11 O c to b e r th e p ric e , as p ro v id e d b y th e A S X w e b site , w o u ld have been 9 7 .4 1 . The
y ie ld in d ic a te d is 1 0 0 - 9 7 .4 1 = 2 .5 9 p e r c e n t and, a g a in u s in g E q u a tio n 1 7 .1 0 , th e d o lla r p ric e is:
p_ $ 10 0 0 000
_ 1 + (0.0259) (9 0 /3 6 5 )
= $ 9 9 3 654.22
Ig n o rin g tra n s a c tio n costs, th is gives a loss o f $ 9 7 .4 0 .
1 7 .6 .2 1 Uses of the bank bill futures contract

The b a n k b ill c o n tra c t can be use d in s p e c u la tio n , h e d g in g a n d a rb itra g e .
Speculation with bank bill futures LEARNING

OBJECTIVE 7
A ll fu tu re s c o n tra c ts le n d th e m se lve s to s p e c u la tio n . There is n o th in g spe cia l to e x p la in a b o u t th is . Explain speculation
I f tra d e rs can fo re ca st th e s u b se q u e n t course o f th e b a n k b i ll fu tu re s p ric e , th e y can m a ke m o n e y s im p ly and hedging
b y b u y in g (s e llin g ) w h e n th e fu tu re s p ric e is lo w (h ig h ). strategies using the
major financial futures
contracts traded on the
Hedging with bank bill futures Australian Securities
As has been e x p la in e d , s im p le h e d g in g in v o lv e s a fu tu re s tra n s a c tio n , w h ic h la rg e ly o ffs e ts a r is k to w h ic h Exchange
th e h e dg er is a lre a d y exposed. T his is illu s tra te d in d e ta il in E xa m p le 17.6.
Exam ple 17.6

S e v e ra l w e e k s a g o , th e fin a n c ia l c o n tro lle r o f A n n a m a y Ltd d e c id e d th a t th e c o m p a n y sh o u ld b o r r o w b y
issu in g a 9 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n . A s th e fu n d s w e re n o t n e e d e d fo r a n o th e r 2
w e e k s , it w a s d e c id e d th a t th e issue w o u ld n o t b e m a d e u n til th e 2 w e e k s h a d p a s s e d . In h e r p la n n in g ,
th e fin a n c ia l c o n tro lle r a s s u m e d th a t th e 9 0 - d a y b a n k b ill ra te w o u ld n o t c h a n g e fro m its th e n c u rre n t le vel
o f 4 . 4 0 p e r c e n t p e r a n n u m . H o w e v e r, she w a s a w a r e th a t a risk w a s in v o lv e d a n d th e re fo re d e c id e d
th a t A n n a m a y s h o u ld p ro te c t itse lf a g a in s t a n in c re a s e in b ill ra te s b y s e llin g o n e b a n k b ill fu tu re s c o n tra c t.
This w a s d o n e a t a p ric e o f 9 5 . 7 8 . D u rin g th e n e x t 2 w e e k s th e fin a n c ia l c o n tro lle r w a s a m a z e d to see
th e 9 0 - d a y b ill ra te c lim b ra p id ly . A n n a m a y e v e n tu a lly issu ed a b ill a t a ra te o f 5 . 5 0 p e r c e n t p e r a n n u m
a n d lifte d the h e d g e b y re v e rs in g its future s p o s itio n a t a p ric e o f 9 4 . 7 0 .
The fin a n c ia l c o n tro lle r is a s k e d to p ro v id e a re p o r t to th e B o a rd o f D ire c to rs o n th e fo llo w in g m atters:
a) th e (gro ss) d o lla r s h o rtfa ll th a t A n n a m a y w o u ld h a v e fa c e d if a fu tu re s c o n tra c t h a d n o t b e e n

e n te re d in to
b) th e g a in o r loss m a d e o n th e fu tu re s c o n tra c t ( ig n o r in g tra n s a c tio n costs)
continued
B usiness finance
continued
c) th e n e t d o lla r s h o rtfa ll
d) a n e x p la n a t io n o f (c) in te rm s o f b a s is risk
e) a b r ie f a s s e s s m e n t o f th e e ffe c tiv e n e s s o f th e h e d g e .
SOLUTION
T h e a n s w e rs to th e s e q u e s tio n s a r e a s fo llo w s :
Dl ,u • $100 0000
Planned borrowinq = ----------------------------------
1 + (0 .0 4 4 0 ) ( 9 0 /3 6 5 )
= $ 9 8 9 2 6 7 .1 3
n) A . ,, $1000000
ul Actual borrowinq = ----------------------------------
1 + (0 .0 5 5 0 ) ( 9 0 /3 6 5 )
$ 9 8 6 6 1 9 .8 1
D o lla r shortfall (gross) = $ 9 8 9 2 6 7 . 1 3 - $ 9 8 6 6 1 9 . 8 1
= $ 2 6 4 7 .3 2
b) T h e re is a n o tio n a l s a le a t 9 5 . 7 8 — th a t is, a t 4 . 2 2 p e r c e n t p e r a n n u m — f o llo w e d b y a n o tio n a l

p u rc h a s e a t 9 4 . 7 0 — th a t is, a t 5 . 3 0 p e r c e n t p e r a n n u m .
$ 10 0 0 0 0 0
N o tio n a l in flo w from sale :
1 + (0 .0 4 2 2 ) ( 9 0 /3 6 5 )
$ 9 8 9 7 0 1 .6 8
$ 10 0 0 0 0 0
N o tio n a l o u tflo w from purchase
1 + ( 0 .0 5 3 0 ) ( 9 0 /3 6 5 )
$ 9 8 7 1 0 0 .0 9
Result from futures = $ 9 8 9 7 0 1 .6 8 - $ 9 8 7 1 0 0 .0 9
= $ 2 6 0 1 .5 9 (gain)
c) N e t d o lla r s h o rtfa ll = $ 2 6 4 7 . 3 2 - $ 2 6 0 1 . 5 9
= $ 4 5 .7 3
d) B a sis is s p o t p r ic e less fu tu re s p r ic e . W h e n th e h e d g e w a s e n te re d , th e b a s is w a s :
(Price at y ie ld o f 4 .4 0 % ) less (price a t yie ld o f 4 .2 2 % )
= $ 9 8 9 2 6 7 .1 3 - $ 9 8 9 7 0 1 .6 8
= -$ 4 3 4 .5 5
W h e n th e h e d g e w a s lifte d , th e b a s is w a s :
(Price at y ie ld o f 5 .5 0 % ) less (price a t y ie ld o f 5 .3 0 % )

= $ 9 8 6 6 1 9 .8 1 - $ 9 8 7 1 0 0 .0 9
= - $ 4 8 0 .2 8
C h a n g e in basis = (later basis) less (ea rlie r basis)
= -$ 4 8 0 .2 8 - ( - $ 4 3 4 .5 5 )
= -$ 4 5 .7 3
A s a s h o rt h e d g e r's n e t re s u lt is g iv e n b y th e c h a n g e in th e b a s is , th is in d ic a te s th a t th e h e d g e r's
n e t re s u lt is a loss o f $ 4 5 . 7 3 , w h ic h is th e re s u lt c a lc u la te d in p a r t ( c ) .18
18 See Table 17.6. Note that Annamay Ltd has been a little unlucky. Given that, at maturity, a futures price must be very
close to the spot price, it follows that, on average, the basis will tend towards zero as time passes and the maturity date
becomes closer. However, in this example, the basis has gone from -$434.55 to -$480.28—that is, it has moved further
away from zero.
e) W it h o u t th e h e d g e , th e d o lla r s h o rtfa ll w o u ld h a v e b e e n $ 2 6 4 7 . 3 2 . W it h th e h e d g e , th e n e t
d o lla r s h o rtfa ll is o n ly $ 4 5 . 7 3 , a r e d u c tio n o f 9 8 . 3 p e r c e n t. T he re s u lt c a n a ls o (e q u iv a le n tly ) b e
a sse ssed in te rm s o f y ie ld s . A n n a m a y 's to ta l fu n d s in flo w is th e a m o u n t b o r r o w e d p lu s th e n e t g a in
o n th e fu tu re s c o n tra c t.
T h is is:
$ 9 8 6 6 1 9 .8 1 + $ 2 6 0 1 .5 9
= $ 9 8 9 2 2 1 .4 0
T he re p a y m e n t r e q u ire d is $1 m illio n in 9 0 d a y s ' tim e . T h e im p lie d a n n u a l n o m in a l y ie ld is:
/ $1 0 0 0 0 0 0 ^ 365
V $ 9 8 9 2 2 1 .4 0 ~ ) X ~90
= 4.419%
T his c o m p a re s w ith a p la n n e d b o r r o w in g ra te o f 4 . 4 0 p e r c e n t. C le a r ly th e h e d g e h a s b e e n
e ffe c tiv e .
In E xam p le 17 .6, A n n a m a y L td in te n d e d to issue a s e c u rity , w h ic h , w it h th e e x c e p tio n o f th e in te n d e d

date o f issue, m a tc h e d p re c is e ly th e s e c u rity s p e c ifie d in th e fu tu re s c o n tra c t. In o th e r w o rd s, b o th th e
s e c u rity o f in te re s t to A n n a m a y a n d th e s e c u rity s p e c ifie d in th e fu tu re s c o n tra c t w e re 9 0 -d a y b a n k-
accepted b ills . A close m a tc h b e tw e e n th e s e c u rity o f in te re s t to th e h e d g e r a n d th e s e c u rity s p e c ifie d in
th e fu tu re s c o n tra c t increases th e lik e ly q u a lity o f th e hedge. H o w e ve r, as e x p la in e d in S e ctio n 17 .5.4,
th e re are o fte n s p e c ific a tio n diffe re nce s* b e tw e e n th e h e d g e rs needs a n d th e fu tu re s c o n tra c t. T his is
illu s tra te d in E xam p le 17.7.
Example 17.7
S u p p o s e th a t, in s te a d o f 9 0 - d a y b a n k b ills , A n n a m a y Ltd h a d p la n n e d to issu e 1 2 0 - d a y b a n k b ills .
A s th e re is n o fu tu re s c o n tr a c t o n 1 2 0 - d a y b a n k b ills , A n n a m a y w o u ld s till h a v e h e d g e d u s in g th e
9 0 - d a y b a n k b ill c o n tra c t. A s s u m e th a t a ll o th e r fa c ts r e m a in th e s a m e a n d th e re le v a n t d a ta a r e as
s h o w n in T a b le 1 7 .9 .
TABLE 17.9 Yields for Example 17.7 ：
B a n k b ills Y ie ld w h e n h e d g e Y ie ld w h e n h e d g e
e n te re d (% p .a .) lifte d [% p .a .)
90-day ba nk b ills 4.40 5.50
1 2 0 -day ba nk b ills 4.55 5.70
90-day ba nk b ill fu tu re s 4.22 5.30
T he fin a n c ia l c o n tr o lle r is r e q u ire d to r e p o r t o n th e f o llo w in g m a tte rs :
a) th e (gross) d o lla r s h o rtfa ll th a t A n n a m a y w o u ld h a v e fa c e d if a fu tu re s c o n tra c t h a d n o t b e e n

e n te re d in to
b) th e g a in o r loss m a d e o n th e fu tu re s c o n tra c t ( ig n o r in g tr a n s a c tio n costs)
c) th e n e t d o lla r s h o rtfa ll
d) a n e x p la n a tio n o f (c) in te rm s o f b a s is ris k a n d s p e c ific a tio n d iffe re n c e s
e) a b r ie f a s s e s s m e n t o f th e e ffe c tiv e n e s s o f th e h e d g e .
continued
B usiness finance
continued
SOLUTION
T he a n s w e rs to th e se q u e s tio n s a r e a s fo llo w s :
a) $1000000
Planned borrowing :
1 + (0 .0 4 5 5 )(1 2 0 /3 6 5 )
$985 2 6 1 .5 7
$ 10 0 0 0 0 0
Actual borrowing
1 + (0 .0 5 7 0 )(1 2 0 /3 6 5 )
= $ 9 8 1 6 0 4 .9 9
Dollar shortfall (gross) = $ 9 85 2 6 1 .5 7 - $981 6 0 4 .9 9
= $ 3 6 5 6 .5 8
b) A s th is c a lc u la tio n in v o lv e s o n ly th e fu tu re s c o n tra c t, it is th e s a m e a s in E x a m p le 1 7 . 6 — th a t is, th e
re s u lt is a g a in o f $ 2 6 0 1 . 5 9 .
c) N e t d o lla r s h o rtfa ll = $ 3 6 5 6 . 5 8 - $ 2 6 0 1 . 5 9
= $ 1 0 5 4 .9 9
d) T h is n e t s h o rtfa ll c a n b e b ro k e n in to c o m p o n e n ts re fle c tin g b a s is ris k a n d s p e c ific a tio n d iffe re n c e s .

T h e la tte r a ris e s b e c a u s e A n n a m a y h a s risks r e la te d to 1 2 0 - d a y b ills b u t is u s in g fu tu re s o n 9 0 - d a y
b ills to h e d g e a g a in s t th e se risks. T a b le 1 7 . 1 0 s h o w s th e re su lts in d e t a il. A ll p ric e s a r e c a lc u la te d
u s in g E q u a tio n 1 7 . 1 0 .
TABLE 17.10 Basis risk and specification differences in Example 17.7

D e s c rip tio n P rice w h e n h e d g e P rice w h e n h e d g e lifte d C hange
e n te re d
($> ($ ) ($ )
1. Basis risk
90-day b a nk b ill (spot) 9 8 9 2 6 7 .1 3 9 8 6 6 1 9 .8 1
Bank b ill fu tu re s 989 701.68 9 8 7 1 0 0 .0 9
-4 3 4 .5 5 -4 8 0 .2 8 -4 5 .7 3
2. Specification differences
1 2 0 -day b a n k b ill (spot) 985 261.57 9 8 1 6 0 4 .9 9
90-day b a n k b ill (spot) 9 8 9 2 6 7 .1 3 9 8 6 6 1 9 .8 1
-4 0 0 5 .5 6 - 5 014.82 -1 0 0 9 .2 6
-1 0 5 4 .9 9
e) T he h e d g e h a s r e d u c e d th e d o lla r s h o rtfa ll fro m $ 3 6 5 6 . 5 8 to $ 1 0 5 4 . 9 9 ; th is is a re d u c tio n o f

7 1 .1 p e r c e n t. T he n o m in a l a n n u a l y ie ld is:
( $ 1 0000 0 0 _________ 〇 x ^ = 4 . 8 8 1 %
V $ 9 8 1 6 0 4 .9 9 + $ 2 6 0 1 .5 9 J 12 0
T h is c o m p a re s w ith a p la n n e d y ie ld o f 4 . 5 5 0 p e r c e n t. A lth o u g h th e h e d g e h a s b e e n q u ite e ffe c tiv e ,
its p e r fo r m a n c e fa lls s h o rt o f th e e x c e lle n t p e r fo r m a n c e in E x a m p le 1 7 . 6 .
In b o th E xam p le s 1 7 .6 a n d 1 7 .7 th e h e d g e r e s ta b lis h e d a s h o rt fu tu re s p o s itio n — t h a t is, th e hedge

was a ch ie ved b y f ir s t e n te rin g a fu tu re s c o n tra c t to sell.
E xa m p le 1 7 .8 illu s tra te s a hedge t h a t re q u ire s t h a t a b a n k b ill fu tu re s c o n tra c t be h e ld lo n g — th a t is,
th e fu tu re s c o n tra c t is f ir s t b o u g h t a n d s u b s e q u e n tly sold.
Exam ple 17.8

The C h e s te rh e a to n In v e s tm e n t F und c h o s e to h e d g e w h e n it w a s to ld to e x p e c t a n in flo w o f a r o u n d
$1 m illio n in 2 m o n th s ’ tim e , to b e in v e s te d in 9 0 - d a y b a n k b ills . W h e n th e h e d g e w a s e n te re d , y ie ld s
p e r a n n u m w e r e 8 . 4 5 p e r c e n t (spo t) a n d 8 . 8 0 p e r c e n t (fu tu re s). W h e n th e h e d g e w a s lifte d , y ie ld s
w e r e 7 . 1 5 p e r c e n t (spo t) a n d 7 . 3 8 p e r c e n t (fu tu re s ). D e s c rib e a n a p p r o p r ia te h e d g e , a n d assess its
e ffe c tiv e n e s s in th e lig h t o f s u b s e q u e n t y ie ld s , ig n o r in g tra n s a c tio n costs.
SOLUTION
The C h e s te rh e a to n In v e s tm e n t F u n d b u y s a b a n k b ill fu tu re s c o n tra c t. T h e n o tio n a l p u rc h a s e p r ic e is
$ 9 7 8 7 6 2 . 2 0 a n d th e n o tio n a l s e llin g p r ic e is $ 9 8 2 1 2 7 . 9 6 , g iv in g a g a in o f $ 3 3 6 5 . 7 6 . W h e n th e
h e d g e is lifte d , 9 0 - d a y b a n k b ills o ffe r a y ie ld o f 7 . 1 5 p e r c e n t. T h is im p lie s a p r ic e o f $ 9 8 2 6 7 5 . 3 0 .
U s in g its g a in fro m th e fu tu re s c o n tra c t, C h e s te rh e a to n c a n b u y such a b ill fo r a n e t o u tla y o f
$ 9 7 9 3 0 9 . 5 4 , im p ly in g th a t its a n n u a l y ie ld w ill b e :
/ $ 1 000000 365
8.568%
V $9 79 3 0 9 .5 4 "90~
T h is is in fa c t s lig h tly h ig h e r th a n th e p la n n e d ra te o f 8 . 4 5 0 p e r c e n t. T h e fa c t th a t th is is n o t e q u a l
to th e p la n n e d ra te in d ic a te s th a t n o t a ll risks w e r e e lim in a te d b y th e h e d g e , b u t it is c le a r th a t th is
h e d g e h a s b e e n v e r y e ffe c tiv e .
Arbitrage with bank bill futures

As we m e n tio n e d e a rlie r, an a rb itra g e is a set o f s im u lta n e o u s tra n s a c tio n s in d iffe re n t m a rk e ts t h a t
guarantees a ris k -fre e p r o fit. A lth o u g h th e w o rd ‘a rb itra g e ’ is s o m e tim e s used v e ry loosely, i t is used in
th is c h a p te r in its precise sense. F o r exa m p le , i f an in v e s to r is assured o f a p o s itiv e re tu rn , a t n o ris k , fro m
a n e t in v e s tm e n t o f ze ro d o lla rs , th e n a rb itra g e has been achieved. O b v io u s ly i f m a rk e ts are e ffic ie n t,
a rb itra g e s h o u ld n o t be p o ssib le . I f th e re are n o tra n s a c tio n costs a n d in v e s to rs can b o rro w o r le n d a t th e
same m a rk e t y ie ld s, th e n th e re w i ll be an a rb itra g e o p p o r tu n ity p re s e n t unless:
(1 + z » ( l H- itj ) = 1 + /r 17.11
w h ere t = th e m a t u r ity da te o f th e fu tu re s c o n tra c t

z't = th e (s p o t) y ie ld o n a b ill m a tu rin g a t da te t
it T= th e (fu tu re s )19 y ie ld f o r a fu tu re s c o n tra c t, m a tu r in g a t d a te t, o n a b ill m a tu rin g a t a la te r d a te T
iT= th e (s p o t) y ie ld o n a b ill m a tu r in g a t date T
The lo g ic b e h in d E q u a tio n 1 7 .1 1 is th e sam e as t h a t used in S e ctio n 4 .6 .3 to e x p la in th e e x p e c ta tio n s
th e o ry o f th e te rm s tru c tu re o f in te re s t rates. Suppose th a t, o n da te zero, an in v e s to r in v e s ts $1 a t a y ie ld
of it f o r a p e rio d of t days a n d s im u lta n e o u s ly buys a fu tu re s c o n tra c t t h a t e n title s h im to in v e s t, o n date
t, th e proceeds o f h is in v e s tm e n t a t a y ie ld o f it T T here fore, a t da te T, th e in v e s to r has an a ccu m u la te d
sum o f $ 1 (1 + it )(1 + itT). T h is a m o u n t is p e rfe c tly foreseeable o n da te zero. C le a rly th e in v e s to r s h o u ld
com pare th is a m o u n t w it h th e a c c u m u la te d s u m i f o n da te zero he in s te a d in v e s ts in a b ill t h a t m a tu re s o n
date T a n d o ffe rs a y ie ld o f iT. O n an in v e s tm e n t o f $1 th is w ill p ro d u ce an a c c u m u la te d su m o f $ 1 (1 + iT).
The in v e s to r w ill choose th e a lte rn a tiv e t h a t p ro d u ce s th e g re a te r su m o n d a te T. Because c o m p e titio n
be tw ee n tra d e rs s h o u ld e lim in a te a rb itra g e o p p o rtu n itie s , i t is e xp ected t h a t b o th a lte rn a tiv e s s h o u ld
y ie ld th e sam e a c c u m u la te d su m . T h e re fo re E q u a tio n 1 7 .1 1 s h o u ld h o ld .
E q u a tio n 1 7 .1 1 im p lie s t h a t th e fu tu re s y ie ld it T, w h ic h w ill p re v e n t a rb itra g e , is:
17.12
l + it
19 Strictly speaking, it T should be a forward yield, but this difference does not significantly affect the gist of the argument. The
forward contract matures on date t; the underlying ‘commodity’ is a bank bill that is delivered on date t and matures on date
T. In the context of a bank bill futures contract traded on the Australian Securities Exchange it is required that T - t = 9 0 days.
4^^
I f th e a c tu a l fu tu re s y ie ld is less th a n t h is y ie ld , a n a rb itra g e o p e ra tio n k n o w n as cash and carry
is fe a s ib le . I f th e o p p o s ite is tr u e , th e n a n a rb itra g e o p e ra tio n k n o w n as reverse cash and carry is
fe a s ib le .20 A n im p o r t a n t c o n c lu s io n to d ra w is t h a t th e b a n k b i l l fu tu r e s p ric e m u s t be c lo s e ly re la te d
to c u r r e n t b i ll y ie ld s .
1 7 .7 Financial futures on the Australian

Securities Exchange: the 10-year
Treasury bond futures contract21
W h e re a s th e b a n k b ill c o n tra c t is s u ita b le f o r s p e c u la tio n , h e d g in g a n d a rb itra g e in s h o r t- te r m in te re s t
ra te s, th e 1 0 -y e a r T re a s u ry b o n d c o n tra c t is d e s ig n e d f o r s im ila r o p e ra tio n s in v o lv in g lo n g -te rm
in te r e s t ra te s.
17.7.1 | A brief review of bond pricing

A b o n d pays a series o f eq u a l in te re s t p a y m e n ts a t eq ua l tim e in te rv a ls th r o u g h o u t its life . These p a y m e n ts
are k n o w n as cou po ns. A t m a t u r ity th e face va lu e is re p a id . In A u s tra lia m o s t g o v e rn m e n t b o n d s pa y
in te re s t tw ic e each year. B on ds can be b o u g h t a n d sold, a n d p rice s ris e a n d fa ll a c c o rd in g to m a rk e t
forces. G ive n a b o n d p ric e i t is alw ays p o ssib le to calcula te th e y ie ld to m a tu r ity , w h ic h is s im p ly th e
b o n d s in te r n a l ra te o f re tu rn . A lte rn a tiv e ly , g iv e n a re q u ire d y ie ld to m a tu r ity , a b o n d p ric e can alw ays be
calcula ted. In A u s tra lia , i t is u s u a l to q u o te b o th c o u p o n in te re s t rates a n d y ie ld s o n an a n n u a l basis, even
th o u g h a ll c a lc u la tio n s ta k e in to a c c o u n t th e fa c t t h a t cash flo w s are in fa c t h a lf-y e a rly . The a n n u a l rates
are s im p ly d o u b le th e h a lf-y e a r rates.
A s ta n d a rd b o n d -p ric in g f o rm u la is:
17.13
" i [ (1 + 〇 nJ (1 + i)n
w h e re P =bond p ric e
C = c o u p o n p a y m e n t p e r h a lf-y e a r
z = h a lf-y e a rly y ie ld
n = n u m b e r o f h a lf-y e a rs to m a t u r ity
V = face value
E q u a tio n 1 7 .1 3 is illu s tra te d in E xa m p le 17.9.
Exam ple 17.9

C o n s id e r a b o n d w ith e x a c tly 3 y e a r s to m a tu rity , a fa c e v a lu e o f $ 1 0 0 a n d a c o u p o n in te re s t ra te o f
6 .6 p e r c e n t p e r a n n u m , p a y a b le h a lf-y e a rly . If th e r e q u ire d y ie ld is 7 . 2 p e r c e n t p e r a n n u m , w h a t is
th e p r ic e o f th e b o n d ?
SOLUTION
T he h a lf- y e a r ly c o u p o n p a y m e n t is:
0.5 x $100x0.066 = $3.30
20 Details of these arbitrages are beyond the scope of this book. Briefly, in a cash-and-carry operation the investor
simultaneously (on date zero) issues t-day bills, buys T-day bills and sells the futures contract. On date t, the bills held have
become (T - t)-day bills and are delivered in order to settle the sold futures position; the sum received will be more than
enough to pay out the maturing bills issued. In a reverse cash-and-carry operation the investor simultaneously (on date zero)
issues T-day bills, buys t-day bills, and buys the futures contract. On date t, the funds from the maturing bills are used to buy
the bills received under the terms of the futures contract. On date T, funds from the maturing bills held will be more than
sufficient to pay out the maturing bills issued.
21 The 3-year Treasury bond futures contract is similar in concept and may be used in similar fashion to the 10-year contract.
The re q u ire d y ie ld p e r h a lf-y e a r is:
0.5 x 0 .0 7 2 = 0 .0 3 6
Using E quation 17.1 3 , the p ric e P is:
p _ $ 3 .3 0 ^ 1 \ + $100
0 .0 3 6 V (1.03 6)6 / + (1.03 6)6
= $ 1 7 .5 2 6 6 1 2 + $ 8 0 .8 8 0 0 6 1
= $ 9 8 .4 0 6 6 7 3
O b vio u sly, i f m a rk e t in te re s t rates fa ll, th e n so do re q u ire d yie ld s , a n d c o n s e q u e n tly b o n d p rice s rise.

Conversely, i f y ie ld s rise, th e n b o n d p rice s fa ll.
1 7 .7 .2 1Specification of the 10-year bond futures contract

The 1 0 -yea r b o n d fu tu re s c o n tra c t has th e fo llo w in g m a jo r fe a tu re s:
a Contract unit. The c o n tra c t u n it is a 1 0 -y e a r g o v e rn m e n t b o n d w it h a face va lu e o f $ 1 0 0 0 0 0 , o ffe rin g

a c o u p o n ra te o f 6 p e r c e n t p e r a n n u m (payable h a lf-y e a rly ),
b Settlement. The c o n tra c t is s e ttle d b y cash, n o t b y d e liv e ry . A ll c o n tra c ts s t ill in existe nce a t th e close
o f tra d in g are closed o u t b y th e c le a rin g house. In e ffe c t th e c le a rin g h o u se assum es t h a t a ll tra d e rs
have closed o u t. The p ric e use d to close o u t is a p ro x y m a rk e t p ric e , w h ic h is c a lc u la te d b y o b ta in in g
fro m 10 b o n d dealers th e y ie ld a t w h ic h th e y w o u ld b u y a n d se ll b o n d s o n a b a s k e t o f m a tu r itie s set
d o w n in advance b y th e exchange. The tw o h ig h e s t b u y in g y ie ld s a n d th e tw o lo w e s t s e llin g y ie ld s are
discard ed a n d th e re m a in in g y ie ld s are averaged. T his average y ie ld is th e n c o n v e rte d to a s e ttle m e n t
pric e u s in g E q u a tio n 1 7 .1 3 , th e b o n d -p ric in g fo rm u la .
C Quotations. L ik e th e b a n k b i ll c o n tra c t, th e b o n d c o n tra c t is q u o te d as 1 0 0 m in u s th e a n n u a l
percentage y ie ld , b u t has a m in im u m flu c tu a tio n o f 0 .0 0 5 .
d Termination of trading. T ra d in g ceases a t 12 n o o n o n th e f ifte e n th day o f th e c o n tra c t m o n th , o r th e
n e x t tra d in g day i f t h a t is n o t a bu sin ess day. S e ttle m e n t d a y is th e b u sin e ss day fo llo w in g th e date
on w h ic h tra d in g ceases.
To illu s tra te th e p r ic in g o f th e 1 0 -y e a r b o n d fu tu re s c o n tra c t, c o n s id e r th e p ric e o f 9 6 .0 1 f o r th e

D ecem ber (2 0 1 3 ) 1 0 -y e a r b o n d fu tu re s c o n tra c t p ro v id e d o n th e A u s tra lia n S e cu ritie s E xchange
w ebsite a fte r th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 . The im p lie d y ie ld is 1 0 0 - 9 6 .0 1 = 3 .9 9 p e r c e n t p e r
a n n u m , o r 1 .9 9 5 p e r c e n t p e r h a lf-y e a r. The face va lu e is $ 1 0 0 0 0 0 . The h a lf-y e a rly co u p o n ra te is 0.5 x 6
p e r ce n t = 3 p e r cen t. T h e re fo re , each c o u p o n p a y m e n t is $ 3 0 0 0 . The te r m is 10 years, o r 20 h a lf-y e a rs .
U sin g E q u a tio n 1 7 .1 3 , th e d o lla r p rice , P, im p lic it in th is fu tu re s p ric e is:
$3000 1 \ $10 0 000

0.01995 (1.0 19 9 5 )20/ (1.0 19 9 5 )20
= $ 4 9 077.98 + $ 6 7 3 6 3 .1 4
= $ 1 1 6 4 4 1 .1 2
I t is clear th a t, w h e n u s in g E q u a tio n 1 7 .1 3 f o r th e 1 0 -y e a r b o n d fu tu re s c o n tra c t, C is alw ays $ 3 0 0 0

and V is alw ays $ 1 0 0 000.
m
1 7 .7 .3 1 Uses of the 10-year bond futures contract LEARNING
OBJECTIVE 7
The 1 0 -ye a r b o n d fu tu re s c o n tra c t can be used in s im ila r w ays to th o s e e x p la in e d f o r th e b a n k b ill c o n tra c t Explain speculation
an d th e re fo re we do n o t e x p la in the se w ays in f u ll d e ta il. and hedging
strategies using the
Speculation with 10-year bond futures major financial futures
contracts traded on the
As always, sp e cu la to rs are h o p in g to p r o f it b y c o rre c tly a n tic ip a tin g p ric e changes. F o r e xa m p le , i f a lo n g Australian Securities
p o s itio n is e n te re d in to a t a fu tu re s p ric e o f 9 6 .0 1 a n d re ve rse d o u t a t 9 6 .0 6 , a g a in is m ade. As s h o w n in Exchange
th e p re v io u s c a lc u la tio n s , a fu tu re s p ric e o f 9 6 .0 1 c o rre sp o n d s to a d o lla r p ric e o f $ 1 1 6 4 4 1 .1 2 . A p ric e o f
9 6 .0 6 co rre s p o n d s to a h a lf-y e a rly y ie ld o f 1 .9 7 p e r c e n t a n d hence to a d o lla r p ric e o f:
_ $3000 } _ 1 $100 000

0.0197 (1.01 97 )20 (1 .0 1 9 7 )20
= $ 1 1 6 8 9 0 .8 4
The g a in is th e re fo re $ 1 1 6 8 9 0 .8 4 - $ 1 1 6 4 4 1 .1 2 = $ 4 4 9 .7 2 .
Hedging with 10-year bond futures

The 1 0 -y e a r b o n d fu tu re s c o n tra c t can be a u s e fu l h e d g in g in s tr u m e n t w h e re th e re is an e x p o su re
to cha ng es in lo n g - te r m fix e d in te r e s t ra te s. F o r e x a m p le , an in v e s to r w h o h o ld s lo n g - te r m b o n d s
o r d e b e n tu re s w i ll s u ffe r a c a p ita l lo ss i f y ie ld s in cre a se . Such a n in v e s to r m ig h t c o n s id e r s e llin g
b o n d fu tu re s . S im ila rly , a c o m p a n y t h a t p la n s to b o r r o w fu n d s in th e f u t u r e o n a lo n g - te r m fix e d
in te r e s t ba sis w i ll lo se i f y ie ld s in c re a s e b e fo re th e fu n d s are b o rro w e d . A g a in , s e llin g b o n d fu tu re s
c o u ld be c o n s id e re d . A lte r n a tiv e ly , an in v e s to r w h o p la n s to b u y b o n d s , o r a c o m p a n y t h a t has issu e d
d e b e n tu re s b u t is p la n n in g to re p u rc h a s e th e m , c o u ld c o n s id e r b u y in g b o n d fu tu re s . These are
e s s e n tia lly s tr a ig h tfo r w a r d a p p lic a tio n s , as d e m o n s tra te d in E x a m p le 1 7 .1 0 .
Exam ple 17.
W a n t d o u g h Ltd is c o m m itte d to is s u in g 7 -y e a r, 8 p e r c e n t p e r a n n u m d e b e n tu re s in 2 m o n th s 7 tim e a n d

p la n s to b o r r o w $ 5 m illio n . T he d e b e n tu re s w ill p a y in te re s t tw ic e p e r a n n u m . W a n t d o u g h d e c id e s
to h e d g e u s in g fu tu re s c o n tra c ts o n 1 0 -y e a r g o v e r n m e n t b o n d s . T hese a r e c u r r e n tly p r ic e d a t 9 5 . 0 0 .
W a n t d o u g h a ssu m e s th a t a n x p e r c e n t c h a n g e in th e fu tu re s y ie ld w ill b e m a tc h e d b y a n x p e r c e n t
c h a n g e in th e r e q u ire d ra te o f re tu rn o n its d e b e n tu re s . T h e p r o b le m is to d e s ig n a s u ita b le h e d g e .
SOLUTION
W a n td o u g h sells 1 0 -y e a r b o n d fu tu re s. It w ill still e n c o u n te r b a s is risk a n d it a ls o fa c e s s p e c ific a tio n
d iffe re n c e s in th a t th e re a re im p o r ta n t d iffe re n c e s b e tw e e n 1 0 -y e a r 6 p e r c e n t g o v e rn m e n t b o n d s a n d
7 -y e a r 8 p e r c e n t c o m p a n y d e b e n tu re s . N o t m u ch c a n b e d o n e a b o u t b a s is risk, b u t risks s te m m in g fro m
s p e c ific a tio n d iffe re n c e s c a n b e p a r tly c o n tro lle d b y c a r e fu lly s e le c tin g th e n u m b e r o f fu tu re s c o n tra c ts to
b e s o ld . S u p p o s e th a t th e fu tu re s p ric e fa lls fro m 9 5 . 0 0 to 9 4 . 0 0 , d u e to , say, a 1 p e r c e n t rise in c u rre n t
y ie ld s o n g o v e rn m e n t b o n d s . U s in g E q u a tio n 1 7 . 1 3 , th e c o n tra c t v a lu e w o u ld fa ll b y $ 7 7 9 4 . 5 8 (fro m
$ 1 0 7 7 9 4 . 5 8 to $ 1 0 0 0 0 0 ) . N o w s u p p o s e th a t, s im u lta n e o u s ly , th e re q u ire d y ie ld o n th e d e b e n tu re s
a ls o rise s b y 1 p e r c e n t fro m 8 p e r c e n t p e r a n n u m to 9 p e r c e n t p e r a n n u m . U s in g E q u a tio n 1 7 . 1 3 ,
a n d a s s u m in g th a t th e p r o p o s e d c o u p o n ra te o f 8 p e r c e n t is m a in ta in e d , th e fu n d s ra is e d w o u ld b e :
$200000 1 ______ 1_ $5 0 0 0 0 0 0
0 .0 4 5 [ (1 .0 4 5 )14 (1 .0 4 5 )14
= $ 4 7 4 4 4 2 9 .3 7
T h e re fo re , th e re w o u ld b e a s h o rtfa ll o f $ 2 5 5 5 7 0 . 6 3 . T he n u m b e r o f c o n tra c ts r e q u ire d to h e d g e

th is s h o r tfa ll w o u ld th e re fo re b e :
$ 2 5 5 5 7 0 .6 3
$ 7 7 9 4 .5 8
= 3 3 contracts
T h e re fo re , W a n t d o u g h s h o u ld sell 3 3 fu tu re s c o n tra c ts .
The use o f 1 0 -ye a r b o n d fu tu re s c o n tra c ts f o r a h e d g in g p u rp o s e is illu s tra te d in E x a m p le 1 7 .1 1 , w h ic h

is a c o n tin u a tio n o f E xa m p le 17 .10.
Exam ple 1 7 .1 1
S u p p o s e th a t W a n t d o u g h sells 3 3 b o n d fu tu re s c o n tra c ts a t th e c u r r e n t fu tu re s p r ic e o f 9 5 . 0 0 a n d th a t
w h e n th e d e b e n tu re s a r e issu e d th e fu tu re s p r ic e is 9 4 . 5 8 a n d th e r e q u ire d y ie ld o n th e d e b e n tu re s is
8 .5 0 p e r c e n t p e r a n n u m . T h e p r o b le m is to assess th e e ffe c tiv e n e s s o f th e h e d g e .
SOLUTION
U s in g E q u a tio n 1 7 . 1 3 , th e c h a n g e in th e fu tu re s p r ic e is $ 3 3 6 2 . 1 3 p e r c o n tra c t, g iv in g a p r o fit o f
$1 1 0 9 5 0 fro m 3 3 c o n tra c ts . A g a in , u s in g E q u a tio n 1 7 . 1 3 , if th e r e q u ire d y ie ld is 8 . 5 0 p e r c e n t
p e r a n n u m ( 4 . 2 5 p e r c e n t p e r h a lf-y e a r), th e n 7 - y e a r d e b e n tu re s w ith a fa c e v a lu e o f $ 5 m illio n
o ffe r in g a c o u p o n ra te o f 4 p e r c e n t p e r h a lf-y e a r w ill ra is e $ 4 8 7 0 1 1 4 , th e re b y g iv in g a g ro s s
s h o rtfa ll o f $ 1 2 9 8 8 6 . A fte r ta k in g a c c o u n t o f th e p r o fit o n fu tu re s , th e n e t s h o rtfa ll is $ 1 8 9 3 6 .
T h e re fo re , th e fu tu re s h e d g e h a s e lim in a te d m o re th a n 8 5 p e r c e n t o f th e s h o rtfa ll th a t o th e r w is e
w o u ld h a v e o c c u r r e d . M o s t o f th e o th e r 1 5 p e r c e n t is d u e to th e fa c t th a t, w h ile th e fu tu re s p ric e
changed b y 0 .4 2 (fro m 9 5 . 0 0 to 9 4 . 5 8 ) , th e d e b e n tu re y ie ld c h a n g e d b y 0 . 5 0 p e r c e n t (fro m
8 . 0 0 p e r c e n t to 8 . 5 0 p e r c e n t). A s d is c u s s e d in E x a m p le 1 7 . 1 0 , W a n t d o u g h 's a s s u m p tio n w a s o n e
fo r o n e : if th e d e b e n tu re y ie ld c h a n g e d b y o n e p e r c e n ta g e p o in t th e fu tu re s y ie ld w o u ld a ls o c h a n g e
b y o n e p e rc e n ta g e p o in t. H a d th e r e q u ire d d e b e n tu re y ie ld c h a n g e d to 8 . 4 2 p e r c e n t (in s te a d o f to
8 .5 0 p e r ce n t) th e g ro s s fu n d s s h o rtfa ll w o u ld h a v e b e e n $ 1 0 9 3 9 1 a n d th e re w o u ld th e n h a v e b e e n
a s m a ll n e t g a in o f $ 1 5 5 9 .
The d e ta il o f the se c a lc u la tio n s is less im p o r ta n t th a n th e re c o g n itio n th a t it is n o t c o rre c t s im p ly
to h e d g e th e fa c e v a lu e . H a d th is b e e n d o n e , 5 0 fu tu re s c o n tra c ts w o u ld h a v e b e e n s o ld (b e c a u s e
$ 5 0 0 0 0 0 0 / $ ! 0 0 0 0 0 = 5 0 ) . T his w o u ld h a v e e x p o s e d th e c o m p a n y to n e t losses if y ie ld s h a d fa lle n .

interbank cash rate futures contract
The 3 0 -d a y in te rb a n k cash ra te fu tu re s c o n tra c t has th e fo llo w in g m a jo r fe a tu re s:
a Contract unit. The c o n tra c t u n it is th e average m o n th ly in te rb a n k o v e rn ig h t cash ra te payable o n a

n o tio n a l su m o f $3 0 0 0 0 0 0 . T h e re fo re , a 0 .0 1 p e r c e n t increase (decrease) in th e cash ra te w ill re s u lt
in an in crea sed (decreased) in te re s t p a y m e n t o f $3 0 0 0 0 0 0 x 0 .0 0 0 1 x (3 0 /3 6 5 ) = $ 2 4 .6 5 7 5 . This
a m o u n t is ro u n d e d to $ 2 4 .6 6 .
b Settlement. The c o n tra c t is s e ttle d b y cash. A ll c o n tra c ts s t ill in existe nce a t th e close o f tra d in g
are closed o u t b y th e c le a rin g house. The cash s e ttle m e n t p ric e is e q u a l to 1 0 0 m in u s th e m o n th ly
average o f th e in te rb a n k o v e rn ig h t cash ra te f o r th e c o n tra c t m o n th . The m o n th ly average is fo u n d
b y ta k in g th e su m o f th e d a ily in te rb a n k o v e rn ig h t cash rates, as p u b lis h e d b y th e R eserve B a n k
o f A u s tra lia , a n d d iv id in g b y th e n u m b e r o f days f o r t h a t m o n th .22
c Quotations. The 3 0 -d a y in te r b a n k cash ra te c o n tra c t is q u o te d as 1 0 0 m in u s th e cash s e ttle m e n t ra te
an d has a m in im u m flu c tu a tio n o f 0 .0 0 5 .
d Termination o f trading. T ra d in g ceases a t 4 :3 0 p m o n th e la s t bu sin ess d a y o f th e c o n tra c t m o n th .
S e ttle m e n t da y is th e second bu sin ess d a y a fte r th e la s t tra d in g day.
L ike th e b a n k b ill c o n tra c t, th is c o n tra c t is s u ita b le f o r s p e c u la tio n , h e d g in g a n d a rb itra g e in s h o rt

te rm in te re s t rates.
S p e c u la tio n u s in g th e 3 0 -d a y in te rb a n k cash ra te c o n tra c t is illu s tra te d in E xa m p le 17 .12.
Exam ple 17.
O n 2 6 J u ly 2 0 1 3 , th e c lo s in g p r ic e o f th e A u g u s t 2 0 1 3 3 0 - d a y in te r b a n k c a s h ra te c o n tra c t w a s
9 7 . 4 0 . T h is e q u a te s to a n a v e r a g e o v e r n ig h t c a s h ra te o f 2 . 6 0 p e r c e n t. T h e R e se rve B a n k o f A u s tr a lia
(RBA) h a d a b o a r d m e e tin g s c h e d u le d fo r 6 A u g u s t 2 0 1 3 a n d th e c u r r e n t o v e r n ig h t c a s h ra te w a s
6^
2 . 7 5 p e r c e n t p e r a n n u m . S u p p o s e L a u ra b e lie v e d th a t th e R BA w o u ld m a k e th e d e c is io n to d e c re a s e
continued
22 Note that although the contract s title refers to the Ô-day interbank cash rate1, its price is calculated by reference to the
average cash rate over the whole expiry month of the contract. For example, a contract expiring in August will have a
settlement price determined over the 31 days of August.
4^^
B usiness finance
continued
in te re s t ra te s to 2 . 5 0 p e r c e n t a t its 6 A u g u s t 2 0 1 3 m e e tin g . S he th e re fo re d e c id e d to b u y 2 0 0 3 0 - d a y
in te r b a n k c a s h ra te c o n tra c ts o n 2 6 July.
A t its m e e tin g o n 6 A u g u s t th e R BA d e c re a s e d th e c a s h ra te to 2 . 5 0 p e r c e n t a n d o n th a t d a y th e
c lo s in g p r ic e o f th e A u g u s t 2 0 1 3 3 0 - d a y c a s h ra te c o n tr a c t w a s 9 7 . 4 5 5 .
If L a u ra re v e rs e d o u t h e r p o s itio n o n 6 A u g u s t, h e r to ta l g a in c o u ld b e c a lc u la te d a s fo llo w s :
N o t io n a l p u rc h a s e a t: 2 0 0 x 9 7 . 4 0 x $ 2 4 . 6 6 = $ 4 8 0 3 7 6 . 8 0 (o u tflo w )
N o t io n a l s a le a t: 2 0 0 x 9 7 . 4 5 5 x $ 2 4 . 6 6 = $ 4 8 0 6 4 8 . 0 6 (in flo w )
G a in (n e t in flo w ) : $ 2 7 1 .2 6
A s d e t a ile d o n th e A u s t r a lia n S e c u ritie s E x c h a n g e w e b s ite , th is c o n t r a c t m a y a ls o b e u s e d

to fo r e c a s t c h a n g e s in th e R B A t a r g e t c a s h ra te . F o r e x a m p le , a s n o te d a b o v e , th e R B A h a d
a s c h e d u le d b o a r d m e e tin g o n 6 A u g u s t 2 0 1 3 a n d o n 2 6 J u ly 2 0 1 3 th e c lo s in g p r ic e o f th e
3 0 - d a y c a s h r a te c o n t r a c t w a s 9 7 . 4 0 , e q u a tin g to a y ie ld o f 2 . 6 0 p e r c e n t p e r a n n u m . T h e re fo re ,
th e e x p e c t e d a v e r a g e t a r g e t c a s h r a te f o r th e 3 1 days o f August 2 0 1 3 im p lie d b y th e 3 0 - d a y
I n te r b a n k C a s h R a te F u tu re s C o n t r a c t w a s 2 . 6 0 p e r c e n t p e r a n n u m . S u p p o s e w e a s s u m e th a t
th e R B A d e c is io n w a s e ith e r to le a v e th e t a r g e t c a s h r a te u n c h a n g e d a t 2 . 7 5 p e r c e n t p e r a n n u m
o r d e c r e a s e it to 2 . 5 0 p e r c e n t p e r a n n u m . T h e n a s a t 2 6 J u ly w e k n o w (o r m ig h t a s s u m e ) th e
f o llo w in g in fo r m a t io n :
• T he e x p e c te d a v e r a g e ta r g e t c a s h ra te f o r th e 31 days o f A ugust 2 0 1 3 is 2 . 6 0 p e r c e n t p e r
annum .
• T he ta r g e t c a s h ra te f o r 6 d a y s (fro m 1 A u g u s t to 6 A u g u s t) w ill b e 2 . 7 5 p e r c e n t p e r a n n u m .
• T h e t a r g e t c a s h ra te f o r th e 2 5 d a y s fro m 7 A u g u s t to 3 1 A u g u s t w o u ld b e e ith e r 2 . 5 0 o r 2 . 7 5
per cent per annum .
T he p r o b a b ilit y o f ra te s r e m a in in g u n c h a n g e d (p) m a y th e re fo r e b e c a lc u la te d a s:
( 吾）X 2.75+ [ p x ( 菩 ) X 2 . 75 + ( l - p l x 信 ) X 2.50] =2.60
T h e re fo re , o n 2 6 J u ly 2 0 1 3 th e im p lie d p r o b a b ilit y o f a c h a n g e in th e ta r g e t c a s h ra te (1 — p ) w a s
7 4 p e r c e n t.23,24

Securities Exchange: the share price
LEARNING
OBJECTIVE 6
Understand and
index S&P/ASX 2 0 0 (SPI 200)
explain the features
of the major financial futures contract
futures contracts
traded on the
Australian Securities 17.9.1 | A brief review of Australian Securities Exchange indices
Exchange
The A u s tr a lia n S e c u ritie s E xch a n g e (A S X ) c a lc u la te s a n u m b e r o f in d ic e s t h a t p ro v id e s u m m a ry
m e a su re s o f th e m o v e m e n t o f sha re p ric e s . In a d d itio n to in d u s tr y - s p e c ific in d ic e s , in d ic e s are
c a lc u la te d to p ro v id e m ea sure s o f m a rk e t-w id e m o v e m e n ts . M o v e m e n ts in th e se in d ic e s p ro v id e a
c le a r in d ic a t io n o f m o v e m e n ts in th e g e n e ra l le v e l o f sh a re p ric e s . C o n s e q u e n tly , th e p e rc e n ta g e change
23 It may also be seen that the closing price of the August 2013 30-day cash rate contract of 97.45 on 6 August 2013, after
the RBA Board had met, reflected an expected average target cash rate for the 31 days of August 2013 of 100 - 97.45 or
2.55 per cent. This figure equates to a cash rate of 2.75 per cent for the first 6 days of August and an expected cash rate of
2.50 per cent for the remaining 25 days.
24 The approach of using the 30-day interbank cash rate in the manner suggested by the Australian Securities Exchange
(see www.asx.com.au/prices/targetratetracker.htm) to predict changes in the RBA cash rate can be overly simplistic, as
demonstrated by Easton and Pinder (2007).
4^^
in th e in d e x is lik e ly to a p p ro x im a te c lo s e ly th e p e rc e n ta g e cha ng e in th e v a lu e o f a w e ll-d iv e rs ifie d

p o r tf o lio o f A u s tr a lia n lis te d shares. O n e su ch in d e x is th e A ll O rd in a rie s In d e x . T h is in d e x is ba sed
o n an average o f th e sha re p ric e s o f th e 5 0 0 la rg e s t c o m p a n ie s (as m e a s u re d b y m a rk e t c a p ita lis a tio n )
t h a t are lis te d o n th e A SX. The sh a re p ric e in d e x fu tu re s c o n tra c t t h a t is tra d e d o n th e A S X is based
o n th e S & P /A S X 2 0 0 In d e x (SPI 2 0 0 ). T h is in d e x is ba se d o n an average o f th e sha re p ric e s o f th e 2 0 0
co m p a n ie s lis te d o n th e A S X t h a t ha ve th e la rg e s t m a r k e t c a p ita lis a tio n a n d th e h ig h e s t v o lu m e o f
shares tra d e d .25
1 7.9.2! Specification of the S&P/ASX 200 futures contract

The S & P /A S X 2 0 0 (SPI 2 0 0 ) fu tu re s c o n tra c t has th e fo llo w in g m a jo r fea tu res:
a Contract unit. The c o n tra c t u n it is th e v a lu e o f th e S & P /A S X 2 0 0 In d e x , m u ltip lie d b y $25.

b Settlement. The c o n tra c t is n o t d e live ra b le . A ll c o n tra c ts s t ill in existe nce a t th e close o f tra d in g are
closed o u t b y th e c le a rin g ho use a t th e re le v a n t in d e x v alue , ca lcu la te d to one d e c im a l place. The cash
s e ttle m e n t p ric e is th e ‘spe cia l o p e n in g q u o ta tio n ’ o f th e S & P /A S X 2 0 0 In d e x o n th e la s t tra d in g day.
This special o p e n in g q u o ta tio n is c a lc u la te d u s in g th e f ir s t tra d e d p ric e o f each c o m p o n e n t share o f
th e in d e x o n th e la s t tra d in g day.
c Quotations. The c o n tra c t is q u o te d as th e v a lu e o f th e S & P /A S X 2 0 0 In d e x . I t is q u o te d to one f u ll
in d e x p o in t.
d Termination of trading. T ra d in g ceases a t 12 n o o n o n th e t h ir d T h u rsd a y o f th e c o n tra c t m o n th .
S e ttle m e n t day is th e f ir s t b u sin e ss d a y fo llo w in g th e cessa tion o f tra d in g .
F o r exam ple, th e p ric e o f th e D e ce m b e r (2 0 1 3 ) SPI 2 0 0 c o n tra c t p ro v id e d o n th e A u s tra lia n S e c u ritie s

Exchange w e b s ite a fte r th e close o f tra d in g o n 4 O c to b e r 2 0 1 3 was 5 2 0 4 . T his m ea ns t h a t in d o lla r te rm s
th e c o n tra c t p ric e o n 4 O c to b e r 2 0 1 3 was 5 2 0 4 x $ 2 5 = $ 1 3 0 1 0 0 .
LEARNING
17.9.3! Uses of the S&P/ASX 200 futures contract OBJECTIVE 7
Explain speculation
and hedging
strategies using the
Speculation with SPI 2 0 0 futures major financial futures
Because th e SPI 20 0 fu tu re s p ric e is h ig h ly c o rre la te d w it h th e S & P /A S X 2 0 0 In d e x , i t is a s im p le m a tte r contracts traded on the
Australian Securities
to use SPI 20 0 fu tu re s f o r s p e c u la tiv e p u rp o se s. T his is illu s tra te d in E xa m p le 1 7 .1 3 .
Exchange
Exam ple 17.13

O n 4 O c to b e r 2 0 1 3 th e S & P /A S X 2 0 0 In d e x c lo s e d a t 5 2 0 8 a n d th e D e c e m b e r ( 2 0 1 3 ) SPI 2 0 0
fu tu re s p ric e w a s 5 2 0 4 . S u p p o s e th a t a s p e c u la to r b e lie v e s th a t s h a re p ric e s a r e lik e ly to ris e in th e
fo llo w in g d a y s a n d sh e th e re fo r e d e c id e s to b u y D e c e m b e r SPI 2 0 0 fu tu re s . O n 2 4 O c t o b e r 2 0 1 3 th e
s p e c u la to r fin d s th a t th e S & P /A S X 2 0 0 In d e x h a s ris e n to 5 3 7 3 a n d th e D e c e m b e r SPI 2 0 0 fu tu re s
p r ic e h a s ris e n to 5 3 6 9 . T h e p o s itio n is re v e rs e d o u t b y ta k in g a s o ld p o s itio n a t 5 3 6 9 .
A lth o u g h th e s p e c u la to r ’s g a in h a s a c c r u e d o v e r tim e b y a p p lic a t io n o f th e m a rk -to -m a rk e t ru le , th e
to ta l g a in c a n b e c a lc u la te d a s fo llo w s :
N o tio n a l p u rc h a s e a t: 5 2 0 4 x $ 2 5 = $ 1 3 0 1 0 0 (o u tflo w )
N o tio n a l s a le a t: 5 3 6 9 x $ 2 5 = $ 1 3 4 2 2 5 (in flo w )
G a in (ne t in flo w ) : $ 4125
Hedging with SPI 2 0 0 futures

A lth o u g h s p e c u la tio n is th e m o s t o b v io u s a p p lic a tio n o f SPI 2 0 0 fu tu re s , th e re are also h e d g in g uses.
E xam p le 1 7 .1 4 p ro v id e s a s im p le a p p lic a tio n .26
25 Details of the indices calculated by the Australian Securities Exchange may be obtained from the Australian Securities
Exchange website www.asx.com.au.
26 For a more advanced discussion, see Figlewski and Kon (1982).
4^^
Exam ple 17.
M ic h a e l S a in t m a n a g e s a p o r tf o lio o f A u s tr a lia n s h a re s w ith a c u rre n t m a rk e t v a lu e o f $ 1 5 1 0 7 0 0 0 .

T he p o r t f o lio is to b e s o ld in 4 w e e k s ' tim e . T h e SPI 2 0 0 fu tu re s p r ic e t o d a y is 5 4 2 1 . T he fo llo w in g
tw o p r o b le m s a re re le v a n t:
a) S a in t re q u ire s a s s is ta n c e in d e s ig n in g a n a p p r o p r ia te h e d g e .
b) Later, th e p o r tf o lio is s o ld f o r $ 1 4 4 4 4 5 0 0 a n d th e fu tu re s p o s itio n is re v e rs e d o u t a t a p r ic e o f

5 1 5 9 . S a in t w is h e s to assess th e e ffe c tiv e n e s s o f th e h e d g e .
SOLUTION
P o s s ib le s o lu tio n s to th e se p ro b le m s a r e a s fo llo w s :
a) T he fu tu re s p r ic e a t th e in itia tio n o f th e h e d g e is 5 4 2 1 x $ 2 5 = $ 1 3 5 5 2 5 . To d e s ig n a h e d g e , so m e
a s s u m p tio n s m ust b e m a d e a b o u t th e re la tio n s h ip b e tw e e n c h a n g e s in th e v a lu e o f th e p o r tf o lio
a n d c h a n g e s in th e SPI 2 0 0 fu tu re s p r ic e . F o r e x a m p le , it m ig h t b e a s s u m e d th a t p r o p o r tio n a te
c h a n g e s in th e p o r tf o lio 's v a lu e w o u ld b e m a tc h e d b y p r o p o r tio n a t e c h a n g e s in th e fu tu re s p ric e .
In o th e r w o r d s , in d e s ig n in g th is h e d g e it is a s s u m e d th a t if th e p o r tf o lio 's v a lu e d e c re a s e s b y x p e r
c e n t, th e n so a ls o w ill th e SPI 2 0 0 fu tu re s p r ic e d e c re a s e b y x p e r c e n t. U s in g E q u a tio n 1 7 . 9 , th e
n u m b e r o f fu tu re s c o n tra c ts in d ic a te d is:
f* _ Ns so
- n 'fTo
v a lu e o f s p o t p o s itio n
v a lu e o f o n e fu tu re s c o n tra c t
_ $15107000
=5421 x $25
= - l 1 1 .4 7
%-111
T h a t is, 1 1 1 fu tu re s c o n tra c ts s h o u ld b e s o ld ,
b) T h e e ffe c tiv e n e s s o f th e h e d g e is s u m m a ris e d in T a b le 1 7 . 1 1 .
TABLE 1 7 .1 1 H e d g in g o u t c o m e in E x a m p le 1 7 .1 4
D a te SPI 2 0 0 fu tu re s p ric e SPI 2 0 0 fu tu re s p r ic e fo r P o rtfo lio v a lu e

p e r c o n tra c t (in d e x 111 c o n tra c ts ($ )
fo rm ) ($)
W h e n hedge entered 5421 (sold) 15 043 275 15107000
W h e n hedge lifte d 5159 (bo ug ht) 14316225 14444500
G ain (loss) 727050 (6 6 2 5 0 0 )
T h e re fo re th e h e d g e h a s , in fa c t, re s u lte d in a n e t g a in o f:
$727050 - $662500 = $64550
T h e re a r e t w o re a s o n s w h y th e re s u lt is n o t p re c is e ly z e r o . First, th e n u m b e r o f c o n tra c ts s o ld
w a s 1 1 1 n o t 1 1 1 . 4 7 . H o w e v e r, th is is a m in o r f a c to r in th is e x a m p le . If it h a d b e e n p o s s ib le to sell
1 1 1 . 4 7 c o n tra c ts th e n e t g a in w o u ld in fa c t h a v e b e e n $ 6 7 6 2 8 . 5 0 . S e c o n d , w h ile th e p o r tf o lio v a lu e
d e c re a s e d b y 4 . 3 9 p e r c e n t, th e SPI 2 0 0 fu tu re s p r ic e d e c re a s e d b y 4 . 8 3 p e r c e n t. T h e re fo re , th e loss
o n th e p o r tf o lio w a s m o re th a n o ffs e t b y th e g a in o n th e s o ld fu tu re s c o n tra c ts . T h e re a r e t w o fa c to rs
th a t a re lik e ly to e x p la in th e d iffe re n c e b e tw e e n th e fu tu re s p r ic e fa ll o f 4 . 8 3 p e r c e n t a n d th e p o r tf o lio
fa ll o f 4 . 3 9 p e r c e n t. T h e se a r e b a s is ris k a n d s p e c ific a tio n d iffe re n c e s b e tw e e n th e c o m p o s itio n o f
th e S & P /A S X 2 0 0 In d e x a n d th e c o m p o s itio n o f M ic h a e l S a in t's p o r tf o lio . In c lu d e d in th e la tte r is th e
p o s s ib ility o f d iv id e n d s b e in g r e c e iv e d , w h e r e a s th e S & P /A S X 2 0 0 In d e x d o e s n o t in c lu d e re in v e s te d
d iv id e n d s .
O b v io u s ly , it is f a ir ly c ru d e to a s s u m e th a t th e re w ill b e e q u a l p r o p o r tio n a t e c h a n g e s in th e p o r tfo lio 's

v a lu e a n d th e SPI 2 0 0 fu tu re s p r ic e . A s lig h tly m o re s o p h is tic a te d a p p r o a c h is to a p p ly E q u a tio n 1 7 7 ,
w h ic h g iv e s th e ris k -m in im is in g h e d g e r a tio , h *:
C o v IS ^ ^ )
V a rlM
In th e c a s e o f SPI 2 0 0 fu tu re s , E q u a tio n 1 7 . 7 is m o re r e c o g n is a b le if re w ritte n a s:
C ow(Rp ,R f )
Wqt[Rf)
w h e re Rp = re tu rn s o n th e h e d g e r s p o r tf o lio o f sh a re s
Rp = re tu rn s o n th e SPI 2 0 0 fu tu re s c o n tra c t
A n e s tim a te o f h * is fo u n d b y p e r fo r m in g th e re g re s s io n :
R p t = Q p + P p R p f + fJf 17.14
T he e s tim a te p p is a n e s tim a te o f h * . N o te th a t w h ile p p w ill b e o f th e s a m e o r d e r o f m a g n itu d e
as th e a s s e t 'b e ta s 7 w e d is c u s s e d in C h a p te r 7 , th e h e d g in g b e ta in E q u a tio n 1 7 . 1 4 is a d iffe re n t
c o n c e p t. A h e d g in g b e ta is e s tim a te d b y re g re s s in g p o r tf o lio re tu rn s o n SPI 2 0 0 fu tu re s ; a n a sse t b e ta
is e s tim a te d b y re g re s s in g p o r tf o lio re tu rn s o n th e S & P /A S X 2 0 0 In d e x itse lf.
F in a n c e
BARINGS______________________________________________________
in A C T IO N
A w e ll- d o c u m e n te d c a s e o f e x t r a o r d in a r y s p e c u la tio n is t h a t o f th e 2 4 0 - y e a r - o ld B ritis h b a n k ,
B a rin g s , th a t c o lla p s e d in 1 9 9 5 d u e to th e lo sses in c u r r e d b y th e S in g a p o r e - b a s e d t r a d e r N ic k
L e e s o n .27
N ic k L e e s o n g a in e d a p o w e r f u l r e p u t a t io n w it h in th e b a n k b y a p p a r e n t ly g e n e r a t in g m a s s iv e
p r o fits . H e d id th is b y b u y in g J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t s t h a t w e r e t r a d e d o n th e
S in g a p o r e I n t e r n a t io n a l M o n e t a r y E x c h a n g e (S IM E X ) a n d s im u lt a n e o u s ly s e llin g c o n t r a c t s
w ith id e n t ic a l s p e c if ic a tio n s o n th e O s a k a E x c h a n g e . T h is a r b it r a g e a c t iv it y in v o lv e s little ris k
a n d w o u ld b e e x p e c t e d to g e n e r a t e a n u m b e r o f s m a ll g a in s a n d s m a ll lo s s e s r e s u ltin g fr o m
s lig h t d iff e r e n c e s in th e p r ic e s o f th e c o n t r a c t o n th e t w o e x c h a n g e s . H o w e v e r , L e e s o n w a s
a b le to h id e h is lo s s e s in a s p e c ia l a c c o u n t. A s a r e s u lt, it a p p e a r e d t h a t h e w a s g e n e r a t in g
h u g e p r o fits . F o r e x a m p le , in 1 9 9 4 h e r e p o r t e d p r o fits o f £ 2 8 m illio n b u t h a d h id d e n lo s s e s
o f £ 1 8 0 m illio n .
In e a r ly 1 9 9 5 , L e e s o n e s t a b lis h e d lo n g p o s it io n s in th e J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t .
T h is m e a n t t h a t h e w o u ld p r o f it if th e J a p a n e s e s to c k m a r k e t ro s e . H o w e v e r , o n 1 7 J a n u a r y
1 9 9 5 a n e a r t h q u a k e h it th e J a p a n e s e c it y o f K o b e a n d th e J a p a n e s e s to c k m a r k e t fe ll b y
a p p r o x im a t e ly 1 3 p e r c e n t o v e r th e n e x t 5 w e e k s . L e e s o n t r ie d to r e c o v e r th e r e s u lta n t lo s s e s
b y t a k in g m o r e lo n g p o s it io n s in th e J a p a n e s e s to c k in d e x fu tu re s c o n t r a c t a n d a t o n e p o in t in
m id - F e b r u a r y h e h a d e n t e r e d b o u g h t p o s it io n s t o th e v a lu e o f U S $ 3 b illio n .
O n 1 3 F e b r u a r y 1 9 9 5 , a n in v e s t ig a t io n s o f f ic e r a r r iv e d fr o m L o n d o n c h a r g e d w it h th e ta s k
o f f in d in g o u t w h y th e b a n k w a s b e in g r e q u ir e d to m a k e m a r g in c a lls o n th e s e fu tu r e s c o n t r a c t s
th a t h a d n o w r e a c h e d e x t r a o r d i n a r y a m o u n ts . O n 2 3 F e b r u a r y , h e s p o k e w it h L e e s o n , w h o
f le d S in g a p o r e th e n e x t d a y , le a v in g b e h in d lo s s e s o f a r o u n d U S $ 1 . 4 b illio n .
27 For details of the collapse of Barings Bank, see Chance and Brooks (2010, p. 579), Leeson and Whitley (1996) and Sheedy and
McCracken (1997, pp. 36-41). The movie R o gu e T ra d e r (1998) tells the story of the collapse of Barings Bank.
4^^
B usiness finance
F in a n c e
SOCIETE GENERALE___________________________________________
in A C T IO N
T h e la r g e s t lo ss r e p o r t e d d u e to u n a u th o r is e d t r a d in g w a s r e p o r t e d b y th e F re n c h b a n k S o c ie te
N ew s
G e n e r a le in J a n u a r y 2 0 0 8 . 28
In J a n u a r y 2 0 0 8 , th e F re n c h b a n k S o c ie te G e n e r a le r e p o r t e d lo s s e s o f 4 . 9 b i lli o n e u r o s d u e to
th e a c t iv it ie s o f t r a d e r J e r o m e K e r v ie l. K e r v ie l h a d w o r k e d f o r s e v e r a l y e a r s in th e b a n k 's b a c k
o f f i c e — w h e r e t r a n s a c t io n s a r e p r o c e s s e d a n d c o n t r o lle d — b e f o r e b e in g e m p lo y e d a s a t r a d e r
in e a r ly 2 0 0 5 . H is jo b a s a t r a d e r w a s to h e d g e th e b a n k ’s a c t iv itie s b y t a k in g p o s it io n s in
s h a r e fu tu r e s m a rk e ts t h a t w e r e th e o p p o s it e o f th e b a n k 's e x is tin g p o s itio n s .
H o w e v e r , K e r v ie l a ls o u s e d h is e x p e r ie n c e o f w o r k in g in th e b a n k ’s b a c k o f f ic e to h id e
m a s s iv e s p e c u la t io n t h a t h e u n d e r to o k b y t r a d in g in E u r o p e a n s h a r e m a r k e t fu tu r e s c o n tra c ts .
H e m a d e u n a u th o r is e d t r a d e s to th e v a lu e o f 3 0 b illio n e u r o s in 2 0 0 7 , u n a u th o r is e d t r a d e s t h a t
re s u lte d in a p r o f it o f 1 . 4 b illio n e u r o s b y th e e n d o f th e y e a r .
In a n n o u n c in g th e f r a u d in J a n u a r y 2 0 0 8 , S o c ie te G e n e r a le s ta te d t h a t K e r v ie l h a d
e s t a b lis h e d fu tu re s m a r k e t p o s it io n s w o r t h a p p r o x im a t e ly 5 0 b illio n e u r o s . B y w a y o f
c o m p a r is o n , th e b a n k 's v a lu e w a s e s tim a te d a s a p p r o x im a t e ly 3 5 b i lli o n e u r o s . T h e c o m p a n y
c lo s e d o u t th e p o s it io n s a t a lo s s o f 6 . 3 b illio n e u ro s , r e s u ltin g in a n e t lo s s o f 4 . 9 b illio n e u ro s
a f t e r t a k in g in to a c c o u n t th e 1 . 4 b illio n e u r o p r o f it t h a t K e r v ie l h a d m a d e in 2 0 0 7 .
T h e c o r p o r a t e g o v e r n a n c e fa ilu r e s o f th e B a r in g s c a s e a n d t h a t o f S o c ie te G e n e r a le d is p la y
c o n s id e r a b le s im ila r ity , a n d h ig h lig h t th e n e e d f o r c le a r ris k m a n a g e m e n t c o n t r o ls — c o n t r o ls
t h a t in c lu d e c o m p le te s e p a r a t io n o f th e r e p o r t in g a n d t r a d in g ro le s .
Valuation of financial futures

contracts
In S e c tio n 1 7 .4 w e an alysed som e o f th e d e te rm in a n ts o f fu tu re s price s. T h a t a n a lysis a p p lie s to fu tu re s
c o n tra c ts o n p h y s ic a l c o m m o d itie s a n d to fu tu re s c o n tra c ts o n fin a n c ia l ‘c o m m o d itie s ’. I n th is s e c tio n we
b u ild o n t h a t an alysis, b u t n a rro w o u r focu s to b a n k-a cce p te d b ill fu tu re s c o n tra c ts a n d share p ric e in d e x
fu tu re s c o n tra c ts .
E q u a tio n 17 .1 p ro v id e d a re s tr ic tio n o n th e v a lu a tio n o f a fu tu re s c o n tra c t:
F<S + C
w h e re F = fu tu re s p ric e
S = c u rre n t s p o t p ric e
C = c a rry in g cost
I f th e c o m m o d ity can re a d ily be so ld s h o rt, a n d i f th e o p p o r tu n it y c ost o f in v e s tm e n t is th e o n ly fo r m
o f c a rry in g cost, th e n i t can be s h o w n t h a t E q u a tio n 1 7 .1 s h o u ld h o ld as an e q u a lity :
7.15
17.10.1 | Valuation of bank bill futures contracts

I f i t is assum ed t h a t b a n k b ills can be so ld s h o rt, th e n E q u a tio n 1 7 .1 5 s h o u ld a p p ly to b a n k b ill fu tu re s .29
In th is case i t is u s u a l to express C in te rm s o f th e y ie ld it a p p lic a b le t o th e te r m t o f th e fu tu re s c o n tra c t—
LEARNING t h a t is, th e c a rry in g co st is:
OBJECTIVE 8
Understand the C= Sit
valuation of 90-day
bank-accepted bill
futures contracts and 28 For discussion of the unauthorised trading reported by Societe Generale, see various editions of the A u str a lia n F in a n c ia l
share price index R eview (January 2008 to October 2010).
futures contracts 29 This assumption is not as unreasonable as it may appear. When a bank bill is issued, it is effectively sold at its market price
and it is subsequently repurchased at its face value.
S u b s titu tin g E q u a tio n 1 7 .1 6 in to E q u a tio n 1 7 .1 5 gives:
F = S (l + it)
Im p lic itly , th e p r ic in g o f b a n k b ill fu tu re s was also c o n sid e re d in th e d iscu ssio n o f a rb itra g e in S e ctio n
17 .6.3. This c o n c lu d e d w ith E q u a tio n 17 .12:
1 4- i T
h .T =
1 + it
w here t = th e m a t u r ity d a te o f th e fu tu re s c o n tra c t

it T= th e (fu tu re s ) y ie ld f o r a fu tu re s c o n tra c t, m a tu r in g a t da te t, o n a b ill m a tu r in g a t a la te r d a te T
iT = th e (s p o t) y ie ld o n a b ill m a tu rin g a t d a te T
it = th e (s p o t) y ie ld o n a b ill m a tu rin g a t d a te t
E q u a tio n 1 7 .1 2 is c o n s is te n t w ith E q u a tio n 1 7 .1 7 . I f th e b ill u n d e rly in g th e fu tu re s c o n tra c t has a face
value o f V d o lla rs , th e n b y d e fin itio n :
17.18
1 + h .T
17.19
1 +
V is
The s p o t p ric e S o f a T -day b ill t h a t also has a face v a lu e o f b y d e fin itio n :
■
17.20
1 + /t
F = S (\ + it)
This is th e re s u lt s ta te d in E q u a tio n 17 .17.
A c c o rd in g to th is e q u a tio n th e b a n k b ill fu tu re s p ric e is s im p ly th e s p o t p ric e o f th e re le v a n t b a n k
b ill, a ccu m u la te d a t th e y ie ld a p p lica b le to th e te r m o f th e fu tu re s c o n tra c t. The R e le va n t b a n k b i l i 1 is
not u s u a lly a 9 0 -d a y b a n k b ill. F o r exa m ple, i f a b a n k b ill fu tu re s c o n tra c t m a tu re s in 3 0 days* tim e , th e
re le va n t b a n k b ill c u r r e n tly has a te rm o f 1 2 0 days. H e an ey a n d L a y to n (1 9 9 6 ), u s in g A u s tra lia n d a ta ,
p ro v id e evidence t h a t is c o n s is te n t w ith th e p ro p o s itio n t h a t E q u a tio n 1 7 .1 7 is a re lia b le re p re s e n ta tio n
o f th e re la tio n s h ip b e tw e e n b a n k b ill fu tu re s a n d s p o t prices.
1 7 .1 0 .2 1 Valuation of share price index futures contracts

The v a lu a tio n o f share p ric e in d e x fu tu re s can be a p p ro a ch e d in a s im ila r m a n n e r. T his p ro b le m is s lig h tly
m ore co m p le x because d iv id e n d s are p a id o n m o s t shares in th e in d e x , b u t th e c a lc u la tio n o f th e share p ric e
in d e x excludes d iv id e n d s . A s in th e d is c u s s io n o f b ill fu tu re s , w e c o n tin u e to ig n o re th e m a rk -to -m a rk e t
ru le , an d in s te a d assum e t h a t th e cash flo w s o c c u r o n ly o n D a te 1, th e e x p iry d a te o f th e fu tu re s c o n tra c t.
Suppose th a t o n D ate 0 an in v e s to r b u ys a ll th e shares in th e in d e x a t a to t a l c o st o f S〇 , a n d also b o rro w s a
sum o f m o n e y e q u a l to PV(D)} th e p re s e n t v a lu e o f th e d iv id e n d s t h a t th e shares w ill g e ne rate o n D a te 1.
A ll th e shares in th e in d e x are s u b s e q u e n tly so ld o n D a te 1 a t t h e ir then c u rre n t s p o t va lu e o f Sv O n th e
same date, th e lo a n is re p a id a n d d iv id e n d s o f D are collecte d. P u ttin g th is in ta b u la r fo rm :
TABLE 17.12 Strategy producing a future cash flow of S]

O n D a te 0 O n D a te 1
A c tio n C a s h flo w A c tio n C a s h flo w
Buy in de x - S〇 Sell in de x 4
B orro w PV(D) +PV(D) Repay loan -D

C ollect divide nd s +D
T otal PV(D)-S0 T otal 5a
4^^
B usiness finance
As an a lte rn a tiv e , suppose t h a t o n D a te 0 th e in v e s to r b u ys share p ric e in d e x fu tu re s (p rice F 〇 ) th a t

Fq
m a tu re o n D a te 1 a n d also d e p o s its (le n d s) th e s u m o f -~ — to e a rn in te re s t a t a ra te r. O n D ate 1, th e
fu tu re s c o n tra c t is s e ttle d a n d th e d e p o s it (p lu s in te re s t) is w ith d ra w n . The fu tu re s c o n tra c t is s e ttle d
b y a n o tio n a l sale a t Fv th e fu tu re s p ric e o n D a te 1. H o w e ve r, as D a te 1 is th e e x p iry d a te o f th e fu tu re s
c o n tra c t, convergence b e tw e e n s p o t p rice s a n d fu tu re s p rice s s h o u ld e n sure t h a t F1= S2, th e s p o t p ric e on
D ate 1. The cash flo w fr o m th e fu tu re s c o n tra c t is th e re fo re F-^ - F = S1- F〇
〇 . P u ttin g t h is in ta b u la r fo rm :
TABLE 17.13 Alternative strategy producing a future cash flow of

O n D a te 0 O n D a te 1
A c tio n C a sh f lo w A c tio n C a sh flo w
B uy fu tu re s 0 S ettle fu tu re s S1~ F 0
D e p o sit 厂 0 F 〇 W ith d ra w deposit +F 〇

1 + r 1 + r plus in te re s t
T otal
F 〇
T otal Si
1 + r
The p o in t to n o te a b o u t Tables 1 7 .1 2 a n d 1 7 .1 3 is t h a t b o th in d ic a te a n e t cash in flo w o f d o lla rs

o n D a te 1 . 〇 f course i t is n o t k n o w n w h a t 夕上 w i ll be, b u t i t is k n o w n t h a t b o th ta b le s — t h a t is, b o th
in v e s tm e n ts — w ill gene rate th e sam e fu tu re cash flo w . T h e re fo re , b o th in v e s tm e n ts s h o u ld cost th e same
o n D a te 0:
PV{D)-S0 = - - ^ -
1 + /•
S o lv in g f o r th e fu tu re s p ric e F a n d, since th e y are n o lo n g e r needed, d ro p p in g th e s u b s c rip ts , gives:
F = [S-PV(D)](\-^r) 17.21
E q u a tio n 1 7 .2 1 a n d E q u a tio n 1 7 .1 7 have th e sam e fo rm , exce pt t h a t E q u a tio n 1 7 .2 1 has a s im p le

a d ju s tm e n t t h a t take s in to a cco u n t th e c o m p lic a tio n caused b y d iv id e n d s . E q u a tio n 1 7 .2 1 im p lie s th a t
th e share p ric e in d e x fu tu re s p ric e w ill g e n e ra lly exceed th e c u rre n t in d e x value , b u t m a y n o t do so i f
in te re s t rates are lo w re la tiv e to th e d iv id e n d y ie ld f r o m th e shares t h a t c o m p ris e th e in d e x . C u m m in g s
a n d F rin o (2 0 0 8 ) p ro v id e evide nce f o r th e A u s tra lia n m a rk e t th a t, a fte r a llo w in g f o r ta x a tio n effects,
E q u a tio n 1 7 .2 1 is a re lia b le re p re s e n ta tio n o f th e re la tio n s h ip b e tw e e n share p ric e in d e x fu tu re s p rice s
a n d s p o t share p ric e in d e x values.
VLEARNING
17.11 Forward-rate agreements
F o rw a rd -ra te a g re e m e n ts (F R A s) are p riv a te a g re e m e n ts b e tw e e n tw o p a rtie s . U s u a lly a t le a s t one o f th e
p a rtie s is a b a n k o r o th e r fin a n c ia l in s titu t io n . F R As are n o t fu tu re s c o n tra c ts b u t w e discuss th e m in th is
OBJECTIVE 9 c h a p te r because th e y are o fte n used as an a lte rn a tiv e to in te re s t-ra te fu tu re s c o n tra c ts .
Understand and
explain the uses Lo o se ly sp e a kin g , an FR A w o rk s as fo llo w s . Suppose P a rty A a n d P a rty B e n te r in to a n F R A. This m eans
of forward-rate t h a t if, o n a sp e cifie d fu tu r e da te, in te re s t rates are ôw*, th e n P a rty A m u s t p a y cash to P a rty B— and
agreements th e lo w e r th e in te re s t rates have fa lle n , th e m o re cash A m u s t p a y B. H o w e ve r, th e reve rse also ho ld s. If,
o n th e sp e c ifie d fu tu re date, in te re s t rates are ^ ig h * , th e n B m u s t p a y cash to A — a g ain, th e h ig h e r th e
in te re s t rates have becom e, th e m o re cash B m u s t p a y to A . In e ffe c t, such a c o n tra c t p ro v id e s b o th p a rtie s
w ith a g u a ra n te e d in te re s t ra te in th e fu tu re . Thus, f o r exa m ple, P a rty A m ig h t be a co m p a n y p la n n in g to
b o rro w o n th e e x p iry d a te o f th e FR A. I f in te re s t ra te s ris e b e fo re th e lo a n is m ad e, th e F R A gives A a cash
in flo w t o co m p e n sa te f o r th e h ig h e r in te re s t rate. I f, in s te a d , in te re s t rates fa ll d u r in g th e p e rio d , th e FRA
re q u ire s A to m ake a cash p a y m e n t, b u t t h is is c o m p e n sa te d b y th e lo w e r in te re s t ra te t h a t w ill be charged
o n th e fu n d s b o rro w e d .
W e n o w t u r n to E xa m p le 1 7 .1 5 , w h ic h p ro v id e s a d e ta ile d e x p la n a tio n o f h o w FRAs w o rk .
4^^
Exam ple 17.
C o m p a n y A in te n d s to b o r r o w $1 m illio n in 3 m o n th s 7 tim e . T h is w ill b e r e p a id (w ith in te rest) in a lu m p

sum , 1 8 0 d a y s la te r. R e p a y m e n t w ill th e re fo re o c c u r a p p r o x im a te ly 9 m o n th s fro m n o w . A t p re se n t,
th e in te re st ra te o n a 1 8 0 - d a y lo a n is a b o u t 9 . 4 0 p e r c e n t p e r a n n u m . C o m p a n y A fe a rs th a t in
6
3 m o n th s 7 tim e th is ra te m ig h t h a v e rise n s u b s ta n tia lly . T h e re fo re , C o m p a n y A a p p r o a c h e s B a n k B to
set u p a fo r w a r d - r a te a g re e m e n t (FRA). T he b a n k a g re e s , se ttin g a c o n tra c t ra te o f 9 . 5 0 p e r c e n t p e r
a n n u m . T his m e a n s th a t if, in 3 m o n th s ' tim e w h e n th e FRA e x p ire s , th e 1 8 0 - d a y b a n k b ill ra te e x c e e d s
9 .5 0 p e r c e n t, B a n k B w ill p a y C o m p a n y A e n o u g h c a sh to c o m p e n s a te . In re tu rn , C o m p a n y A ha s
a g re e d th a t if, a t th a t tim e , th e 1 8 0 - d a y b a n k b ill ra te is less th a n 9 . 5 0 p e r c e n t p e r a n n u m , C o m p a n y
A w ill p a y e n o u g h c a s h to B a n k B to c o m p e n s a te . N o te th a t th e c a s h f lo w re p re s e n ts o n ly a difference
in in te re st p a y m e n ts , n o t th e to ta l in te re s t p a y m e n t. F urthe r, n o p a y m e n t o f p r in c ip a l is in v o lv e d .
To s h o w h o w th e c a s h f lo w in a n FRA is c a lc u la te d , a s s u m e th a t w h e n th e FRA e x p ire s th e m a rk e t
in te re s t ra te f o r a te rm o f 1 8 0 d a y s is 1 0 . 2 5 p e r c e n t p e r a n n u m . N o tio n a lly , th e FR A c o m m its
C o m p a n y A to th e f o llo w in g c a s h flo w s .
A t d a te o f FRA e x p ir y :
$1000000
1 + (0 .0 9 5 0 )(1 8 0 /3 6 5 )
$ 9 5 5 2 4 7 . 3 2 = sum b o r r o w e d
1 8 0 d a y s a fte r FRA e x p ir y :
o u tflo w (re p a y m e n t) o f $1 0 0 0 0 0 0
H o w e v e r, a t th e FRA's e x p ir y d a te , th e p re s e n t v a lu e o f th is o u t flo w is o n ly :
$1000000
1 + (0 .1 0 2 5 )(1 8 0 /3 6 5 )
= $951 884.21
S in c e in te re s t ra te s h a v e in c re a s e d , B a n k B w ill h a v e to p a y C o m p a n y A a sum s u ffic ie n t to

c o m p e n s a te C o m p a n y A f o r th e in c re a s e . T he s e ttle m e n t a m o u n t is e q u a l to th e d iffe re n c e b e tw e e n
th e p re s e n t v a lu e o f $1 0 0 0 0 0 0 d is c o u n te d a t th e in te re s t ra te s p e c ifie d in th e FR A o f 9 . 5 0 p e r c e n t
a n d th e p re s e n t v a lu e o f $ 1 0 0 0 0 0 0 d is c o u n te d a t th e c u rre n t m a rk e t in te re s t ra te (see C a r e w 1 9 9 4 ) .
T h a t is:
r . $1000000 $1000000
Settlement am ount = -------------------------------------------------------------------------------
1 + (0 .0 9 5 )(1 8 0 /3 6 5 ) 1 + (0.1025) (1 8 0 /3 6 5 )
= $ 9 5 5 2 4 7 .3 2 - $ 9 5 1 884.21
= $ 3 3 6 3 .1 1
U n d e r th e te rm s o f th e FRA, B a n k B p a y s C o m p a n y A th e sum o f $ 3 3 6 3 . 1 1 .
M o r e g e n e r a lly th e s e ttle m e n t a m o u n t Q is:
Q - _____________ 1
F — 17.22
1 + lit/365) 1 + (rf/3 6 5 )
w h e re F = fa c e v a lu e
/ = th e in te re s t ra te s p e c ifie d in th e FRA
r = c u rre n t m a rk e t in te re s t ra te
t = num ber o f days
T he e ffe c t o f th e FRA is th a t C o m p a n y A is a b le to b o r r o w a t a n e t c o s t o f 9 . 5 0 p e r c e n t p e r a n n u m ,
d e s p ite th e in c re a s e in in te re s t ra te s . H o w e v e r, th e a c tu a l b o r r o w in g b y C o m p a n y A w ill s till ta k e p la c e
a t th e c u rre n t m a rk e t ra te o f 1 0 . 2 5 p e r c e n t. C o m p a n y A c a n b o r r o w $ 9 5 1 8 8 4 . 2 1 fo r 1 8 0 d a y s
a t a n in te re s t ra te o f 1 0 . 2 5 p e r c e n t p e r a n n u m ; a d d in g to th is a m o u n t th e in flo w o f $ 3 3 6 3 . 1 1 fro m
B a n k B, C o m p a n y A w ill h a v e fu n d s o f $ 9 5 5 2 4 7 . 3 2 a v a ila b le . T he r e p a y m e n t r e q u ire d is:
$951 884.21 [1 + (0 .1 0 2 5 )(1 8 0 /3 6 5 )] = $ 1 0 0 0 0 0 0
O f c o u rs e , th is is th e s a m e a s th e a m o u n t r e q u ire d to r e p a y a lo a n o f $ 9 5 5 2 4 7 . 3 2 a t 9 . 5 0 p e r c e n t
p e r a n n u m o v e r 1 8 0 d a y s , a s r e q u ire d b y C o m p a n y A . T h a t is, C o m p a n y A h a s lo c k e d in a n in te re s t
ra te o f 9 . 5 0 p e r c e n t o n its fu tu re b o r r o w in g s .
B usiness finance
F R A s a re a ls o e n t e r e d in t o b e t w e e n b a n k s a n d d e p o s i t o r s . In t h is c a s e , th e b a n k p a y s th e d e p o s it o r
i f in t e r e s t r a t e s d e c r e a s e d u r in g th e life o f th e F R A , a n d th e d e p o s i t o r p a y s th e b a n k i f i n t e r e s t r a t e s
in c r e a s e d u r in g th e life o f th e F R A . H o w e v e r, in m o s t F R A s th e c lie n t is a p r o s p e c t iv e b o r r o w e r se e k in g
p r o t e c tio n a g a i n s t r i s i n g in t e r e s t r a t e s , r a t h e r t h a n a p r o s p e c t iv e d e p o s i t o r s e e k in g p r o t e c tio n a g a in s t
fa llin g in t e r e s t r a t e s . F in a lly , m a n y F R A s a r e a g r e e m e n t s b e tw e e n b a n k s , r a t h e r t h a n a g r e e m e n t s b e tw e e n
c lie n ts a n d b a n k s .
M a n y c o m p a n ie s , p a r tic u la r ly t h o s e t h a t a r e s m a ll o r m e d iu m in s iz e , p r e f e r to u s e a n F R A r a th e r
t h a n a f u t u r e s c o n tr a c t. T h is is la r g e ly b e c a u s e a n F R A c a n b e t a ilo r e d m o r e c lo s e ly t o t h e ir sp e c ific n e e d s
in r e la t io n to a m o u n t, t im in g a n d c h o ic e o f i n t e r e s t ra te . In a d d it io n , F R A s d o n o t n o r m a lly im p o s e th e
s a m e c o m p le x d e p o s i t a n d m a r g in r e q u ir e m e n t s a s e x is t in f u t u r e s c o n t r a c t s .
H o w e v e r, la r g e r c o m p a n ie s , a n d p a r tic u la r ly c o m p a n ie s in th e fin a n c e in d u s tr y , m a y p r e fe r a f u t u r e s
c o n t r a c t b e c a u s e i t o ffe r s th e fle x ib ility o f b e in g a b le to r e v e r s e o u t a t a n y tim e th r o u g h a t r a n s a c t io n o n
LEARNING th e f u t u r e s e x c h a n g e . In d e e d , b a n k s a n d o t h e r fin a n c ia l i n s t i t u t i o n s u s e f u t u r e s c o n t r a c t s to h e d g e th e
OBJECTIVE 10
r is k s th e y c r e a te b y e n t e r in g in t o F R A s w ith th e ir c lie n ts.
Identify the
characteristics and
uses of interest rate
swaps and currency
swaps
17.12
SWAP
an agreement between
two counterparties to
exchange sets of future
17.1 2.1 | W h a t is a swap?
cash flows
A sw ap i s a n a g r e e m e n t b e tw e e n tw o c o u n t e r p a r t ie s to e x c h a n g e s e t s o f fu t u r e c a s h flo w s. Th e tw o m a jo r
INTEREST RATE SWAP f o r m s o f sw a p c o n t r a c t s a r e in terest rate sw aps and currency sw aps.30 In a n i n t e r e s t r a te sw a p , a s e t
agreement between
o f fu t u r e c a s h flo w s c a lc u la te d u s in g fu t u r e flo a t in g i n t e r e s t r a t e s a r e s w a p p e d f o r a s e t o f fu t u r e c a s h
two counterparties
flo w s c a lc u la te d u s i n g a fix e d in t e r e s t ra te . B o th s e t s o f c a s h flo w s a r e in th e s a m e c u rre n c y . A flo a t in g
to exchange interest
payments for a specific in t e r e s t r a t e , w h ic h is a ls o k n o w n a s a v a r ia b le o r a d ju s t a b le i n t e r e s t r a te , is o n e t h a t c h a n g e s a s tim e
period, related to p a s s e s , w h e r e a s a fix e d i n t e r e s t r a te h a s th e s a m e v a lu e t h r o u g h o u t a c o n tr a c t. In a c u r r e n c y sw a p , a s e t o f
an agreed principal fu tu r e c a s h flo w s c a lc u la te d u s in g a n in t e r e s t r a te in o n e c u rre n c y is s w a p p e d f o r a s e t o f fu t u r e c a s h flo w s
amount. The most
c a lc u la te d u s in g a n i n t e r e s t r a t e in a n o t h e r c u rre n c y . In m o s t c u rre n c y s w a p s , lo a n p r in c ip a ls a r e a ls o
common type of interest
e x c h a n g e d . In t h is s e c t io n w e f o c u s o n i n t e r e s t r a te s w a p s ; c u r r e n c y s w a p s a r e d i s c u s s e d in S e c t io n 1 7 .1 3 .
rate swap involves an
exchange of a set of S w a p s a re p o s s ib ly th e m o s t s ig n ific a n t fin a n c ia l in v e n tio n o f th e p a s t 4 0 y e a r s . F r o m a t r a d in g v o lu m e
fixed-interest payments o f n e a r z e r o in 1 9 8 1 , w ith in 1 0 y e a r s th e v o lu m e w a s in th e h u n d r e d s o f b illio n s o f U S d o lla r s an n u ally .
for a set of floating- In J u n e 2 0 1 3 , th e g r o s s m a r k e t v a lu e o f in t e r e s t r a te s w a p s o u t s t a n d in g w a s U S $ 1 3 .6 6 trillio n , w h ile th e
interest payments. All c o r r e s p o n d in g fig u re fo r c u rre n c y s w a p s w a s U S $ 1 .1 3 trillio n (B a n k fo r I n te r n a tio n a l S e t t le m e n ts , T ab le 1 9 ,
payments are in the
same currency
www.bis.org).31 F ig u r e s p r e p a r e d fo r th e A u s tr a lia n F in a n c ia l M a r k e ts A s s o c ia tio n in d ic a te t h a t th e tu r n o v e r
o f sw a p s in th e A u s tr a lia n m a r k e t in 2 0 1 2 - 1 3 w a s $ 1 0 4 8 0 b illio n , o f w h ich $ 7 4 8 1 b illio n , o r 7 1 p e r ce n t,
w a s in t e r e s t r a te sw a p s (A u stra lia n F in a n c ia l M a r k e ts A s s o c ia tio n 2 0 1 3 , www.afma.com.au).
1 7 .1 2 .2 1 Interest rate swaps

S u p p o s e y o u a r e a p p r o a c h e d b y P a r ty A , w h o in v it e s y o u to p a r t ic ip a t e in th e f o llo w in g fin a n c ia l g am e *.
CURRENCY SWAP
P a r ty A o f f e r s to p a y y o u th r e e c a s h flo w s — th e f ir s t w ill b e p a id 1 y e a r f r o m n o w , t h e s e c o n d w ill b e p a id
agreement between
two counterparties 2 y e a r s f r o m n o w a n d th e t h ir d w ill b e p a id 3 y e a r s fr o m n o w . T h e se c a s h flo w s w ill m im ic th e in t e r e s t
to exchange sets of p a y m e n t s t h a t w o u ld b e p a y a b le o n a 3 - y e a r flo a t in g - r a te lo a n o f $ 1 m illio n . S p e c ific a lly :
interest payments for
a specific period, • th e f ir s t c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y t o d a y s 1 - y e a r in t e r b a n k in t e r e s t
related to agreed r a t e 32, w h ic h is 5 .0 p e r c e n t;
principal amounts • th e s e c o n d c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y th e 1 - y e a r in t e r b a n k in t e r e s t
in two different r a te t h a t w ill b e o b s e r v e d 1 y e a r fr o m to d a y ; a n d
currencies. Usually,
there is also an
exchange of loan 30 Terminology varies. Currency swaps are also called ‘cross-currency swaps’ and ‘cross-currency basis swaps’. Other types of
principals at the start swaps include commodity swaps and credit default swaps.
and almost always 31 To give these impressive amounts some context, the gross market value of forward-rate agreements (FRAs) outstanding was
a re-exchange of US$0.17 trillion. Australia’s gross domestic product in 2013 was about US$1.6 trillion. US gross domestic product in 2013
principals at the end was about US$15.7 trillion.
of the agreement 32 An interbank interest rate is the rate applicable to deposits lodged by one bank with another bank. The interbank market is
active and interbank interest rates are determined by market forces.
C hapter seventeen F utures c o n t r a c t s a n d swaps
• th e th ir d c a s h flo w w ill b e c a lc u la te d b y m u ltip ly in g $ 1 m illio n b y th e 1 - y e a r in t e r b a n k i n t e r e s t r a te

t h a t w ill b e o b s e r v e d 2 y e a r s fr o m to d a y .
O f c o u r s e , P a r ty A w a n t s s o m e t h in g f r o m y o u in r e tu r n : y o u a r e r e q u ir e d to m a k e p a y m e n ts to P a rty
A o n th e s a m e fu t u r e d a t e s . Y o u r p a y m e n t s w ill m im ic th e i n t e r e s t p a y m e n t s t h a t w o u ld b e p a y a b le o n a
th re e - y e a r fix e d - ra te lo a n o f $ 1 m illio n . T h a t is , e a c h o f y o u r p a y m e n t s w ill b e $ 1 m illio n m u ltip lie d b y a
fix e d in t e r e s t ra te , s. P a r ty A a s k s y o u : w h a t v a lu e o f s w o u ld in d u c e y o u to p a r t ic ip a t e in t h is g a m e ? The
p r o p o s e d g a m e is illu s t r a t e d in F ig u re 1 7 .2 .
N O TIO N A L PRINCIPAL
(OR N O TIO N A L
am ount ) OF A N
INTEREST RATE SWAP
each gross swap
payment is calculated
by multiplying an
interest rate by the
In F ig u r e 1 7 .2 , b x is t h e 1 - y e a r i n t e r b a n k i n t e r e s t r a t e o b s e r v e d o n d a t e 1 a n d b 2 is th e 1 - y e a r
notional amount.
in t e r b a n k i n t e r e s t r a t e o b s e r v e d o n d a t e 2 . N a tu r a lly , y o u w o u ld lik e t h e f ix e d i n t e r e s t r a t e , s, to The notional amount
b e a s lo w a s p o s s ib l e , w h ile P a r t y A w o u ld lik e s to b e a s h ig h a s p o s s ib l e . S u p p o s e y o u a n d P a r t y A corresponds to the
a g r e e t h a t s w ill b e 5 .1 0 p e r c e n t . T h is g a m e p r o d u c e s t h e s a m e c a s h flo w s a s a 3 - y e a r ‘p la i n v a n il l a ’ o r principal of the loan
<f ix e d - f o r - f lo a t in g , i n t e r e s t r a t e s w a p .33 In t h i s s w a p , y o u a r e c a lle d th e p a y - f ix e d c o u n t e r p a r t y , w h ile interest flows that the
swap mimics. In nearly
P a r ty A is c a lle d th e r e c e iv e - fix e d c o u n t e r p a r t y . O n e a c h o f t h e t h r e e s w a p p a y m e n t d a t e s , a n e t c a s h
all cases, the notional
flo w o c c u r s b e t w e e n th e p a r t i e s . N o t e t h a t th e p r in c i p a l o f t h e l o a n b e i n g m im ic k e d — in t h i s c a s e , amount in an interest
$ 1 m illio n — is n e v e r p a i d a n d h e n c e is r e f e r r e d to a s t h e n o t io n a l p r in c ip a l ( o r n o t io n a l a m o u n t) rate swap is never
o f th e in te r e s t r a te s w a p . T h e s e f e a t u r e s a r e i l l u s t r a t e d in E x a m p l e 1 7 .1 6 . paid
Example 17.
E x a c tly 3 y e a rs a g o , c o u n te r p a r tie s A a n d B e n te re d in to a p la in v a n illa in te re s t ra te s w a p . C o u n te r p a r ty
6
A w a s th e re c e iv e -fix e d c o u n te r p a r ty a n d c o u n te r p a r ty B w a s th e p a y - fix e d c o u n te r p a r ty . T h e n o tio n a l
a m o u n t w a s $1 m illio n . T he s p e c ifie d f lo a t in g ra te w a s th e 1 -y e a r in te r b a n k in te re s t ra te . T he a g r e e d
fix e d s w a p ra te w a s 5 . 1 0 p e r c e n t. T h re e y e a rs a g o , th e 1 -y e a r in te r b a n k in te re s t ra te w a s 5 . 0 0 p e r
c e n t; 2 y e a rs a g o it w a s 5 . 2 5 p e r c e n t; 1 y e a r a g o it w a s 4 . 9 0 p e r c e n t a n d t o d a y it is 4 . 6 0 p e r c e n t.
W h a t n e t c a s h flo w s d id th e s w a p p ro d u c e ?
The n e t c a s h flo w s a r e s h o w n in T a b le 1 7 . 1 4 .
TABLE 17.14 Cash flows in an interest rate swap

Date 1-year inter Floating-rate gro ss Fixed-rate gross N et swap paym ent
bank rate swap paym ent swap paym ent m ade
(°/〇 p-a.) (A owes B) (B ow es A)
Three y ears a g o (D ate 0) 5 .0 0 — — —
Tw o y ears a g o (D ate 1) 5 .2 5 0 .0 5 0 0 x $ l m = 0 .0 5 1 0 x $ l m = $ 1 0 0 0 (B p a id A)
$50000 $51000
c o n tin u e d
33 To keep the game* simple, we have used annual swap payments. In practice, swaps that on initiation have a term of 3 years or
less will generally specify quarterly cash flows, while longer-term swaps will specify half-yearly cash flows.
B usiness finance
Table 17.14 continued

Date l-year inter Floating-rate gross Fixed-rate gross N et swap payment
bank rate swap paym ent swap paym ent m ade
( % p.a.) (A owes B) (B owes A)
O ne y e a r a g o (D ate 2) 4 .9 0 0 .0 5 2 5 x $ l m = 0 .0 5 1 0 x $ l m = $ 1 5 0 0 (A p a id B)
BBSW
$52500 $51000
BBSW is the bank
bill reference rate T o d ay (D ate 3) 4 .6 0 0 .0 4 9 0 x $ l m = $ 2 0 0 0 (B p a id A)
0 .0 5 1 0 x $ l m =
and is the standard
$49000 $51000
benchmark for the
floating-rate cash
flows in short-term A s s h o w n in T a b le 1 7 . 1 4 , w h e n th e fix e d ra te is less th a n th e f lo a t in g ra te , th e g ro s s s w a p p a y m e n t
interest rate swaps in o w e d b y c o u n te r p a r ty A — th e p a y - fix e d c o u n t e r p a r t y — is less th a n th e g ro s s s w a p p a y m e n t o w e d b y
Australia. It is a set of c o u n te r p a r ty B. H e n c e , th e n e t c a s h f lo w is fro m B to A . W h e n th e fix e d ra te is g r e a te r th a n th e flo a tin g
representative market
interest rates for
ra te , th e o p p o s ite o c c u rs : A 's g ro s s s w a p p a y m e n t is g r e a te r th a n B 's, so th e n e t c a s h f lo w is fro m 入
to B. N o te th a t t o d a y 's 1 -y e a r in te r b a n k ra te is n o t re le v a n t.
bank bills and similar
securities, quoted on a
per annum basis using
exact day-counts. E x a m p le 1 7 .1 6 is s lig h tly s im p le r t h a n re a lity . In p ra c tic e , s h o r t - t e r m s w a p s u s u a lly s p e c ify q u a r te r ly
Six BBSW rates are s w a p p a y m e n ts . T y p ically , in A u s tr a lia , th e flo a t in g r a te in a s h o r t - t e r m s w a p is d e fin e d a s th e 3 - m o n th
calculated daily at
BBSW in t e r e s t r a t e 一 u s u a lly r e fe r r e d to a s ‘3 - m o n th B B S W ’ 一 w h ic h is a r e p r e s e n t a t iv e m e a s u r e o f
approximately 10:10
m a r k e t in t e r e s t r a t e s c a lc u la te d e v e r y b u s i n e s s d a y f o r 3 - m o n t h s e c u r itie s g u a r a n t e e d b y m a jo r A u s tr a lia n
am Sydney time for
terms of 1 ,2 , 3, 4, 5 b a n k s . B B S W r a t e s a r e q u o t e d a s a n a n n u a l s im p le i n t e r e s t r a te a n d e x a c t d a y - c o u n ts a r e u s e d . A m o r e
and 6 months r e a listic e x a m p le is p r o v id e d in E x a m p le 1 7 .1 7 .
Example 17.
On 1 A p r il 2 0 1 4 , c o u n te r p a r tie s A a n d B e n te r in to a n in te re s t ra te s w a p . T he n o tio n a l a m o u n t
is $ 1 0 m illio n a n d c a s h flo w s a r e to b e m a d e q u a r t e r ly f o r 1 y e a r. C o u n te r p a r ty A a g re e s to p a y
c o u n te r p a r ty B flo a tin g - r a te p a y m e n ts c a lc u la te d a c c o r d in g to 3 -m o n th B B S W . C o u n te r p a r t y B a g re e s
to p a y c o u n te r p a r ty A fix e d -ra te p a y m e n ts a t 9 . 0 0 p e r c e n t p e r a n n u m . A y e a r la te r th e a g r e e m e n t
h a s e n d e d a n d A 's fin a n c ia l m a n a g e r c a lls f o r a r e p o r t o n th e c a s h flo w s th a t w e r e m a d e in th e s w a p .
O n 1 A p r il 2 0 1 4 , w h e n th e s w a p w a s e n te re d in to , 3 -m o n th B B S W w a s 7 . 6 0 p e r c e n t p e r a n n u m .
S u b s e q u e n tly , o n th e f o llo w in g d a te s , 3 -m o n th B B S W w a s :
• 1 J u ly 2 0 1 4 8 .7 0 per cent
• 1 O c to b e r 2 0 1 4 9 .3 5 per cent
• 1 J a n u a ry 2 0 1 5 9 .2 5 p e r c e n t.
T he r e p o r t c o u ld ta k e th e fo rm s h o w n in T a b le 1 7 . 1 5 . 34
TABLE 17.15 Counterparty A: report on interest rate swap

Date Days in 3-month Floating-rate gross Fixed-rate gro ss swap Sw ap payment
period BBSW swap paym ent paym ent m ade
ended ( % p.a.) (A owes B) (B owes A)
1 A pril 2 0 1 4 — 7 .6 0 — — —
1 J u ly 2 0 1 4 91 8 .7 0 0 .0 7 6 x 9 1 / 3 6 5 x 0 .0 9 x 9 1 / 3 6 5 x $ 3 4 9 0 4 .1 1
$ 1 0 m = $ 1 8 9 4 7 9 .4 5 $ 1 0 m = $ 2 2 4 3 8 3 .5 6 (B p aid A)
1 O c to b e r 2 0 1 4 92 9 .3 5 0 .0 8 7 x 9 2 / 3 6 5 x 0 .0 9 x 9 2 / 3 6 5 x $ 7 5 6 1 .6 5
$ 1 0 m = $ 2 1 9 2 8 7 .6 7 $ 1 0 m = $ 2 2 6 8 4 9 .3 2 (B p aid A)
continued
34 In this example, we have assumed that payments are made on non-business days such as weekends and public holidays
such as 1 January 2015. In practice, this is not the case.
C hapter seventeen Futures c o n t r a c t s a n d swaps
Date Days in 3-m onth Floating-rate gro ss Fixed-rate gro ss swap Sw ap paym ent
period BBSW swap paym ent paym ent m ade
ended ( % p.a.) (A owes B) (B owes A)
i i
1 Ja n u a r y 2 0 1 5 92 9 .2 5 0 .0 9 3 5 x 9 2 / 3 6 5 x 0 .0 9 x 9 2 / 3 6 5 x $ 8 8 2 1 .9 2
$ 1 0 m = $ 2 3 5 6 7 1 .2 4 $ 1 0 m = $ 2 2 6 8 4 9 .3 2 (A p a id B)
1 A pril 2 0 1 5 90 — 0 .0 9 2 5 x 9 0 / 3 6 5 x 0 .0 9 x 9 0 / 3 6 5 x $ 6 1 6 4 .3 8
$ 1 0 m = $ 2 2 8 0 8 2 .1 9 $ 1 0 m = $ 2 2 1 9 1 7 .8 1 (A p a id B)
W h ile E x a m p le s 1 7 .1 6 a n d 1 7 .1 7 s e t o u t th e m e c h a n ic s o f i n t e r e s t r a te s w a p s th e y d o n o t m a k e c le a r
th e m o tiv a t io n s f o r su c h t r a n s a c t io n s . I n t e r e s t r a t e s w a p s m a y b e u s e d f o r th r e e m a in p u r p o s e s :
1 s p e c u la tin g
2 h e d g in g
3 r e d u c in g b o r r o w in g c o s t s .
We n o w d is c u s s e a c h o f t h e s e u s e s . In d o in g s o , w e w ill a s s u m e t h a t th e g r o s s sw a p p a y m e n ts a r e m a d e ,
ev en t h o u g h in p r a c tic e o n ly a n e t s w a p p a y m e n t is m a d e . T h is a s s u m p t i o n w ill m a k e th e d is c u s s io n e a s ie r
to fo llo w b u t in n o w ay a ffe c t s i t s s u b s t a n c e .
Speculating
S u p p o s e t h a t tw o c o m p a n ie s , B N R a n d A A , e n t e r in t o a 4 - y e a r i n t e r e s t r a te s w a p in w h ic h B N R is th e
p a y -fix e d c o u n t e r p a r t y a n d A A is th e r e c e iv e -fix e d c o u n te r p a r ty . Th e n o t io n a l a m o u n t o f th e s w a p is
$ 1 0 0 m illio n a n d sw a p p a y m e n t s a r e m a d e e v e r y 6 m o n t h s . The fix e d s w a p r a te is 3 .0 5 p e r c e n t p e r h a lf-
y e a r a n d th e f lo a t in g sw a p r a t e is 6 - m o n th B B S W p e r h a lf- y e a r .35 Th e sw a p is illu s t r a t e d in F ig u r e 1 7 .3 .
In t h is sw a p , B N R is th e p a y - fix e d c o u n t e r p a r t y a n d h e n c e w ill re c e iv e flo a t in g - r a te sw a p p a y m e n ts . I f

B N R is s p e c u la t in g , th e n B N R m u s t b e p r e d ic tin g t h a t i n t e r e s t r a t e s w ill r is e . I f t h is p r e d ic tio n p r o v e s to
b e c o rre c t, th e n th e flo a t in g r a t e sw a p p a y m e n t s t h a t B N R r e c e iv e s fr o m A A w ill in c r e a s e b u t th e fix ed -
r a te sw a p p a y m e n ts t h a t B N R p a y s to A A w ill n o t in c r e a s e . H en ce , h ig h e r i n t e r e s t r a t e s w o rk in B N R s
fa v o u r. O f c o u r s e , i f B N R s p r e d ic tio n p r o v e s to b e in c o r r e c t, a n d i n t e r e s t r a t e s d e c r e a s e , th e n B N R lo s e s .
A A m a y a lso b e sp e c u la tin g o n th e fu tu r e c o u rse o f in te r e s t ra te s . If th is is th e c a se , A A m u s t b e p re d ic tin g
th a t in te r e s t r a te s w ill fall. I f t h is p re d ic tio n p ro v e s to b e c o rre c t, th e n th e flo a tin g - ra te sw a p p a y m e n ts th a t
AA p a y s to B N R w ill d e c re a se b u t th e fix e d -ra te sw a p p a y m e n ts t h a t A A re ceiv e s fr o m B N R w ill n o t d e c re a se .
H en ce, low er in te r e s t r a te s w o rk in A A s fa v o u r. I f A A s p re d ic tio n p ro v e s to b e in c o rre c t, th e n A A lo se s.
O f c o u r s e , th e p r e d ic tio n s m a d e b y B N R a n d A A c a n n o t b o t h b e c o r r e c t. B u t e a c h c o u n t e r p a r t y h a s
s p e c u la te d in a w ay t h a t is c o n s is t e n t w ith i t s p r e d ic tio n s .
Hedging
S u p p o se th a t C o m p a n y A A is a b a n k a n d it h a s re c e n tly re ceiv e d a su r g e o f $ 1 0 0 m illio n in 4 -y e a r fix e d -ra te
d e p o sits. In te r e st o n th e se d e p o s it s is p a id a t th e fix e d ra te o f 5 .9 0 p e r c e n t p e r a n n u m , p ay a b le h alf-yearly.
T h at is, th e in te r e s t c o s t fo r A A is 2 .9 5 p e r c e n t p e r h alf-y e ar, w h ich r e s u lts in h a lf-y e a rly in te r e s t p a y m e n ts
35 In this example, we follow the usual practice in Australia of specifying the floating rate in a swap without any margin for
credit risk. To simplify the discussion we use the term 'half-year* as if it were always exactly 0.5 of a year. In fact, in the
financial markets, the length of a given half-year depends on when it starts and ends. The number of days in a half-year can
be as low as 181 or as high as 184. Hence, the fraction of a year represented by a given half-year is between 181/365 and
184/365; that is, between 0.498590 and 0.504110.
4^^
B usiness finance
o f 0 .0 2 9 5 x $ 1 0 0 m illio n , w h ich e q u a ls $ 2 9 5 0 0 0 0 . B u t s u p p o s e a ls o t h a t m o s t o f A A s b o r r o w e r s— t h a t is,

p e o p le to w h o m A A h a s le n t m o n e y — h a v e b o rr o w e d fr o m th e b a n k o n a flo a tin g - ra te b a s is . H en ce, A A h a s
fix e d -ra te d e p o s it c o s t s b u t flo a tin g - ra te lo a n re v e n u e s. I f in te r e s t r a te s fall in th e fu tu re , A A w ill b e in tro u b le:
its c o s t o f d e p o s it s is fix e d b u t its re v e n u e fr o m lo a n s w ill d e c lin e in lin e w ith th e fall in th e flo a tin g in te r e s t
rate. W ith th e s a m e c o s t a n d lo w e r re v e n u e s, A A s p r o fita b ility a n d /o r its so lv e n c y w ill b e je o p a r d ise d .
T o h e d g e t h is r is k , A A e n t e r s in t o th e in t e r e s t r a te sw a p i ll u s t r a t e d in F ig u r e 1 7 .3 . The o u tc o m e is
s h o w n in F ig u r e 1 7 .4 .
A s s h o w n in F ig u r e 1 7 .4 , e v e ry h a lf- y e a r A A p a y s i t s l e n d e r s in t e r e s t a t th e fix e d r a t e o f 2 .9 5 p e r ce n t.
It a ls o m a k e s sw a p p a y m e n t s o f 6 - m o n th B B S W p e r h a lf- y e a r to B N R a n d re c e iv e s sw a p p a y m e n t s o f 3 .0 5
p e r c e n t p e r h a lf- y e a r fr o m B N R . H e n c e , A A s h a lf- y e a r ly n e t c a s h o u tflo w is g iv e n b y:
$ 1 0 0 0 0 0 0 0 0 x (2 .9 5 % + 6 - m o n t h B B SW p e r h a l f - y e a r - 3 .0 5 % )
= $ 1 0 0 0 0 0 0 0 0 x (6 - m o n th B B SW p e r h a lf- y e a r - 0 .1 0 % )
L o o k e d a t fr o m A A s v ie w p o in t, th e sw a p c o n v e r t s th e $ 1 0 0 m illio n f r o m a fix e d - r a te lia b ility o n w h ic h

it p a y s 2 .9 5 p e r c e n t p e r h a lf- y e a r to a flo a t in g - r a te lia b ility o n w h ic h it p a y s 6 - m o n t h B B S W p e r h a lf- y e a r
m in u s 0 .1 p e r c e n t p e r h a lf-y e a r.
B y s w itc h in g fr o m fix e d - r a te b o r r o w in g t o flo a t in g - r a te b o r r o w in g , A A r e d u c e s i t s r is k . I f in t e r e s t
r a t e s r is e , i t s c o s t s w ill r is e b u t s o a l s o w ill i t s r e v e n u e s . I f in t e r e s t r a t e s fa ll, i t s r e v e n u e s w ill fa ll b u t s o
a ls o w ill i t s c o s t s . H e n c e , i t s p r o f ita b ilit y a n d liq u id ity w ill n o t su ffe r.
B N R m a y a ls o h a v e e n t e r e d in to t h is sw a p to h e d g e in t e r e s t r a t e r isk . F o r e x a m p le , B N R m a y h a v e a p r e
e x is t in g flo a t in g - r a te lo a n b u t p r e - e x is t in g fix e d - r a te r e v e n u e s . T h is m is m a tc h is risk y . The in t e r e s t r a te
s w a p c o n v e r t s B N R f r o m b e in g a f lo a tin g - r a te b o r r o w e r to b e in g a fix e d - r a te b o rr o w e r, h e n c e e lim in a tin g
th e r is k y m is m a tc h .
Reducing borrow ing costs

In s o m e c ir c u m s t a n c e s , a n i n t e r e s t r a t e s w a p c a n r e d u c e th e b o r r o w in g c o s t s o f b o t h p a r t i e s to th e sw a p .
T o s e e t h is , s u p p o s e t h a t b o t h B N R a n d A A h a v e p r e - e x is t in g d e b t s . A s in th e p r e v io u s c a s e , A A is a b a n k
a n d h a s a fix e d - r a te lia b ility to p a y $ 2 9 5 0 0 0 0 e v e r y 6 m o n t h s o n d e p o s i t s o f $ 1 0 0 m illio n . B N R w ish e s
to b o r r o w o n a fix e d - ra te b a s i s b u t d o e s n o t h a v e a d e b t r a t i n g fr o m a n y o f th e d e b t - r a t in g a g e n c ie s .36
W ith o u t a d e b t r a t in g , B N R f in d s i t im p o s s ib le o r e x p e n s iv e to is s u e i t s o w n fix e d - r a te d e b t s e c u r itie s .
H o w e v e r, B N R is a b le to b o r r o w $ 1 0 0 m illio n f r o m i t s b a n k o n a flo a tin g - r a te b a s i s . S p e c ific a lly , th e lo a n
r e q u ir e s B N R to m a k e h a lf-y e a rly in t e r e s t p a y m e n t s f o r 4 y e a r s a t 6 - m o n t h B B S W p e r h a lf- y e a r p lu s a
b a s is p o in t c r e d it- r is k m a r g in o f 0 .2 5 p e r c e n t (o r 2 5 b a s is p o in t s ) e v e r y 6 m o n t h s .37
0.01 per cent, often B N R a n d A A e n t e r in t o t h e i n t e r e s t r a t e s w a p i l l u s t r a t e d in F ig u r e 1 7 .3 . T h e o u t c o m e is i ll u s t r a t e d
abbreviated to 1 bp in F ig u r e 1 7 .5 .
36 The major agencies are Standard & Poors, Moody s and Fitch. For further details, see Section 4.7.
37 Typically, interest rates are quoted on an annual basis. In practice, the interest rate on BNRs loan would be described as being
6-month BBSW plus a margin of 50 basis points per annum, with interest payable half-yearly. One basis point is 0.01 per cent
per annum. On a half-yearly basis, this rate is 6-month BBSW per half-year plus 25 basis points per half-year.
The sw a p r e q u ir e s th e fo llo w in g g r o s s sw a p p a y m e n t s e v e ry s ix m o n t h s :
• A A p a y s B N R th e s u m o f $ 1 0 0 m illio n x 6 - m o n t h B B S W p e r h a lf- y e a r ; a n d
• B N R p a y s A A th e s u m o f $ 1 0 0 m illio n x 3 .0 5 p e r c e n t, w h ic h e q u a ls $ 3 0 5 0 0 0 0 .
A s sh o w n in F ig u r e 1 7 .5 , e v e r y h a lf- y e a r B N R p a y s i t s le n d e r i n t e r e s t a t th e f lo a t in g r a te o f 6 - m o n th
B B SW p e r h a lf- y e a r + 0 .2 5 p e r c e n t. I t a ls o m a k e s sw a p p a y m e n t s o f 3 .0 5 p e r c e n t to A A a n d re c e iv e s sw a p
p a y m e n ts o f 6 - m o n th B B SW p e r h a lf- y e a r f r o m A A . H e n c e , B N R s h a lf- y e a r ly n e t c a s h o u tflo w is 3 .3 0 p e r
c e n t o f $ 1 0 0 m illio n , o r $ 3 3 0 0 0 0 0 , c o m p r is e d a s fo llo w s:
$ 1 0 0 0 0 0 0 0 0 x [ (6 - m o n th B B SW p e r h a lf - y e a r + 0 .2 5 % ) + 3 .0 5 % - 6 - m o n t h B B SW p e r h a lf-y e a r]
= $ 1 0 0 0 0 0 0 0 0 x 3 .3 0 %
= $3 3 0 0 0 00
B y e n te r in g in to t h is i n t e r e s t r a te sw a p , B N R h a s in e ffe c t s w itc h e d f r o m b e in g a flo a t in g - r a te b o r r o w e r

p a y in g 6 - m o n th B B SW p e r h a lf- y e a r + 0 .2 5 p e r c e n t p e r h a lf- y e a r to a fix e d - r a te b o r r o w e r p a y in g 3 .3 0 p e r
c e n t p e r h a lf-y e a r.
A s s h o w n in o u r d i s c u s s i o n o f h e d g in g , fr o m A A s v ie w p o in t th e sw a p c o n v e r t s th e $ 1 0 0 m illio n fr o m
a fix e d -ra te lia b ility to a flo a t in g - r a te lia b ility . I t s n e t c o s t is 6 - m o n th B B S W p e r h a lf- y e a r m in u s 0 .1 0 p e r
c e n t p e r h a lf-y e a r.
T o ill u s t r a t e h o w t h i s i n t e r e s t r a t e s w a p c o u ld r e d u c e t h e b o r r o w in g c o s t s o f b o t h c o m p a n ie s ,
s u p p o s e t h a t , b e f o r e e n t e r i n g in t o th e s w a p , B N R c o u ld h a v e b o r r o w e d a t a fix e d i n t e r e s t r a t e o f
3 .3 2 5 p e r c e n t p e r h a lf- y e a r , w h ile A A c o u ld h a v e b o r r o w e d a t a f l o a t in g i n t e r e s t r a t e o f 6 - m o n t h B B S W
p e r h a lf- y e a r . B u t , a s w e s h o w e d a b o v e , t h e p o s t - s w a p b o r r o w in g c o s t s w e re a fix e d r a t e o f 3 .3 0 p e r
c e n t p e r h a lf- y e a r f o r B N R a n d a f l o a t in g r a t e o f 6 - m o n t h B B S W p e r h a lf - y e a r m i n u s 0 .1 p e r c e n t
p e r h a lf- y e a r f o r A A . T h u s, t h e s w a p h a s r e d u c e d B N R s f ix e d - r a t e b o r r o w in g c o s t b y 0 .0 2 5 p e r c e n t p e r
h a lf- y e a r a n d r e d u c e d A A s f l o a t i n g r a t e b o r r o w i n g c o s t b y 0 . 1 0 0 p e r c e n t p e r h a lf- y e a r . T h e s i t u a t i o n
is s u m m a r is e d in T a b le 1 7 .1 6 .
TABLE 17.16 Pre-swap and post-swap interest rates (per half-year) faced by
companies BNR and A A
P re -s w a p
F ix e d in te r e s t ra te p e r h a lf-y e a r F lo a tin g in te r e s t ra te p e r h alf-y ear
C om p an y B N R 3 .3 2 5 % 6 -m o n th BB SW p e r h alf-y e ar + 0 .2 5 0 %
C om p an y AA 2 .9 5 0 % 6 -m o n th BB SW p e r h alf-y ear
D ifferen ce 0 .3 7 5 % 0 .2 5 0 %
continued
B usiness finance
F ix e d in te r e s t rate F lo a tin g in te r e s t rate
C o m p an y B N R 3 .3 0 0 %
C o m p an y AA 6 -m o n th BB SW p e r h alf-y e ar - 0 .1 0 0 %
C o st sa v in g 3 .3 2 5 % - 3 .3 0 0 % = 0 .0 2 5 % 6 -m o n th BB SW p e r h alf-y e ar - (6 -m o n th
BB SW p e r h alf-y e ar - 0 .1 0 0 % ) = 0 .1 0 0 %
A s s h o w n in T a b le 1 7 .1 6 , b o t h p a r t i e s a c h ie v e lo w e r b o r r o w i n g c o s t s . B N R s p r e f e r e n c e is to b o r r o w
a t a fix e d i n t e r e s t r a t e . I f i t d o e s s o b y g o i n g d ir e c t ly t o t h e f ix e d - r a t e l o a n m a r k e t th e c o s t w ill b e 3 .3 2 5
p e r c e n t p e r h a lf- y e a r . B u t i f i t d o e s s o in d ir e c tly , b y f i r s t b o r r o w in g a t a f l o a t in g i n t e r e s t r a t e a n d t h e n
e n t e r i n g in t o t h e i n t e r e s t r a t e s w a p , i t s c o s t w ill b e 3 .3 0 0 p e r c e n t p e r h a lf- y e a r . B N R t h e r e f o r e s a v e s
0 .0 2 5 p e r c e n t p e r h a lf- y e a r . S im ila r ly , A A r e d u c e s i t s f l o a t in g - r a t e c o s t f r o m 6 - m o n t h B B S W p e r h a lf-
y e a r i f it g o e s t h e d ir e c t r o u t e , o r t o 6 - m o n t h B B S W p e r h a lf - y e a r - 0 . 1 0 0 p e r c e n t p e r h a lf - y e a r b y
g o i n g t h e in d ir e c t r o u t e . A A t h e r e f o r e s a v e s 0 .1 0 0 p e r c e n t p e r h a lf - y e a r . T h e t o t a l c o s t s a v in g a c h ie v e d
b y t h e t w o p a r t i e s i s 0 .0 2 5 + 0 .1 0 0 = 0 .1 2 5 p e r c e n t p e r h a lf- y e a r .
W o u ld B N R g o to all t h a t e f f o r t to sa v e a m e r e 0 .0 2 5 p e r c e n t p e r h a lf- y e a r ? Y es. T h e lo a n p r in c ip a l is
$ 1 0 0 m illio n , s o 0 .0 2 5 p e r c e n t p e r h a lf-y e a r c o r r e s p o n d s to $ 2 5 0 0 0 p e r h a lf-y e a r. I g n o r in g d is c o u n tin g ,
o v e r 4 y e a r s th is is a s a v in g o f $ 2 0 0 0 0 0 . E v e n a la r g e c o m p a n y w ill n o t w a n t to fo r g o a s a v in g o f $ 2 0 0 0 0 0 .
In a d d itio n , th e e f f o r t re q u ir e d is n o t v e r y g r e a t. F o r m a n y la r g e c o m p a n ie s , e n t e r in g in t o a n in t e r e s t ra te
sw a p is a v e r y s t r a ig h t f o r w a r d tr a n s a c t io n . In t e r e s t r a te s w a p s a r e s t a n d a r d is e d c o n tr a c ts a n d a r e fr e q u e n tly
t r a d e d b e tw e e n b a n k s a n d a ls o b e tw e e n b a n k s a n d la r g e c o m p a n ie s . L iq u id ity is h ig h a n d t r a n s a c t io n c o s t s
a re low . A A w ill a ls o m a k e th e e f f o r t b e c a u s e i t s c o s t s a v in g s a re e v e n g r e a t e r th a n t h o s e a v a ila b le to B N R .
A s s h o w n in T a b le 1 7 .1 6 , th e f ix e d - r a te d iffe r e n c e b e t w e e n th e c o m p a n ie s i s 0 .3 7 5 p e r c e n t p e r h a lf-
y e a r, w h ile th e f lo a t in g - r a te d iffe r e n c e is 0 .2 5 0 p e r c e n t p e r h a lf- y e a r . It i s n o a c c id e n t t h a t th e d iffe r e n c e
in t h e s e d if f e r e n c e s — g iv e n b y 0 .3 7 5 m in u s 0 . 2 5 0 — i s e q u a l to th e t o t a l c o s t s a v in g s o f 0 .1 2 5 p e r c e n t
p e r h a lf- y e a r . I t c a n b e s h o w n t h a t i t is a lw a y s th e c a s e . T o s e e t h i s , im a g in e t h a t t h e f ix e d sw a p p a y m e n ts
w e re s e t a t 2 .9 5 p e r c e n t p e r h a lf - y e a r (f o r B N R p a y in g A A ) a n d th e f l o a t in g s w a p p a y m e n t s w e re s e t a t
6 - m o n t h B B S W p e r h a lf- y e a r + 0 .2 5 p e r c e n t ( f o r A A p a y in g B N R ). T h e s e s w a p p a y m e n t s a r e e q u a l to
th e tw o c o u n t e r p a r t ie s * b o r r o w in g r a t e s , t h u s r e s u lt i n g in a s t r a i g h t s w a p o f d e b t s . T h e r e fo re , a f t e r th e
s w a p , B N R w o u ld p a y a fix e d r a t e o f 2 .9 5 0 p e r c e n t p e r h a lf- y e a r w h ile A A w o u ld p a y a f l o a t in g r a t e o f
6 - m o n t h B B S W p e r h a lf- y e a r + 0 .2 5 0 p e r c e n t p e r h a lf- y e a r . T h is o u t c o m e is a s a v in g o f 0 .3 7 5 p e r c e n t
p e r h a lf - y e a r fo r B N R b u t a n a d d it i o n a l c o st o f 0 .2 5 0 p e r c e n t p e r h a lf - y e a r f o r A A . T h e t o t a l h a lf- y e a r ly
s a v in g s a v a ila b le a r e t h e r e f o r e 0 .3 7 5 p e r c e n t m in u s 0 .2 5 0 p e r c e n t, w h ic h e q u a ls 0 .1 2 5 p e r c e n t.
O f c o u r s e A A w o u ld n o t a g r e e to th e s e sw a p p a y m e n ts b u t th e c a lc u la tio n s s h o w t h a t a t o t a l sa v in g o f
0 .1 2 5 p e r c e n t is a c h ie v a b le . Th e o n ly t h in g w r o n g w ith th e s t r a ig h t sw a p is t h a t th e d iv isio n o f th is sa v in g
b e tw e e n th e tw o c o u n t e r p a r t ie s is u n e q u a l; in fa c t, it is s o u n e q u a l th a t A A w o u ld lo se . T o m a k e th e sw a p
a ttr a c tiv e to b o t h c o u n t e r p a r t ie s r e q u ir e s t h a t m o r e o f th e t o t a l s a v in g o f 0 .1 2 5 p e r c e n t p e r h a lf-y e a r flo w s
to AA. In th is p a r tic u la r c a s e , th e so lu tio n a d o p t e d is t o s e t B N R s sw a p p a y m e n ts e q u a l to 3 .0 5 0 p e r c e n t
p e r h a lf- y e a r a n d to s e t A A s sw a p p a y m e n ts e q u a l to 6 - m o n th B B SW p e r h a lf-y e a r. W h a t m a t t e r s h e re is th e
n e t sw a p p a y m e n t. F o r e x a m p le , th e s a m e r e s u lt c o u ld b e a c h ie v e d b y a d d in g , say , 1 p e r c e n t to b o t h sw a p
p a y m e n ts , s o th a t B N R s sw a p p a y m e n t is e q u a l to 4 .0 5 0 p e r c e n t p e r h a lf-y e a r a n d A A s sw a p p a y m e n t is
e q u a l t o 6 - m o n th B B SW p e r h a lf-y e a r + 1 p e r c e n t p e r h a lf-y e a r. Th e e x t r a 1 p e r c e n t a d d e d to B N R s sw a p
p a y m e n t is s im p ly ‘h a n d e d b a c k ’ to B N R b y th e e x t r a 1 p e r c e n t a d d e d to AA’s sw a p p a y m e n t.
In p r a c tic e , i t i s s o m e t i m e s th e c a s e t h a t s t r o n g e r b o r r o w e r s lik e A A h a v e a g r e a t e r c o s t a d v a n t a g e o v e r
w e a k e r b o r r o w e r s lik e B N R in fix e d - r a te b o r r o w in g t h a n in f lo a t in g - r a te b o r r o w in g . In t h e s e c a s e s , th e re
w ill b e a p o s it iv e d iffe r e n c e - in - d iffe r e n c e s a n d th e r e fo r e th e r e i s s c o p e f o r a c h ie v in g c o s t s a v in g s f o r b o th
c o u n t e r p a r t ie s t h r o u g h th e m e c h a n is m o f a n a p p r o p r ia te ly d e s ig n e d in t e r e s t r a te s w a p . In s o m e c a s e s ,
w e a k e r b o r r o w e r s m a y fin d t h a t th e y c a n o b t a in flo a t in g - r a te fin a n c e b u t n o t fix e d - r a te fin a n c e . F o r th e s e
c o m p a n ie s , fix e d - r a te f u n d in g is a c h ie v a b le o n ly b y b o r r o w in g a t a f lo a t in g r a te a n d th e n u s i n g a n in t e r e s t
r a te sw a p to sw itc h to a fix e d r a te .
T h is e x p la n a t io n is b a s e d o n th e a r g u m e n t t h a t w h ile th e s t r o n g e r c o u n t e r p a r t y h a s a n a b so lu te c o s t
a d v a n t a g e in b o t h f o r m s o f b o r r o w in g , it is lik e ly t o h a v e a c o m p a rativ e a d v a n t a g e in fix e d - r a te b o rr o w in g .
The t o t a l c o s t is th e r e fo r e m in im is e d b y th e s t r o n g e r c o u n t e r p a r t y in itia lly b o r r o w in g a t a fix e d in t e r e s t

ra te , w h ile th e w e a k e r c o u n t e r p a r t y in itia lly b o r r o w s a t a flo a t in g i n t e r e s t r a te . Th e sw a p p a y m e n ts a re
c h o se n to e n s u r e t h a t b o t h c o u n t e r p a r t ie s h a v e a p o s it iv e s h a r e o f th e t o t a l c o s t s a v in g a v a ila b le .38
A lth o u g h m a n y o f th e e a r ly in t e r e s t r a te s w a p s w e re d e s ig n e d in t h is w ay, it w o u ld b e u n u s u a l t o d a y to
fin d tw o p a r t ie s lin k e d in t h is w a y to a c h ie v e s im u lt a n e o u s s a v in g s fo r b o t h p a r t i e s . S w a p s n o w a r e u s u a lly
in te r m e d ia te d . T h a t is , in s t e a d o f B N R a n d A A b e in g d ire c tly lin k e d b y a s w a p , B N R w o u ld e n t e r in to a
sw a p w ith a b a n k , w h ile A A w o u ld a ls o e n t e r in to a sw a p w ith a b a n k . A n a n a lo g y m a y h e lp . B a n k s b o r r o w
fro m th e ir d e p o s i t o r s a n d le n d to t h e ir b o r r o w e r s . B u t a b a n k d o e s n o t m a t c h a n y p a r tic u la r b o r r o w e r
w ith a n y p a r tic u la r d e p o s it o r . F o r e x a m p le , a b a n k n e v e r s a y s to a p o t e n t ia l d e p o s it o r , b e f o r e w e a c c e p t
y o u r d e p o s it w e w ill f ir s t c h e c k t h a t th e r e is a m a t c h in g p o t e n t i a l b o rr o w e r*. N e it h e r d o e s a b a n k e v e r s a y
to a p o t e n tia l b o rr o w e r, ‘b e fo r e w e a p p r o v e y o u r lo a n w e w ill f ir s t c h e c k t h a t th e r e i s a m a t c h in g p o t e n tia l
d e p o sito r*. In s te a d , a b a n k k e e p s a b a la n c e b e tw e e n i t s to ta l d e p o s i t s a n d i t s to ta l lo a n s . S im ila rly , b a n k s
p a r tic ip a t in g in th e sw a p m a r k e t a t t e m p t to b a la n c e t h e ir t o t a l p a id s w a p p o s i t io n s (th e ir c a s h o u tflo w s)
a n d th e ir t o t a l received sw a p p o s i t io n s (th e ir c a s h in flo w s ). H e n c e , in th e sw a p m a r k e t, m o s t a c tiv e
p a r t ic ip a n t s w ill e n t e r in t o a s w a p w it h o u t h a v in g a p a r tic u la r o f f s e t t i n g lo a n in m in d .
In A u s tr a lia , m a n y i s s u e s o f d e b e n t u r e s a n d c o r p o r a t e b o n d s tr a d e in m a r k e t s c h a r a c t e r is e d b y lo w
liq u id ity . H en ce , i f a b o r r o w e r w is h e s to r e v e r s e i t s c o m m it m e n t , it w ill fin d it d iffic u lt a n d / o r e x p e n s iv e
to b u y b a c k i t s b o n d s . In c o n t r a s t , th e sw a p m a r k e t o f f e r s a h ig h le v e l o f liq u id ity . A s a r e s u lt , a b o r r o w e r
c a n e a s ily r e v e r s e i t s c o m m it m e n t b y e n t e r in g in t o a sw a p . A f u r t h e r p o s s ib l e b e n e fit o f h a v in g a sw a p
m a r k e t r e la te s to c r e d it a s s e s s m e n t . B e fo r e a b a n k m a k e s a lo a n , it a s s e s s e s th e c r e d it - w o r t h in e s s o f th e
p o t e n tia l b o rr o w e r. If, s u b s e q u e n t ly , th e b o r r o w e r u s e s a n in t e r e s t r a te sw a p to c o n v e r t t h is lo a n fr o m
(sa y ) a flo a tin g - r a te b a s i s to a fix e d - r a te b a s i s , th e in itia l f lo a tin g - r a te lo a n r e m a in s in fo rc e . T y p ically ,
th e o r ig in a l le n d e r is a b a n k . T h u s, in t e r e s t r a te s w a p s a llo w th e i m p o r t a n t t a s k o f c r e d it a s s e s s m e n t to
re m a in la rg e ly in th e h a n d s o f th e b a n k s , w h ic h a r e u s u a lly s e e n a s h a v in g m o r e e x p e r ie n c e a n d b e t t e r
a c c e ss to in f o r m a t io n th a n m a n y o t h e r p o t e n t i a l le n d e r s . It a ls o m e a n s t h a t b o r r o w e r s c a n o b t a in fix ed -
ra te fu n d in g w ith o u t in c u r r in g th e le g a l a n d a d m in is t r a t iv e c o s t s o f i s s u i n g d e b e n t u r e s o r c o r p o r a t e
b o n d s . T h e se c o s t s c a n b e s u b s t a n t i a l .
N o t all in t e r e s t r a te s w a p s a r e p la in v a n illa lik e th e o n e d e s c r ib e d a b o v e . T h ere a r e m a n y m o r e
sp e c ia lis e d t y p e s o f i n t e r e s t r a t e s w a p s . F o r e x a m p le , o n e v a r ia t io n is th e f o r w a r d - s t a r t i n g s w a p , w h ic h is
a s t a n d a r d sw a p w ith a d e f e r r e d s t a r t d a te . A n o t h e r is th e k n o c k o u t s w a p , in w h ic h th e sw a p t e r m in a t e s
if a sp e c ifie d e v e n t o c c u r s, s u c h a s th e f lo a t in g r a te r i s i n g a b o v e a c e r ta in lev e l.
In 2 0 0 9 , in r e s p o n s e t o th e g lo b a l fin a n c ia l c r is is , l e a d e r s o f th e G 2 0 c o u n t r ie s 39 c o m m it te d to th e
p r o p o s a l t h a t t r a n s a c t i o n s in s t a n d a r d is e d o v e r - th e - c o u n te r d e r iv a t iv e s , in c lu d in g s w a p s , s h o u ld b e
c e n tra lly c le a r e d th r o u g h c le a r in g h o u s e s , k n o w n a s c e n tr a l c o u n t e r p a r t ie s , o r C C P s, r a t h e r t h a n s e t t l e d
b e tw e e n e a c h p a ir o f c o u n t e r p a r t ie s t o a c o n tr a c t. S u c h a p r o c e s s r e d u c e s c r e d it r is k a n d s im p lifie s th e
t a s k o f c r e d it a s s e s s m e n t . T h e A u s tr a lia n G o v e r n m e n t h a s a u t h o r i s e d th e A S X a n d L C H .C le a r n e t to
e s t a b lis h c le a r in g h o u s e s . L C H .C le a r n e t is a m u ltin a tio n a l c le a r in g h o u s e w h ic h is m a jo r it y o w n e d b y th e
L o n d o n S to c k E x c h a n g e G r o u p .
17.13 Currency swaps

m
C u rre n c y s w a p s fa ll in to s e v e r a l c a t e g o r ie s . In th e in t e r b a n k m a r k e t, th e m o s t c o m m o n f o r m o f c u r r e n c y
sw a p is a f lo a t in g - fo r - flo a t in g c u rre n c y sw a p , w h ic h is a ls o k n o w n a s a c r o s s - c u r r e n c y b a s i s s w a p . In LEARNING
OBJECTIVE 10
th is ty p e o f s w a p , b o t h s e t s o f s w a p p a y m e n t s a r e c a lc u la te d u s in g flo a t in g i n t e r e s t r a t e s b u t th e sw a p
Identify the
p a y m e n ts a re in d iffe r e n t c u r r e n c ie s. U su a lly , th e r e is a ls o a n e x c h a n g e o f p r in c ip a ls a t th e s t a r t o f th e characteristics and
a g r e e m e n t a n d a re - e x c h a n g e o f p r in c ip a ls a t th e e n d o f th e a g r e e m e n t . H e n c e , u n lik e th e n o t io n a l uses of interest rate
a m o u n t o f a n i n t e r e s t r a te s w a p , th e c o r r e s p o n d in g a m o u n t s in a c u r r e n c y sw a p a r e n o t u s u a lly n o tio n a l: swaps and currency
th e y a re p a id a t th e s t a r t a n d e n d o f th e sw a p . swaps
38 The comparative advantage explanation has been criticised because it relies on the fixed- and floating-rate debt markets
being segmented, so that fixed and floating interest rates are determined independently of each other. If these markets are
unified, rather than segmented, then other explanations are required. While many of the swaps entered into in the early
1980s achieved large savings for both counterparties, as competition increased, this reason for using swaps lost much of its
strength. For a detailed discussion, see Smith, Smithson and Wilford (1990, Chapter 10).
39 The G20 consists of 20 countries that together account for about 85 per cent of world gross domestic product. Members
include the US, China, Japan, France, Germany, Italy, the UK and Australia.
4^^
A lth o u g h flo a tin g - fo r - flo a tin g c u rre n c y s w a p s a r e th e m o s t c o m m o n , th e m e c h a n ic s o f c u rre n c y sw a p s
a re e a s ie r to e x p la in b y c o n s id e r in g a fix e d -fo r-fix e d c u rre n c y sw a p , in w h ic h a fix e d - ra te c o m m itm e n t in
o n e c u rre n c y is e x c h a n g e d fo r a fix e d - ra te c o m m itm e n t in a n o th e r c u rre n c y .40 The s t r u c t u r e o f a fix ed -fo r-
fix e d c u rre n c y sw a p is illu s tr a te d in E x a m p le 1 7 .1 8 .
Example 17.
Y a n k c o e n te rs in to a 3 -y e a r fix e d -fo r-fix e d c u rre n c y s w a p w ith B ritc o . T he lo a n p rin c ip a ls a r e £ 1 0 0 m illio n
a n d U S $ 2 0 0 m illio n a n d th e c u rre n t s p o t e x c h a n g e ra te is U S $ 1 = £ 0 . 5 0 0 0 . T he s w a p re q u ire s Y a n k c o
to m a k e a n n u a l s w a p p a y m e n ts o f 1 1 .8 p e r c e n t to B ritc o in US d o lla r s , w h ile B ritc o m a ke s a n n u a l
s w a p p a y m e n ts o f 1 3 . 3 p e r c e n t to Y a n k c o in U K p o u n d s .41 T h e re is a n e x c h a n g e o f p r in c ip a ls a t the
s ta rt o f th e s w a p a n d a re -e x c h a n g e o f p r in c ip a ls a t th e e n d o f th e s w a p .
T he c a s h flo w s re q u ire d b y th e s w a p a r e set o u t in T a b le 1 7 . 1 7 .
TABLE 17.17 F》
ayments in a fixed-for-fixed currency swap
E nd o f y e a r S w a p p a y m e n ts m a d e
B y B ritc o to Y a n k c o B y Y a n k c o to B ritc o
0 £100m $200m
1 $ 2 3 .6 m £ 1 3 .3 m
2 $ 2 3 .6 m £ 1 3 .3 m
3 $ 2 3 .6 m £ 1 3 .3 m
3 $200m £100m
A s s h o w n in T a b le 1 7 . 1 7 , th e s w a p c o m m its B ritc o to m a k e a se rie s o f c a s h p a y m e n ts in d o lla r s

to Y a n k c o , a n d c o m m its Y a n k c o to m a k e a se rie s o f c a s h p a y m e n ts in p o u n d s to B ritc o . H e n c e , th e
fu tu re s w a p p a y m e n ts re s e m b le a p a c k a g e o f f o r w a r d c o n tra c ts . F o r e x a m p le , a t th e e n d o f th e firs t
a n d s e c o n d y e a rs , B ritc o w ill p a y $ 2 3 . 6 m illio n a n d r e c e iv e in re tu rn £ 1 3 . 3 m illio n , a n d a t th e e n d
o f th e t h ir d y e a r, B ritc o w ill p a y $ 2 2 3 . 6 m illio n a n d re c e iv e in re tu rn £1 1 3 .3 m illio n . T h is set o f
fu tu re c a s h flo w s is lik e h a v in g 1 -y e a r, 2 - y e a r a n d 3 -y e a r f o r w a r d c o n tra c ts to sell d o lla r s a n d b u y
p o u n d s .42 Im p o rta n tly , h o w e v e r, e a c h im p lie d f o r w a r d e x c h a n g e ra te w ill not n e c e s s a rily e q u a l th e
c o r r e s p o n d in g f o r w a r d e x c h a n g e ra te set in th e f o r w a r d e x c h a n g e m a rk e t.
A s w ith i n t e r e s t r a t e s w a p s , th e r e a r e th r e e m a in u s e s o f c u r r e n c y sw a p s :
• s p e c u la t in g
• h e d g in g
• r e d u c in g b o r r o w in g c o s t s .
W e n o w d is c u s s b r ie fly e a c h o f t h e s e u s e s .
Speculating
B r itc o m a y b e p r e d ic tin g t h a t in th e c o m in g y e a r s , th e d o lla r w ill w e a k e n a g a i n s t th e p o u n d (a n d th e r e fo r e
th e p o u n d w ill s t r e n g th e n a g a i n s t th e d o lla r ). In t h a t c a s e , B r i t c o s fu t u r e d o lla r o u tflo w s w ill b e w o r th
l e s s (in p o u n d t e r m s ) a n d i t s fu t u r e p o u n d in flo w s w ill b e w o r t h m o r e (in d o lla r t e r m s ) . T h a t is, th e
f o r e c a s t c h a n g e in th e e x c h a n g e r a te w ill b e in B r i t c o s fa v o u r.
40 It is easy to show that combining an interest rate swap and a floating-for-floating currency swap creates the equivalent of
a fixed-for-floating currency swap. Further, combining an interest rate swap and a fixed-for-floating currency swap creates
the equivalent of a fixed-for-fixed currency swap. In this sense, therefore, markets for fixed-for-fixed and fixed-for-floating
currency swaps are redundant.
41 Also referred to as pounds sterling'; standard nomenclature is GBP, indicating Great Britain pounds. Standard nomenclature
for US dollars is USD. For ease of expression, in the remainder of this section we will refer to these two currencies as simply
pounds and dollars.
42 In practice, currency forward contracts with terms longer than 1 year are relatively rare in the wholesale currency markets.
Hence, the existence of currency swaps can be seen as a way of filling this gap.
S im ila rly , if Y an k co is u s i n g th e sw a p fo r s p e c u la t iv e p u r p o s e s , th e n Y a n k c o m u s t b e p r e d ic tin g th e

o p p o s ite e x c h a n g e r a te c h a n g e : a s t r o n g e r d o lla r a n d a w e a k e r p o u n d . B e c a u s e th e sw a p c o m m it s Y a n k c o
to fu tu r e p o u n d o u tflo w s , a n d fu t u r e d o lla r in flo w s , Y a n k c o b e n e f i t s fr o m a s t r o n g e r d o lla r a n d a w e a k e r
pound.
E x is tin g b o r r o w e r s c a n a ls o u s e i n t e r e s t r a t e s w a p s to s p e c u la t e o n e x c h a n g e r a te m o v e m e n ts . F o r
e x a m p le , s u p p o s e Y a n k c o h a d a p r e - e x is t in g d e b t in d o lla r s b u t th e p o u n d in t e r e s t r a te is lo w e r th a n
th e d o lla r in t e r e s t ra te . Y a n k c o c o u ld u s e a c u r r e n c y s w a p to c o n v e r t i t s h ig h - in t e r e s t d o lla r d e b t to low -
in t e r e s t p o u n d d e b t. In e ffe c t, t h is a c tio n is a s p e c u la t io n t h a t th e d o lla r w ill n o t d e p r e c ia t e a g a i n s t th e
p o u n d , b e c a u s e i f i t d o e s s o , th e p o u n d i n t e r e s t c o s t w ill r is e in d o lla r t e r m s , p o t e n tia lly e lim in a t in g
th e a p p a r e n t i n t e r e s t s a v in g s . A s e x p la in e d in th e fo llo w in g F in a n c e in A c tio n , it h a s b e e n c la im e d t h a t
th e A u s tr a lia n G o v e r n m e n t e n te r e d in to c u r r e n c y s w a p s in t h is w ay.
F in a n c e
TREASURY'S CURRENCY SWAPS CRASH_______________________
in A C T IO N
A c u r r e n c y s w a p c a n b e u s e d to c o n v e r t d e b t fr o m a h ig h in te re s t r a te d o m e s tic c u r r e n c y lo a n to
N ews
a lo w in te re s t r a te f o r e ig n c u r r e n c y lo a n — w h ic h w ill s a v e th e b o r r o w e r m o n e y u n le s s , o f c o u rs e ,
th e d o m e s tic c u r r e n c y d e p r e c ia te s . T h e n th e b o r r o w e r fa c e s th e p r o s p e c t o f th e b e n e fit o f th e
lo w e r in te re s t r a te b e in g w ip e d o u t b y lo sse s o n th e e x c h a n g e ra te . W o u ld a n y o n e ta k e s u ch a
ris k ? A c c o r d in g to th is e d it o r ia l in a M e lb o u r n e n e w s p a p e r in 2 0 0 2 s o m e o n e d id . T h e A u s t r a lia n
G o v e rn m e n t n o less.
F o r th e fir s t tim e s in c e th e 1 9 9 0 r e c e s s io n , A u s t r a lia n t a x p a y e r s a r e a t r is k o f f u n d in g h e a v y

lo s s e s b y a g o v e r n m e n t f in a n c ia l a u t h o r ity . T h is tim e th e c u lp r it is th e F e d e r a l T re a s u ry ,
th r o u g h its c u r io u s p r a c t ic e o f t a k in g o u t u n h e d g e d c r o s s - c u r r e n c y s w a p s to r e d u c e th e in te r e s t
b u r d e n o n th e p u b lic d e b t . C u r io u s , b e c a u s e th e T r e a s u r y h a s b e e n s o d is m is s iv e o f A s ia n
c o u n tr ie s t h a t m a d e s im ila r m is ta k e s . Y e t a t n o s ta g e d i d it o r T r e a s u r e r P e te r C o s te llo w a r n
us t h a t o u r m o n e y w a s a t r is k , u n til L a b o r s e n a to r s n o te d a s in g le - lin e e n t r y o n p a g e 8 0 o f a n
a n n u a l r e p o r t r e v e a lin g t h a t in ju s t t w o y e a r s th e T r e a s u r y h a d ru n u p m o r e th a n $ 3 b illio n o f
p r o s p e c tiv e f o r e ig n e x c h a n g e lo s s e s . B y J u n e 2 0 0 1 , its c u r r e n c y s w a p s h a d t u r n e d $ 8 b illio n
o f d e b t in to a lm o s t $ 1 2 b i lli o n , r u n n in g u p u n r e a lis e d lo s s e s o f $ 3 . 8 b illio n . A t th is s ta g e th e s e
a r e p r o s p e c tiv e lo s s e s ; w h e t h e r th e y o c c u r d e p e n d s o n w h e r e o u r d o lla r g o e s . B u t if th e d o lla r
s ta y s r o u g h ly w h e r e it is, th e y a r e lo s s e s t h a t A u s t r a lia n f a m ilie s w i ll h a v e to p a y .
W h y d i d th e T r e a s u r y r is k o u r m o n e y ? It b e g a n w it h a p la u s ib le r a t io n a le : in 1 9 8 7 a
d e c a d e o f h ig h in f la t io n a n d c u r r e n c y p lu n g e s h a d le ft A u s t r a lia n b o n d r a te s u n c o m f o r t a b ly
h ig h , s o th e T r e a s u r y t o o k a d v a n t a g e o f lo w e r U S r a te s b y s w a p p in g p a r t o f its A u s t r a lia n
d o lla r d e b t f o r a U S d o lla r d e b t . T h is g a v e it lo w e r in te r e s t b ills a t th e r is k o f h ig h e r c o s ts if o u r
d o lla r fe ll h e a v ily . F o r a d e c a d e th e s t r a t e g y w o r k e d ; th e T r e a s u r y c la im s t a x p a y e r s g a in e d
m o r e th a n $ 2 b illio n fr o m lo w e r in te r e s t ra te s .
B u t it w a s a h ig h - ris k s t r a t e g y t h a t w o u ld c o lla p s e if th e d o lla r c o lla p s e d . In a n a d m ir a b ly
c a r e fu l r e p o r t in 1 9 9 9 , th e A u s t r a lia n N a t i o n a l A u d it O f f ic e p o in t e d o u t: 'T r e a s u r y h a s
u s e d c r o s s - c u r r e n c y s w a p s , n o t to h e d g e e x is tin g e x p o s u r e s , b u t to c r e a te n e w e x p o s u r e s to
U S d o lla r s . .. [T h is ] is in c o n t r a s t to th e p r a c tic e s o f o t h e r s o v e r e ig n d e b t m a n a g e r s , s ta te
tr e a s u r y c o r p o r a t io n s a n d m o s t p r iv a t e s e c to r p r a c t ic e ’ . B y m id -1 9 9 9 th e T r e a s u r y h a d
s w a p p e d $ 3 8 b illio n o f A u s t r a lia n d e b t in to U S d o lla r d e b t t h r o u g h 3 3 2 t r a n s a c t io n s .
Y e t in 1 9 9 7 th e e n t ir e p o lic y r a t io n a le h a d d is a p p e a r e d . W it h in f la t io n a n d t h e b u d g e t
b a la n c e u n d e r c o n t r o l, th e g a p b e t w e e n U S a n d A u s t r a lia n b o n d ra te s h a d v ir t u a lly v a n is h e d .
A n d th e A u s t r a lia n d o lla r p lu n g e d in to t e r r it o r y t h a t m e a n t h e a v y lo s s e s f o r u n h e d g e d d e b t ;
fr o m a lm o s t 8 0 U S c e n ts a t th e e n d o f 1 9 9 6 , it s a n k to 6 5 a t th e e n d o f 1 9 9 7 , 6 1 b y m id -
1 9 9 8 a n d 5 1 b y m i d - 2 0 0 1 . T r e a s u r y r e v ie w e d th e p o lic y , b u t in s te a d o f g e t tin g o u t, g a m b le d
o n th e d o lla r r e b o u n d in g . It w a s w r o n g , a n d t a x p a y e r s n o w s ta n d to lo s e h e a v ily . W e a r e
o w e d a fu ll e x p la n a t io n , a fu ll d is c lo s u r e a n d a c k n o w le d g e m e n t o f r e s p o n s ib ilit y b y b o th
T re a s u re r P e te r C o s te llo a n d T r e a s u r y s e c r e ta r y K e n H e n r y .
Source: 'Treasury's currency swaps crash', The Age, 6 March 2002, p. 14.
4 ^^
Hedging
Suppose instead th a t Britco has a pre-existing contract which w ill generate future US dollar cash
inflows fo r Britco. I f Britcos shareholders are British, the US dollar inflow s are an exchange-rate risk:
the shareholders are concerned about the future pound values o f these US dollar inflows. In this case,
entering in to the currency swap provides Britco w ith a hedge. When Britco receives the future dollar
inflows, the swap ensures th a t they are effectively passed through to Yankco, so th a t B ritcos net cash
flows consist only o f the pound inflow s from Yankco.
Similarly, the currency swap would represent a hedge fo r Yankco i f it has a pre-existing contract which
w ill generate future pound inflow s fo r Yankco. On a net basis, the swap converts Yankco from receiving
pound inflow s to receiving dollar inflows.
Many Australian companies— particularly banks— have borrowed foreign currencies in overseas
markets and, almost immediately, have entered into currency swaps to elim inate the exchange-rate
risk. Motives fo r seeking funding from overseas vary. The borrower may consider the interest rate to be
attractive or the borrow er may fear th a t a large transaction in the domestic Australian m arket may force
interest rates to rise, thus increasing the cost. Similarly, foreign issuers o f Australian dollar bonds in the
Australian m arket (known as ‘kangaroo bonds’）have entered into currency swaps to elim inate exchange-
rate risk (Arsov et al. 2013).
Reducing borrow ing costs

Like in te re st rate swaps, under some circumstances a currency swap may reduce the cost o f borrow ing
fo r b o th parties. Using a fixed-for-fixed currency swap to reduce borro w in g costs is illu stra te d in
Example 17.19.
Example 17.19
Y a n k c o w is h e s to b o r r o w £ 1 0 0 m illio n f o r 3 y e a rs a n d B ritc o w is h e s to b o r r o w $ 2 0 0 m illio n fo r
3 y e a rs . T he c u rre n t s p o t e x c h a n g e ra te is $1 = £ 0 . 5 0 0 0 . B o th c o m p a n ie s w is h to r e p a y u s in g th e
s ta n d a r d b o n d c a s h f lo w p a t te r n — th a t is, in te re s t is p a id a t th e e n d o f e a c h y e a r a n d th e p r in c ip a l is
r e p a id in fu ll a t th e e n d o f th e th ir d y e a r. T he in te re s t ra te s (in p e r c e n t p e r a n n u m ) a p p lic a b le to th e
tw o b o r r o w e r s a r e s h o w n in T a b le 1 7 .1 8 .
TABLE 17.18 Interest rates payable by Britco and Yankco

In te re st ra te s (% p .a .)
Com pany O n $ b o r r o w in g s O n £ b o r r o w in g s
Britco 12.0 14.5
Yankco 10.0 13.5
L o o s e ly s p e a k in g , w h ile Y a n k c o c a n b o r r o w m o re c h e a p ly th a n B ritc o in b o th c u rre n c ie s , it h a s

a 2 - p e r c e n ta g e p o in ts ( 2 0 0 b p s) a d v a n ta g e in d o lla r b o r r o w in g s b u t o n ly a 1- p e r c e n ta g e p o in t
( 1 0 0 b p s ) a d v a n ta g e in p o u n d b o r r o w in g s .
T he s ta n d a r d fu n d in g c o s t a r g u m e n t f o r c u r r e n c y s w a p s is to s u g g e s t th a t Y a n k c o s h o u ld in it ia lly
b o r r o w d o lla r s , w h ile B ritc o s h o u ld in it ia lly b o r r o w p o u n d s , a n d th e t w o s h o u ld th e n s w a p lo a n
c o m m itm e n ts . T his is a c h ie v e d b y Y a n k c o a n d B ritc o e n te rin g in to a c u r r e n c y s w a p w h ic h re q u ire s
e x c h a n g in g c a s h flo w s o n e a c h in te re s t p a y m e n t d a te a n d a t th e in it ia t io n a n d m a tu rity o f th e lo a n .
A lth o u g h le g a lly th e o r ig in a l lo a n c o n tra c ts b e tw e e n Y a n k c o a n d th e d o lla r le n d e rs , a n d b e tw e e n
B ritc o a n d th e p o u n d le n d e rs , re m a in u n d is tu rb e d , th e econom ic e ffe c t is th a t B ritc o a n d Y a n k c o h a v e
s w a p p e d lo a n c o m m itm e n ts .
H o w e v e r , a s tra ig h t s w a p o f lo a n c o m m itm e n ts is u n lik e ly . In th is e x a m p le , a s in m a n y s w a p s , o n e
c o u n te r p a r ty is f in a n c ia lly s tro n g e r th a n th e o th e r: Y a n k c o is c le a r ly th e s tro n g e r c o u n te r p a r ty b e c a u s e
it c a n b o r r o w a t lo w e r in te re s t ra te s th a n B ritc o in b o th c u rre n c ie s . In a s tra ig h t s w a p , Y a n k c o w ill
s im p ly e n d u p p a y in g th e h ig h e r in te re s t ra te r e q u ire d o n a lo a n to B ritc o . T hus, Y a n k c o w ill n e e d a n
in d u c e m e n t to e n te r in to th e s w a p . S u ch a n in d u c e m e n t m ig h t b e a c h ie v e d in a n u m b e r o f d iffe re n t
w a y s . F o r e x a m p le , B ritc o c o u ld o ff e r Y a n k c o a fe e , p e rh a p s in th e fo rm o f a llo w in g Y a n k c o to re ta in
s o m e o f its lo a n p r in c ip a l, w h ile B ritc o tra n s fe rs th e w h o le o f its lo a n p r in c ip a l to Y a n k c o . A lte r n a tiv e ly ,

B ritc o c o u ld m a k e s w a p p a y m e n ts to Y a n k c o a t a n in te re s t ra te h ig h e r th a n th e 1 0 p e r c e n t re q u ire d
b y Y a n k c o to r e p a y its US d o lla r c re d ito rs . A th ir d a p p r o a c h , w h ic h w e e x p la in b e lo w , in v o lv e s a n
in te r m e d ia r y a n d tw o c u r r e n c y s w a p s . O n e s w a p is b e tw e e n B ritc o a n d th e in te r m e d ia r y , w h ile
th e o th e r s w a p is b e tw e e n Y a n k c o a n d th e in te r m e d ia r y . T he d e ta ils a r e se t o u t in F ig u re 1 7 . 6 a n d
T a b le 1 7 . 1 9 .
ure 17.6 Post-swap cash flows

m
▼
Pou nd U S d o lla r
lenders lenders
- US$ cash flow

— £ cash flow
The p re -s w a p a n d p o s t-s w a p n e t c a s h flo w s a r e s h o w n in T a b le 1 7 . 1 9 .
TABLE 17.19 Pre-swap and pos swap net cash flows 卜
End o f y e a r P re -s w a p c a s h flo w s P o s t-s w a p n e t ca sh flo w s

「
B ritc o Yankco B ritc o Yankco In te rm e d ia ry
0 +£100m +US$200m +US$200m +£100m —
1 -£14.5m -US$20m -US$23.6m -£13.3m +US$3.6m -£1.2m
2 -£14.5m -US$20m -US$23.6m -£13.3m +US$3.6m-£1.2m
3 -£14.5m -US$20m -US$23.6m -£13.3m +US$3.6m -£1.2m
3 -£100m -US$200m -US$200m -£100m —
A s s h o w n in F ig u re 1 7 . 6 , a fte r th e s w a p B ritc o h a s e x a c tly o ffs e ttin g in flo w s a n d o u tflo w s in p o u n d s

a n d is p a y in g 1 1 .8 p e r c e n t fo r US d o lla r s . T h is is 0 . 2 p e r c e n t b e tte r th a n B ritc o c o u ld h a v e a c h ie v e d
fo r its e lf d ire c tly . A fte r th e s w a p , Y a n k c o h a s e x a c tly o ffs e ttin g in flo w s a n d o u tflo w s in d o lla r s , a n d is
p a y in g 1 3 . 3 p e r c e n t f o r p o u n d s . T h is is 0 . 2 p e r c e n t b e tte r th a n Y a n k c o c o u ld h a v e a c h ie v e d f o r its e lf
d ire c tly . T h e fin a n c ia l in te r m e d ia r y c a r r ie s a n e x c h a n g e ris k in th a t o n e a c h in te re s t p a y m e n t d a te ,
it ha s a n e t d o lla r in flo w o f (0 .1 1 8 - 0 . 1 0 ) x $ 2 0 0 m illio n = $ 3 . 6 m illio n , a n d a n e t p o u n d o u tflo w
o f ( 0 . 1 4 5 - 0 . 1 3 3 ) x £ 1 0 0 m illio n = £ 1 . 2 m illio n . T h e in te r m e d ia r y m ig h t s e e k to h e d g e th is ris k
b y e n te rin g in to f o r w a r d c o n tra c ts , o r b y e n te rin g in to o th e r s w a p s . A lte r n a tiv e ly , if th e in te r m e d ia r y
d o e s n o t h e d g e th is ris k , its n e t c a s h f lo w w ill b e n e g a tiv e o n ly in th e e v e n t th a t th e d o lla r d e p re c ia te s
b y o n e -th ird in 3 y e a rs fro m a v a lu e o f £ 0 . 5 0 0 0 p e r d o lla r to less th a n £ 0 . 3 3 3 3 p e r d o lla r . T he
in te r m e d ia r y m a y r e g a r d th is v a lu e lo ss a s u n lik e ly a n d h e n c e a ris k w o r th c a r r y in g .
4^^
B usiness finance
As we discussed fo r interest rate swaps, an interm ediary would n o t norm ally lin k two particular
currency swaps in the way th a t may be inferred from Figure 17.6. Like interest rate swaps, currency
swaps are standardised and many m arket participants w ill m on itor th e ir total exposures by currency and
tim ing, rather than seeking to hedge individually each currency swap. That is, like interest rate swaps,
currency swaps are intermediated.
A lth ou g h speculating, hedging and reducing borro w in g costs are the m ain reasons to use currency
swaps, m arket p articip a nts have also found currency swaps a useful to o l in s tru c tu rin g contracts th a t
exploit tax advantages, or th a t reduce the im pact o f governm ent regulations. For example, in the
past, US companies have used currency swaps as p a rt o f a m ethod to e xploit some tax advantages o f
b o rro w in g yen.43
CREDIT RISK One fin al issue is c re d it ris k . The credit risk o f a currency swap is usually considerably greater than
possibility of loss the credit risk o f an interest rate swap. The m ain reason fo r the higher risk is th a t currency swaps usually
because a party fails
require a re-exchange o f principals on the m a tu rity date, whereas in interest rate swaps there is no
to meet its obligations
exchange o f principals. Obviously, loan principals involve sums th a t are much greater than the associated
periodic interest flows. In practice, however, there have been relatively few defaults. Moreover, although
the development o f centralised clearing is less advanced fo r currency swaps than fo r interest rate swaps,
the trend towards centralisation and/or tig h te r regulation o f participating banks is expected to reduce
credit risk.
43 F o r d e t a ils , s e e S m it h , S m it h s o n a n d W ilfo r d ( 1 9 9 0 , p p . 2 2 0 - 4 ) .
M 3 I A 3 H JSI33HM3A3S
SUMMARY
T h is c h a p te r e x a m in e d fiv e m a in issues: A u s tr a lia n S e c u ritie s E x c h a n g e , n a m e ly th e 9 0 - d a y
• First, a d is c u s s io n was p r o v id e d o f w h a t fu tu re s b a n k - a c c e p te d b ill fu tu re s c o n tra c t, th e 1 0 -y e a r
c o n tra c ts a r e a n d h o w fu tu re s m a rk e ts a r e o r g a n is e d . T re a s u ry b o n d fu tu re s c o n tra c t, th e s h a re p r ic e in d e x
T his d is c u s s io n in c lu d e d a n e x p la n a tio n o f h o w th e fu tu re s c o n tra c t, a n d th e 3 0 - d a y in te r b a n k c a s h ra te
c le a r in g house in te rp o s e s its e lf b e tw e e n tra d e rs , fu tu re s c o n tra c t. H a v in g d e ta ile d th e s p e c ific a tio n
a n d h o w th is p ro c e s s a llo w s tra d e rs to c lo s e o u t (o r o f th e se c o n tra c ts , e x a m p le s w e r e p r o v id e d o f h o w
re ve rse ) th e ir c o n tra c ts b e fo re th e m a tu rity d a te . A n th e s e c o n tra c ts m a y b e u se d fo r s p e c u la tio n a n d
e x p la n a tio n o f th e system o f d e p o s its , m a rg in s a n d h e d g in g p u rp o s e s .
th e m a rk -to -m a rk e t ru le w a s a ls o p r o v id e d . F o u rth , th e c h a p te r p r o v id e d a n a n a ly s is o f so m e
• S e c o n d , th e c h a p te r d e a lt w ith s p e c u la tio n s tra te g ie s o f th e d e te rm in a n ts o f fu tu re s p ric e s a n d s p e c ific a lly
th a t m a y b e e m p lo y e d u s in g fu tu re s m a rk e ts . F ive k in d s e x a m in e d th e v a lu a tio n o f b a n k - a c c e p te d b ill fu tu re s
of s p e c u la tio n w e re id e n tifie d — n a m e ly s c a lp in g , c o n tra c ts a n d s h a re p r ic e in d e x fu tu re s c o n tra c ts .
s p r e a d in g , s tr a d d lin g , day t r a d in g and lo n g -te rm F o r w a r d - r a te a g re e m e n ts , w h ic h a r e o fte n u se d as

(o r o v e rn ig h t) p o s itio n ta k in g . T he p ro c e s s e s o f s h o rt a n a lte r n a tiv e to in te re s t-ra te fu tu re s c o n tra c ts , w e r e
H ld
h e d g in g and lo n g h e d g in g w e re a ls o e x p la in e d . a ls o d is c u s s e d .
Im p e rfe c t c o n v e rg e n c e , b a s is ris k a n d s p e c ific a tio n F in a lly , th e c h a p te r d e s c rib e d th e m e c h a n ic s o f in te re s t
d iffe re n c e s w e r e d is c u s s e d a s re a s o n s w h y h e d g in g ra te s w a p s a n d c u rre n c y s w a p s a n d illu s tra te d h o w
pq •
w ith fu tu re s c o n tra c ts m a y n o t b e p e rfe c t.
T h ird , th e c h a p te r p r o v id e d d e ta ils o f th e s p e c ific a tio n
s w a p s m a y b e use d to s p e c u la te o n fu tu re c h a n g e s
in in te re s t ra te s o r e x c h a n g e ra te s, to h e d g e in te re s t
vHu
o f fo u r f in a n c ia l fu tu re s c o n tra c ts tra d e d on th e ra te risk a n d exchange ra te ris k , and to re d u c e

b o r r o w in g costs.
C H A P T E R S E V E N T E E N REVmv\^
KEY TERMS
b a sis 519 m a rg in c a ll 512
b a sis p o in t 548 m a r k in g - to -m a r k e t 51 1
BBSW 546 n o tio n a l p r in c ip a l (o r n o tio n a l a m o u n t) o f a n in te re s t
c a ll o p tio n o n a fu tu re s c o n tra c t 513 ra te s w a p 545
c a r r y in g co s t 51 3 p u t o p tio n o n a fu tu re s c o n tra c t 513
c re d it ris k 556 s h o rt h e d g e r 517
c u rre n c y s w a p 544 s h o rt s e llin g 511
fo r w a r d c o n tra c t 509 s p e c u la to rs 508
fu tu re s c o n tra c t 508 s p o t p ric e 514
h e d g e rs 508 s p re a d 516
in te re s t ra te s w a p 544 sw ap 544
lo n g h e d g e r 517
t ) d SELF-TEST PROBLEMS
1 S u p p o s e th a t, a t a p a r tic u la r tim e , th e J u n e fu tu re s p r ic e is $1 2 0 0 a n d th e S e p te m b e r fu tu re s p r ic e is $1 2 6 0 .
You a r e c o n v in c e d th a t th e s p r e a d b e tw e e n th e J u n e a n d S e p te m b e r p ric e s w ill s o o n w id e n , b u t y o u h a v e n o
b e lie f a s to w h e th e r b o th p ric e s w ill ris e , o r b o th p ric e s w ill fa ll. W h a t a c tio n (s ) s h o u ld y o u ta k e ? S h o w th a t as
a re s u lt o f y o u r a c tio n (s ) y o u w ill m a k e a p r o fit, if, o n a s u b s e q u e n t d a te , th e J u n e fu tu re s p r ic e is $1 3 0 0 a n d
th e S e p te m b e r fu tu re s p r ic e is $ 1 3 8 0 .
2 O n 2 S e p te m b e r th e q u o te d p r ic e o f th e 9 0 - d a y b a n k b ill fu tu re s c o n tra c t m a tu rin g o n 1 2 D e c e m b e r w a s

9 2 . 0 0 . O n 8 S e p te m b e r th e p r ic e w a s 9 2 . 5 0 . T h e fa c e v a lu e o f th e b a n k b ills u n d e r ly in g o n e c o n tra c t
is $1 m illio n . S u p p o s e t h a t H a r o ld s o ld 1 5 su ch c o n tra c ts o n 2 S e p te m b e r a n d c lo s e d o u t h is p o s itio n o n
8 S e p te m b e r. Ig n o r in g tr a n s a c tio n co sts, h o w m u c h h a s H a r o ld m a d e (o r lo st)?
Solutions to self-test problem s are a v a ila b le in A p p e n d ix B.
QUESTIONS
1 [LO 1] W h a t a r e th e m a jo r d iffe re n c e s b e tw e e n a f o r w a r d c o n tra c t a n d a fu tu re s c o n tra c t?
2 [LO 1: D is tin g u is h b e tw e e n th e te rm s volume tra d e d a n d open positions.
3 [L O 1] D is tin g u is h b e tw e e n th e f o llo w in g , p r o v id in g in y o u r a n s w e r b r ie f e x a m p le s to illu s tra te th e p o in ts

yo u m ake:
a) d e liv e r a b le fu tu re s c o n tra c t a n d n o n -d e liv e ra b le fu tu re s c o n tra c t
b) s p e c u la to r a n d h e d g e r
c) s h o rt h e d g e r a n d lo n g h e d g e r.
4 [LO 1] G o to th e A u s tr a lia n S e c u ritie s E x c h a n g e w e b s ite (w w w.asx.com .au) a n d fin d th e 'c o m m o d itie s ' o n
w h ic h fu tu re s c o n tra c ts a r e t r a d e d . W h y is th e re n o t a fu tu re s c o n tra c t o n w in e ?
5 [L O 2 ] E x p la in h o w th e A u s tr a lia n S e c u ritie s E x c h a n g e p ro te c ts its e lf a g a in s t th e ris k th a t b u y e rs a n d s e lle rs

o f fu tu re s c o n tra c ts m ig h t d e fa u lt o n th e ir o b lig a tio n s .
6 [L O 3 ] D e fin e w h a t is m e a n t b y th e te rm ’ c a r r y in g c o s t’ w h e n d e a lin g w ith th e p r ic in g o f fu tu re s c o n tra c ts .
H o w m ig h t y o u e s tim a te th is c o s t w h e n d e a lin g w ith a fu tu re s c o n tr a c t o n a c o m m o d ity su ch a s w h e a t?
7 [LO 4 ] E x p la in w h a t is m e a n t b y a p e r fe c t h e d g e . D o e s a p e r fe c t h e d g e a lw a y s le a d to a b e tte r o u tc o m e
th a n a n im p e r fe c t h e d g e ?
8 [L O 4 】Futures markets are re a lly there fo r the benefit o f speculators, not hedgers. Very fe w contracts e n d in
delivery, so obviously the futures m arket traders a re n 't interested in the a ctu a l com m odities, a n d i f they're not
interested in the a ctual com m odities, they c a n 't be hedgers. M a n y contracts a re n 't even deliverable. H o w
could anyone hedge w ith contracts like that? C o n s id e r c a r e fu lly th e v a r io u s c la im s m a d e in th is s ta te m e n t.
.557
B usiness finance
9 [L O 5 ] W h a t is m e a n t b y b a s is risk?
10 [L O 6 ] C o n s id e r th e e ffe c ts o f a n o v e r n ig h t s h a re p r ic e fa ll o f a r o u n d 2 5 p e r c e n t o n :
a) a s p e c u la to r w ith a lo n g p o s itio n in th e SPI 2 0 0 fu tu re s c o n tra c t
b) a s u p e ra n n u a tio n fu n d w ith a s h o rt p o s itio n in th e SPI 2 0 0 fu tu re s c o n tra c t.
11 [LO 1 0 ] E x p la in h o w a n in te re s t ra te s w a p m a y b e u se d f o r s p e c u la tiv e o r h e d g in g p u rp o s e s , d e p e n d in g on
th e c irc u m s ta n c e s o f th e s w a p p a r tic ip a n t .
12 [LO 1 0 ] W h y d o in te re s t ra te s w a p s a lm o s t n e v e r re q u ire a n e x c h a n g e o r r e -e x c h a n g e o f p r in c ip a ls b u t
u s u a lly c u r r e n c y s w a p s re q u ire a n e x c h a n g e a n d a r e -e x c h a n g e o f p r in c ip a ls ?
13 [LO 1 0 ] E x p la in h o w a fix e d -fo r-fix e d c u r r e n c y s w a p m a y b e u se d f o r s p e c u la tiv e o r h e d g in g p u rp o s e s ,

d e p e n d in g o n th e c irc u m s ta n c e s o f th e s w a p p a r tic ip a n t.
PROBLEMS
1 Determinants of futures prices [LO 3]
O n a p a r tic u la r d a y in th e X a n a d u Futures E x c h a n g e th e f o llo w in g g o ld fu tu re s p ric e s w e re o b s e rv e d :
D e liv e ry d a te (m o n th s ) F utures p ric e p e r o u n c e ($ )
1 1379
2 1388
3 1410
6 1419
12 1439
In X a n a d u th e in te re s t ra te is 0 . 5 p e r c e n t p e r m o n th (c o m p o u n d ). It costs $ 2 p e r o u n c e p e r m o n th (p a y a b le
fo r th e w h o le p e r io d , in a d v a n c e ) to s to re a n d in s u re g o ld . E ach fu tu re s c o n tra c t c o v e rs 8 o u n c e s o f g o ld .
T he c u rre n t s p o t p r ic e o f g o ld is $ 1 3 7 3 p e r o u n c e .
Id e n tity a n y a r b it r a g e o p p o rtu n itie s . E x p la in h o w such o p p o r tu n itie s c o u ld b e e x p lo ite d a n d c a lc u la te th e p r o fit

p e r c o n tra c t. Ig n o re tra n s a c tio n costs, ta x e s a n d a n y in te re s t re c e iv e d o r fo r g o n e d u e to d e p o s its o r m a rg in s .
2 Speculation w ith 90-day bank bill futures contracts [LO 7]
O n 3 0 S e p te m b e r 2 0 1 3 , th e q u o te d p ric e o n th e D e c e m b e r 2 0 1 3 9 0 - d a y b a n k b ill fu tu re s c o n tra c t w a s
9 7 . 5 1 . P e n n y b e lie v e d th a t in te re s t ra te s w o u ld fa ll o v e r th e n e x t m o n th . S u p p o s e th a t sh e b o u g h t fiv e c o n tra c ts
o n 3 0 S e p te m b e r 2 0 1 3 a n d c lo s e d o u t h e r p o s itio n o n 31 O c to b e r 2 0 1 3 a t a p r ic e o f 9 7 . 4 2 . Ig n o rin g
tra n s a c tio n costs, h o w m uch h a s P e n n y m a d e (o r lost)?
3 Speculation w ith 10-year bond futures contracts [LO 7 】

O n 3 0 S e p te m b e r 2 0 1 3 , th e D e c e m b e r 2 0 1 3 1 0 -y e a r b o n d fu tu re s c o n tra c t w a s p r ic e d a t 9 6 . 1 4 . S e a n ,
u n lik e P e n n y in P ro b le m 2, b e lie v e d th a t in te re s t ra te s w o u ld ris e o v e r th e n e x t m o n th . S u p p o s e th a t he s o ld
s ix c o n tra c ts o n 3 0 S e p te m b e r a n d c lo s e d o u t h is p o s itio n o n 31 O c to b e r a t a p ric e o f 9 6 . 0 2 . Ig n o rin g
tra n s a c tio n costs, h o w m uch h a s h e m a d e (o r lost)?
4 Speculation w ith SPI 200 futures contracts [LO 7]

O n 3 0 S e p te m b e r 2 0 1 3 , th e D e c e m b e r 2 0 1 4 SPI 2 0 0 fu tu re s c o n tra c t w a s p ric e d a t 5 2 2 3 . 0 . M e g a n
b e lie v e d th a t th e sh a re m a rk e t w a s lik e ly to fa ll o v e r th e n e x t m o n th . S u p p o s e th a t she s o ld se ve n c o n tra c ts on
3 0 S e p te m b e r a n d c lo s e d o u t h e r p o s itio n o n 31 O c to b e r a t a p ric e o f 5 4 1 6 . 0 . Ig n o r in g tra n s a c tio n costs,
h o w m u ch h a s sh e m a d e (o r lost)?
5 Using 30-day interbank cash rate futures contracts [LO 7]
O n 2 3 A p r il 2 0 1 3 , th e c lo s in g p r ic e o f th e M a y 2 0 1 3 3 0 - d a y in te rb a n k c a s h ra te c o n tra c t w a s 9 7 . 0 6 . The
R eserve B a n k o f A u s tra lia (RBA) h a d a b o a r d m e e tin g s c h e d u le d fo r 7 M a y 2 0 1 3 a n d th e c u rre n t o v e rn ig h t
c a s h ra te w a s 3 p e r c e n t p e r a n n u m . O n 2 3 A p r il, w h a t w a s th e p r o b a b ilit y im p lie d b y th e p r ic e o f th e M a y
2 0 1 3 3 0 - d a y in te r b a n k c a sh ra te c o n tra c t th a t th e R B A w o u ld d e c re a s e th e c a s h ra te to 2 . 7 5 p e r c e n t a t its
M a y m e e tin g ?
558
f
CHAPTER SEVENTEEN REVIEW

6 Speculation with bank bill futures contracts [LO 7]
The 9 O c to b e r 2 0 0 4 A u s tra lia n fe d e ra l e le c tio n w a s o n e in w h ic h th e p o s s ib le e ffe c t o f th e e le c tio n o u tc o m e
o n in te re s t ra te s w a s a k e y p o in t o f d iffe re n tia tio n b e tw e e n th e p a rtie s . T h e th e n P rim e M in is te r J o h n H o w a r d
a n d his L ib e ra l-N a tio n a l P a rty c o a litio n g o v e rn m e n t c a m p a ig n e d u n d e r th e s lo g a n th a t re -e le c tin g th e m w o u ld
'K e e p in te re s t ra te s lo w '. In a d d itio n , th e y ra n a d v e rtis e m e n ts s h o w in g th e d o u b le - d ig it in te re s t ra te s th a t
p re v a ile d u n d e r L a b o r g o v e rn m e n ts in th e 1 9 8 0 s a n d e a r ly 1 9 9 0 s . T he A u s tra lia n L a b o r P a rty (ALP) c o u n te re d
b y q u o tin g a Reuters s u rv e y o f 1 4 fin a n c ia l m a rk e t e c o n o m is ts , a ll o f w h o m s ta te d th a t th e p a r ty in g o v e rn m e n t
w o u ld m a k e n o d iffe re n c e to th e le ve l o f in te re s t ra te s o v e r th e fo llo w in g th re e y e a rs . O n 8 O c to b e r 2 0 0 4 , th e
q u o te d p ric e o n th e M a r c h 2 0 0 5 9 0 - d a y b a n k b ill fu tu re s c o n tra c t w a s 9 4 . 5 2 . M a r g a r e t b e lie v e d th a t in te re s t
rates w o u ld fa ll f o llo w in g th e e le c tio n o n 9 O c to b e r. S u p p o s e th a t she b o u g h t e ig h t c o n tra c ts o n 8 O c to b e r
a n d c lo s e d o u t h e r p o s itio n o n 11 O c to b e r a t a p ric e o f 9 4 . 5 7 . Ig n o rin g tra n s a c tio n costs, h o w m u ch h a s
M a r g a r e t m a d e (or lost)?
7 Speculation with 10-year bond futures contracts [LO 7]

〇n 8 O c to b e r 2 0 0 4 , th e D e c e m b e r 2 0 0 4 1 0 -y e a r b o n d fu tu re s c o n tra c t w a s p r ic e d a t 9 4 . 4 3 5 . M ic h a e l,
u n lik e M a r g a r e t in P ro b le m 6 , b e lie v e d th a t in te re s t ra te s w o u ld rise fo llo w in g th e fe d e ra l e le c tio n o n
9 O c to b e r. S u p p o s e th a t h e s o ld tw o c o n tra c ts o n 8 O c to b e r a n d c lo s e d o u t his p o s itio n o n 1 1 O c to b e r a t a
p ric e o f 9 4 . 5 2 5 . Ig n o rin g tra n s a c tio n costs, h o w m u ch ha s he m a d e (o r lost)?
8 Using 30-day interbank cash rate futures contracts [LO 7]

O n 8 O c to b e r 2 0 0 4 , th e N o v e m b e r 2 0 0 4 3 0 - d a y in te rb a n k c a s h ra te fu tu re s c o n tra c t w a s p ric e d a t 9 4 . 7 4
a n d o n 11 O c to b e r 2 0 0 4 it w a s p ric e d a t 9 4 . 7 4 5 . T he R e serve B a n k o f A u s tr a lia (RBA) h a d a s c h e d u le d
b o a r d m e e tin g o n 2 N o v e m b e r 2 0 0 4 . S u p p o s e w e a ssu m e th a t th e d e c is io n fa c e d b y th e R BA b o a r d w a s
to e ith e r le a v e th e ta r g e t c a s h ra te u n c h a n g e d a t 5 . 2 5 p e r c e n t p e r a n n u m o r in c re a s e it to 5 . 5 p e r c e n t p e r
a n n u m . W h a t w e re th e im p lie d p r o b a b ilitie s , o n 8 a n d 1 1 O c to b e r, o f th e R BA b o a r d le a v in g th e ta rg e t c a sh
ra te u n c h a n g e d o n 2 N o v e m b e r?
9 Hedging with 90-day bank bill futures contracts [LO 7 】
You a re th e fin a n c e m a n a g e r o f P la y S a fe L t d . 〇n 2 8 A u g u s t, P la y S a fe ’s B o a rd o f D ire c to rs d e c id e s th a t, in
7 w e e k s ' tim e , P la y S a fe w ill issue n in e b a n k b ills , e a c h w ith a fa c e v a lu e o f $ 1 0 0 0 0 0 a n d a te rm o f 1 2 0
d a y s . In its p la n n in g , th e B o a rd h a s a s s u m e d th a t y ie ld s w ill n o t c h a n g e fro m th e ir c u rre n t le ve ls. O n 2 9 A u g u s t
y o u a re to ld to a r r a n g e a h e d g e fo r P la y S a fe . O n th a t d a te , y o u a re g iv e n th e f o llo w in g d a ta :
Bank bill yields 90 days: 5.82% per annum

120 days: 6.07% per annum
Bank bill futures September: 94.10
December: 93.85
You a r r a n g e a n a p p r o p r ia te h e d g e . S e v e ra l m o n th s la te r y o u a r e a s k e d to w r ite a r e p o r t o n y o u r h e d g in g
p e rfo rm a n c e , in c lu d in g re a s o n s fo r a n y n e t g a in o r loss m a d e . C o n s u ltin g th e re c o rd s , y o u d is c o v e r th a t th e
b ills w e re issu ed o n tim e a t a ra te o f 7 . 3 7 p e r c e n t p e r a n n u m a n d th e fu tu re s c o n tra c t w a s re v e rs e d a t 9 2 . 6 5 .
A t th a t tim e th e 9 0 - d a y b ill ra te w a s 7 .1 3 p e r c e n t p e r a n n u m . D e s c rib e h o w y o u w o u ld h a v e h e d g e d in this
s itu a tio n . W h a t m a jo r p o in ts w o u ld y o u m a k e in th e re p o rt? In c lu d e re le v a n t c a lc u la tio n s .
10 Using 90-day bank bill futures contracts [LO 7]

J a n e H e d g e s h a s t o d a y in v e s te d in a 1 8 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n , p r ic e d to y ie ld
6 . 3 0 p e r c e n t p e r a n n u m . S im u lta n e o u s ly she h a s s o ld a fu tu re s c o n tra c t o n a 9 0 - d a y b a n k b ill w ith a
fa c e v a lu e o f $1 m illio n . T he fu tu re s c o n tra c t w ill e x p ir e in 9 0 d a y s ' tim e fro m to d a y . T he fu tu re s p r ic e is
9 3 . 5 5 . J a n e in te n d s to settle th e fu tu re s c o n tra c t b y d e liv e ry . Ig n o rin g a n y e ffe cts fro m th e m a rk -to -m a rk e t rule,
w h a t y ie ld (s im p le in te re st, in p e r c e n t p e r a n n u m ) w ill J a n e a c h ie v e o n h e r in ve stm e n t? W h a t , if a n y th in g ,
d o e s this im p ly a b o u t to d a y 's 9 0 - d a y b a n k b ill y ie ld ? W h y ?
11 Using 90-day bank bill futures contracts [LO 7]

T oda y, H a n k Ltd issu e d a 1 2 0 - d a y b a n k b ill w ith a fa c e v a lu e o f $1 m illio n a t a y ie ld o f 8 . 9 0 p e r c e n t p e r
a n n u m . S im u lta n e o u s ly , H a n k b o u g h t a fu tu re s c o n tra c t o n a 9 0 - d a y b a n k b ill a t a p ric e o f 9 1 . 0 3 . The fu tu re s
c o n tra c t m a tu re s in 3 0 d a y s 7 tim e a n d is b a s e d o n a fa c e v a lu e o f $1 m illio n . H a n k in te n d s to a llo w th e fu tu re s
c o n tra c t to b e s e ttle d b y d e liv e ry . Ig n o rin g a n y e ffe c ts fro m th e m a rk -to -m a rk e t ru le , d e s c r ib e c a r e fu lly th e
e c o n o m ic s u b s ta n c e o f H a n k 's tra n s a c tio n s . In c lu d e in y o u r a n s w e r d e ta ils o f a ll c a s h flo w s (a m o u n t, tim in g
a n d w h e th e r th e y a re in flo w s o r o u tflo w s ). W h a t y ie ld (s im p le in te re st, in p e r c e n t p e r a n n u m ) w ill H a n k p a y ?
W h a t , if a n y th in g , d o e s th is im p ly a b o u t to d a y 's in te re s t rates? W h y ?
559
12 Hedging with 10-year bond futures contracts [LO 7]
T h u rb e r Ltd is a firm o f u n d e rw rite rs th a t t o d a y h a s h a d to ta k e u p a t fa c e v a lu e ( $ 7 .5 m illio n ) 8 -y e a r
d e b e n tu re s issu e d b y B e e th a m P ro p e rtie s Ltd. T he B e e th a m d e b e n tu re s o ffe r a c o u p o n ra te o f 6 . 5 p e r c e n t
p e r a n n u m , p a y a b le h a lf-y e a rly . T h u rb e r is th e re fo re a n 'u n w illin g le n d e r’ bu t, fo r v a rio u s re a s o n s , T h u rb e r
in te n d s to h o ld th e B e e th a m d e b e n tu re s u n til th e firs t c o u p o n d a te , w h ic h is in 6 m o n th s 7 tim e , a n d th e n sell the
d e b e n tu re s . T h u rb e r in te n d s to h e d g e b y u s in g th e A S X fu tu re s c o n tra c t o n 10 -y e a r g o v e rn m e n t b o n d s . The
c u rre n t p ric e o f th is c o n tra c t is 9 5 . 0 0 .
a) H o w m a n y A S X c o n tra c ts s h o u ld b e e n te re d in to ? S h o w y o u r c a lc u la tio n s a n d e x p la in b rie fly .
b) W h a t risks (if a n y ) d o y o u th in k T h u rb e r m a y still fa c e , d e s p ite h a v in g h e d g e d ?
13 Speculation wirti SPI 200 futures contracts [LO 7]

O n 1 8 F e b ru a ry y o u o b s e rv e th a t th e S & P /A S X 2 0 0 In d e x sta n d s a t 6 3 1 7 . 4 , w h ile th e M a r c h SPI 2 0 0 future s
p ric e is 6 3 5 3 a n d th e Ju n e SPI 2 0 0 fu tu re s p r ic e is 6 3 9 0 . You b e lie v e th a t th e d iffe re n c e b e tw e e n th e M a r c h
a n d Ju n e fu tu re s p ric e s is to o n a r r o w a n d w ill s o o n w id e n , b u t y o u h a v e n o v ie w s as to w h e th e r th e S & P /
A S X 2 0 0 In d e x o r th e SPI 2 0 0 fu tu re s p ric e s w ill in c re a s e o r d e c re a s e . H o w c a n y o u r b e lie fs b e p u t to th e
(fin a n c ia l) test? S h o w th a t, if y o u r p r e d ic tio n is rig h t, y o u w ill p r o fit fro m tr a d in g fu tu re s, re g a rd le s s o f w h e th e r
s h a re p ric e s a s a w h o le in c re a s e o r d e c re a s e .
14 Hedging with SPI 200 futures contracts [LO 7]

You a r e th e m a n a g e r o f th e D o rfm a n In ve stm e n t F u n d . O n 9 M a y y o u re c e iv e n o tic e th a t a s e g m e n t o f th e fu n d
m ust b e s o ld o n o r a b o u t 3 0 M a y . T h is s e g m e n t c o m p ris e s a b r o a d ly b a s e d s e le c tio n o f lis te d A u s tra lia n sha res
a n d is c u rre n tly v a lu e d a t $ 6 1 6 5 0 0 0 0 . T he ris k is h e d g e d u s in g J u n e SPI 2 0 0 fu tu re s. O n 2 8 M a y th e s h a re s
a re s o ld a n d th e fu tu re s c o n tra c t is re v e rs e d . R e le v a n t d a ta a r e as fo llo w s :
rPortfolio value
O n 9 M ay
$61650000
O n 28 M ay
$58400000
|
S&P/ASX 200 6322.6 6028.6
SPI 200 futures 6351 6041
B e a rin g in m in d th a t o n 9 M a y y o u d o n o t k n o w th e 2 8 M a y o u tc o m e s , r e p o r t o n h o w y o u w o u ld h a v e
h e d g e d . In c lu d e in y o u r r e p o r t th e n u m b e r o f fu tu re s c o n tra c ts a n d w h e th e r th e y w e r e b o u g h t o r s o ld . Assess
th e e ffe c tiv e n e s s o f th e h e d g e a n d e x p la in a n y im p e rfe c tio n s e x p e rie n c e d .
15 Valuation of SPI 200 futures contracts [LO 8]

A s a t to d a y 's d a te , th e v a lu e o f sh a re s in th e M o n r o v ia n s h a re p ric e in d e x (SPI) is $ 1 2 6 0 0 0 . A 4 -m o n th fu tu re s
c o n tra c t o n th o se sh a re s is p r ic e d a t $1 2 5 9 1 3 . In 4 m o n th s ’ tim e , d iv id e n d s to ta llin g $ 5 2 0 3 w ill b e p a id o n
th e s h a re s. O f co u rs e , S, th e v a lu e o f sh a re s a t th a t tim e , is c u rre n tly n o t k n o w n . In M o n r o v ia th e in te re s t ra te
fo r b o th b o r r o w in g a n d le n d in g is 1 p e r c e n t p e r m o n th (c o m p o u n d ). T h e re a re n o tra n s a c tio n costs o r ta x e s in
M o n r o v ia .
a) S u p p o s e th a t to d a y y o u b u y th e sh a re s in th e in d e x a n d a ls o b o r r o w $ 5 0 0 0 . A fte r 4 m o n th s y o u
c o lle c t th e d iv id e n d s , sell th e sh a re s a n d r e p a y th e lo a n . C a lc u la te th e re s u ltin g c a s h flo w s fo r to d a y
a n d a fte r 4 m on th s.
b) S u p p o s e in s te a d th a t t o d a y y o u b u y th e fu tu re s c o n tra c t a n d d e p o s it th e sum o f $ 1 2 1 0 0 0 in a n
in te re s t-b e a rin g a c c o u n t. A fte r 4 m o n th s y o u settle o n th e fu tu re s c o n tra c t a n d w ith d r a w y o u r d e p o s it (w ith
in te re st). C a lc u la te th e re s u ltin g c a s h flo w s fo r to d a y , a n d a fte r 4 m o n th s.
c) E x p la in in d e ta il w h y th e a b o v e c a lc u la tio n s s h o w th a t th e fu tu re s c o n tra c t is c o rre c tly p ric e d to d a y .
d) If t o d a y th e fu tu re s p ric e is $ 1 2 6 9 1 3 , c a lc u la te th e c u rre n t a n d fu tu re c a s h flo w s th a t re s u lt if to d a y th e

fo llo w in g tra n s a c tio n s a re e n te re d in to s im u lta n e o u s ly : b o r r o w $ 1 2 6 0 0 0 , b u y sh a re s a n d sell th e future s
c o n tra c t. C o m m e n t.
16 Forward-rate agreements [LO 9]

C u rz o n Ltd n e e d s to b o r r o w $ 5 m illio n in 2 m o n th s , tim e . This a m o u n t w ill b e r e p a id (w ith interest) in a lu m p
sum 9 0 d a y s la te r. R e p a y m e n t w ill th e re fo re o c c u r a p p r o x im a te ly 5 m o n th s fro m n o w . C u rz o n e n te rs in to
a fo r w a r d - r a te a g re e m e n t w ith a b a n k , w ith th e c o n tra c t ra te set a t 7 . 5 0 p e r c e n t p e r a n n u m . W h a t ca sh
p a y m e n t, if a n y , w ill th e b a n k b e re q u ire d to p a y C u rz o n Ltd?
C hapter seventeen F utures c o n t r a c t s a n d sw aps
CHAPTER SEVENTEEN REVIEW

17 Interest rate swap [LO 10]
A s s u m e th a t t o d a y 's d a te is 1 M a r c h 2 0 1 5 . B u c k la n d B u ild in g Ltd (BBL) c a n b o r r o w f o r 3 y e a rs a t a
fix e d in te re s t ra te o f 7 . 8 p e r c e n t p e r a n n u m , w ith in te re s t p a y a b le h a lf-y e a rly . T h e a n n u a l in te re s t ra te
fo r th e c o r r e s p o n d in g f lo a t in g - r a t e lo a n is 6 -m o n th B B S W p lu s a m a r g in o f 6 0 b a s is p o in ts . T h e c u r r e n t
6 -m o n th B B S W is 6 . 1 5 p e r c e n t p e r a n n u m . F o r s im ila r lo a n s , A u b u r n B a n k Ltd (ABL) p a y s a fix e d r a te o f
7 .1 0 p e r c e n t p e r a n n u m a n d a flo a t in g r a te o f B B S W p lu s 5 b a s is p o in ts . BBL w is h e s to o b t a in fix e d - r a te
fu n d in g o f $ 2 5 m illio n a n d A B L w is h e s to o b t a in f lo a tin g - r a te fu n d in g f o r th e s a m e a m o u n t. A s s u m e th a t
e v e r y d a y is a b u s in e s s d a y a n d th a t e v e r y p e r io d o f 6 c o n s e c u tiv e c a le n d a r m o n th s is e x a c tly e q u a l to
h a lf a y e a r.
a) W h a t to ta l c o s t s a v in g (p e r h a lf-y e a r) is a v a ila b le if in it ia lly BBL b o r r o w s a t a flo a tin g ra te , A B L b o r r o w s a t

a fix e d ra te a n d th e y th e n e n te r in to a n in te re s t ra te s w a p ?
b) A s s u m e th a t th e s w a p re q u ire s flo a tin g -ra te p a y m e n ts a t 6 -m o n th B B S W fla t (th a t is, w ith n o m a rg in a d d e d ) .

D e s ig n a s w a p th a t a llo c a te s o n e -th ird o f th e to ta l c o s t s a v in g to BBL a n d tw o -th ird s to ABL. A fte r th e s w a p ,
w h a t fix e d ra te (p e r h a lf-y e a r) d o e s BBL p a y a n d w h a t flo a tin g ra te (p e r h a lf-y e a r) d o e s A B L p a y ?
c) O v e r th e n e x t th re e y e a rs , 6 -m o n th B B S W w a s :
O n 1 S e p te m b e r 2 0 1 5 : 6 . 6 5 p e r c e n t p e r a n n u m
O n 1 M a rc h 2 0 1 6 : 7 .3 5 p e r ce n t p e r a n nu m
O n 1 M a rc h 2 0 1 7 : 7 .5 5 p e r ce n t p e r a n nu m
O n 1 M a rc h 2 0 1 8: 7 .6 5 p e r cen t p e r annum
C a lc u la te the n e t s w a p p a y m e n t m a d e o n e a c h d a te a n d state w h e th e r th e p a y m e n t w a s m a d e b y BBL o r ABL.
18 Fixed-for-fixed currency swap [LO 10]

P a n th e r is a S ou th A fr ic a n c o m p a n y a n d R e in d e e r is a S w e d is h c o m p a n y . T he fix e d in te re s t ra te s a t w h ic h th e y
c a n b o r r o w m o n e y, r e p a y a b le a s a n in te re s t-o n ly lo a n o v e r 3 y e a rs (w ith a n n u a l p a y m e n ts ), a re :
S o u th A f r ic a n r a n d (Z A R ) B o r r o w in g
Panther 14.5% p.a. 4.5% p.a.
Reindeer 15.9% p.a. 4.8% p.a.
U ltim a te ly , P a n th e r w is h e s to b o r r o w S EK 2 0 0 m illio n , w h ile R e in d e e r w is h e s to b o r r o w Z A R 2 5 0 m illio n .

In itia lly , P a n th e r w i ll b o r r o w r a n d w h ile R e in d e e r w ill b o r r o w k r o n o r . T h e c u r r e n t e x c h a n g e r a te is
SEK 1 = Z A R 1 . 2 5 . A n in v e s tm e n t b a n k h a s o f f e r e d to e n te r in to s t a n d a r d f ix e d - fo r - fix e d c u r r e n c y s w a p s
w ith b o th c o m p a n ie s . T h e b a n k w o u ld m a k e Z A R s w a p p a y m e n ts a t 1 4 . 5 p e r c e n t p e r a n n u m to P a n th e r,
in re tu rn f o r S EK s w a p p a y m e n ts a t 4 . 3 p e r c e n t p e r a n n u m . T h e b a n k w o u ld m a k e SEK s w a p p a y m e n ts
to R e in d e e r a t 4 . 8 p e r c e n t p e r a n n u m in re tu rn f o r Z A R s w a p p a y m e n ts a t 1 5 . 8 p e r c e n t p e r a n n u m .
a) C o m p le te th e f o llo w in g tw o ta b le s . U se p lu s s ig n s fo r c a s h in flo w s a n d m in u s s ig n s fo r c a sh o u tflo w s .
Panther’s cash flows (amounts)

P re -s w a p c a s h flo w s S w a p c a s h flo w s (SEK) S w a p c a sh flo w s (ZA R ) Pos 卜s w a p c a sh flo w s
Year 0
Year 1
Year 2
Year 3
561
B usiness finance
Reindeer’s cash flows (amounts)

P re -s w a p c a sh flo w s S w a p c a sh flo w s (SEK) S w a p c a sh flo w s (ZA R ) P o s t-s w a p c a s h flo w s
YearO
Year 1
Year 2
Year 3
b) S h o u ld P a n th e r a n d R e in d e e r a c c e p t th e b a n k 's o ffe r? E x p la in .
c) If P a n th e r a n d R e in d e e r a c c e p t th e b a n k ’s o ffe r, w h a t risk(s) d o e s th e b a n k in c u r? E x p la in .
REFERENCES
Arsov, I., M oran, G ., Shanahan, B. & Stacey, K.; 'OTC French, K.R., 'A comparison of futures and forward prices',
derivative reform and the Australian cross-currency swap Journal of Financial Economics, November 1983, pp. 31 1-42.
market', Bulletin, Reserve Bank of Australia, Sydney, June Frino, A. & Jamecic, E., Introduction to Futures and
20 1 3 , pp. 5 5 -6 3 . Options Markets in Australia, Pearson Education Australia,
Australian Financial Markets Association, 2013 Australian Sydney, 20 0 5 .
Financial Markets Report, Sydney, 20 13 . Heaney, R.A. & Layton, A.P., 'A test of the cost of carry
Carew, E., Fast Forward: The History of the Sydney Futures relationship in Australia', Applied Financial Economics,
Exchange, Allen & Unwin, Sydney, 1993. April 1996, pp. 1 4 3 -5 4 .
------, How Australia's Forward-rote Agreement Markets Howard, L. & Jameson, K., 'The futures markets', in R. Bruce
Operate, Australian Financial Markets Association, et al. (eds), Handbook of Australian Corporate Finance,
Sydney, 1994. 5th edn, Butterworths, Sydney, 1997.
Chance, D.M. & Brooks, R., An Introduction to Derivatives Hunt, B. & Terry, C., Financial Institutions and Markets,
and Risk Management, 8th edn, Thomson Learning, Mason, 6th edn, Cengage, Australia, 201 1.
O hio, 20 10 . Kolb, R.W. & O verdahl, J. A ., Understanding Futures
Cornell, B. & Reinganum, M ., 'Forward and futures prices: Markets, 6th edn, John W ile y & Sons, Hoboken,
evidence from the foreign exchange markets7, Journal of N e w Jersey, 2 0 0 6 .
Finance, December 19 81 , pp. 1 0 3 5 -4 5 . Leeson, N . & W hitley, E., Rogue Trader: How I Brought
C o x , 丄， Ingersoll, J. & Ross, S., The relation between Down Borings Bonk and Shook the Financial World, Little,
forw ard prices and futures prices', Journal of Financial Brown and Company, Boston, 19 96 .
Economics, December 1981, pp. 3 2 1 -4 6 . M arkovic, M ., yThe legal status of futures market participants
Cummings, J.R. & Frino, A., 'Tax effects on the pricing in Australia7, Company and Securities Law Journal, April
of Australian stock index futures7, Australian Journal of 1989, pp. 8 2 -1 0 0 .
Management, December 2 0 0 8 , pp. 3 9 1 -4 0 6 . Sheedy, E. & McCracken, S., Derivatives: The Risks that
Easton, S.A. & Pinder, S.M., 'Predicting Reserve Bank of Remain, Allen & Unwin, Sydney, 1997.
Australia interest rate announcements using the 30-day Smith, C.W . Jr, Smithson, C.W . & W akem an, L.M., 'The
interbank cash rate futures contract: beware o f the target evolving market for swaps', in J.M. Stern & D.H. Chew
rate tracker', Australian Economic Review, M arch 20 0 7 , (eds), The Revolution in Corporate Finance, 2nd edn, Basil
pp. 1 1 9 -2 2 . blackwell, O xford, 1992, pp. 3 5 5 -6 7 .
Figlewski, S. & Kon, S., 'Portfolio management with stock -------, -------, & W ilfo rd , D.S.; Managing Financial Risk,
index futures', Financial Analysts Journal, January-February Harper Business, N e w York, 1990.
1982, pp. 5 2 -9 .
562
CHAPTER CONTENTS
18.1 O p t io n s o n f o r e ig n c u r r e n c y 588
■
18.2
In tr o d u c t io n 564
O p t io n s a n d o p t io n m a r k e ts 564 O p t io n s , f o r w a r d s a n d fu tu re s 591
18.3 B in o m ia l o p t io n p r ic in g 577 O p t io n s o n fu tu re s 593
18.4 T h e B la c k - S c h o le s m o d e l o f c a ll C o n t in g e n t c la im s 595
o p t io n p r ic in g 582
LEARNING OBJECTIVES
1 u n d e r s ta n d th e m a jo r t y p e s a n d c h a r a c t e r is tic s o f o p t io n s a n d d is tin g u is h b e t w e e n o p t io n s a n d fu tu re s
2 id e n t if y a n d e x p la in th e f a c to r s t h a t a f f e c t o p t io n p r ic e s
3 u n d e r s ta n d a n d a p p l y b a s ic o p t io n p r ic in g th e o r e m s , in c lu d in g p u t - c a ll p a r it y
4 u n d e r s ta n d th e b in o m ia l m o d e l a n d th e B la c k - S c h o le s m o d e l o f o p t io n p r ic in g a n d c a lc u la t e o p t io n p r ic e s
u s in g th e s e m o d e ls
5 e x p la in th e c h a r a c t e r is t ic s a n d u se s o f f o r e ig n c u r r e n c y o p t io n s a n d o p t io n s o n fu tu re s
6 d e f in e a c o n t in g e n t c la im a n d e x p la in th e o p t io n - lik e f e a tu r e s o f s e v e r a l c o n t in g e n t c la im s .
B usiness finance
Introduction
In this chapter we consider financial contracts known as options. M ost o f this chapter is concerned w ith
options to buy or sell shares, b ut other types o f options are also considered. An option is a special case of
CONTINGENT CLAIM a type o f contract called a co n tin g e n t claim . Stated simply, a contingent claim is an asset whose value
asset whose value depends on the value o f some other asset. A surprisingly large num ber o f financial arrangements fall into
depends on the value
this category. Contingent claims are discussed in Section 18.8. First, however, we consider options and
of some other asset
option markets.
18.2 Options and option markets

m
LEARNING
OBJECTIVE 1 18.2.1 | W h a t is an option?
Understand the
major types and An option is the rig h t (but n o t the obligation) to force a transaction to occur at some fu tu re tim e on terms
characteristics
and conditions agreed to now. For example, the buyer o f a call o p tio n on shares obtains the rig h t to buy
of options and
distinguish between shares in the future from the seller (also known as the writer*) o f the call at a price determ ined now.1 A t
options and futures a future tim e, the buyer o f the call can exercise the rig h t to obtain the shares at the predeterm ined price,
regardless o f what is then the current m arket price o f the shares. Similarly, the buyer o f a p u t o p tio n
CALL OPTION
right to buy an has the rig h t to sell the shares in the future to the w rite r o f the p ut at a predetermined price, regardless
underlying asset at a o f w hat is then the share s current m arket price. This rig h t to buy (in the case o f a call) or to sell (in the
fixed price case o f a p ut) m ust be paid fo r by the option buyer at the tim e the option is purchased. The am ount paid
is called the option price and is determ ined by m arket forces.
PUT OPTION
The Australian Securities Exchange (ASX) provides facilities fo r the trading o f calls and puts on the
right to sell an
underlying asset at a shares o f more than 60 companies listed in Australia.2 The follow ing example, taken fro m th a t market,
fixed price illustrates the nature o f a call option. On Friday 9 August 2013, the closing price o f the 'September 2013
36.00* series o f call options on the shares o f BHP B illito n (BHP) was $0.85. The closing price o f BHP
shares on the same date was $35.29. Here, ^September* refers to the m onth in which the call expires. In
EXERCISE (OR STRIKE) this case, the date o f expiry is 27 September 2013.3 The figure *36.00* indicates an e x e rcise price (or
PRICE str ik e p rice) o f $36, while the $0.85 is the price o f the call. Shares in BHP are the underlying shares*
fixed price at which
in this transaction and each option contract covers 100 shares. Therefore, the buyer o f one call contract
an underlying asset
can be traded, paid 100 x $0.85 = $85 to obtain the rig h t to buy 100 BHP shares at any tim e between 9 August 2013
pursuant to the terms and 27 September 2013, at a predetermined price o f $36 per share. I f the buyer calls on the w rite r to
of an option contract ‘deliver’ （sell) the underlying shares, he or she is said to ‘exercise’ the option. If, as in this example, the call
buyer is able to exercise at any tim e up to (and including) the expiry date, the option is said to be o f the
<Am erican, type; i f exercise can occur only on the expiry date (and n o t before), i t is said to be an o ption o f
the <European, type.
The follow ing example, taken from the same m arket on the same day, illustrates the nature o f a put
option. On 9 August 2013, the closing price o f the ‘September 37.00’ series o f p ut options on the shares
o f BHP was $2.02. As m entioned in the previous paragraph, the closing price o f BHP shares on th a t day
was $35.29 and the expiry date fo r the September series was 27 September 2013. The exercise price
was $37 and the price o f the p ut was $2.02 per share. The buyer o f one p u t contract paid 100 x $2.02 =
$202 to obtain the rig h t to sell 100 BHP shares at any tim e between 9 August 2013 and 27 September
2013 at a predeterm ined price o f $37 per share. I f the p ut buyer requires the p ut w rite r to purchase the
1 Shares are of course not the only assets that can be the subject of an option contract. For example, there are options on stock
market indices, debt instruments, foreign currencies and futures contracts. The last two are discussed in Sections 18.5 and
18.7. Detailed discussion of all four can be found in standard specialised textbooks such as Hull (2013).
2 In addition to standard put and call options, other option-style securities are also traded on the ASX. For example, ASX
warrants are option-style securities that are issued by financial institutions and frequently have quite different payoff
structures than standard exchange traded options. For example, a warrant may have a 'barrier1requirement that dictates that
the warrant terminates once a certain price level, or barrier, is reached.
3 The ASX website provides an up-to-date calendar of expiry dates at www.asx.com.au/documents/about/t24_trading_calendar
.pdf.
4^^
C hapter eighteen O p tio n s a n d c o n t in g e n t claim s
underlying shares, he or she is said to exercise* the option. As w ith calls, puts traded in this m arket are
o f the American type.
Options on shares may be created by the company whose shares underlie the option contract, or by parties
who have no association w ith the company. O ptions created by the company are nearly always call options
and may be created fo r a num ber o f reasons, o f which two are the most common. First, these call options
may be issued to investors as a means o f raising capital fo r the company. The sale o f the options raises
capital and there w ill be a fu rth e r inflow o f capital i f the options are subsequently exercised. Options o f
this kind may be listed on a stock exchange and appear in the share lists together w ith other securities
issued by the company. Second, the company may issue call options to senior employees or directors o f the
company. Typically, in the case o f listed companies, options o f this kind form p art o f the compensation
package fo r managers and are n o t a significant source o f capital fo r the company.
Options can also be created by parties who may have no association w ith the company. For example,
two share m arket observers, A and B, may enter in to a private option contract on the shares o f BHP. This
w ill not raise any capital for BHP and does n o t require any agreement or involvem ent on the p art o f BHP.
Frequently, one or other o f the parties w ill be a shareholder in the company— fo r example, B may be a
shareholder who buys a p ut on BHP shares to give protection against a fall in BHPs share price. However,
it may be that neither p arty is a shareholder at the tim e o f entering into the option contract. O nly i f the
option is subsequently exercised w ill it be necessary fo r shares to be delivered. Shares fo r this purpose can
be purchased in the open m arket i f and when the o ption is exercised. Many o f the term s in private o ption
contracts w ill be subject to negotiation between the parties. A fte r negotiation the contract w ill specify at
least the following:
• the type and number o f shares to be optioned

• the exercise price
• the expiry date
• the adjustment ( if any) to be made in the event o f a change in capital structure (due to any bonus or
rights issues, fo r example)
• the adjustment (if any) to be made in the event o f a dividend payment
• and, o f course, the price o f the option.
On payment o f the option price the buyer and w rite r are bound contractually.
While options created by private negotiation have the advantage th a t the features desired by the
parties can be specified precisely, there are three m ajor disadvantages. First, since there is no organised
system fo r bringing together potential parties to the contract, it w ill often be very d iffic u lt to fin d a
party w ith whom to contract. Second, even i f such a party is found and a contract entered into, i t w ill
not be possible to reverse out o f the contract before the agreed expiry date. Third, it w ill be necessary to
investigate the credit-worthiness o f the other p arty every tim e an option is created. A solution to all three
problems is to establish an organised market, called a listed option m arket, th a t provides a standardised
form o f option contract, a list o f options in which trading can be undertaken and a procedure th a t avoids
the need fo r repeated checking o f credit-worthiness. The Australian Securities Exchange provides a
market o f this type.4
In a listed option market, traders select the desired underlying share, expiry date and exercise price
from a lis t o f those available. Each contract covers a fixed num ber o f shares, and, although adjustments are
made fo r new share issues during the life o f the option, they are n ot made fo r ordinary dividend payments.5
The only negotiable term is the option price, which is determ ined by m arket forces. An individual buyer
in any option series is n ot bound contractually to an individual w riter, b ut rather the class o f buyers (as a
whole) is bound contractually to the class o f w riters (as a whole), w ith exercise notices being distributed
randomly between individual writers. However, exercise is not common because, instead o f exercising, the
holder o f a call option can take his or her p ro fit by selling the call in the secondary m arket.6 I t is possible
4 Similar observations were made in Chapter 17 about the development of futures contracts from forward contracts. There are
many similarities between the organisation of a listed option market and the organisation of a futures market.
5 Adjustments are made in the case of special* and 'abnormal* dividends (see Australian Securities Exchange, 2013).
6 Some reasons for preferring a sale to an exercise are explained in Section 18.2.8. As a consequence, in practice relatively few
options are exercised.
B usiness finance
in this case th a t the buyer w ill be an existing w rite r who wishes to cancel out his or her position, in order
to avoid being exercised against. The organisers o f the market check the credit-worthiness o f traders and,
in a manner sim ilar to the role o f the futures m arket authorities, take the role o f counterparty in every
transaction. A description o f this process in the futures m arket is provided in Section 17.2.2.
There are numerous option markets around the w orld organised along these lines. The firs t such
market to be established was the Chicago Board Options Exchange, which opened in 1973. In Australia, a
market w ith a sim ilar structure was opened in 1976. M ost share options in Australia are traded through
ASX Ltd, w ith the exchange also offering options on several futures contracts.
18 .2 .3 1O ption contracts and futures contracts

It is im p o rta n t to distinguish between option contracts and futures contracts because it is often mistakenly
thought th a t there are only m inor differences between them. O f course, there are some notable similarities.
For example, both types o f contract may involve the delivery o f some underlying asset at a future date and
at a predetermined price. However, there are very significant differences between them. M ost im portantly,
a futures contract r e q u ir e s the delivery o f the underlying asset, whereas an option buyer c h o o s e s whether
delivery w ill occur— th a t is, buyers in futures contracts have an obligation to buy the underlying asset,
whereas buyers of, say, call options have the rig h t to buy i f they so choose. Therefore, if buyers in futures
contracts take no action to cancel th e ir positions, they w ill be required to buy the underlying asset at the
expiry o f the contract. I f buyers o f call or p u t options take no action to cancel th e ir positions, the options
sim ply expire and there are no subsequent transactions. A related difference concerns payment. When a
futures contract is made, the payment o f the futures price is not required u n til the expiry date, b ut when
an o ption contract is made, the buyer m ust imm ediately pay the option price to the w rite r.7 I f the option
is subsequently exercised, there is a fu rth e r transaction when the exercise price is paid.
18.2.41 Payoff structures for calls and puts

I t is an axiom o f finance theory that, ultim ately, the prospect o f future cash flows is the only source o f
PAYOFF STRUCTURE value. An alternative term fo r the future cash flows o f a contract is its p a y o ff s tru c tu re . The easiest
set o f fu tu re ca sh flo w s financial contract to value is one th a t promises (w ith certainty) a fixed am ount to be paid in cash on a
fixed fu tu re date— th a t is, the payoff structure is a single cash flow w ith a probability o f 1.0. The payoff
structures fo r options are more complicated because the payoff (cash flow) depends on the share price on
the expiry date o f the option.
Consider the BHP 36.00 call option discussed in Section 18.2.1. If, on the calls expiry date, the BHP
share price is $36 or less, the call w ill be w o rth n othing on expiry. There w ill be no payoff at all. For
example, there is no value in having a call th a t is about to expire and which gives the call holder the rig h t
to pay $36 per share when the m arket price is only, say, $35 per share. If, however, the share price at the
expiry o f the call is more than $36, then the payoff per share is the difference between the share price and
the exercise price o f $36. For example, i f the share price at the expiry o f the call is $37, the payoff is $1.
This is the payoff because the call holder could exercise the call and pay the exercise price o f $36 per share,
and then imm ediately resell the share fo r its m arket price o f $37, producing a net cash inflow o f $1 per
share. In summary, the payoff on a call option is:
M a x [0 ,S * - A ]
where S* = the share price on the calls expiry date8
X = the exercise price o f the call
The payoff structure is shown in more detail in Table 18.1. The inform a tion in Table 18.1 is shown in
graphical form in Figure 18.1.
The payoff structure fo r a p u t option is illustrated using, as an example, the BHP 37.00 p ut option also
discussed in Section 18.2.1. If, on the p u ts expiry date, the BHP share price is $37 or more, the p u t w ill be
w o rth n othing on expiry. There w ill be no payoff at all. For example, there is no value in having a p ut that
7 Some options on futures contracts are an exception to this rule.

8 Throughout this chapter, an asterisk (*)is used to indicate the value of the variable on the options expiry date. Note also that
in previous chapters we have used the symbol P for the share price. However, in the option pricing literature it is standard to
use S for the share price.
C hapter eighteen O p tio n s a n d c o n t in g e n t c laim s
TABLE 18.1 Payoff structure for a bought call with an exercise price of $36.00
If th e s h a re p ric e ($) o n th e c a ll’s e x p ir y d a te is T hen th e p a y o f f (ca sh flo w ) ($ ) to th e c a ll h o ld e r is
34.00 0
34.50 0
35.00 0
35.50 0
36.00 0
36.50 0.50
37.00 1.00
37.50 1.50
38.00 2.00
38.50 2.50
Figure 18.1 Payoff structure: call (bought)
is about to expire and which gives the p ut holder the rig h t to sell a share fo r $37 when the m arket price is
already, say, $38 per share. However, if the share price on the expiry date o f the p u t is less than $37, then
the payoff is the difference between the exercise price o f $37 and the share price. For example, i f the share
price at the expiry o f the p u t is $35.50, the payoff is $1.50. In summary, the payoff on a p ut option is:
M a x [0 ,X -S * ]
where S* = the share price on the p u ts expiry date

X = the exercise price o f the p ut
The payoff structure is shown in more detail in Table 18.2. The inform a tion in Table 18.2 is shown in
graphical form in Figure 18.2.
1 8 .2 .5 1 Factors affecting call option prices LEARNING

OBJECTIVE 2
The aim o f this section is to develop an in tu itiv e understanding o f the factors th a t w ill affect the price o f
a call option.9 Discussion o f form al valuation models is undertaken in Sections 18.3 and 18.4. the factors that affect
Table 18.3 shows the prices o f selected call options on BHP B illito n shares on 9 and 12 August 2013. option prices
9 Similar factors are relevant to the determination of put prices. These are discussed in Section 18.2.6.
4^^
B usiness finance
TABLE 18.2 Payoff structure for a bought put with an exercise price of $37.00
If th e s h a re p ric e ($ ) o n th e p u t's e x p ir y d a te is | T hen th e p a y o f f (cash flo w ) ($ ) to th e p u t h o ld e r is
34.50 2.50
35.00 2.00
35.50 1.50
36.00 1.00
36.50 0.50
37.00 0
37.50 0
38.00 0
38.50 0
Rgure 18.2 Payoff structure: put (bought)

gjpôd
Table 18.3 provides the market prices o f nine call options on BHP. Panel A o f the table provides the
prices o f these nine options at the close o f trading on Friday 9 August 2013. Panel B provides the prices of
these options at the close o f business one trading day later. Panel C shows the percentage change in each
call price between the tw o trading days. In the follow ing discussion we use the prices shown in Table 18.3
to illustrate the factors th a t affect call prices.
Options have value because o ption buyers can exercise the option to th e ir advantage, should the
o p p o rtu n ity to do so arise. A fundam ental advantage o f holding a call option is th a t i t may be possible
to obtain the underlying shares more cheaply by exercising the option than by direct share purchase.
Intuitively, the price paid fo r the rig h t to exercise should therefore reflect, among other factors, the
probability th a t the share price w ill rise above the exercise price (or rise fu rth e r above it, i f it has already
been exceeded). This probability should, in tu rn , be related to the follow ing factors.
The current share price

The higher the current share price, the greater is the probability th a t the share price w ill increase above
the exercise price, and therefore the higher the call price, other things being equal. Ignoring m arket
imperfections, a call whose underlying share price is already above the exercise price m ust be w orth at
least the difference between the two. This am ount is the cash flow th a t w ill occur i f the call is exercised
C hapter eighteen O p tio ns a n d c o n t in g e n t cla im s
TABLE 18.3 Closing prices of selected call options on BHP Billiton shares on
Friday 9 August 2013 and Monday 12 August 2013
P an el A : C a ll p ric e s o n F r id a y 9 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 5 . 2 9 )
E xe rcise p ric e s ($)
E x p iry d a te $ 3 5 .0 0 $ 3 6 .0 0 $ 3 7 .0 0
27 September 2013 1.44 0.85 0.43
30 October 2013 1.67 1.10 0.67
28 November 2013 2.00 1.44 0.98
P an el B: C a ll p ric e s o n M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p ric e == $ 3 6 . 1 4 )
E xe rcise p ric e s ($ )
E x p iry d a te $ 3 5 .0 0 $ 3 6 .0 0 $ 3 7 .0 0
27 September 2013 2.07 1.33 0.77
30 October 2013 2.25 1.57 1.03
28 November 2013 2.52 1.89 1.38
Panel C : P e rc e n ta g e c h a n g e in p ric e s fro m F rid a y 9 A u g u s t 2 0 1 3 to M o n d a y 1 2 A u g u s t 2 0 1 3

(s h a re p r ic e c h a n g e = 2 .4 % )
E x p iry d a te $ 3 5 .0 0 $ 3 6 .0 0 $ 3 7 .0 0
27 September 2013 44 56 79
30 October 2013 35 43 54
28 November 2013 26 31 41
Source: Compiled from IRESS Financial Database.
immediately, and is referred to as the calls in trin sic value. However, even a call whose exercise price INTRINSIC VALUE
is above the current price o f the underlying share m ust be w orth something. I t has value as long as value of an option if
exercised immediately
there is some chance, however small, th a t at some p o in t in the calls life the in trin s ic value may become
positive. In Table 18.3, every call commands a price th a t is greater than its in trin s ic value. For example, on
9 August, the in trin sic value o f the September 35.00 call is 29 cents, and its price is $1.44. The dependence
o f the call price on the current share price can be seen in the fact th a t all six calls increased in price when
there was an increase in the price o f the underlying shares. Note also th a t the magnitude o f the percentage
increases fo r the call prices far exceeds the percentage increase o f 2.4 per cent in the share price— th a t is,
the leverage offered by call options is very high.
The exercise price

Clearly, the higher the exercise price, the lower is the probability th a t the share price w ill increase above
the exercise price, and, therefore, the lower the call price, other things being equal. This relationship can
be seen in the prices given in Table 18.3. On both 9 August and 12 August, fo r any given expiry date, the
call price falls when we consider higher exercise prices. For example, on 9 August, the price o f the options
expiring in September is $1.44 when the exercise price is $35, falling to $0.85 when the exercise price is
$36 and finally just $0.43 when the exercise price is $37.
The term to expiry

The longer the term to expiry, the greater is the probability th a t the share price w ill increase above the
exercise price. Therefore, the longer the term to expiry, the greater is the call price, other things being
equal. To make the same p o in t in a slightly different way, consider tw o American calls th a t are equivalent
4^^
B usiness finance
in every respect, except th a t one has a shorter term to expiry than the other. In the period before the
expiry o f the shorter-term call, both calls provide the option buyer w ith the same rights. However, the
rights conferred by the longer-term call continue fo r a fu rth e r period. Therefore, the longer-term call is
TIME VALUE more valuable. The am ount o f the call price over and above any in trin sic value is called the tim e value,
value of an option in since w ith all other factors constant it w ill be greater, the longer the term to expiry. Note, however, that
excess of its intrinsic term to expiry is only one factor determ ining the tim e value. I t should also be distinguished from the
value
‘tim e value o f money’，which is dealt w ith below. This effect o f term to expiry on call price can also be
seen in the prices given in Table 18.3. On b oth 9 August and 12 August, fo r any given exercise price,
the call price increases when we consider later expiry dates. For example, on 12 August, the price o f the
options w ith an exercise price o f $35 is $2.07 fo r the options expiring in September, rising to $2.25 fo r
the options expiring in October and then to $2.52 fo r the November series.
The volatility of the share

VOLATILITY The volatility o f a share is the va riab ility o f its price over tim e.10 The effect o f v o la tility on call price
variability of a is illustrated in the follow ing simple example. Consider a high v o la tility share, H, whose current price
share price; can is $5, and a low v o la tility share, L, whose current price is also $5. Consider call options on H and L at a
be measured by
mom ent before expiry. The exercise price o f both call options is $5. As explained previously, calls at expiry
the variance (or the
standard deviation) are w o rth a positive am ount i f the difference between the share price and the exercise price is positive.
of the distribution of Otherwise they are w o rth zero. Suppose fu rth e r th a t the probabilities o f various share prices at expiry are
returns on the share known to be those shown in Table 18.4.
TABLE 18.4 Probability distributions for shares H and L

S h a re H S h a re L
S h a re p r ic e ($ ) P ro b a b ility V a lu e o f c a ll ($) S h a re p ric e ($) P ro b a b ility V a lu e o f c a ll ($ )
4.00 0.2 0.00 4.00 0.04 0.00
4.50 0.2 0.00 4.50 0.16 0.00
5.00 0.2 0.00 5.00 0.60 0.00
5.50 0.2 0.50 5.50 0.16 0.50
6.00 0.2 1.00 6.00 0.04 1.00
The expected values o f the calls on shares H and L are:

E (call on H) = (0.2)($0.50) + (0.2)($1.00) = $0.30
E (call on L) = (0.16)($0.50) + (0.04)($1.00) = $0.12
The call on the lo w -vo la tility share is less valuable than the call on the h ig h -v o la tility share. This result
is n o t peculiar to this p articular example and i t has been shown (M erton 1973a, p. 149) that, other things
being equal, calls on h ig h -vo la tility shares are w o rth more than calls on lo w -v o la tility shares.
The basic reason fo r this result is the asymmetric nature o f the payoffs on a call option. As shown in
Table 18.4, when a call expires, the holder is ind iffe re nt between all the share prices th a t are less than
or equal to the exercise price. A ll such share prices are equally disastrous fo r the call holder because in
all such cases the value o f the call is zero. However, at expiry, fo r share prices th a t exceed the exercise
price, the value o f the call increases by 1 cent fo r every 1-cent increase in the share price. A t times before
expiry this asymmetry is n ot as sharp, b u t it remains true th a t the holder o f a call benefits more from ,
say, a 1-cent increase in share price than is lost from a 1-cent decrease in share price. W hile a higher share
price v o la tility increases the chance o f both large increases and large decreases in the share price, the
asymmetric features just described mean th a t the holder o f a call gains more from the increased chance
o f a large increase in share price than is lost from the increased chance o f a large decrease in share price.
Therefore, on balance, the call holder has a favourable view o f vo latility. Higher v o la tility increases the
price o f a call, other things being equal.
10 Volatility can be measured in various ways. One frequently used measure is the variance of the returns on the share in a
recent period.
C hapter eighteen O p tio ns a n d c o n t in g e n t c laim s
The risk-free interest rate

The buyer o f a call option can defer paying fo r the shares. (O f course, the call also confers the rig h t n o t to
buy the shares at all, b ut this is n ot the p o in t we are making.) Because interest rates are positive, money
has a tim e value, so the rig h t to defer payment is valuable. The higher the interest rate, the more valuable
is this right. Therefore, it is plausible to suggest th a t the higher the risk-free interest rate, the higher is
the price o f a call, other things being equal.
Expected dividends
I t was explained in Section 11.4.4 that when a company pays a dividend the share price w ill fall on the
ex-dividend date. It has already been explained in this chapter th a t the price o f a call w ill decrease i f the
price o f the underlying share decreases. It is to be expected, therefore, th a t a call on a share th a t w ill go
ex-dividend before the expiry o f the call is w o rth less than i f the share either never pays dividends or, i f it
does pay dividends, w ill n ot reach the next ex-dividend date u n til after the call has expired. In short, calls
on shares th a t pay high dividends during the life o f the call are w o rth less than calls on shares th a t pay
low dividends during the life o f the call, other things being equal.
The effect o f dividends on call price may be reduced, though n ot eliminated, i f the option is o f the
American type.11 As m entioned in Section 18.2.1, this type o f option may be exercised at any tim e before
expiry. By exercising just before an ex-dividend date, the holder o f a call becomes a shareholder and is
therefore entitled to the dividend. The cost o f this strategy is th a t the calls expiry date is, in effect, shifted
to the ex-dividend date, thereby reducing its effective term to expiry. As explained earlier, a shorter term
to expiry reduces the tim e value o f a call and hence reduces its price. Therefore, in deciding whether a call
should be exercised before an ex-dividend date, the call holder needs to balance carefully the benefit of
obtaining the dividend against the cost o f fo rfe itin g the options tim e value.
To summarise, other things being equal, call prices should be higher (lower):
a the higher (lower) the current share price

b the lower (higher) the exercise price
c the longer (shorter) the te rm to expiry
d the more (less) volatile the underlying share
e the higher (lower) the risk-free interest rate
1 the lower (higher) the expected dividend to be paid follow ing an ex-dividend date th a t occurs during
the term o f the call.
The buyer o f a p ut option obtains the rig h t to sell shares at the exercise price. The higher the exercise
price, the more the buyer o f the put stands to gain. For example, the rig h t to sell a share fo r $1 is more
valuable than the rig h t to sell fo r only 90 cents, other things being equal. Therefore, fo r p u t options,
the higher the exercise price, the higher is the price o f the option. For call options the opposite is true.
Similarly, the rig h t to sell a share at a fixed price is less valuable the higher the current share price, other
things being equal. For example, suppose th a t the holder o f a p ut exercised her rig h t to sell a share at the
exercise price o f $1. I f the current share price is 90 cents, the holder o f the p ut gains 10 cents because she
has been able to sell the share fo r 10 cents more than it is currently w orth. I f the share price had been
higher— say, 95 cents— the gain would have been only 5 cents. Therefore, higher share prices im ply lower
put prices, other things being equal. For call options, the opposite is true.
The relationship between price and term to expiry is straightforw ard in the case o f American puts.
Consider two American puts, equivalent in all respects except th a t one has a longer term to expiry. Both
puts may be exercised at any tim e up to (and including) th e ir respective expiry dates. Therefore, the long
term put perm its exercise at all times p erm itted by the short-term put, b u t in addition the long-term p ut
11 European-type options may contain a clause that adjusts the contract’s terms if there is a dividend. These ‘dividend protection
clauses*, as they are known, also reduce, but do not eliminate, the effects of dividends on the calls price.
B usiness finance
perm its exercise after the expiry o f the short-term put. Therefore, fo r American puts, a longer term to
expiry increases the value o f the put, other things being equal.12 This is also true o f call options.
Table 18.5 shows the prices o f selected p u t options on BHP B illito n shares on Friday 9 August 2013
and Monday 12 August 2013.
TABLE 18.5 Closing prices of selected put options on BHP Billiton shares on Friday
9 August 2013 and Monday 12 August 2013
P an el A : Put p ric e s o n F r id a y 9 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 5 . 2 9 )
E xe rc is e p ric e s ($ )
E x p ir y d a te $ 3 5 .0 0 $ 3 6 .0 0 $ 3 7 .0 0
27 September 2013 0.86 1.34 2.02
30 October 2013 1.13 1.59 2.23
28 November 2013 1.43 1.83 2.42
P a n e l B: Put p ric e s o n M o n d a y 1 2 A u g u s t 2 0 1 3 (s h a re p r ic e = $ 3 6 . 1 4 )
E x p ir y d a te $ 3 5 .0 0 $ 3 5 .0 0 $ 3 7 .0 0
27 September 2013 0.57 0.94 1.45
30 October 2013 0.84 1.19 1.71
28 November 2013 1.11 1.47 1.96
P an el C : P e rc e n ta g e c h a n g e in p ric e s fro m F r id a y 9 A u g u s t 2 0 1 3 to M o n d a y 1 2 A u g u s t 2 0 1 3
(s h a re p r ic e c h a n g e = 2 .4 % )
E xe rc is e p ric e s ($ )
E x p ir y d a te $ 3 5 .0 0 $ 3 6 .0 0 $ 3 7 .0 0
27 September 2013 -34 -30 -28
30 October 2013 -26 -25 -23
28 November 2013 -22 -20 -19
Source: Compiled from IRESS Financial Database.
The influences o f exercise price and term to expiry can be seen in the p ut prices given in Table 18.5. On
both trading dates, fo r any given expiry date, the p ut price is higher the higher is the exercise price. For
example, on 9 August, the price o f the September 37.00 exceeds th a t o f the September 36.00, which in
tu rn exceeds th a t o f the September 35.00. These prices illustrate that, other things being equal, a higher
exercise price implies a higher p u t price. Comparing puts o f different terms, it is also clear th a t a longer
term implies a higher p ut price, other things being equal. On b oth trading dates, fo r any given exercise
price, the p ut price is higher the longer is the term to expiry. For example, on 9 August 2013, the price o f
the September 35.00 p u t is $0.86, while the price o f the October 35.00 is $1.13.
The effect o f the share price on the prices o f p u t options is also dearly evident in Table 18.5. On
M onday 12 August the share price was higher than i t had been on the previous Friday and, as a result, all
p ut prices had decreased on th a t day. As w ith calls, the percentage changes in the p ut prices exceed the
percentage change in the share price. Unlike a call, a p ut has a m axim um possible value. For example, in
the case o f the October 36.00 p u t in Table 18.5, even i f the price o f BHP shares should fall to zero, the
12 For a European put, the relationship between price and the term to expiry is more complex. On the one hand, a short
term European put can be exercised earlier than an otherwise equivalent long-term European put, therefore generating an
earlier cash inflow for the holder of the put. This suggests that a short-term European put is m ore valuable than a long-term
European put. On the other hand, a longer term to expiry increases the probability that the share price will fall below the
exercise price, and this suggests that a short-term European put is le ss valuable than a long-term European put. For any given
European put, both factors are relevant and either influence can dominate the other, depending on the put being considered.
4 ^^
C hapter eighteen O p tio ns a n d c o n t in g e n t cla im s
payoff to the holder o f the put cannot exceed $36. Because share prices can never fall below zero, a put
can never be w orth more than its exercise price.
The buyer o f a p ut option w ill gain i f share prices fall. Consequently, puts are especially attractive to
shareholders who fear th a t the share price may decrease, b u t who nevertheless do n o t wish to sell th eir
shares. Consider, fo r example, an investor who on 9 August 2013 bought a BHP share fo r $35.29 and a
BHP September 35.00 p u t fo r $0.86, m aking a to ta l outlay o f $36.15. The p ut option ensures that, u n til
it expires in September, the investor is guaranteed th a t he or she w ill n ot have to sell th e ir shares fo r
less than $35 per share. Thus i f the share price decreased to, say, $31— which represents a loss o f $4.29
or 13.8 per cent o f the share price o f $35.29— this investor w ill be able to sell at $35 and thus w ill lose
only $0.29 or 0.8 per cent o f the to ta l outlay o f $36.15. In effect, the purchase o f a p ut is like buying an
insurance policy against the share price falling below a given level.
As w ith call options, higher share v o la tility implies a higher option price. Higher v o la tility implies a
greater chance o f large increases and large decreases in the share price. From the p u t holders view point,
share price increases are bad news, while decreases are good news. But a p ut holder gains more from a
share price decrease than is lost from an increase o f the same amount. So, on balance, a p ut holder has a
favourable view o f share price vo latility.
Because a p ut confers the rig h t to receive a future cash inflow, it is expected th a t p u t prices should be
negatively related to interest rates. A higher interest rate reduces the present value o f whatever future
cash inflow may be received. Finally, dividend payments reduce share prices, which benefits p ut holders,
so higher expected dividend payments increase p ut prices.
The effects fo r American calls and puts are summarised in Table 18.6. Positive (negative) means the
option price responds in the same (opposite) direction to a change in the factor affecting prices.
TABLE 18.6 Factors affecting American option prices

F a cto r C a ll p ric e s Put p ric e s
Current share price Positive Negative
Exercise price Negative Positive
Term to expiry Positive Positive
Volatility of the share Positive Positive
Risk-free interest rate Positive Negative
Expected dividends Negative Positive
18.2.7! Put-call parity

For European options on shares th a t do n o t pay dividends there is an equilibrium relationship between
LEARNING
the prices o f puts and calls th a t are w ritte n on the same underlying share, are traded simultaneously and OBJECTIVE 3
have the same exercise price and term to expiry. This relationship, known as pu t-call parity, was derived Understand and apply
by Stoll (1969) and subsequently analysed fu rth e r by M erton (1973b). We now derive and explain this basic option pricing
relationship. theorems, including
put-call parity
It is assumed th a t options are traded in frictionless markets and th a t no security (or p o rtfo lio )
dominates any other security (or p ortfo lio ). The meaning o f ‘dominance’ in this context may be illustrated
as follows. Suppose th a t on some future date there can be only three possible sets o f m arket conditions or
PUT-CALL PARITY
States o f the world*, and the payoffs on securities (or portfolios) A and B in these states w ill be as shown relationship that
in Table 18.7. exists between the
price of a call option
and the price of the
TABLE 18.7 Payoffs showing a dominant portfolio corresponding put
option
P o rtfo lio P a y o ff ($ ) in :
S ta te 1 S ta te 2 S ta te 3
A 5 7 11
B 5 7 10
4^^
B usiness finance
I f A and B sell fo r the same price today, then A dominates B because A pays the same as B in States
1 and 2, b u t pays more than B in State 3. Therefore, to prevent dominance, the price o f A today m ust be
greater than the price o f B. Formally, A dominates B if, on some known date in the future, the payoff on
A is greater than the payoff on B in one (or more) o f the possible states, and the payoff on A is at least
as great as the payoff on B in all other possible states. A special case o f the no-dominance requirement
arises i f A and B have the same payoff in all possible states. In th a t case A and B m ust command the same
price today. I f the m arket is perfect, a no-dominance requirem ent is equivalent to a requirem ent th a t no
arbitrage opportunities exist.
Using these assumptions, i t can be shown th a t the follow ing relationship, known as p u t-c a ll parity,
exists between p ut and call prices:
p= c- s+777 IliU
where p = the price o f the European put
c = the price o f the corresponding European call
S= the share price
X = the exercise price
〆 = the risk-free interest rate fo r borrow ing or lending fo r a period equal to the term o f the p u t and
the call
Expressed in words, p u t-ca ll parity says that the p u t price equals the call price, less the share price,
plus the present value (at the risk-free interest rate fo r the term o f the option) o f the exercise price.
TABLE 18.8 Payoffs showing put-call parity

P o rtfo lio V a lu e n o w P a y o ff in S ta te 1 (S * > X ) P a y o ff in S ta te 2 (S " < X )
X
A c+ , (S*-X)+X =S* o +x =x
1+ 〆
B p+ S o +s* =s* (X- S*) + S* = X
To prove th a t Equation 18.1 holds, consider two portfolios, A and B. The com position and payoffs
X
o f these p ortfo lio s are shown in Table 18.8. Portfolio A consists o f the call, plus an investm ent o f ~
dollars invested at the risk-free rate, to mature on the expiry date o f the p u t and the call. Therefore, the
X
cash o utflo w required to set up Portfolio A is c 4- -------Portfolio B consists o f the p ut plus one share. The
outflow required to set up Portfolio B is therefore p + S. As both options are European, they cannot be
exercised before expiry, and the relevant 'states o f the world* are as follows: State 1 is a share price th a t is
greater than or equal to the exercise price (S* > X ) and State 2 is a share price th a t is less than the exercise
price (S* < X). I f State 1 occurs, then the call is w o rth S* - X and the p u t is w o rth zero. I f State 2 occurs,
then the call is w o rth zero and the p u t is w o rth X- S*. In either state, the risk-free investm ent w ill mature
w ith a value of:
X
(1 + / ) = X
I f State 1 occurs, then both A and B have a payoff o f S*, b u t i f State 2 occurs, then b oth A and B have a
payoff o f X Therefore, there is no reason to prefer A to B (or vice versa). Therefore, to prevent dominance,
A and B m ust command the same price now — th a t is, the cost o f A and B m ust always be equal. This
requires that:
X p+ S
1 +〆
Rearranging this expression gives Equation 18.1.

This theorem has three im p o rta n t implications. First, i f a form ula can be derived to price, say, a
European call, then by using Equation 18.1, a form ula can be derived to price the equivalent put. Second,
4^^
C hapter eighteen O p tio ns a n d c o n t in g e n t c laim s
Equation 18.1 does n o t include the expected retu rn on the underlying share, im plying th a t the expected
return is not directly relevant to pricing puts or calls. For example, suppose th a t an investor expects the
price o f the underlying share to increase in the near future. Obviously such an investor is likely to buy a
call, and sell a put. I t is tem pting— b ut incorrect— to suggest th a t this action w ill tend to increase the call
price (because the demand fo r calls has increased) and decrease the p ut price (because the supply o f puts
has increased). But i f this happened, Equation 18.1 would be violated and a profitable arbitrage would
exist. Therefore, the expected return on the share is n ot directly relevant to option pricing. Third, i f the
expected future v o la tility o f the share increases, w ith o u t a simultaneous change in the level o f today s
share price, then the prices o f all puts and calls on the share should also increase (see Finance in Action).
Put-call p arity should hold true both before and after a change in volatility.
Investors1expectations o f the future direction o f a share price are relevant to the determ ination o f the
share price itse lf — th a t is, the share price w ill reflect the influence o f these expectations. Therefore these
expectations are relevant to o ption pricing b ut only via th e ir influence on the share price itself. They have
no independent role to play. This conclusion has great significance fo r attem pts to construct formulae to
price options because it implies th a t these form ulae do not need to include a measure o f expectations o f
the future direction o f the share price. Such measurements are notoriously d iffic u lt to make.
F in a n c e
VOLATILITY IS THE KEY TO PRICE MOVEMENTS________________
in ACTION
If a c o m p a n y 's fu tu r e s u d d e n ly lo o k s m o r e u n c e r t a in , th e s h a re m a r k e t w i ll e x p e c t its fu tu r e s h a re
p r ic e v o la t ilit y to b e h ig h e r. In p r in c ip le , th is s h o u ld m e a n t h a t b o th p u t a n d c a ll o p t io n s o n th e
s h a re s s h o u ld in c re a s e in p r ic e . N ic e t h e o r y . . . b u t d o e s it r e a lly w o r k t h a t w a y in p r a c tic e ? Yes,
it d o e s !
T h e ru m o u r la s t w e e k t h a t B r a m b le s w a s a t a k e o v e r t a r g e t c a u s e d its s h a r e s to ris e a n d
B r a m b le s ' v o la t ilit y to ju m p in th e d e r iv a tiv e s m a r k e ts . M o s t B r a m b le s d e r iv a t iv e s e lle rs , o p t io n
w r ite r s a n d w a r r a n t is s u e rs im m e d ia t e ly b e g a n a s k in g m o r e m o n e y f o r s h o r te r - d a te d o p t io n s
a n d w a r r a n t s o v e r s h a re s in th e t r o u b le d c o m p a n y . T h is in c lu d e d b o t h p u ts a n d c a lls , a lth o u g h
s h o r te r - d a te d c a lls ( O c t o b e r a n d D e c e m b e r e x p ir ie s ) w e r e th e h ig h e s t p r ic e d in te rm s o f
im p lie d v o la t ility .
T h e s e lle rs w e r e a s k in g m o r e o n th e lo g ic a l e x p e c t a t io n o f g r e a t e r u n c e r t a in t y in th e
B ra m b le s s h a r e p r ic e w h ile th e r u m o u r p e rs is ts . T h e e x te n t o f th is u n c e r t a in t y c a n b e a s s e s s e d
fro m a c lo s e e x a m in a t io n o f th e im p lie d v o l a t ili t y e x p e c t a t io n s o v e r B r a m b le s a t- o r c lo s e -to -th e -
m o n e y o p t io n s fr o m ju s t u n d e r 3 0 p o in ts to ju s t u n d e r 3 5 p o in ts o v e r th e w e e k .
Source.. 'Volatility is the key to price movements,, John Wasiliev, yAusfra//an F/nanc/a/ /?ev/evv, 24 September 2003.
The p u t-ca ll p arity theorem applies only to European options, whereas, in practice, most options are
of the American type. W hile there is no simple equation lin k in g the values o f American puts and calls,
upper and lower bounds have been established, as shown below:
X
c —S + < p < c -S X
1+〆， 18.2
where p = the price o f the American put
c = the price o f the corresponding American call
S = the share price
X = the exercise price
r = the risk-free interest rate fo r borrow ing
In effect, the lower bound in Equation 18.2 matches the result fo r European p u t-c a ll parity, while the
upper bound exceeds this lower bound by the difference between the exercise price and the present value
o f the exercise price. When the risk-free interest rate fo r borrow ing is low and/or the term o f the options
is short, the present value effect w ill be small and hence the gap between the upper and lower bounds w ill
also be small.13
13 For a detailed treatment of put-call parity under a range of conditions see Cox and Rubinstein (1985).
4^^
Loudon (1988) studied approximately 1300 pairs o f prices fo r BHP puts and calls in 1985 and concluded
th a t although violations o f p u t-c a ll p a rity were n o t uncommon, investors facing norm al transaction costs
would be unable to p ro fit from the violations. More recently, Ofek, Richardson and W hitelaw (2004)
tested fo r violations o f p u t-ca ll p a rity fo r approximately 80 000 matched pairs o f options trading on US
exchanges between 1999 and 2001 and report th a t the p a rity relationship is frequently violated and that
profitable strategies could be employed even after accounting fo r transaction costs.
1 8 .2 .8 1The minimum value of calls and puts

Assuming frictionless markets and the same no-dominance fram ework used earlier to derive the p u t-ca ll
p a rity theorem, the m inim um value o f a European call on a share that does n ot pay dividends is:
M in c = Max 0, S - 18.3
To prove this equation, consider two portfolios, A and Their composition and payoffs are shown
in Table 18.9. As in the p ro of o f p u t-c a ll parity, Portfolio A consists o f the call and a risk-free investm ent
X
of | + dollars. Portfolio Br consists o f just one share. The two relevant states are again State 1 (S* > X )
and State 2 (S* < X ).
TABLE 18.9 Payoffs showing the minimum value of a call optio n

Portfolio Value now Payoff in State 1 (S* > X) Payoff in State 2 (S* < X)
X
A c+ ------7 (S *-X )+ X = S * o +x = x
1+ 〆
B, S S* s*
The explanation o f the entries in the table fo r Portfolio A is the same as in the proof o f p u t-c a ll parity.
Portfolio Br, which consists o f only the share, pays o ff S* regardless o f the state th a t occurs. Therefore, if
State 1 occurs, both A and B/ have a payoff o f S*, b ut i f State 2 occurs, then A pays o ff more than Br because
in th a t state, X > S*. Invoking the no-dominance assumption, it follows th a t the value o f A m ust therefore
be no less than the value o f Br at all times before the call expires— th a t is:
> S
which implies that:

X
c > S-
The right-hand side o f this inequality can be negative but, because o f lim ite d liab ility, call prices can
never be negative— th a t is, c > 0. Combining these tw o inequalities gives Equation 18.3.
This result has an im p o rta n t im plication: in the absence o f dividends, American call options should
n o t be exercised before expiry. Clearly the holder o f an American call would n o t even consider exercise
unless the share price, S, exceeded the exercise price, X. Suppose th a t S > X and the holder o f an American
call has decided to dispose o f the call. To do so a choice m ust be made between exercising the call and
selling the call. However, this choice is easy. I f the call is exercised, the payoff (or, net cash flow) is
X
S - X b u t i f the call is sold, then, by Equation 18.3, the payoff is at least S----------which w ill exceed S - X
1+ 〆
provided only th a t the interest rate is positive. Given th a t interest rates are always positive, the payoff
from selling the call m ust exceed the payoff from exercising the call. I t follows th a t an American call w ill
never be exercised early and, accordingly, the rig h t to do so is valueless. The call m ig ht just as well be
European. Under the conditions we have assumed, the d istin ction between European calls and American
calls is irrelevant to th e ir valuation.
C hapter eighteen O ptions a n d c o n tin g e n t claims
A t first sight this conclusion may be surprising, b ut i t has an in tu itiv e explanation. I f a call is exercised
early, the options life is cut short, so the call holder fo rfeits any tim e value the option had. One reason call
options have a tim e value is th a t interest rates are positive, so later cash outflows are preferred to early
cash outflows. By exercising early, the call holder m ust pay fo r the shares earlier than would otherwise
have been necessary. Thus, i f a call holder has decided to dispose o f the option, he or she should always
prefer to sell the call rather than exercise it.
The rule against early exercise does n ot necessarily hold i f an ex-dividend date w ill occur during the
life o f the call. As m entioned in Section 18.2.5, early exercise o f an American call can be rational in these
circumstances. Traditionally it has been thought th a t early exercise o f a call would be rational only on
the date imm ediately preceding the ex-dividend date; at all other times, selling the call w ill generate a
greater cash flow fo r a call holder who wishes dispose o f the option. More recently however, A lp ert (2010)
has demonstrated th a t tax effects can overturn this conclusion— th a t is, the after-tax cash flow from
selling the call may be less than the after-tax cash flow from exercising the call. Using a sample o f UK
options, A lp ert finds empirical evidence to suggest th a t many exercises th a t appear irra tion al in a no-tax
framework may be rational i f tax effects are considered. Using sim ilar methodology, Phang and Brown
(2011) study 454 instances o f the early exercise o f call options in the Australian m arket. They find that
approximately tw o-thirds o f these instances occurred on the day im m ediately preceding the ex-dividend
date. They also report th a t approximately 80 per cent o f the rem aining instances o f early exercise may
be explained by option holders m aking th e ir exercise decision on the basis o f m axim ising th e ir after tax
cash flows.
The m inim um value o f a European p ut can be found by combining p u t-c a ll p a rity (Equation 18.1) and
the m inim um value o f a European call (Equation 18.3). The result is:
X
M in p = Max 〇, 18.4
However, unlike the case o f calls, the expression fo r the m inim um value o f a European p ut cannot be
used to show that the d istin ction between American and European options is irrelevant fo r puts, even
in the absence o f dividends. I t can be rational to exercise an American p ut before expiry, and therefore
American puts are w o rth more than th e ir European counterparts. Again there is an in tu itiv e explanation.
If a put is exercised, tw o things happen. First, as w ith calls, the o ptions tim e value is forfeited and this
outcome is undesirable. Second, the p ut holder is paid fo r the shares earlier than would otherwise be the
case. Because early cash inflow s are preferred to later cash inflows, this outcome is desirable. In some
circumstances— fo r example, i f the current share price is very low and interest rates are very high— the
second effect outweighs the first, and in these cases the rig h t to exercise early is valuable.
Binomial option pricing

So far we have developed some logical bounds on option prices. For example, we have established that
L E A R N IN G
the price o f a long-term American option should exceed th a t o f its short-term counterpart. Similarly, we
O B JEC TIVE 4
have established th a t a p ut option can never be w o rth more than the exercise price. W hile these sorts o f
U nde rstand the
relationships are useful, they do n ot answer the fundam ental question we w ant to ask about any given b inom ial m odel and
option: how much (exactly) is i t worth? That is, w hat should be its price? the B la ck -S ch o le s
Binomial option pricing is an im p o rta n t and widely used approach to answering this question. m odel of option
pricing a n d calculate
Binomial option pricing was firs t suggested by W illiam Sharpe, and developed in an article by Cox, Ross
option prices using
and Rubinstein (1979). In this section we present the m ain features o f th e ir m odel.14
these m odels
18.3.1 |T h e b asic idea: pricing a single-period call option

using the binomial approach
The distinguishing feature o f binom ial option pricing is its assumption that, after a given tim e period,
the price o f the underlying asset can be one o f only tw o numbers— hence the use o f the term ‘binom ial’,
14 The ASX website provides a link to a calculator that will estimate option prices using the binomial model; see www.asx.com.
au/prices/calculators.htm.
4^^
B usiness finance
which means *two numbers,. This assumption may sound unrealistic, b ut it turns out th a t the approach
gives very realistic answers, provided th a t a large num ber o f short tim e periods are used in the analysis.
However, in this section we restrict ourselves to the single-period case, which, although clearly unrealistic,
perm its a clear illu stratio n o f basic principles. We explain these principles using Example 18.1.
E xample 18.1
Consider a 1-year call option with a $10.50 exercise price, on a share whose current price is $10.
6
It is known that in 1 year’s time the share price will be either $1 1.50 or $9.50. No other share price
outcome is possible: the share price will definitely be one of these two numbers. The 1-year risk-free
interest rate is 8 per cent per annum.
Using only this information, together with the standard assumption that arbitrage will not be
possible, we can work out what today's call price should be. To do this, we first calculate the payoffs.
If, at the expiry of the call in 1 year's time, the share price is $ 1 1.50, the call's payoff will be $ 1 1.50
- $ 1 0 .5 0 = $1. If the other share price ($9.50) occurs, the call's payoff will be zero. We now
compare the payoffs on Portfolios A and B:
Portfolio A: Buy two calls, each costing c dollars.
Portfolio B: Buy one share ($10) and borrow $ 9 .5 0 /1 .0 8 = $8.80, which is the present value of
$9.50.
The payoffs on these portfolios are shown in Table 18.10.
TABLE 18.10 Payoffs for a single-period binomial model

I Portfolio Cash flow now Payoff if P = $9.50 Payoff if P = $11.50 丨
A: Buy 2 calls -2c 0 $2.00
B: Buy 1 share -$10.00 $9.50 $11.50
Borrow $9.50/1.08 +$8.80 -$9.50 -$9.50
Total (B) -$1.20 0 $2.00
The payoffs shown in Table 18.10 are identical. It does not matter whether an investor chooses
Portfolio A or B: the outcome in both cases is a cash flow of zero if the expiry share price is $9.50,
or a cash flow of $2 if the expiry share price is $1 1.50. Since A and B are, in effect, the same thing,
they should be worth the same today. To prevent arbitrage, the cash flow required today to set up
Portfolio A should equal the cash flow required today to set up Portfolio B—that is:
-2 c = -$ 1 .2 0
which, of course, solves to give today's call price, c, of $0 .6 0 .15
Example 18.1 illustrates the fact th a t buying calls (Portfolio A) is like borrow ing to buy shares
(Portfolio B). In Example 18.1, buying two calls was like borrow ing to buy one share. We could equally well
describe this as 'buying one call is like borrow ing to buy h a lf a share*. O f course, the figure o f one-half is
peculiar to this example. It is found by calculating the ratio o f the option spread and the share spread— in
this case the calculation is:
$ !-$0
$ 11.5 0 - $ 9.50
HEDGE RATIO (OR
一 1
DELTA)
ratio of the c h a n g e in 一 2
an option price that
results from a c h a n g e
In other cases, this ratio could be any number between zero and 1. This ratio is called the h edge ratio
in the price of the (o r d elta ). Estimates o f option deltas are provided in the M arket Wrap section o f the Australian Financial
underlying asset Review.
$9.50 、
15 We have rounded this answer. A more accurate answer i s : - $ 10 - =$0.601 851 85.
2 1.08 ,
18.3.21 Risk neutrality as a solution method

Perhaps the most remarkable feature o f Example 18.1 is n ot th a t we could w ork out the call price, b ut th a t
we were able to do so w ith o u t m aking any assumption about risk. The call in Example 18.1 is w orth 60
cents, regardless o f the risk preferences o f traders in the m arket. If, fo r example, everyone in the m arket
were risk averse, they would set the call price at 60 cents. I f everyone were risk neutral (or fo r th a t matter,
risk seeking) they would s till set the call price at 60 cents.16
We can use this fact to provide an easy solution method. We pretend th a t all investors are risk RISK NEUTRALITY
neutral. This means th a t they ignore risk in th eir decision making. In a m arket comprising only risk- situation in which
investors are
neutral traders, all assets are priced so th a t they are expected to yield the risk-free return. In a risk-neutral
indifferent to risk;
world, pricing assets is thus very easy. It is sim ply a m atter o f finding out the expected value o f a future assets are therefore
cash flow and then discounting this value at the risk-free interest rate. We reiterate th a t our answer does priced such that they
not depend on risk neutrality. We would get the same answer fo r the call price i f we assumed, say, risk are expected to yield
aversion. We choose risk n eu tra lity only because it is easy. To illustrate how the m ethod works we show the risk-free interest
rate
in Example 18.2 how the call o ption in Example 18.1 would be priced i f every trader were risk neutral.
Example 18.2
A share is worth $ 10 today and promises to pay off either $ 11.50 or $9.50 in 1 year's time. We will 6 ^
call the payoff of $1 1.50 'State U' (for 'up’）and the payoff of $9.50 'State D’ （for 'down’). Given
that this is a risk-neutral world, we can deduce the probabilities of States U and D occurring. This
deduction is possible because, under risk neutrality, $10 must equal the expected payoff in 1 year,
discounted for 1 year at the risk-free interest rate—that is:
$1〇 p ($ n .5 0 ) + (1-p)($9.50)
1.08
where p = the probability of State U occurring
1 - p = the probability of State D occurring
Solving this equation gives p = 0.65 and 1 - p = 0 .3 5 .17
Turning our attention to the call option, its payoff is $1 in State U and $0 in State D. In a world
of risk neutrality, the call price, c, will also equal its expected payoff, discounted at the risk-free
interest rate:
(0.65)($l) + (0.35)($0)
c_ r 〇8
= $0,601 851 85
=$0.60
This, of course, is the same answer as we found in Example 18.1 when we did not pretend that all
market participants were risk neutral.
18.3.31 Binomial option pricing with many time periods

The single-period case is n ot realistic, b ut the basic principles can be extended to more than one period.
In practice it is usual to use, say, 100 or 200 tim e periods. The calculations are readily made using a
computer. To explain the procedures, we use three tim e periods.
The solution to a m ulti-period binom ial option-pricing problem has three m ajor stages.
a Stage 1: Building up a lattice o f share prices.

b Stage 2: Calculating the option payoffs at expiry from the expiry share prices,
c Stage 3: Calculating option prices by calculating expected values and then discounting at the risk
free interest rate.
16 How is this possible? Essentially, the reason is that we could redesign Portfolios A and B to give two risk-free outcomes.
Regardless of individual differences in attitudes to risk, all market participants will agree that risk-free is indeed risk-free and
will price the portfolios accordingly.
17 A warning: these probabilities do depend on risk neutrality. They are not the probability of any actual event occurring in the
real world.
These stages are explained in Example 18.3.
E xample 18.3
We wish to value a three-month call option with an exercise price of $10.25. The current share price
is $10 and the risk-free interest rate is 1.5 per cent per month. We use three time periods of 1 month
each. It is assumed that at the end of each month the share price can move to only one of two values.
Stage 1: The lattice of share prices

In Stage 1, our objective is to lay out all the future share prices that can arise, given our assumptions.
In this example it is assumed that each month the share price can rise by 4 per cent or fall by 3.846
per cent. Our choice of 3.846 per cent is, of course, deliberate, and is equal to 1 - 1/ 1.04. The effect
is that a rise (fall) in the share price in any given month will be exactly offset if there is a fall (rise) in
the following month. For example, starting from $10; if the share price rises by 4 per cent in the first
month, and then falls by 3.846 per cent in the second month, its price after 2 months is:
$10.00(1.04)(1 -0 .0 3 8 4 6 )
= $ ,0 .0 0 (!.0 4 ) ( ^ )
= $ 10.00
The benefit of defining the 'up7 and 'down' states in this way is the dramatic reduction in the
number of future possible share prices that need to be considered.
In Figure 18.3, the possible future share prices are shown on a lattice diagram in bold type. We
have labelled each node of the lattice with a capital letter. Today is represented by node A. Nodes
8 and C represent the two possible share prices at the end of the first month:
• If the share price increases in the first month: $ 10.00 x 1.04, then 8 = $ 10.40.
• If the share price decreases in the first month: $ 1 0 .00/1 .04, then C = $9.6154.
Figure 18.3 Lattice of share prices and call prices
r $ 1 1 .2 4 8 6
$ 0 .9 9 8 6
$ 1 0 .4 0 0 0
$ 0 .1 5 0 0
$ 9 .6 1 5 4
$ 0.0
j $ 8 .8 9 0 0
$0.0*
•
Similarly, nodes D, E and F represent the three possible share prices at the end of the second
month:
• If the share price increases in the first month and increases again in the second month: $10.00 x
1.04 x 1.04, then D = $10.8160.
• If the share price increases (decreases) in the first month and then decreases (increases) in the
second month: $10.00 x 1 .0 4 /1 .0 4 , then E = $10.00.
• If the share price decreases in the first month and decreases again in the second month:
$ 1 0 .0 0 /1 .0 4 /1 .0 4 , then F = $9.2456.
Nodes G, H, I and J represent the four possible share prices at the expiry date of the call and are
derived from nodes D, E and F by multiplying or dividing by 1.04 as appropriate.
Stage 2: Option payoffs at expiry

As we know the expiry share prices from Stage 1, it is a simple matter to calculate the matching call
option payoffs. Because the exercise price is $10.25, the call's payoffs are $0.9986 if the expiry
share price is $1 1.2486 (node G); $0.15 if the expiry share price is $10.40 (node H]; and zero
if the expiry share price is $9.6154 (node /) or $8.89 (node J). The call's payoffs are shown on
Figure 18.3 in italic \ype.
Stage 3: Discounting
Using the risk-neutral solution method, it is a simple matter to calculate the present value of the call's
payoffs. As in the single-period example, we first need to find the probabilities of a rising and falling
share price. The risk-neutral probabilities are the same at every node. Taking node 8 as an example,
$10.40 must equal the discounted expected value, where the discounting is done at the risk-free
interest rate of 1.5 per cent per month:
〇 (p )($ 1 0 .8 1 6 )^ (1 -p )($ 1 0 .0 0 )
1 .0 1 5
where, as before, p is the probability of a rise in price and 1 - p is the probability of a fall. This
equation solves to give p = 0.6814 and 1 - p = 0.31 86.
We can now work back through the lattice from expiry to the present, at each node calculating the
present value of the expected payoff. For example, at node D, the call's price is:
( 0 .6 8 1 4 ) ( $ 0 . 9 9 8 6 ) + ( 0 . 3 1 8 6 ) ( $ 0 . 15 )
1 .0 1 5
= $ 0 .7 1 7 5
Similarly, at node E, the call's price is:

( 0 .6 8 1 4 ) ( $ 0 .1 5 ) + ( 0 .3 1 8 6 ) ( $ 0 )
1 .0 1 5 ~ ~
= $ 0 .1 0 0 7
Working back through the lattice to today (node >A) gives the call's price as $0.3658 or about
37 cents.
Example 18.3 is a realistic treatm ent o f a binom ial option pricing problem in all b ut two respects. First,
the number o f tim e periods was set at only three, whereas i t should be set at 30 or more to get an accurate
answer. However, this accuracy is achieved sim ply by using a computer to perform the calculations. No
new issue o f principle is involved. Second, we made no attem pt to ju s tify our choice o f ‘up’ and ‘down’
factors o f 4 per cent per m onth and 3.846 per cent per m onth, respectively. In practice, these factors are
selected very carefully. Typically, the model user decides on w hat is thought to be an accurate estimate o f
the standard deviation o f the d istrib u tio n o f share prices on the expiry date o f the option. In other words,
it is necessary to forecast the vo la tility o f share returns during the life o f the option. A simple form ula
then provides the and *down, factors th a t w ill produce a d istrib u tio n o f expiry share prices th a t has
the desired standard deviation. For example, the up* factor is given by e(Ts^ t where a is the standard
deviation and At the length o f each tim e period.18
18 Details are beyond the scope of this book. For an excellent treatment see Hull (2013).
4^^
So far we have discussed the binom ial approach fo r the case o f a call option on a share th a t does n o t pay
dividends. Fortunately, i t is easy to use the binom ial approach to value put options and the binom ial
model can also be m odified to incorporate dividends.
Once the lattice o f future share prices is laid out, a p u t option can be priced as easily as a call option.
The p ut option payoffs are calculated and then the same procedure o f discounting expected values is
undertaken. Moreover, the American feature is easily incorporated sim ply by checking, at each node,
whether the calculated option price is less than the payoff from immediate exercise. I f it is, then the
payoff value is substituted fo r the calculated price.
Similarly, the problem o f valuing options on dividend-paying shares is relatively easy to handle using
the binom ial approach. A t the ex-dividend date, all possible share prices are reduced to reflect the payment
o f the dividend. A practical d iffic u lty here is that the lattice no longer conveniently recombines, w ith the
result th a t there is a very rapid increase in the num ber o f nodes (possible share prices) th a t need to be
analysed. However, the power o f modern computers means th a t the m ethod is feasible.
The Black-Scholes model of call

option pricing
The binom ial model provides a numerical solution to the option pricing problem b u t i t does n o t provide
an exact equation. In a very famous article, Black and Scholes (1973) presented a m odel th a t expresses
the price o f a call as a function o f five variables:19
a the current price o f the underlying share

b the exercise price o f the call
C the calls term to expiry
d the v o la tility o f the share (as measured by the variance o f the d istrib u tio n o f returns on the share)
e the risk-free interest rate.
This model stim ulated a great deal o f fu rth e r research in to options and, because o f its importance, is
presented here in some detail.
The Black-Scholes model assumes the following:
a There exists a constant risk-free interest rate at which investors can borrow and lend u nlim ited
amounts.
b Share returns follow a random walk in continuous tim e w ith a variance (volatility) proportional
to the square o f the share price. The variance is a know n constant. This assumption relates to the
behaviour o f the share price over tim e. In particular, returns on this share are assumed to follow
a random walk and the share is continuously traded in the m arket. The m odel is therefore cast
in continuous tim e, as d istinct from discrete tim e, which considers a series o f tim e periods. The
d istrib u tio n o f the rate o f return on the shares has a known, constant variance, which is a measure
o f vo latility. It can also be shown th a t this assumption implies th a t the d istrib u tio n o f possible share
prices on any given future date (such as on the options expiry date) is lognormal. Empirical studies
suggest th a t share markets do n o t behave in exactly the way assumed in the model. W hile trading
in many shares is frequent, it is n o t lite ra lly continuous. V o la tility is unlikely to be constant. The
random-walk model and the lognorm al d istrib u tio n are n o t perfect descriptions o f th e ir real-world
counterparts.
c There are no transaction costs, taxes or other sources o f frictio n .
19 The Australian Securities Exchange website provides a calculator that will estimate option prices using the Black-Scholes
model; see www.asx.com.au/prices/calculators.htm.
d Short selling is allowed w ith no restrictions or penalties. This assumption means th a t any num ber o f
securities can be sold, regardless o f the num ber actually held. For example, two calls can be w ritte n
(sold) even i f only one share is held, and there is no need to deposit cash to secure such a position.
These four assumptions define conditions in the share and option markets. In addition, Black and
Scholes simplified the problem w ith tw o fu rth e r assumptions:
e There are no dividends, rights issues or other complicating features.
The call is o f the European type.
Assumptions (e) and (f) are in fact alternatives, since it was shown in Section 18.2.8 th a t i f assumption
(e) holds, then the d istin ction between American and European calls is irrelevant. Therefore, i f assumption
(e) is made, the pricing form ula w ill be valid fo r both American and European calls.
W ith these assumptions, the price, cf o f any given call is a function only o f the current share price, S,
and time, t. The risk-free interest ra te ,〆，the vo latility, (J2, and the exercise price, X ，
are know n constants
in the problem.
1 8 .4 .2 1 The Black-Scholes equation

Using these assumptions, Black and Scholes showed th a t the price o f the call option m ust be:
c = SN(dl )-X e ~ r，TN (d 2) 18.5
£n{S/X) + ^ ct2)T
where d\
c rV f
h i(S /X ) + ( / - ㈣丁
rV T
d\ - a V f
N ( d ) indicates the cumulative standard norm al density function w ith upper integral lim it d. In other
words, N (d) is the area under the standard norm al curve from -〇〇 to d. The definitions o f S, X and G 2
are as given previously and T is the term to expiry. N id ^ and N (d 2) are probabilities and are therefore
numbers between zero and 1. Values o f the fu nctio n N can be found using Table 5 o f Appendix A, or the
NORMSDIST function in M icrosoft Excel . In continuous tim e, e_r,T is the appropriate discount factor fo r
T periods at rate / per period. Therefore Xe~r， T is the present value o f X. The application o f Equation 18.5
is illustrated in Example 18.4.
E xample 18.4
Suppose that we wish to find the Black-Scholes price for a call with the following characteristics:
Current share price: S = $17.60
Exercise price: X = $16.00
Term to expiry: 7 = 3 months = 0.25 years
Volatility (variance): a2 = 0.09 per annum
Standard deviation: a = 0.3 per annum
Risk-free interest ra te :〆 = 0.1 per annum, continuously compounding
The first task is to calculate and c/2:
, £n($ 17.60/$ 16.00) + [0.1+ (0.5)(0.09)]0.25
1 0 .3 V 0 2 5
= M i l ) + 0.03625
0.15
« 0.8771
d2 % 0 .8 7 7 -0 .1 5
« 0.7271
continued
B usiness finance
continued
Consulting the table of values for the standard normal distribution N [ .) , or by using the Microsoft
Excel® NORMSDIST function, we find that:
N(dJ = N(0.8771) = 0.8098 and

N(d2) = N(0.7271) = 0.7664
The discounting factor e~r，

T = e~0025 = 0.9753. Substituting into Equation 1 8.5:
c= S N (d 1)-X e -/ r N(d2)
=($ 17.60)(0.8098) - ($ 16.00)(0.9753)(0.7664)
=$2,293
The Black-Scholes call price is therefore approximately $2.29.
Table 18.11 shows fu rth e r examples o f the call prices that result from the Black-Scholes model if
different values o f the variables are assumed. Also shown in the table is the greater o f (S - Xe~r， T) and zero,
which is the m inim um theoretical price; equivalently, it is the call price under conditions o f perfect certainty.
TABLE 18.11 Examples of Black-Scholes call opti<〕n prices

Example Share price (S) 1Exercise price (X) Term to expiry Volatility (a) Risk-free Model price Greater of zero and
m interest rate (〆} (c) (cents) S - Xe_r"r (cents)
(a) 1.00 1.00 0.25 0.3 0.10 7.22 2.47
(b) 1.10 1.00 0.25 0.3 0.10 14.33 12.47
(c) 1.00 1.10 0.25 0.3 0.10 3.22 0
(d) 1.00 1.00 0.50 0.3 0.10 10.91 4.88
(e) 1.00 1.00 0.25 0.4 0.10 9.17 2.47
(f) 1.00 1.00 0.25 0.3 0.15 7.89 3.68
Each o f the examples (b) to (f) changes one o f the values used in Example (a). Therefore, the effect
o f a higher share price— Example (b)— is shown to be a substantial rise in the call price, as discussed in
Section 18.2.5. The direction o f influence o f the other variables is likewise in line w ith our comments in
th a t section. These conclusions are quite general and do n ot depend on the particular numbers used in the
examples. Similarly, the model price is never less than the m inim um theoretical price.
The Black-Scholes model (Equation 18.5) is shown graphically in Figure 18.4. For some given
vo latility, interest rate and exercise price, Figure 18.4 plots call price against share price fo r different
values o f term to expiry. For a finite, positive value o f T, the curve approaches asym ptotically the broken
line representing c = S - Xe~r，T as S increases. A t expiry, T = 0, the call is w o rth S* - X or zero, whichever is
the greater, while a perpetual call (T 〇〇) commands a price equal to the share price.
The Black-Scholes model is set in continuous tim e, rather than discrete tim e. Hence, the risk-free
interest rate, r used in the model is an interest rate th a t assumes continuous compounding. In practice,
interest rates are almost never quoted on a continuously compounding basis. Fortunately, to calculate
Black-Scholes prices in practice we do n o t have to convert observed interest rates, which assume discrete
compounding, to th e ir continuously compounding counterparts. The Black-Scholes equation (Equation
18.5) can be rew ritten as:
c = SN(dx) - PVXN(d2) 18.6
X
where PVX =
l+ R
(n(S/PVX) + \c r2T
d\
d2 = d \ - a V T
4^^
Figure 18.4 Graphical representation of the Black-Scholes equation

sSIJd
IIDU
Xe_r i C
S h a re price (S)
In Equation 18.6, R is the observed effective interest rate on a risk-free investm ent fo r a term equal to
the term o f the option. The application o f Equation 18.6 is illustrated in Example 18.5.
E xample 18.5
Suppose that we wish to find the Black-Scholes price for a call option with the following characteristics: 6 ^
Volatility (variance): a2 = 0.16 per annum
Standard deviation: 〇 = 0.4 per annum
Risk-free interest rate: R = 5 per cent per half-year
The first task is to calculate the present value of the exercise price:
$10.50
PVX:
1.05
$ 10.00
The next task is to calculate ^ and d2 using Equation 18.6:

, 肋 ($9.95/$ 10.00) + (0.51(0.161(0.5)
M 〇-995) + 0.04
= 0.2828
= 0.1237
c/2 = 0.12 37 -0.2 82 8

= -0.1591
Consulting the table of values for the standard normal distribution N[.), or by using the Microsoft
) = N(0.1237) = 0.5492 and
N(d2) = N(-0.1591) = 0.4368
continued
4^^
B usiness finance
continued
Substituting into Equation 18.6:

c = S N [d } ) - PVX N [d 2)
=($9.951(0.5492 卜 ($ 10.001(0.4368)
= $ 1.10
To verify that Equation 18.6 gives the same valuation as the original Black-Scholes equation
(Equation 18.5), we first note that the continuously compounding interest rate that is equivalent to 5
per cent per half-year is 9.758 per cent per annum.20 Calculating the values to input into Equation
18.5 we find that:
fn(S/X) + (〆 + 士a2) 7
d] = oTf
= ^n($9.95/$ 10.50) + (0.097 580 + 0.5 x 0.16) (0.5)
0 .4 \/ 〇3 ~
= M(0.947 619)+ 0.088 790
0.2828
= 0.1237
= d] - (Jy/T
= 0 .12 37 -0.2 82 8
= -0.1591
As shown above,
N ( ^ ) = N (0.1237) = 0.5492 and
N [d 2 ) = N (-0 .1591) = 0.4368
Substituting into the original Black-Scholes equation (Equation 18.5):

c= S N (d 1)-X e -r，T N(d2)
= ($9.95)(0.5492)-($10.50)e-(〇09758)(°'5)(0.4368)
=($9.95)10.5492) - ($10.50)(0.952 381 )(0.4368)
= $ 1.10
Equations 18.5 and 1 8.6 provide the same valuation —$ 1 .1 0 —for the option.
By invoking Equation 18.1, the p u t-c a ll p a rity equation, the Black-Scholes analysis also provides an
equation to value European puts on shares th a t do n o t pay dividends.21 In a continuous tim e form ulation
Equation 18.1 is:
p = c - S + Xe~r，
T 18.7
where p = the price o f the European put.
S ubstituting Equation 18.5 in to Equation 18.7 and rearranging gives:
p = S[N{d{) - 1 ] + Xe~rJT[ l - N ( d 2)]
Equation 18.8 is the Black-Scholes European p u t pricing m odel.22 The application o f Equation 18.8 is
20 B e c a u s e ^ 7 = e_0 09758x 0-5 = e ^ 04879 = 0.952 381 = 1/1.05.~

21 Note that it is necessary to assume a European-type put a n d no dividends because, even in the absence of dividends, it can
sometimes pay to exercise prematurely an American-type put. This feature makes the pricing of American-type puts more
complex than the pricing of American-type calls.
22 Because N ( d j) - 1 = - N(-rfj) and 1 - N (d 2) = N ( - d 2), Equation 18.8 can also be written as p = - S N ^ - d ^ + X e~ rTN { - d 2).
m ure 18.4 Graphical representation of the Black-Scholes equation
Share price (S)
In Equation 18.6, R is the observed effective interest rate on a risk-free investm ent fo r a term equal to
the term o f the option. The application o f Equation 18.6 is illustrated in Example 18.5.
E xample 18.5
Suppose that we wish to find the Black-Scholes price for a call option with the following characteristics:
Volatility (variance): a 2 = 0.16 per annum
Standard deviation: a = 0.4 per annum
Risk-free interest rate: R = 5 per cent per half-year
The first task is to calculate the present value of the exercise price:
PVX=㈣
1.05
= $ 10.00
The next task is to calculate and d2 using Equation 18.6:

, M $ 9 . 9 5 / $ 1 0 .0 0 ) + ( 0 . 5 ) ( 0 . 16 ) (0 .5 )
------------------ 0 ^ 3
= ^ n ( 0 .9 9 5 ) + 0 . 0 4
0 .2 8 2 8
= 0 .1 2 3 7
d2 = 0.12 37 -0.2 82 8
= -0.1591
Consulting the table of values for the standard normal distribution N[.), or by using the Microsoft
N(d} ) = N(0.1237) = 0.5492 and
N[d2) = N (-0 .1591) = 0.4368
continued
4^^
B usiness finance
continued
Substituting into Equation 18.6:
c = S N [d ] ) - PVX N (d2)
= ($9.95)(0.5492) - ($ 10.00)(0.4368)
=$1.10
To verify that Equation 18.6 gives the same valuation as the original Black-Scholes equation
(Equation 18.5), we first note that the continuously compounding interest rate that is equivalent to 5
per cent per half-year is 9.758 per cent per annum.20 Calculating the values to input into Equation
18.5 we find that:
en[S/X\+ + T
d] 〇 7r
= £n($9.95/$ 10.50) -f (0 .097580 + 0.5 x 0.16) (0.5)
0 .4 ^ 0 5 ~
= M Q -9 4 7 6 1 9 )+ 0.088 790
0.2828
= 0.1237
d2 = d ] - o V j
= 0 .1 2 3 7 -0 .2 8 2 8
= -0.1591
As shown above,
N (d !) = N (0 .1237) = 0.5492 and
N [d 2 ) = N(-0.1591) = 0.4368
Substituting into the original Black-Scholes equation (Equation 18.5):
c=SN (d1)-X e -/ r N(d2)

= ($9.95)(0.5492)-($10.50)e-(a 〇9758H〇 -5)(〇 .4368)
= ($9.95)(0.5492) - ($10.50)(0.952 381 )(0.4368)
= $ 1.10
Equations 18.5 and 18.6 provide the same valuation —$ 1 .1 0 —for the option.
By invoking Equation 18.1, the p u t-c a ll p a rity equation, the Black-Scholes analysis also provides an
equation to value European puts on shares th a t do n o t pay dividends.21 In a continuous tim e form ulation
Equation 18.1 is:
p = c - S + Xe~r，
T 18.7
where p = the price o f the European put.
S ubstituting Equation 18.5 in to Equation 18.7 and rearranging gives:
p = S[N (dj) - 1 ] + Xe-r ，T[ l - N ( d 2)] 18.8

Equation 18.8 is the Black-Scholes European p u t pricing m odel.22 The application o f Equation 18.8 is
20 Because = e-0 09758^ 5 = e"004879 = 0.952 381 = 1/1.05.~

21 Note that it is necessary to assume a European-type put a n d no dividends because, even in the absence of dividends, it can
sometimes pay to exercise prematurely an American-type put. This feature makes the pricing of American-type puts more
complex than the pricing of American-type calls.
22 Because N ( d ^ - 1 = - N (- ^ ) and 1 - N (d 2) = N ( - d 2), Equation 18.8 can also be vmtten as p = - S N i - d ^ + X e~ rTN ( - d 2).
4^^
Example 18.6
Suppose that we wish to find the Black-Scholes price for the put option that is the counterpart to the
call option described in Example 18.4—that is:
Current share price: P = $17.60
Volatility (variance): a 2 = 0.09 per annum
Standard deviation: o = 0.3 per annum
Risk-free interest rate: 〆 = 0.1 per annum, continuously compounding
The calculations in Example 18.4 showed that with these values, NIc/]) = 0.8098, N ic y = 0.7664
and e_rT= 0.9753. Substituting into Equation 18.8, the Black-Scholes European put price is:
p = S[N(d,) - 1] + XeVT[l - N(c/2)]

= ( $ 1 7 . 6 0 ) ( 0 . 8 0 9 8 - 1 ) + |$ 1 6 .0 0 ) ( 0 .9 7 5 3 ) ( 1 - 0 . 7 6 6 4 )
=$0,298
The Black-Scholes European put price is therefore slightly less than 30 cents.
1 8 .4 .3 1A brief assessment of the Black-Scholes

model
An appealing feature o f the Black-Scholes m odel is th a t i t specifies a p articula r fu n ctio n a l fo rm
lin k in g the variables, rather th an sim ply specifying the direction o f each variables influence. Slightly
less obvious, b u t also a strength o f the model, is the num ber o f variables th a t i t does not include. As
suggested earlier, the retu rn th a t investors expect on the underlying share has no place in the model.
No assumption concerning the a ttitu d e o f investors towards risk is required or im plied. Conversely,
the variables th a t are present in the m odel are fo r the m ost p a rt observable and have reliable data
available. The share price, exercise price and term to expiry are directly observable, and good proxies
exist fo r the risk-free interest rate. M easuring a share s v o la tility is subject to error; Black (1975, p. 36)
described i t as *the big unknow n in the o ption formula*. However, i f a share s v o la tility (as measured
by the variance o f the rate o f retu rn) is constant, as the m odel assumes, then the sequence o f past
prices may be used to produce an accurate estimate o f the v o la tility . Therefore, although investors1
expectations o f the re tu rn on the share have no place in the equation, th is is n o t true o f v o la tility
expectations. The model, in effect, sidesteps th is problem by assuming th a t the v o la tility is a know n
constant. In practice, users o f the m odel may tr y a range o f values fo r th is variable. In o the r cases, users
may take m arket prices o f options and then solve the Black-Scholes equation fo r the v o la tility ‘im p lie d ’
by the m arket price o f the option. Indeed, estimates o f ‘im plied v o la tility ’ are o f great interest to m arket
participants as they are o fte n interpreted as pro vid ing current in fo rm a tio n about expectations o f
future price vo la tility. Perhaps the m ost w idely cited im plied v o la tility measure is the Chicago Board
Options Exchange V o la tility Index (VIX). This index is constructed by analysing the traded prices o f a
series o f options w ritte n on the S&P 500 share price index— an index th a t reflects the price movements
o f a p o rtfo lio o f shares in the very largest companies traded in the US— and estim ating the level o f
v o la tility im plied by those o p tio n prices over the next 30 days. N ot only is th is in fo rm a tio n interesting
in terms o f gauging current m arket sentim ent, b u t w ith the in tro d u c tio n o f futures contracts (in 2003)
and options contracts (in 2006) w ritte n on the VIX , hedgers and speculators now have the a b ility to
effectively trade in vo la tility. Follow ing its development by Professor Robert Whaley, the Chicago Board
Options Exchange introduced V IX in 1993 w ith tw o m ain purposes. First, V IX was designed to provide
m arket participants w ith a measure o f current expectations o f s h ort-term v o la tility , and second to then
enable derivative contracts to be developed and traded on such a measure. Since its intro d u ctio n , VIX
has often been cited as an aggregate measure o f the level o f apprehension fe lt by m arket traders about
future price movements.
B usiness finance
Finance
H O W TO MEASURE FEAR WITH OPTIONS CONTRACTS!
IN ACTION
In endeavouring to understand the Market Volatility Index (VIX), it is essential to remember that
it is not a backward-looking tool, as commentators sometimes suggest, measuring volatility
that has already come to pass; instead, it is forward-looking, measuring volatility that investors
expect to see. The VIX can be likened to a bond's yield to maturity—the discount rate that
equates a bond's price to the present value of its promised payments. A bond’s yield is implied
by its current price but it represents the expected future return of the bond over its remaining
life. Similarly, VIX is implied by the current prices of S&P 5 0 0 index options but represents the
expected future market volatility over the next 30 calendar days.
Strictly speaking, volatility describes unexpected upward or downward movements;
however, the S&P 5 0 0 index option market has become dominated by hedgers who buy index
puts when they are concerned about the possibility of a drop in the stock market—essentially
'insuring' themselves—which explains why the VIX has been dubbed the ’ investor fear gauge ’！
Purchasing insurance is nothing new; we routinely purchase home and contents insurance as a
means o f insuring our home value in the event of theft or natural disasters. If the chance of theft
in your neighbourhood rises, your insurance company is likely to increase its premium. The
same is true for portfolio insurance: the more investors demand, the higher the price. VIX is an
indicator that reflects the price of portfolio insurance.
Source: Information drawn from 'Understanding VIX', Robert Whaley, Journal of Portfolio Management, Spring 2009,
pp. 9 8 -1 0 5 .
18.5 Options on foreign currency

So far, we have confined our discussion almost entirely to options on shares. However, there are options
on a wide variety o f underlying assets— even the weather! (See Finance in Action.) Fortunately, most
o f the principles we have covered also apply to options on other underlying assets. In this section we
consider options on foreign currency. O ptions on futures contracts are considered in Section 18.7.
Finance
HEDGING THE WEATHER______________________________________
in ACTION
Looked at one way, an option is an insurance contract. If a shareholder buys a put option, he
or she has protection against the share price falling below the exercise price of the option. So,
couldn't the idea of an option be extended to pretty much anything that someone might want to
insure against? If, say, I’ m worried about cold weather, why can’t i buy an option that will pay off
only if the weather gets too cold? Or, if Tm worried about wet weather, why can't I buy an option
that pays off only if it rains? Well, you can, as shown in the following excerpt.
In the summer of 2 0 0 1 , Dieter Worms could only sit and watch as rain kept golfers away
from the fairways of his Gut Apeldor golf club in Hennstedt, about 100 kilometres north of the
German city of Hamburg. The weather in 2001 was m iserable/ says 54-year-old Worms.
;W h a t I hate as the owner of a golf course is to get frustrated more and more every minute
when you see the rain coming down in buckets —and not just for one day but for weeks and
months/
In 2 0 0 2 Worms resolved to avoid a repeat of his frustration by buying a weather derivative
from Societe Generale SA, France's third-largest bank by assets. He decided he could put up
with 5 0 rainy days from M ay to September, the period when golf courses typically make about
80 per cent of their income. Once the number of days with more than a millimetre of rain
passed 50, the derivatives contract started paying compensation for every wet day.
Worms is one of thousands of business owners around the world who have sought to protect
their balance sheets from the weather. The Weather Risk Management Association
(vsrww.wrma.org), a Washington-based trade group, shows that the number of weather risk-
management contracts signed w orldw ide almost trebled to about 12 0 0 0 in the 12 months
ended in March 200 3 from the year-earlier period. The contracts had an underlying value of
$4.2 billion. In Europe, the number of contracts almost doubled to 1480 from 765.
S o u rc e : B a se d on 'H e d g in g the w e ather', M a r k G ilb e rt a n d A le ja n d ro B a rb a jo sa , B lo o m b e r g M a rk e ts , vol. 1 3, no. 7,
July 2 0 0 4 , pp. 9 9 - 1 0 2 . "
18.5.1 | W h a t is an option on foreign currency?

A call (put) option on foreign currency is a contract th a t confers the rig h t to buy (sell) an agreed quantity
o f th a t foreign currency at a given exchange rate. O ptions on foreign currency are traded in organised L E A R N IN G
markets such as the Philadelphia Exchange, as well as in ‘over-the-counter’ markets and by privately O B JEC T IV E 5
E xp lain the
arranged contracts. A company selling, say, US dollars (in retu rn fo r Australian dollars) can equivalently
characteristics a n d
be said to be purchasing Australian dollars (using US dollars). In the same way, a p u t option to sell US uses of foreign
dollars (for Australian dollars) can equivalently be described as a call option to buy Australian dollars currency options a n d
(using US dollars). Example 18.7 illustrates the nature o f options on foreign currency.23 options on futures
E xample 18.7
On 24 August, Westpac Bank sold a 3-month US dollar put option (equivalently, a 3-month Australian
dollar call option). The purchaser was an Australian exporter looking to insure the value of a future
US dollar receipt against a possible depreciation in the value of the US dollar (equivalently, an
appreciation in the value of the Australian dollar). The underlying currency amount was US$5 million
and the exercise price was A$1 = US$0.71 18. At the time the option was purchased, the spot
rate was also A$1 = US$0.7118. The price of this option was US$0.0199 per US$1; that is,
the exporter paid US$(0.0199 x 50 0 0 0 0 0 ) = US$99500, which at the time was equivalent to
A $ (9 9 5 0 0 /0 .7 1 18) = A$1 397 8 6 . On payment of this sum, the exporter obtained the right to sell
US$5 million at the price of US71.18 cents per Australian dollar—that is, US$5 million could be
sold for A $ (5 0 0 0 0 0 0 /0 .7 1 1 8) = A $ 7 0 2 4 4 4 5 . The cost of this right was US$99500. The payoff
structure is shown in Table 18.12.
TABLE 18.12 Payoff structure for purchase of a put contract on US$5 million at
an exercise price of A$1 = US$0.7118
If the spot rate per A $ 1 on the Then the payoff (cash flow) to the put holder is:
put’s expiry date is:
In US$ In A$ equivalent
U S $ 0 .6 8 0 0 0
0
U S $ 0 .6 9 0 0 0 0
U S $ 0 .7 0 0 0 0 0
U S $ 0 .7 1 0 0 0 0
U S $ 0 .7 1 1 8 0 〇
U S $ 0 .7 2 0 0 0 .0 0 8 2 x 5 m / 0 .7 1 1 8 = 5 7 6 0 0 5 7 6 0 0 / 0 .7 2 = 8 0 0 0 1
U S $ 0 .7 3 0 0 0 .0 1 8 2 x 5m /0 .7 1 1 8 = 1 2 7 8 4 5 1 2 7 8 4 5 / 0 .7 3 = 1 7 5 1 3 0
U S $ 0 .7 4 0 0 0 .0 2 8 2 x 5 m / 0 .7 1 1 8 = 1 9 8 0 8 9 1 9 8 0 8 9 / 0 .7 4 = 2 6 7 6 8 8
U S $ 0 .7 5 0 0 0 .0 3 8 2 x 5 m / 0 .7 1 1 8 = 2 6 8 3 3 4 2 6 8 3 3 4 / 0 .7 5 = 3 5 7 7 7 8
continued
23 We are grateful to Westpac Banking Corporation for providing the information used in this example. We have rounded final
calculations to the nearest dollar.
4 ^^
continued
A s c an be seen from the p ayo ff structure in Table 1 8 .1 2 , the put provides protection a g a in st the
effects of a dep reciating U S do llar (equivalently, an ap p re ciatin g Australian dollar). This protection
be gin s to take effect w hen the value of an Australian do llar reaches the exercise price of U S 7 1 .1 8
cents.
Ifr instead, protection w a s sou ght a g a in s t the effects of an ap p re ciatin g U S d o llar (equivalently, a
dep reciating Australian dollar), a call option to buy U S dollars is required. The p ayo ff structure for a
trader w h o buys a call option on U S $ 5 million at an exercise price of A $ 1 = U S $ 0 ,7 3 1 8 is show n
in Table 1 8.13.
TABLE 18.13 Payoff structure for purchase of a call contract on US$5 million
at an exercise price of A$1 = US$0.7318
If the spot rate per A$1 on the Then the payoff (cash flow) to the put holder is:
puts expiry date is:
In US$ In A$ equivalent
US$0.7000 0.0318 x 5m/0.7318 = 217272 217272/0.70 = 310389
US$0.7100 0.0218 x 5m/0.7318 = 148948 148948/0.71 = 209 786
US$0.7200 0.0118 x 5m/0.7318 = 80623 80623/0.72 = 111977
US$0.7300 0.0018 x 5m/0.7318 = 12 298 12298/0.73 = 16847
US$0.7318 0 0
US$0.7400 〇 0
US$0.7500 0 0
US$0.7600 0 0
US$0.7700 0 0
1 8 .5 .2 1 Combinations of options on foreign currency

Some o f the most frequent uses th a t have been made o f options on foreign currency involve combining
two or more such options. For example, options can be combined to produce an arrangement sometimes
know n as a ‘range forw ard’ or a ‘collar’. This arrangement is shown in Example 18.8.
Example 18.8
Conquest Investments Ltd expects to receive a cash inflow of A $30 million in the next month and plans
to convert this sum to US dollars to invest in a US company. At current exchange rates, the US dollar
value of this inflow is around US$17 million. Tim Johns, the manager of Conquest Investments, wants
to be guaranteed to receive a minimum of US$25.68 million for delivery of the A $30 million. Should
the Australian dollar appreciate in the next month, Johns is willing to accept a ceiling of receiving no
more than US$26.28 million in return for delivery of the A$30 million. To lock in simultaneously the
minimum of US$25.68 million and the maximum of US$26.28 million, Johns combines the purchase
of a put to sell A $30 million (with an exercise price of US85.60 cents) with the sale of a call to
purchase A$30 million (with an exercise price of US87.60 cents). The cash inflow from selling the call
can then be used to help pay for the put.24 The payoff structure is shown in Table 18.14.
Table 18.14 shows that, whatever the future exchange rate may be, Conquest Investments Ltd
will receive no less than US$25.68 million but no more than US$26.28 million. If the future spot
rate is between US85.60 and US87.60 cents per A $ l, the payoff on both options is zero and the
arrangement requires only a spot transaction.
24 In practice it is common for the exercise prices to be selected carefully so that the put price equals the call price. Therefore the
inflow from one exactly offsets the cost of the other, making the deal appear 'free*.
TABLE 18.14 Payoff structure for Example 18.8, Conquest Investments Ltd
If the spot rate Then the US$ cash flows are:
per A 〇>1 on the Purchase of US$ Total
〇n the pu㈣〇n the call⑹
expiry date is:
(spot)(c)
US$0.8200 +1080000 0 +24600000 +25680000
US$0.8300 +780000 0 +24900000 +25 680000
US$0.8400 +480000 0 +25 200000 +25680000
US$0.8500 +180000 0 +25500000 +25 680000
US$0.8560 0 0 +25 680000 +25 680000
US$0.8600 0 0 +25800000 +25800000
US$0.8700 0 0 +26100000 +26100000
US$0.8760 0 0 +26280000 +26280000
US$0.8800 0 -120000 +26400000 +26280000
US$0.8900 0 -420000 +26700000 +26280000
US$0.9000 0 -720000 +27000000 +26280000
US$0.9100 0 -1020000 +27300000 +26280000
(°l For e x p iry spot rates less than the exercise price of U S $ 0 . 8 5 6 0 , e a ch calculation is + ( U S $ 0 . 8 5 6 0 - e x p iry
spot rate) x 3 0 million.
(b) For e x p iry spot rates greater than the exe rcise price o f U S $ 0 . 8 7 6 0 , e a ch calculation is -(e x p ir y spot
rate - U S $ 0 . 8 7 6 0 ) x 3 0 million.
(cl Each calculation is e x p iry sp ot rate x 3 0 million.
18.6 Options, forwards and futures

There is a simple relationship between prices o f European options and forw ard prices. As forw ard
contracts are most frequently encountered in foreign currency dealings, we w ill explain the relationship
using options on foreign currency and forw ard contracts on foreign currency. However, in principle it
holds fo r a much wider range o f underlying assets.
E xample 18.9
Suppose that, in Example 18.8, the exercise price of the call had, like that of the put, been US85.60
cents. In that case, the payoffs are as shown in Table 18.15.
TABLE 18.15 Payoffs for put bought and call sold, both with an (exercise price
of US85.60 cents
If the spot rate per Then the US$ cash flows are:
Aq> 1 on the expiry 〇n the puH。）〇n the call⑹ Purchase of US$ (spot” c) Total
date is:
US$0.8200 +1080000 0 +24600000 +25 680000
US$0.8300 +780000 0 +24900000 +25680000
US$0.8400 +480000 0 +25 200000 +25 680000
continued
B usiness finance
If the spot rate per Then the US$ cash flows are:
A$1 on the expiry
On the puH°^ 〇n the cal 1(6) Purchase of US$ (spot)㈦ Total
date is:
US$0.8500 +180000 0 +25 500000 +25 680000
US$0.8560 0 0 +25 680000 +25 680000
US$0.8600 0 -120000 +25800000 +25 680000
US$0.8700 0 -420000 +26100000 +25 680000
US$0.8800 0 -720000 +26400000 +25 680000
US$0.8900 0 -1020000 +26700000 +25 680000
问 For e x p iry spot rates less than the exercise price of U S $ 0 . 8 5 6 0 , e a ch calculation is + ( U S $ 0 . 8 5 6 0 - e xp iry
spot rate) x 3 0 million.
^ For e x p iry spot rates greater than the exercise price o f U S $ 0 . 8 5 6 0 , e a ch calculation is (e xpiry spot
rate - U S $ 0 . 8 5 6 0 ) x 3 0 million.
(CJ C a lcu la te d usin g 3 0 million x spot rate.
The final column of Table 18.15 shows that this combination of transactions is equivalent to a
guarantee that A$30 million can be sold for US$16.68 million. In effect, therefore, this combination
is equivalent to having a forward contract to sell A $30 million at a forward price of US55.60 cents
per A$ 1.
It is a simple matter to provide an algebraic proof. Given that:
Total cash flow = cash flow from put + cash flow from call + cash flow from spot transaction
then if S < X, the total cash flow is:
(X -S * ) + 0 + S*
= X
but if S > X, the total cash flow is:
〇 _ (S* - X) + S*
= X
Therefore, the future total cash flow is always X.
Suppose that the price of the put was equal to the price of the call, and both the put and the call
have the same exercise price, term to expiry, and so on. In this case, the arrangement illustrated in
Table 18.15 requires no net initial cash inflow or outflow and it therefore replicates a forward contract
at both initiation and expiry. To prevent arbitrage, the forward price (exchange rate) should therefore
equal the exercise price of the options. In summary, if the prices of a put and its counterpart call are
equal, the forward price for the underlying asset should equal the exercise price of the options.
As we discussed in Section 18.2.1, forw ard contracts are very sim ilar to futures contracts. Therefore,
i f the prices o f a p ut and its counterpart call are equal, the futures price fo r the underlying asset should
approximately equal the exercise price o f the options.
A fu rth e r connection between option contracts and futures contracts is through a security know n as
a ‘low exercise price o ptio n ’ (LEPO). Such contracts are listed on the ASX. Consider a 1-m onth call option
w ith an exercise price o f 1 cent, on a share whose current m arket price is $10. Clearly, there is v irtu a lly
no chance th a t the share price w ill be anywhere near 1 cent during the coming m onth. Accordingly,
the o ption is almost certain to be exercised ( if n o t sold to someone else before expiry). The true option
element is thus exceedingly small and, in effect, a LEPO is v irtu a lly a com m itm ent to purchase. Who
would n o t expect to exercise an option to buy a share fo r 1 cent when the current share price is around
$10? Furtherm ore— unlike the rules applying to norm al share options— the ASX rules on LEPOs do not
require th a t LEPO buyers pay the option price at the in itia tio n o f the contract. Instead, the ASX merely
requires th a t LEPO buyers pay a m argin call i f the share price falls, and th a t LEPO sellers pay a m argin call
i f the share price rises. The result, therefore, is th a t a LEPO requires no payment at in itia tio n b u t produces
cash inflows or outflows as the share price changes, and ( if n o t earlier reversed) is v irtu a lly certain to
result in a purchase o f the share. This description is almost identical to th a t o f a futures contract on a
share. In other words, financially speaking, a LEPO is almost identical to a futures contract on a share.
Options on futures
A number o f futures exchanges, including the ASX, have introduced options on th e ir more heavily traded
futures contracts.25 A call o ption on futures confers on the buyer o f the call the rig h t to enter into a
futures contract as a buyer. Similarly, a p u t option on futures confers on the buyer o f the p u t the rig h t to
enter into a futures contract as a seller. O ften the expiry date o f the option is sh ortly before the expiry
date o f the futures contract.
For example, suppose th a t on 15 February the price o f a futures contract on gold, m aturing on 20 May,
is $1500. On 15 February it may also be possible to buy a call option on this futures contract w ith an
exercise price of, say, $1540 and an expiry date o f 13 May. This call confers the rig h t to assume the role o f
buyer in the futures contract at a futures price o f $1540. On 15 February this o ption may be w orth, say,
$30. Suppose th a t the futures price o f gold increases and th a t by 10 May the futures price has reached
$1630 and the call buyer wishes to take the p ro fit. I f the call is an American type the call buyer could
exercise the call on 10 May, thereby becoming registered from th a t date as a futures buyer at a price
o f $1540. Through operation o f the m ark-to-m arket rule, the sum o f $90 w ill be credited to the buyer.
Alternatively, instead o f exercising the call, i t could sim ply be sold in the options m arket. In principle the
price obtained should be $90 o r more.
Options on futures have proved to be popular w ith traders, particularly in the case o f options on
financial futures. Although there are many possible reasons fo r this popularity, options on futures have
three attributes th a t may have prom pted m arket participants to trade in the option rather than in the
underlying futures contract:
a Open futures positions entail very high risks fo r a speculator, p articularly i f those positions are held
fo r a long time. For example, i f a m arket participant believed th a t the share price index (SPI) was
likely to rise substantially in the next 2 months, then w ith o u t options, and apart from buying the
shares themselves, the only way to speculate on this belief is to buy SPI futures. M any speculators
would n ot w ant to take th is risk, sim ply because they could incur large losses i f the SPI should fall.
A call o ption on futures allows the speculator to pay a given sum (the option price) in retu rn fo r
avoiding the p ossibility o f large losses. The a b ility to p ro fit i f the belief proves correct is unimpaired.
In short, options on futures can preserve the basic speculative uses o f futures, b u t w ith o u t the
open-ended com m itm ent th a t futures themselves require,
b Hedgers may n o t be certain enough o f th e ir own circumstances to ju s tify accepting the obligations
o f a futures contract. Consider the follow ing situation. A small m anufacturer has tendered fo r
a particular job and the manager believes th a t although there is a fa ir chance o f success, i t is
n ot certain. I f the tender is accepted, there w ill be an immediate need fo r short-term funding o f
approximately $1 m illio n to buy the necessary raw materials. O f course, i f the tender is n o t accepted,
there is no such need. The manager believes th a t there is a need to hedge, because the financial
via b ility o f the project w ill be threatened i f interest rates increase between now and the date on
25 In this section it is assumed that the reader is familiar with futures contracts. Futures contracts are explained in detail in
Chapter 17.
A B usiness finance i
which the name o f the successful tenderer w ill be announced. This risk cannot be hedged using
futures contracts because a futures contract is a com m itm ent, b u t the m anufacturer cannot be
com m itted to the project unless and u n til the tender is accepted. A t present the m anufacturers need
to hedge is contingent on the future outcome o f the tender process. The m anufacturer could set up a
contingent hedge by buying a p u t option on a bank b ill futures contract. The am ount paid fo r the put
is like an insurance premium. I f interest rates rise, bank b ill futures prices w ill fa ll and the p u t w ill be
more valuable. The p u ts increased value w ill protect the manufacturer, should protection be needed.
O f course, i f interest rates fall, so w ill the p ut price. Indeed, the p ut price may even fa ll to zero and
the m anufacturer w ill then have lost the to ta l price paid fo r the put. This is like buying fire insurance
and n o t having a fire. No claim is made on the insurance policy and the prem ium is lost.
C The deposit/m argin system is simpler fo r option buyers than fo r futures traders. (O ption sellers s till
face u nlim ited risks so there are s till complications applicable to them.) Once option buyers have paid
the option price they can make no fu rth e r losses. Consequentiy, there is little or no reason to subject
option buyers to a stringent deposit/margin system. For this reason, smaller futures traders may prefer
to buy a call instead o f buying futures. Similarly, they may prefer to buy a p ut instead o f selling futures.
1 8 .7 .3 1 Pricing options on futures

The valuation o f options w ritte n on futures contracts, such as those traded on the Australian Securities
Exchange,26 has been derived by Asay (1982) and Lieu (1990) and is provided by the follow ing formulae:
c = FN{d3) - X N ( d 4) 18.9
p = X N (-d 4) - F N ( - d 3) n s iP !
where ^ 刚 ^
a y/T
d^- crVT
where
c = price o f the call
p = price o f the p ut
F = futures price
X = exercise price
T = term to expiry o f the option
O2 = v o la tility o f the futures price
Note th a t the form ulae above look very sim ilar to the standard Black-Scholes equations (Equations
18.5 and 18.8) w ith the only notable differences being th a t the share price has been replaced by the price
o f a futures contract w ritte n on the share and the omission o f the interest rate from the form ula. The
in tu itio n behind the interest rate omission is straightforw ard, because in the standard Black-Scholes
equations the interest rate represents compensation to the trader fo r having funds tie d up in the share.
As a futures contract requires no in itia l investm ent, there is no need to include an interest rate when
estim ating the value o f futures options.
1 8 .7 .4 1 Specification of the SPI 200 futures options contract

The SPI 200 futures options contract has the follow ing m ajor features:
a Option style. American.

b Contract unit. The contract u n it is the value o f the SPI 200 futures contract, w hich its e lf is valued by
reference to the S&P/ASX 200 Index m ultiplie d by $25.
26 Black (1976) derived the pricing formula for futures options traded in markets where the option premium is payable up-front.
However, the premium on futures options traded on the ASX is not paid immediately but is instead marked to market in
a similar way as is any position in a futures contract. Asay (1982) and Lieu (1990) adjust Blacks model to account for this
difference in market structure.
C Settlement. The contract is deliverable and may be exercised on any business day up to and including
the last trading day. Upon exercise the holder w ill receive (deliver) the underlying SPI 200 futures
contract position at the exercise price.
d Quotations. The contract is quoted as the value o f the SPI 200 futures contract to 0.5 index points,
e Exercise prices. Set at intervals o f 25 basis points. New o ption exercise prices are created
automatically as the underlying futures contract price fluctuates,
f Termination o f contract. A ll trading ceases at 12 noon on the th ird Thursday o f the contract m onth,
w ith settlem ent occurring the day follow ing the close o f trading.
Example 18.10 illustrates the use o f options contracts w ritte n on the SPI 200 futures contract.
Example 18.10
Diacono Fidelity is a superannuation fund that collects contributions from its members on a quarterly
basis and invests those funds in a diversified portfolio of Australian equities. It is 5 July 2013 and the
management of the fund is concerned that the general level of share prices will rise prior to 3 October
2013, when it is next going to invest the funds. It has approximately $ 1 500 00 in contributions
that will be invested. W hile Diacono Fidelity could hedge the risk of prices rising by taking a long
position in a futures contract, they wish to still benefit from any possible decline in market prices that
might occur prior to the funds being invested, and hence determine that it would be optimal to take a
position in a futures option contract instead.
On 5 July 2013, the S&P/ASX 200 Index closed at 4841.7 and the December 2013 S&P/ASX
SPI 200 Index futures contract closed at 4790 or at a contract price of 4790 x $25 = $119 750.
Diacono Fidelity decides to buy a December 2013 call option written on the SPI 200 Index futures
contract and with an exercise price of 5150 points (or at a contract price of 5150 x $25 = $128
750). The closing price of the December 2013 SPI 200 call options with an exercise price of 5150
points on 5 July was 39.5 points, which equates to a contract price of 39.5 x $25 = $987.50. So on
5 July 201 3, Diacono Fidelity agreed to pay $987.50 for the right to enter into the SPI 200 futures
contract at any time before 12 noon on 19 December 2013 at a notional price of $128750.
On 3 October 2013 the S&P/ASX 200 Index closed at 5234.9 and the December 2013 S&P/
ASX SPI 200 Index futures contract closed at 5230 or at a notional contract price of 5230 x $25 =
$130750. Diacono Fidelity could have exercised the futures option to enter into the futures contract
as a buyer at a notional price of $ 1 2 8 7 5 0 and reversed out as a seller at $1 30750 , resulting in a
gain of $2000. After deducting the price of the call option of $987.50, the net gain would have been
$ 1012.50, which could then be used to offset the generally higher level of equity prices that Diacono
Fidelity now faces in the market.
18.8 Contingent claims

im
L E A R N IN G
18.8.1 | W h a t is a contingent claim? O B JEC T IV E 6

Define a contingent
claim a n d exp lain the
A t the most basic level, an option on shares is sim ply an agreement th a t allows a choice about buying or
option-like features
selling shares to be made at a later date. The choice w ill be exercised i f i t is in the interests o f the option of several contingent
holder to do so. The decision w ill depend on the future value o f the shares. A contingent claim, is an claim s
asset whose value depends on the given value o f some other asset. A call option is perhaps the simplest
type o f contingent claim. A large number o f financial contracts are contingent claims and this raises
the possibility th a t such contracts m ig ht be valued using an option pricing (tha t is, contingent-claims)
approach. In the follow ing six sections we provide examples o f financial contracts th a t can be interpreted
as options. However, detailed discussion o f the pricing form ulae is beyond the scope o f the book.
18 .8 .2 | Rights issues
One o f the simplest contingent claims arises when a company raises new share capital by way o f a
renounceable rights issue. In this case a shareholder is given the rig h t to purchase new shares in the
B usiness finance
company at an issue price set by the company. The rights m ust be sold or taken up by a specified date. In
fact, a rig h t is sim ply a call option issued by the company. Unlike listed call options, exercise o f this rig h t
does affect the company s capital structure because new capital is raised. Furtherm ore, in practice the life
o f a rig h t is usually much shorter than the life o f m ost listed call options. Nevertheless, a rig h t is a call
option and therefore can be valued using option pricing principles.27
18 .8.3 |C o n ve rtib le bonds

A convertible bond is a type o f debt security that, in addition to paying interest, gives the investor the
rig h t to convert the security in to shares o f the company. For example, on the m a tu rity o f the convertible
bond, the investor can accept a cash payment in the usual way, or can take a predeterm ined number
o f shares instead o f the cash payment. The choice is up to the investor. A convertible bond is therefore
equivalent to ordinary debt plus a call o ption on the shares o f the company.28
1 8 .8 .4 1 Valuation of levered shares and risky zero-coupon debt

One o f the firs t contracts to be identified as a contingent claim is a share in a company th a t has debt
outstanding. Such a share is know n as a levered share1. Because companies cannot offer government
guarantees, there is some risk o f default. Consider, fo r example, the shareholders in a company th a t has
issued zero-coupon debt.29 W hen the debt matures, the shareholders m ust make a choice th a t resembles
the choice facing the holder o f a call option th a t has reached its expiry date. The shareholders can direct
the company to repay the debt o r they can allow the company to default. Choosing to repay is equivalent
to the shareholders exercising a call option to reclaim the company s assets from the debtholders.
Choosing to default is equivalent to the shareholders allowing the call to expire unexercised. I t is as i f the
shareholders have transferred the company s assets to the debtholders b u t have a call o ption to buy back
the assets by repaying the debt on the m a tu rity date. The m ajor variables involved in p ricing a call option
are reinterpreted as shown in Table 18.16.
TABLE 18.16 Interpreting a levered share as a call option on a company's assets

Call option on shares Levered share interpretation
The current (market) value o f the share The current (market) value of the company s assets
The exercise price The amount due at the debts m aturity (the face value
o f the debt)
The term to expiry of the option The term to m aturity o f the debt
The volatility o f the share The volatility o f the company’s assets
The risk-free interest rate The risk-free interest rate
In principle, therefore, we could value the shares using an option pricing approach. Given th a t the
m arket value o f the company is equal to the sum o f the m arket value o f the shares and the m arket value
o f the debt, once we know the value o f the shares we can calculate the value o f the debt as well.
1 8 .8 .5 1 Valuation of levered shares and risky coupon-paying debt

The contingent-claims approach can also be applied to the problems o f valuing risky coupon-paying debt
and valuing the shares o f a company th a t has issued this type o f debt. A lthough this is a more d iffic u lt
application, it is relatively simple to explain the insight th a t enables the problem to be solved. In this
27 For a detailed discussion, see Smith (1977).

28 For a detailed discussion, see Ingersoll (1977). A shorter and more accessible discussion can be found in Courtadon and
Merrick (1992, pp. 271-2).
29 The most important distinguishing feature of zero-coupon debt is that it is repaid by a single lump sum paid on the maturity
date. No intermediate (or coupon) interest payments are required. It is also known as pure discount1debt.
4 ^^
case shares can be regarded as a sequence o f call options. On the debts m a tu rity date, a payment w ill be
due and w ill consist o f the face value plus the last coupon. Consider a date after the second-last coupon
payment, but before the m a tu rity date. Looking ahead to the m a tu rity date, the lum p-sum payment
due at m a tu rity is the exercise price o f a simple call option. This is the case discussed in the previous
section. But to have reached this far, the shareholders m ust have paid the second-last coupon. That is,
the shareholders m ust have decided to pay the second-last coupon, rather than default at th a t time.
Therefore, the second-last coupon is also an option. I t is like a call option, where the underlying asset is
the simple call o ption represented by the fin al repayment. In other words, paying the second-last coupon
gives shareholders the option o f proceeding on to the m a tu rity date, where they face th e ir final option
C O M P O U N D OPTION
o f repaying o r defaulting on the debt. The second-last coupon is therefore an option on an option, or, as option on an option
i t is sometimes called, a compound option (Geske 1979,1977). W orking backwards in this way, we can (e.g. an option to buy
value the shares. The value o f the risky debt is given by the value o f the assets, less the value o f the shares. an option)
The net present value (NPV) approach to project evaluation, which we explained in detail in Chapters 5
and 6, is based on an analogy between a proposed investm ent project and a bond. Like a bond, a project
produces a set o f future cash flows. The NPV approach proposes that, like the cash flows o f a bond, the
cash flows o f a project should be discounted to a present value and summed to find the to ta l value o f the
project.
W hile the NPV approach has proved to be an extrem ely valuable to o l in project evaluation, this
does n o t mean i t is always the best to o l to use. There are tw o flaws in the bond analogy. First, in the
bond m arket an investor can purchase a bond today a n d /o r an identical bond at some fu tu re date. But
in real investm ent projects, th is is frequently n o t the case. For example, co nstructio n o f an office block
on a p articula r site could be started now, or at th is tim e next year. C onstruction cannot be started
on both dates. Second, once a bond is purchased, the cash flows to the investor are fixed. N othing
the investor does can change the cash flows produced by the bond. But in real investm ent projects
managers can intervene in the project a fte r i t has begun and thus influence the cash flows generated
by the project. For example, a project can be abandoned. Consider, fo r example, a gold m ine th at,
given the cu rren t price o f gold, has a negative NPV (see Brennan & Schwartz 1992).30 Does th is im p ly
th a t the m ine is worthless? No. Ownership o f the m ine confers a num ber o f rig h ts th a t are valuable,
including the rig h t to close the m ine and the rig h t to reopen i t at a la te r date. W hether and when these
rights w ill be exercised w ill depend on the cost o f exercising the rig hts and the fu tu re price o f gold.
In short, these rig hts attached to m ine ownership are like options: the option to abandon and the O PTION TO A B A N D O N
option to reopen. right to discontinue an

investment project
Mine ownership is, o f course, ju st one example, and many projects involve Veal* options.31 In this
paragraph we describe several im p o rta n t categories o f real options. M any investm ent proposals im p lic itly O PTIO N TO REOPEN
right to restart a
include an option to defer. For example, a b uilding m ig ht be constructed today, or next year, or the year
shut-down investment
after that. The option to defer can be valuable because during the period o f deferral new in fo rm a tio n may project
emerge and may affect the investm ent decision. A related option is the option to study. For example,
OPTIO N TO DEFER
instead o f sim ply accepting o r rejecting an investm ent proposal, there is often an option to undertake
right to b e g in an
a p ilo t project to collect more in fo rm a tio n about the likely outcomes o f the proposed project. O ther investment project at a
investment projects are likely to lead to fu rth e r investm ent opportunities. For example, a project may later date
include an option to expand at a later date the o utp ut o f a given product or to expand the range o f
OPTION TO STUDY
products th a t the company produces. right to gath er more
A ll options are valuable: by definition, an option cannot have a negative value. Estim ating the inform ation on an
value o f a real option is often a significant challenge to managers, b u t is w orthw hile given the many investment project
insights provided by option pricing theory. For example, the o ption to abandon a project and sell o ff the OPTION TO EXPAND
assets previously com m itted is an example o f an Am erican-style p ut option held by the firm . Whereas right to incre ase the
the valuation o f a p u t option on a share is relatively straightforw ard, it is more d iffic u lt to id e n tify and scale of a n investment
project
measure those variables th a t are inputs in to the valuation o f real options. Table 18.17 illustrates the lin k
30 The original academic work is Brennan and Schwartz (1985).

31 For a detailed treatment of real options, see Trigeorgis (1996). For more accessible discussions, see Leslie and Michaels
(1997), Copeland and Keenan (1998) and Dixit and Pindyck (1995).
B usiness finance
between those variables th a t are inputs in to the valuation o f puts w ritte n on ordinary shares and those
th a t are necessary fo r valuing the option to abandon a project.
TABLE 18.17 Variables that have；

an impact on the value of the option to abandon
a project
Put option on shares Option to abandon a project
The current (market) value o f the share The present value o f the expected cash flows from the project
The exercise price The salvage value of the assets committed to the project
The term to expiry o f the option The remaining life o f the project
The vo la tility of the share The volatility of the expected cash flows from the project
The risk-free interest rate The risk-free interest rate
W hen m ig h t management choose to exercise its option to abandon operations and sell o ff the projects
assets? To begin w ith , standard option pricing theory tells us th a t it is n o t optim al to exercise a p u t option
early sim ply because the exercise price exceeds the current value o f the asset, and hence the company
should n o t autom atically abandon operations as soon as the present value o f the expected cash flows
from the project is less than the salvage value o f the projects assets. The in tu itio n behind this decision
when considering puts w ritte n on shares is th a t p rio r to expiry there is s till a chance th a t the share price
may again be greater than the exercise price, in which case the option holder may regret having made the
decision to sell at the exercise price. In term s o f the real option, the logic is very sim ilar in th a t a decision
to sell o ff the assets fo r th e ir salvage value precludes the company from p articipating in any wealth that
m ight be created i f the expected cash flows from the project are subsequently greater than the salvage
value o f the assets. O ption pricing theory also demonstrates th a t i t m ig ht be optim al to exercise a p ut
option early i f the value o f the asset is very low relative to the o ptions exercise price. This suggests that,
in terms o f our option to abandon, the decision to sell o ff the project s assets w ill only be made when the
present value o f the expected cash flows from the project are so far below the salvage value o f the assets
th a t the company would be better o ff accessing the cash from the asset sale rather than w aitin g to see how
the u ncertainty associated w ith the project is resolved.
Some managers fear th a t allowing th e ir project analysts to include option values w ill lead to
unjustifiable increases in capital expenditure. However, this is n o t necessarily the result. For example,
recognising th a t a project has an option to defer can lead to lower capital expenditure. I f the project is
n o t deferred, the option value is lost. Moreover, while it is true th a t all options have value, it is also true
th a t many options are more valuable i f le ft unexercised. Thus, fo r example, the optim al decision may be
to retain the option to expand by n o t investing in a new p la nt today, rather than to exercise the option by
investing in a larger plant.
C hapter eighteen O ptions a n d c o n t in g e n t claims
CHAPTER S G H T E E N REVIEW
SUMMARY
• An option is the right to force a transaction to occur An equilibrium relationship between put and call
at some future time on terms and conditions decided prices, known as put-call parity, shows that a
upon now. For example, the buyer of a call (put) European put on a share that does not pay dividends
option on shares obtains the right to buy (sell) the can be replicated by a combination of the share, a
shares at a fixed price, known as the exercise risk-free deposit and the counterpart call.
price. Options that can be exercised at any time up Binomial option pricing is a practical way to price
to expiry are known as 'American options', while many options. It provides a numerical solution
those that can be exercised only on the expiry date, method rather than a valuation equation. An option
and not before, are known as 'European options’ . pricing equation, developed by Black and Scholes,
The buyer of an option obtains a right, whereas the is an important milestone in finance theory and has
buyer in a futures contract takes on an obligation. performed well in empirical tests, both in Australia
• A contingent claim is an asset whose value depends and overseas, if a dividend-adjusted version of the
on the given value of some other asset. An option is model is used. The model can also be adapted to
one kind of contingent claim. price options on assets other than shares, including
• The cash flows at expiry of an option depend only options on foreign currency and options on futures.
on the expiry share price and the exercise price. A large number of financial contracts are contingent
Before expiry, call option prices are influenced by a claims and an option pricing approach has often
number of factors, including the current share price proved useful in analysing and pricing these
(a positive influence), the exercise price (negative), contracts. Examples include rights issues, convertible
the term to expiry (positive), share volatility (positive), bonds, shares in a levered company and the default
the risk-free interest rate (positive) and expected risk structure of interest rates. Real options, such
dividends (negative). Put option prices are affected as options to abandon or expand a project, are
by the same influences, but some of the signs are important in project evaluation.
reversed.
KEY TERMS
call option 564 option to reopen 597
compound option 597 option to study 597
contingent claim 564 payoff structure 566
exercise (or strike) price 564 put option 564
hedge ratio (or delta) 578 put-call parity 573
intrinsic value 569 risk neutrality 579
option to abandon 597 time value 570
option to defer 597 volatility 570
option to expand 597
SELF-TEST PROBLEMS
A European call option is currently priced at $1.70 and has an exercise price of $15 and a term
to expiry of 8 months. The current price of the underlying share is $14.90. The share does not pay
dividends. The risk-free interest rate is 0.75 per cent per month (compound). The price of the equivalent
put option is $0.83. Show that:
a) the price of the call option exceeds its minimum theoretical price
b) an arbitrage profit would be earned by simultaneously buying the put, selling the call, buying the share
and borrowing the present value of the exercise price
c) explain the result in (b).
599
B usiness finance
2 Use the binomial model to price a call option with the following features: exercise price $6, term to
expiry 2 months, current share price $6.50, 'up7 factor 1.05 per month, /down, factor 1 /1 .0 5 per month
and risk-free interest rate 1 per cent per month. Use two time periods, each of 1 month.
3 Use the Black-Scholes model to calculate the price of a European call option with the following features:
exercise price $12, term to expiry 3 months, current share price $12.15, volatility (standard deviation)
20 per cent per annum and risk-free interest rate 10 per cent per annum (continuously compounding). The
underlying share does not pay dividends.
QUESTIONS
1 [LO 1] Distinguish between the following:
a) put option and call option
b) American option and European option
c) option contract and futures contract
d) time value of an option and time value of money.
2 [LO 1】 Selling a share is the opposite o f buying a share. Therefore, an option to sell a share must be the
opposite o f an option to buy a share. Is this statement true? Explain.
3 [LO 2] List and explain the factors likely to influence the value of a call option.
4 [LO 2] Options ore so risky that trading in them is really just another form o f gam bling. Discuss.
5 [LO 2] In 2002 a former executive with Macquarie Bank, Simon Hannes, was jailed for insider trading.
The offence related to Mr Hannes trading on the basis of information he had received indicating the likely
takeover of the transport company TNT by the Dutch firm KPN. Specifically, having learnt of the impending
takeover, and at a time when TNT was trading at approximately $1.56 per share, Mr Hannes purchased
almost $ 9 0 0 0 0 worth of short-dated call options with an exercise price of $2. Following the public
announcement of the takeover bid, the share price for TNT increased to approximately $2.40 per share.
Mr Hannes attempted to sell his options but the trades were questioned by his broker. Had the sale been
successful he would have generated a profit in excess of $2.3 million.
a) Why do you think Mr Hannes employed options rather than shares to exploit the price-sensitive information
he had in his possession? Specifically, why do you think he used short-dated out-of-the-money call options?
b) Could Mr Hannes have used put options to exploit the same information?
6 [LO 3 】 W hat is the value of a call option on its expiry date? Why? W hat is the value of a put option on its
expiry date? Why?
7 [LO 3] W hat is the minimum value of a call option on a share that does not pay dividends? Why?
8 [LO 3] Explain briefly why it is generally not rational to exercise a call option before its expiry date. Under
what circumstances can it be rational? In these cases, what do option holders obtain, and what do they
forgo?
9 [LO 3] A call option has no maximum possible value; a put option does. Why?
10 [L〇 5] Diacono Shoes Ltd is an Australian manufacturer of upmarket shoes that utilises high-qualityleather
imported from Italy. The firm's CEO, Mr Lyle Diacono, is concerned about the possible increase in the price
of the Italian leather that the firm uses due to an appreciation in the euro relative to the Australian dollar,
and is considering alternative hedging strategies to mitigate this risk. He has been in contact with his
friendly investment banker, who has pointed out that the firm might benefit by locking in an exchange rate
using currency futures contracts or alternatively might consider buying options written on currency futures
contracts. Assuming that he wants to mitigate the risk associated with adverse currency movements, what are
the factors that Mr Diacono should consider when choosing between currency futures contracts and options
written on currency futures contracts?
11 [L〇 5] Ozzie Glassworks Ltd of Adelaide has been awarded the contract to supply glass for a giant
aquarium to be built in Lancaster, England. However, the contract is conditional on the promoter of the
600
CHAPTER EIGHTEEN REVIEW

project obtaining a construction approval from the Lancaster City Council. Ozzie Glassworks has quoted a
fixed price of U K£2000000. W hat advice would you give Ozzie Glassworks? Explain.
12 [L0 6] Parklands Ltd has issued debentures. Explain how Parklands shares are similar to options.
13 [LO 6] Hi Gear Toys Ltd is facing severe financial difficulties; its cash flows are barely enough to cover
its fixed-interest commitments. Hi Gear's share price is very low. Alf Hawke, Hi Gear's managing director,
decides that the company should begin manufacturing a new toy that just might prove to be a runaway
success (but probably will not). Alf announces the decision at a press conference. Do you think Hi Gear's
share price would rise, fall or stay about the same? Why?
PROBLEMS
1 Option pricing [LO 3]
The following is an extract from the Xanadu Financial Review of 2 November 2014.
Call Option Trading
Company: Jempip Industries Ltd
Last sale price: $3.27
Expiry month Exercise price Last sale

($) ($)
December 2014 2.75 0.51
December 2014 3.00 0.32
December 2014 3.25 0.09
December 2014 3.50 0.04
December 2014 4.00 0.04
March 2015 2.75 0.64
March 2015 3.00 0.44
March 2015 3.25 0.18
March 2015 3.50 0.06
March 2015 4.00 0.04
The risk-free interest rate in Xanadu is 1 per cent per month. Jempip options cover 1000 shares per contract,
may be exercised at any time, expire at the end of their expiry month and are not protected against dividend
payments. Jempip pays dividends of 10 cents per share in April and October each year. Which prices appear
to violate option pricing theory? Give brief reasons.
2 PuH:all parity [LO 3]

You observe the following prices in a situation in which European put-call parity ought to apply:
Put price $1.95
Call price $1.10
Share price $20.00
Exercise price $22.00
Term to expiry 4 months
Risk-free interest rate 1% per month (compound)
601
a) Show that put-call parity is breached in this case.
b) Calculate the payoffs to show that the following strategy is an arbitrage: sell the call, buy the put, buy the
share and borrow the present value of the exercise price for 4 months.
Option pricing [LO 3]
You observe the following prices in a situation in which call options should sell for at least their minimum
theoretical price of M ax [0, current share price - present value of the exercise price]:
Call price $0.33
Share price $17.50
Exercise price $18.00
Term to expiry 6 months
Risk-free interest rate 10% p.a. (simple, i.e. 5% for a 6-month period)
W hat should the minimum call price be? Calculate the payoffs to show that the following strategy is an
arbitrage: buy the call, short sell the share and lend $17.17 at the risk-free interest rate for 6 months.
Putâll parity [LO 3]
Put and call options are available on the shares of Christopher Toms Ltd (CTL). The options are of the European
type. CTL is due to pay its next dividend of 10 cents per share in January 2015. The risk-free interest rate is
1 per cent per month. On 31 August 2014 you observe the following market prices for CTL call options:
Company: CTL
Last sale price: $2.00
Expiry date Exercise price Option price

($) ($)
30 November 2014 2.25 0.10
30 November 2014 5.00 0.005
Use put-call parity to estimate market prices for the November 2.25 and November 5.00 put options. If these
put options had been of the American type, what would their minimum values have been? Does this suggest
that, unlike call options, some American put options should be exercised prematurely? Why, or why not?
Binomial option pricing [LO 4 】
Use binomial option pricing to price a 3-month European call option with an exercise price of $15 on a share
whose current price is also $15. Use three time periods of 1 month each, a monthly 'up factor7of 1.02 and a
monthly 'down factor7 of 1/1.02. The risk-free interest rate is 0.5 per cent per month.
Binomial option pricing [LO 4]
Use binomial option pricing to calculate the price of the European put option that matches the call option in the
previous problem. Does put-call parity hold?
Black-Scholes pricing [LO 4]
a) Calculate the Black-Scholes price for a call option with the following features: share price $3, exercise
price of $2.75, term to expiry 3 months, risk-free interest rate 10 per cent per annum (continuously
compounded) and volatility (variance) 0.16 per annum. Calculate the Black-Scholes price of a put option
with the same features.
b) Calculate the Black-Scholes price for the same call option if the share price increases by 1 cent to $3.01.
By how much does the call price change? How could you use this information to hedge against share price
changes?
c) Compare the percentage change in the call price with the percentage change in the share price if the share
price increases from $3 to $3.01. Why might this comparison be useful to someone with inside information
on the company that issued the shares?
Black-Scholes pricing [LO 4]
Calculate the Black-Scholes price for a call option with the following features: share price $25, exercise
price $24.50, term to expiry 1 year, risk-free interest rate 6 per cent per annum (compounding annually) and
volatility (variance) 0.0625 per annum.
CHAPTER EIGHTEEN H E V H W
9 Black-Scholes pricing [LO 4]
Calculate the Black-Scholes price for a call option with the following features: share price $1 2.32, exercise
price $1 2.50, term to expiry 180 days, risk-free 180-day bill rate 7.5 per cent per annum and volatility
(variance) 0.0225 per annum.
10 Currency option [LO 5]
Today is 8 August 2015. The Red Claret Hotel Group is selling a travel business that it has been operating in
Kyoto, Japan. As a result, it expects to receive approximately 800 million yen in November 2015. The current
exchange rate is about 63 yen to one Australian dollar. Because of its other financial commitments, Red Claret
needs to be sure that it will receive at least A $12.3 million from the sale, regardless of any movements in the
exchange rate. If the exchange rate moves in the company’s favour during the next few months, the company
is willing to forgo any gain accruing above an inflow of A$1 3.0 million. Foreign currency options on yen are
available in contracts covering 100 million yen each, with exercise prices in half-yen steps, expiring on the
second Thursday in August, September, October, November and December. What option contract(s) should
Red Claret enter into? Explain.
11 Futures options pricing [LO 5 】
Use the futures call option pricing model (Equation 18.9) to value the following call option on the SPI 200
futures contract:
• current futures price is 6170 points
• exercise price (X) is 6000 points
• term (T) of the option is 3 months
• volatility (a2) of the futures contract is 20 per annum
• risk-free interest rate (/) is 6.75 per cent per annum (continuously compounding).
12 Real options [LO 6]
Duff Ltd is a brewing company that was established 3 years ago. When it commenced operations,
management purchased a bottling machine for $1.2 million. This machine has the ability to be converted so
that it also inserts corks into wine bottles. The conversion costs $250000. An equivalent machine, without the
ability to be converted so that it also seals wine bottles, would have cost $800000.
a) Define the option described above (i.e. name it and label it as either a put or a call option).
b) In addition to the risk-free rate of return and the term to expiry, the following four characteristics have been
shown to affect the value of an option:
i) current value of asset
ii) exercise price of option
iii) volatility of asset returns over the life of the option
iv) dividends paid during life of option.
Describe these characteristics in relation to the option possessed by Duff Ltd.
c) The /premium, for a financial option is the price paid to acquire it. Is there any premium associated with the
real option described above?
d) Are there any circumstances in which Duff Ltd may exercise its option early? Explain the advantages and
disadvantages associated with early exercise.
13 Options in loan contracts [LO 6]
The loan contract described as follows is a simplified version of an actual security: RA Best Constructions
International Ltd seeks to borrow from Multi Bank the sum of US$10 million, repayable by a single payment to
be made in 1 year's time. However, this payment is made up of two components:
• Component 1 is a payment of US$2 million, which for convenience may be called 'interest7at the rate of
20 per cent per annum.
• Component 2 is the payment of an amount that depends on the exchange rate between yen and US dollars
on the maturity date of the loan. We may call this a repayment, R, in full satisfaction of the principal, X,
which is owed. If the future exchange rate, S, is 169 (or more) yen per US dollar, then the full principal of
603
B usiness finance
US$10 million must be repaid. If the future exchange rate is 84.5 (or fewer) yen per US dollar, then none
of the principal needs to be repaid; Best is 'forgiven7 all the debt. If the future exchange rate falls between
84.5 and 169 yen per US dollar, the repayment required is related to the principal according to the
following formula:
甲 )
When Multi Bank investigated this proposal, the exchange rate was 185 yen per US dollar. At the same date
the interest rate that Best would have paid for a standard 1-year fixed rate US dollar loan was
11 per cent per annum.
a) Taking Multi Bank's viewpoint, analyse the loan in terms of its options characteristics.
b) Again taking Multi Bank's viewpoint, and assuming that you have a model that can be used to value any
opltion you may define, explain how you would investigate this proposal.
REFERENCES
Alpert, K., 'Taxation and the early exercise of call options', Geske, R., 'The valuation of corporate liabilities as
Journal of Business Finance and Accounting, June/July 2010, compound options7, Journal of Financial and Quantitative
pp. 7 1 5 - 3 6 . Analysis, November 1977, pp. 541-52.
Asay, M.R., yA note on the design of commodity options ____, ;The valuation of compound options', Journal of
con\rac\s , Journal of Futures Markets, 1982, pp. 1-8. Financial Economics, March 1979, pp. 63-81.
Australian Securities Exchange, Explanatory Note for ASX Hull, J., Fundamentals of Futures and Options Markets,
Option Adjustments, 2013. Available at www.asx.com 8th edn, Prentice-Hall, Englewood Cliffs, New Jersey, 2013.
.au/documents/products/Explanatory_Note_for_Option_ Ingersoll, J., yA contingent-claims valuation of convertible
Adjustments_andTerminations.pdf. securities,/ Journal of Financial Economics, May 1977,
Black, F., Tact and fantasy in the use of options', Financial pp. 289-322.
Analysts Journal, July/August 1975, pp. 3 6 -4 1 ,6 1 -7 2 . Leslie, K.J. & Michaels, M.P., 'The real power of real
____, 'The pricing of commodity contracts’ ，Jouma/ of options', The McKinsey Quarterly, no. 3, 1997, pp. 4-22.
Financial Economics, January/târch 1976, pp. ] 67-79. Lieu, D. 'Option pricing with futures-style margining', Journal
____, & Scholes, M., 'The pricing of options and corporate of Futures Markets, 1990, pp. 327-38.
liabilities', Journal of Political Economy, May/June 1 9 7 3 , Loudon, G.F., 'Put-call parity theory: evidence from the big
p p .6 3 7 -5 4 . Australian', Australian Journal of Management, June 19887
Brennan, MJ. & Schwartz, E.S., 'Evaluating natural resource pp. 53-67.
investments', Journo/of Bus/ness, 1985, pp. 135-58. Merton, R.C., 'Theory of rational option pricing', Bell Journal
____, 'A new approach to evaluating natural resource of Economics and Management Science, Spring 1973a,
investments', in J.M. Stern & D.H. Chew (eds), The Revolution pp. 141-83.
in Corporate Finance, 2nd edn, Basil Blackwell, Oxford, ____,'The relationship between put and call prices:
1 9 9 2 , pp. 1 0 7 - 1 6 . comment', Journal of Finance, March 1973b, pp. 183-4.
Brenner, M., Courtadon, G. & Subrahmanyam, M., 'Options Ofek, E.; Richardson, M. & Whitelaw, R.F., limited arbitrage
on the spot and options on futures', Journal of Finance, and short sales restrictions: evidence from the options
December 1985, pp. 1303-17. markets', Journal of Financial Economics, November 2004,
Copeland, T.E. & Keenan, P.T., 'How much is flexibility pp. 305-42.
worth?', The McKinsey Quarterly, no. 2, 1998, pp. 39-49. Phang, G. & Brown, R., 'Rational early exercise of call
Courtadon, G.R. & Merrick, The option pricing model options: Australian evidence7, Accounting and Finance,
and the valuation of corporate securities’，in 丄M. Stern & 2011, pp. 732-44.
D.H. Chew (eds), The Revolution in Corporate Finance, 2nd Smith, C.W. Jr〆Alternative methods for raising capital:
edn, Basil Blackwell, Oxford, 1992, pp. 265-78. rights versus underwritten offerings', Journal of Financial
Cox, J.C., Ross, S.A. & Rubinstein, M., 'Option pricing: a Economics, December 19 7 7 , pp. 273-307.
simplified approach,/ Journal of Financial Economics, 1979, Stoll, H.R., 'The relationship between put and call option
pp. 229-63. prices, Journal of Finance, December 1969, pp. 802-24.
Cox, J.C. & Rubinstein, M., Option Markets, 1st edn, Trigeorgis, L., Real Options: Managerial Flexibility and
Prentice-Hall, Englewood Cliffs, New Jersey, 1985. Strateqy in Resource Allocation. MIT Press. Cambridqe
Dixit, A.K. & Pindyck, R.S., 'The options approach to capital (Mass.), 1996.
investment7, Harvard Business Review, May/June 1995, Whaley, R., 'Understanding V\Xf, Journal o f Portfolio
pp. 105-15. Management, Spring 2009, pp. 98-105.
604
CHAPTER CONTENTS
ic t i Introduction 606 ICTE! Regulation and tax effects of takeovers
19.2 Reasons for takeovers 608 19.6 Takeover defences
19.3 Economic evaluation of takeovers 614 Corporate restructuring
19.4 Alternative valuation approaches 618 19.8 Empirical evidence on takeovers
LEARNING OBJECTIVES
1 evaluate suggested reasons for takeovers
2 explain how to estimate the gains and costs of a takeover
3 explain the main differences between cash and share-exchange takeovers
4 outline the regulation and tax effects of takeovers in Australia
5 outline defence strategies that can be used by target companies
6 identify the various types of corporate restructuring transactions
7 outline the main findings of empirical research on the effects of takeovers on shareholders7 wealth.
Takeovers are im p o rta n t transactions in the m arket fo r corporate control. A takeover typically involves one
company purchasing another company by acquiring a controlling interest in its vo ting shares. Such an
investm ent is variously described as a ‘takeover’, an ‘acquisition’ o r a ‘merger’. I t is possible to distinguish
TAKEOVER between mergers and takeovers, b u t in this chapter the term ta k e o v e r w ill generally be used to refer to
acquisition of control all instances where an acquiring company1 achieves control o f another company, referred to as the ta rg e t
o f one company by
com pany.
another
The m arket fo r corporate control is a m arket in which alternative teams o f managers compete fo r the
TARGET COMPANY
rig h t to control corporate assets and make top-level management decisions (Jensen & Ruback 1983).
object of a
takeover bid
Essentially, by changes in control, corporate assets can be quickly redeployed in ways expected to bring
economic benefits and add value fo r shareholders. O ther transactions in this m arket include divestitures,
spin-offs and buyouts, all o f which are defined and discussed in Section 19.7. The m ain topic o f this
chapter is takeovers, because they are the m ost im p o rta n t o f these transactions in the Australian m arket
fo r corporate control.
A fte r a takeover, the acquiring company obtains control o f the target company s assets, so a takeover
is an indirect investm ent in assets. The fact th a t the investm ent is made indirectly does n ot change the
basic principle th a t an investm ent should proceed if, and only if, it has a positive net present value (NPV).
Despite this basic sim ila rity between takeovers and other investm ents, there are several reasons why
takeovers should be treated as a separate topic. These reasons include:
a takeovers are controversial and at times there has been rather heated public debate about whether
takeover a ctivity is beneficial to shareholders and the economy
b the NPV o f a takeover can be very d iffic u lt to estimate, b u t correct analysis w ill be easier i f i t is based
on an understanding o f why takeovers occur and on knowledge o f the evidence on th e ir effects on
returns to investors
C a t a k e o v e r m a y g iv e r is e t o c o m p le x le g a l, a c c o u n t in g a n d t a x q u e s t io n s
d the acquiring company s plans may be frustrated by defensive tactics employed by the management
o f the target company, or by the interven tion o f other potential acquirers.
Takeover activity fluctuates widely over tim e. These fluctuations are reflected in Figure 19.1, which shows
th a t between 1974 and 2013 the num ber o f bids fo r Australian listed companies varied between a high of
289 in 1988 and a low o f 38 in 1994 and 2002.
These fluctuations are o fte n described as takeover ‘waves’. In the US, takeover waves have
occurred at the tu rn o f the tw e n tie th century, in the 1920s, the 1960s, the 1980s and a fu rth e r
wave o f takeover a c tiv ity began in 1993 (Gaughan 1994; Andrade, M itc h e ll & Stafford 2001). The
phenom enon o f takeover waves is n o t fu lly understood, b u t there is evidence th a t takeover a c tiv ity
in A ustralia is p o sitive ly related to the behaviour o f share prices. For example, Bishop, Dodd and
O fficer (1987) reported a close relationship between changes in share prices and the num ber o f
takeovers in the period 1972 to 1984. The explanation preferred by Bishop, Dodd and O fficer fo r
th is relatio n ship is th a t periods when the prices o f shares are increasing rapidly are also periods o f
o ptim ism fo r investm ent. The increase in share prices w ill reflect increased demand fo r real goods,
which w ill require companies to increase th e ir productive capacity. W hile companies w ill increase
th e ir capacity by investing in new p la n t and equipm ent (in te rn a l investm ent), managers w ill also be
loo king fo r o p p o rtu n itie s to take co n tro l o f existing assets, p a rtic u la rly assets th a t are n o t being used
efficiently. W hen such o p p o rtu n itie s are found there w ill be an increase in takeover a c tiv ity (external
investm ent). In short, b o th in te rn a l and external inve stm en t w ill respond to th e same economic
forces. Therefore, a relationship between the state o f the economy and the level o f takeover a c tiv ity
1 When a takeover bid is first announced, the eventual outcome is unknown. Therefore we also use the terms bidder* or
offeror1when a takeover is still in progress.
C hapter nineteen A nalysis o f takeovers
Figure 19.1 Number of takeover bids for Australian listed companies 1974-2013
S E J Ij p
a)
4SJI
u
.9
p
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5
o
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oJa
o
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Sources: S. Bishop, P. Dodd & R.R. O fficer, 'Australian takeovers: the evidence 1 9 7 2 -1 9 8 5 ', Policy Monograph, 12, Centre
for Independent Studies, St Leonards, 19 8 0, 1 9 8 7; 1 985 to 1990, Corporate Adviser; 1995 to 2 0 1 3 , SDC Platinum.
is to be expected. In the m ost recent A ustralian study o f the relationship between takeover a ctivity,
share prices and economic conditions, Finn and Hodgson (2005) examined 1665 successful takeovers
th a t occurred between 1972 and 1996. They conclude th a t share prices and takeover a c tiv ity share
a common lon g-te rm trend, w hich is co ntrary to previous studies th a t have suggested th a t each
responds to the o the r over a sh orter tim efram e. F urther, they fin d th a t aggregate takeover a c tiv ity is
influenced by fundam ental economic factors such as in d u s tria l production, capital expenditure and
interest rate levels, rather th an by speculative a ctivity.
Researchers in the US have noted th a t at any given tim e, takeover a ctivity exhibits ind ustry clustering
and each wave o f takeovers is different in terms o f in d u stry composition. These observations suggest
that a significant p o rtio n o f takeover a ctivity m ig ht be due to economic shocks at the in d u s try level. For
example, an industry m ight be affected by m ajor technological changes, supply shocks such as changes in
commodity prices, and deregulation (Andrade, M itche ll & Stafford 2001). These shocks can lead to excess
capacity and stim ulate an increase in takeovers th a t lead to liqu id atio n o f m arginal assets. Im portantly,
research by H arford (2005) shows th a t in order fo r an economic shock to induce a wave o f merger
activity, there also needs to be sufficient capital available to acquirers to fund the acquisitions. Andrade
and Stafford (2004) demonstrate th a t in addition to takeovers providing an o p p o rtu n ity fo r companies
operating in growth industries to expand productive capacity, they also provide the mechanism by which
companies operating in industries th a t are contracting and have low grow th prospects exit the industry
and allow invested capital to be redeployed elsewhere. As Jensen (1988) points out, i f an in d u stry has
suffered slowing growth, i t is preferable th a t excess capacity is reduced in this orderly way rather than the
more costly and disorderly process o f bankruptcy.
1 9 .1 .2 1 Types of takeover HORIZO NTAL

TAKEOVER
Takeovers are usually classified as follows: takeover of a target
company operating
• A h o rizo n ta l tak eov er is the takeover o f a target company operating in the same line o f business in the same line
as the acquiring company. An example o f this fo rm o f takeover is the takeover by Westpac Bank o f of business as the
St George bank in 2008. acquiring company
B usiness finance
VERTICAL TAKEOVER A v e rtica l ta k eo v er is the takeover o f a target company th a t is either a supplier o f goods to, or
takeover of a target a consumer o f goods produced by, the acquiring company. An example is the 2012 acquisition o f
company that is either
the ta xi company Yellow Cabs by Cabcharge Australia, a provider o f payment services fo r the taxi
a supplier of goods
to, or a consumer of
industry.
goods produced by, A co n g lo m era te ta k eo v er is the takeover o f a target company in an unrelated type o f business.
the acquiring company There have been a num ber o f high-profile acquisitions o f this type. For example, over the last
CONGLOMERATE 30 years Wesfarmers has acquired companies operating in industries as diverse as retail, m ining,
TAKEOVER liquefied petroleum gas d istrib u tio n and insurance.
takeover of a target
company in an
unrelated type of
business
Reasons for takeovers

Just as there are different types o f takeovers, so there are many different reasons w hy takeovers occur.
We begin by presenting a fram ework fo r the evaluation o f these reasons and then discuss some o f the
suggested reasons individually.
As noted above, takeovers are p a rt o f the m arket fo r corporate control in which alternative
LEARNING
management teams compete fo r the rig h t to manage corporate assets. C om petition in th is m arket should
OBJECTIVE 1
Evaluate suggested ensure th a t asset control is acquired by those teams th a t are expected to be the m ost efficient in u tilising
reasons for takeovers those assets. It should also ensure th a t the interests o f management cannot diverge too far fro m those
o f shareholders. For example, suppose th a t a company is poorly managed, resulting in low profits and
a low share price. An o pp o rtu n ity then exists fo r a more efficient management team to take over this
company, replace the inefficient managers and reverse the poor performance o f the company. However,
the m arket fo r corporate control should n ot be viewed only as providing a severe disciplinary measure
against incom petent management. Increased p ro fita b ility through a change o f management does n ot
necessarily im ply th a t the previous management was incompetent, only th a t a more efficient team was
available (Dodd & Officer 1986).
Wealth (or value) can be created by combining tw o companies i f the takeover transfers control o f
assets to managers who can recognise more valuable uses fo r those assets, either w ith in the combined
SYNERGY company or by redeployment o f the assets elsewhere. The term sy n erg y is often used to describe the
in takeovers, the value gains th a t can be associated w ith com bining tw o entities. In other words, i f there are synergistic
situation where the
benefits associated w ith combining tw o companies A and T, then the combined company w ill be w orth
performance and
more than the sum o f th e ir values as independent entities:
therefore the value
of a combined entity
yAT> K A+ y T
exceeds the sum of the
previously separate where VAT = the value o f the assets o f the combined company
components
VA = the value o f Company A operating independently
VT = the value o f Company T operating independently
In th is chapter the subscripts A and T are used to denote the acquiring and target companies,
respectively.
To summarise, the m ain im plications o f this approach are th a t takeovers are value-increasing
transactions and th a t the m arket fo r corporate control is influenced largely by the existence o f synergies.
I t follows that, in evaluating the suggested reasons fo r takeovers, we need to consider whether the
particular reason suggested is consistent w ith the existence o f an economic gain from combining two
companies. The suggested reasons fo r takeovers th a t we w ill evaluate are as follows:
• the target company is managed inefficiently

• the acquiring and target companies have assets th a t are complementary
• the target company is undervalued
• cost reductions result from the takeover
« incireased m arket power results from the takeover
• diversification benefits result from the takeover
• the target company or the acquiring company has excess liq u id ity or free cash flow
• tax benefits result from the takeover
• there are increased earnings per share and price-earnings ratio effects.
1 9 .2 .1 1 Evaluation of the reasons for takeovers

The target com pany is managed inefficiently
In this case, the acquiring company s managers may see an o p p o rtu n ity to use the target company s assets
more efficiently. The more efficient use o f assets may result in an increase in the value o f the target
company. However, the acquiring company s aspiration to improve the efficiency o f the target company s
operations may n o t always be realised. Even i f an acquiring company is managed efficiently, this does not
necessarily mean th a t its managers w ill be able to improve the performance o f another company. This is
particularly so where the two companies operate in different industries. This suggests th a t improvements
in efficiency are less likely to be achieved w ith a conglomerate takeover. As a corollary, improvements in
efficiency are most likely to be achieved w ith a h orizontal takeover, as the acquiring company s managers
are likely to have the expertise needed to manage the target company s operations more efficiently.
However, the m arket value o f a company may be low, n ot because its managers are inefficient, b ut
because they make decisions in th e ir own interests rather than in those o f the company s shareholders.
The discussion o f agency costs in Chapter 1 suggests th a t managers may attem pt to transfer wealth from
shareholders to themselves. I f the value reduction is large, it is likely th a t the company w ill eventually be
identified as a takeover target, since an acquiring company w ill be able to eliminate, or at least reduce, the
agency costs, thereby providing benefits fo r its own shareholders.
Complementary assets
A takeover can be attractive i f either or b oth o f the companies can provide the other w ith needed assets
at relatively low cost. For example, this can occur when the target company s managers are considered
to have valuable skills. The m otive fo r the takeover is to acquire expertise. I t may be cheaper to acquire
this expertise via a takeover than to hire and tra in new staff. This is often an argum ent fo r taking over
small, often unlisted, companies th a t have failed to realise th e ir fu ll p otential because th e ir managers do
not have skills in all areas o f management. For example, a group o f engineers may establish a computer
hardware company th a t does n o t earn a satisfactory p ro fit because the engineers lack m arketing skills.
A large company w ith a strong m arketing team may take it over because it is seen as a relatively cheap
means o f acquiring the technical skills o f the target company s staff. Similarly, the complementary skills
o f the acquiring company s sta ff may be used to improve the targets profitability.
The target com pany is undervalued

Describing a target company as sim ply ‘undervalued’ is n o t very meaningful, since a takeover always
implies th a t the target is w o rth more to the acquiring company than i t was w o rth to its previous
shareholders. Managers o f acquiring companies often refer to th e ir targets as ^presenting w onderful
opportunities’ or ‘too good to pass up’，suggesting th a t they believe in th e ir a b ility to id e n tify ‘bargains’.
Chapter 16 presents empirical evidence on m arket efficiency which suggests th a t m ost managers w ill
find i t very d ifficu lt to id e n tify such opportunities. However, even i f managers are able to id e n tify
undervalued shares, i t is n ot necessary to buy whole companies, paying premiums fo r control, to p ro fit
from th e ir a b ility to ide ntify ‘bargains’. Instead, they could buy a parcel o f the shares at the m arket price,
w ait u n til the m arket recognises the shares* value, and then sell.
I t has never been seriously suggested th a t share markets are fu lly efficient in the strong-form sense.
I t is therefore possible th a t a company s managers may have private inform a tion n o t yet reflected in the
price o f another company s shares. Share acquisition follows, and may extend to acquiring a controlling
interest in the target company.
CORPORATE RAIDERS
A takeover may also occur when the m arket value o f the target company is less than the sum o f the aggressive corporate
m arket values o f its assets. This does n o t necessarily mean th a t the share m arket is inefficient, as the or individual investors
company s share price may accurately reflect the value o f its assets in th e ir current use. However, such w ho purchase a
a company can become a takeover target because other managers recognise the existence o f alternative, com pany’s shares
w ith the intention
better uses fo r the assets. Investors who focus on searching fo r takeover opportunities o f this type are
of achieving a
often referred to as co rp o ra te raiders or asset strippers. Their activities can be regarded as involving a controlling interest and
form o f synergy because a crucial factor is the skill o f the acquiring company s managers in identifyin g replacing the existing
opportunities to create value by redeploying assets to alternative uses. management
Cost reductions
A nother reason fo r takeovers is th a t the to ta l cost o f operating the combined company is expected to be
less than the cost o f operating the tw o companies separately. These cost savings may be due to various
economies o f scale, and are therefore more likely to be achieved in the case o f a h orizontal takeover.
For example, tw o fu rn itu re manufacturers, by combining, may be able to reduce th e ir production costs
because production runs w ill be longer, resulting in the fixed costs o f a production run being incurred less
frequently. Cost savings may also be achieved in a vertical takeover. For example, combining companies
where one is a supplier to the other may result in more efficient coordination o f the activities o f the
tw o companies. One reason is th a t the costs o f comm unication and various form s o f bargaining can be
reduced by a vertical takeover.
Increased market pow er

Taking over a company in the same in d u stry may increase the m arket power o f the combined company.
The increase in m arket power may enable the acquiring company to earn m onopoly profits i f there are
significant barriers to e n try in to the industry. Governments frequently legislate to prevent takeovers
th a t are considered likely to result in an excessive level o f concentration in an industry. Section 50 o f the
Competition and Consumer A ct 2010 prohibits a company from acquiring the shares or assets o f another
company where the acquisition is likely to result in a substantial lessening o f com petition in a market.
The Australian C om petition and Consumer Commission (ACCC, www.accc.gov.au) has issued Merger
Guidelines th a t explain the procedures and policies th a t it w ill follow in determ ining w hether i t w ill oppose
a particular takeover on the grounds th a t the takeover is anticom petitive. An example o f such opposition
occurred in October 2012 when the ACCC announced th a t i t would oppose the acquisition o f a small
chain o f three hardware stores around Ballarat in country V ictoria by the jo in t venture partners behind
the Masters chain o f hardware stores. The m ain reason given fo r the decision was th a t the ACCC believed
th a t the acquisition would result in a substantial lessening in com petition in the hardware m arket in the
Ballarat region.
Diversification benefits
Portfolio theory shows th a t investors can reduce th e ir risk by holding a diversified p o rtfo lio o f assets.2
A sim ilar reason has been advanced to ju s tify a takeover. The takeover, i t is suggested, enables a company
to reduce risk via diversification. Assume th a t a steel m anufacturer diversifies its interests by taking
over an o il exploration company. The question is: Does the reduced risk brought about by the takeover
benefit the steel m anufacturers shareholders? The somewhat surprising answer is generally no. The steel
m anufacturers shareholders already had the o p p o rtu n ity to hold shares in o il exploration companies so
the takeover does n o t provide any investm ent o p p o rtu n ity th a t did n o t previously exist. Therefore, when
shareholders themselves hold diversified p ortfolios, diversification by a company is a neutral factor th a t
w ill neither alter its m arket value n o r benefit its shareholders. Takeovers m otivated by diversification
can be beneficial to managers. Therefore, the occurrence o f such takeovers can indicate the existence o f
agency problems.3
A related argum ent is th a t com bining tw o companies whose earnings streams are less than perfectly
correlated w ill lower the risk o f default on debt, so th a t the debt capacity o f the com bination is greater
than the sum o f the debt capacities o f the tw o companies operating separately. This is the result o f the
co-insurance effect, which means th a t lenders to one company can now be paid o ut o f the combined assets o f
both companies. W hile the co-insurance argum ent is essentially correct, the problem is th a t shareholders
w ill n ot necessarily benefit from the reduction in default risk and interest cost o f debt.
2 See Section 7.5.

3 However, there may be cases where company diversification is of value to investors. Shareholdings in a private family
company may represent a high proportion of the family's wealth and the family members may wish to reduce their risk by
diversifying. To obtain the funds to invest elsewhere, they might have to sell part of their interest in the company, but this
would mean diluting their control, and might also cause a large capital gains tax bill. Because of these barriers, diversification
by the company will almost certainly be more attractive than diversification by the individual shareholders. Such cases are the
exception rather than the rule, and for public companies whose shareholders can diversify cheaply, company diversification
will not add value for shareholders.
Suppose th a t two companies, each w ith debt securities outstanding, merge. The default risk o f
each company s debt w ill fall and the value o f the debt securities w ill increase. This effect is called the
co-insurance, effect because each company reduces the default risk o f the other. This gain to debtholders
is at the expense o f shareholders, who now have to guarantee the debt o f b oth companies, and the loss
to shareholders exactly offsets the gain to debtholders. I f tw o companies combine and then borrow, the
shareholders w ill benefit from a lower interest rate, b ut they are providing the lenders w ith lower risk,
so there is s till no net gain. However, shareholders can benefit from the co-insurance effect to the extent
that expected bankruptcy costs are reduced, or there are net tax savings. Therefore, while combining
companies can yield genuine financing benefits, i t is d oubtful th a t th e ir magnitude is sufficient to ju s tify
many takeovers.
Excess liquidity or free cash flow

A company w ith excess liq u id ity may be identified as a takeover target by companies seeking access to
funds. However, i t seems d iffic u lt to ju s tify paying a prem ium to obtain control o f a company fo r this
reason alone, because the capital m arket can provide funds at lower transaction costs. On the other
hand, companies w ith excess liq u id ity may tu rn to the acquisition o f other companies rather than retu rn
more cash to th e ir shareholders. Such takeovers may result from managers pursuing th e ir own interests,
rather than m axim ising the wealth o f shareholders. Managers may pursue greater m arket share in
existing lines o f business or diversification in to additional industries because larger companies are often
associated w ith higher salaries and benefits, and more prom otion opportunities. Jensen argued that
this conflict o f interest can be severe in companies th a t generate substantial free cash flow and can lead
to such companies engaging in takeovers th a t generate very small benefits, or even value reductions.4
For example, diversification programs achieved through takeovers are likely to benefit managers b ut
may reduce shareholders* wealth. Where managers persist in this type o f activity, th e ir own company is
likely eventually to become a takeover target. Therefore, the free cash flow hypothesis shows how some
takeovers are evidence o f the conflicts o f interest between shareholders and managers, while others are
a response to the problem.
Tax benefits
Taking over a company w ith accumulated tax losses may reduce the to ta l tax payable by the combined
company. In Australia, the Commissioner o f Taxation restricts the use o f past accumulated tax losses
to situations where i t can be shown th a t either the continuity-of-ownership-and-control test or the same-
business test is satisfied.5 To pass the continuity-of-ow nership-and-control test requires th a t owners
o f at least 51 per cent o f the company s shares when it incurred losses remain as owners when those
accumulated losses are offset against taxable income and the effective control o f the company has n ot
changed between the generation and u tilisa tio n o f the tax losses. The same-business test provides that
where the continuity-of-ow nership-and-control test is n o t satisfied, the past accumulated losses can s till
be offset against taxable income where the acquired company continues in the same business after the
takeover. For companies w ith resident shareholders, the incentive to reduce company tax payments in
this way is much smaller under the im putation tax system than it was under the classical tax system.
This follows from the fact that, as discussed in Chapter 11, company tax is essentially a w ithholding
tax against the personal tax liabilities o f shareholders. Hence, other things being equal, a reduction o f
company tax w ill mean th a t shareholders have to pay more personal tax on dividends. Therefore, any
advantage associated w ith low ering company tax payments w ill be only a tim in g advantage.
In an international setting there are p otentially substantial gains to be made by acquirers operating
in high-tax jurisdictions ta king over target companies which are located in countries w ith lower tax rates.
For example, in 2013 the US pharmaceutical company Perrigo launched a successful bid fo r Irish drug
company Elan Corporation. Following the acquisition, Perrigo shifted its headquarters to Ireland so as
to take advantage o f the significantly lower corporate tax rate in Ireland (12.5 per cent) than in the US
(40 per cent).
4 Free cash flow is defined as operating cash flow in excess of that required to fund all projects that have positive net present
values. See Jensen (1986 and 1998).
5 See Subdivision 165-A of the Incom e T a x A ss e s s m e n t A c t 1 9 9 7 .
Increased earnings per share and price-earnings ratio effects
Corporate financial objectives are sometimes expressed in term s o f grow th in earnings per share (EPS),
and this may lead an acquiring company to evaluate the effect o f a proposed takeover on its EPS.
U nfortunately, this approach is unreliable. W hile a takeover th a t is economically viable should lead
to increased EPS fo r the acquiring company, i t is easy to design a takeover th a t produces no economic
benefits, b u t which nevertheless produces an immediate increase in EPS. Example 19.1 illustrates this
situation.
E xample 19.1
T h is e x a m p le re fe rs to th e d a ta in T a b le 1 9 .1 .
TABLE 19.1 Effect of takeover on earnings per share and market value of
Company A
Item Com pany A C om pany T C o m b in e d c o m p a n y A +T
No. of shares 200000 100000 250000
Earnings ($/year) 200000 100000 300000
EPS ($) 1.00 1.00 1.20

：
Share price ($) 10.00 5.00 10.00
P-E ratio 10.00 5.00 8.33
Market value o f equity ($m) 2.00 0.50 2.50
S u p p o s e th a t th e re a r e n o e c o n o m ic b e n e fits a s s o c ia te d w ith c o m b in in g c o m p a n ie s A a n d T. If A
a c q u ir e s T b y is s u in g o n e o f its s h a re s , w o r th $ 1 0 , f o r e v e r y t w o T s h a re s , a ls o w o r th a to ta l o f $ 1 0 ,
w h a t is th e e ffe c t o f th e ta k e o v e r o n th e EPS a n d v a lu e o f C o m p a n y A ?
SOLUTION
A s th e re a r e n o e c o n o m ic b e n e fits , th e e a r n in g s o f th e c o m b in e d c o m p a n y w ill s im p ly b e th e sum
o f th e in d iv id u a l c o m p a n ie s 7 e a r n in g s , $ 3 0 0 0 0 0 p e r a n n u m . T h e ta k e o v e r w ill m e a n is s u in g a
fu rth e r 5 0 0 0 0 A s h a re s , m a k in g 2 5 0 0 0 0 o n issu e, a n d th e EPS f o r th e c o m b in e d c o m p a n y w ill b e
$ 3 0 0 0 0 0 / 2 5 0 0 0 0 = $ 1 . 2 0 , a n im m e d ia te in c re a s e o f 2 0 p e r c e n t. A lth o u g h th e ta k e o v e r looks
a ttr a c tiv e , it cannot b e a ttr a c tiv e b e c a u s e th e ta k e o v e r g e n e ra te s n o e c o n o m ic b e n e fits . T h e fa c t th a t it
h a s n o e c o n o m ic b e n e fits is se e n in th e fin a l r o w o f T a b le 1 9 . 1 : th e c o m b in e d c o m p a n y is w o r th o n ly
th e sum o f th e v a lu e s o f th e t w o in d iv id u a l c o m p a n ie s .
The reason th a t EPS increases in Example 19.1 is sim ply th a t A was able to acquire a company w ith
earnings o f $100000 per annum by issuing only 50000 o f its shares. This, in tu rn , was possible because
As price-earnings ratio o f 10 was greater than T s ratio o f 5. The effect we have illustrated here is called
bootstrapping and i t occurs in share-exchange takeovers whenever the acquiring company s price-
earnings ratio exceeds the target company s price-earnings ratio. Therefore, i f EPS is used in takeover
evaluation it is im p o rta n t to distinguish between the effects o f true grow th and the bootstrap effect. To
avoid confusion, i t m ig ht be better sim ply to ignore EPS in the context o f takeovers.
We do n o t expect everyone to heed our last piece o f advice so we w ill go one step fu rth e r to h ig hligh t
another way in which analysis* based on EPS can be misleading. An analyst, impressed by the 20 per cent
increase in EPS resulting from As acquisition o f T, m ig ht be tempted to value the combined company by
applying As price-earnings ratio o f 10 to the new EPS o f $1.20, giving a share price o f $12 and an equity
value o f $12 250 000 = $3 m illion. But this m ust be wrong, because, w ith no economic benefits, the value
o f the combined company can only be $2.5 m illion , so the share price is $10 and the price-earnings ratio
is 8.33 rather than 10. We have more to say about the use o f price-earnings ratios later in the chapter, b ut
the p o in t we wish to emphasise now is th a t there is no basis fo r assuming th a t an acquiring company s
pre-takeover price-earnings ratio w ill continue to apply to a combined company.
1 9 .2 .2 1 Survey evidence of the motives for takeovers

Having evaluated possible reasons fo r one company acquiring another, i t is useful at th is p o in t to
consider w hat the managers o f acquiring companies have to say about th e ir rationale fo r takeovers.
Mukherjee, Kiym az and Baker (2004) surveyed the chief financial officers o f US bidder companies th a t
had been involved in the 100 largest takeovers in each year between 1990 and 2001, and asked them
to id e n tify the relative im portance o f a lternative reasons fo r the acquisition. Results are provided in
Table 19.2.
TABLE 19.2 Motives for takeovers

M o tiv e P e rc e n ta g e o f re s p o n d e n ts th a t ra n k e d th is m o tiv e as
m o st im p o r ta n t
Take advantage o f synergy 37.3
Diversify 29.3
Achieve a specific organisational form as part o f an 10.7

ongoing restructuring program
Acquire a company below its replacement cost 8.0
Use excess free cash 5.3
Reduce tax on the combined company due to tax 2.7

losses of the acquired company
Other 6.7
Source: T.K. Mukherjee, H. Kiym az «& H. Baker, 'M erger motives and target valuation: a survey of evidence from CFOs7,
Journal o f Applied Finance, W inter 2 0 0 4 , p. 15. © The Financial M anagem ent Association International, University of South
Florida, CO BA 4 2 0 2 East Fowler Avenue, BSN 3331 Tampa FL 3 3 6 2 0 -5 5 0 0 , w w w .fm a .o rg
The relative importance o f realising synergistic benefits is n o t unexpected given th a t these benefits
are perhaps the easiest to id e n tify — and hence communicate to shareholders o f b oth the bidder and
target companies. O f interest, given the discussion in Section 19.2.1, is the relatively high ranking given
to diversification as a justifica tion fo r takeover activity. W hen quizzed fu rth e r on the sources o f the
diversification benefits, the m ost popular response was th a t diversification Results in much less devastating
effects on the firm during economic downturns. W hile this response is consistent w ith the n otio n that
shareholders may benefit through the company diversifying by the consequent reduction in expected
bankruptcy costs_ due to a lower probability o f bankruptcy— it is also consistent w ith management
attem pting to protect the value o f th e ir own capital (both financial and human), which is largely tied up
in the company. This second effect is an example o f an agency problem th a t m ight adversely affect the
value o f the company, especially i f managers are w illin g to overpay fo r targets in order to realise these
diversification benefits.
1 9 .2 .3 1 The roles of takeovers

The valid reasons fo r takeovers can be classified in to tw o groups, w hich suggests tw o m ain roles fo r
takeovers. F irst, the th re at o r p o te n tia l fo r takeover can discipline management o f target companies.
To be effective, threats m ust sometimes be carried out, and in cases where significant inefficiencies
or agency problems rem ain despite the th re at, the managers o f target companies can be replaced
via takeovers. Evidence th a t the tu rn ove r rate fo r the to p executive o f target companies increases
dram atically fo llo w in g a takeover is provided by M a rtin and M cConnell (1991). They also found th a t
in cases where the top executive was replaced a fte r a takeover, target companies had been p erfo rm in g
poorly relative to o th e r companies in th e ir ind ustry. These results indicate th a t the takeover m arket is
im p o rta n t in c o n tro llin g the behaviour o f managers. H arfo rd (2003) w ent even fu rth e r by exam ining
the fu tu re em ploym ent prospects o f target directors fo llo w in g successful takeover bids. He reports
th a t n o t only are directors o f poorly p e rfo rm in g acquired companies lik e ly to lose th e ir board seat,
B usiness finance
b u t they are also less lik e ly to acquire another d irectorship in the fu tu re relative to a co ntrol group o f
other directors.
Second, takeovers can take advantage o f synergies such as economies o f scale or complem entarity
between assets. A basic difference between these tw o roles is th a t in the firs t case the gains are associated
w ith changes o f control, whereas in the second case, the gains are associated w ith combining previously
separate assets or companies. A nother difference is th a t takeovers designed to replace management are
more likely to be hostile than those driven by synergies.
In b o th cases there are usually other ways in which sim ilar benefits can be achieved. Poor management
could be replaced by a company s own Board o f Directors and synergies associated w ith combining assets
can be achieved through jo in t ventures. Therefore, takeovers are one way in which management can be
improved or synergies exploited, b u t the prevalence o f takeovers suggests th a t they are often the most
effective way.
ik
LEARNING
OBJECTIVE 2
19.3 Economic evaluation of takeovers
For an acquiring company, takeovers are investments th a t should proceed i f th e ir net present value (NPV)
is positive. This may sound simple, b u t takeovers are typically complex; the benefits involved may not
be obvious, and there are several ways in which NPV analysis could be applied to them . Some o f these
Explain how to
estimate the gains and ways are best avoided because they are p articularly prone to the effects o f forecast errors. Therefore, i t is
costs of a takeover desirable to use a fram ework th a t directs atte ntio n to the key issues o f id e n tifp n g and quantifying the
benefits o f a proposed takeover and comparing benefits w ith costs.
Assume th a t you are an investm ent analyst employed by Company A to evaluate the takeover o f
Company T. The gain from the takeover can be defined as the difference between the value o f the combined
company and the sum o f th e ir values as independent entities:
Gain = VÂT- ( K A + y T)
The logic o f Equation 19.1 is th a t i t should prom pt the follow ing question: W hat characteristics o f
this takeover mean th a t the tw o companies should be w o rth more when combined than when separate?
However, the fact th a t there is a gain from the takeover does n o t necessarily mean th a t i t should proceed.
Management also has to consider the cost o f obtaining control o f the target. Assuming fo r the present
th a t cash is used to buy Company T, the net cost is defined as:
Net cost = cash - VT 19.2

The term net cost is used to emphasise th a t we are considering cost in terms o f the premium paid over
T s value as an independent entity. The takeover w ill have a positive NPV fo r Company As shareholders
only i f the gain exceeds the net cost:
NPVa = gain - net cost

= gain - cash + yT > 0 19.3
I f NPVa is equal to zero, then Equation 19.3 can be used to find the value o f Company T to Company A,
V ^ ) , which is the maximum price A should pay fo r the target:
1/聊 = cash = gain + V"T 19.4

Therefore, the valuation o f Company T can be broken in to tw o steps: the firs t is to estimate VT and
the second is to estimate the gain from the takeover. I f the target is a listed company, the evidence on
m arket efficiency shows th a t the m arket capitalisation o f the company s securities should be an unbiased
estimate o f VT , so the main emphasis should be on estim ating the gain. In other words, i t is necessary
to focus on the incremental cash flow effects o f the takeover. There are likely to be effects on both cash
inflows and outflows, which can be categorised as in the follow ing checklist:
Increm ental inflows
a sales revenue
b proceeds from disposal o f surplus assets.
Incremental outflows
a operating costs
b taxes paid
C capital investm ent to upgrade existing assets or acquire new assets.
Valuation o f a target company based on increm ental cash flows is illustrated in Example 19.2.
Example 19.2
You a re a n a n a ly s t f o r M a y f a ir Ltd, w h ic h is c o n s id e r in g th e a c q u is itio n o f B o a r d Ltd. Y ou h a v e
id e n tifie d th e f o llo w in g e ffe c ts o f th e ta k e o v e r:
• in v e s tm e n t o f $ 4 0 0 0 0 0 w ill b e r e q u ire d im m e d ia te ly to u p g r a d e s o m e o f B o a r d 's o ld e r assets

• a s s e t u p g r a d in g , e c o n o m ie s o f s c a le a n d im p r o v e d e ffic ie n c y w ill in c re a s e n e t o p e r a tin g c a s h
flo w s b y $ 2 9 0 0 0 0 p e r a n n u m in p e r p e tu ity
• s o m e o f BoarcTs asse ts th a t h a v e b e e n p r o d u c in g a c a s h in flo w o f $ 7 0 0 0 0 p e r a n n u m w ill b e
s o ld . T he n e w o w n e rs o f th e s e asse ts s h o u ld b e a b le to use th e m m o re p r o fita b ly a n d s a le p r o c e e d s
a re e x p e c te d to b e $ 8 0 0 0 0 0
• n e w p la n t c o s tin g $1 m illio n w ill b e p u rc h a s e d a n d is e x p e c te d to g e n e r a te n e t o p e r a tin g c a sh
flo w s o f $ 2 3 0 0 0 0 p e r a n n u m in p e rp e tu ity .
B o a r d ’s a c tiv itie s a r e a ll o f th e s a m e ris k a n d th e r e q u ire d ra te o f re tu rn is 1 5 p e r c e n t p e r a n n u m .
Y o u r c h ie f e x e c u tiv e h a s a s k e d y o u to e s tim a te :
a) th e g a in fro m th e ta k e o v e r
b) th e m a x im u m p r ic e th a t M a y f a ir s h o u ld b e p r e p a r e d to p a y f o r B o a r d 's s h a re s .
SOLUTION
a) B a s e d o n y o u r e s tim a te s , th e o v e r a ll c h a n g e in n e t o p e r a tin g c a s h flo w s w ill b e
$ 2 9 0 0 0 0 - $ 7 0 0 0 0 + $ 2 3 0 0 0 0 = $ 4 5 0 0 0 0 p e r a n n u m . T h is h a s a p re s e n t v a lu e o f
$ 4 5 0 0 0 0 / 0 . 1 5 = $ 3 m illio n . T h e g a in w ill b e :
G a in = $ 3 0 0 0 0 0 0 - $ 4 0 0 0 0 0 + $ 8 0 0 0 0 0 - $1 0 0 0 0 0 0
=$2400000
b) T h e m a x im u m p r ic e M a y f a ir s h o u ld b e p r e p a r e d to p a y is th e v a lu e o f B o a rd Ltd a s a n in d e p e n d e n t
e n tity , p lu s th e g a in o f $ 2 . 4 m illio n . B o a rd h a s 5 m illio n s h a re s o n issu e , w h ic h h a v e a m a rk e t
p r ic e o f $ 2 e a c h . A s s u m in g th a t m a rk e t p r ic e e q u a ls v a lu e a s a n in d e p e n d e n t e n tity :
Vj = 5 0 0 0 0 0 0 x $ 2 = $ 1 0 0 0 0 0 0 0
and:
VJ[A] = $ 2 4 0 0 0 0 0 + $ 1 0 0 0 0 0 0 0 = $ 1 2 4 0 0 0 0 0
so th e m a x im u m p r ic e M a y f a ir s h o u ld b e p r e p a r e d to p a y is:
$ 1 2 4 0 0 0 0 0 / 5 0 0 0 0 0 0 = $ 2 . 4 8 p e r s h a re
19.3.1 I Comments on estimation of takeover gains

The cash flow effects in Example 19.2 were deliberately kept very simple so th a t complex discounted
cash flow calculations would n o t cloud the central issue o f the incremental effects o f a takeover. In doing
so, the impression may have been given that, apart from assessing any immediate cash flow effects
associated w ith sale or purchase o f assets, estim ating the gain from a takeover only involves estimating
the incremental operating cash flows and discounting these cash flows at the target company s required
rate o f return.
In some cases this may be so, b ut in other cases there w ill be a need to divide the increm ental cash flows
into different risk classes and apply a different discount rate to each class, and there may be cases where
discounted cash flow analysis is n o t the best approach at all. For example, a takeover may open up new
grow th opportunities, which result in intangible strategic benefits whose values are very uncertain. The
imm ediate cash flow effect o f investing in such opportunities is generally negative, b u t these outlays may
be necessary in order to have the o pp o rtu n ity o f entering a new development. The outlays can therefore
be viewed as the purchase price o f an option, and the option-pricing principles discussed in Chapter 18
are likely to be more applicable than discounted cash flow analysis.6
1 9 .3 .2 1 Comparing gains and costs

LEARNING In Example 19.2, the gain from M ayfair Ltd acquiring Board Ltd was estimated to be $2.4 m illion. Before
OBJECTIVE 3
m aking an offer, M ayfair s management also has to consider the net cost o f the takeover. The m ethod
Explain the main
differences between used to estimate the net cost differs, depending on w hether the acquiring company pays cash fo r the
cash and share- target or issues shares in exchange fo r the shares o f the target company. Estim ation o f the net cost o f a
exchange takeovers cash takeover is illustrated in Example 19.3.
Example 19.3
S u p p o s e th a t M a y f a ir p a y s $ 2 . 3 0 p e r s h a re fo r B o a rd , g iv in g a to ta l o u t la y o f $ 1 1 .5 m illio n . W h a t is:
a) th e n e t c o s t o f th e ta k e o v e r?
b) th e g a in to M a y f a ir 's s h a re h o ld e rs ?
SOLUTION
a ) 丨
n E q u a tio n 1 9 . 2 , th e n e t c o s t o f a c a s h ta k e o v e r w a s d e fin e d a s th e a m o u n t o f c a s h p a id , m in u s
th e v a lu e o f th e ta r g e t a s a n in d e p e n d e n t e n tity . T h e n e t c o s t is:
N e t cost = cash - V j
= $11 5 0 0 0 0 0 - $ 1 0 0 0 0 0 0 0
=$1500000
T his resu lt s h o w s th a t $ 1 . 5 m illio n o f th e to ta l g a in a s s o c ia te d w ith th e ta k e o v e r g o e s to B o a rd ’s

s h a re h o ld e rs . T his is th e c o s t to M a y f a ir o f g a in in g c o n tro l o f B o a rd .
b) T h e N P V f o r M a y f a ir 's s h a re h o ld e rs (E q u a tio n 1 9 .3 ) is:
NPV a = g a in - n e t c o s t
= $ 2 4 0 0 0 0 0 -$ 1 5 0 0 0 0 0
=$900000
Example 19.3 illustrates a fundam ental point: the am ount o f the cash consideration determines how
the to ta l gain is divided between the tw o sets o f shareholders: every additional dollar paid to Boards
shareholders means a dollar less fo r M ayfair s shareholders.
For a cash takeover, comparing gains and costs is straightforward when, as we have assumed so far,
the value o f the target as an independent e ntity is equal to its m arket value. Suppose, however, that Board
Ltd has been regarded by m arket participants as a likely takeover target and this speculation has increased
its share price from $1.70 to $2. In other words, part o f the possible gains from a takeover are already
impounded in Boards m arket price and VT is only $8.5 m illion, rather than the m arket value o f $10 m illion.
The true value o f Board to M ayfair is $8.5 m illio n + $2.4 m illio n = $10.9 m illion , which means th a t
paying $11.5 m illio n w ill harm, rather than benefit, M ayfa irs shareholders. In terms o f our previous
calculations, the gain is s till $2.4 m illion , b u t the true net cost is:
Net cost = cash - VT

= $ 1 1 5 0 0 0 0 0 - $8 5 00 000
= $3000000
and:
NPVa = gain - net cost
= $ 2 4 0 0 0 0 0 - $ 3 0 0 0 000
= -$ 6 0 0 0 0 0
6 For a detailed discussion o f valuation methods, see Roller, Goedhart and Wessels (2010).
This problem highlights tw o im p o rta n t lessons fo r the management o f acquiring companies. First,
management should check th a t the share price o f a proposed target has n o t already been increased by
takeover rumours. Second, management should keep its takeover intentions completely confidential
u n til form ally announcing the bid.
Finally, in m aking a d istin ction between value and m arket price, we are n o t suggesting th a t there is
any m arket inefficiency, or th a t there is anything w rong w ith the m arket price. In fact the m arket would
be inefficient i f it did not respond to rum ours o f a possible takeover. The problem is th a t i f there are
rumours th a t have increased the targets share price, the m arket price no longer gives a measure o f the
targets value as an independent entity.
1 9 .3 .3 1 Estimating cost for a share-exchange takeover

Estimating the net cost o f a cash takeover offer is straightforw ard.7 In the case o f the proposed takeover
o f Board by M ayfair, the net cost was:
Cash - = $11500 000 - $ 10 000 000

= $1500000
Calculation o f the cost is more complex when the acquiring company issues shares in exchange fo r
the targets shares. The cost in this case depends on the post-takeover price o f the acquiring company s
shares. Calculation o f the net cost o f a share-exchange takeover is illustrated in Example 19.4.
E xample 19.4
M a y f a ir h a s 2 0 m illio n s h a re s o n issu e w ith a m a rk e t p r ic e o f $ 4 . 6 0 e a c h b e fo r e th e ta k e o v e r b id fo r
6
B o a rd is a n n o u n c e d . M a y f a ir o ffe rs o n e o f its s h a re s f o r e v e r y t w o s h a re s in B o a rd . W h a t is th e n e t
c o s t o f th e ta k e o v e r?
SOLUTION
B a s e d o n th e s e te rm s , M a y f a ir a p p e a r s to b e p a y in g $ 2 . 3 0 p e r s h a re fo r B o a rd so it m ig h t see m th a t
th e n e t c o s t w o u ld re m a in a t $ 1 . 5 m illio n . H o w e v e r, th e n e t c o s t d e p e n d s o n th e v a lu e o f th e M a y f a ir
s h a re s is s u e d to B o a rd 's s h a re h o ld e rs a n d th is d e p e n d s o n M a y f a ir 's s h a re p r ic e after th e ta k e o v e r
o ffe r is a n n o u n c e d . T he v a lu e o f th e c o m b in e d c o m p a n y c a n b e fo u n d b y r e a r r a n g in g E q u a tio n 1 9 . 1 :
Vat = W + VT + g a in
= 2 0 0 0 0 0 0 0 x $ 4 .6 0 + $ 1 0 0 0 0 0 0 0 + $ 2 4 0 0 0 0 0
=$104400000
A fte r th e ta k e o v e r, th e n u m b e r o f M a y f a ir s h a re s o n issu e w ill b e 2 0 m illio n + 2 . 5 m illio n a n d th e

v a lu e o f th e s h a re s is s u e d to a c q u ir e B o a rd is:
2 5
^ x$1 0 4 400 000 = $ l l 600 000
If B o a rd is w o r th $ 1 0 m illio n a s a n in d e p e n d e n t e n tity , th e n e t c o s t o f a c q u ir in g B o a rd is:
$ 1 1 6 0 0 0 0 0 - $ 1 0 0 0 0 0 0 0 = $1 6 0 0 0 0 0
In general the estimated cost o f a share-exchange takeover is:
Net cost = b x V ^ j- VT
where b = the fraction o f the combined company th a t w ill be owned by the form er shareholders o f the
target company.
The NPV fo r M ayfair’s shareholders (Equation 19.3) is now:
7 Fortunately, cash-only offers are the most common in practice although over the years they have fallen in popularity. To
illustrate, Da Silva Rosa et al. (2000) reports that in 1988 approximately 81 per cent of the bids were cash bids. In contrast,
in 2009 only 54 per cent of the bids for Australian listed firms were cash bids, 31 per cent were share-only bids and the
remaining 10 per cent offered a mix of cash and/or shares.
i B usiness finance
NPV^ = gain - net cost

= $ 2 400 00 0 -$ 1 600 000
=$ 80 0 000
These calculations show th a t fo r the share-exchange offer the true net cost is expected to be $100 000
more than i t would have been i f M ayfair had paid cash fo r Board. Similarly, the NPV to M ayfair s
shareholders is $100 000 less than i t would have been under the cash offer. This difference arises because
M ayfair s shares are w o rth more after the takeover than they were w o rth previously. I f the m arket
agrees w ith M ayfair s valuations, then once the takeover bid is announced, M ayfair s share price w ill
be $104.4 m illion /2 2.5 m illio n = $4.64 or 4 cents more than its pre-bid price. Therefore, since Boards
shareholders w ill receive M ayfair shares, rather than cash, they w ill receive p art o f the takeover gain.
I t should now be clear th a t there is a basic d istin ction between cash offers and share-exchange offers:
fo r a cash offer, the net cost is independent o f the takeover gain; fo r a share-exchange offer, the cost
depends on the takeover gain, because the cost is a fu nctio n o f the acquiring company s share price after
the bid is announced. Consequently, the cost o f a share-exchange takeover can only be estimated when the
bid is at the planning stage. Equation 19.5 can be used to make the estimate.
A nother im p o rta n t d istin ction between cash and share-exchange offers is th a t a share exchange
mitigates the effect o f valuation errors. For example, suppose th a t after acquiring Board Ltd, M ayfair s
management finds th a t Boards assets are w o rth only $5 m illion. I f M ayfair paid $11.5 m illio n cash to
Boards form er shareholders, then the cash is gone forever and M ayfair s shareholders w ill bear the fu ll
loss o f $6.5 m illion. However, i f M ayfair acquired Board by issuing shares, p a rt o f the loss w ill be borne
by Board's form er shareholders.
Alternative valuation approaches

The takeover analysis in Section 19.3 is based on m arket values and estimates o f the present value of
increm ental cash flows. In some cases, m arket values may n ot be available because the target company
is unlisted, or they may be considered unreliable, perhaps because the shares are rarely traded. In such
cases, there w ill be a need to use other valuation approaches, the m ost popular o f w hich are based on
earnings and assets.8
In this approach, the bidder values the target by firs t estim ating the future earnings per share (EPS) o f
the target. The EPS figure is then m ultiplie d by an appropriate1price-earnings (P-E) ratio to obtain an
im plied price (valuation) o f the target. This approach can be given a theoretical u nderpinning by lin k in g
i t to the present value o f a perpetuity. I f the appropriate P-E ratio is regarded as 1 /r, the inverse o f the
discount rate, then, using the p erpetuity form ula the present value is:
PV= EPS/r
= EPSx l/ r
= EPS x P-E
=P
Im p o rta n t assumptions underlying this approach include:
• the company s future earnings stream can be represented by a single number, typically referred to
as ‘future m aintainable earnings’
• risk differences between companies can be fu lly captured in the discount rate, r.
As Penman (2013, p. 181) points out, when these conditions are n o t met, the P-E ratio should not
be accorded any theoretical significance and is best regarded as a summary indicator o f a company s
perceived capacity to generate earnings.
Even where these assumptions hold, capitalising earnings using a P-E m ultiple should not be regarded
as discounting future earnings. The cash flows to investors in shares are dividends, n o t earnings, part o f
8 For a discussion o f the valuation methods that are most commonly used, see Mukherjee, Kiymaz and Baker (2004).
which are reinvested each year. Therefore, we can regard the value o f a share as the present value o f a stream
o f dividends, or equivalently, as the present value o f a stream o f earnings minus the present value o f the
reinvested (retained) earnings stream. Discounting earnings rather than dividends amounts to including
all the returns from an investm ent w ith o u t allowing fo r the outlay needed to generate those returns.
1 9 .4 .2 1 Valuation based on assets

A company s equity can be valued by deducting its to ta l liabilities from the sum o f the m arket values o f its
assets. This approach may be appropriate where the bidder intends to sell many o f the targets assets or
where the company has been operating at a loss. Criticisms o f this approach include the following:
• figures in the balance sheet based on historical cost are u nlikely to provide a reliable guide to m arket
values
• intangible assets may n o t be included in the balance sheet
• there may be com plem entarity between assets so th a t the to ta l m arket value o f the assets may be
greater than the sum o f th e ir individual m arket values.
Even where reliable m arket values can be found fo r all identifiable assets, the resultant valuation w ill
rarely coincide exactly w ith the m arket value o f the company s equity.
19.5 Regulation and tax effects of takeovers

m
Takeover activity and procedures are regulated by Commonwealth legislation. The m ost im p o rta n t
legislation is Chapter 6 o f the Corporations A ct 2001.9 The Australian Securities and Investments LEARNING
OBJECTIVE 4
Commission (ASIC, www.asic.gov.au) has a significant role in adm inistering activities covered by the
Outline the regulation
legislation. For example, ASIC can obtain inform a tion on the beneficial ownership o f shares, and can and tax effects of
allow exemptions from compliance w ith the legislation. Also ASIC can apply to the Takeovers Panel takeovers in Australia
(www.takeovers.gov.au) fo r an acquisition o f shares to be declared unacceptable or fo r a declaration o f
unacceptable circumstances. The panel can make such a declaration even i f the legislation has n ot been
contravened. Furthermore, s. 659B o f the Corporations A ct dictates th a t parties to a takeover do n o t have
[ww^|
the rig h t to commence civil litig a tio n in relation to a takeover while i t is current. Instead, the power to
resolve disputes during this period resides w ith the Takeovers Panel, which also has the power to review
certain decisions made by ASIC where those decisions are made w ith respect to parties to a takeover. The
objectives o f the takeovers legislation are set o ut in s. 602.
The legislation seeks to ensure that:
• the acquisition o f control over vo ting shares in a listed company or an unlisted company w ith more
than 50 members takes place in an efficient, com petitive and inform ed m arket
• the shareholders and directors o f a target company
- know the id e n tity o f the bidder
- have a reasonable tim e to consider the proposal
- are given enough info rm a tio n to enable them to assess the m erits o f the proposal
• as far as practicable, all shareholders have a reasonable and equal o p p o rtu n ity to participate in any
benefits offered by the bidder
• an appropriate procedure is followed in the case o f the compulsory acquisition o f vo ting shares or
interests or any other kin d o f securities.
The takeovers legislation provides that, unless the procedures laid down in Chapter 6 o f the
Corporations A ct are followed, the acquisition o f additional shares in a company is virtu a lly prohibited if
this would:
a result in a shareholder being e ntitled to more than 20 per cent o f the voting shares; or
b increase the voting shares held by a party th a t already holds between 20 per cent and 90 per cent o f
the voting shares o f the company.
9 For a detailed discussion, see Levy and Pathak (2012).

B usiness finance
Any investor is p erm itted to purchase up to 20 per cent o f a company s shares at any tim e, subject
to the requirem ent th a t once the holding exceeds 5 per cent, a substantial shareholding notice m ust be
issued w ith in tw o business days, or by 9:30 am on the next business day i f a takeover bid is currently
underway. Furtherm ore, when a substantial shareholder s interest in a company increases or decreases
by 1 per cent or more the m arket m ust be inform ed o f this change. The takeover threshold has been set at
20 per cent because anyone who owns less than 20 per cent o f a company s shares is u nlikely to be able to
exercise control. I f an investor wishes to exceed the 20 per cent threshold and obtain control o f a target
company, this can generally be done only by follow ing one o f the tw o procedures th a t the legislation
permits: an off-m arket bid o r a m arket bid.
An off-m arket bid can be used to acquire shares th a t are listed on a stock exchange or shares in an
unlisted company. A m arket bid is applicable only where the target is listed on a stock exchange. Creeping
takeovers*, which are discussed in Section 19.5.4, are also allowed.
ASIC provides news and policy statements on takeovers on its website w w w.asic.gov.au/asic/ASIC.
|w w ^ J N SF/byHeadline/Takeovers.
19.5.1 | Off-m arket bids

An acquiring company can make an off-m arket bid (whether by way o f a cash offer, a share exchange or a
com bination o f these) to acquire shares in the target company. This offer m ust remain open fo r between
1 and 12 m onths and may be fo r 100 per cent or a specified p roportion o f each holders shares.
A broad outline o f the steps involved in an off-m arket bid is provided in s. 632 o f the Corporations A ct
and shown in Figure 19.2.
Figure 19.2 Outline of steps in an off-market bid

Com pany
Step 1 bidder's statement • ASIC

(together with offer document) w
W • target
• market^0)
Step 2 notice that step 1 has been done — -------► • ASIC
Step 3 bidder's statement and offers • holders o f bid

class securities
Step 4 notice that step 3 has been done • ASIC

------ > • target
• market ㈣
Target
Step 5 target's statement • bidder

• holders o f bid
---------- > class securities
• ASIC
• market(〇l
^ This means that a copy of the document should be sent to any exchange on which a target company's shares are listed for
publication to the wider market.
Source: Corporations Act 2001.

Once an off-m arket bid has been made fo r a listed company, the offeror is allowed to purchase target
company shares on the stock exchange. An offeror can increase its offer price b u t has to pay this increased
amount to all shareholders who accept the offer, including any who have previously accepted a lower price.
19.5.2|M arket bids

A m arket bid is possible only where the shares o f the target company are listed on a stock exchange.
Im portantly, the buyer m ust pay cash fo r the shares and the offer cannot be conditional. Like an off-m arket
bid, the offer m ust be open fo r a period o f 1 to 12 m onths. Figure 19.3 from s. 634 o f the Corporations A ct
gives a broad outline o f the steps involved in a m arket bid. In this case, i f the offer price is increased, there
is no need to pay the higher price to target shareholders who sold p rio r to the increase.
Figure 19.3 Outline of steps in a market bid

Com pany
Step 1 announcement of bid to the market
Step 2 bidder's statement • market

'W
• target
• ASIC
Step 3 bidder's statement and any other w • holders of bid

documents sent with it to the market class securities
Step 4 copy o f documents sent to holders • market

• ASIC
Target
• market
Step 5 target's statement
• target
• ASIC
• holders o f bid
class securities
Bidder
Step 6 makes offers on the market
Source: Corporations Act 2001.
19.5.31 Disclosure requirements

The Corporations A ct includes im p o rta n t provisions fo r the disclosure o f inform a tion by bidders and
targets. The aim is to make im p o rta n t inform a tion related to the takeover more accessible through the
provision o f a bidder’s statement and a target’s statement. The info rm a tio n th a t should be contained in
a bidders statement is the same w hether the bid is an off-m arket or m arket bid. The inform a tion to be
contained in a bidders statement includes:
• the id e n tity o f the bidder
• details o f the bidders intentions regarding the continuation o f the targets business and any m ajor
changes to be made to the business
B usiness finance
• details o f how cash consideration w ill be obtained

• where securities are offered as consideration, inform a tion fo r a prospectus fo r an offer o f those
securities
• the price(s) paid by the bidder to acquire the targets securities during the previous 4 m onths
• fo r an off-m arket bid, the bidders voting power in the target
• any other m aterial info rm a tio n th a t may assist the target company s shareholders in deciding
w hether to accept the offer.
The target m ust respond to the takeover bid by issuing a targets statement, which is the same fo r
b oth off-m arket and m arket bids. In general, the targets statement m ust include all info rm a tio n that
target shareholders would reasonably require to make an inform ed decision on whether to accept the
bid. I t m ust also contain a statement by each director o f the target recommending whether or n ot the
bid should be accepted and giving reasons fo r the recommendation. Alternatively, each director m ust
provide a statement giving reasons why a recommendation is n o t made. The targets statement m ust
be accompanied by an experts report i f the bidder is connected w ith the target. Specifically an experts
report is required i f the bidder s voting power in the target is 30 per cent or more, or i f a director o f the
bidder is a director o f the target. The expert m ust have a professional reputation* and is required to state,
w ith reasons, whether the offer is considered to be fa ir and reasonable.
This approach is p erm itted by s. 611 o f the C o rp o ra tio n s A c t. It allows the acquisition o f no more than
3 per cent o f the target company s shares every 6 m onths, provided th a t the threshold level o f 19 per cent
has been m aintained fo r at least 6 months. No public statement is necessary. Because o f the tim e required
to achieve control, the creeping takeover approach is o f little commercial significance.
PARTIAL TAKEOVER P a rtia l ta k e o v e rs, where a bidder seeks to gain control by acquiring only 51 per cent, or perhaps less,
takeover in which o f the target company s shares, have been the subject o f particular regulatory attention. The reasons are,
a bidder seeks to
first, th a t the prem ium fo r control may be paid to only a favoured group o f shareholders, and second, th a t
acquire no more than
part o f a com pany’s
there is p otential fo r target shareholders to be coerced into accepting an offer th a t is n o t in th e ir best
issued shares interests.
Suppose th a t an offer is made fo r 40 per cent o f the shares in a company, and the holders o f 80 per
cent o f the shares accept. Under a pro-rata offer, the bidder would then accept h a lf o f the shares offered
by each o f these holders, who would be the only ones to share in the control prem ium . Pro-rata bids
have been prohibited in Australia since 1986. The bidder in a p artial takeover m ust specify a t th e o u ts e t
the pro po rtio n o f each holders shares th a t the bidder w ill offer to buy. This m ethod is referred to as
PROPORTIONAL BID a p ro p o rtio n a l bid. An example is the August 2013 bid by Loyal Strategic Investm ent Ltd fo r 75 per
partial takeover bid cent o f each shareholder s shareholding in the exploration company Coalbank Ltd. A disadvantage o f
to acquire a specified
propo rtio na l bids is greater uncertainty about th e ir outcome from the view point o f the bidder, because
proportion o f the
shares held by each the bidder m ust estimate the likely response rate o f target shareholders.
shareholder A company s constitution may provide th a t a p roportional takeover bid fo r the company can proceed
only i f shareholders vote to approve the bid. The C o rp o ra tio n s A c t allows this restriction on proportional
takeovers b u t also specifies th a t any shareholder approval requirements generally cease to apply after
3 years. Some companies have adopted these requirements, which, while restricted in duration, can be
renewed in the same way as they were originally adopted. Partial takeover bids have become extremely
rare in Australia.
Two companies th a t are contem plating a frie n d ly m erging o f th e ir operations may consider entering
in to a sc hem e o f a r ra n g e m e n t rather than proceed w ith a takeover bid. Such schemes are court-approved
unions th a t are governed by Chapter 5 o f the C o rp o ra tio n s A c t 2 0 0 1 . Before a court grants its approval
fo r a scheme o f arrangement, i t w ill require a w ritte n statem ent by ASIC th a t i t has no objection to
the scheme and w ill then need to be satisfied th a t the scheme is n o t designed to avoid the takeover
provisions o f Chapter 6. The a ttra ctio n o f a scheme o f arrangem ent to frie n d ly parties may be th a t it
provides greater ce rta inty w ith regards to the tim in g o f the acquisition events. The proposed scheme
o f arrangement is sent to all shareholders by the target company and a vote is conducted. Provided
th a t more than 50 per cent o f shareholders holding at least 75 per cent o f shares in the company vote
in favour o f the scheme, the scheme w ill be passed, subject to the c o u rts approval, allow ing all shares
in the target company to be transferred to the bidder. In contrast, a bidder engaged in an off-m arket
bid needs to acquire the approval o f at least 75 per cent o f shareholders h olding at least 90 per cent
o f the shares in the target company before i t can com pulsorily acquire the rem aining shares. There
has been some suggestion th a t the so-called ‘headcount’ requirem ent th a t more than 50 per cent o f
the shareholders need to agree before a scheme is approved by the courts is unnecessarily restrictive.
In recent years there have been a num ber o f high-profile mergers th a t have taken place via a scheme
o f arrangement. These mergers include the merger between Adelaide Bank and Bendigo Bank th a t
resulted in the subsequent d elisting o f Adelaide Bank shares and the renam ing o f Bendigo Bank as
Bendigo and Adelaide Bank Ltd. A nother such merger occurred in the $14.6 b illio n merger between
the large wealth management company AM P Ltd and the smaller financial services company AXA Asia
Pacific Holdings Ltd.
Other legislation th a t may influence a bidders decision to make a takeover offer includes:
• the C o m p e titio n a n d C o n s u m e r A c t 2 0 1 0 , which was referred to in Section 19.2.1

• the F o re ig n A c q u is itio n s a n d T a k e o v e rs A c t 1 9 7 5 1which provides the Commonwealth Treasurer w ith
the power to p ro h ib it takeovers follow ing advice received from the Foreign Investm ent Review Board
(w w w.firb.gov.au). An example o f the Treasurer exercising this power occurred in November 2013. | WWW I
Archer Daniels M idland Company, a US-based global grain group, launched a $3.4 b illio n takeover
bid fo r GrainCorp, one o f Australia’s largest agricultural companies. The Treasurer prohibited the
takeover on the grounds th a t GrainCorp controlled the p o rt netw ork th a t handled in excess o f
85 per cent o f to ta l grain exports from the country and th a t to allow the acquisition was against
the national interest
• other Commonwealth legislation th a t may in h ib it takeovers in specific industries, such as the
banking and media industries.
In addition to this legislation, some o f the listin g rules o f the ASX also affect takeovers. These include
a requirement th a t directors m aintain secrecy during discussions bearing on a p otential takeover offer
and a requirement restricting directors o f a target company from m aking an allotm ent o f shares fo r a
period o f 3 m onths after receiving a takeover offer.
In September 1999, the Com m onwealth G overnm ent released the re p o rt o f the Ralph Review o f
Business Taxation (Ralph Review) th a t included recomm endations on capital gains tax re lie f where
the consideration in a takeover was an exchange o f shares. This recom m endation was im plem ented
in the N e w B u s in e s s T a x S y s te m (C a p ita l G a in s T a x ) A c t 1 9 9 9 1w hich to ok effect from 10 December 1999.
The legislation allows the target company to apply to the A ustralian Taxation Office (ATO), on behalf
o f its shareholders, fo r re lie f fro m capital gains tax where the consideration fo r a takeover is in the
form o f an exchange o f shares. The effect o f the legislation is th a t shareholders in the target company
are able to defer a p o te n tia l capital gains tax lia b ility u n til the shares in the acquiring company they
accepted as consideration are sold.
It was claimed in evidence to the Ralph Review th a t acquiring companies were often forced to pay a
capital gains tax prem ium , to induce the target shareholders w ith p otential capital gains tax liabilities to
accept the offer. This meant th a t takeover bids included a cash component so th a t target shareholders
had the cash necessary to pay any resulting capital gains tax liability. I t was claimed th a t offer prices were
forced up and there was a bias against those bids th a t solely involved a share exchange. An example cited in
this context is the 1997 takeover o f the Bank o f Melbourne by Westpac. Westpacs offer o f $1,435 b illio n
B usiness finance
included a cash component to enable Bank o f Melbourne shareholders to meet th e ir potential capital
gains tax liability. The importance o f capital gains tax relief to the success o f a proposed acquisition is
readily illustrated by reference to the failed acquisition by private hospital operator Healthscope o f the
diagnostics division o f Symbion Health follow ing the refusal by the ATO to grant relief fro m capital gains
tax to Symbion Health’s shareholders.
As management is obliged to act in the best interests o f shareholders, the way in which it deals w ith a
potential takeover bid raises many corporate governance issues. As a takeover bid implies a potential
change in the ownership and control o f the company, which in tu rn may threaten the tenure o f the
existing management team, i t is no surprise th a t the Takeovers Panel has provided considerable direction
about how management should conduct its e lf during the b id process.
The panels directions cover the increasingly im p o rta n t issue o f break fee agreements entered into
by companies in takeover negotiations. A break fee agreement is an arrangement entered in to by two
companies where one promises to pay the other a sum o f money i f certain events occur th a t have the
effect o f causing the proposed merger to fail. In 2000, less than 4 per cent o f Australian takeover bids
involved break fee agreements, while by 2006 the p roportion had increased to more th an 43 per cent o f
bids. For example, in 2004 WMC Resources entered into a $92 m illio n break fee agreement w ith BHP
B illito n th a t would be triggered by a number o f events, including the w ithdraw al o f the Boards support
fo r the bid or the eventual success o f a competing bid. A t the tim e o f BHP B illito n s bid, W MC was subject
to a hostile bid (at a lower price) by another m ining company, Xstrata. U ltim ately, BHP was successful in
its acquisition and the break fee was never paid. The im p o rta n t question raised in the financial press at
the tim e o f the BHP B illito n bid was whether break fees were detrim ental to target shareholders.
There are many competing theories about the impact o f break fees on shareholder wealth.10 One
argument suggests th a t break fees are an example o f an agency cost imposed on target company
shareholders by entrenched management teams seeking to maximise th e ir personal u tility by diverting
control o f the company to a specific favoured acquirer. The cost to shareholders is in the fo rm o f a reduction
in the prem ium th a t they may have received were alternative bidders n o t dissuaded from bidding by the
presence o f the break fee agreement (see Bates & Lemmon 2003; Officer 2003; and Rosenkranz & Weitzel
2007). Given this interpretatio n o f break fees i t is no surprise th a t the Takeovers Panel has provided some
direction on when a break fee agreement would be acceptable. The panels position, as stated in Guidance
Note 7: Lock-up Devices, involves a <b rig h t-lin e , approach to regulation in th a t it suggests, in Section 9,
that, *111 the absence o f other factors, a break fee n ot exceeding 1 per cent o f the equity value o f the target
is generally n o t unacceptable. There may be facts which make a break fee w ith in the one per cent guideline
unacceptable— fo r example, i f triggers fo r payment o f the fee are n o t reasonable (from the p o in t o f view
o f coercion)’.
Alternatively, i t has been argued th a t break fees ultim ately benefit target shareholders fo r at least
three reasons. First, the break fee sim ply represents compensation paid to the bidder to cover costs th a t
it incurs in conducting the bid. W ith o u t the promise o f such compensation, the bidder would n o t have
launched a bid fo r the target in the firs t place, thereby denying target shareholders the o p p ortu nity
to receive a control premium. Second, break fees may help target companies overcome inform ation
asym m etry by signalling to the potential acquirer (and the m arket generally) th e ir com m itm ent to the
takeover process. Third, the break fee agreement m ig ht be used by target companies as a mechanism by
which they can negotiate a higher control premium on behalf o f th e ir shareholders.
U ltim ately, the impact o f break fees on target shareholders wealth is an empirical question th a t has
been considered by a num ber o f studies. In the US, where there are no s tric t restrictions on the size o f
the break fees agreed between companies, there is strong evidence th a t target shareholders receive higher
premiums when such agreements are in place (see Bates & Lemmon 2003; Officer 2003; and Rosenkranz
& W eitzel 2007). In contrast, in th e ir exam ination o f the impact o f break fees in Australia, Chappie,
Christensen and Clarkson (2007) report th a t target shareholders receive smaller control premiums and
lower share returns where a break fee agreement is in place. This leads the authors to suggest th a t the
cap placed on break fees by the Takeovers Panel prevents target companies from u tilis in g break fees as an
incentive mechanism so as to increase returns fo r target shareholders.
10 For a detailed discussion o f break fee agreements, see Curtis and Pinder (2007).
19.6 Takeover defences

m
W hile most takeover bids th a t are announced succeed, there are also many cases where management
LEARNING
o f the target company is successful in preventing a change in control. The Takeovers Panel has issued a
OBJECTIVE 5
guidance note relating to takeover defences in which i t states th a t a decision about the ownership and
O utline defence
control o f a company should ultim ately be made by shareholders and n o t by management.11 Nevertheless, strategies that can
the guidance note concedes th a t where a targets management believes resistance is in the best interests be used by target
o f the company s shareholders, such action would be consistent w ith the objectives o f Chapter 6 o f the companies
Corporations Act. Defence measures are o f tw o basic types: those th a t pre-empt or discourage bids and
those implemented after a bid is received. The more common categories o f strategy include the follow ing
(Casey & Eddey 1986).
19.6.1 | Poison pills

Poison p ills are a pre-emptive measure employed so as to make the target company less attractive to PO ISON PILL
a potential bidder in the event th a t i t is successful in its takeover attem pt. An example o f a poison p ill strategic move by a
com pany that may
defence relates to Liberty M edia Corporation s announcement on 3 November 2004 th a t it had reached
become a takeover
an agreement w ith a th ird p arty allowing it to increase its holding in News Corporation by 8 per cent to target to make its
17.1 per cent. In response, News Corporation announced the establishment o f a ‘Shareholder Rights Plan’ shares less attractive
that would be triggered i f any p arty acquired more than 15 per cent (or i f currently holding more than to an acquirer by
15 per cent, increased its holding by more than 1 per cent). The plan would enable shareholders, other increasing the cost of
a takeover (e.g. an
than the party who had triggered the event, to purchase one additional share fo r each share owned at
issue of securities that
h alf the prevailing m arket price, resulting in a significant d ilu tio n in the value and size o f Liberty s stake w ill convert to shares
in News Corporation. In defence o f the adoption o f the poison p ill scheme, News Corporation chairman if a takeover bid
Rupert Murdoch claimed th a t i t was fo r the good o f small shareholders as i t prevented an acquirer from occurs)
gaining control o f News Corporation shares at depressed prices. The poison p ill defence proved successful
when in December 2006 News Corporation agreed to swap its controlling stake in satellite broadcaster
DirecTV in retu rn fo r L ib erty’s stake in News Corporation.
1 9 .6 .2 1 Acquisition by friendly parties

The management o f a target company seeks the assistance o f a *white knight*, who generally purchases
the targets shares on the open m arket w ith the aim o f either d riving up the share price, or preventing
the bidder from achieving its m in im u m acceptance level. An example from the mid-1980s occurred when
Bond Corporation was believed to be preparing fo r a takeover bid o f biscuit m anufacturer A rn o tts . US
company Campbell Soup Company purchased shares as a frien dly party and acquired a strategic parcel
(or ‘blocking stake’）o f A rn o tt’s shares th a t effectively stymied Bond C orporation’s takeover ambitions.
Interestingly, the *w hite knight* in th is case its e lf turned in to a predator in 1992. A fte r having acquired
33 per cent o f A rn o tt s shares, Campbell Soup announced its own bid fo r A rn o tts , which was successfully
finalised in 1997. More recently, lu xu ry car-maker Porsche acquired a strategic stake in Volkswagen in
order to prevent a hostile bid from other car manufacturers and/or private equity groups. Volkswagen
manufactured key components fo r Porsche and hence an acquisition by a hostile th ird party w ould have
exposed Porsche to significant business risk. Subsequently, Porsche launched a failed bid fo r control
o f Volkswagen. This was followed by a successful bid by Volkswagen fo r a significant pro po rtio n o f the
Porsche business.
1 9 .6 .3 1 Disclosure of favourable information

Management o f a target company may release in fo rm a tio n th a t w ill, i t hopes, convince shareholders
th a t the bid undervalues the company. Such in fo rm a tio n includes p re lim ina ry earnings results, new
contracts and statements o f asset m arket values and p ro fit forecasts. The release o f such in fo rm a tio n
11 G u id an ce N o te 1 2 : F r u str a tin g A ction is a v a ila b le a t th e T a k e o v e r s P a n e l s w e b s ite , www.takeovers.gov.au.

A B usiness finance
is designed to make the takeover p ro h ib itiv e ly expensive fo r the bidder a nd /o r deliver a dditional value
to shareholders in the fo rm o f an increased offer price. In recent years the regulatory authorities have
emphasised th a t any in fo rm a tio n released by target management durin g the course o f a takeover
attem pt m ust be accurate. This p o in t was w ell illu stra te d in Ju ly 2001 when ASIC launched civil
proceedings against three form er directors o f GIO Insurance L td in relation to p ro fit forecasts issued
by GIO d u rin g a takeover a tte m p t by AM P Ltd. Forecasts issued by GIO durin g this period predicted
profits o f $80 m illio n from its reinsurance business fo r the financial year ending June 1999. Following
the successful acquisition by AMP, GIO declared a before-tax loss o f $759 m illio n fo r the same period
and ASIC alleged th a t the directors prosecuted w ithh eld in fo rm a tio n concerning the m agnitude o f the
losses. A n othe r im pedim ent to listed target companies selectively releasing favourable in fo rm a tio n
is the continuous disclosure obligations as set o ut in Australian Securities Exchange L isting Rule 3.1,
which states: 'Once an e n tity is or becomes aware o f any in fo rm a tio n concerning i t th a t a reasonable
person w ould expect to have a m aterial effect on the price or value o f the entity's securities, the e n tity
m ust im m ediately te ll ASX th a t in fo rm a tio n ’. Consequently, a company th a t fu lfils its continuous
disclosure requirements w ill fin d i t more d iffic u lt to keep good news from the m arket in an e ffo rt to
defend against possible takeover bids.
The management o f a target company often claims th a t the bid is inadequate and may also appeal to
regulatory authorities such as the Foreign Investment Review Board, the Australian C om petition and
Consumer Commission and/or the Takeovers Panel. They may also criticise the bidding company, as
occurred repeatedly during the hostile takeover b id fo r Patrick Corporation by the Toll Holdings group.
Chris Corrigan, the chief executive o f Patrick Corporation, fiercely defended his company from acquisition
in w hat has been one o f the m ost v itrio lic takeover contests witnessed in Australia. For example, Corrigan
placed advertisements in newspapers stating th a t ‘Patrick needs Toll like a fish needs a bicycle’ and when
Patricks corporate strategy was criticised by Paul L ittle, the chief executive o f Toll, he responded by
saying th a t was *like being called stupid by the village idiot* (Chessel 2005).
The significance o f the target directors* attitude to a takeover bid places the onus on directors to ensure
that th e ir recommendation is consistent w ith their responsibilities to shareholders. Directors o f a target
company may be faced w ith a conflict o f interest, because a takeover bid th a t they believe to be in the best
interests o f shareholders may leave them unemployed i f it is successful. Therefore, directors o f a target
company may oppose a bid because they place th eir own interest above th eir responsibilities to shareholders.
On the other hand, resistance to a takeover bid can benefit shareholders i f i t forces the bidder to increase
the offer, or attracts a higher offer from another bidder. The impact o f the defence by a target company s
management against a takeover offer has been the subject o f research in Australia and overseas.
Maheswaran and Pinder (2005) examined 133 bids fo r companies listed on the ASX. They found that
resistance by a target company s Board reduced the probability th a t a b id w ould be successful and increased
the likelihood th a t the offer price would be increased by the bidder, b u t had no im pact on the chances that
a competing bidder would launch an alternative bid fo r the target company s shares. Interestingly, they
fin d th a t there is no evidence o f a relationship between the m agnitude o f the control prem ium offered
and the incidence o f bid resistance. In a sim ilar study, Schwert (2000) analysed 2346 takeover contests
th a t had occurred in the US. He found th a t he could n o t differentiate on economic grounds between bids
th a t had been rejected by target management and those th a t had been accepted.
The contention th a t managerial resistance to takeovers may n o t be in the best interests o f shareholders
is o f concern since the ‘m arket fo r corporate control’ concept sees takeovers as a mechanism fo r resolving
shareholder-manager conflicts by replacing inefficient managers. The effectiveness o f th is m arket w ill be
reduced i f such managers use defensive tactics to entrench th e ir positions. O f course, it is poorly perform ing
managers who are likely to have the greatest d iffic u lty in m aintaining employment o r obtaining other
jobs after a takeover. Empirical evidence supports this contention in th a t companies whose management
resisted takeover are characterised by poorer performance p rio r to the takeover bid (Morck, Shleifer &
Vishny 1988; Maheswaran & Pinder 2005). The problem o f managers giving predominance to th e ir own
interests may be overcome by structuring the compensation o f top-level managers so th a t th e ir own
interests w ill be better aligned w ith those o f shareholders. Some companies approach this problem by
offering top-level managers large term ination payments (golden parachutes*) i f they lose th e ir jobs due
to a takeover. Such payments may be effective in preventing managers from resisting a takeover bid
th a t is in the best interests o f shareholders. However, i f the payments are too generous, they may cause
managers to recommend th a t shareholders accept an inadequate bid.
19.7 Corporate restructuring

While mergers and takeovers remain the m ost frequent transactions in the m arket fo r corporate control,
in recent years there has been an upsurge in transactions where companies or groups were reduced in LEARNING
OBJECTIVE 6
size by asset disposals, divided in to separate entities or transferred to private ownership. We begin by
Identify the various
defining the m ost frequent o f these restructuring transactions: types o f corporate
restructuring
• Divestitures. Assets (often in the form o f a whole subsidiary, branch or division) are sold to another
transactions
company.
• Spin-offs. The operations o f a subsidiary are separated from those o f its parent by establishing the
subsidiary as a separate listed company. However, there is no change in ownership because shares in
the form er subsidiary are distributed to the shareholders o f the parent company.
• Leveraged buyouts. A company or division is purchased by a small group o f (usually in stitu tio n a l) LEVERAGED BUYOUT
investors using a high p roportion o f debt finance. Where the investors are headed by the company s company takeover
that is largely financed
senior managers, the buyout is often referred to as a m an a g em e n t bu yout. A fte r a buyout the
using borrowed funds;
company is privately owned and the shares are n o t norm ally listed on a stock exchange. the remaining equity
is privately held by
The follow ing subsections briefly summarise the evidence on the wealth effects o f restructuring
a small group of
transactions and discuss possible explanations.12 investors
M AN AG EM EN T BUYOUT
19.7.1 | Divestitures purchase o f all o f a
com pany’s issued
A d iv estitu re (or sell-off] involves assets, which may be a whole subsidiary, being sold fo r cash, and shares by a group
is therefore essentially a reverse takeover from the view point o f the seller. An example o f such a sell-off led by the com pany’s
management
occurred in February 2014 when Royal Dutch Shell sold o ff its Australian-based oil refinery and 870 petrol
stations to the Swiss-based m ultina tio na l energy company V ito l fo r $2.9 billion. The frequency o f DIVESTITURE (OR
divestitures, and the value o f the assets involved, has increased over the last 20 years, w ith Eckbo and s ell- o f f )
Thorburn (2008) reporting th a t in 2006 approximately $320 billion o f assets across 3500 divestitures sale o f a subsidiary,
were sold in the US. W hile takeovers increase the wealth o f target (seller) shareholders, it has also been division or collection
of related assets,
found that divestitures create value fo r the shareholders o f selling companies. Eckbo and Thorburn (2008)
usually to another
survey the evidence provided by a num ber o f studies in the topic area and report th a t shareholders in company
selling companies earn— on average— a return o f 1.2 per cent upon the announcement o f the divestiture.
Furthermore, shareholders in the companies on the buy-side o f the divestiture transaction also enjoy an
increase in wealth as the average share price reaction to the announcement th a t th e ir company has bought
the divested assets is 0.5 per cent. Possible reasons as to why the market perceives divestitures as good
news are: an increase in corporate focus fo r the selling company, the elim ination o f negative synergies that
arise through the cross-subsidisation o f poorly perform ing segments o f the company, and the fact th a t the
buying company is able to derive greater value o ut o f the divested assets than the selling company.
1 9 .7 .2 1 Spin-offs
SPIN-OFF
In this type o f transaction, a single organisational structure is replaced by tw o separate units under the separation of
essentially the same ownership. Eckbo and Thorburn (2008) review the results o f 19 studies into the certain assets (or
valuation effects o f sp in -o ff a ctivity and, sim ilar to the findings relating to divestitures, report th a t the a division) from a
company upon which
average share price reaction to the announcement o f a spin-off was 3.3 per cent. In terms o f explaining this
are issued new shares
positive result fo r shareholders there are a num ber o f additional factors— in addition to those relating to that are allocated to
the benefits also relating to divestitures— th a t p rio r studies have highlighted. For example, the positive the com pany’s existing
share price reaction m ig ht reflect the transfer o f wealth from bondholders to shareholders, as valuable shareholders
12 T h e fo llo w in g d is c u s s io n r e lie s s u b s t a n t ia l ly o n E c k b o a n d T h o r b u r n ( 2 0 0 8 ).
B usiness finance
assets are removed from the reach o f creditors. Alternatively, the spin-off m ig ht reflect the increased
expectation o f the receipt o f a control prem ium as the transaction has increased the probability o f a
takeover o f the newly listed subsidiary and/or the parent company. The positive wealth effect m ight also
reflect the reduction in in fo rm a tio n asymm etry between management s valuation o f the company and
the m arkets valuation. Specifically, i t has been suggested th a t a spin-off reduces the problem associated
w ith aggregating financial inform a tion across the company and faced by anyone attem pting to value the
company, such as security analysts.
An example o f a significant spin-off occurred in 2007, when Toll Holdings, at the tim e Australias
largest tran spo rt and logistics company, spun o ff its p o rt and rail assets in to a new company, Asciano,
while continuing to operate its sizeable logistics business. As p art o f the spin-off process, m ost o f the
debt held by the combined group was assigned to Asciano, because its p o rtfo lio o f quality tangible assets
provided superior debt capacity. As a consequence, Toll was then able to raise additional debt to fund
future corporate acquisitions such as the $191 m illio n takeover o f Singapore-based logistics group
Sembawang Kim trans Ltd.
1 9 .7 .3 ! Buyouts
BUYOUT (OR A b u y o u t o r g o in g -p riv a te tra n sa ctio n can take one o f a num ber o f forms, each o f which involves a
GOING-PRIVATE)
rearrangement o f financial and ownership structures o f a single operating entity. Consequently, there
TRANSACTION
is no scope fo r operating synergies such as economies o f scale. Figure 19.4 indicates the rise and fall o f
transfer from public
ownership to private buyout a ctivity in the US in recent years.
ownership o f a
company through
purchase of its shares :igure 19.4 US leveraged buyout activity
by a small group
of investors that
sometimes includes the 45< 1 800
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Source: Adapted from Standard and Poors, Cross-Market Commentary: The Value o f Announced LBOs in 2013 Dropped
Compared with 2 012 Levels, N e w York, January 2 0 1 4 .
Buyouts may be in itia te d by vendors and th e ir advisers or by management. Management presumably

expects to gain from the transaction and there is evidence th a t the form er public shareholders also gain
through receiving a substantial prem ium over the previous share price.13 I t follows th a t some real gain
must be expected to follow fro m the transfer from public to private ownership. One source o f gain is the
avoidance o f listin g fees and shareholder servicing costs, which can be quite substantial fo r small public
companies. Another is the effect on managerial incentives. Managers who also own th e ir company stand
to benefit more than salaried employees from th e ir efforts.
In addition to pure* going-private transactions, where managers use th e ir own resources, possibly
supplemented by personal borrow ing, to buy out the previous shareholders, there are leveraged buyouts,
which involve significant corporate borrowing. These buyouts are almost always arranged by a buyout
specialist who invests equity capital in the company, arranges the necessary debt finance and takes an
active part in overseeing its performance. Figure 19.4 indicates the great increase in leveraged buyout
activity in the early to mid-2000s and then the subsequent fall in this type o f a ctivity during the global
financial crisis and the near-collapse o f worldwide debt markets. The v ia b ility o f a leveraged buyout
transaction is heavily dependent upon the availability o f large amounts o f relatively cheap debt.
The subsequently high deb t-e q uity ratios o f buyout companies do n ot necessarily mean th a t private
companies have an inherently greater debt capacity than th e ir public counterparts. In m ost leveraged
buyouts, early repayment o f p art o f the debt is a high p rio rity and the in itia l high level o f debt is feasible
because most such buyouts involve low -risk businesses w ith stable cash flows. The debt finance has an
im portant positive role by giving the new owners an even greater incentive to improve efficiency. Because
of the severe penalties associated w ith default, it is im p o rta n t to elim inate waste and generate cash flows
that are sufficient to service the debt.
The gains associated w ith transferring some companies to private ownership prom pt the follow ing
question: Should all companies be privately owned? The answer is no. Public companies have the advantage
o f access to equity capital on term s th a t reflect the diversification benefits available to investors in the
capital market. The value o f such access depends on the grow th opportunities available to the company.
Therefore, public ownership has im p o rta n t advantages fo r large-scale enterprises th a t involve significant
risks and have an ongoing need to raise capital; in other cases, however, private ownership can be
advantageous.14
F in a n c e
SWAGGERS G ONE OUT OF THE BUYOUT FUNDS_____________
in A C T IO N
The following excerpts were taken from an article in the Australian Financial /?ev/ew examining
the decline in the level of buyout activity. The article notes that buyout funds rely heavily upon
access to debt and the consequences of a contraction in debt markets such as that which occurred
with the sub-prime mortgage crisis in 2007.
Heilman & Friedm an’s C ap ita l Partners IV Fund has generated a 3 6 per cent return for
investors since 2 0 0 0 . Kohlberg Kravis Roberts7 M illennium Fund has done even better,
notching a 41 per cent take since 2 0 0 2 . But investors in private equity funds w hoV e
enjoyed large returns like these during the buyout boom should brace themselves for a
fall. Buyout firms relied on cheap debt in the past 2 years to finance the biggest deals of
all time, often paying premiums o f more than 3 0 per cent. But as the sub-prime m ortgage
meltdown rattles credit markets, firms w ill have to sell their companies to buyers w ho no
longer have access to low-cost loans. That w ill cut the sale prices of the companies and
slash the buyout funds7 returns, says b illio n a ire financier W ilb u r Ross. "W hen it comes time
to resell these investments, w e ll likely be in a very different rate environm ent/ says Ross,
whose N e w York-based W L Ross & Co focuses on distressed assets such as vehicle
spare-parts makers. 'The im plications for returns could be substantial/
continued
13 For example, in a sample of 57 going-private proposals that involved a cash consideration, the premium averaged
56.31 per cent over the market price 2 months before the announcement. See De Angelo, De Angelo and Rice (1984).
14 Recent evidence on the performance of buyouts is provided by Cohns, Mills and Towery (2014).
B usiness finance
continued
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h is to r y . In th e U S in th e fir s t h a lf o f th is y e a r , m e g a d e a ls f o r T X U C o r p , F irs t D a ta C o r p
a n d E q u it y O f f ic e P r o p e r tie s T ru s t— a ll t o p p in g U S $ 2 0 b i lli o n ( $ 2 4 . 5 b i l l i o n ) — w e r e p a r t
o f a r e c o r d U S $ 6 1 6 b illio n in a n n o u n c e d p u r c h a s e s . T h a t ’s ju s t s h y o f 2 0 0 6 ’s r e c o r d to ta l
o f U S $ 7 0 1 . 5 b i lli o n , B lo o m b e r g d a t a s h o w s . C h e a p c r e d it fu e lle d th e fr e n z y . T h e e x t r a
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2 .4 1 p e r c e n t a g e p o in ts in J u n e , th e lo w e s t o n r e c o r d . T h e r a te s e n a b le d b u y o u t f ir m s , w h ic h
u s e c r e d it to f in a n c e a b o u t t w o - t h ir d s o f a c o m p a n y ’s p u r c h a s e p r ic e , to r a t c h e t u p t h e ir b id s .
P re m iu m s f o r U S c o m p a n ie s , o r th e p e r c e n t a g e o f f e r e d a b o v e th e t a r g e t 's s to c k p r ic e , s o a r e d to
3 9 p e r c e n t in J u n e c o m p a r e d w it h 2 3 p e r c e n t a y e a r e a r lie r .
G a v in M a c D o n a ld , M o r g a n S ta n le y 's h e a d o f E u r o p e a n m e r g e r s a n d a c q u is it io n s , s a id
in A p r i l a U S $ 1 0 0 b illio n le v e r a g e d b u y o u t w a s p o s s ib le . B u t b y J u ly th e a p p e t it e f o r d e a ls ,
e s p e c ia lly r e c o r d - b r e a k in g o n e s , h a d e v a p o r a t e d . In v e s to rs , s u r p r is e d b y t h e ir le v e l o f
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a n d b o n d s t h a t b a n k s h a d s la te d to fu n d le v e r a g e d b u y o u ts . In v e s to rs b a lk e d a t c r e d it te rm s
t h a t a l lo w e d c o m p a n ie s to r e p a y d e b t b y is s u in g m o r e b o n d s . L e n d e rs h a d to r e w o r k o r
c a n c e l a t le a s t 4 5 lo a n a n d b o n d o f f e r in g s s in c e th e b e g in n in g o f Ju ly , in c lu d in g d e b t to p a y
f o r C e r b e r u s C a p it a l M a n a g e m e n t ’s a c q u is it io n o f C h r y s le r . B u y o u t fir m s a n d s e lle rs a r e a ls o
r e n e g o t ia t in g d e a ls to g e t f in a n c in g a n d k e e p th e m a l i v e . 〇n A u g u s t 2 6 , H o m e D e p o t, th e
w o r ld 's b ig g e s t h o m e - im p r o v e m e n t r e ta ile r , a g r e e d t o s e ll its c o n s t r u c t io n s u p p ly u n it B a in
C a p it a l, C la y t o n D u b ilie r & R ic e a n d C a r ly le G r o u p f o r U S $ 8 . 5 b illio n . T h a t's 1 8 p e r c e n t
le ss th a n th e p r ic e n e g o t ia t e d in J u n e , H o m e D e p o t s a id th is w e e k . M a n y o t h e r d e a ls a r e n 't
g e t t in g d o n e . T h e v a lu e o f a n n o u n c e d b u y o u ts d r o p p e d to U S $ 1 8 b i lli o n f r o m A u g u s t 1 t o 2 6 .
T h a t c o m p a r e s w it h U S $ 8 7 . 4 b illio n la s t m o n th a n d U S $ 1 3 1 . 1 b i lli o n in J u n e , B lo o m b e r g
d a ta s h o w s .
P r iv a te e q u it y fir m s w i ll a ls o s t r u g g le to s e ll t h e ir h o ld in g s to c o r p o r a t io n s a n d o t h e r fu n d
m a n a g e r s a t h ig h p r ic e s . In 2 0 0 5 , H e ilm a n & F r ie d m a n p a id U S $ 1 .1 b i lli o n f o r in te r n e t
a d v e r t is in g c o m p a n y D o u b le c l ic k a n d , le ss th a n 2 y e a r s la te r, a g r e e d to s e ll it t o G o o g le
f o r U S $ 3 .1 b illio n . T h e s e la r g e p a y - o ffs w i l l b e m u c h h a r d e r to g e t in c o m in g y e a r s a s th e
c o s t o f c r e d it ris e s , s a y s S c o tt S p e r lin g , c o - p r e s id e n t o f b u y o u t f ir m T h o m a s H L e e P a rtn e rs
in B o s to n .
Source: 'Swagger's gone out o f the buy-out funds', Jason Kelly, Australian Financial Review, 31 August 2 0 0 7 , p. 40.
19.8 Empirical evidence on takeovers

There has been considerable empirical research in to takeovers. For example, many studies have evaluated
LEARNING the wealth effects o f takeovers on shareholders o f the acquiring and target companies. These studies use
OBJECTIVE 7
share price changes around the tim e o f the firs t public announcement o f a takeover to measure these
Outline the main
findings of empirical wealth effects. Abnorm al returns on shares in both acquiring and target companies around the tim e o f
research on the the takeover announcement are measured by the difference between actual and expected returns. The
effects of takeovers on expected returns take account o f the influence o f m arket-wide events on the returns fro m an individual
shareholders, wealth company s shares. A p art from market-wide events, the only factor assumed to be common to all
companies in the studies is th e ir involvem ent in takeover negotiations. Therefore, the abnormal returns
are a measure o f the wealth effects o f the takeover.15
In discussing the evidence, we make substantial use o f a paper by Andrade, M itche ll and Stafford
(2001), w hich examined US mergers from 1973 to 1998, and a paper by Brown and da Silva Rosa (1997),
who evaluated takeovers in Australia during the period January 1974 to November 1995.
15 This event study* methodology is commonly employed in tests of the efficient market hypothesis and is outlined in
Chapter 16.
One result th a t stands out in all market-based studies is th a t target company shareholders earn significant
positive abnormal returns. For example, Brown and Da Silva Rosa (1997) found an average abnormal
return o f 25.5 per cent over the 7-m onth period around the takeover announcement. For the 1528 target
companies in th e ir sample, the to ta l increase in shareholders1 wealth was approximately $15 billion.
These results probably understate the to ta l wealth effects o f takeovers fo r target shareholders. Casey,
Dodd and Dolan (1987) reported substantial abnormal returns on target company shares around the
tim e th a t significant shareholding notices were filed. For th e ir sample, this occurred on average 127 days
before the announcement o f a takeover bid. Significant gains to target shareholders are to be expected
because the acquiring company m ust offer more than the previous m arket price o f the shares. The current
shareholders are, by defin itio n, parties who prefer to hold rather than sell the shares at the previous
m arket price.
Several studies report th at, on average, the shares in target companies perform ed poorly before
the takeover bid. Brown and Da Silva Rosa found evidence o f very poor pre-bid performance by target
companies. For th e ir sample o f 1371 targets, the average abnormal retu rn over the period from m onths
-3 6 to - 6 relative to the bid was -23 .3 per cent. This is consistent w ith the concept th a t takeovers transfer
control o f assets to companies w ith more efficient managers or more profitable uses fo r those assets.
The in itia l increase in wealth o f the target company s shareholders appears to be m aintained, even
where the takeover bid is unsuccessful. This could be because the bid prom pted a change in the target
company s investm ent strategy, which is expected to improve performance, or because inform a tion
released during the b id caused the m arket to revalue the shares. A nother explanation is th a t the m arket
may expect a fu rth e r bid fo r the target company. Research by Bradley, Desai and Kim (1983) is consistent
w ith the last explanation. They found th a t many companies th a t were the subject o f an in itia l unsuccessful
takeover bid received a subsequent successful bid w ith in 5 years o f the first. These subsequent bids resulted
in fu rth e r positive abnormal returns fo r target shareholders. Where no subsequent bid eventuated, the
shares o f the unsuccessful targets declined, on average, to th e ir (market-adjusted) pre-bid level. Based on
this evidence, i t appears th a t the gains associated w ith takeover bids are perm anent only where a change
in control occurs— th a t is, the results do n o t support the suggestion th a t gains to target shareholders
result from the m arkets reassessment o f previously undervalued shares.
W hile it seems obvious th a t the higher the price offered by an acquirer the more likely i t is th a t the
target shareholders w ill accept the bid, a more recent paper has considered the importance o f the price
offered relative to the recent h isto ry o f the share price o f the target company. Baker, Pan and W urgler
(2012) analysed over 7000 takeover bids in the US and demonstrated th a t an inordinate num ber o f bid
prices are set at a recent peak in the share price. For example, they show th a t the m ost common offer price
set by acquirers exactly matched the highest price th a t the target company s shares had reached over the
52 weeks before the announcement o f the takeover b id.16 Furtherm ore, they show th a t the likelihood o f
the bid being accepted jumps abnorm ally when the offer price exceeds a peak price. The authors interpret
these results as being consistent w ith the psychological phenomenon know n as anchoring1, in th a t target
shareholders anchor th e ir required compensation at recent share price peaks.
On average, the shareholders o f acquiring companies earn positive abnormal returns in the years
before the takeover b id is made. Brown and Da Silva Rosa (1997) found th a t average abnormal returns
accumulated to almost 32 per cent over the period from -3 6 to -6 m onths before the bid. This suggests
that takeover bids are typically made by companies th a t have been doing well, and have demonstrated
an a bility to manage assets and growth. In the 7-m onth period around the announcement o f the bid, the
average abnormal return fo r successful bidders was 5.0 per cent. W hile Australian studies fin d positive
abnormal returns to bidders over a 7-m onth period, other studies th a t have measured returns over shorter
periods surrounding the announcement o f takeover bids have found th a t the average abnormal retu rn to
shareholders o f bidding companies is close to zero, and negative in some cases. Moreover, announcement
16 To ensure that their sample of prices is not affected by the bid itself, Baker, Pan and Wurgler (2012) measure the 52-week
high over the 52 weeks ending 30 days prior to the announcement of the bid.
B usiness finance
o f a takeover bid is associated w ith a share price decline in a significant p ro po rtio n o f individual cases.17
Jarrell and Poulsen (1989) identified three general explanations th a t have been offered fo r the negligible
wealth effects fo r acquiring company shareholders. These explanations are:
a takeovers are profitable, b u t the wealth effects are disguised

b com petition depresses returns to acquirer
C takeovers are neutral or poor investments.
The rationale fo r each o f these explanations is now discussed.
The wealth effects of takeovers are disguised

Essentially, this explanation suggests th a t takeovers are profitable b u t the announcement o f an
individual takeover has little effect on the acquiring company s share price. One reason is th a t acquiring
companies are typically much larger than th e ir targets, so w hile there may be a w orthw hile dollar gain
to shareholders, the gain is small relative to the to ta l value o f the acquiring company. A second reason
is th a t many companies have a known strategy o f grow th by acquisition. Therefore, the expected gains
from th is strategy may already be reflected in the companies’ share prices, and the announcement o f
a particular bid conveys little new inform a tion to the m arket.18 Third, announcement effects th a t are
small o r negative may also reflect m arket reaction to the financing o f the takeover. In particular, a share-
exchange offer may signal th a t the management o f the acquiring company considers th a t its shares are
overvalued. Therefore, the takeover its e lf may have a positive announcement effect, b u t this can be offset
by the effects o f the inform a tion related to the financing o f the takeover.19
Com petition depresses returns to acquirers

The returns to successful bidders are likely to be lower if a takeover is resisted by target management or
contested by m ultiple bidders. There is evidence th a t abnormal returns to target shareholders are higher
when there are m ultiple bidders, in which case gains to acquiring company shareholders are insignificantly
different from zero. However, when there is only one bidder, acquiring company shareholders earn
significant positive returns. The degree o f com petition in takeovers could be influenced by changes
in government regulation, development o f innovative financing techniques and the use o f defensive
strategies by target companies. Therefore, the returns to acquirers may have changed over time.
Takeovers are neutral or poor investments

This explanation is th a t many takeovers are bad investments and the small or negative returns to
acquiring company shareholders correctly reflect this situation. One advocate o f th is explanation is
Roll (1986), who argued th a t many managers o f acquiring companies are affected by hubris*. In other
words, they are supremely confident th a t th e ir a bility to value other companies is better than th a t o f
the market. Consequently, they are likely to pay more fo r target company shares than they are w orth,
and Roll argued th a t the large returns to target company shareholders represent wealth transfers from
the shareholders o f acquiring companies. A recent study by Levi, Li and Zhang (in press) considered the
issue o f overconfidence and how the gender m ix on a company s board o f directors may have an impact
on shareholder wealth. They report th a t companies w ith female directors are less likely to undertake
acquisitions and, where they do, they tend to pay lower control premiums. The authors interpret this
result as indicating th a t female directors are inherently less overconfident than th e ir male counterparts
and th a t this can help create shareholder value. There is also evidence th a t m any acquired companies are
later divested, which may indicate th a t the original takeover turned o ut to be a failure.20
To assess the va lid ity o f these explanations, Jarrell and Poulsen (1989) examined the returns to
acquiring company shareholders in a large sample o f successful tender offers over the period 1963 to
1986. They found th a t returns to acquirers were positively related to the size o f the target relative to the
17 For example, Dodd (1992, p. 515) notes that results reported in two US studies show that in more than 40 per cent of cases,
the bidding company s share price fell when a takeover bid was announced.
18 For evidence on the prior capitalisation of takeover gains, see Schipper and Thompson (1983).
19 For Australian evidence on the effects of the method of payment in takeovers see Da Silva Rosa et al. (2000), while Bugeja and
Da Silva Rosa (2008) demonstrate how the tax position of the target shareholder affects the method of payment decision.
20 However, it has been reported that divestiture of previously acquired companies often yields profits for the selling company.
Therefore, subsequent divestiture does not necessarily mean that the original acquisition was a failure. See Kaplan and
Weisbach (1992).
4^^
bidder, which is consistent w ith the explanation th a t returns to acquirers can be disguised when target
companies are small. They also found th a t returns to acquirers were smaller when the bid was opposed
by target management, and were lower after changes in regulation th a t favoured competing bidders. In
summary, th e ir results support the firs t two explanations, b u t they also note th a t some other studies
have found evidence th a t supports the argument th a t takeovers are poor investm ents.21
1 9 .8 .3 1 Are takeovers poor investments?

While there is conclusive evidence th a t target company shareholders gain significantly from takeovers, the
evidence on returns to acquiring company shareholders is much less conclusive. Consequently, whether
takeovers generate net gains fo r shareholders has been a contentious issue.
Bradley, Desai and Kim (1988) studied this issue by examining the returns to shareholders o f matched
pairs o f target and acquiring companies in successful tender offers over the period 1963 to 1984. They
found an average gain o f $117 m illio n , or 7.4 per cent, in the combined wealth o f shareholders. The total
percentage gain remained remarkably constant over tim e and by far the larger share o f the gain w ent to the
target shareholders, although the division o f the gain shifted against the acquiring company shareholders
over time. In general, th e ir results support the hypothesis th a t takeovers yield real, synergistic gains and
do n ot support Rolls wealth transfer* hypothesis. Announcement period abnormal returns fo r a much
larger sample o f US mergers and takeovers are shown in Table 19.3.
TABLE 19.3 Announcement period abnormal returns (%) by decade for

US mergers
P e rio d 1 9 7 3 -7 9 1 9 8 0 -8 9 1 9 9 0 -9 8 1 9 7 3 -9 8
Target
[-1 ，+1] 16.0(a) 16.0(a) 15.9 16.0(fl)
[-20, Close] 24.8(°) 23.9(a) 23.3(fl) 23.8
Acquirer
[-1, + i] -0.3 -0.4 -1.0 -0.7
[-20, Close] -4.5 -3.1 -3.9 -3.8
Combined
[-1, +1] 1.5 2.6(fl) 1.4(fl) 1.8(fl)
[-20, Close] 0.1 3.2 1.6 1.9
Number of observations 598.0 1226.0 1864.0 3688.0
Statistically significant at the 5 per cent level.

Source: G. Andrade, M . M itchell and E. Stafford, 'N e w evidence and perspectives on mergers', Journal of Economic
Perspectives, Spring 2001; p. 110.
Table 19.3 shows announcement period abnormal returns over tw o event windows— the 3 days
immediately surrounding the takeover announcement, and a longer window beginning 20 days before
the announcement and ending at the close o f the takeover.
As usual, these results show th a t target company shareholders are clear winners in takeovers, w ith
abnormal returns over the 3-day event w indow being remarkably consistent at 16 per cent over the
whole period. The abnormal returns over the 3-day event window, fo r the target and acquirer combined,
average 1.8 per cent fo r the whole sample. This result is statistically significant and suggests that, on
average, takeovers do increase shareholders* wealth. The results fo r acquirers suggest that, on average,
21 For example, there is evidence that some types of takeover harm the shareholders of acquiring companies. See Mitchell and
Lehn (1990). This evidence is discussed in Section 19.8.4.
A B usiness finance
takeovers may well be poor investments fo r shareholders o f the acquiring company. However, while all the
estimates are negative, none is statistically significant. Therefore, while i t is clear th a t acquiring company
shareholders are n o t big winners, i t is also d iffic u lt to claim th a t they are generally losers.
More info rm a tio n on the wealth effects o f takeovers can be obtained by also considering the m ethod
o f paym ent— or the financing o f the transaction. Table 19.4 shows average announcement period returns
when the sample studied by Andrade, M itche ll and Stafford (2001) is s p lit in to subsamples on the basis
o f w hether any shares were used to finance the takeover.
The results in Table 19.4 show th a t announcement period abnormal returns fo r acquirers are negative
only when the acquirer uses shares to finance the transaction. When the payment to target shareholders
includes at least a share component, the 3-day average abnormal retu rn to acquirers is a statistically
significant -1.5 per cent.
TABLE 19.4 Announcement period abnormal returns (%) for subsamples

1973-98
F o rm o f p a y m e n t S h a re s N o sh a re s
Target
[-1, + i] 13.0(fl) 20.1(«)
[-20, Close] 20.8(fl) 27.8(〇)
Acquirer
[-1, + i] -1.5(a) 0.4
[-20, Close] -6.3 -0.2
Combined
[-1, +1] 0.6 3.6(a)
[-20, Close] -0.6 5.3
Number o f observations 2194.0 1494.0
Statistically significant at the 5 per cent level.

Source: G . Andrade, M . M itchell and E. Stafford, 'N e w evidence and perspectives on mergers7, Journal o f Economic
Perspectives, Spring 2 0 0 1 , p. 112.
W hen the payment does n o t include any shares, the average abnormal retu rn is an insignificant
0.4 per cent. For the acquiring company a share-exchange takeover can be regarded as tw o simultaneous
transactions: acquisition o f another company and a share issue. As discussed in Chapter 13 there is
evidence that, on average, share issues are associated w ith negative abnormal returns o f about -1.5 to
- 3 per cent around the tim e o f the announcement. Explanations fo r this fin d in g focus on differences
between the inform a tion available to managers and outside investors. I f managers are more likely to
issue equity when they believe the company s shares are overpriced, investors w ill respond to an issue
announcement by m arking down the share price. Even i f this explanation is n o t accepted, the evidence
suggests th a t when assessing the wealth effects o f takeovers fo r shareholders i t is im p o rta n t to distinguish
between share and non-share takeovers.
The results in Table 19.4 show th a t target shareholders also receive higher returns when payment fo r
the takeover does n ot include shares. Therefore, it is n o t surprising th a t differences in financing are also
related to differences in the overall wealth effects o f takeovers. As shown in Table 19.4, the combined
average abnorm al returns fo r share-financed takeovers are indistinguishable from zero, b u t fo r non-share
takeovers the corresponding result is 3.6 per cent.
In summary, the evidence on announcement-period share m arket returns suggests that, in general,
takeovers create value fo r the shareholders o f the combined companies. However, in cases where target
shareholders are paid w ith the acquirers shares, the gains to target shareholders are offset by losses fo r
the acquirer and the combined wealth effects are negligible. In Australia, by way o f contrast, there is only
weak support fo r the view th a t differences in the financing o f takeovers are related to the overall wealth
effects o f takeovers. In a study o f 240 takeover bids between 1988 and 1996, Da Silva Rosa et al. (2000)
found th a t abnormal returns earned by bidders and targets over the bid announcement period were n ot
significantly associated w ith the proposed m ethod o f financing the takeover.
More recently, in the US Betton, Eckbo and Thorburn (2010) report evidence th a t suggests th a t rather
than the m ethod o f payment being the key driver o f bidding shareholder returns, it may instead be the
size o f the bidder and the status o f the target company th a t is im p orta nt. Specifically, they report th a t
bidding company returns tend to be negative when the bidding company is very large and when the bid is
fo r a publicly listed target rather than one th a t is privately owned, irrespective o f the m ethod o f payment.
In contrast, they report th a t shareholders o f bidding companies th a t are small and th a t are bidding fo r
non-listed targets tend to earn significantly positive returns and th a t these returns are actually higher
when it is a share-financed bid. Sim ilar results have also recentiy been reported fo r the Australian m arket
by Shams, Gunasekarage and Colombage (2013).
Long-term abnorm al returns

In an efficient m arket, announcement-period share price reactions should be unbiased responses to all the
inform ation contained in the announcement o f a takeover. However, several studies th a t measure long
term share returns over periods o f up to 5 years after com pletion o f a takeover cast doubt on whether
announcement-period returns do provide adequate measures o f the wealth effects o f takeovers. For
example, Loughran and V ijh (1997) examined 947 acquisitions over the period 1970 to 1989 and tracked
the returns on the shares o f the acquiring company fo r 5 years after completion o f the acquisition. They
found th a t these 5-year abnormal returns differed significantly w ith the fo rm o f payment. Acquirers
that issued shares as payment had average abnormal returns o f -24 .2 per cent, whereas those th a t paid
cash recorded abnormal returns o f 18.5 per cent. In some subsamples where they also distinguished
between takeovers and tender offers, the retu rn differences were even greater. I f the long-term post
takeover abnormal returns to acquirers are negative, these returns could outweigh the gains earned by
shareholders in the announcement period and the net wealth effect o f takeovers could be negative. For
example, Loughran and V ijh found th a t target shareholders who held on to the acquirer s shares received
as payment in share-exchange takeovers did n o t earn significant abnormal returns.
It is n o t d ifficu lt to find possible reasons fo r a relationship between the fo rm o f payment and the
p ro fita b ility o f acquisitions. Shares are usually issued as payment in mergers th a t are friendly deals
supported by managers o f the target. Cash is usually paid in tender offers th a t are more likely to be
hostile and are followed by high turnover o f target management as the acquirer seeks to realise efficiency
gains. W hile there may be large differences in the gains associated w ith different types o f acquisitions,
i f the m arket is efficient it should n o t take years fo r the effects to be reflected in share prices. However,
m arket inefficiency is n o t the only possible explanation fo r the inconsistency between long-term
abnormal returns and the announcement-period returns. A nother explanation lies in the accuracy o f
the models used to estimate expected returns. Over a 3-day event w indow the expected re tu rn is close
to zero, so it is easy to determ ine th a t announcement-period returns o f about 2 per cent or even less are
abnormal. However, as the retu rn w indow becomes longer, the model o f expected returns becomes much
more im portant, and measures o f long-term performance can also be sensitive to bias inherent in some
research designs. Brown and Da Silva Rosa assessed the long-run performance o f acquiring companies
in the Australian m arket and found th a t i t is im p o rta n t to control fo r factors such as company size and
survival. Survival is im p o rta n t because the average returns to companies th a t survive over a given period
differ from those recorded by newly listed companies and by companies th a t delist due to takeover,
merger or bankruptcy. Brown and Da Silva Rosa (1998, p. 36) found th a t when appropriate controls were
used, the post-bid performance o f acquiring companies did n ot differ significantly from the performance
o f control companies. They concluded: <rIhe long-term performance o f the acquiring firm s in the post
merger period is consistent w ith the proposition th a t the m arket fo r corporate control is inform ationally
efficient,. In the US, Betton, Eckbo and Thorburn (2010) examined 15 298 successful takeovers conducted
between 1980 and 2003. They reported th a t there is no statistically reliable evidence th a t the average
long-run performance fo r these companies was significantly different to th a t o f a sample o f matched
companies that had n o t been involved in takeovers.
B usiness finance
Several studies provide evidence on the characteristics o f takeovers th a t are likely to harm rather than
benefit the shareholders o f acquiring companies. There are at least three reasons w hy the managers o f
acquiring companies m ig ht pay more than targets are w orth.
a Rolls hubris hypothesis suggests th a t managers pay too much fo r target companies because they
overestimate th e ir a b ility to run them.
b Managers may pursue th e ir own objectives rather than those o f th e ir companies, shareholders. In
particular, as discussed in Section 19.2.1, Jensen (1986) argued th a t value-reducing takeovers w ill
be common when the acquiring company has significant free cash flow th a t gives management
the a b ility to finance unprofitable investments. He also argues th a t m any takeovers are designed
to reverse previous unprofitable takeovers. In other words, many companies th a t have made
unprofitable takeovers w ill, themselves, become targets in takeovers designed to reverse the original
value reduction. Therefore, while takeovers can be a ‘problem ’, they can also provide a ‘solution’.
C Some managers may make unprofitable takeovers sim ply because they are poor managers, possibly
seeking other fields in which they hope to p erform better. Some o f the many US studies th a t provide
relevant empirical evidence are now outlined.
Lang, Stulz and W alkling (1989) studied successful tender offers and classified the acquiring and target
companies using Tobins Q ratio, which is the ratio o f a company s market value to the replacement cost o f
its assets. The Q ratio was used as a measure o f managerial performance on the basis th a t well-managed
companies th a t make profitable investments should have Q ratios greater than 1, w hile poorly managed
companies are likely to have Q ratios less than 1. The authors found significant relationships between
Q ratios and the p ro fita b ility o f takeovers to acquiring company shareholders. Takeovers th a t involved
a high-Q acquirer and a low -Q target produced gains o f approximately 10 per cent fo r shareholders,
b ut when a low -Q acquirer announced a bid fo r a high-Q target, acquiring company shareholders lost
approximately 4 per cent on average.22
M itche ll and Lehn (1990) tested whether some takeovers are designed to change the control o f
companies th a t had previously made value-reducing acquisitions. Two groups o f companies th a t had made
takeover bids were identified: (a) those subject to a later takeover bid w ith in the study period (‘targets’),
and (b) those n o t subject to a bid w ith in th a t period (non-targets*). Takeover announcements by the
‘targets’ were associated w ith significant losses fo r shareholders, while those by the ‘non-targets’ were
associated w ith significant gains. Many o f the o riginal acquisitions were later reversed, either by voluntary
divestiture or by a hostile <bust-up, takeover. When M itche ll and Lehn examined the m arket response to
the in itia l takeover, they found significant differences between the ‘divested’ and ‘n ot divested’ groups.
The average m arket response was positive fo r those th a t were n o t divested, negative fo r those th a t were
divested, and even more negative fo r those th a t were followed by a *bust-up, takeover. Their results are
consistent w ith the argument th a t one role o f takeovers is to discipline managers who fa il to maximise
profits, including those who make value-reducing takeovers. Their results also indicate th a t the stock
m arket is able to distinguish between ‘good’ and ‘bad’ bidders.
M orck, Shleifer and Vishny (1990) examined the possibility th a t managerial objectives may lead
to unprofitable takeovers. They suggested th a t takeovers th a t benefit managers are like ly to involve at
least one o f three characteristics: diversification, rapidly growing targets and poor past performance by
the acquiring company. Their results show th a t all three characteristics are associated w ith losses for
shareholders o f acquiring companies— th a t is, acquiring companies do systematically pay too much in
takeovers in which the benefits fo r managers are particularly large.
The evidence seems clear th a t a ctivity in the m arket fo r corporate control has a positive effect on wealth.
For example, Brown and Da Silva Rosa estimated th a t the bids fo r 1528 targets covered by th e ir study
created value o f $15 b illio n fo r the shareholders o f target companies.
22 The results reported by Lang, Stulz and Walkling (1989) for tender offers have also been supported for takeovers, and are not
an artefact of the characteristics of the bid itself, such as the method of payment. See Servaes (1991).
■ R NINETEEN A NALYSIS OF TAKEOVERS
The evidence discussed above was obtained from market-based studies— th a t is, studies th a t used
share prices to measure the effects o f takeovers. Some researchers have preferred to use accounting
data to assess the effects o f takeovers on company perform ance by exam ining measures o f p ro fita b ility,
risk and growth. For example, McDougall and Round (1986) used th is approach to study Australian
takeovers. In common w ith other sim ilar studies, they were unable to fin d any evidence o f benefits
such as improved p ro fita b ility or reduction o f risk. In fact, they concluded th a t a strategy o f corporate
acquisition resulted in a deterioration in the performance o f the m erging firm s relative b oth to th e ir
pre-takeover experience, and also compared w ith the experience o f the m atching non-m erging firm s,
measured in accounting terms* (p. 182). Australian studies o f takeover a c tivity in the petroleum
ind ustry (Hyde 2002), the banking sector (Avkiran 1999) and between credit unions (Ralston, W rig h t
& Garden 2001) reaffirm the fin d in g th a t there is little evidence th a t performance o f the merged entity,
measured using accounting data, improves in the post-acquisition period. The accounting-based results
are clearly inconsistent w ith those o f the more popular market-based studies. This suggests th a t at least
one o f the tw o approaches is unreliable. Bishop, Dodd and O fficer (1987, pp. 3 3 -4) argued th a t there are
serious problems in using accounting data to assess the effects o f takeovers. For example, the benefits
o f a takeover may take years to be fu lly reflected in earnings and are likely to show up at d ifferent times
fo r different companies. Therefore, the effects may be d iffic u lt to detect. Further, p ro fita b ility ratios are
likely to be biased, owing to revaluation o f the target company s assets and w rite -o ff o f takeover-related
goodwill.
Market-based studies are also subject to p otential measurement problems. Share price changes
around the tim e a takeover is announced w ill show how investors expected the takeover to w ork out,
but the expected effects may n o t eventuate. These studies m ust also rely on some model o f the norm al
returns on shares to estimate the abnormal returns related to takeovers. Simmonds (2004) demonstrates
that returns to the shares o f bidding companies may be biased downwards when a risk-adjusted model o f
expected returns is used. To overcome this, Simmonds suggests th a t substituting the actual retu rn from
the m arket as a proxy fo r expected retu rn fo r the bidding company's shares w ill yield more reliable results.
In summary, while the market-based approach is generally preferred, i t is n o t infallible and i t would
be desirable to show th a t the results o f market-based studies can be supported by other independent
evidence.
This approach was adopted by Healy, Palepu and Ruback (1992), who used b o th accounting data
and share price data to examine the effects o f the 50 largest mergers in the US between 1979 and
m id-1984. To m inim ise the problem s involved in using accounting data, they focused on estimates
o f operating cash flows before interest and tax, rath er th an on accounting p ro fit, w hich could be
influenced b o th by the m ethod o f accounting fo r the takeover and by the financing o f the takeover.
Healy, Palepu and Ruback fo un d th a t a fte r the takeovers, perform ance d id im prove significantly, on
average, relative to the perform ance o f o th e r companies in the same industries. The im provem ent
was greatest in takeovers th a t involved overlapping businesses. Also, they found a strong positive
relationship between th e ir estimates o f takeover-related changes in operating cash flows and share
price changes o f the companies involved in the takeover at the tim e th a t takeovers were announced.
In summary, they provided fu rth e r evidence th a t takeovers do result in im proved perform ance and
they showed th a t, when im plem ented carefully, the accounting-based and market-based approaches
can yield consistent results.
Market-based studies are useful in documenting the magnitude o f takeover-related wealth changes fo r
shareholders, b u t they provide no inform a tion about the source o f the wealth changes. Some critics have
suggested th a t the wealth increases received by shareholders do n ot represent real economic gains but
instead are the result o f various redistributive effects. One such hypothesis is based on alleged m arket
myopia. According to this hypothesis, investors are said to be preoccupied w ith short-term earnings
performance and w ill undervalue companies th a t undertake long-term developments, m aking them
prim e targets fo r takeover. O ther redistributive hypotheses are based on suggestions th a t takeovers
transfer wealth from debtholders to shareholders, or impose losses on employees o f the target company.
In addition, there are those hypotheses discussed earlier in the chapter: target undervaluation due to
m arket inefficiency, tax benefits and m onopoly power.
Em pirical evidence soundly rejects the ‘undervaluation’ hypothesis and the ‘m arket myopia’
hypothesis. Tax benefits do appear to have at least a m in o r role in m otivating takeover activity, b ut the
evidence is inconsistent w ith shareholder gains being transferred from debtholders or employees (Jarrell,
Brickley & N etter 1988, p. 58). This is n o t to suggest th a t there are no losers in the m arket fo r corporate
control: managers o f target companies are obvious losers in some, possibly many, cases, b ut there is no
evidence o f systematic losses th a t could offset the large gains to shareholders.
Having firs t identified improvements in post-merger cash flow performance, Healy, Palepu and Ruback
(1992) proceeded to explore the sources o f the changes in cash flow. The changes could have arisen from
a variety o f sources, including higher operating margins, greater asset pro du ctivity or lower labour costs.
The changes m ig ht also have been achieved by cu tting outiays on capital investm ent and research and
development (R & D). They found th a t the higher post-merger cash flows were due p rim a rily to increased
asset p ro d u ctivity and there was some evidence o f lower labour costs. They found no significant changes
in capital outlays or in R & D expenditures. Therefore, the improved cash flows were n o t due to focusing
on short-term performance at the expense o f long-term viability. Fee and Thomas (2004) go fu rth e r
by exam ining the financial statements n o t only o f the acquiring company b u t also o f the suppliers and
customers o f the company. They fin d little evidence to suggest th a t the gains to acquiring companies are
due to th e ir being able to exert m onopolistic power and charge customers more. Instead, they report
th a t the gains to acquiring companies are largely linked to increased buying power th a t results in getting
better deals from suppliers.
A fte r surveying the vast body o f Australian evidence, Da Silva Rosa and W alter (2004) drew the
follow ing conclusions:
a Takeovers are in itia te d by companies th a t are high perform ers and are seeking to continue to
perform well.
b Target shareholders enjoy significant gains when th e ir company is subject to a takeover bid,
b ut these gains tend to dissipate where the b id is unsuccessful and no follow -up b id is
launched.
C Shares in acquiring companies tend to underperform in the m arket follow ing acquisition. This is at
least p a rtly due to the relatively high costs incurred by acquirers as a consequence o f the Australian
regulatory environm ent in the m arket fo r corporate control.23
d Following acquisition, the analysis o f the long-run performance o f combined entities indicates th a t
the anticipated benefits from the acquisition often fa il to materialise. However, Da Silva Rosa and
W alter note th a t the methodological problems associated w ith studies o f this type mean th a t it is
very d iffic u lt to reach any strong conclusions about the long-run performance o f successful bidding
companies.
23 F o r e x a m p le , D a S ilv a R o s a a n d W a lte r ( 2 0 0 4 ) a r g u e t h a t th e b i d d e r s m a r k e t v a lu e is r e d u c e d b y th e r e q u ir e m e n t t h a t th e y
s t a n d in th e m a r k e t fo r a 1 - m o n th p e r io d c o m m e n c in g 1 4 d a y s a f t e r th e ta k e o v e r a n n o u n c e m e n t b e c a u s e th e y a r e g iv in g
a w a y a p o t e n t ia lly v e r y v a lu a b le p u t o p t io n t o t a r g e t s h a r e h o ld e r s .
CHAPTER NINETEEN REVIEW

SUMMARY
• Takeovers are an important part of the market for paid and the value of the target as an independent
corporate control in which alternative management entity. However, in the case of a share-exchange
teams compete for the right to manage corporate offer, the net cost depends on the share price of the
assets. The takeover of one company by another is acquiring company after the takeover offer has been
an indirect investment in real assets and, like any announced.
other investment, should proceed only if it has a • Takeovers are regulated by legislation thatemphasises
positive NPV. equity between shareholders of the target company
• Takeovers occur frequently in Australia, and the level and requires disclosure of information by bidders.
of takeover activity varies considerably over time. • With very limited exceptions, an investor may not
The reasons for this variation are not fully understood, acquire more than 20 per cent of a company’s
but there is evidence that industry shocks, such as shares unless the investor makes a takeover bid
deregulation, play an important role. for the company by way of either an off-market
• There are three main types of takeover (horizontal, bid or a market bid.
vertical and conglomerate) and many different • In the case of a partial takeover, the bidder must
reasons why takeovers occur. specify, at the outset, the proportion of each
• Combining two companies can create value by holder’s shares that the bidder will offer to buy.
transferring control of assets to managers who • The market for corporate control also includes
can use or deploy those assets more efficiently. transactions in which companies or groups are
• Other sources of value gains (synergistic reduced in size by asset disposals ('divestitures’),
benefits) from takeovers include replacing divided into separate entities (/spin-offs,) or
inefficient management, economies of scale, transferred to private ownership ('buyouts'). These
cost savings through vertical integration, and corporate restructuring transactions are associated
complementarity between the skills and expertise with increases in value that can be significant. In
of the two entities. some cases, the explanations for the gain may be
• Suggested reasons for takeovers that are of similar to those for takeover gains. In other cases, the
dubious validity include diversification benefits explanation rests on factors such as lower agency
and effects on earnings per share. costs and effects on managerial incentives.
• Economic evaluation of proposed takeovers should • There is ample empirical evidence that takeovers
focus on identifying and quantifying the benefits of provide substantial benefits for the shareholders
the takeover and comparing those benefits with the of target companies. The evidence on benefits to
associated costs. This leads to valuing the target the shareholders of acquiring companies is less
company using an incremental approach—that is, a conclusive. Abnormal returns on acquiring company
listed target would be valued by taking the market shares around the time of takeover bids are much
price as a starting point and adding to it the present smaller in percentage terms than those on target
value of the incremental net cash flows expected to company shares.
result from the takeover. This present value represents • W hile takeovers generate net benefits for
the gain from the takeover. The NPV to the acquiring shareholders on average, there is evidence that some
company is the gain minus the net cost of acquiring types of takeover consistently harm the shareholders
the target, where the net cost is the premium paid over of acquiring companies. Such takeovers may serve
and above the target's value as an independent entity the objectives of managers and are a /problem, for
• There is a fundamental difference between cash and investors, but the market for corporate control can
share-exchange takeover offers. In a cash offer, the also provide a 'solution7 in that many unprofitable
net cost is simply the difference between the cash takeovers are later reversed.
KEY TERMS
buyout (or going-private) transaction 628 poison pill 625
conglomerate takeover 608 proportional bid 622
corporate raiders 609 spin-off 627
divestiture (or sell-off) 627 synergy 608
horizontal takeover 607 takeover 606
leveraged buyout 627 target company 606
management buyout 627 vertical takeover 608
partial takeover 622
SELF-TEST PROBLEMS
1 Alpha Ltd is considering the acquisition of Beta Ltd. Both companies are wholly equity financed and each
has 2 million shares on issue. The annual net cash flows of Alpha and Beta are $1 million and $500000,
respectively, and these cash flows are expected to remain constant in perpetuity. Alpha shareholders
require a rate of return of 20 per cent per annum, but Beta's operations are of higher risk and its
shareholders require a 25 per cent per annum rate of return. After the takeover, Beta's net cash flow is
expected to increase to $7 5 0 0 0 0 per annum in perpetuity with no change in risk.
a) Calculate the price per share at which Beta represents a zero net present value investment to Alpha.
b) Calculate the value of Beta as an independent entity.
c) Alpha offers $2.6 million cash for 100 per cent of Beta. Calculate the effect of the takeover on the
wealth of each company's shareholders.
2 Bako Ltd (B) has completed an exhaustive evaluation preparatory to the proposed acquisition of 50 per cent
of the shares of Cullen Ltd (C). On the basis of this evaluation, B7s management has estimated that the
value of B's equity will increase from $320 million to $380 million as a result of the partial takeover. The
pre-takeover number of shares in the two companies is 80 million in B and 20 million in C. Bys management
is now considering whether to proceed with the takeover by making one of the following bids:
a) a cash offer for C’s shares of $5 per share (C's shares are currently selling for $4)
b) a share offer of 3 shares in B for every 2 shares in C.
Should B proceed with the takeover in either case?
Solutions to self-test problems ore available in Appendix B.
QUESTIONS
1 [LO 1] Explain the following terms:
a) market for corporate control
b) synergy
c) disciplinary takeover
d) takeover waves
e) coinsurance effect
f) free cash flow
g) bootstrapping
h) off-market bid
i) market bid
j) proportional bid
k) white knight
l) golden parachute
m) spin-off
n) leveraged buyout
o) hubris
p) corporate raider.
2 [LO 1] Duck Ltd, a conglomerate, has a market capitalisation of $400 million. The management of
Drake Ltd believes that it can acquire Duck for $500 million and sell its divisions separately for a total of
about $800 million. Outline possible reasons for the difference between these values.
3 [ID ]] Takeovers are important because they provide the only w ay to exploit synergies and ensure that
managers o f corporations act in the interests o f shareholders. Comment on this statement.

4 [LO 1] Takeover activity tends to vary significantly over time. Outline the factors that may explain this variation.
5 [ L O l] There are three types of takeover: horizontal, vertical and conglomerate. Give recent Australian
examples of each type of takeover.
6 [LO 1】 /A company ccrn reduce /7s r/s/c by tat/ngf over crnof/ier company. Do you agree with this statement? Is
it a justifiable reason for a takeover?
7 [LO 1] A company with accumulated tax losses is necessarily a valuable takeover proposition. Discuss this
statement.
8 [LO 2] Budget Computers specialises in buying second-hand computers and renting them out. Owing to
rapid technological changes and intense competition, Budget has recorded losses in recent years and is now
threatened with liquidation. Its major asset is a stock of largely obsolete computers. Fleeting Electrics Ltd is
a newly listed company with interests in consumer electrical goods. The Chairman of Fleeting suggests that
it should acquire Budget for two reasons. First, it provides diversification, and second, he argues that by
injecting fresh capital, Budget can be 'rescued' and should appreciate markedly in value. Critically evaluate
the Chairman's arguments.
9 [LO 2] The value of Minnow Ltd to W hale Ltd can be determined by:
a) discounting Minnow's net cash flows to a present value
b) the present value of Minnow's expected future dividends
c) estimating the present value of the incremental net cash flows directly attributable to the takeover, and add
ing this to the current market value of Minnow.
Critically evaluate each of these approaches. Which one would you advise the management of Whale to use?
Give reasons.
10 [L0 2]
a) In an efficient market, the price of a company's shares is an unbiased estimate of their 'true' value. How
might the 'true7value of a takeover target differ from its value to a potential bidder? What relationship
exists between this latter value and the actual offer price?
b) Asset backing is irrelevant os a measure o f the worth o f a company subject to o takeover bid. Comment on
this statement.
11 [L〇 2] Carrion Ltd has announced a takeover bid for Elephant Ltd, one of Australia’s largest companies.
The Chairman of Carrion argues that the takeover will be economically viable because it will lead to more
efficient management of Elephant’s assets, there are tax advantages involved, and value can be created by
dividing Elephant into three or four separate entities, each based on a single line of business.
a) Critically evaluate each of the three reasons for takeover viability suggested by the Chairman.
b) Assuming that Carrion already holds 15 per cent of Elephant's shares, briefly outline the legislative require
ments that must be met in any bid for control of the target.
c) Elephant's shares had a market price of $7.90 prior to any purchases by Carrion. Analysts employed by
Carrion have valued the shares at $1 1.50, based on the present value of future net cash flows. Outline the
relationship you would expect between these values and Carrion's bid price.
12 [L0 3] There is no reason for on acquiring company to prefer a cosh b id to a shore exchange or vice verso.
Discuss this statement.
13 [L0 4] W hat are the benefits and costs of an unregulated market for takeovers? In view of the Australian
legislation regulating takeovers, evaluate the benefits and costs.
14 [LO 4] The Takeovers Panel is just another form o f government bureaucracy that is a waste o f resources that
could easily be 'token over' itself by the Australian Securities and Investment Commission without any effect
on the market for corporate control. Evaluate this statement. (Hint: access the website www.takeovers.gov.au
to review the make-up and powers of the panel as well as some of the decisions reached.)
15 [L0 4] W hat are the benefits and costs associated with having the Australian Competition and Consumer
Commission (ACCC) involved with the market for corporate control? Give an example of where the ACCC
has not permitted an acquisition to proceed and outline its reasons for doing so. (Hint: www.accc.gov.au
provides access to the news releases issued by the ACCC explaining the reasons for their decisions.)
16 [L 0 4 ] Outline the factors that the management of a bidding company should take into account when
deciding whether to make an off-market or an on-market offer for a target.
641
B usiness finance
17 [LO 5] As management knows more about the doy-to-day running o f the company than shareholders,
shareholders should always follow monogement's lead in rejecting a takeover b id that management soys is
against the best interests o f shareholders. Comment on this statement.
18 \X〇 6] Investing private equity in a buyout is less risky than investing in an initial public offering. Discuss
this statement.
19 [LO 6] Leveraged buyout activity increased dramatically between 2000 and 2006. Suggest reasons for this
increase.
20 [LO 6] Taking a company private often results in significant pressure being placed on the management team
to cut costs and moke operations more efficient. Discuss this statement.
21 [L0 7] The evidence is clear that takeovers in aggregate in Australia have resulted in substantial increases
in the value of the corporate economy (Bishop, Dodd & Officer 1987, p. 6). Outline the major points that
support this conclusion.
22 [L0 7] Maureen Carroll examines the share prices of companies that are the targets of takeover bids. She
finds that their share prices rise substantially when the bid is announced and, over the next 12 months,
do not drop back to the pre-bid level, even if the takeover is unsuccessful. Advise Maureen of possible
explanations for this observation.
23 [L0 7] Claire McDonald is concerned that market-based evidence on the effects of takeovers may be
misleading. She agrees that target company shareholders gain substantially, but argues that these gains
could be the result of wealth transfers from employees, and from the shareholders of acquiring companies.
Claire says, 1 won't be convinced that takeovers are beneficial until someone can show exactly where the
gains come from,. Outline evidence that should convince Claire that takeovers provide real benefits.
cA1
PROBLEMS
Evaluating takeovers and N P V [LO 2]
Yam Ltd (Y) has been evaluating the acquisition of Xavier Ltd (X). The annual expected cash flows of Y and X
are, respectively, $1.16 million per annum in perpetuity and $640000 per annum in perpetuity. These cash
flows are expected to be unaffected by the takeover. The systematic risk (beta) of Y is 0.75 and of X is 1.0.
The risk-free interest rate is 10 per cent and the expected excess return on the market portfolio is 6 per cent.
Calculate the price at which X represents a zero net present value investment. Is it likely that Y's shareholders
will benefit from the takeover?
2 Evaluating takeovers [LO 2]
Assume the information in Problem 1, except that the post-takeover cash flow of the two companies is expected
to be $1.95 million per annum in perpetuity. Is the acquisition likely to be of benefit to Y's shareholders?
3 Alternative approaches to target valuation [LO 2]
Farrout Ltd is planning to acquire a small boat builder, Winged Keel Pty Ltd. Three opinions have been
obtained on the value of the target. These are as follows:
a) Based on the latest earnings of Winged Keel, and applying Farrout's price-earnings ratio, the company is
worth $1.2 million.
b) Based on total tangible assets, a value of $2 million is indicated.
c) Based on the present value of Winged Keel's expected future dividends, it is worth $1.5 million.
Evaluate each of these approaches and indicate any inherent problems. Which would you select as the most
appropriate?
4 Evaluating takeovers [LO 2]
Squire Clothing is considering the acquisition of the Skintight Jeans Company. Squire will pay $2 million to
buy Skintight’s assets and will also assume its liabilities of $900000. It has been estimated that Skintight's
existing assets will generate pre-tax cash flows of $500000 per annum for 25 years. The assets can be
depreciated for tax purposes at 20 per cent per annum straight-line, with no salvage value. The company tax
rate is 33 per cent and Squire estimates that an investment of this level of risk should yield 12 per cent per
annum after tax. Evaluate the proposed takeover.
642
C H A P T E R MNETEElSf S V I E W
5 Evaluating cash versus share offers [LO 2, 3 】
Crocodile Ltd is considering the acquisition of Shark Finance. The values of the two companies as separate
entities are $10 million and $5 million, respectively. Crocodile estimates that by combining the two companies
it will reduce selling and administrative costs by $250000 per annum in perpetuity. Crocodile can either pay
$7 million cash for Shark or offer Shark a 50 per cent holding in Crocodile. If the opportunity cost of capital is
10 per cent per annum:
a) What is the gain, in present value terms, from the merger?
b) What is the net cost of the cash offer?
c) What is the net cost of the share alternative?
d) What is the NPV of the acquisition under:
i) the cash offer
ii) the share offer?
6 EPS bootstrapping [LO 2 3] ,
Progressive Ltd is determined to increase its earnings per share from $1 to $1.33, so it acquires Lo-Gear. The
following facts are provided:
I Item Progressive Lo-Gear Merged company 1
Earnings per share ($) 1.00 1.25 1.33
Price per share ($) 20.00 12.50 ?
Price-earnings ratio 20.00 10.00 ?
Number of shares 100000 200000 ?
Total earnings ($) 100000 250000 ?
Total market value ($) 2 000000 2500000 ?
There are no economic benefits from combining the two companies. In exchange for Lo-Gear's shares,
Progressive issues just enough of its own shares to ensure its $1.33 earnings-per-share objective.
Complete the table for the merged company.
w
How many shares of Progressive are exchanged for each share of Lo-Gear?
What is the net cost of the takeover to Progressive?
W hat is the change in the total market value of the Progressive shares that were on issue before the
takeover?
Based on these results, comment on the use of earnings-per-share comparisons in assessing the viability of
takeovers.
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645
CHAPTER TWENTY
Management of
short-term assets:
inventory
CHAPTER CONTENTS
20.1 Introduction 6 47 20.7 I Inventory costs: retailing and w holesaling 650
20.2 The im portance o f short-term financial 20.8 Inventory costs: m anufacturing 651
decisions 6 47
20.9 Inventory m anagem ent under certainty 652
20.3 Types o f short-term asset 648
20.10 Inventory m anagem ent under uncertainty 658
20.4 The need for short-term asset managem ent 648
20.11 Inventory m anagem ent and the 'just-in-time’
20.5 Short-term assets and short-term liabilities 649 system 661
20.6 O ve rvie w of inventory m anagem ent 6 50
LEARNING OBJECTIVES
1 understand the im portance o f short-term assets in the Australian econom y
2 identify the three m ajor types o f short-term assets
3 evaluate the need fo r short-term asset m anagem ent
4 understand the relationship between short-term assets and short-term liabilities
5 identify the benefits and costs o f holding inventory
6 understand the nature o f acquisition costs, ca rrying costs and stockout costs
7 understand and a p p ly the econom ic order quantity model
8 understand and a p p ly models o f inventory m anagem ent under uncertainty
9 understand the difference between specifying an acceptable p ro b a b ility o f stockout and specifying an
acceptable expected customer service level.
C hapter tw enty M a n a g e m e n t o f short -term assets : in v en t o r y
20.1 Introduction
M ost o f the financial decisions considered in previous chapters were long term , involving such decisions
as the choice o f capital structure and the selection o f investments in property, plant and equipment.
These assets are regarded as long term because norm ally they do n ot need to be replaced fo r several
years. However, most companies also hold short-term assets such as in v en to ry , liquid a ssets and INVENTORY
accounts receivable (o r d e b to r s). These are short 1 6 ^ * because any individual item o f inventory, or comprises raw
materials, work in
any particular liqu id asset, or any single account receivable w ill generally be replaced or burned over* in
progress, supplies
a m atter o f days, weeks or m onths. Both short-term assets and long-term assets require a com m itm ent used in operations
of resources by the company, and thus both form s o f investm ent deserve careful analysis by the financial and finished goods
manager. Similarly, both short-term and long-term liabilities deserve the financial managers attention. LIQUID ASSETS
In a company s statement o f financial position (often called its 'balance sheet,), short-term assets comprise cash and
are referred to as cu rren t a sse ts and short-term liabilities are referred to as cu rren t lia b ilitie s. The assets that are readily
distinction between ‘current’ and ‘non-current’ is the tim e period involved. A current asset w ill norm ally convertible into
cash, such as bills of
be converted into cash in less than one year, while a current lia b ility is due fo r payment in less than
exchange
one year. A ll other assets and liabilities are classified as non-current. In this chapter, we use the terms
ACCOUNTS RECEIVABLE
‘current， and ‘short-term ’ interchangeably.
(o r debtors)
In Sections 20.2 to 20.5 we consider the general area o f investm ent in short-term assets and the sum of money owed to
incurrence o f short-term liabilities, while in Sections 20.6 to 20.11 we consider the management o f a seller as a result of
inventory. In the next chapter we w ill consider the management o f liquid assets and accounts receivable. having sold goods or
services on credit
20.2 The importance of short-term

financial decisions LEARNING
OBJECTIVE 1
Compared w ith m u ltim illio n dollar investments in, say, m ining ventures, automated factories or space
Understand the
technology, the issues involved in investm ent in short-term assets may appear trivia l. Although such a importance of short
view is understandable, it is nevertheless incorrect from both theoretical and empirical viewpoints. term assets in the
It was made clear in the chapters dealing w ith long-term investments th a t funds are invested to Australian economy
earn a competitive return. Short-term investments use resources in exactly the same way as long-term
CURRENT ASSETS
investments: a dollar invested in a short-term asset is a dollar n ot invested in some other asset. As a cash, inventory,
result, the wealth-m axim ising company w ill w ant to ensure th a t all its investments are selected and accounts receivable
managed efficiently. and other assets
It is true th a t short-term financial decisions are usually less complex than long-term financial decisions. that will normally be
converted into cash
For example, a decision to build an automated factory may be based on forecasts o f cash flows fo r perhaps
within a year
15 years, as well as an analysis o f the risks involved. In contrast, a decision to invest surplus cash in,
say, 90-day bank bills can be based on cash flow forecasts fo r a few m onths and a comparison o f current CURRENT LIABILITIES
debt or other
interest rates on other short-term investments. However, the fact th a t short-term financial decisions are
obligations due for
generally less complex does n o t necessarily mean th a t they are less im p o rta n t than long-term decisions. payment within a year
A company may have invested in projects w ith large positive net present values and adopted an ideal
debt-equity ratio, but may get into severe d ifficu lty because it overlooked the need to have sufficient cash
available to meet this year s fixed commitments.
Regardless o f how im p o rta n t an issue may appear to be in principle, its practical economic significance
w ill generally be lim ite d i f there is very little money involved. However, there can be no doubt th a t a great
deal o f money is involved in short-term asset holdings. In Australia, the typical company holds about one-
th ird o f its to ta l assets in short-term assets. However, this varies considerably between industries and
even between companies operating in the same industry. For example, at the end o f the 2013 financial
year, the proportion o f to ta l assets held as short-term assets was 29 per cent fo r Boral, a building and
construction materials company, 31 per cent fo r Heemskirk Consolidated, a small m ining company,
but only 14 per cent fo r BHP B illiton, a diversified m ining company, 86 per cent fo r Paperlinx, a paper
manufacturer and wholesaler and 28 per cent fo r W oolworths, a large retailer.
V LEARNING
20.3 Types of short-term asset
The short-term assets held by businesses are o f three m ajor types as follows.
OBJECTIVE 2
Identify the three 20.3.1 | Inventory
major types of short
term assets
For a manufacturer, inventory includes raw materials, w ork in progress and finished goods n ot yet
sold. For a wholesaler or retailer, inventory consists m ostly o f merchandise in the warehouse or on the
shelves.
2 0 .3 .2 1 Liquid assets (cash and short-term investments)

V irtu a lly all companies need to have at least some cash on hand in order to carry on business. For many
purposes short-term investments such as bills o f exchange, overnight deposits and very short-term bank
deposits are a good substitute fo r cash and have the added advantage th a t they generate interest revenue.
2 0 .3 .3 1 Accounts receivable (debtors)

Companies often extend short-term credit to th e ir customers. For example, a supplier o f goods may not
require payment o f the am ount owed u n til a period o f 30, 60 or even 90 days has passed. D uring the
period from the date o f purchase to the date o f payment, the supplier has the short-term asset, account
receivable’.
V LEARNING
20.4 The need for short-term asset
management
OBJECTIVE 3
In a simple w orld o f frictionless, perfect markets there would be no need fo r a company to hold short
Evaluate the need
for short-term asset term assets and consequently issues concerning th e ir management would not arise. For example, i f a
management company required more raw materials it would be able to obtain them instantaneously at the current
m arket price. Under these conditions there would clearly be no need to hold an inventory o f raw materials.
The same is true o f other forms o f inventory. Cash holdings are in the same position because any shortage
could be instantaneously m et at the current m arket price (interest rate). Similarly, in the case o f accounts
receivable there would be no need fo r the company to w ait fo r the custom ers paym ent because, as we
explain in Chapter 21, the asset could be sold fo r its present value.
The p o in t is that, unlike most o f the topics studied in finance, the model o f the frictionless, perfectly
competitive m arket is usually not a useful starting p o in t fo r the analysis o f short-term asset management.
This is n o t because markets in short-term assets are n ot competitive; indeed, they are often highly
competitive. The problem lies more in the assumption that markets are <frictionless,. For example, a
m ajor reason fo r holding inventories o f raw materials is the fact th a t there are delays and uncertainties
involved in obtaining new supplies. Delays and uncertainties involve costs (both explicit and im p licit)
and therefore constitute a source o f ^friction. To a lesser extent the same is true o f cash. Finally, while it
is true th a t accounts receivable can often be sold (‘factored’ or ‘discounted’）i f desired, most companies
choose n o t to do so.1W hile there w ill be legal and adm inistrative costs involved in discounting, perhaps
o f even more significance are the ‘inform a tion costs’. Many companies know th e ir customers well and can
form reliable estimates o f the likelihood o f receiving payment, b ut the discounting company— th a t is, the
purchaser o f the accounts receivable— would need to expend resources to obtain the in fo rm a tio n i t needs
to form its own estimates. Naturally, the cost o f obtaining this info rm a tio n is b u ilt in to the price offered
by the discounting company. The result, o f course, is th a t a company w ill usually choose to hold rather
1 F a c t o r in g a n d d is c o u n t in g a re d is c u s s e d in C h a p t e r 1 0 .
than sell an account receivable. Again, therefore, a source o f fric tio n has proved to be significant. In this
case the frictio n is the cost o f obtaining inform ation.
Because we do n ot assume frictionless, perfect markets, the analysis o f short-term asset management
tends to have a different ‘feel’ from many other topics in finance. Indeed, many o f the issues involved are
often discussed n ot only in finance b ut also in related disciplines such as management accounting and
operations research. Nevertheless, the management o f short-term assets should be o f v ita l concern to
the financial manager. As noted previously, short-term assets involve a com m itm ent o f the company s
resources. Good decisions w ill mean efficient use o f those resources and w ill result in increased wealth fo r
the shareholders; poor decisions w ill have the opposite effect.
In principle, decisions about investments in short-term assets can be approached using the net present
value model in the same way as decisions about long-term assets. For example, an account receivable
should be held if its net present value is positive, but should not be held i f its net present value is negative.
As usual, the appropriate discount rate to apply is the o p p o rtu n ity cost o f capital, which in this case is
the rate o f retu rn required on an asset th a t has the same risk as the account(s) receivable. To estimate
the opp ortu nity cost, the capital asset pricing model could be applied, given an estimate o f the beta o f
accounts receivable.2 Unfortunately, such estimates are d ifficult, i f n ot impossible, to obtain. In most
cases, pursuing this approach does n ot provide practical solutions in this area, despite the v a lid ity o f the
principles involved. Although wealth m axim isation is s till the ultim ate objective, different techniques are
often needed to estimate and optim ise the costs and benefits.
20.5 Short-term assets and short-term

liabilities LEARNING
OBJECTIVE 4
Although the focus o f Chapters 20 and 21 is the management o f short-term assets, it should also be
Understand the
remembered that managers m ust also make decisions about short-term liabilities. Managers are likely to relationship between
try to m aintain a fa irly stable relationship between the m a tu rity structure o f the company s assets and short-term assets and
the m a tu rity structure o f its liabilities. For example, life insurance companies tend to hold a relatively short-term liabilities
large proportion o f th e ir assets in the fo rm o f long-term investments because the average life insurance
policy is not expected to mature u n til a relatively long tim e has elapsed. This ‘m atching policy’ also applies
to shorter m aturities, so a company whose current assets comprise a relatively large pro po rtio n o f its
total assets w ill often make greater use o f short-term debt than other companies.
The basic ideas underlying the m atching policy are easily explained. Assume th a t a company has only
one non-current asset. By borrow ing fo r a period equal to the assets life, management expects th a t the
asset w ill generate cash flows sufficient to meet the payments required by the loan. A short-term asset
and its matching lia b ility may each involve only one cash flow. The m atching policy is seen very clearly in
the case o f trade bills, which usually require the drawer to pay the face value o f the b ill on a future date
that coincides w ith the date on which the drawer expects to receive payment fo r the goods that have
been sold.3 I f the m a tu rity o f the lia b ility is shorter than the life o f the asset, then there is a risk th a t the
company either w ill not have sufficient cash to repay the debt or w ill n ot be able to renew the debt. I f
the m a tu rity o f the debt is longer than the life o f the asset, then there is a risk th a t the company w ill not
have sufficient alternative sources o f cash at the end o f the assets life to continue meeting the interest
payments on the debt.
To illustrate the m atching policy, we considered matching a p articular asset w ith a particular lia b ility
but, in practice, the matching policy usually does n o t need to be carried to such an extreme. Instead,
managers w ill often focus on broad aggregates relating to different classes o f assets and liabilities. For
example, managers may classify assets and liabilities into fo ur m a tu rity classes: very short term , short
term, medium term and long term . W ith in each class, managers w ill seek to m aintain a balance between
assets and liabilities. Alternatively, the managers may seek to balance the average m a tu rity o f assets
and liabilities. A more sophisticated approach is to calculate the ‘duration’ o f the company’s assets and
select a matching lia b ility structure. As discussed in Appendix 4.1, duration is the appropriate measure o f
m atu rity where i t is sought to immunise a p o rtfo lio against changes in interest rates.
2 S e e S e c tio n 7 .6 .2 fo r a d is c u s s io n o f th e c a p it a l a s s e t p r ic in g m o d e l.
3 S e e S e c tio n 1 0 .5 .3 fo r a m o re d e t a ile d d e s c r ip tio n o f b ills o f e x c h a n g e .
20.6 Overview of inventory management
There are three m ain types o f inventory.
LEARNING
OBJECTIVE 5 a Raw materials inventory comprises inventory th a t w ill fo rm p art o f the completed product o f a
Identify the benefits m anufacturer, but which has yet to enter the production process. For example, iro n ore is an
and costs of holding im p o rta n t raw m aterial th a t would be held in inventory by a steel producer,
inventory
b Work in progress inventory comprises p a rtia lly completed products th a t require additional processing
before they become finished goods.
c Finished goods inventory fo r a m anufacturer is completed products n o t yet sold; fo r a retailer or
wholesaler i t is merchandise on hand.
Inventories form a substantial p art o f a typical company s investm ent in short-term assets. For
example, at the end o f the 2013 financial year, Boral held 37 per cent o f its short-term assets in the
form o f inventories, while the corresponding percentages fo r Heemskirk, BHP B illiton , Paperlinx and
W oolworths were 24, 29, 30 and 68 per cent respectively. The size o f the investm ent suggests that
inve ntory management is needed in every business.
Before considering in detail the costs and benefits o f holding inventory, the m ajor issues involved in
inve ntory management are illustrated by a simple example. Suppose th a t the manager o f a retail store is
considering the level o f inventory the store should hold. I f too little inventory is held there w ill frequently
be occasions when customers w ill arrive at the store, ready and w illin g to buy a product, only to fin d that
it is unavailable. Sales w ill be lost and customer goodwill w ill suffer. Also, i f the inve ntory level is too low,
the store w ill need to reorder the products it sells at more frequent intervals, thus incu rring the costs o f
ordering more often than would otherwise be the case. I f too much inventory is held these problems w ill be
avoided, b ut a different set o f problems w ill arise. H igh inve ntory levels tie up large amounts o f capital
and lead to high storage and insurance costs.
The choice o f inventory level therefore involves a balancing o f costs and benefits. However, it is
convenient to th in k o f the benefits as costs avoided*. For example, the benefit o f a retailer always having
inve ntory on hand can be thought o f as avoiding the costs* o f lost sales and lost customer goodwill.
Viewed in this way, inventory management becomes a problem o f cost m inim isation.
The costs o f holding inventory are generally classified in to three groups: acquisition costs, carrying costs
and stockout costs.
V LEARNING
20.7 Inventory costs: retailing and
wholesaling
OBJECTIVE 6
Understand the nature 20.7.1 I Acquisition costs
of acquisition costs,
carrying costs and The m ost obvious cost o f acquiring inventory is the price paid fo r each u n it o f inventory. However,
stockout costs unless there are qua ntity discounts available (as discussed in Section 20.9.4), the u n it price is the same,
regardless o f inventory policy, and is therefore n ot relevant to the choice o f policy. Relevant acquisition
costs are those th a t vary w ith the inventory policy adopted. These costs include:
a ordering costs: clerical and adm inistrative costs are incurred every tim e an order is placed
b freight and handling costs: every order placed w ill result in freight costs and, when the goods are
received, handling costs
c quantity discounts forgone: larger orders w ill often attract a discount in price. I f smaller orders are
placed, these discounts w ill n ot be obtained and consequently an o p p o rtu n ity cost is incurred.
Per u n it o f inventory, each o f these costs w ill be lower, the larger the order placed. Large orders im ply
relatively infrequent ordering and high inventory levels.
C hapter tw enty M a n a g e m e n t o f short -term assets : in v en to r y
2 0 .7 .2 1 Carrying costs
A fter inventory has been acquired, it m ust be held (or carried*). The higher the inve ntory level, the higher
w ill be the to ta l carrying costs. Carrying costs include:
a Opportunity cost of investment. Inventory ties up capital th a t could have been invested elsewhere in
the company s activities. For example, i f the o pp o rtu n ity cost o f capital is 10 per cent per annum,
then holding $100 o f inventory involves an annual cost o f $10.
b Storage costs. A fte r inventory is received, it m ust be stored. This w ill involve the payment o f rent
or, i f the company owns its storage facilities, the forgoing o f rental revenue th a t could otherwise
have been earned. Storage costs can be high fo r goods th a t are bulky and also fo r those th a t require
special handling, such as refrigeration.
c Insurance premiums. I f the inventory is insured, the premiums w ill probably vary directly w ith the
value o f the inventory held.
d Deterioration and obsolescence. Losses attributable to these factors are likely to be higher fo r higher
levels o f inventory. For a spectacular case, see Finance in Action,
e Price movements. I f there is a decrease in the price o f merchandise held in inventory, a loss is incurred.
I f there is an increase in price, a gain is made, and this element o f the carrying cost is negative.
WINE MYSTERY DOESN'T HOLD WATER_______________________ Finance

in ACTION
In 2013, the Australian company Treasury W ine Estates discovered that its US branch held in
N ews
its inventory millions of dollars7 worth of wine that it thought had been sold. In addition to the
resulting embarrassment, the costs were expected to be huge, as revealed in the following excerpts
from an article by Elizabeth Knight in the Melbourne newspaper The Age.
We now have the great Treasury W ine Estates mystery—millions of litres of wine thought to
have been sold to US consumers have miraculously appeared in warehouses and supermarket
shelves. The real mystery is not how they came to be there or even why $35 million (yes, that's
$35 million) of wine w ill be flushed down the toilet or buried in landfill, it's why we only heard
about it this week. How do you misplace that much wine without management knowing?
The stock [that is, the share price] got beaten around on M onday following the astounding
announcement that excess inventory would cost the company $1 6 0 million in provisions and
wipe $30 million from earnings in the 2 0 1 4 year.
Source: 'W ine mystery doesn't hold water7, Elizabeth Knight, The Age, 17 July 201 3.
2 0 .7 .3 1 Stockout costs
Avoidance o f stockout costs is the m ajor benefit o f holding inventory. I f a company s inventory o f a
particular item is completely exhausted, customers may purchase elsewhere in order to obtain immediate
delivery. Sales are lost. M any customers soon lose patience in this situation and may switch all th e ir
business to a competitor, thus causing fu rth e r sales to be lost.
20.8 Inventory costs: manufacturing
20.8.1 | Inventories of raw materials

The costs th a t apply to a m anufacturer faced w ith the problem o f choosing an inventory level fo r raw
materials are sim ilar to those that apply to retailers and wholesalers. The m ajor difference relates to
stockout costs. For a manufacturer, a shortage o f raw materials inventory w ill disrupt the production
process and impose costs because equipm ent and labour w ill be underutilised.
B usiness finance
2 0 .8 .2 1 Inventories of finished good!

As well as holding an inventory o f raw materials, m ost manufacturers hold an inventory o f th e ir finished
products. In this case, carrying costs and stockout costs are sim ilar to those faced by a retailer or a
wholesaler, b u t the acquisition costs d iffer in th a t the set-up costs fo r a production run may also have to
be included. Set-up costs are the costs incurred each tim e a new production run is started. H igh set-up
costs call fo r larger production runs to spread the costs over a greater num ber o f units produced in each
run. In tu rn , this implies th a t a high level o f finished products inve ntory w ill be carried.
A rigorous way o f determ ining the inventory level th a t m inimises the costs o f holding inventory is to
use a quantitative model. One such model is the economic order q ua n tity model, w hich is discussed in
the next section.
20.9 Inventory management under certainty

The economic order q ua ntity model is designed to help a manager determ ine the inve ntory level that
LEARNING m inimises the to ta l costs associated w ith inventory.
OBJECTIVE 7
Understand and apply
the economic order
quantity model
20.9.1 I The economic order quantity (EOQ) model
The EOQ model assumes th a t demand fo r the product is constant (per u n it o f tim e) and know n w ith
certainty.4 I t is also assumed th a t no q ua ntity discounts are available and th a t orders o f new inventory
are filled in sta n tly— th a t is, the lead tim e between ordering and receiving items to be held in inventory
is assumed to be zero. There is, therefore, no need to order inventory u n til the current inventory level
reaches zero. This situation is illustrated in Figure 20.1.
Figure 20.1 Inventory cycles
c
D
〇■
_g
Cycle (time)
The company places an order fo r Q units at tim e zero. Since demand is constant, th is inventory level
w ill then fa ll steadily over tim e. A t Time 1, inve ntory has reached zero, so a new order fo r Q units is placed
and in sta n tly filled, restoring the inventory level to Q. The second cycle then begins and the process is
repeated. This process continues throughout the year.
4 In S e c t io n 2 0 .1 0 t h is a s s u m p t io n i s r e m o v e d a n d th e p r o b le m is e x a m in e d a llo w in g f o r u n c e r t a in d e m a n d .
The problem is to choose an order q ua ntity Q th a t w ill m inim ise the to ta l cost o f the inve ntory policy.
The value o f Q th a t achieves th is goal is called the econom ic o rd e r q u a n tity (EOQ) and is denoted here ECONOMIC ORDER
by Q*. A fte r Q* has been calculated, the optim al tim e period between the placement o f each order is found QUANTITY (E O O )
optimal quantity of
by dividing demand per period, D, by the economic order quantity, Q*. For example, i f demand is 12 000
inventory ordered that
units per year, and the economic order q ua ntity is found to be 1000, orders need to be placed 12 times minimises the cost
per year— th a t is, m onthly. of purchasing and
In calculating EOQ, the n ota tion we use is: holding the inventory
D = demand (in physical u nits) per period (e.g. demand per year)
a = acquisition costs ($) per order placed
c = carrying cost ($) per period per u n it o f inventory, including the o p p o rtu n ity cost o f capital invested in
inventory
Q = q uantity (in physical units) per order
p = price ($) per u n it o f inventory
Inventory policy w ill affect the acquisition costs and carrying costs. These costs are defined as follows:
Acquisition costs per year
= acquisition costs per order x num ber o f orders per year
D
= a—
Q
Carrying costs per year
= annual carrying cost per u n it o f inventory x average inventory
In each cycle the in itia l inventory is Q units, and over the cycle the inve ntory declines steadily to zero.
Therefore, the average inve ntory level is —.
Therefore:
Carrying costs per year :

2
The annual to ta l cost, TC, o f the inventory policy is the sum o f the acquisition and carrying costs and
is given by:
tc= — + c-2^ B9SVI

Q
The relationship between acquisition and carrying costs and the to ta l cost o f the inventory policy is
Figure 20.2 Determining economic order quantity

puoUOUDbuaos 如 s o u
s ! J Oc a > 6u!XJJ
a)
.E
CO
Order size (units)
5 N o te t h a t n o s t o c k o u t c o s t h a s b e e n s p e c ifie d . U n d e r c o n d it io n s o f c e r ta in ty , s t o c k o u t s n e e d n e v e r o c c u r. S im ila r ly , s t o c k o u t s
n e e d n e v e r o c c u r if o r d e r s a re fille d in sta n tly .
aD
Note th a t acquisition costs,—— , decrease as the order quantity, Q, increases because w ith a larger order
Q
q ua ntity there w ill be fewer orders. However, carrying costs, increase as the order q ua ntity increases
because w ith larger orders, the average inve ntory level w ill be higher. The economic order quantity, Q*,
is the value o f Q, which m inimises to ta l cost. This qua ntity may be found using the follow ing equation:6
l2aD
Q*
The application o f this model is illustrated in the follow ing three Examples.
E xample 20.1
Retailing
Clarke's Photography Store sells 12 0 0 0 packets of photographic paper per year. The wholesale price
is $3 per packet. The cost of processing each order to be placed with the wholesaler is $1 2.50 and
carrying costs are 30 cents per packet per year. W hat is the economic order quantity and the optimal
time period between orders?
SOLUTION
In this example D = 12000, a = $1 2.50 and c = $0.30. Using Equation 20.2:
l2aD
Q*
2 x $12.50 x 12000
~ V $0.30
=1000 packets
12 000
The number of orders per ye a r:
1000
12
Therefore, orders are placed monthly.
E xample 20.2
Manufacturing (raw materials inventory)
Cranfield Manufacturing Ltd uses 4500 metres of wire each year in its production process. Acquisition
costs are $250 per order and the wire costs $1 per metre per year to store. W hat is the economic
order quantity and the optimal time period between orders?
SOLUTION
In this example D = 4500, a = $250 and c = $1. Using Equation 20.2:
2oD
Q*
2 x $250x4500
= V $1
= 1 50 0 metres
4500
The number of orders per years :
1500
Therefore, orders are placed three times per year—that is, once every 4 months.
6 Equation 20.2 may be derived by differentiating Equation 20.1 w ith respect to Q and setting the derivative equal to zero.
Manufacturing (finished goods inventory)

Example 20.3
Dunbar Fabricating Ltd produces a specialised type of metal sheeting. Demand is 5000 sheets per
6 ^
year. Each production run costs $1750 to set up and storage costs are $25 per sheet per year. What
is the optimal size of a production run and the optimal number of runs per year?
SOLUTION
In this example D = 5000, a = $1750 and c = $25. Using Equation 20.2:
!2aD
Q* =
2 x $1750x5000
$25
8 3 7 sheets
5000
The number of production runs per year is or approximately six per year. Therefore, a
83 7
production run should be scheduled every 2 months.
2 0 .9 .2 | Cost estimation
The relevant costs in the EOQ model are increm ental costs and may be d iffic u lt to estimate in practice.
Accounting systems may not be designed to separate inventory costs from other operating costs and,
even i f they are, they w ill generally provide average rather than m arginal costs. Fortunately, both the
optim al order q uantity and, more im portantly, to ta l inventory costs are likely to be fa irly insensitive to
errors in estimates o f u n it costs. Two factors contribute to this property o f the model. First, suppose
the acquisition cost, at is doubled, or the carrying cost, c, is halved. The optim al order quantity, Q*, w ill
then increase by a factor o f only i f all other factors remain unchanged. Second, the to ta l cost, TC,
in Equation 20.1 is generally n o t very sensitive to changes in the order quantity. As may be seen from
Figure 20.2, this is p articularly so in the region o f Q*. Example 20.4 illustrates the effects o f a large error
in estimating the acquisition cost.
Cost estimation
Example 20.4
In Example 20.1, D = 12 000, a = $ 12.50, c = $0.30 and it was found that Q *= 1000. Suppose that
6 ^
the true value of the acquisition cost a is $25 per order, but management believes it is only $1 2.50.
What is the effect of this estimation error on the company's total cost?
SOLUTION
The effect of this estimation error can be assessed by comparing:
a) the cost of the optimal inventory policy that management would adopt if it had the correct
information, with
b) the cost of the inventory policy that management believes to be optimal, based on its incorrect
estimates.
Using the true value of a and Equation 20.2, the economic order quantity would be:
l2aD
Q* =
12 x $25 x 12000
V $0.30
1414 packets
continued
continued
The annual total cost of the optimal inventory policy using Equation 20.1 would be:
了广 $25 x 12 000 $0.30 x 1414
1414 2
=$ 4 2 4
But management, believing that a is $12.50, will choose an order quantity of 1000 packets. The
annual cost of this policy is:
了广 $25 x 12000 $ 0 .3 0 x 1 0 0 0
1000 2
=$ 45 0
The annual cost of adopting management's estimate of a is only $26 or 6.1 per cent more than the
annual cost under the 'true7optimal policy. Therefore, the EOQ model is fairly robust, and should work
well in practice, despite difficulties in making accurate estimates of the input data.
2 0 .9 .3 |T h e EOQ model with positive lead time

In the previous discussion, lead tim e was assumed to be zero— th a t is, it was assumed th a t when an order
was placed i t was filled instantly. In m ost cases such an assumption is unrealistic, because after an order
has been placed it w ill almost always take tim e fo r the goods to be delivered and placed in inventory.
W ith a positive lead tim e, a new order m ust be placed before the current inventory level reaches zero.
To m inim ise carrying costs, the reorder p o in t is chosen so th a t goods from the new order are placed in
inve ntory just as the inventory level reaches zero. This process is illustrated in Example 20.5.
Example 20.5
Referring to Example 20.2, suppose that it takes 1 month for Cranfield’s wire orders to be delivered
and placed in inventory. W hat is the effect of this lead time on Cranfield's inventory policy?
SOLUTION
Under these circumstances, Cranfield simply reorders wire when the current inventory level is equal
to 1 month's usage. The amount used each month is 1^22 = 375. This is illustrated in Figure 20.3.
Figure 20.3 Choosing a reorder point

2 0 .9 .4 1 The EOQ model with quantity discounts

I f discounts are available on larger qua ntity orders, then the price o f the inventory is relevant to
determ ining the economic order quantity. As the order q ua ntity increases, the purchase o f the inventory
benefits from the lower price paid fo r each u n it o f inventory, and from spreading the other acquisition
costs over a larger order quantity. However, carrying costs increase as the inventory level increases. The
procedures fo r dealing w ith q ua ntity discounts are shown in Example 20.6.
Example 20.6
Consider again the case of Clarke's Photography Store, discussed in Example 20.1. In that example,
annual demand, D, was 12000 packets of paper; the price, p, was $3 per packet; acquisition
costs, a, were $1 2.50 per order; and carrying costs, c, were 30 cents per packet per year. Suppose,
however, that the wholesaler offers Clarke’s Photography Store quantity discounts as shown in
Table 20.1.
What is the optimal inventory policy with the quantity discounts?
TABLE 20.1 Photographic paper prices

with quantity discounts
Purchase quantity, Q Price per packet, p ($)
1-500 3.00
501-1499 2.98
1500-2499 2.96
2500-4999 2.94
5000 and over 2.92
SOLUTION
The annual total cost, TC, to Clarke's Photography Store is given by:
TC = inventory costs + acquisition costs + carrying costs
aD cQ
= pD+— + —
Q 2
= 12000p+ 1 5 〇 Q〇Q + 〇 , i 5 Q
In the absence of quantity discounts, the economic order quantity, Q * , was found to be 1000 packets.
It can be shown that with quantity discounts the optimal price-quantity combination must be one of the
following combinations (Goetz 1965):
a) p= $3.00 and Q = 500
b) p= $2.98 and Q = 1000
c) p= $2.96 and Q = 1500
d) p= $2.94 and Q = 2500
e) p= $2.92 and Q = 5000
These combinations are found by the following procedure. First, locate the optimal quantity in the
absence of quantity discounts, and the price that would be payable for that quantity if there were
quantity discounts. In this case Q = 1000 and p = $2.98. This is Combination (b). Next, in each of
the quantity ranges provided in Table 20.1, select the quantity nearest to the optimal quantity in the
absence of discounts (in this case 1000). For example, in the quantity range 2500-49 99, the quantity
nearest to 1000 is 2500. The price payable in that case is $2.94 per packet. This is Combination (d).
continued
B usiness finance
continued
The final step is to calculate the total cost for each of the combinations of price and quantity, and to
select the combination that achieves the lowest total cost. These calculations are as follows:
$150000
12 000 x $3.00 $0.15 x 500 = $36375
500
$150000
12 000 x $2.98 + + $0.15 x 1000 = $36060
1000
$150000
12 000 x $2.96 + + $0.15 x 1500 = $35 845
1500
$150000
12 000 x $2.94 + + $0.15 x 2 5 0 0 = $35715
2500
$150000
12 000 x $2.92 + + $0.15 x 5000= $35 820
5000
The lowest cost combination is (d), and the economic order quantity is therefore 2500 packets.
20.10 Inventory management under

uncertainty
LEARNING
OBJECTIVE 8 In Section 20.9 i t is assumed th a t management is certain about the value o f each relevant variable. In
Understand and apply
particular, it is assumed th a t retailers and wholesalers know, w ith certainty, the level o f demand, while
models of inventory
management under manufacturers are assumed to know, w ith certainty, the rate at which the raw m aterials inventory would
uncertainty be used in production. Suppose, however, th a t demand (or usage as the case may be) is uncertain. I f the
lead tim e between placement o f an order and its delivery is zero, the presence o f uncertainty is n ot a
problem. I f demand or usage should suddenly increase, management can respond by sim ply placing an
order th a t is filled instan tly and therefore no stockout need occur. However, as explained previously, the
lead tim e fo r fillin g orders is usually positive, and therefore stockouts may occur during this time.
Inventory management requires tw o im p o rta n t decisions. First, management m ust choose the quantity
to be ordered. Second, management m ust choose the reorder point— th a t is, the level o f inventory that
w ill trigger the placement o f a new order. M ost o f the discussion o f inventory decisions under certainty
related to the qua ntity decision. The reorder p o in t decision was solved sim ply by reordering when the
current inve ntory level would just equal demand (or usage) during the lead tim e. In Example 20.5,
Cranfields reorder p o in t is 375 metres o f wire, because this level is exactly equal to 1 m onth s usage and
the lead tim e is 1 m onth. The new order would arrive at Cranfields factory at precisely the m om ent when
the inve ntory reached zero. In contrast, under uncertainty, w hile the q ua ntity decision w ill be the same as
th a t made when certainty is assumed, the reorder p o in t decision requires a more sophisticated analysis.
A standard approach to inventory management under uncertainty is as follows. First, the q ua ntity
decision is made by applying the certainty-based EOQ model, using the best estimate o f demand (or
usage). Second, the reorder p o in t decision is made by adding a 'safety stock* to the reorder p o in t th a t
would have been chosen under conditions o f certainty— th a t is, management deliberately chooses to
reorder at a tim e when the current inve ntory level exceeds the qua ntity likely to be required during the
SAFETY STOCK lead tim e. The am ount o f this excess is called the s a fe ty sto ck. For example, i f the rate at which Cranfield
additional inventory uses w ire is uncertain, its management may decide on a safety stock o f 250 metres o f wire. In th a t case
held when demand is
the reorder p o in t is (375 + 250) = 625 metres instead o f 375 metres. An order is placed when 625 metres
uncertain, to reduce
the probability of a
o f wire is s till in inventory, even though i t is expected th a t when the new order arrives in 1 m on ths time,
stockout only 375 metres w ill have been used so there w ill s till be 250 metres o f wire in inventory. Figure 20.4
shows the expected inventory level through time.
So fa r we have illustrated the notion o f safety stock b ut have n o t provided any insig ht in to the factors
th a t determine its size. There are two approaches to determ ining safety stock size: the firs t specifies an
acceptable p robability o f a stockout occurring during the lead tim e and the second specifies an acceptable
expected level o f customer service.
Figure 20.4 Choosing a reorder point with safety stock

〇
Ch
\l
\
\ Rec)rder >rder Recjrder
Dint Dint Dint
I
Metre of wire
\ A
hO
Cm
o
\ \ Safety
ro
Oi
O
stock
i i i , , , i 1 .
0 1 2 3 4 5 6 7 8 9 10 11 12
Month
Both approaches are explained by using the example o f Q uintro Electronics Ltd, a wholesale supplier
o f electronic components. Q uintro is open fo r business fo r 50 weeks each year. The annual demand fo r
one o f Q uintro s components is 50 000 units. The lead tim e fo r new orders is exactly 1 week. On a weekly
basis, demand has an expected value, £(D), o f 1000 and the probability d is trib u tio n shown in Table 20.2.
TABLE 20.2 Probability distribution of weekly demand

Probability Quantity demanded
0.02 665
0.05 700
0.10 800
0.18 900
0.30 1000
0.18 1100
0.10 1200
0.05 1300
0.02 1335
Acquisition costs are $200 per order, and carrying costs are 20 cents per component per year.
Regardless o f the approach taken to calculate the safety stock, using Equation 20.2 the economic order
quantity, Q*, is found to be:
* 一 / 2 x $200 x 50 000
一 V $0.20
= 1 0 000 units
The next problem is to determ ine the reorder point. To what level should inve ntory be allowed to fall
before a new order is placed? The tw o approaches to answering this question are explained in Sections
20.10.1 and 20.10.2.
20.10.1 | Specifying an acceptable probability of stockout
The firs t approach requires th a t Q u in tro s management m ust determ ine an acceptable probability o f a
stockout during the lead tim e o f 1 week. Suppose Q u in tro s management decides th a t it is prepared to
accept a 2 per cent probability o f a stockout. From Table 20.2 it can be seen th a t there is a 2 per cent
chance th a t demand during the lead tim e w ill be more than 1300 units. The safety stock is therefore 300
units and the reorder p o in t is 1300 units. I f a safety stock level o f 300 units is held, the customers’ needs
w ill be less than fu lly satisfied in 2 per cent o f all lead times.
20.10.2 I Specifying an acceptable expected customer service level

The approach based on stockout probability is often unsatisfactory because fo r m ost suppliers it focuses on
the w rong measure. Suppose, fo r example, th a t during a particular lead tim e, demand exceeds 1300 units.
LEARNING In this case Q uintro cannot meet the demand fo r electronic components and this is therefore one o f those
OBJECTIVE 9 lead tim es during which a stockout occurs. However, this does not indicate anything about the magnitude
Understand the
o f the stockout problem. Knowing th a t a stockout has occurred does n o t provide any inform a tion on
difference between
specifying an
how many sales were lost. Given th a t the cost o f a stockout depends directly on the num ber o f lost sales,
acceptable probability sim ply know ing th a t a stockout has occurred provides very little info rm a tio n about the costs incurred.
of stockout and Likewise, know ing the probability o f a stockout provides very little in fo rm a tio n about the likely costs. For
specifying an example, suppose demand during a particular lead tim e is 1335 units. In this case only 35 units o f sales
acceptable expected
have been lost, and the stockout cost is quite low.
customer service level
The same p o in t can be made by referring to the customer service leveF, which can be quantified by
calculating the ratio o f sales to the level o f orders and expressing this ratio as a percentage. I f demand is
1335 units, the customer service level is 1300/1335 or 97.38 per cent. This indicates th a t a high service
level, and therefore a low level o f stockout costs, has been m aintained, notw ith stan d in g the fact th a t a
stockout has occurred. Presumably, most managers are more concerned about the im pact o f a stockout on
the customer service level than they are about the probability o f a stockout. This suggests th a t inventory
policy should be based on an expected (target) level o f customer service, rather than on a target level o f
stockout probability. The procedures needed to calculate the inve ntory level required fo r this policy are
set out in Example 20.7.
E xample 20.7
Suppose that Quintro's management decides that it will accept, on average, a 98 per cent expected
customer service level during the lead time—that is, it is Quintro's policy that there should be a
probability of 0.02 that any particular customer's demand during the lead time will not be met. What
is the required level of safety stock and the corresponding reorder point?
SOLUTION
For each possible quantity demanded, the customer service level will be 100 per cent if the safety
stock is sufficient to meet the level of demand. If the safety stock is insufficient to meet the level of
demand, the customer service level will be the sum of the expected demand during the lead time
(in this case 1000 units) and the safety stock divided by the quantity demanded. For example, if
the safety stock is 50 units, the customer service level in those cases where demand is 1 100 will be
1000 + 50 〇「 95 45 per cent. The expected customer service level may then be found by summinq
1100
across the customer service levels for each possible quantity demanded.
For example, if the safety stock is 50 units, then the expected customer service level given the
possible levels of demand shown in Table 20.2 is:
1050
0 .0 2 x 1 + 0 .0 5 x 1 + 0 . 1 0 x 1 + 0 . 1 8 x 1 + 0 . 3 0 x 1 + 0 . 1 8 x
1100
1050 1050 1050
+ 0 .1 0 x + 0.05 x + 0 .0 2 x
1200 1300 1335
9 6 .5 4 %
Similarly, if the safety stock is 300 units, then the expected customer service level is:
0.02 x 1 +0.05 x 1 + 0 .1 0 x 1 +0.18 x 1 + 0 .3 0 x 1 +0.18 x 1 + 0 .1 0 x 1

1300
+ 0.05 x 1 + 0.02 x
1335
=99.95%
The target customer service level of 98 per cent may then be found by trial and error. The safety
stock level must be increased if it provides an expected customer service level of less than 98 per cent,
and it has to be decreased if it provides an expected customer service level of more than 98 per cent.
In this example, if the safety stock level is 99 units, then the expected customer service level is:
1099
0.02 x 1 + 0.05 x 1 + 0.10 x 1 + 0.18 x 1 + 0.30 x 1 + 0.18 x
1100
1099 1099 1099
+ 0.10 x - ^ - + 0 . 0 5 x + 0.02 x
1200 1300 1100
= 98%
which is equal to the specified target. Therefore, the required safety stock is 99 units, and, since the
expected demand during the lead time is 1000 units, the reorder point is 1099 units.
The result in Example 20.7 may be compared w ith a reorder p o in t o f 1300 units, which is the
solution calculated in Section 20.10.1 when the stockout p ro b a b ility was set at 2 per cent. I f a new
order is placed when the in ve n to ry level falls to 1300 u nits, there is a 2 per cent chance th a t, at the end
o f the lead tim e, no in ve n to ry w ill remain. O f course, at any p o in t during the lead tim e th is p ro b a b ility
is much smaller. For example, a customer who arrives ju s t after the s ta rt o f the lead tim e is almost
guaranteed th a t his or her order w ill be met. However, th is is n o t given any w eight in the decision to
set the inve ntory level at 1300. Instead, the focus is on conditions at the end o f the lead tim e. As shown
earlier, the expected custom er service level associated w ith a reorder p o in t o f 1300 is 99.95 per cent.
This is an extrem ely high level.
In contrast, the customer service level approach takes account o f conditions throughout the lead time.
W ith the reorder p o in t set at 1099 units, the probability o f a stockout is 0.35. Therefore, customers who
arrive at the end o f the lead tim e face a 35 per cent chance th a t th e ir orders w ill n ot be met. However,
customers who arrive at the sta rt o f the lead tim e face an almost 0 per cent chance th a t th e ir orders
w ill n ot be met. Overall, the average chance o f unm et orders during the lead tim e is 2 per cent and the
expected customer service level is therefore 98 per cent. In general, there is no reason w hy suppliers
should focus only on the end o f the lead tim e, since customers at th a t p o in t are neither more nor less
valuable than customers at any other time. The expected customer service level approach is therefore
preferred.
Inventory management and the

'just-in-time' system
The <just-in-tim e , system is a way o f organising high volume repetitive m anufacturing o f goods such
as m otor vehicles, engines and power tools.7 I t is based on the concept, firs t introduced by the Toyota
M otor Corporation, th a t raw materials, equipment and labour are each supplied only in the amounts
required, and at the times required, to perform the m anufacturing task. Therefore, a basic element
o f the system is the coordination o f production processes so th a t raw materials and components are
delivered to the location where they are needed at precisely the times they are required. Compared w ith a
traditional system, this synchronisation o f delivery w ith demand reduces inventory levels, lead times and
7 F o r a m o re d e t a ile d d is c u s s io n o f th e ju s t- in - tim e s y s t e m , s e e L a n g fie ld - S m it h , T h o rn e a n d H ilto n ( 2 0 1 2 , C h a p t e r 1 5 ).

delivery quantities. For example, items th a t are bulky, expensive and obtained from local suppliers may
be delivered once per day or even once per shift.
In industries where both customers and suppliers adopt the just-in-tim e approach, inventories o f raw
materials, w ork in progress and finished goods can be reduced substantially. However, the just-in-tim e
system is n o t sim ply an inventory management system. Its adoption w ill reduce inventory, b ut th a t is
n ot its m ajor function; rather, i t is a system th a t focuses on the elim ination o f waste in all forms, and
improvements flow from reducing the need to hold inventories. For example, a machine th a t form s part
o f a production line may break down several times per day. The trad ition al solution m ight be to hold large
safety stocks o f this machines inputs and outputs. This ties up capital and requires storage facilities.
Under the just-in-tim e system the machine would be redesigned so th a t i t operated more reliably, thereby
e lim inating the need fo r safety stocks. The result is an im provem ent in overall efficiency, as well as a
reduction in inventory costs.
W hile many m anufacturing operations may be able to reduce w ork in progress by this approach,
complete adoption o f the just-in-tim e system involves radical changes in relationships between
manufacturers and suppliers, and in handling facilities. For example, the requirements fo r effective
just-in-tim e operation include reliable quality o f supplies and transportation, short distances between
suppliers and buyers, and frequent delivery o f small quantities o f goods. Where these requirements
cannot be met, an im p o rta n t role remains fo r inventory management.
MS A a A l N 3 M l a 3 1 d v H u
SUMMARY
• Assets such as inventory, liquid assets and accounts • Determining an optimal inventory level involves
receivable are described as 'short term, because they minimising the total of the relevant costs. These are
are turned over rapidly. The resources committed to costs that vary with the inventory policy adopted.
pq such assets are large, and if shareholders' wealth
is to be maximised, the company's short-term
For retailers and wholesalers, the costs of holding
inventory can be classified into three groups:
assets need to be selected carefully and managed acquisition costs, carrying costs and stockout costs.
efficiently. In turn, acquisition costs include ordering costs,
• Unlike most topics in finance, the model of a freight and handling costs and, in some cases,
perfectly competitive, frictionless market is often quantity discounts forgone. Each of these costs will
not a useful starting point for analysing short-term be lower per unit of inventory, the larger the order
asset management. This is because there would be placed. Carrying costs include the opportunity cost
no need to hold short-term assets, such as inventory, of capital invested in inventory, storage costs and
in a world of perfectly competitive, frictionless insurance costs.
markets. While the relevant markets are generally • When demand is known with certainty, inventory
competitive, it is the frictions in these markets that management can be based on the economic order
give rise to the need to hold short-term assets. quantity (EOQ) model. The EOQ model estimates an
• Managers must make decisions concerning short optimal order quantity such that the total of acquisition
term liabilities as well as short-term assets. An costs and carrying costs is minimised. Inputs to the
approach that is employed by many companies model include marginal costs, which may be di 仟icult
involves matching maturity structures of assets and to estimate. However, the model is robust in that total
liabilities. This approach minimises the risk that a costs are relatively insensitive to estimation errors.
company will have insufficient cash to meet liabilities • When demand is uncertain, the order quantity
as they fall due. decision may be the same as that under certainty,
• There are three main types of inventory: raw but the reorder point is changed by adding a safety
materials, work in progress and finished goods. stock to the reorder point, which would be chosen
• If a retailer or wholesaler holds too little inventory, under certainty. The size of the safety stock may
there will be lost sales due to stockouts and goods be determined on the basis of the probability of a
will have to be ordered frequently. stockout or, preferably, on the basis of specifying an
• If too much inventory is held, extra capital will be acceptable level of customer service. Customer service
tied up and the costs of storage and insurance is defined as the ratio of sales to orders and reflects
will increase. the magnitude of any loss of sales due to stockouts.
662
C hapter tw enty M a n a g e m e n t o f short -term assets : in v e n t o r y
nHAPTER T W E N T Y REVIEW
KEY TERMS
accounts receivable (or debtors) 647 inventory 647
current assets 647 liquid assets 647
current liabilities 647 safety stock 658
economic order quantity (EOQ) 653
th SELF-TEST PROBLEMS
1 Each year, Palmer Engineering Ltd produces 500 high-quality jet sprockets used in aircraft engines.
A production run costs $3000 to set up and storage costs are $48 per sprocket per annum. Calculate
the optimal size of a production run and the number of runs per annum.
2 Ron Harper operates a large sports store specialising in cricket equipment. Harper buys cricket balls from
Mackintosh Sports Ltd. It takes Mackintosh 1 month to process and deliver an order. Harper estimates that
during the cricket season the monthly demand for cricket balls follows the probability distribution overleaf.
j Probability Q u antity dem anded 1
0.10 1600
0.20 1800
0.50 2000
0.15 2200
0.03 2400
0.02 2600
What reorder point will ensure that there is only a 5 per cent chance that a stockout will occur during
the lead time? What reorder point will ensure that the expected customer service level during the
lead time is 95 per cent?
QUESTIONS
1 [LO 1] Relative to total assets, businesses in the retail and wholesale sectors invest substantially more in
short-term assets than do businesses in the service sector. Suggest reasons for this difference.
2 [L O l] For the average company, cash represents a much smaller percentage of its total short-term assets
than accounts receivable. Suggest reasons for this difference.
3 [ID ]] Uncertainty makes it difficult for a financial manager to forecast a company's requirement for short-
term funds. Discuss. W hat steps can a financial manager take to minimise the resulting risks to the company?
4 [LO 1] Explain why the proportion of a company's total assets tied up in inventory varies widely from
company to company. Give examples.
5 [LO 2] Distinguish between the major types of short-term asset.
6 [LO 3] Should the decision to invest in short-term assets be approached differently from the decision to invest
in long-term assets? Why?
7 [LO 4] Explain the 'maturity matching7 concept. W hy do many companies pursue policies based on this
idea?
663
B usiness finance
8 [LO 5】For a retailer, what are the major costs and benefits of holding inventory? What different benefits
and costs apply to raw materials inventory held by a manufacturer?
9 [LO 6] Distinguish between acquisition costs and carrying costs.
10 [LO 7] The Economic O rder Quantify model is essentially a w ay to find the optim al mix o f acquisition costs
and carrying costs. Do you agree? Why?
n [LO 8] W hat is 'safety stock'? Explain how it is possible that safety stock might be negative.
12 [LO 8] Because it is impossible to obtain precise measures o f the necessary data, theoretical inventory
management models are virtually useless. Comment on this statement.
13 [LO 9] Explain briefly why the expected customer service level approach to inventory management is
preferable to the acceptable probability of stockout approach.
CA PROBLEMS
1 Inventory management under certainty [LO 5 】
The Leichhardt Pharmacy sells 5000 bottles of vitamin C tablets each year. The clerical and related costs of
placing and processing an order amount to $25 and the carrying costs are 16 cents per bottle per annum.
Calculate the economic order quantify (EOQ) and the time period between placement of orders.
2 Inventory management under certainty [LO 7]
Drummond Garden Tools Ltd specialises in the manufacture of lawn rakes. Every 6 months, Drummond buys
1500 rake handles from Kilmarnock Timber Mills at a cost of $1.50 per handle. The clerical and processing
cost is $75 per order, and each handle costs $1.80 per annum to store. Calculate Drummond's economic
order quantity (EOQ) and the annual cost saving that would be achieved using the EOQ.
3 Inventory management with quantity discounts [LO 7]
The vitamin C tablet manufacturer who supplies the Leichhardt Pharmacy (see Problem 1) has begun offering
quantity discounts to its customers as follows:
1 Q u antity ordered Price per bottle ($) |
1 -9 9 9 2.00
1 0 0 0 -1 9 9 9 1.99
2 0 0 0 -2 9 9 9 1.98
3 0 0 0 -3 9 9 9 1.97
4000+ 1.96
Calculate the new economic order quantity (EOQ).

4 Inventory management under uncertainty [LO 9]
Driscoll Magazines Ltd places orders for new stock every month. The new stock arrives 1 week after placement
of the order. Driscoll has estimated that weekly demand follows the probability distribution below.
丨 Probability Q u antity dem anded f
0.060 100
0.150 120
0.460 140
0.166 160
0.144 180
0.020 200
664
C hapter tw enty M a n a g e m e n t o f short -term assets : in v e n t o r y
CHAPTER T W E N T Y R E V S W
What reorder point will ensure that there is a 2 per cent chance that a stockout will occur during the lead time?
What reorder point will ensure that the expected customer service level during the lead time is 98 per cent?
Inventory management under uncertainty [LO 9 】
Using the data on Cranfield Manufacturing Ltd in Example 20.2:
a) calculate the total annual cost of the optimal inventory policy
b) show that any order quantity between 1095 and 2055 metres results in an annual cost within 5 per cent of
the minimum. Comment on the implications of this result.
REFERENCES
Goetz, B.x Quantitative Methods: A Survey and Guide for Scherr, F.C., Modern Working Capital Management: Text
Managers, M cG raw-H ill, N e w York, 1965. and Cases, Prentice-Hall, Englewood Cliffs, N ew Jersey,
Hill, N.C. & Sartoris, W.L., Short-term Financial 1989.
Management: Text and Cases, 3rd edn, M acm illan, Silver, E.A., Pyke, D.F. & Peterson, R.; Inventory Management
N ew York, 1995. and Production Planning and Scheduling, John W ile y &
Kallberg, J.G. & Parkinson, K.L.; Current Asset Management, Sons, Hoboken, N ew York, 1998.
John W ile y & Sons, N ew York, 1984. Smith, K.V. & G allinger, G .W ., Readings on Short
Langfield-Smith, K., Thorne, H. & Hilton, R.W., Management term Financial Management, 3rd edn, West, St Paul,
Accounting: Information for Managing and Creating Value, Minnesota, 1988.
6th edn, M cG raw-Hill, Sydney, 2 0 1 2 .
CHAPTER CONTENTS
Introduction 66 7 2 1 .7 I Overview of accounts receivable
management
Overview of liquidity management 66 7
— B Q Credit policy
Cash budgeting 6 /0
BE1 The choice of short-term securities Collection policy

673
21 .5 Types of short-term investment 67 4 Evaluation of alternative credit and
collection policies
21.6 The corporate treasurer and liquidity
management 675 Appendix 21.1 Financial statement
analysis
LEARNING OBJECTIVES
1 define liquid assets
2 distinguish between liquidity management and treasury management
3 identify the motives for holding liquid assets
4 prepare a cash budget
5 identify avenues for short-term investment by companies
6 define accounts receivable and distinguish between trade credit and consumer credit
7 identify the benefits and costs of holding accounts receivable
8 identify the four elements of credit policy
9 understand the factors in implementing a collection policy
10 apply the net present value method to evaluate alternative credit and collection policies
11 apply financial statement analysis to short-term asset management.
C hapter tw en ty - o n e M a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable
Introduction
In this chapter we continue the discussion o f short-term asset management by considering the
management o f a company s liq u id assets (cash and short-term investments) and accounts receivable.
Management o f these assets is considered in turn.
First, every company needs to m aintain liq u id ity in order to ensure th a t its creditors are paid on time.
O f course, this objective could easily be m et by a company holding a large p roportion o f its assets in liqu id
form . However, because cash does n o t earn interest, and the retu rn on short-term investments is often
quite low, such a policy would conflict w ith the company’s ultim ate goal o f m axim ising shareholders’
wealth. In general, therefore, a company w ill hold a relatively small p roportion o f its short-term assets
in the form o f cash. For example, at the end o f the 2013 financial year, Boral Ltd and Paperlinx Ltd held
only 8 and 9 per cent respectively o f th e ir short-term assets in the form o f cash, while the comparable
percentage fo r BHP B illito n Ltd was 31 per cent. Clearly, the management o f a company s liq u id resources
is an im portant aspect o f financial management. This is considered in Sections 21.2 to 21.6.
Second, m ost companies sell on credit— th a t is, instead o f a company exchanging its products fo r
cash, it w ill agree to deliver the products immediately, in retu rn fo r the customers promise to pay at a
later date. For instance, payment may n ot be required u n til a period o f 30 days has elapsed. D uring this
period the selling company holds an asset Accounts receivable1. Companies that sell on credit w ill have a
considerable p roportion o f th e ir short-term assets in the form o f accounts receivable. For example, at the
end o f the 2013 financial year, Boral Ltd held 48 per cent o f its short-term assets in the fo rm o f accounts
receivable, while the comparable percentages fo r BHP B illito n Ltd and Paperlinx Ltd were 34 per cent and
60 per cent, respectively. As w ith any other short-term asset, accounts receivable needs to be managed
efficiently, w ith the ultim ate goal o f m axim ising shareholders’ wealth. The management o f accounts
receivable is considered in Sections 21.7 to 21.10.
21.2 Overview of liquidity management

LEARNING
21.2.1 | W hat are 'liq u id ’ assets? OBJECTIVE 1
Define liquid assets
Liquid a ssets comprise cash and assets th a t can be converted in to cash in a very short tim e, and whose
cash value can be predicted w ith a low degree o f error. Examples o f assets w ith these features include LIQUID ASSETS
comprise cash and
‘at call’ deposits w ith banks, money m arket dealers or other financial intermediaries, and various short
assets that are readily
term marketable securities, such as bills o f exchange and commercial paper. These assets are described in convertible into
Chapter 10. cash such as bills of
exchange
2 1 .2 .2 1 Liquidity management and treasury management

Liquidity m a n ag em en t refers to the decisions made by the management o f a company about the
composition and level o f the company s liqu id resources. In Australia, this typically involves deciding on
LEARNING
the m ix o f liqu id assets (such as cash, interest-bearing deposits and securities) th a t a company w ill try
OBJECTIVE 2
to achieve, as well as the level o f bank overdraft usage. It is usual fo r a company in Australia to use an Distinguish between
overdraft provided by its bank. Under the terms o f such an agreement, the company is able to overdraw liquidity management
its bank account up to some agreed lim it. This means th a t the company can borrow any am ount up to the and treasury
agreed lim it. Therefore, a company can guarantee immediate access to cash by m aintaining an unused management
overdraft lim it. Also, a company may arrange stand-by facilities, such as an approved line o f credit, which
can be drawn down i f required. Liq uid ity management is n o t therefore confined to management o f cash LIQUIDITY
M AN AGEM EN T
and liqu id assets, b u t also extends to the management o f bank overdraft and other sources o f short-term
involves decisions
borrowing. about the composition
T reasu ry m a n a g em en t is a broader concept than liq u id ity management and includes liq u id ity and level of a
management as one o f its functions. Many companies have established a separate group or departm ent, company’s liquid assets
TREASURY under the control o f the company treasurer, to manage the company s liq u id ity and to oversee its exposure
MANAGEMENT to various kinds o f financial risk. Foreign exchange provides one example o f exposure to risk. I f a company
involves the
exports, im ports, borrows foreign currency or lends foreign currency, then there is the risk o f loss from
management of
financial assets
exchange rate movements. For example, i f the Australian dollar depreciates, an im p orte r w ill face a higher
and includes the cost o f im ports in Australian dollar terms. The treasurer w ill advise on whether this risk should be hedged
management of short and, i f so, how it is to be hedged. A nother facet o f the treasury s role in a company is the management of
term financial assets, interest rate risk. For example, suppose th a t a company has borrowed money on a floating interest rate
long-term financing
basis and has lent money on a fixed interest rate basis. I f the general level o f interest rates increases, the
and risk management
company could fin d its e lf in difficulty, because while the interest cost o f its borrowed funds has increased,
the interest received on the funds i t has le n t remains fixed. Similarly, if a company holds a p o rtfo lio o f
fixed interest securities, or i f i t has plans to buy or sell (issue) fixed interest securities, there is a risk
due to the possibility o f changing interest rates. Issues o f this type were considered in Appendix 4.1 and
Chapters 17 and 18.
21.2.3! Centralisation of liquidity management

M any companies centralise the liq u id ity management function, even i f many other functions are n ot
centralised. The m ain reason is th a t centralisation allows the m atching o f inflow s and outflows fo r the
whole company, w ith consequent savings. This principle is clearly seen in Example 21.1.
The centralisation o f liq u id ity management also facilitates the development o f specialised staff by
having them concentrated in one area o f the business. Any economies o f scale can also be exploited.
O f course, it should also be borne in m ind th a t there can be diseconomies o f scale. For example, the
centralisation o f liq u id ity management is likely to be a failure i f there is poor comm unication between the
operating divisions and the group responsible fo r liq u id ity management.
E xample
Megacorp Ltd has a manufacturing division and a customer services division. On a particular day,
the manufacturing division must meet a net cash outflow of $1500 00; on the same day, the customer
services division receives a net cash inflow of $50000. If both divisions are operated independently,
the manufacturing division will need to borrow $ 1 500 00 and the customer services division will
be able to invest $5000 0. Clearly, it is easier if, instead, the company simply borrows the net
requirement of $1000 00, and since the borrowing rate will exceed the lending rate, it is cheaper to
do so. For example, if the time period involved is 7 days and the annual interest rates are 15 per cent
per annum (borrowing) and 12 per cent per annum (lending), what is the cost saving from centralised
liquidity management?
SOLUTION
The net interest cost would be calculated as follows:
a) If liquidity management were centralised, then the net interest cost would be:
7
$100000 X 0.15 X
365
=$287.67
b) If liquidity management were not centralised, then the net interest cost would be:
7
$ 1 5 0 0 0 0 x 0 .1 5 $50000 x 0.12 x
3 65' 365 y
=$316.44
The cost saving from centralisation is $316.44 - $287.67 = $28.77. If the situation in this
7-day period is typical of the company's operations, then over a year the savings would amount
to 52 x $28.77 = $1496.04. In practice, the savings may be reduced by the transaction and
communication costs required to achieve centralisation.
2 1 .2 .4 1 Motives for holding liquid assets

Studies of the motives for holding liquid assets have a long history in the literature of economics. The
conventional classification of motives, often attributed to Keynes, divides the motives into three groups:
LEARNING
the tra n sa c tio n s m otive, the p re c au tio n a ry m o tive and the sp e c u lativ e m o tiv e .1
OBJECTIVE 3
Identify the motives for
Transactions motive holding liquid assets
Many businesses face a continuous outflow of cash to meet expenses but will often receive a continuous
inflow of cash, particularly from sales. If these inflows and outflows were perfectly matched in both timing
and amount, then no liquid assets would be required. While the timing of a company s cash outflows can
be controlled by management, the timing of many of its inflows depends on the actions of its customers.
Consequently, perfect synchronisation is virtually impossible to achieve, with the result that some liquid
assets must be held for transaction purposes.
Precautionary motive
Future cash inflows and outflows cannot be forecast with perfect certainty. There is, therefore, always the
possibility that extra cash will be needed to meet unexpected costs, or to take advantage of unexpected
opportunities. Liquid assets are therefore held as a precaution to cover outflows resulting from these
unexpected events. However, the precautionary motive will be weaker if a company can arrange a source
of finance that can be called on in times of need. In Australia, bank overdrafts, commercial bill facilities
and corporate credit cards provide this type of finance.
Speculative motive
When interest rates increase, there is a fall in the market value of income-producing assets such as bonds.
Keynes hypothesised that when an individual forecasts an increase in interest rates he or she will sell bonds
and, instead, hold cash or bank deposits in order to avoid the resulting capital loss. Therefore, liquid asset
holdings depend in part on expectations of interest rate changes. Keynes termed this the 'speculative
motive*. Speculation may be a potent force for companies in the finance sector. For example, a money
market dealer may change the size and/or composition of its portfolio, depending on its expectations of
market conditions. However, outside the finance sector it is doubtful whether the speculative motive has
a role in liquidity management practices.
In summary, for m ost companies, transaction-based motives are probably the dominant influences
and are the focus of our discussion of liquidity management.
2 1 .2 .5 ! M ajo r issues in liquidity management

All companies have cash receipts and need to make cash payments. Because the cash receipts and
payments will not generally be matched in time and amount, the company s cash position must be
forecast, monitored and managed. If this is not done, the following situations are likely to arise:
a If the cash payments exceed the cash receipts, the company will need to borrow money to make the
payments, or else postpone payment. If it borrows money, it will need to pay interest and, probably,
fees. Alternatively, if payment is postponed, the likely result is disruption to its business and/or
damage to its financial reputation.
b If the cash receipts exceed the cash payments, resulting in a large cash balance, the company is
failing to make the best use of its resources. The net funds obtained could be invested to earn
interest or used to reduce the company s debt.
In short, the major issues in liquidity management are to ensure that the company has adequate liquid
resources to make cash payments as the need arises, without holding such a high level of liquid assets
that the company s resources are used inefficiently. This balance is achieved by first forecasting the likely
1 In fa c t, K e y n e s ( 1 9 3 6 , C h - 1 5 ) s p e c if ie d fo u r m o t iv e s t h a t h e te r m e d th e ‘in c o m e m o t iv e ’, th e ‘b u s i n e s s m o t iv e ’, th e
p r e c a u t io n a r y m o tiv e * a n d t h e s p e c u la t iv e m o tiv e *. T h e fir s t r e la t e s m a in ly t o t r a n s a c t io n s b y in d iv id u a ls a n d th e s e c o n d to
t r a n s a c t io n s b y e n t e r p r is e s ; t h e s e tw o a re th e r e f o r e o ft e n c o m b in e d in t o a s in g le t r a n s a c t io n s m o tiv e .
B usiness finance
p a tte rn s o f cash re c e ip ts a n d p a y m e n ts , a n d th e n a d o p tin g an a p p ro p ria te m ix o f cash, liq u id assets and

s h o r t- te rm b o rro w in g . A s e ve n ts u n fo ld , th e cash p o s itio n is m o n ito re d , n e w fo re ca sts are m ade a n d a
n e w m ix a d o p te d . A basic t o o l in fo re c a s tin g cash flo w s is th e cash b u d g e t. This to o l is o u tlin e d in th e n e x t
se ctio n .
Cash budgeting
*
A cash b u d g et p ro v id e s a fo re c a s t o f th e a m o u n t an d t im in g o f th e cash re c e ip ts an d p a y m e n ts t h a t w ill
LEARNING re s u lt fr o m th e co m p a n y s o p e ra tio n s o v e r a p e rio d o f tim e . To a ssist in d a y -to -d a y cash m a n a g e m e n t,
OBJECTIVE 4
fo re ca sts o f re c e ip ts a n d p a y m e n ts m a y be m ad e f o r each day o f th e c o m in g w eek. A lte rn a tiv e ly , foreca sts
Prepare a cash budget
m a y be m a d e o n a w e e k ly basis f o r a n u m b e r o f w eeks in advance, o r f o r each m o n th o f th e n e x t fin a n c ia l
year. A cash b u d g e t o n a m o n th - b y - m o n th basis is u s u a lly p re p a re d as p a r t o f th e o v e ra ll m a s te r b u d g e t
C A S H B U DG ET f o r th e n e x t fin a n c ia l ye a r a n d i t is u s e fu l as an in d ic a tio n o f th e c o m p a n y s s h o r t- r u n d e b t-p a y in g a b ility .
forecast of the amount In a d d itio n , m o n th ly fo re ca sts s h o u ld ta ke in to a cco u n t seasonal a n d o th e r p re d ic ta b le v a ria tio n s in cash
and timing of the cash
flo w s . C learly, th e cash b u d g e t is o n ly as u s e fu l f o r d e cisio n m a k in g as th e accuracy o f th e e s tim a te s used
receipts and payments
in its p re p a ra tio n . A c o m p a n y w h o se cash flo w s are su b je c t to a g re a t de al o f u n c e r ta in ty s h o u ld p ro v id e a
that will result from a
company’s operations s a fe ty m a rg in in th e fo r m o f a m in im u m cash balance, o r have re a d y access to b o rro w in g , o r b o th , to tid e
over a period of time i t o v e r p e rio d s w h e n cash p a y m e n ts exceed cash rece ip ts. The cash b u d g e t th e re fo re assists th e tre a s u re r
in fo re c a s tin g w h e n such excesses o f p a y m e n ts o v e r re c e ip ts are lik e ly to occur.
The ba sic s tru c tu re o f a cash b u d g e t is v e ry sim p le . A fo re c a s t o f cash re ce ip ts a n d p a y m e n ts is m ade
f o r each tim e p e rio d . O fte n th is w ill be d o n e b y fo re c a s tin g s e p a ra te ly th e m a jo r c o m p o n e n ts o f th e
cash flo w s . F o r exa m ple, separate fo re ca sts m a y be m ad e f o r p a y m e n ts f o r wages, m a te ria ls a n d pow er.
In p ra ctice , dozens o f separate foreca sts m a y be m ade. M a n y o f the se fo re ca sts w ill, in t u r n , d e p e n d on
th e fo re c a s t le v e l o f sales. Cash re ce ip ts are o b v io u s ly re la te d to th e sales le ve l, b u t so also are m a n y cash
p a y m e n ts . F o r e xa m p le , in a m a n u fa c tu rin g com pany, h ig h sales m ea ns h ig h p ro d u c tio n , w h ic h , in tu r n ,
m ea ns t h a t m o re ra w m a te ria ls w ill n e ed to be p u rcha sed. In a d d itio n , th e c o rp o ra te tre a s u re r m a y sp e cify
th a t, f o r s a fe ty reasons, a g iv e n m in im u m re q u ire d cash balance s h o u ld be b u ilt in to th e b u d g e t. The le ve l
a t w h ic h th is m in im u m is set is o fte n d e te rm in e d o n a n ad h o c basis. G ive n fo re ca sts o f to t a l re ce ip ts,
to t a l p a y m e n ts a n d th e m in im u m re q u ire d balance, th e fo re c a s t cash s h o rta g e (to be b o rro w e d ) o r cash
s u rp lu s (to be in v e s te d ) is s im p ly :
(Total receipts) less (Total payments) less (Minimum required balance)
21.3.1 | Forecasting cash receipts

The sales fo re ca st is p ro b a b ly th e m o s t im p o r t a n t fa c to r a ffe c tin g th e accuracy o f th e cash b u d g e t. A n
e rro r in th e fo re c a s t o f sales w ill be re fle c te d in an e r r o r in th e e xp e cte d c o lle c tio n s fr o m cu sto m e rs. Such
an e rro r w ill also a ffe c t b u d g e te d cash p a y m e n ts , as th e c o m p a n y s le v e l o f o p e ra tio n s w ill u s u a lly be
a d ju s te d in response to e xp e cte d changes in th e le v e l o f sales.
The p re p a ra tio n o f a sales fo re c a s t u s u a lly in v o lv e s th e fo llo w in g steps. F irs t, a th o ro u g h a n a lysis o f
p a s t sales p e rfo rm a n c e is m ad e f o r each p ro d u c t. A n y re la tio n s h ip o r tr e n d o b se rve d can th e n be ta k e n
in to a c c o u n t in m a k in g th e sales fo re c a s t. F o r exa m ple, a seasonal p a tte r n o f sales m a y be o b se rve d an d
th e n b u ilt in to th e fo re ca st. Second, som e fa c to rs e x te rn a l to th e c o m p a n y w i ll have a n im p o r t a n t e ffe ct
o n th e sales fo re ca st. F o r exa m ple, th e fo re ca ste rs w ill p ro b a b ly use p ro je c tio n s o f lik e ly b u sin ess an d
e c o n o m ic c o n d itio n s p re p a re d b y o u ts id e c o n s u lta n ts or, in v e ry la rg e o rg a n is a tio n s , b y an in -h o u s e
e c o n o m is t.
A f te r th e sales fo re c a s t has b e en p re p a re d , th e n e x t ste p is to e s tim a te th e cash re c e ip ts fr o m sales.
Cash sales p re s e n t n o p ro b le m because th e cash is rece ive d im m e d ia te ly . H o w e ve r, c re d it sales re q u ire
e s tim a tio n o f th e t im in g o f cash re ce ip ts. T his w i ll be in flu e n c e d b y th e c o m p a n y s c re d it te rm s , th e ty p e o f
c u s to m e r, a n d th e ge n e ra l c re d it a n d c o lle c tio n p o lic ie s o f th e c o m p a n y .2 E xp e rie n ce w i ll u s u a lly in d ic a te
th e p r o p o r tio n o f t o ta l sales t h a t are cash sales; th e re m a in d e r w ill be c re d it sales. The ra te o f c o lle c tio n
m a y be e s tim a te d fr o m an a n alysis o f p a s t reco rds, ta k in g in to a c c o u n t a n y s pe cia l fa c to rs .
2 The management of accounts receivable is discussed later in this chapter.

2 1 .3 .2 1 Forecasting cash payments

In th e case o f a m a n u fa c tu rin g com p an y, a fte r th e sales fo re c a s t has be en p re p a re d , a p ro d u c tio n
schedule c o n s is te n t w it h th is fo re c a s t is e s ta b lis h e d f o r each p ro d u c t. O n th e basis o f th e p ro d u c tio n
schedule, m a n a g e m e n t can e s tim a te th e e xp ected p a y m e n ts f o r m a te ria ls a n d la b o u r. A c o m p a n y w ill
also in c u r ove rh e a d costs, w h ic h in c lu d e th e cost o f s u p p lie s, in su ra n ce , lig h t a n d p o w e r, a n d re p a irs an d
m a in te n a n ce . In som e cases, th e se goods a n d services m a y be o b ta in e d o n c re d it a n d th e re fo re th e re
w ill be a la g b e tw e e n th e d a te o f p u rcha se a n d th e da te o f th e cash p a y m e n t. F o r exa m ple, i f s u p p lie rs
o f m a te ria ls se ll o n 30 days* c re d it a n d do n o t send in vo ice s u n t il th e e n d o f th e m o n th o f purchase,
th e p u rch a se r m a y have a p e rio d o f u p to 2 m o n th s b e tw e e n th e d a te o f p u rcha se a n d th e da te o f cash
p a ym e n t. O th e r re g u la r cash p a y m e n ts m a y in c lu d e a d m in is tra tiv e expenses, m a rk e tin g expenses a n d
in te re s t p a y m e n ts . P a ym e n ts t h a t ty p ic a lly are m ade less fre q u e n tly , b u t are n e v e rth e le s s re la tiv e ly
p re d icta b le , in c lu d e in c o m e ta x p a y m e n ts , c a p ita l e x p e n d itu re s a n d d iv id e n d p a y m e n ts .
The p re p a ra tio n o f a s im p le cash b u d g e t is illu s tra te d in E xa m p le 21.2.
E xample 21.2
Lancaster Ltd has forecast its monthly sales for the next 6 months as shown in Table 21.1.
TABLE 21.1 Monthly sales forecast

Month Sales ($'0001
January 1600
February 1750
M arch 1750
A p ril 1800
M ay 1900
June 1900
It is expected that in each month, 20 per cent of sales will be cash sales and 80 per cent of sales
will be credit sales. It is forecast that the collection pattern for credit sales will be as follows:
a) 5 per cent in the month of sale
b) 80 per cent in the month following sale
c) 10 per cent in the second month following sale
d) 2.5 per cent in the third month following sale
e) 2.5 per cent uncollectable (bad debts).
Management requests that you use this information to forecast cash collections (receipts) from
Lancaster's customers in April, May and June.
SOLUTION
The first step is to divide total sales into cash sales (20 per cent) and credit sales (80 per cent) as
TABLE 21.2 Cash and credit sales

Total sales Cash sales Credit sales
($'000) ($，000) ~] ($'000)

M o n th
Jan ua ry 1600 320 1280
February 1750 350 1400
continued
B usiness finance
:: :: Total sales Cash sales Credit sales

M o n th
($ ' 0 0 0 ) ($ ，0 0 0 ) ($ ，0 0 0 )
M arch 1750 350 1400
A p ril 1800 360 1440
M ay 1900 380 1520
June 1900 380 1520
Credit sales then generate cash receipts according to the pattern of collections, as shown in
Table 21.3.
TABLE 21.3 Cash receipts for Lancaster Ltd

Are collected as cash receipts ($'000) in:
11 III.
I January February March April May June
J a n u a ry (1280) 64 1024 128 32 —

F ebru ary (1400) — 70 112 0 140 35 —
M arch (1400) — — 70 112 0 140 35
A p r il (1440) — — — 72 1152 144
M ay (1520) — — — — 76 1216
June (1520) 一一 — — — 76
C re d it sales collected — — — 1364 1403 1471
Cash sales 320 350 350 360 380 380
Cash receipts ($*000) 一一 — 1724 1783 1851
The cash receipts for January, February and March are incomplete because insufficient information
has been provided. For example, January will see a cash receipt from the credit sales made in
December. Presumably, Lancaster will already have actual (rather than forecast) figures for December's
credit sales, and for the cash already collected from these sales. These figures would then be used
in forecasting the collections for January and subsequent months. In practice, Lancaster Ltd would
then have to forecast other cash receipts, as well as cash payments and the minimum required cash
balance to complete its cash budget. The resulting forecasts for the June quarter might be those shown
in Table 21.4.
TABLE 21.4 Lancaster Ltd: forecast cash receipts and payments for June quarter,
by month
April ($，000) May ($'000) June ($，000)
Cash balance a t b e g in n in g o f m o n th 740 564 547
add Cash receipts:

C ollections fro m custom ers 1 7 24 1783 1851
C hapter tw en ty - o ne M a n a g e m e n t o f short -term assets : liq uid assets a n d a c c o u n t s receivable
Table 2 1 . 4 continued
A pril ($，000) M ay ($’000) June ($'000)
D ividends on in ve stm e n ts in o th e r — 310 —

companies
Sale o f e q u ip m e n t 300 — —
O th e r 50 40 140
Total cash receipts 2074 2133 1991
T otal cash available 2814 2697 2538
less Cash paym ents:
Payments to cred itors 1400 1600 1300
Wages and salaries 500 525 510
D ividends — — 500
Incom e ta x — — —
Purchase o f land 300
O th e r 50 25 30
Total cash paym ents 2250 2150 2340
Cash balance a t end o f m o n th 564 547 198
Required m in im u m cash balance 300 300 300
Cash (required) available fo r 264 247 ( 10 2 )

in ve stm e n t
F in a lly , a c tu a l resu lts s h o u ld b e c o m p a r e d w ith fo re c a s t re su lts o n a n o n g o in g b a s is . F a c to rs

in flu e n c in g th e c a s h p o s itio n o f th e c o m p a n y th a t w e r e n o t fo re s e e n w h e n th e c a s h fo re c a s t w a s
p r e p a r e d m a y b e d is c lo s e d b y th e c o m p a r is o n s . F o r e x a m p le , c u s to m e rs m a y n o t b e p a y in g th e ir
a c c o u n ts as p r o m p tly a s h a d b e e n e x p e c te d a n d , as a re s u lt, c a s h re c e ip ts m a y b e less th a n
th o se fo re c a s t. In th e e v e n t o f la r g e v a r ia tio n s fro m th e c a s h b u d g e t, th e b u d g e t s h o u ld b e re v is e d
im m e d ia te ly . C o m p a ris o n s b e tw e e n th e b u d g e te d a n d a c tu a l fig u re s m a y a ls o in d ic a te w a y s in w h ic h
th e fo re c a s tin g p r o c e d u r e c a n b e im p r o v e d .
2 1 .4 The choice of short-term securities

There are m a n y typ e s o f in v e s tm e n ts in w h ic h a c o m p a n y can in v e s t te m p o r a r ily id le cash. These
in v e s tm e n ts o ffe r a w id e ran ge o f r is k a n d re tu rn . The tre a s u re r has th e o p p o r tu n it y to in v e s t in h ig h e r-
y ie ld in g se c u ritie s , p ro v id e d t h a t he o r she is p re p a re d to accept th e g re a te r r is k o f such in v e s tm e n ts .
The g re a te r ris k m a y re fe r n o t o n ly to th e r is k t h a t rates o f r e tu r n m a y change (interest rate risk), but
also to th e p o s s ib ility o f d e fa u lt (default or credit risk) a n d to th e r is k a sso cia te d w it h th e liq u id it y o f
th e in v e s tm e n t (liquidity risk). F o r exa m ple, an in v e s tm e n t in a ca ll d e p o s it w it h a b a n k is u n c e rta in to
th e e x te n t th a t th e b a n k m a y be u n a b le to m e e t its c o m m itm e n ts . H o w e ve r, f o r m o s t b a n ks, m o s t o f th e
tim e , th e p ro b a b ility o f d e fa u lt is v e ry lo w a n d th e re fo re th e d e fa u lt r is k is v e ry s m a ll. A r is k o f g re a te r
consequence relates to th e liq u id it y o f th e in v e s tm e n t. The m o re d iff ic u lt i t is to c o n v e rt a s e c u rity in to
cash, th e g re a te r is th e liq u id it y r is k o f t h a t s e c u rity . F o r exa m p le , a 3 -m o n th te r m d e p o s it w it h a b a n k
is ris k ie r th a n a ca ll d e p o s it w it h th e sam e b a n k , as th e co m p a n y m a y u n e x p e c te d ly n e ed th e cash b e fo re
th e 3 m o n th s have elapsed.
B usiness finance
Types of short-term investment

The fo llo w in g d iscu ssio n does n o t a tte m p t to c o m p ile a c o m p le te lis t o f p o ssib le in v e s tm e n ts , b u t
LEARNING does e x a m in e som e o f th e avenues a va ila b le f o r in v e s tin g a c o m p a n y s te m p o ra rily id le cash. F o r each
OBJECTIVE 5
in v e s tm e n t w e h ig h lig h t th e c h a ra c te ris tic s t h a t are im p o r t a n t to a tre a s u re r w h o m u s t choose th e m o s t
Identify avenues for
short-term investment a p p ro p ria te fo rm s o f in v e s tm e n t, g iv e n th e c o m p a n y s circu m sta n ce s. Table 2 1 .5 p ro v id e s som e s h o rt
by companies te r m in te re s t ra te s a n d y ie ld s.
TABLE 21.5 Examples of short-term interest rates and yields

Type of investment Interest rates and yields (% p.a.)
G o ve rn m e n t b o nd s— 5 years 3.393
Cash, average 11 am rate 2.500
90-day b a n k b ills 2.690
180-day b a n k b ills 2.700
Cash m anagem ent tru s ts — M acquarie C M T 2.500
Source: Australian Financial Review, 18 March 2014.
21.5.1 | Deposits of funds with financial institutions

Several ty p e s o f fin a n c ia l in s t it u t io n accept d e p o s its .3 The basic te rm s o f th e d e p o s it w i ll d iffe r fr o m one
k in d o f in s t it u t io n to a n o th e r a n d a tre a s u re r s choice w i ll d e p e n d o n the :
a period th a t the funds are available fo r investm ent

b risk th a t the company is prepared to accept
C required rate o f return.
Banks
A c o m p a n y can in v e s t fu n d s in in te re s t-b e a rin g te r m d e p o s its w it h a b a n k o r p u rch a se c e rtific a te s o f
d e p o s it f r o m a b a n k . T erm s to m a t u r ity f o r te r m d e p o s its a n d c e rtific a te s o f d e p o s it are n e g o tia b le .
C e rtific a te s o f d e p o s it are m o re liq u id th a n te r m d e p o s its as th e y are m a rk e ta b le . F u n d s can also be
in v e s te d f o r v e ry s h o rt te rm s ; f o r exa m ple, fu n d s m a y be p lace d o n 2 4 -h o u r call. The d e fa u lt r is k associated
w it h d e p o s itin g fu n d s w ith a b a n k is v e ry lo w an d, i f s u b je c t to th e g o v e rn m e n t g u a ra n te e , n o n -e x is te n t.
C o n s e q u e n tly th e in te re s t rates o ffe re d te n d to be less th a n th o s e f o r m o s t a lte rn a tiv e in v e s tm e n ts .
Cash management trusts

Cash m a n a g e m e n t tru s ts a ct as in te rm e d ia rie s b e tw e e n s m a ll in v e s to rs a n d th e m o n e y m a rk e ts . M a n y
co m p a n ie s are la rge e n o u g h to e n te r th e m o n e y m a rk e ts d ire c tly , b u t s m a lle r c o m p a n ie s m a y fin d in d ire c t
access v ia th e tru s ts to be an a ttra c tiv e o u tle t f o r fu n d s a va ila b le f o r in v e s tm e n t f o r p e rio d s as s h o rt as a
fe w days.
2 1 .5 .2 1 Discounting of commercial bills

The c o m m e rc ia l b ills m a rk e t was discussed in C h a p te r 10. A c o m p a n y can in v e s t its id le cash balances
in th is m a rk e t in one o f tw o ways. F irs t, a co m p a n y can be th e o r ig in a l d is c o u n te r o f a c o m m e rc ia l b ill
and, as a re s u lt, s u p p ly fu n d s to th e d ra w e r o f th e b ill. Second, a c o m p a n y can <re d is c o u n t, a b ill t h a t has
3 These were discussed in Chapter 8.

previously been discounted by another party. This sim ply means th a t the b ill is purchased from another
investor in the bills m arket. Such purchases are easily arranged as there is an active m arket in bills. The
m arketability o f commercial bills is one o f the m ajor advantages o f this form o f investm ent.
21.6 The corporate treasurer and liquidity

management
The demand fo r liq u id ity stems from transactions th a t result in cash inflows and payments that are n ot
synchronised in either tim in g or amount. One means o f reducing the necessary cash balance is to smooth
the pattern o f cash flows. For example, the company may be able to negotiate credit terms w ith suppliers
so that payment is not required u n til the goods are sold. Similarly, the dates on which employees’ wages
are paid could be altered to b ring these dates more in to line w ith times when the company has a cash
surplus. In fact, there are opportunities fo r reducing a company s cash requirements wherever the pattern
o f cash payments can be brought more in to line w ith the pattern o f cash inflows. Usually this w ill require
delaying cash payments fo r as long as possible, in order to bring them closer to the tim e when the goods
and services acquired can be converted in to cash inflow s through sales.
Acceleration o f the flow o f cash inflows w ill also have a desirable effect on liquidity. In this case the aim
is to reduce the tim e th a t elapses between the date o f sale and the date o f the cash inflow. These issues fall
into the category o f credit and collection policy* and are discussed in Sections 21.7 to 21.10.
Overview of accounts receivable

m
management LEARNING
OBJECTIVE 6
The purpose o f our discussion o f accounts receivable management is to id e n tify the variables th a t can be
Define accounts
influenced by the manager responsible fo r accounts receivable, and to discuss techniques and procedures receivable and
that may be employed in choosing the o ptim um values fo r these variables. Collectively, these decisions distinguish between
are often referred to as the company s credit and collection policies. Establishment o f a credit policy involves trade credit and
four elements: consumer credit
a Is the company prepared to offer credit?

b I f credit is to be offered, w hat standards w ill be applied in the decision to grant credit to a customer?
C How much credit should a customer be granted?
d W hat credit terms w ill be offered?
When credit has been offered and accepted, the company m ust then seek to ensure th a t the promised A C C O U N T S RECEIVABLE
amount is received. Inevitably, some accounts w ill prove d iffic u lt to collect and the company w ill need to sum of money owed to
take steps to recover the am ount owing— th a t is, the company w ill adopt a collection policy. This requires a seller as a result of
having sold goods or
the manager to determine which procedures w ill be used to encourage payment, and fo r how long these
services on credit
procedures should be followed. In practice, credit and collection policies w ill be interrelated, b ut it is
convenient in the firs t instance to consider them separately. T R AD E CREDIT
Before fu rth e r discussion o f credit and collection policies, we firs t describe the characteristics o f arrangement in which
a seller of goods or
accounts receivable in more detail and indicate the benefits and costs o f holding accounts receivable.
services allows the
purchaser a period of
time before requiring
payment; it is
21.7.1 | W hat are accounts receivable? equivalent to a short
term loan made by the
Accounts receivable represent money owed to a company from the sale, on credit, o f goods or services seller to the purchaser,
in the norm al course o f business. Trade credit refers to credit sales made to other businesses, whereas of an amount equal to
consum er credit refers to credit sales made to individuals. Trade credit terms may provide a discount fo r the purchase price
C O N S U M E R CREDIT prom pt payment, whereas consumer credit terms are unlikely to have this feature. Consumer credit may
credit extended
also require the customer to pay a service fee, b ut this is unusual in the case o f trade credit.
to individuals by
suppliers of goods An individual or business purchasing goods on credit from a retailer may either charge the amount to
and services, or by a credit account or enter in to a longer-term consumer credit agreement, which is likely to require regular
financial institutions repayment o f an agreed amount. W hile some m ajor retailers continue to provide credit, the provision of
through credit cards credit has largely been taken over by financial in s titu tio n s th a t issue credit cards. These cards allow goods
OPEN ACCOUNT
and services to be purchased on credit w ith o u t credit being extended by the retailer. Trade credit, however,
an arrangement continues to be provided by manufacturers, wholesalers and other providers o f goods and services.
under which goods or A business purchasing goods on credit may be offered trade credit on open account, or, i f the amount
services are sold to a involved is substantial, the business may be required to negotiate a b ill o f exchange.4 Trade credit on
customer on credit, but
open account is the more usual method. For example, a tim be r yard is likely to provide trade credit on
with no formal debt
open a cco u n t to builders who obtain th e ir supplies regularly from the yard. This requires little or no
contract. Payment is
due after an account is form al documentation and the selling company sends regular statements to n o tify its customers o f their
sent to the customer current indebtedness.
In the remainder o f this chapter, decisions relating to trade credit on open account are considered.
However, much o f the material presented is applicable to other form s o f trade credit and to consumer credit.
Benefits and costs of granting credit

The m ajor benefits and costs o f granting credit can be illustrated by a simple example. Suppose th a t the
manager o f a suburban tim ber yard is reviewing the businesss accounts receivable policy. A lenient policy
would be to provide credit to nearly all customers who request it, to allow these customers a long credit
LEARNING
OBJECTIVE 7 period, and to delay taking steps to collect overdue accounts. Such a policy would alm ost certainly attract
Identify the benefits new customers and perhaps w in more business from existing customers. However, a lenient policy would
and costs of holding also increase costs substantially. The long credit period would tie up resources th a t could otherwise be
accounts receivable invested elsewhere. Further, the costs o f adm inistering the accounts would rise, and the lower credit
standard required o f customers would lead to increased costs o f collection and a higher incidence o f
unpaid accounts. Conversely, a very stric t policy would keep these costs at very low levels, b ut would also
lead to lost sales as customers turned to competing tim ber yards whose policies were more lenient. The
aim o f the manager is to choose the set o f policies th a t w ill maximise the net benefit to the tim ber yard.
The benefits and costs are now explained in more detail.
Benefit of increased sales

A company w ill offer credit terms to its customers only i f its management believes th a t there w ill be an
increase in sales. The benefit is therefore the net increase in sales revenue directly attributable to the
credit terms offered. In calculating the effect o f increased sales on p ro fit, it is, o f course, necessary to
deduct fro m the increase in sales revenue the cost o f the goods sold and other associated costs, such as
delivery costs.
Opportunity cost of investm ent

Accounts receivable tie up funds th a t could be invested in some other way. There is, therefore, an
o pp o rtu n ity cost, which is equal to the return th a t these funds could otherwise have earned.
Cost of bad debts and delinquent accounts

D E L IN Q U E N T Some customers may delay unduly the payment o f th e ir accounts (called d e lin q u e n t accounts) and
ACCOUNTS
others may n ot pay th e ir accounts at all (called bad debts). A delinquent account means th a t the supplier
accounts where
payment has not been m ust w ait a longer tim e before i t receives payment, and therefore the o p p o rtu n ity cost is greater. A bad
made by the due date debt means th a t the supplier incurs the cost o f a credit sale w ith o u t obtaining any benefit.
B A D DEBTS
Cost o f adm inistration
accounts that
have proven to be Each credit account m ust be administered. A t a m inim um , these costs w ill generally include staff costs,
uncollectable and are the costs o f checking the credit-worthiness o f customers, and office expenses such as stationery, postage
written off
and telephone charges. Delinquent accounts impose fu rth e r costs because o f the collection costs they
involve. Collection costs may include fu rth e r staff costs and office expenses and, as a fin al step, the costs
4 See Section 10.5.3 for a description of bills of exchange.

C hapter tw en ty - o ne M a n a g e m e n t o f short -term assets : u q u id assets a n d a c c o u n t s receivable
o f legal action. Such action may be justified i f the am ount involved is substantial and there is a reasonable
probability th a t the debtor has the a b ility to pay.
Cost of additional investm ent

Increased sales w ill, o f themselves, generally involve fu rth e r costs. For example, a higher inventory level
may be required.5 In the case o f a manufacturer, new investm ent in p la nt and equipment may be needed
to meet the increased demand.
21.8 Credit policy

In Section 21.7, fo ur elements o f c r e d it p o lic y were mentioned. These elements are now considered
LEARNING
further.
OBJECTIVE 8
Identify the four
elements of credit
policy
21.8.1 I The decision to offer credit
In principle, a company m ust decide whether it w ill sell on a s tric tly cash only* basis or whether some CREDIT P O LIC Y
credit w ill be extended. In practice an individual company w ill often have little choice b ut to extend credit. supplier’s policy on
whether credit will be
I f competitors provide credit to customers, it is likely th a t the company w ill also have to extend credit
offered to customers
if it is to retain its customers* business. The reason is simple: an offer o f credit is equivalent to a price and on the terms that
reduction and, naturally, a lower price tends to increase demand. It was noted earlier that from the sellers will be offered to those
viewpoint the need to w ait fo r payment involves an o pp o rtu n ity cost. Equally, from the buyers view point, customers
the ability to defer payment is equivalent to a price reduction. For example, i f a customer has a required
rate o f return o f 1 per cent per m onth, and buys an item fo r $101 on 1 m onth s credit, the effective cost
in today’s terms is only $100.6
2 1 .8 .2 1 Selection of credit-worthy customers

A company w ill usually offer sim ilar term s to all its credit-w orthy customers, b u t it m ust firs t decide which
o f its customers w ill be granted credit and which w ill be refused credit— th a t is, it needs inform a tion
about the riskiness o f extending credit to a particular customer at a particular time. In reaching a decision
about granting credit, one o f the best guides is often the company s own experience w ith the customer.
One technique th a t is a useful aid in deciding whether to grant credit is the decision tree*. This technique
was discussed in Chapter 6 and is illustrated in the context o f the selection o f credit-w orthy customers
by Example 21.3.
E xample 21.3
S u p p o s e th a t C o m p a n y A h a s a la r g e n u m b e r o f c r e d it c u s to m e rs a n d it re c e iv e s fro m C o m p a n y B a
re q u e s t f o r c r e d it f o r th e p u rc h a s e o f 1 0 0 u n its o f C o m p a n y A 's p r o d u c t a t $ 1 0 p e r u n it. In th e firs t
in s ta n c e , C o m p a n y A h a s th re e c h o ic e s :
a) it m a y g r a n t th e re q u e s t im m e d ia te ly
b) it m a y re fu s e th e re q u e s t im m e d ia te ly , o r
c) it m a y p o s tp o n e th e d e c is io n p e n d in g in v e s tig a tio n .
A t a m in im u m , th is in v e s tig a tio n w ill u s u a lly in v o lv e c h e c k in g its o w n re c o rd s to se e if C o m p a n y B

ha s re c e iv e d c r e d it fro m C o m p a n y A in th e p a s t.7 S u ch a n in v e s tig a tio n w ill s h o w w h e th e r C o m p a n y
B is a lo w c r e d it ris k , a h ig h c r e d it ris k o r is a n e w c u s to m e r a b o u t w h o m n o in fo r m a tio n is a v a ila b le
continued
5 The costs associated with investments in inventory were discussed in Chapter 20.
6 More formally, from the buyer s viewpoint, the present value of $101 payable in 1 months time is $101/1.01 or $100.
7 Other forms of investigation, such as checking with a credit bureau, are discussed later in this section.
continued
fro m th e c o m p a n y 's re c o rd s . C o m p a n y A w is h e s to c h o o s e th e c o u rs e o f a c tio n th a t h a s th e lo w e s t

e x p e c te d c o s t. T h e p o s s ib le a c tio n s c o n fro n tin g C o m p a n y A a r e s h o w n in th e fo rm o f a d e c is io n tre e
in F ig u re 2 1 . 1 .
Figure 21.1 Decision tree showing possible courses of action for Company A
To e m p lo y th is a p p r o a c h , it is n e c e s s a ry to e s tim a te th e c o s t a s s o c ia te d w ith e a c h e n d p o in t o n
th e tre e . In tu rn , th is re q u ire s in fo r m a tio n o n th e f o llo w in g ite m s :8
a) th e m a r g in a l c o s t o f p r o d u c in g e a c h u n it, th e s a le s re v e n u e g e n e r a te d b y e a c h u n it a n d th e
m a r g in a l n e t b e n e fit o f e a c h u n it s o ld ; in th is e x a m p le , th e m a r g in a l c o s t o f e a c h u n it is a s s u m e d to
b e $ 7 , a n d s in c e th e a s s o c ia te d s a le s re v e n u e is $ 1 0 , th e m a r g in a l n e t b e n e fit is $ 1 0 - $ 7 = $ 3 .
T h e re fo re , f o r th is o r d e r th e m a r g in a l c o s t is $ 7 0 0 a n d th e m a r g in a l n e t b e n e fit is $ 3 0 0
b) th e c o s t o f in v e s tig a tio n , a s s u m e d in th is e x a m p le to b e $ 2 p e r in v e s tig a tio n
c) th e p r o b a b ilit y th a t C o m p a n y B is lo w ris k , h ig h ris k o r is a n e w c u s to m e r; in th is e x a m p le ,

C o m p a n y A 's e x p e r ie n c e s u g g e s ts th a t th e se p r o b a b ilit ie s a r e 0 . 8 0 , 0 . 1 5 a n d 0 . 0 5 , re s p e c tiv e ly
d) th e c o s t o f c a p it a l, a s s u m e d in th is e x a m p le to b e 2 p e r c e n t p e r m o n th 9
e) d a t a f o r e a c h c a t e g o r y o n th e p r o b a b ilit y o f p a y m e n t, th e p r o b a b ilit y o f a b a d d e b t o c c u r r in g
( w h ic h is s im p ly 1 m in u s th e p r o b a b ilit y o f p a y m e n t), th e a v e r a g e w a it in g p e r io d fro m th e d a te o f
s a le to th e d a te o f p a y m e n t, a n d th e a v e r a g e c o lle c tio n c o s t. T h e se d a ta a r e s h o w n in T a b le 2 1 . 6 .
TABLE 21.6 Data relating to Example 21.3

Probability of Probability of Average waiting Average
Decision payment bad debt period (months) ： collection cost ($)
No investigation 0.93 0.07 2 5
F in din g o f investigation:
Low risk 1.00 0 1 2
High risk 0.60 0.40 7 20
New customer 0.80 0.20 3 8
8 To simplify the example it is assumed that there are no costs of additional investment in non-current assets or inventory.
9 To simplify the discussion, we use simple interest— that is, 2 per cent for 1 month, 4 per cent for 2 months, and so on.
To d e te rm in e w h e th e r a c u s to m e r s h o u ld b e g r a n te d c r e d it im m e d ia te ly , re fu s e d c r e d it im m e d ia te ly
o r in v e s tig a te d , th e m a n a g e r n e e d s to c o m p a r e th e co sts o f th e s e a lte rn a tiv e s .
T he c o s t o f g ra n tin g c r e d it is g iv e n b y :
E x p e c te d b a d d e b t c o s t + in v e s tm e n t o p p o r tu n it y c o s t + c o lle c tio n c o s t
= ( p r o b a b ilit y o f b a d d e b t) ( $ 7 0 0 ) + ( 0 . 0 2 x $ 7 0 0 ) ( w a itin g p e r io d ) + c o lle c tio n c o s t
The c o s t o f refusing c r e d it is g iv e n b y :
E x p e c te d v a lu e o f m a r g in a l n e t b e n e fit f o r g o n e = ( p r o b a b ilit y o f p a y m e n t) ( $ 3 0 0 )
U s in g th e s e e q u a tio n s , th e c o s t a t e a c h e n d p o in t o n th e d e c is io n tre e c a n b e c a lc u la te d a s s h o w n
b e lo w .
Grant credit immediately
C o st = (0 .0 7 x $ 7 0 0 ) + (0 .0 2 x $ 7 0 0 x 2) + $ 5 = $ 8 2
Investigate, with the follow ing findings and decisions
L o w r is k / g r a n t : C o s t = (0 x $ 7 0 0 ) + ( 0 . 0 2 x $ 7 0 0 x 1) + $ 2 = $ 1 6
L o w r is k /r e fu s e : C ost = jl x $ 3 〇6| = $ 3 0 0
H ig h r is k / g r a n t : C o s t= ( 0 .4 x $ 7 0 0 ) + (0 .0 2 x $ 7 0 0 x 7) + $ 2 0 = $398
H ig h r is k /r e fu s e : C o s t= ( 0 .6 x $ 3 0 0 ) = $180
N e w c u s t o m e r / g r a n t: C o s t = ( 0 .2 x $ 7 0 0 ) + (0 .0 2 x $ 7 0 0 x 3) + $ 8 = $ 1 9 0
N e w c u s to m e r /re fu s e : C o s t = ( 0 .8 x $ 3 0 0 ) = $240
Refuse credit immediately
C o s t= (0 .9 3 )($ 3 0 0 ) = $ 2 7 9
T hese a m o u n ts a r e s h o w n o n th e d e c is io n tre e in F ig u re 2 1 . 2 . If a n in v e s tig a tio n is u n d e rta k e n ,

th e re is a p r o b a b ilit y o f 0 . 8 0 th a t C o m p a n y B w ill b e fo u n d to b e in th e lo w -ris k c a te g o r y . In th a t
c a s e , th e lo w e r c o s t d e c is io n is to g r a n t c r e d it (s in c e $ 1 6 is less th a n $ 3 0 0 ) . If C o m p a n y B is fo u n d
to b e in th e h ig h -ris k c a t e g o r y ( p r o b a b ilit y 0 . 1 5 ) , th e re q u e s t w ill b e re fu s e d (co st $ 1 8 0 ) . If C o m p a n y
B is fo u n d to b e a n e w c u s to m e r ( p r o b a b ilit y 0 . 0 5 ) , th e re q u e s t w ill b e g r a n te d (c o s t $ 1 9 0 ) . T h e
in v e s tig a tio n its e lf w ill c o s t $ 2 . T h e re fo re , th e to ta l e x p e c te d c o s t o f in v e s tig a tin g th e re q u e s t is:
$ 2 + ( 0 .8 x $ 1 6 ) + ( 0 . 1 5 x $ 1 8 0 ) + ( 0 . 0 5 x $ 1 9 0 ) = $ 5 1 . 3 0
Figure 21.2 Decision tree showing costs of alternative actions for Company A
continued
B usiness finance
continued
F in a lly , c o m p a r in g th e th re e d e c is io n s — g r a n t im m e d ia te ly , re fu s e im m e d ia te ly o r in v e s tig a te — it is
fo u n d t h a t th e lo w e s t-c o s t c h o ic e is to in v e s tig a te th is re q u e s t. T h e e x p e c te d c o s t o f in v e s tig a tin g th e
re q u e s t is $ 5 1 . 3 0 , a s a g a in s t $ 8 2 fo r a n im m e d ia te g r a n tin g o f c r e d it a n d $ 2 7 9 fo r a n im m e d ia te
re fu s a l o f c r e d it. If th e in v e s tig a tio n s h o w s th a t C o m p a n y B is e ith e r a n e x is tin g c u s to m e r in th e lo w -
ris k c a t e g o r y o r a n e w c u s to m e r, th e re q u e s t w ill b e g r a n te d . H o w e v e r, if C o m p a n y B is a n e x is tin g
c u s to m e r in th e h ig h -ris k c a te g o r y , th e re q u e s t w ill b e re fu s e d .
The decision-tree approach discussed in Example 21.3 is appropriate fo r a company th a t relies to a

large extent on inform a tion obtained from experience w ith its own customers. Undoubtedly, this is a
convenient and very useful source o f inform ation. Frequently, however, companies look to other sources
as well. For example, Company A may require Company B to complete a credit application form . Generally,
this form w ill require the applicant to provide the names o f b oth trade and bank referees who can be
contacted to provide info rm a tio n on the applicants credit-worthiness. Larger companies may have a credit
rating assigned by a credit rating agency, such as Fitch Ratings, M oody s Investors Service or Standard
& Poors.10 O ther m ajor sources o f info rm a tio n are credit bureaus such as Dun & Bradstreet. These
bureaus m aintain records o f companies’ financial details, including th e ir record in paying trade debts,
and provide this in fo rm a tio n to interested parties fo r a fee. O ther in fo rm a tio n on the credit-worthiness
o f Company B may be obtained from other businesses w ith which i t has an account. These businesses w ill
have first-hand knowledge o f Company Bs payment record. Company A may also require inform a tion on
the financial condition o f Company B. This is usually obtained from the company s financial statements
and from the completed application form . Company As m ain concern is the short-term liq u id ity position
o f Company B as this provides a measure o f its a b ility to pay. In addition, the value o f Company Bs
unencumbered non-current assets provides some indication o f the degree o f security. The use o f financial
statem ent analysis in credit policy is discussed in Appendix 21.1.
The credit standards th a t a company applies w ill influence the incidence o f bad debts and delinquent
accounts. A company w ill incur v irtu a lly no bad debts i f it applies very high standards, b u t in doing so it
w ill probably have to forgo sales.
2 1 .8 .3 ! Limit of credit extended

Even i f Company B is accepted as a credit-w orthy customer by Company A, i t is usual fo r A to place a
lim it on the m axim um am ount o f credit it is prepared to extend to B. The lim it w ill depend, in part, on
CREDIT P E R IO D the expected value o f Bs purchases from A. However, A may n o t wish to extend to B sufficient credit to
period between the finance the fu ll am ount o f Bs purchases. The most obvious advantage to A o f im posing a credit lim it is
date that a purchaser
that it reduces the m axim um loss th a t A can suffer i f B defaults. The a b ility to set a lim it is particularly
is invoiced and the
date when payment useful w ith new customers. A t first, a relatively low lim it can be set in order to reduce the risk, but, as tim e
is due passes, and the account is satisfactorily maintained, higher lim its can be established. In th is way, business
is n o t lost because o f refusal to grant credit, b ut the risk exposure is n o t excessive.
D IS C O U N T PE R IO D
period during which
a discount for prompt
payment is available 2 1 .8 .4 ! Credit terms
to the purchaser
A company s credit term s specify a credit period, and may also specify a discount period(s) and a discount
D IS C O U N T RATE rate(s). The credit period is the period th a t elapses between the date when the purchasing company is
expression of the price
invoiced and the date when payment is due.11 The discount period is the period th a t elapses between the
reduction a purchaser
date when the purchasing company is invoiced and the date when the discount is forgone. The discount
will receive if payment
is made within the rate expresses, in effect, the price reduction th a t the purchasing company w ill receive i f it pays w ith in
discount period the discount period.
10 See Section 4.7 for a description and examples of such ratings.

11 The statement of account is the regular notification that the selling company sends to its debtors to indicate their current
indebtedness. These statements are normally sent out monthly, often at the end of the month. This practice is important
because the credit period does not commence from the date of sale but rather from the date on the monthly statement.
Debtors can use this to their advantage by purchasing at the beginning of the month and stretching a 30-day credit period
into an almost 60-day credit period.
Typical examples o f credit terms are as follows:
• n/30: There is no discount and the credit period is 30 days. A fte r the expiration o f the credit period,
the purchaser is in default.
• 2/10, n/30: The discount rate is 2 per cent, the discount period is 10 days and the credit period is
30 days. Therefore, i f Company B purchases, on credit, goods w o rth $100 from Company A, and the
purchase is included in its statement o f account dated 31 March, then Company B would have to pay
only $98 i f the account is paid by 10 A p ril. I f it forgoes the discount, Company B is required to pay
$100 by the end o f A pril. A fte r th a t date, Company B would be in default.
• SW/IO, 2y2/30: There are tw o discount periods. A higher discount o f 3Y2 per cent is allowed i f
payment is made w ith in 10 days o f being invoiced, while a discount o f 2 V2 per cent is received i f
payment is made w ith in 30 days. The credit period is also set at 30 days. Therefore, a company w ill
receive a discount fo r paying w ith in the credit period.
A company offers a discount to accelerate its cash in flo w a nd /or to improve its competitive position. If
we consider the credit terms 2/10, n/30, the purchasing company obtains an effective reduction in price
by paying w ith in 10 days. Therefore, a company may obtain a larger share o f the m arket fo r its product
by offering higher discounts than its competitors. Also, the discount w ill encourage the company s credit
customers to pay earlier. In percentage terms, the financial inducement to pay earlier can be quite large.
Referring again to the credit terms 2/10, n/30, consider the position o f Company B on 10 A p ril. To find
a better use fo r its $98, Company B would need to find an investm ent that, w ith zero risk, can tu rn $98
into $100 w ith in 20 days. The annual effective rate o f retu rn required is therefore:
365
V 98/
= 4 4 .6 %
Earlier payments by customers w ill reduce the am ount th a t Company A has tied up in receivables, and
w ill also reduce the incidence o f bad debts and delinquent accounts. In tu rn , this w ill reduce its collection
costs.
Collection policy
A company th a t never has a bad debt almost certainly has a sub-optim al credit policy— th a t is, if a more
lenient policy were adopted, then the increase in sales would more than offset the losses imposed by a LEARNING
OBJECTIVE 9
few bad debts. For m ost companies, some bad debts are inevitable. N otw ithstanding this fact, it is also
Understand the factors
true th a t in most cases some attem pt to collect overdue debts is w orthw hile. These efforts are referred to in implementing a
as the company s collection policy. collection policy
The critical problem in collection policy is the need to recognise when an account warrants special
attention. Obviously it is n o t sensible to in stitu te legal action on a $10 account th a t is 2 days overdue. C O LLEC T IO N P O U C Y
But what i f the account were fo r $10 m illion , rather than $10? Is action warranted i f a $1000 account policy adopted
is 30 days overdue? I f so, w hat action should be taken? There are no hard and fast answers to these by a company in
regard to collecting
questions. However, most businesses adopt a set o f procedures. Generally, attem pts to collect an account
delinquent accounts
that is overdue begin w ith a standard rem inder notice, followed by personal letters and telephone calls. either informally or
Eventually, visits may be made in person. The last resort is legal action, b u t this can be very expensive by the use of a debt
and may involve long delays. An alternative is to employ a debt collection agency, b ut this too can be collection agency
expensive. I t may also sometimes pay a business to accept a p artial payment, rather than continue w ith
attempts to collect the fu ll am ount owed.
As the am ount spent on collection activities increases, i t is to be expected th a t bad debt losses w ill be
reduced and the average collection period w ill be shorter. However, these relationships are unlikely to be
linear. For example, an in itia l small level o f expenditure is unlikely to have any marked effect in reducing
bad debts, or in shortening the average collection period, while additional expenditures are likely to have
a much greater effect. However, beyond a certain level o f collection expenditure the benefits w ill dim inish
u n til eventually a saturation p o in t is reached. The relationship between the average collection period and
the level o f collection expenditures is likely to be similar.
B usiness finance
Collection policy involves a trade-off between the costs o f collection and the benefits o f lower bad debt
losses and a shorter average collection period, which in tu rn w ill result in a reduction in the company s
investm ent in accounts receivable. Comparing these costs and benefits to determ ine a preferred policy is
likely to involve considerable judgm ent. Also, in determ ining a collection policy, it is im p o rta n t to take
account o f the effect o f the collection policy on sales, as a more forceful collection procedure may adversely
affect sales. For example, i f collection procedures are begun too early, customers may be offended and
switch to alternative suppliers.
21.10 Evaluation of alternative credit and

LEARNING
collection policies
OBJECTIVE 10
The net present value (NPV) m ethod o f evaluating investm ent projects was discussed in Chapters 5
Apply the net present
value method to and 6. The investm ent projects analysed in those chapters related to investments in non-current assets,
evaluate alternative such as property, plant and equipment. However, in principle, the NPV m ethod is appropriate fo r other
credit and collection types o f investm ent, including investm ent in accounts receivable. In this section, we consider the
policies application o f the NPV m ethod to a company’s credit and collection policies.
The benefits associated w ith a change in credit policy can be measured by the net increase in sales
revenue, w hile the costs w ill include m anufacturing, selling, collection and adm inistration expenses, and
bad debts. In addition, by discounting the net cash flows generated by the credit policy at the cost of
capital, the analysis w ill incorporate the cost to the company o f having funds tied up in receivables.12 If
all the benefits and costs associated w ith a particular credit policy are quantified and expressed in present
value terms, the particular credit policy under consideration w ill be profitable if the net present value
is positive. The company s optim um credit policy is the one th a t results in the largest net present value.
The application o f NPV analysis to the evaluation o f alternative policies is outlined in the follow ing
examples. We begin w ith a highly sim plified in Example 21.4, and introduce additional factors relevant
to the decision in subsequent Examples 21.5-21.9. The examples are intended m ainly to illustrate the
factors th a t could influence the p ro fita b ility o f a credit policy. In practice, many companies adopt credit
policies th a t are sim ilar to those followed by others in the same industry. However, i f sufficient data are
available to estimate the effects o f changes in the terms offered, and competitive conditions suggest that
changes may be feasible, then a credit manager could use the approach embodied in these examples to
assess whether it is desirable to m odify the present policy.
Example 21.4
Z e lc o Ltd, w h ic h c u rre n tly d o e s n o t o ffe r c r e d it, is c o n s id e r in g e x te n d in g c r e d it to its c u s to m e rs f o r a
p e r io d o f 6 0 d a y s . T h is is a s s u m e d to re s u lt in a n in c re a s e in s a le s re v e n u e o f $ 2 0 0 0 0 . T he a d d itio n a l
c o s t a s s o c ia te d w ith th e se s a le s is $ 1 6 0 0 0 . In itia lly , it is a s s u m e d th a t Z e lc o ’s e x is tin g c a s h c u s to m e rs
w ill n o t s e e k c r e d it if th e p r o p o s e d c r e d it p o lic y is in tr o d u c e d . It is a ls o a s s u m e d th a t th e re a r e n o b a d
d e b ts , a d m in is tr a tio n co sts o r c o lle c tio n c o sts a n d th a t a ll c r e d it c u s to m e rs w ill ta k e fu ll a d v a n ta g e
o f th e c r e d it te rm s b y d e la y in g p a y m e n t u n til th e 6 0 t h d a y . 13 Z e lc o 's c o s t o f c a p it a l is 2 p e r c e n t p e r
m o n th .14 W h a t is th e N P V o f e x te n d in g c r e d it to c u s to m e rs ?
12 The required rate of return depends on the risk class of credit customers. In addition, the analysis should take into account
the costs of financing any additional inventory or non-current assets that the company requires to support a higher level of
operations. In the subsequent examples it will be assumed that these costs have been included in the costs associated with
the sale. However, in practice, these costs will only include accounting costs, such as the cost of the goods sold and delivery
charges. Therefore, it is usually necessary to impute a figure so as to include the cost of the additional funds invested in
inventory and non-current assets.
13 In t±iis and subsequent examples, it is assumed for simplicity that the credit period and the discount period extend from the
date of purchase, rather than from the date on the monthly statement.
14 In accordance with business practice, the length of the credit period is referred to in terms of days. However, to make the
present value calculations less cumbersome, monthly discounting is used. It is assumed that 1 month equals 30 days and, to
ease the exposition, the phrase at the end of the month* will be stated more simply as at month, since all cash flows in these
examples are assumed to occur at the end of the month.
SOLUTION
G iv e n th e s e a s s u m p tio n s , th e in v e s tm e n t o p p o r tu n it y b e in g c o n s id e r e d b y Z e lc o c o n s is ts o f a n in itia l
o u tla y o f $ 1 6 0 0 0 a t tim e z e r o , a n d a c a s h in flo w o f $ 2 0 0 0 0 a t th e e n d o f M o n th 2 . W it h a c o s t o f
c a p ita l o f 2 p e r c e n t p e r m o n th , th e N P V o f th e p r o p o s e d p o lic y is:
N PV = $ 2 ° 0 0 0 - $ 1 6 0 0 0
( 1. 02)2
=$3223.38
S in c e th e N P V is p o s itiv e , th e p r o p o s e d c r e d it p o lic y is p r o fita b le .
The credit policy proposed in Example 21.4 did n ot offer discounts fo r payments received before the
expiration o f the credit period. This possibility is shown in Example 21.5.
E xample
S u p p o s e th a t th e a s s u m p tio n s m a d e in E x a m p le 2 1 . 4 a r e r e ta in e d , e x c e p t th a t Z e lc o n o w o ffe rs a
d is c o u n t o f 2V2 p e r c e n t f o r p a y m e n ts re c e iv e d w ith in 3 0 d a y s — th a t is, th e p r o p o s e d c r e d it te rm s a re
2 V 2 / 3 0 , n / 6 0 . It is e s tim a te d th a t 7 5 p e r c e n t o f c r e d it c u s to m e rs w ill ta k e a d v a n ta g e o f th e d is c o u n t.
W h a t is th e N P V o f e x te n d in g c r e d it o n th e s e re v is e d te rm s?
SOLUTION
A s in E x a m p le 2 1 . 4 , th e in it ia l o u t la y is $ 1 6 0 0 0 . T h e c a s h in flo w a t M o n th 1 is (1 - 0 . 0 2 5 ) x 0 . 7 5
x $ 2 0 0 0 0 = $ 1 4 6 2 5 a n d th e c a s h in flo w a t M o n th 2 is 0 . 2 5 x $ 2 0 0 0 0 = $ 5 0 0 0 . T he N P V o f th e
p ro p o s e d p o lic y is th e re fo re :
N P V = iI^ + l ^ -$ 1 6 0 0 0
1.02 ( 1. 02)2
= $ 3 1 4 4 .0 8
T he N P V o f th is p o lic y is p o s itiv e a n d it is th e re fo re p r e fe r r e d to th e c u rre n t p o lic y o f n o t o ffe r in g

c r e d it a t a ll. H o w e v e r, th e N P V o f th is p o lic y is less th a n th e N P V o f a c r e d it p o lic y th a t o ffe rs n o
d is c o u n t fo r e a r ly p a y m e n t. T h is in d ic a te s th a t Z e lc o s h o u ld n o t o ffe r th e d is c o u n t a s s u m e d in th e
e x a m p le .
Example 21.5 did n o t allow fo r the possibility th a t the offer o f a discount could well attract even more
new customers to Zelco. Because a discount amounts to a reduction in price, i t is possible that demand
would increase. The increased demand could be sufficient to ju s tify offering the discount. This is shown
in Example 21.6.
E xample 21.6
It is n o w a s s u m e d th a t, a s w e ll as th e a d d itio n a l s a le s o f $ 2 0 0 0 0 a s s u m e d in E x a m p le s 2 1 . 4 a n d
2 1 . 5 , fu rth e r s a le s o f $ 4 0 0 0 (a t a c o s t o f $ 3 2 0 0 ) a r e m a d e to c u s to m e rs , a ll o f w h o m ta k e a d v a n ta g e
o f th e 2 p e r c e n t d is c o u n t. W h a t is th e e ffe c t o f th e a d d it io n a l s a le s o n th e N P V o f e x te n d in g c re d it?
continued
continued
SOLUTION
T he in it ia l o u tla y is n o w $ 1 6 0 0 0 + $ 3 2 0 0 = $ 1 9 2 0 0 . T h e c a s h in flo w a t M o n th 1 is $ 1 4 6 2 5 +
((1 - 0 . 0 2 5 ) x $ 4 0 0 0 ) = $ 1 8 5 2 5 a n d th e c a s h in flo w a t M o n th 2 re m a in s a t $ 5 0 0 0 . T he N P V o f
th e p r o p o s e d p o lic y is th e re fo re :
除 $ 1 8 5 2 5 + $5000
-$ 1 9 2 0 0
1.02 ( 1.02)2
= $ 3 7 6 7 .6 1
S in c e th e N P V is p o s itiv e , a n d e x c e e d s th e N P V c a lc u la te d in E x a m p le 2 1 . 6 , th e p r o p o s e d p o lic y
t h a t o ffe rs a 2 p e r c e n t d is c o u n t f o r p a y m e n t re c e iv e d w ith in 3 0 d a y s is p r e fe r a b le to a p o lic y th a t
o ffe rs n o d is c o u n t f o r e a r ly p a y m e n t.
To summarise the position so far, the in itia l outlay is $19200, the cash in flo w at M o n th 1 is $18525
and the cash inflo w at M on th 2 is $5000. Bad debts and delinquent accounts have so fa r been ignored. The
effect o f bad debts and delinquent accounts is illustrated in Example 21.7.
E xample 21.7
It is n o w a s s u m e d th a t th e o ffe r o f a d is c o u n t w ill still re s u lt in a c a s h in flo w o f $1 8 5 2 5 a t M o n th 1 ;
b u t o f th e r e m a in in g $ 5 0 0 0 o w in g , $ 3 0 0 0 w ill b e p a id o n tim e (a t M o n th 2), $ 1 0 0 0 w ill b e p a id
la te (a t M o n th 3 ), $ 4 0 0 w ill b e p a id still la te r (a t M o n th 4 ) a n d $ 6 0 0 w ill n e v e r b e p a i d — th a t is, b a d
d e b ts w ill a m o u n t to u n p a id a c c o u n ts o f $ 6 0 0 . W h a t w ill b e th e e ffe c t o f b a d d e b ts a n d d e lin q u e n t
a c c o u n ts o n th e N P V o f e x te n d in g c re d it?
SOLUTION
B a s e d o n th e a b o v e a s s u m p tio n s , th e N P V is:
NPV = $18 525 + $3000 + $ 1000 + $4〇° -$19200

1.02 ( 1. 02)2 ( 1. 02)3 ( 1. 02)4
=$3157.13
S in c e th e N P V is p o s itiv e , th e p r o p o s e d c r e d it p o lic y is still a n a c c e p ta b le in v e s tm e n t.
The costs o f adm inistration and collection s till have to be included in the analysis. A large proportion
o f these costs do n o t depend on the value o f the account. For example, the clerical cost o f producing and
sending a tax invoice fo r a customer who owes $200 is n o t likely to be different from the cost incurred fo r
a customer who owes $10000. A t the level o f the individual account, the to ta l am ount spent in an effort
to collect the am ount owing w ill increase, the longer the account remains unpaid. However, taking the
company s m on thly spending on collection procedures fo r all accounts th a t have been granted credit at a
given p o in t in tim e, the am ount spent each m onth on collection is likely to decrease as tim e passes. For
example, suppose th a t 10 accounts are overdue and the company spends $2 per account to send a first
rem inder notice. Expenditure on collection procedures fo r th a t m onth is therefore $20. If, in the next
m onth, seven o f these accounts have been paid, there are three rem aining unpaid accounts to be sent a
second rem inder notice at a to ta l cost o f $6. Expenditure on collection has therefore fallen from $20 to
$6. The extent o f this decrease may be lessened by the fact th a t later stages o f the collection procedure
may be more expensive on a per account, basis. For example, a personal le tte r uses more staff tim e and
therefore imposes more costs than sending a standard rem inder notice. A d m in istra tio n and collection
costs are illustrated in Example 21.8.
Example 21.8
Zelco estimates administration costs to be $200 at Month 0 ; $100 at Month 1 and $150 at Month 2.
6
Collection costs are estimated to be $70 at Month 3 and $40 at Month 4. W hat is the NPV after
allowing for administration and collection costs?
SOLUTION
After including administration and collection costs, the initial outlay is therefore $ 1 9 2 0 0 + $200 =
$19400, and the net cash flows in the following months are $1 8525 - $100 = $1 8 4 25; $3000 -
$150 = $2850; $1000 - $70 = $930 and $400 - $40 = $360.
$18425 $2850 $930 $360

------------- + -----------^ + --------- - + ----------- - $ 1 9 4 0 0
1.02 ( 1. 02 卩 ( 1. 02)3 ( 1. 02)4
$ 2 6 1 2 .0 0
Since the NPV is positive, the proposed credit policy is still an acceptable investment.
So far it has been assumed th a t Zelcos existing customers, all o f whom pay cash, w ill n o t also demand
that they be granted credit. W hile many existing customers would no doubt continue to pay cash, i t is
inevitable th a t some would now seek to obtain credit. I f these customers are credit-w orthy, a refusal o f
credit could well be offensive and may therefore result in lost sales. Some existing cash-paying customers
would therefore become credit customers and this would impose fu rth e r costs on Zelco. This is illustrated
in Example 21.9.
Example 21.9
It is now assumed that existing customers switch $ 1500 0 worth of business from a cash basis to a
credit basis. W hat is the effect of this change on the NPV of extending credit?
SOLUTION
Table 21.7 shows the estimated changes to Zelco's cash flows.15
TABLE 21.7 Cash flow effects of existing cash customers switching to credit
Accounts paid Discount Administration cost Collection cost Total
Month ($) ($> ($) ($> ($)
0 — — -140 — -140
1 10000 -250 -50 — 9 700
2 4000 — -150 — 3850
3 500 — — -30 470
4 200 — — -30 170
The present value of the cash flows is as follows:
DV/ $9700 $3850 $470 $170

1.02 ( 1. 02)2 ( 1. 02) J ( 1. 02)4
= $ 1 3 6 7 0 .2 5
continued
15 Note that there is no entry in Table 21.7 to show the costs of manufacturing the goods. Such costs are not incremental, since
they are incurred regardless of whether the sale is for credit or cash.
B usiness finance
continued
T he c o r r e s p o n d in g c a s h s a le s to ta lle d $ 1 5 0 0 0 , so , in p re s e n t v a lu e te rm s , th e in c re a s e d c o s t
im p o s e d b y th e n e e d to g r a n t c r e d it to c u s to m e rs w h o c u r r e n tly p a y c a s h is $ 1 5 0 0 0 - $ 1 3 6 7 0 . 2 5
= $ 1 3 2 9 . 7 5 . T h e N P V o f th e p r o p o s e d c r e d it p o lic y is r e d u c e d b y th is a m o u n t. T h e f in a l e s tim a te o f
th e N P V is th e re fo re $ 2 6 1 2 . 0 0 - $ 1 3 2 9 . 7 5 = $ 1 2 8 2 . 2 5 .
We have now examined a num ber o f components o f credit and collection policies and decided th a t each
should be set w ith the aim o f m axim ising the net present value resulting from the company s investm ent
in accounts receivable. The above examples show that, other things being equal, the net present value w ill
be lower i f customers accept discounts offered fo r early payment and i f customers pay late, or fa il to pay
at all fo r credit purchases. Net present value w ill also be lowered by collection costs and by cash customers
transferring to credit. The credit managers job is to ensure th a t other things are n o t equal— th a t is,
the company s policies should be designed so th a t the costs o f extending credit are outweighed by the
benefits.
SUMMARY
M SA3H 3NO-A1N3M1
• A c o m p a n y ’s liq u id re s o u rc e s c o m p r is e c a s h a n d s e rv ic e s in th e n o r m a l c o u rs e o f b u s in e s s . A c c o u n ts
s h o rt-te rm in v e s tm e n ts . re c e iv a b le a ris e b e c a u s e a c o m p a n y o ffe rs c r e d it to
• L iq u id ity m a n a g e m e n t re fe rs to d e c is io n s m a d e b y c u s to m e rs in o r d e r to b e n e fit fro m in c re a s e d s ales.
m a n a g e m e n t a b o u t th e c o m p o s itio n a n d le v e l o f a T he co sts o f o ffe r in g c r e d it in c lu d e th e o p p o r tu n ity
c o m p a n y ’s liq u id re s o u rc e s . c o s t o f fu n d s tie d u p in a c c o u n ts r e c e iv a b le , th e costs
• If to o little is h e ld in liq u id fo rm , a c o m p a n y m a y o f b a d d e b ts a n d d e lin q u e n t (s lo w -p a y in g ) a c c o u n ts
s o m e tim e s b e u n a b le to m e e t its c o m m itm e n ts . a n d a d d it io n a l a d m in is tr a tio n co sts.
• If to o m u c h is h e ld in liq u id fo rm , a c o m p a n y ’s D e c is io n s c o n c e r n in g m anagem ent of a c c o u n ts
ra te o f re tu rn m a y b e c o m e u n a c c e p ta b ly lo w . r e c e iv a b le in v o lv e c r e d it a n d c o lle c tio n p o lic ie s .
• T re a s u ry m a n a g e m e n t in c lu d e s liq u id it y m a n a g e m e n t G iv e n th a t c r e d it is to be o ffe r e d , c r e d it p o lic y
to g e th e r w ith d e c is io n s about th e c o m p a n y ’s e n c o m p a s s e s s e le c tio n o f c r e d it- w o r th y c u s to m e rs ,
e x p o s u re to v a r io u s k in d s o f f in a n c ia l ris k (fo re ig n a n d d e te r m in in g c r e d it lim its a n d c r e d it te rm s.
e x c h a n g e a n d in te re s t ra te risk). • W h e r e a c o m p a n y h a s a d e q u a te d a ta o b ta in e d
• A lth o u g h m o tiv e s fo r h o ld in g liq u id asse ts in c lu d e a : fro m e x p e r ie n c e w ith its c u s to m e rs , d e c is io n
• tra n s a c tio n s m o tiv e tre e s m ay be u s e fu l in d e c id in g w h e th e r to
• p r e c a u tio n a r y m o tiv e a c c e p t, re fu s e o r in v e s tig a te p a r tic u la r re q u e s ts
H JLdvHu
• s p e c u la tiv e m o tiv e f o r c r e d it.

th e c h a p t e r c o n s id e r s o n ly th e firs t o f th e s e in a n y • A c o m p a n y 's c r e d it te rm s s p e c ify a c r e d it p e r io d
d e ta il. and m ay a ls o s p e c ify a d is c o u n t fo r e a r ly
pq • In p r a c tic e , a m a jo r to o l o f liq u id ity m a n a g e m e n t p a y m e n t. If c u s to m e rs r e s p o n d b y m a k in g e a r lie r
is th e c a s h b u d g e t. T h is sets o u t a fo re c a s t o f a p a y m e n ts , th e a m o u n t tie d u p in r e c e iv a b le s w ill
c o m p a n y 's c a s h re c e ip ts a n d c a s h p a y m e n ts . A c tio n b e r e d u c e d , a s w ill c o lle c tio n co sts.
c a n th e n b e p la n n e d to e lim in a te a n y fu tu re ca sh C o lle c tio n p o lic y in v o lv e s a tr a d e - o ff b e tw e e n
s h o rta g e o r to use a n y c a s h s u rp lu s th a t is fo re c a s t th e a m o u n t s p e n t o n c o lle c tio n a c tiv itie s (s e n d in g
to o c c u r. r e m in d e r n o tic e s a n d le tte rs , le g a l a c tio n , a n d so o n )
• In s e le c tin g liq u id a sse ts, a f in a n c ia l m a n a g e r ha s a n d th e b e n e fits o f a r e d u c tio n in b a d d e b t losses
a w id e r a n g e to c h o o s e fro m , in c lu d in g d e p o s its o f a n d a s h o rte r c o lle c tio n p e r io d .
fu n d s w ith f in a n c ia l in s titu tio n s , a n d d is c o u n tin g o f • In s e e k in g an o p tim a l c o lle c tio n p o lic y , th e
c o m m e r c ia l b ills . E a ch o ffe rs a d iffe r e n t c o m b in a tio n e ffe c ts o f a lte r n a tiv e p o lic ie s o n sa le s s h o u ld b e
o f te rm , m a r k e ta b ilit y a n d d e fa u lt ris k . T he fin a n c ia l c o n s id e r e d .
m a n a g e r fa c e s th e d iff ic u lt ta s k o f c h o o s in g a m ix (o r T h e n e t p re s e n t v a lu e m e th o d c a n b e u se d to h ig h lig h t
p o r tfo lio ) th a t is s u ita b le f o r th e c o m p a n y . th e fa c to rs th a t w ill in flu e n c e th e p r o f it a b ilit y o f a
• A c c o u n ts r e c e iv a b le a 「
6 m o n ie s o w e d to a c o m p a n y c o m p a n y 's c r e d it a n d c o lle c tio n p o lic ie s .
o r o th e r b u s in e s s fro m th e s a le , o n c r e d it, o f g o o d s o r
686
OHAPTEH TWENTY-ONE REVIEW

KEY TERMS
a c c o u n ts re c e iv a b le 675 d is c o u n t p e r io d 680
b a d d e b ts 676 d is c o u n t ra te 680
cash b u d g e t 670 liq u id assets 667
c o lle c tio n p o lic y 681 liq u id ity m a n a g e m e n t 667
c o n s u m e r c r e d it 676 open account 676
c re d it p e rio d 680 tr a d e c r e d it 675
c re d it p o lic y 677 tre a s u ry m a n a g e m e n t 668
d e lin q u e n t a c c o u n ts 676
SELF-TEST PROBLEMS
1 W a r n e r Ltd sells o n te rm s o f 2 / 7 , n / 3 0 . C u s to m e r X b u y s g o o d s fro m W a r n e r w ith a n in v o ic e to ta l o f
$1500.
a) If X p a y s 7 d a y s a fte r th e in v o ic e d a te , w h a t d is c o u n t c a n he d e d u c t fro m th e b ill?
b) W h a t e ffe c tiv e a n n u a l in te re s t ra te is im p lic it in th e te rm s o ffe re d ?
2 A n g e lin e Ltd h a s u n til re c e n tly s o ld its p ro d u c ts o n te rm s o f n / 3 0 , a n d th e a v e r a g e c o lle c tio n p e r io d h a s

b e e n 4 5 d a y s . In a n a tte m p t to s h o rte n th e c o lle c tio n p e r io d , it h a s c h a n g e d th e te rm s to 1 / 1 0 , n / 3 0 .
It h a s b e e n fo u n d th a t 7 0 p e r c e n t o f c u s to m e rs p a y w ith in 1 0 d a y s a n d c la im th e d is c o u n t. T h e o th e r
3 0 p e r c e n t p a y , o n a v e r a g e , a fte r 5 0 d a y s . T h e re h a s b e e n n o c h a n g e in s a le s v o lu m e a n d th e r e q u ire d
ra te o f re tu rn is 1 0 p e r c e n t p e r a n n u m . T h e c o s t o f g o o d s s o ld is 7 5 p e r c e n t o f s a le s a n d th e re a r e n o
d e fa u lts . H a s th e c h a n g e in te rm s b e e n p r o fita b le ?
t y QUESTIONS
1 [L O 1 ] W h a t a r e l i q u i d a s s e ts '?
2 [LO 2 ]For most A ustralian com panies, cash is a ve ry sm all p ro p o rtio n o f total assets, a n d therefore cash
m anagem ent is unim portant. D iscu ss th is s ta te m e n t.
3 [L O 3 ] E x p la in th e co sts a n d b e n e fits o f h o ld in g liq u id asse ts.
4 [L O 3：Liquidity risk is m ore im p o rta n t than return risk in the choice betw een alternative short-term
investments. D iscuss.
5 [L O 5 ] A c o m p a n y h a s $1 m illio n in id le fu n d s a n d it is e s tim a te d th a t th e s e w ill b e a v a ila b le f o r in v e s tm e n t
fo r a p p r o x im a t e ly 2 m o n th s . T he tre a s u re r is c o n s id e r in g th e f o llo w in g in v e s tm e n ts :
a) p u rc h a s in g a 1-m o n th b a n k c e rtific a te o f d e p o s it
b) lo d g in g a fix e d d e p o s it w ith a b a n k
c) p u rc h a s in g c o m m e rc ia l b ills .
D iscuss th e a d v a n ta g e s a n d d is a d v a n ta g e s o f e a c h in v e s tm e n t.
6 [L O 5 ] Y ou a r e th e tre a s u re r o f a c o m p a n y th a t h a s $1 m illio n in id le fu n d s to in v e s t f o r a p e r io d o f 9 0 d a y s .
List th e a v a ila b le s h o rt-te rm in v e s tm e n ts a n d o b t a in c u rre n t in te re s t ra te s fro m th e f in a n c ia l p re s s . P re p a re a
r e p o r t a n d r e c o m m e n d e d a c tio n f o r c o n s id e r a tio n b y th e B o a rd o f D ire c to rs , p o in tin g o u t th e re tu rn (s) a n d
risk(s) in v o lv e d .
7 [L O 6 ] There is no diffe re n ce i f a c o m p a n y offers c re d it to customers that are individuals o r to other
businesses, they are still o w e d m oney b y their customers. D iscuss.
8 [L O 7, 8 ] D iscuss th e re a s o n s fo r a c o m p a n y o ffe r in g c r e d it te rm s to its c u s to m e rs .
9 [L O 8 ]
a) A c o m p a n y o ffe rs c r e d it te rm s o f 1 / 7 , n / 3 0 . E x p la in th e m e a n in g o f th e se te rm s.
b) W h a t e ffe c tiv e a n n u a l in te re s t ra te is im p lic it in th is o ffe r?

10 [ L 0 8 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f o ffe r in g a d is c o u n t f o r e a r ly p a y m e n t?
n [ L 0 9 ] W h a t a r e th e a d v a n ta g e s a n d d is a d v a n ta g e s o f a n a g g r e s s iv e c o lle c tio n p o lic y ?
CA PROBLEMS
1 Preparing a cash budget [LO 4]
In la te Ju n e o f e a c h y e a r, D u r a n g o Ltd p re p a re s a c a sh b u d g e t fo r th e n e x t 6 m o n th s. T he c o m p a n y h a s a
p o lic y o f m a in ta in in g a c a sh b a la n c e a t th e b e g in n in g o f e a c h m o n th e q u a l to th e d iffe re n c e b e tw e e n th e
e s tim a te d c a sh in flo w s a n d p a y m e n ts fo r th e m o n th , p lus a s a fe ty m a rg in o f $ 4 0 0 0 .
A c tu a l sales f o r M a y a n d e s tim a te d sales fo r Ju n e a n d fo r th e n e x t 7 m o n th s a r e a s fo llo w s :
May $20000 October $94000

June $28000 November $74000
July $24000 December $52000
August $26000 January $40000
September $50000
A p p r o x im a te ly 2 5 p e r c e n t o f th e sales a re fo r c a s h a n d 7 5 p e r c e n t a re o n c re d it. E x p e rie n c e h a s s h o w n th a t

tw o -th ird s o f a ll c r e d it sales a re c o lle c te d in th e m o n th fo llo w in g sa le , a n d th e r e m a in in g o n e -th ird in th e s e c o n d
m o n th fo llo w in g sa le . N o d is c o u n ts a re g iv e n .
D u ra n g o fo llo w s a p o lic y o f b a s in g its p u rc h a s e s o n e s tim a te d sales. P urch ase s a re e q u a l to 7 0 p e r c e n t o f th e

fo llo w in g m o n th 's e s tim a te d sales. T he p o lic y o f th e c o m p a n y is to e n s u re th a t th e g o o d s n e e d e d in e a c h m o n th
a re a c q u ir e d in th e p r e c e d in g m o n th . D u ra n g o 's s u p p lie rs p e rm it it to ta k e a 2 p e r c e n t d is c o u n t if th e g o o d s
a re p a id f o r w ith in th e firs t 1 0 d a y s o f th e m o n th fo llo w in g p u rc h a s e . A ll g o o d s m ust b e p a id f o r b y th e e n d o f
th e m o n th f o llo w in g p u rc h a s e .
O th e r p a y m e n ts a re e x p e c te d to b e :
July $7 400 October $11000

August $7 450 November $7800
September $9100 December $7150
A t th e b e g in n in g o f July, th e c o m p a n y is e x p e c te d to h a v e $ 8 4 0 0 in its b a n k a c c o u n t.
P re p a re a m o n th ly c a s h b u d g e t f o r D u r a n g o Ltd f o r th e 6 m o n th s e n d e d 3 1 D e c e m b e r. W ill a n y o u ts id e fu n d s
b e re q u ire d ? If so, h o w m u ch ?
2 Selection of credi卜 w orthy customers [LO 10 】

H a y w o r th Ltd uses a d e c is io n -tre e a p p r o a c h fo r s c re e n in g c r e d it a p p lic a n ts . G a b le s Ltd h a s s o u g h t c r e d it fo r
th e p u rc h a s e o f 1 0 0 0 u n its p r ic e d a t $ 1 6 e a c h . T he m a r g in a l c o s t o f p r o d u c in g e a c h u n it is $ 1 2 . B a s e d o n
its p a s t e x p e rie n c e , H a y w o r th e s tim a te s th a t th e re is a 7 0 p e r c e n t c h a n c e th a t G a b le s fa lls in to th e lo w -ris k
c a te g o ry , a 2 0 p e r c e n t c h a n c e th a t it is h ig h risk a n d a 1 0 p e r c e n t c h a n c e th a t it is a n e w c u s to m e r. The
ta b le a b o v e s u m m a ris e s o th e r d a ta e s tim a te d b y H a y w o r th 's c r e d it d e p a rtm e n t.
D e c is io n P r o b a b ility o f P r o b a b ility o f b a d A v e r a g e w a it in g A v e r a g e c o lle c tio n

paym ent debt p e r io d (m o n th s) c o s t ($)
No investigation 0.92 0.08 2 93
Finding of
investigation:
Low risk 1.00 0 1 10
High risk 0.70 0.30 5 400
New customer 0.80 0.20 3 60
CHAPTER TWENTY-ONE REVIEW

T he c o s t o f c o n d u c tin g a n in v e s tig a tio n is $ 2 . H a y w o r th e s tim a te s th e o p p o r tu n ity c o s t o f c a p ita l to b e 2 p e r
c e n t p e r m o n th . W h a t d e c is io n s h o u ld H a y w o r th m a ke ?
3 Evaluation of alternative credit terms [LO 10]

C o m p a n y A a t p re s e n t sells o n ly o n a c a sh b a s is a n d it a v e ra g e s $ 5 0 0 0 0 o f sa le s p e r m o n th , w ith a s s o c ia te d
e x p e n s e s o f $ 4 0 0 0 0 . It is th o u g h t th a t a ll cu s to m e rs w o u ld a c c e p t a n o ffe r o f 9 0 - d a y fre e c r e d it te rm s a n d th a t
th e c o m p a n y 's m o n th ly s a le s w o u ld in c re a s e to $ 5 5 0 0 0 a n d its a s s o c ia te d e x p e n s e s to $ 4 4 0 0 0 . C o m p a n y
A ’s re q u ire d ra te o f re tu rn is 1 p e r c e n t p e r m o n th .
a) A s s u m in g th a t th e re a r e n o costs a s s o c ia te d w ith p r o v id in g c re d it, w ill C o m p a n y A b e n e fit fro m o ffe rin g

such c r e d it term s?
b) If e x p e n s e s re m a in a t 8 0 p e r c e n t o f sa le s, w h a t w o u ld th e in c re a s e in sa le s n e e d to b e in o r d e r to ju s tify
th e p ro v is io n o f th e se c r e d it term s?
4 Evaluation of alternative credit and collection policies [LO 10】

E ach m o n th , J u m b o Pty Ltd sells 1 0 0 0 0 units a t $ 2 5 p e r u n it. T he m a r g in a l c o s t o f p r o d u c in g e a c h u n it is
$ 1 5 . A t p re s e n t a ll o f J u m b o ’s sales a re m a d e o n a s tric t 'c a s h o n ly ' b a s is . J u m b o ’s m a n a g e r b e lie v e s th a t
th e 'c a s h o n ly ' p o lic y h a s le d to m a n y sales b e in g lo s t a s th e re h a v e b e e n a n u m b e r o f e n q u irie s c o n c e r n in g
th e p o s s ib ility o f c r e d it sa le s. J u m b o 's m a n a g e r e s tim a te s th a t a c r e d it p o lic y o f 1 / 3 0 , n / 6 0 c o u ld in c re a s e
sales b y 1 0 0 0 un its p e r m o n th , o f w h ic h 5 0 0 w o u ld b e p a id f o r a t th e e n d o f M o n th 1 a n d 4 0 0 w o u ld b e
p a id fo r a t th e e n d o f M o n th 2 . O f th e re m a in in g 1 0 0 un its, 7 0 a re e x p e c te d to b e p a id fo r a m o n th la te a n d
3 0 a re e x p e c te d to b e b a d d e b ts . A d m in is tr a tio n a n d c o lle c tio n costs a re e s tim a te d to b e $ 2 5 0 (M o n th 0 ),
$ 1 0 0 (M o n th 1), $ 1 0 0 (M o n th 2 ) a n d $ 1 5 0 (M o n th 3 ). H o w e v e r, it is e x p e c te d th a t s o m e e x is tin g c u sto m e rs
w ill a ls o seek c r e d it in o r d e r to o b ta in th e d is c o u n t o ffe re d . T h is is lik e ly to a ffe c t th e s a le o f 6 0 0 u n its. B uye rs
o f th e re m a in in g 9 4 0 0 u n its a r e e x p e c te d to c o n tin u e to p a y c a s h . A d m in is tr a tio n costs a re e s tim a te d to b e
$ 1 5 0 (M o n th 0 ) a n d $ 6 0 (M o n th 1 j. J u m b o ’s r e q u ire d ra te o f re tu rn is 1 .5 p e r c e n t p e r m o n th . S h o u ld J u m b o
a d o p t th e p ro p o s e d c r e d it a rra n g e m e n ts ?
REFERENCES
Bruce R., McKern, B., Pollard, I. & Skully, M . (eds), M ian, S.L. & Smith C .W . Jr, 'Accounts receivable
Handbook of Australian Corporate Finance, 5th edn; management policy: theory and evidence', Journal of
Butterworths, Sydney, 1997. Finance, M arch 1992, pp. 1 6 9 -2 0 0 .
Gallinger, G .W . & Healey, P.B., Liquidity Analysis and -------, ------- , 'Extending trade credit and financing7, Journal
Management, Addison-Wesley, Reading, Massachusetts, of Applied Corporate Finance, Spring 1994, pp. 7 5 -8 4 .
1987. N g, C.K., Smith, J.K. & Smith, R.L., 'Evidence on the
Keynes, J.M., The General Theory of Employment Interest determinants o f credit terms used in interfirm trade7, Journal
and Money, Harcourt Brace & W orld, N e w York, 1936. of Finance, June 1999, pp. 1 1 0 9 -2 9 .
Lundholm, R. & Sloan, R.; Equity Valuation and Analysis, 2nd
edn. M cG raw-Hill. N ew York. 2 0 0 6 .
689
Financial statement analysis
Introduction
In the chapters on short-term asset management, no specific reference has been made to the analysis o f
financial statements, which is frequently used by financial managers in short-term asset management.
Analysis o f financial statements involves the calculation o f financial ratios using the data in the
LEARNING statem ent o f financial performance (income statement) and the statem ent o f financial position.
OBJECTIVE 11 Financial managers frequently examine the values o f certain 'key* ratios as a way o f m o n itoring a
Apply financial company s management o f short-term assets and liabilities. In this appendix, some o f the more
statement analysis frequently used financial ratios are defined, th e ir application examined and th e ir usefulness fo r short
to short-term asset
term asset management discussed.16
management
Measurement and interpretation of several financial ratios

First we define and calculate a number o f financial ratios, using the financial statements o f Harvey
Norm an Holdings Lim ited, shown in Tables A21.1 and A21.2.
Table A 2 1 .1 Harvey Norman Holdings Limited: income statement for the year
ended 30 June 2013
C o n s o lid a te d
“：二 :：心：：丨 ^
2 0 1 3 ( $ '0 0 0 ) 2 0 1 2 ( $ ,0 0 0 )
......... ......... :
Sales revenue 1323481 1407342
Cost of sales (944229) (1025 359)
Gross p rofit 379252 381983
Other revenues 1035 551 1061233
Distribution expenses (11047) (10869)
Marketing expenses (341460) (355456)
Occupancy expenses (286423) (242986)
Administrative expenses (393 236) (404228)
Finance costs (45 774) (49455)
Other expenses from ordinary activities (177236) (164050)
Share of net profit of associates, joint venture entities

and partnerships accounted for using the equity method 28319 11237
P rofit from continuing operations before income

tax expense 187946 227409
Income tax expense (43469) (51094)
P ro fit from continuing operations after tax 144477 176315
P ro fit from continuing operations attributable to

m in o rity interests 2266 3844
P rofit from continuing operations attributable to

members o f the parent 142211 172471
Source: Harvey Norman Holdings Limited, Annual Report 2013, 2013
16 For a more detailed discussion of the usefulness of financial ratios for short-term asset management, see Gallinger and
Healey (1987, Chapter 3).
Current assets
Cash and cash equivalents 161660 172459
Receivables⑷ 1054402 1017973
Other financial assets 19072 24396
Inventories ⑻ 268781 263421
Intangible assets 343 531
Other (prepayments) 27655 20161
Total current assets 1531913 1498941
Non-current assets
Receivables 12 646 10556
Investments accounted for using equity method 175 294 157992
Other financial assets 14223 9355
Investment properties 1694744 1653746
Property, plant and equipment 548903 536277
Intangible assets 58913 57442
Deferred income tax assets 28395 27507
Total non-current assets 2533118 2452875
Total assets 4065 031 3 951816
Current liab ilities
Payables 611758 647279
Interest-bearing liabilities (c)172455 (必234 876
Tax liabilities 23817 13487
Provisions 23338 20497
Other 2 689 1631
Total current liabilities 834057 917770
Non-current liabilities
Interest-bearing liabilities 647 821 544471
Provisions 8 900 8954
Other 16 045 14890
Deferred income tax liabilities 194 353 198849
Total non-current liabilities 867 119 767164
Total liabilities 1 701176 1684934
continued
T a b le A 2 1 .2 continued
Net assets 2363855 2266882
Equity
Contributed equity 259610 259610
Reserves 61799 19376
Retained profits 2008880 1956966
Parent entity interest 2330 289 2 235 952
Outside equity interest 33566 30930
Total equity^ 2363855 2266882
Receivables in 201 1 were $1 0 6 5 2 3 2 0 0 0 .

(bl Inventories in 2011 were $ 3 36 74 2 000.
(cl Includes bank overdraft of $ 3 7 0 9 0 0 0 0 .
Idf Includes bank overdraft of $32 366000.
(el Shareholders7 equity in 201 1 was $2 228461 000.
Source: Harvey Norman Holdings Limited, Annual Report 2013, 2013, pp. 4 7 -8 .
There are fo ur broad categories o f financial ratios. They are liquidity ratios, activity ratios, leverage ratios
and profitability ratios.
Liquidity ratios
Liq uid ity ratios are a measure o f a company s a bility to meet its m aturing short-term financial obligations.
The follow ing ratios are classified as liq u id ity ratios.
Current ratio
Traditionally, the current ratio has been used to measure a company s liquidity. I t is calculated by dividing
to ta l current assets by to ta l current liabilities. Its use dates from the nineteenth century and it is s till
widely used as an im p o rta n t measure o f a company s a b ility to pay its short-term debts when they are
due. Using the data fo r Harvey Norman, the current ratio is as follows:17
^ • total current assets

Current ratio = ----- ------------- . . . . . —
total current liabilities
_ $ 1 5 3 1 9 1 3 000
$834 057 000
= 1 .8 4 (1 .6 3 )
The higher the current ratio, the greater w ill be the company s a b ility to meet its imm ediate financial
obligations. However, the higher this ratio, the greater w ill be the p ro po rtio n o f the company s resources
th a t is tied up in relatively unproductive assets. This may have an adverse effect on p rofitability.
Management therefore has to decide on the appropriate balance between p ro fita b ility and liquidity.
‘Quick’ ratio
The quick ratio is calculated by dividing to ta l current assets, m inus inventories and prepayments, by total
current liab ilities minus bank overdraft. Prepayments are deducted because they represent amounts paid
fo r services yet to be provided and therefore are n o t easily converted in to cash. Similarly, inventory is the
least liq u id current asset and could be d iffic u lt to sell at short notice. Bank overdrafts are deducted from
current liabilities because they are unlikely to be w ithdraw n at short notice.18 The quick ratio is more
useful than the current ratio as a measure o f the company s a b ility to meet its financial obligations should
they become payable almost immediately.
17 The value for each ratio, based on the figures in the 20 11 -12 financial statements, is included in parentheses.
18 See Chapter 10.
A pp en dix 2 1 . 1 F in a n c ia l statement analysis
total current assets - (inventories + prepayments)

Quick ratio =
total current liabilities - bank overdraft
$1 531 913 - ($268 781 000 + $27 655)
$834 057 000 - $37 090 000
$1235 477 000
_ $796967 000
= 1.55(1.37)
As w ith the current ratio, the higher the quick ratio, the greater the company s a b ility to meet its
immediate financial obligations.
Activity ratios
A ctivity ratios measure the effectiveness o f a company s use o f its assets. These ratios generally relate
the amount o f a particular group o f assets (such as inventory, accounts receivable or to ta l assets) to the
activity generated by th a t group (such as sales, cost o f goods sold and net p ro fit). We consider three such
ratios.
Average inventory turnover period

The average inventory tu rn ove r period measures the average tim e a company s inve ntory remains
on hand before being sold, and is usually calculated by dividing the average inve ntory by the cost o f
goods sold.
A . . , average inventory oe「

Average inventory turnover period = ------------------------- x 365
cost o f goods sold
$268 781 000 + $263 421000 365
= 2
$944 249 000
= 1 02 .9 days (106.8 days)
For Harvey Norman the average inventory turnover period decreased from 106.8 days in 2012 to
102.9 days in 2013 一 th a t is, inve ntory was on hand fo r a shorter period before being sold. We discussed
possible solutions to inve ntory management problems in Chapter 20. The ideal average inventory
turnover period fo r a company is affected by the optim al inventory level.
Average collection period

The average collection period is calculated by dividing the average accounts receivable balance by the
average daily credit sales. The average collection period is a measure o f the average num ber o f days a
company m ust w ait after m aking a credit sale before i t receives payment, and indicates w hether accounts
receivable are being collected w ith in a reasonable period o f time. Assuming th a t all o f Harvey Norm ans
sales were on credit in both the 2011-12 and the 2012-13 financial years, the average collection period
is calculated as follows:
A „ . . average receivables
Average collection period = -----------------------------------
average daily credit sales
$1054 402 000 + $1017 973 000
= 2
$1323 481000/365
= 2 8 6 days (270 days)
A short average collection period may indicate high efficiency in collecting accounts receivable.
However, in Section 21.10 it was shown th a t reducing the collection period involves various costs and it
is possible fo r the collection period to be *too short* because the company s credit policy is too restrictive.
Total asset turnover

Total asset turnover measures the turnover o f the company s assets and is calculated by dividing sales by
total tangible assets.
Total asset turnover = ----------------------------
total tangible assets
_ $1323 481000
_ $4 065 031 000 - (59 256 000 + 23 395 000)
= 0 .3 3 (0.36)
where to ta l tangible assets = to ta l assets - (intangible assets + deferred tax assets)

This ratio is a measure o f a company s efficiency in the use o f its assets to generate sales. An efficient
company w ill generate a higher level o f sales w ith a given level o f assets than its less efficient competitors.
A high ratio could also indicate th a t the company is operating at close to its capacity. I f this is the case,
then additional investm ent in assets may be required i f o utp ut and sales are to be increased.
Leverage ratios
Leverage ratios show the extent to which a company uses debt in its capital structure and provide
evidence o f a company s ability to pay lenders in the long run. There are many measures o f leverage, but
we consider only two ratios.
Debt to total assets

This is calculated by dividing to ta l liabilities by to ta l assets.
^ " • 、 total liabilities

Debts to total assets (leverage r a tio ) = --------------------
total assets
_ $1701 176 000
$4 065 031
=41.8% (42.6%)
The higher this percentage, the greater is the company s reliance on debt in its capital structure. The
effects o f leverage on a company s value were considered in Chapter 12, where the use o f m arket values
rather than book values was emphasised. A company s a bility to repay lenders w ill ultim ately depend on
the m arket value o f its assets relative to the face value o f its debt. However, analysts frequently rely on
book values because they are easier to obtain than m arket values.
Interest coverage ratio

The interest coverage ratio, which is also referred to as the times interest earned ratio, is calculated
by dividing a company s net p ro fit before interest and tax by the interest expense. It is a measure o f a
company s a b ility to meet the interest charges on its debt.
T net p ro fit before interest and tax

Interest coverage ratio = ----- -----------------------------------------
interest expense
_ $144 477 000 + $43 469 000 + $45 774 000
$45 774 000
= 5 .1 1 (5.60)
In many ways this ratio is superior to the leverage ratio as a measure o f financial risk because it
attem pts to measure the company s ability to pay the interest on its debt and so avoid future financial
difficulties. The higher this ratio, the greater the reduction in the company s earnings th a t can occur
before it w ill default on its interest payments.
There are two im p o rta n t lim ita tio n s o f the interest coverage ratio. First, it is cash flow and n o t earnings
th a t is im p o rta n t fo r debt-servicing purposes. This lim ita tio n can be addressed by using net p ro fit before
interest and tax plus depreciation and other accruals in the numerator. Second, in addition to interest
payments, there are other financial obligations th a t have to be met. These include dividends on preference
shares, lease payments and repayment o f long-term debt. Therefore, it could be useful to m odify the ratio
by also including these payments in the denominator.
A pp en dix 2 1 . 1 F in a n c ia l statement analysis
Profitability ratios
The aim o f p ro fita b ility ratios is to measure the effectiveness o f management in using a company s
resources to generate returns fo r shareholders.
Profit margin on sales

This ratio is calculated by dividing net p ro fit by to ta l sales revenue. I t shows the am ount o f p ro fit generated
by the company from each dollar o f sales.
net p ro fit after tax

Profit margin =
sales revenue
$144 477 000
$1323 481 000
=10.91% (12.53%)
This is a measure o f relative efficiency, as it reflects managements efforts to generate sales and control
costs. Success in reducing costs w ill increase the p ro fit margin.
Return on shareholders’ equity

This ratio is calculated by dividing net p ro fit by the book value o f average shareholders* equity. I t is a
measure o f the earning power o f the shareholders’ investment.
„ , , ,, , . net p ro fit after tax

Return on shareholders equity = ------------------ ； ----------
shareholders’ equity
$144 477 000 inn
= ------------------------------------------------------x 100
$2 363 855 000 + $2 266 882 000
2
=6 .2 % (7.8%)
Usefulness of financial ratio analysis

So far we have discussed the measurement o f a num ber o f financial ratios, w ith only passing reference to
their usefulness. In assessing the usefulness o f financial ratios it is im p o rta n t to note th a t they are a way
o f summarising large quantities o f data. Also, ratio analysis is usually the firs t step in financial statement
analysis. The purpose o f the analysis differs between ‘insiders’，or managers, and ‘outsiders’，or investors
and creditors. Investors and creditors w ill be interested in attem pting to forecast future earnings and
dividends and in assessing a company s a b ility to repay debts. Managers w ill seek inform a tion th a t they
can use in making decisions about a company s operations.
These decisions may lead to changes in the values o f a company s ratios. However, achieving or
m aintaining certain ratios should generally n o t be seen as an end in itself. Rather, exam ination o f ratios
is most useful as a way o f raising questions and identifyin g issues fo r fu rth e r investigation: it usually does
n ot provide answers. To illustrate the use o f ratios, consider Harvey N orm ans current ratio o f 1.84 at 30
June 2013. W hat inform a tion does this figure convey to management? We suggested th a t a very high
ratio indicates th a t the company has too many o f its resources tied up in relatively unproductive short
term assets. Alternatively, if the current ratio is too low, it may indicate th a t there is a liq u id ity problem.
There are two types o f analysis th a t management could use to decide whether the current ratio o f 1.84
indicates th a t any action is necessary. These are cross-sectional analysis and time-series analysis.
Cross-sectional analysis involves comparing the company s ratio w ith those o f other companies in the
same industry. Companies in the same in d u stry have sim ilar assets and operate in a sim ilar environment,
so the average ratio o f the other companies in the ind ustry may be useful as a benchmark fo r comparison.
If, in our example, the average current ratio o f Harvey N orm ans competitors was, say, 2.68, does this
mean th a t Harvey N orm ans current ratio o f 1.84 is too low? The answer to this question is n o t obvious. I t
may be th a t its competitors have too high a p roportion o f th e ir resources invested in short-term assets. In
general, an industry average does not necessarily reflect an optim al standard o f performance. Nevertheless,
intercom pany comparisons may provide a reason fo r re-examining policies on the management o f short
term assets and policies on other aspects o f a company s operations. For example, i f a company s current
ratio is fa r higher or lower than the in d u stry average, management should seek an explanation fo r the
difference.
Time-series analysis involves studying values o f a single ratio over tim e to determine whether a
company s financial position appears to be im proving, rem aining the same or deteriorating. However,
the exam ination o f a tim e series w ill usually n o t provide all the inform a tion th a t may be needed for
decision-making purposes. For example, although there may be an improvem ent in the p ro fit m argin
from one year to the next, this may s till reflect less than an ideal performance. This m ethod o f evaluation
is fu rth e r complicated by the fact th a t the optim al values o f financial ratios are likely to change over time.
In these circumstances, m aintaining a stable ratio from one year to the next is not necessarily desirable.
For example, the techniques used to determine inventory policy suggest th a t a company s inventory
should increase at a much slower rate than sales. Therefore, a company s optim al inventory turnover
period w ill increase at a much slower rate than sales. This implies th a t the current ratio should decline
as a company s operations grow. Time-series analysis and cross-sectional analysis can be combined by
examining a company s ratios over tim e in conjunction w ith benchmarks, such as in d u stry averages.
Financial ratios and short-term asset management

We now consider in more detail those ratios considered to be useful fo r short-term asset management.
Current ratio and 'quick' ratio

The current ratio and the ûick* ratio serve as measures o f a company s liq u id ity position and consequently
have particular application to liq u id ity management. The current ratio is calculated by dividing the book
value o f current assets by the book value o f current liabilities. Current assets include cash and other liqu id
assets, accounts receivable and inventories. Current liabilities include accounts payable, debts m aturing
w ith in 12 m onths and income tax payable, dividends payable and other payments due w ith in 12 months.
Thus, the current ratio provides an indication o f a company s a bility to meet its imm ediate financial
obligations using assets th a t are expected to be quickly converted in to cash. I f a company is experiencing
financial difficulty, it is likely to pay its creditors more slowly, increase its bank overdraft and, perhaps,
draw on lines o f credit. These measures w ill be reflected in increases in accounts payable and other current
liabilities and a falling current ratio. However, the current ratio does n ot take in to account either the
relative liq u id ity o f the various assets or the relative urgency fo r repayment o f the current liabilities. I t is
n o t useful to know th a t the company has a current ratio o f 2 i f all the liabilities are due to be paid w ith in
a week, and m ost o f the short-term assets cannot be realised w ith in 2 months.
A fu rth e r lim ita tio n o f the current ratio is th a t it includes inventory, which is usually valued at
historical cost, whereas the net selling price o f the inve ntory would provide a better indication o f the
assets a b ility to generate cash. Indeed, a company may have an apparently healthy current ratio largely
because its warehouse is fu ll o f goods th a t are n o t wanted by customers. The main difference between the
current ratio and the quick ratio is th a t the la tte r excludes inventories. I t is intended to provide a more
stringent test o f a company s liq u id ity by including only assets th a t are highly liquid. A quick ratio o f 1 or
more indicates th a t current liabilities can be m et w ith o u t relying on the sale o f inventory.
Finally, a lim ita tio n o f both ratios is th a t the financial statements can be ^window dressed7to improve
these ratios. This may be achieved either by delaying purchases, or by paying o ff a large pro po rtio n o f the
company s current liabilities ju s t before the end o f the financial year. For example, selling marketable
securities to repay debt w ill reduce current assets and current liabilities by the same amount, so the
company s net assets are unchanged, b u t the current ratio w ill change.
The average inventory turnover period measures the average tim e a company s inventory remains on
hand before being sold. This ratio is related to inventory management, because the average inventory
turnover period w ill be a direct result o f the company s inve ntory management policy defined in terms o f
economic order quantities and reorder points. However, the turnover period w ill norm ally reflect other
factors as well. For example, inve ntory levels may increase and the turnover period increase because
o f a decrease in the demand fo r the company s products. A decrease in the inve ntory turnover period
A ppen dix F in a n c ia l statement analysis
is frequently regarded as desirable since p ro fit is generated as inventory is sold— th a t is, turned over.
However, a decrease in the inventory turnover period is n ot necessarily desirable, because it may have
been achieved by reducing the q ua n tity o f inventory to such a low level th a t purchasing costs and stockout
costs have become excessive. The techniques available fo r determ ining the o ptim um inventory holding
and, consequently, the optim um turnover were discussed in Chapter 20. It is im p o rta n t to note th a t the
turnover period, which uses the statement o f financial position data, measures only the average turnover
period fo r all inventory items, whereas it is desirable to ascertain the optim um inventory policy fo r each
individual inventory item or group o f items.
The use o f statement o f financial position data can also involve lim ita tio n s i f demand and inventory
levels are subject to seasonal variations. This problem can be overcome by using the average o f m onthly
inventory figures, i f they are available, instead o f the end-of-year figures.
Average collection period

This ratio measures how quickly customers pay fo r purchases and provides useful inform a tion for
accounts receivable management since there are benefits th a t can result fro m a reduction in the collection
period. A shorter collection period means th a t fewer resources are tied up in accounts receivable and
generally indicates efficiency in the collection o f accounts. However, it needs to be recognised th a t a
continual reduction in the collection period is n ot necessarily a sign o f increasing efficiency. For example,
suppose th a t there are tw o types o f account. The firs t pays at the end o f the credit period (assuming no
cash discount). I f all accounts are o f this type, then the average collection period w ill be equal to the
credit period. In other words, there is a lower lim it to the average collection period, which is set by the
company s credit terms. The second type o f account is a delinquent account, which does n ot pay w ith in
the collection period. As discussed in Section 21.10, attem pting to collect all accounts in tim e involves
collection expenditures th a t are prohibitively high; a company usually has to accept a certain number
o f late collections (that is, delinquent accounts) and non-collections (that is, bad debts). I t follows th a t
the optim al average collection period w ill usually be above the lower lim it set by the company s credit
terms. It is also possible fo r the average collection period to be *too sh ort1, reflecting unduly restrictive
credit terms.
The average collection period provides management w ith info rm a tio n about the quality o f the
company’s accounts receivable and the efficiency o f its credit control. Valuable info rm a tio n can also
be obtained from an ‘age’ analysis o f accounts. This analysis lists debtors’ accounts w ith reference to
the period o f tim e they have been outstanding, and highlights the incidence o f delinquent accounts. It
therefore directs managements atte ntio n to those accounts on which its collection efforts should be
concentrated.
a p p e n d ix a NUM ERICAL TABLES
Table 1 Future v a lu e o f a p re s e n t sum
Table 2 Present v a lu e o f a fu tu re sum
Table 3 F uture v a lu e o f a n o r d in a r y a n n u ity
Table 4 P resent v a lu e o f a n o r d in a r y a n n u ity
Table 5 A re a s u n d e r th e s ta n d a rd n o rm a l c u rv e
TABLE 1 Future value of $1 at the end of n periods

(1 + i)n
0 .5% 0 .66% 0 .7 5 % 1.0% 1.5% 1.75% 2.0% 2.5% 3 .0% 3.5%
1 1.002 50 1.005 00 1.006 67 1.007 50 1.010 00 1.015 00 1.017 50 1.020 00 1.025 00 1.030 00 1.035 00 1
2 1.005 01 1.010 03 1.013 38 1.015 06 1.020 10 1.030 23 1.035 31 1.040 40 1.050 63 1.060 90 1.071 23 2
3 1.007 52 1.015 08 1.020 13 1.022 67 1.030 30 1.045 68 1.053 42 1.061 21 1.076 89 1.092 73 1.108 72 3
4 1.010 04 1.020 15 1.026 93 1.030 34 1.040 60 1.061 36 1.071 86 1.082 43 1.103 81 1.125 51 1.147 52 4
5 1.012 56 1.025 25 1.033 78 1.038 07 1 .0 5 1 0 1 1.077 28 1.090 62 1.104 08 1.131 41 1.159 27 1.187 69 5
6 1.015 09 1.030 38 1.040 67 1.045 85 1.061 52 1.093 44 1.109 70 1.126 16 1.159 69 1.194 05 1.229 26 6
7 1.017 63 1.035 53 1.047 61 1.053 70 1.072 14 1.109 84 1.129 12 1.148 69 1.188 69 1.229 87 1.272 28 7
8 1.020 18 1.040 71 1.054 59 1.061 60 1.082 86 1.126 49 1.148 88 1.171 66 1.218 40 1.266 77 1.316 81 8
9 1.022 73 1.045 91 1.061 63 1.069 56 1.093 69 1.143 39 1.168 99 1.195 09 1.248 86 1.304 77 1.362 90 9
10 1.025 28 1 .0 5 1 1 4 1.068 70 1.077 58 1.104 62 1.160 54 1.189 44 1.218 99 1.280 08 1.343 92 1.410 60 10
11 1.027 85 1.056 40 1.075 83 1.085 66 1.115 67 1.177 95 1.210 26 1.243 37 1.312 09 1.384 23 1.459 97 11
12 1.030 42 1.061 68 1.083 00 1.093 81 1.126 83 1.195 62 1.231 44 1 .268 24 1.344 89 1.425 76 1.511 07 12
13 1.032 99 1.066 99 1.090 22 1.102 01 1.138 09 1.213 55 1.252 99 1.293 61 1.378 51 1.468 53 1.563 96 13
14 1.035 57 1.072 32 1.097 49 1.110 28 1.149 47 1.231 76 1.274 92 1.319 48 1.412 97 1.512 59 1.618 69 14
15 1.038 16 1.077 68 1 .104 80 1.118 60 1.160 97 1.250 23 1.297 23 1.345 87 1.448 30 1.557 97 1.675 35 15
16 1.040 76 1.083 07 1.112 17 1.126 99 1.172 58 1.268 99 1.319 93 1.372 79 1.434 51 1.604 71 1.733 99 16
17 1.043 36 1.088 49 1.119 58 1.135 44 1.184 30 1.288 02 1.343 03 1.400 24 1.521 62 1.652 85 1.794 68 17
18 1.045 97 1.093 93 1.127 05 1.143 96 1.196 15 1.307 34 1.366 53 1.428 25 1.559 66 1.702 43 1.857 49 18
19 1.048 58 1.099 40 1.134 56 1.152 54 1.208 11 1.326 95 1.390 45 1.456 81 1.598 65 1.753 51 1.922 50 19
20 1.051 21 1.104 90 1.142 13 1 .1 6 1 1 8 1.220 19 1.346 86 1.414 78 1.485 95 1.638 62 1.806 11 1.989 79 20
21 1.053 83 1.110 42 1.149 74 1.169 89 1.232 39 1.367 06 1.434 54 1.515 67 1.679 58 1.860 29 2.059 43 21
22 1.056 47 1.115 97 1.157 40 1.178 67 1.244 72 1.387 56 1.464 73 1.545 98 1 .7 2 1 5 7 1.916 10 2 .1 3 1 5 1 22
23 1.059 11 1.121 55 1.165 12 1.187 51 1.257 16 1.408 38 1.490 36 1.576 90 1.764 61 1.973 59 2.206 11 23
24 1.061 76 1 .1 2 7 1 6 1.172 89 1.196 41 1.269 73 1.429 50 1.516 44 1.608 44 1.808 73 2.032 79 2.283 33 24
25 1.064 41 1.132 80 1.180 71 1.205 39 1.282 43 1.450 95 1.542 98 1.640 61 1.853 94 2.093 78 2.363 24 25
30 1.077 78 1.161 40 1.220 59 1 .2 5 1 2 7 1.347 85 1.563 08 1.682 80 1.811 36 2.097 29 2.427 26 2.806 79 30
35 1 .0 9 1 3 2 1.190 73 1.261 82 1.298 90 1.416 60 1.683 88 1.835 29 1.999 89 2.373 21 2.813 86 3.333 59 35
40 1.105 03 1.220 79 1.304 45 1.348 35 1.488 86 1.814 02 2.001 60 2.208 04 2.685 06 3.262 04 3.959 26 40
45 1.118 92 1.251 62 1.348 52 1.399 68 1.564 81 1.954 21 2.182 98 2.437 85 3.037 90 3.781 60 4.702 36 45
50 1.132 97 1.283 23 1.394 07 1.452 96 1.644 63 2.105 24 2.380 79 2.691 59 3 .4 3 7 1 1 4.383 91 5.584 93 50
60 1.161 62 1.348 85 1.489 85 1.565 68 1.816 70 2.432 20 2.831 82 3.281 03 4.399 79 5.891 60 7.878 09 60
698
A ppendix A N umerical tables
TABLE 1 continued
(1 + /)"
n 4 .0% 4 .5 % 5 .0% 6 .0% 7.0% 10.0% 12.0% 1 5.0% 2 0 .0 % n

1 1.040 00 1.045 00 1.050 00 1.060 00 1.070 00 1.080 00 1.10 0 00 1.12 0 0 1.150 1.200 1
2 1.081 60 1.092 03 1.102 50 1.123 60 1.144 90 1.166 40 1.2 10 00 1.254 4 1.322 1.440 2
3 1.124 86 1.1 411 7 1.157 63 1.191 01 1.225 04 1.259 71 1.331 00 1.404 9 1.521 1.728 3
4 1.169 86 1.192 52 1.215 51 1.262 47 1.310 79 1.360 48 1.464 10 1.573 5 1.749 2.074 4
5 1.216 65 1.246 18 1.276 28 1.338 22 1.402 55 1.469 32 1.610 51 1.762 0 2 .0 11 2.488 5
6 1.265 32 1.302 26 1.340 10 1.418 51 1.500 73 1.586 87 1.771 56 1.973 8 2.313 2.938 6
7 1.315 93 1.360 86 1.407 10 1.503 63 1.605 78 1.713 82 1.948 72 2.210 7 2.660 3.583 7
8 1.368 57 1.422 10 1.477 46 1.593 84 1.718 18 1.850 93 2.143 59 2.476 0 3.059 4.300 8
9 1.423 31 1.486 10 1.551 33 1.689 47 1.838 45 1.999 00 2.357 95 2.773 1 3.518 5.160 9
10 1.480 24 1.552 97 1.628 89 1.790 84 1.967 15 2.158 92 2.593 74 3.105 8 4.046 6.192 10
11 1.539 45 1.622 85 1.710 34 1.898 29 2.104 85 2.331 63 2.853 12 3.478 5 4.652 7.430 11
12 1.601 03 1.695 88 1.795 86 2.012 19 2.252 19 2.518 17 3.138 43 3.896 0 5.350 8.916 12
13 1.665 07 1.772 20 1.885 65 2.132 92 2.409 84 2.719 62 3.452 27 4.363 5 6.153 10.699 13
14 1.731 68 1.851 94 1.979 93 2.260 90 2.578 53 2.937 19 3.797 50 4.887 1 7.076 12.839 14
15 1.800 94 1.935 28 2.078 93 2.396 55 2.759 03 3.172 16 4.177 25 5.473 6 8.137 15.407 15
16 1.872 98 2.022 37 2.182 87 2.540 35 2.952 16 3.425 94 4.594 97 6.130 3 9.358 18.488 16
17 1.947 90 2.113 38 2.292 02 2.692 77 3.158 81 3.700 01 5.054 47 6.866 1 10.761 22.186 17
18 2.025 82 2.208 48 2.406 62 2.854 33 3.379 93 3.996 01 5.559 92 7.690 0 12.375 26.623 18
19 2.106 85 2.307 86 2.526 95 3.025 59 3.616 52 4.315 70 6.115 91 8.612 8 14.232 31.945 19
20 2.19112 2.411 71 2.653 30 3.207 13 3.869 68 4.660 95 6.727 50 9.646 3 16.367 38.338 20
21 2.278 77 2.520 24 2.785 96 3.399 56 4.140 56 5.033 83 7.400 25 10.803 8 18.821 46.005 21
22 2.369 92 2.633 65 2.925 26 3.603 53 4.430 40 5.436 54 8.140 27 12.100 3 21.645 55.206 22
23 2.464 72 2.752 17 3.071 52 3.819 74 4.740 52 5.871 46 8.954 30 13.552 3 24.891 66.247 23
24 2.563 30 2.876 01 3.225 10 4.048 93 5.072 36 6.3 411 8 9.849 73 15.178 6 28.625 79.497 24
25 2.665 84 3.005 43 3.386 35 4.291 87 5.427 43 6.848 47 10.834 71 17.000 1 32.919 95.396 25
30 3.243 40 3.745 32 4.321 94 5.743 49 7.612 25 10.062 65 17.449 40 29.960 0 66.212 237.376 30
35 3.946 09 4.667 35 5.516 02 7.686 08 10.676 58 14.785 34 28.102 44 52.800 0 133.175 590.668 35
40 4.801 02 5.816 36 7.039 99 10.285 71 14.974 45 21.724 52 45.259 26 93.051 0 267.862 1 469.771 40
45 5.84118 7.248 25 8.985 01 13.764 61 21.002 45 31.920 44 72.890 48 163.987 6 538.767 3 657.258 45
50 7.106 68 9.032 64 11.477 40 18.420 15 29.457 02 46.901 61 117.390 85 289.002 1 1 083.652 9 100.427 50
60 10.519 63 14.027 41 18.679 19 32.987 69 57.946 43 101.257 06 304.481 64 897.596 9 4 383.999 56 347.514 60
699
TABLE 2 Present value of $1 due at the end of n periods

= d + 〇- n
( i + O"
n 0.25% 0 .5 0 % 0.66% 0 .7 5 % 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% n
1 0.997 51 0.995 02 0.993 38 0.992 56 0.990 09 0.985 22 0.980 39 0.975 60 0.970 87 0.966 18 1
2 0.995 02 0.990 07 0.986 80 0.985 17 0.980 29 0.970 66 0.9 611 6 0.951 81 0.942 59 0.933 51 2
3 0.992 54 0.985 15 0.980 26 0.977 83 0.970 59 0.956 31 0.942 32 0.928 59 0.915 14 0.901 94 3
4 0.990 06 0.980 25 0.973 77 0.970 55 0.960 98 0.942 18 0.923 84 0.905 95 0.888 48 0.871 44 4
5 0.987 59 0.975 37 0.967 32 0.963 33 0.951 46 0.928 26 0.905 73 0.883 85 0.862 60 0.841 97 5
6 0.985 13 0.970 52 0.960 92 0.956 16 0.942 04 0.914 54 0.887 97 0.862 29 0.837 48 0.813 50 6
7 0.982 67 0.965 69 0.954 55 0.940 94 0.932 71 0.901 02 0.870 56 0.841 26 0.813 09 0.785 99 7
8 0.980 22 0.960 89 0.948 23 0.941 98 0.923 48 0.887 71 0.853 49 0.820 74 0.789 40 0.759 41 8
9 0.977 78 0.956 10 0.941 95 0.934 96 0.914 33 0.874 59 0.836 75 0.800 72 0.766 41 0.733 73 9
10 0.975 34 0.951 35 0.935 71 0.928 00 0.905 28 0.861 66 0.820 34 0.7 811 9 0.744 09 0.708 91 10
11 0.972 91 0.946 61 0.929 52 0.921 09 0.896 32 0.848 93 0.804 26 0.762 14 0.722 42 0.684 94 11
12 0.970 48 0.941 91 0.923 36 0.914 24 0.887 44 0.836 38 0.788 49 0.743 55 0.701 37 0.661 78 12
13 0.968 06 0.973 22 0.917 25 0.907 43 0.878 66 0.824 02 0.773 03 0.725 42 0.680 95 0.639 40 13
14 0.965 65 0.932 56 0.9 111 7 0.900 68 0.869 96 0.811 84 0.757 87 0.707 72 0 .6 611 1 0.617 78 14
15 0.963 24 0.927 92 0.905 14 0.893 97 0.861 34 0.799 85 0.743 01 0.690 46 0.641 86 0.596 89 15
16 0.960 84 0.923 30 0.899 14 0.887 32 0.852 82 0.788 03 0.728 44 0.673 62 0.623 16 0.576 70 16
17 0.958 44 0.918 71 0.893 19 0.880 71 0.844 37 0.776 38 0.714 16 0.657 19 0.605 01 0.557 20 17
18 0.956 05 0.914 14 0.887 27 0.874 16 0.836 01 0.764 91 0.700 15 0.6 411 6 0.587 39 0.538 36 18
19 0.953 67 0.909 59 0.881 40 0.867 65 0.827 73 0.753 60 0.686 43 0.625 52 0.570 28 0.520 15 19
20 0.951 29 0.905 06 0.875 56 0.8 611 9 0.819 54 0.742 47 0.672 97 0.610 27 0.553 67 0.502 56 20
21 0.948 92 0.900 56 0.869 76 0.854 78 0.811 43 0.731 49 0.659 77 0.595 38 0.537 54 0.485 57 21
22 0.946 55 0.896 08 0.864 00 0.848 42 0.803 39 0.720 68 0.646 83 0.580 86 0.521 89 0.469 15 22
23 0.944 19 0.891 62 0.858 28 0.842 10 0.795 44 0.710 03 0.634 15 0.566 69 0.506 69 0.453 28 23
24 0.941 84 0.887 19 0.852 60 0.835 83 0.787 56 0.699 54 0.621 72 0.552 87 0.491 93 0.437 95 24
25 0.939 49 0.882 77 0.846 95 0.829 61 0.779 76 0.689 20 0.609 53 0.539 39 0.477 60 0.423 14 25
30 0.927 83 0.861 03 0.819 27 0.799 19 0.741 92 0.639 76 0.552 07 0.476 74 0.411 98 0.356 27 30
35 0.916 32 0.839 82 0.792 50 0.769 88 0.705 91 0.593 86 0.500 02 0.421 37 0.355 38 0.299 97 35
40 0.904 95 0.819 14 0.766 61 0.741 65 0.671 65 0.551 26 0.452 89 0.372 43 0.306 55 0.252 57 40
45 0.893 72 0.798 96 0.741 56 0.714 45 0.639 05 0.511 71 0.410 19 0.329 17 0.264 43 0.212 65 45
50 0.882 63 0.779 29 0.717 32 0.688 25 0.608 03 0.475 00 0.371 52 0.290 94 0.228 10 0.179 05 50
60 0.860 87 0.741 37 0.671 21 0.638 70 0.550 45 0.409 30 0.304 78 0.227 28 0.169 73 0.126 93 60
700
TABLE 2 continued
n 4 .0 % 4 .5 % 5.0% 6 .0% 7.0% 8 .0 % 10.0% 12.0% 1 5.0% 20.0% VI
1 0.961 53 0.956 93 0.952 38 0.943 39 0.934 57 0.925 92 0.909 09 0.892 86 0.869 57 0.833 33 1
2 0.924 55 0.915 72 0.907 02 0.889 99 0.873 43 0.857 33 0.826 45 0.797 19 0.756 14 0.694 44 2
3 0.888 99 0.876 29 0.863 83 0.839 61 0.816 29 0.793 83 0.751 31 0.711 78 0.657 52 0.578 70 3
4 0.854 80 0.838 56 0.822 70 0.792 09 0.762 89 0.735 02 0.683 01 0.635 52 0.571 75 0.482 25 4
5 0.821 92 0.802 45 0.783 52 0.747 25 0.712 98 0.680 58 0.620 92 0.567 43 0.497 18 0.401 88 5
6 0.790 31 0.767 89 0.746 21 0.704 96 0.666 34 0.630 16 0.564 47 0.506 63 0.432 33 0.334 90 6
7 0.759 91 0.734 82 0.710 68 0.665 05 0.622 74 0.583 49 0.513 16 0.452 35 0.375 94 0.279 08 7
8 0.730 69 0.703 18 0.676 83 0.627 41 0.582 00 0.540 26 0.466 51 0.403 88 0.326 90 0.232 57 8
9 0.702 58 0.672 90 0.644 60 0.591 89 0.543 93 0.500 24 0.424 10 0.360 61 0.284 26 0.193 81 9
10 0.675 56 0.643 92 0.613 90 0.558 39 0.508 34 0.463 19 0.385 54 0.321 97 0.247 18 0.161 51 10
11 0.649 58 0.616 19 0.584 67 0.526 78 0.475 09 0.428 88 0.350 49 0.287 48 0.214 94 0.134 59 11
12 0.624 59 0.589 66 0.556 83 0.496 96 0.444 01 0.397 11 0.318 63 0.256 67 0.186 91 0.112 16 12
13 0.600 57 0.564 27 0.530 32 0.468 83 0.414 96 0.367 69 0.289 66 0.229 17 0.162 53 0.093 46 13
14 0.577 47 0.539 97 0.505 06 0.442 30 0.387 81 0.340 46 0.263 33 0.204 62 0.141 33 0.077 89 14
15 0.555 26 0.516 72 0.481 01 0.417 26 0.362 44 0.315 24 0.239 39 0.182 70 0.122 89 0.064 91 15
16 0.533 90 0.494 46 0.458 11 0.393 64 0.338 73 0.291 89 0.217 63 0.163 12 0.106 86 0.054 09 16
17 0.513 37 0.473 17 0.436 29 0.371 36 0.316 57 0.270 26 0.197 84 0.145 64 0.092 93 0.045 07 17
18 0.493 62 0.452 80 0.415 52 0.350 34 0.295 86 0.250 24 0.179 86 0.130 04 0.080 80 0.037 56 18
19 0.474 64 0.433 30 0.395 73 0.330 51 0.276 50 0.231 71 0.163 51 0.116 11 0.070 26 0.031 30 19
20 0.456 38 0.414 64 0.376 88 0.311 80 0.258 41 0.214 54 0.148 64 0.103 67 0.06110 0.026 08 20
21 0.438 83 0.396 78 0.358 94 0.294 15 0.241 51 0.198 65 0.135 13 0.092 56 0.053 13 0.021 74 21
22 0.421 95 0.379 70 0.341 84 0.277 50 0.225 71 0.183 94 0.122 85 0.082 64 0.046 20 0.018 11 22
23 0.405 72 0.363 35 0.325 57 0.261 79 0.210 94 0.170 31 0.111 68 0.073 79 0.040 17 0.015 09 23
24 0.390 12 0.347 70 0.310 06 0.246 97 0.197 14 0.157 69 0.101 53 0.065 88 0.034 93 0.012 58 24
25 0.375 11 0.332 73 0.295 30 0.232 99 0.184 24 0.146 01 0.092 30 0.058 82 0.030 38 0.010 48 25
30 0.308 31 0.267 00 0.231 37 0.174 11 0.131 36 0.099 37 0.057 31 0.033 38 0.015 10 0.004 21 30
35 0.253 41 0.214 25 0.181 29 0.130 10 0.093 66 0.067 63 0.035 58 0.018 94 0.007 51 0.001 69 35
40 0.208 28 0.171 92 0.142 04 0.097 22 0.066 78 0.046 03 0.022 09 0.010 74 0.003 73 0.000 68 40
45 0.1 711 9 0.137 96 0.111 29 0.072 65 0.047 61 0.031 32 0.013 72 0.006 10 0.001 86 0.000 27 45
50 0.140 71 0.110 70 0.087 20 0.054 28 0.033 94 0.021 32 0.008 52 0.003 46 0.000 92 0.000 11 50
60 0.095 06 0.071 29 0.053 54 0.030 31 0.017 26 0.009 88 0.003 28 0.00111 0.000 23 0.000 02 60
701
TABLE 3 F u tu re v alu e o f an a n n u ity o f $1 p e r p e rio d fo r n p e rio d s

s ( M = ( 】+
i
0 .5 % 0.66% 0 .7 5 % 1.0% 1.5% 2 .0% 2.5% 3.0% 3 .5% n

1 1.000 00 1.000 00 1.000 00 1.000 00 1.000 00 1.000 00 1.000 00 1.000 0 1.000 0 1.000 0 1
2 2.002 50 2.005 00 2.006 67 2.007 50 2.010 00 2.015 00 2.020 00 2.025 0 2.030 0 2.035 0 2
3 3.007 51 3.015 03 3.020 04 3.022 56 3.030 10 3.045 23 3.060 40 3.075 6 3.090 9 3.106 2 3
4 4.015 03 4.030 10 4.040 18 4.045 23 4.060 40 4.090 90 4.121 61 4.152 5 4.183 6 4.214 9 4
5 5.025 06 5.050 25 5.067 11 5.075 56 5.101 01 5.152 27 5.204 04 5.256 3 5.309 1 5.362 5 5
6 6.037 63 6.075 50 6.100 89 6.113 63 6.152 02 6.229 55 6.308 12 6.387 7 6.468 4 6.550 2 6
7 7.052 72 7.105 88 7.141 57 7.159 48 7.213 54 7.322 99 7.434 28 7.547 4 7.662 5 7.779 4 7
8 8.070 35 8.141 41 8.189 18 8.213 18 8.285 67 8.432 84 8.582 97 8.736 1 8.892 3 9 .0 517 8
9 9.090 53 9.182 12 9.243 77 9.274 78 9.368 53 9.559 33 9.754 63 9.954 5 10.159 1 10.368 5 9
10 10.113 25 10.228 03 10.305 40 10.344 34 10.462 21 10.702 72 10.949 72 11.203 4 11.463 9 11.731 4 10
11 11.138 54 11.279 17 11.374 10 11.421 92 11.566 83 11.863 26 12.168 72 12.483 5 12.807 8 13.142 0 11
12 12.166 38 12.335 56 12.449 93 12.507 59 12.682 50 13.041 21 13.412 09 13.795 6 14.192 0 14.602 0 12
13 13.196 80 13.397 24 13.532 93 13.601 39 13.809 33 14.236 83 14.680 33 15.140 4 15.617 8 16.113 0 13
14 14.229 79 14.464 23 14.623 15 14.703 40 14.947 42 15.450 38 15.973 94 16.519 0 17.086 3 17.677 0 14
15 15.265 37 15.536 55 15.720 63 15.813 68 16.096 90 16.533 43 16.682 14 17.931 9 18.598 9 19.295 7 15
16 16.303 53 16.614 23 16.825 54 16.932 28 17.257 86 17.932 37 18.639 29 19.380 2 20.156 9 20.971 0 16
17 17.344 29 17.697 30 17.937 61 18.059 27 18.430 44 19.201 36 20.012 07 20.864 7 21.761 6 22.705 0 17
18 18.387 65 18.785 79 19.057 19 19.194 72 19.614 75 20.489 38 21.412 31 22.386 3 23.414 4 24.499 7 18
19 19.433 62 19.879 72 20.184 24 20.338 68 20.810 89 21.796 72 22.840 56 23.946 0 25.116 9 26.357 2 19
20 20.482 20 20.979 12 21.318 80 21.491 22 22.019 00 23.123 67 24.297 37 25.544 7 26.870 4 28.279 7 20
21 21.533 41 22.084 01 22.460 93 22.652 40 23.239 19 24.470 52 25.783 32 27.183 3 28.676 5 30.269 5 21
22 22.587 24 23.194 43 23.610 66 23.822 30 24.471 59 25.837 58 27.298 98 28.862 9 30.536 8 32.328 9 22
23 23.643 71 24.310 40 24.768 07 25.000 96 25.716 30 27.225 14 28.844 96 30.584 4 32.452 9 34.460 4 23
24 24.702 82 25.431 96 25.933 19 26.188 47 26.973 46 28.633 52 30.421 86 32.349 0 34.426 5 36.666 5 24
25 25.764 57 26.559 12 27.106 08 27.384 88 28.243 20 30.063 02 32.030 30 34.157 8 36.459 3 38.949 9 25
30 31.113 31 32.280 02 33.088 85 33.502 90 34.784 89 37.538 68 40.568 08 43.902 7 47.575 4 51.622 7 30
35 36.529 24 38.145 38 39.273 73 39.853 81 41.660 28 45.592 09 49.994 48 54.928 2 60.462 1 66.674 0 35
40 42.013 20 44.158 85 45.667 54 46.446 48 48.886 37 54.267 89 60.401 98 67.402 6 75.401 3 84.550 3 40
45 47.566 06 50.324 16 52.277 34 53.290 11 56.481 07 63.614 20 71.892 71 81.516 1 92.719 9 105.781 7 45
50 53.188 68 56.645 16 59.110 42 60.394 26 64.463 18 73.682 83 84.579 40 97.484 3 112.796 9 130.997 9 50
60 64.646 71 69.770 03 73.476 86 76.424 14 81.669 67 96.214 65 114.051 54 135.991 6 163.053 4 196.516 9 60
702
W
TABLE 3 co n tin u ed
S(n ,i)=
(1 + / 广 - 1
n 4.0% 4 .5% 5 .0 % 6 .0% 7 .0% 8 .0% 10.0% 12.0% 1 5 .0 % 20.0% n

1 1.000 0 1.000 0 1.000 0 1.000 0 1.000 0 1.000 0 1.000 0 1.000 1.000 1.00 1
2 2.040 0 2.045 0 2.050 0 2.060 0 2.070 0 2.080 0 2.100 0 2.120 2.150 2.20 2
3 3.121 6 3.137 0 3.152 5 3.183 6 3.214 9 3.246 4 3.310 0 3.374 3.472 3.64 3
4 4.246 5 4.278 2 4.310 1 4.374 6 4.439 9 4.506 1 4.641 0 4.779 4.993 5.36 4
5 5.416 3 5.470 7 5.525 6 5.627 1 5.750 7 5.866 6 6.105 1 6.353 6.742 7.44 5
6 6.633 0 6.716 9 6.801 9 6.975 3 7.153 3 7.335 9 7.715 6 8.115 8.754 9.93 6
7 7.898 3 8.019 2 8.142 0 8.393 8 8.654 0 8.922 8 9.487 2 10.089 11.067 12.92 7
8 9.214 2 9.380 0 9.549 1 9.897 5 10.259 8 10.636 6 11.435 9 12.300 13.727 16.50 8
9 10.582 8 10.802 1 11.026 6 11.491 3 11.978 0 12.487 6 13.579 5 14.776 16.786 20.80 9
10 12.006 1 12.288 2 12.577 9 13.180 8 13.816 4 14.486 6 15.937 4 17.549 20.304 25.96 10
11 13.486 4 13.841 2 14.206 8 14.971 6 15.783 6 16.645 5 18.531 2 20.655 24.349 32.15 11
12 15.025 8 15.464 0 15.917 1 16.869 9 17.888 5 18.977 1 21.384 3 24.133 29.002 39.58 12
13 16.626 8 17.159 9 17.713 0 18.882 1 20.140 6 21.495 3 24.522 7 28.029 34.352 48.50 13
14 18.291 9 18.932 1 19.598 6 21 .015 1 22.550 5 24.214 9 27.975 0 32.393 40.505 59.20 14
15 20.023 6 20.784 1 21.578 6 23.276 0 25.129 0 27.152 1 31.772 5 37.280 47.580 72.04 15
16 21.824 5 22.719 3 23.657 5 25.672 5 27.888 1 30.324 3 35.949 7 42.753 55.717 87.44 16
17 23.697 5 24.741 7 25.840 4 28.212 9 30.840 2 33.750 2 40.544 7 48.884 65.075 105.93 17
18 25.645 4 26.855 1 28.132 4 30.905 7 33.999 0 37.450 2 45.599 2 55.750 75.836 128.12 18
19 27.671 2 29.063 6 30.539 0 33.760 0 37.379 0 41.446 3 51.159 1 63.440 88.212 154.74 19
20 29.778 1 31.371 4 33.066 0 36.785 6 40.995 5 45.762 0 57.275 0 72.052 102.443 186.69 20
21 31.969 2 33.783 1 35.719 3 39.992 7 44.865 2 50.422 9 64.002 5 81.699 118.810 225.03 21
22 34.248 0 36.303 4 38.505 2 43.392 3 49.005 7 55.456 8 71.402 8 92.502 137.631 271.03 22
23 36.617 9 38.937 0 41.430 5 46.995 8 53.436 1 60.893 3 79.543 0 104.603 159.276 326.24 23
24 39.082 6 41.689 2 44.502 0 50.815 6 58.176 7 66.764 8 88.497 3 118.155 184.167 392.48 24
25 41.645 9 44.565 2 47.727 1 54.864 5 63.249 0 73.105 9 98.347 1 133.334 212.793 471.98 25
30 56.084 9 61.570 6 66.438 8 79.058 2 74.460 8 113.283 2 164.494 0 241.532 434.744 11 81 .8 8 30
35 73.652 2 81.496 6 90.320 3 111.434 8 138.236 9 172.316 8 271.024 4 431.663 881.168 2 948.34 35
40 95.025 5 107.030 3 120.799 8 154.762 0 199.635 1 259.056 5 442.592 6 767.088 1 779.090 7 343.95 40
45 121.029 4 138.850 0 159.700 2 212.743 5 285.749 3 386.505 6 718.904 8 1 358.224 3 585.128 18 281.31 45
50 152.667 1 178.503 0 209.348 0 290.335 9 406.528 9 573.770 2 11 6 3 .9 0 8 5 2 400.008 7 217.716 45 497.19 50
60 237.990 7 289.498 0 353.583 7 533.1281 813.520 4 1253.2133 3 034.816 4 7 471.641 29 219.992 28 1732.57 60
TABLE 4 P re se n t v alu e o f an a n n u ity o f $1 p e r p e rio d fo r n p e rio d s
P = A (» ") = 4i ! 1
(l + 〇 ,!
0.25% 0 .5 % 1.0% 1.5% 2 .0 % 2 .5% 3.0% 3.5% n
1 0.997 51 0.995 02 0.993 38 0.992 56 0.990 10 0.985 22 0.980 39 0.975 6 0.970 9 0.966 2 1
2 1.992 52 1.985 10 1.980 18 1.977 72 1.970 40 1.955 88 1.941 56 1.927 4 1.913 5 1.899 7 2
3 2.985 06 2.970 25 2.960 44 2.955 56 2.940 99 2.912 20 2.883 88 2.856 0 2.828 6 2.801 6 3
4 3.975 12 3.950 50 3.934 21 3.92611 3.901 97 3.854 38 3.807 73 3.762 0 3.717 1 3.673 1 4
5 4.962 72 4.925 87 4.901 54 4.889 44 4.853 43 4.782 65 4.713 46 4.645 8 4.579 7 4.515 1 5
6 5.947 85 5.896 38 5.862 45 5.845 60 5.795 48 5.697 19 5.601 43 5.508 1 5.417 2 5.328 6 6
7 6.930 52 6.862 07 6.817 01 6.794 64 6.728 19 6.598 21 6.471 99 6.349 4 6.230 3 6.114 5 7
8 7.910 74 7.822 96 7.765 24 7.736 61 7.651 68 7.485 93 7.325 48 7.170 1 7.019 7 6.874 0 8
9 8.888 52 8.779 06 8.707 19 8.671 58 8.566 02 8.360 52 8.162 24 7.970 9 7.786 1 7.607 7 9
10 9.863 86 9.730 41 9.642 90 9.599 58 9.471 30 9.222 19 8.982 54 8.752 1 8.530 2 8.316 6 10
11 10.836 77 10.677 03 10.572 42 10.520 67 10.367 63 10.07112 9.786 85 9.514 2 9.252 6 9.001 6 11
12 11.807 25 11.618 93 11.495 78 11.434 91 11.255 08 10.907 51 10.575 34 10.257 8 9.954 0 9.663 3 12
13 12.775 32 12.556 15 12.413 03 12.342 35 12.133 74 11.731 53 11.348 37 10.983 2 10.635 0 10.302 7 13
14 13.740 96 13.488 71 13.324 20 13.243 02 13.003 70 12.543 38 12.106 25 11.690 9 11.296 1 10.920 5 14
15 14.704 20 14.416 62 14.229 34 14.136 99 13.865 05 13.343 23 12.849 26 12.381 4 11.937 9 11.517 4 15
16 15.665 04 15.339 93 15.128 48 15.024 31 14.717 87 14.131 26 13.577 71 13.055 0 12.5611 12.094 1 16
17 16.623 48 16.258 63 16.021 67 15.905 02 15.562 25 14.907 65 14.291 87 13.712 2 13.166 1 12.651 3 17
18 17.579 53 17.172 77 16.908 94 16.779 18 16.398 27 15.672 56 14.992 03 14.353 4 13.753 5 13.189 7 18
19 18.533 20 18.082 36 17.790 34 17.646 83 17.226 01 16.426 17 15.678 46 14.978 9 14.323 8 13.709 8 19
20 19.484 49 18.987 42 18.665 90 18.508 02 18.045 55 17.168 64 16.351 43 15.589 2 14.877 5 14.212 4 20
21 20.433 40 19.887 98 19.535 66 19.362 80 18.856 98 17.900 14 17.011 21 16.184 5 15.415 0 14.698 0 21
22 21.379 95 20.784 06 20.399 67 2 0 .2 11 2 1 19.660 38 18.620 83 17.658 05 16.765 4 15.936 9 15.1671 22
23 22.324 14 21.675 68 21.257 95 21.053 31 20.455 82 19.330 86 18.292 20 17.332 1 16.443 6 15.620 4 23
24 23.265 98 22.562 87 22.110 54 21.889 15 21.243 39 20.030 41 18.913 93 17.885 0 16.935 5 16.058 4 24
25 24.205 47 23.445 64 22.957 49 22.718 76 22.023 16 20.719 61 19.523 46 18.424 4 17.413 1 16.481 5 25
30 28.867 87 27.794 05 27.108 85 26.775 08 25.807 71 24.015 84 22.396 46 20.930 3 19.600 4 18.392 0 30
35 33.472 43 32.035 37 31.124 55 30.682 66 29.408 58 27.075 60 24.998 62 23.145 2 21.487 2 20.000 7 35
40 38.019 86 36.172 23 35.009 03 34.446 94 32.834 69 29.915 85 27.355 48 25.102 8 23.114 8 21.355 1 40
45 42.510 88 40.207 20 38.766 58 38.073 18 36.094 51 32.552 34 29.490 16 26.833 0 24.518 7 22.495 5 45
50 46.946 17 44.142 79 42.401 34 41.566 45 39.196 12 34.999 69 31.423 61 28.362 3 25.729 8 23.455 6 50
60 55.652 36 51.725 56 49.318 43 48.173 37 44.955 04 39.380 27 34.760 89 30.908 7 27.675 6 24.944 7 60
704
r
TABLE 4 co n tin u ed
P = A(n,i) = -
l1 〇+ 〇nJ1
n 4 .0% 4 .5% 5 .0% 6 .0 % 7.0% 8 .0% 10.0% 12.0% 15.0% 20.0% n
1 0.961 5 0.956 9 0.952 4 0.943 3 0.934 5 0.925 9 0.909 1 0.892 9 0.869 5 0.833 3 1
2 1.886 1 1.872 7 1.859 4 1.833 3 1.808 0 1.783 2 1.735 5 1.690 1 1.625 7 1.527 8 2
3 2.775 1 2.749 0 2.723 2 2.673 0 2.624 3 2.577 0 2.486 8 2.401 8 2.283 2 2.106 5 3
4 3.629 9 3.587 5 3.546 0 3.465 1 3.387 2 3.312 1 3.169 8 3.037 3 2.854 9 2.588 7 4
5 4.451 8 4.390 0 4.329 5 4.212 3 4.100 1 3.992 7 3.790 7 3.604 8 3.352 1 2.990 6 5
6 5.242 1 5.157 9 5.075 7 4.917 3 4.766 5 4.622 8 4.355 2 4.111 4 3.784 4 3.325 5 6
7 6.002 1 5.892 7 5.786 4 5.582 3 5.389 2 5.206 3 4.868 4 4.563 8 4.160 4 3.604 6 7
8 6.732 7 6.595 9 6.463 2 6.209 7 5.971 2 5.746 6 5.334 9 4.967 6 4.487 3 3.837 2 8
9 7.435 3 7.268 8 7.107 8 6.801 6 6.515 2 6.246 8 5.759 0 5.328 2 4.771 5 4.031 0 9
10 8.110 9 7.912 7 7.721 7 7.360 0 7.023 5 6.710 0 6.144 5 5.650 2 5.018 7 4.192 5 10
11 8.760 5 8.528 9 8.306 4 7.886 8 7.498 6 7.138 9 6.495 0 5.937 7 5.233 7 4.327 1 11
12 9.385 1 9.118 6 8.863 3 8.383 8 7.942 6 7.536 0 6.813 6 6.194 4 5.420 6 4.439 2 12
13 9.985 6 9.682 9 9.393 6 8.852 6 8.357 6 7.903 7 7.103 3 6.423 5 5.583 1 4.532 7 13
14 10.563 1 10.222 8 9.898 6 9.294 9 8.745 4 8.244 2 7.366 6 6.628 2 5.724 4 4.610 6 14
15 11.118 4 10.739 5 10.379 7 9.712 2 9.107 9 8.559 4 7.606 0 6.810 9 5.847 3 4.675 5 15
16 11.652 3 11.234 0 10.837 8 10.105 8 9.446 6 8.851 3 7.823 7 6.974 0 5.954 2 4.729 6 16
17 12.165 7 11.707 2 11.274 1 10.477 2 9 .7 632 9 .1 216 8.021 5 7.119 6 6.047 1 4.774 6 17
18 12.659 3 12.160 0 11.689 6 10.827 6 10.059 0 9.371 8 8 .2 0 1 4 7.249 7 6.127 9 4.812 2 18
19 13.133 9 12.593 3 12.085 3 11.158 1 10.335 5 9.603 5 8.364 9 7.365 8 6.198 2 4.843 5 19
20 13.590 3 13.007 9 12.462 2 11.469 9 10.594 0 9.818 1 8.513 5 7.469 4 6.259 3 4.869 6 20
21 14.029 2 13.404 7 12.821 2 11.764 0 10.835 5 10.016 8 8.648 6 7.562 0 6.312 4 4.891 3 21
22 14.4511 13.784 4 13.163 0 12.041 5 11.061 2 10.200 7 8.771 5 7.644 6 6.358 6 4.909 4 22
23 14.856 8 14.147 8 13.488 6 12.303 3 11.272 1 10.371 0 8.883 2 7.718 4 6.398 8 4.924 5 23
24 15.247 0 14.495 5 13.798 6 12.550 3 11.469 3 10.528 7 8.984 7 7.784 3 6.433 7 4.937 1 24
25 15.622 1 14.828 2 14.093 9 12.783 3 11.653 5 10.674 7 9.077 0 7.843 1 6.464 1 4.947 6 25
30 17.292 0 16.288 9 15.372 5 13.764 8 12.409 0 11.257 7 9.426 9 8.055 2 6.565 9 4.978 9 30
35 18.664 6 17.461 0 16.374 2 14.498 2 12.947 6 11.654 5 9 .6 441 8.175 5 6.616 6 4.991 5 35
40 19.792 8 18.401 6 17.159 1 15.046 2 13.331 7 11.924 6 9.779 0 8.243 8 6.641 7 4.996 6 40
45 20.720 0 19.156 3 17.774 1 15.455 8 13.605 5 12.108 4 9.862 8 8.282 5 6.654 2 4.998 6 45
50 21.482 2 19.762 0 18.255 9 15.761 8 13.800 7 12.233 4 9.914 8 8.304 5 6.660 5 4.999 5 50
60 22.623 5 20.638 0丨 18.929 3 16.161 4 14.039 2 12.376 6 9.967 2 8.324 0 6.665 1 4.999 9 60
705
TABLE 5 A reas u n d e r th e n o rm a l cu rve fro m - 〇〇 to th e v alu e o f z
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 •09
- 0.0 0.5000 0.4960 0.4920 0.4880 0.4840 0.4801 0.4761 0.4721 0.4681 0.4641
- 0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
- 0.2 0.4207 0.4168 0.4129 0.4090 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
-0 .3 0.3821 0.3783 0.3745 0.3707 0.3669 0.3632 0.3594 0.3557 0.3520 0.3483
-0 .4 0.3446 0.3409 0.3372 0.3336 0.3300 0.3264 0.3228 0.3192 0.3156 0.3121
-0 .5 0.3085 0.3050 0.3015 0.2981 0.2946 0.2912 0.2877 0.2843 0.2810 0.2776
- 0.6 0.2743 0.2709 0.2676 0.2643 0.2611 0.2578 0.2546 0.2514 0.2483 0.2451
-0 .7 0.2420 0.2389 0.2358 0.2327 0.2296 0.2266 0.2236 0.2206 0.2177 0.2148
- 0.8 0.2119 0.2090 0.2061 0.2033 0.2005 0.1977 0.1949 0.1922 0.1894 0.1867
-0 .9 0.1841 0.1814 0.1788 0.1762 0.1736 0.1711 0.1685 0.1660 0.1635 0.1611
- 1.0 0.1587 0.1562 0.1539 0.1515 0.1492 0.1469 0.1446 0.1423 0.1401 0.1379
- 1 .1 0.1357 0.1335 0.1314 0.1292 0.1271 0.1251 0.1230 0 .12 10 0.1190 0.1170
- 1.2 0.1151 0.1131 0 .1112 0.1093 0.1075 0.1056 0.1038 0.1020 0.1003 0.0985
-1 .3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
-1 .4 0.0808 0.0793 0.0778 0.0764 0.0749 0.0735 0.0721 0.0708 0.0694 0.0681
-1 .5 0.0668 0.0655 0.0643 0.0630 0.0618 0.0606 0.0594 0.0528 0.0571 0.0559
- 1.6 0.0548 0.0537 0.0526 0.0516 0.0505 0.0495 0.0485 0.0475 0.0465 0.0455
-1 .7 0.0446 0.0436 0.0427 0.0418 0.0409 0.0401 0.0392 0.0384 0.0375 0.0367
- 1.8 0.0359 0.0351 0.0344 0.0336 0.0329 0.0322 0.0314 0.0307 0.0301 0.0294
-1 .9 0.0287 0.0281 0.0274 0.0268 0.0262 0.0256 0.0250 0.0244 0.0239 0.0233
- 2.0 0.0228 0.0222 0.0217 0.0212 0.0207 0.0202 0.0197 0.0192 0.0188 0.0183
- 2.1 0.0179 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146 0.0143
- 2.2 0.0139 0.0136 0.0132 0.0129 0.0125 0.0122 0.0119 0.0116 0.0113 0.0110
-2 .3 0.0107 0.0104 0.0102 0.0099 0.0096 0.0094 0.0091 0.0089 0.0087 0.0084
-2 .4 0.0082 0.0080 0.0078 0.0075 0.0073 0.0071 0.0069 0.0068 0.0066 0.0064
-2 .5 0.0062 0.0060 0.0059 0.0057 0.0055 0.0054 0.0052 0.0051 0.0049 0.0048
- 2.6 0.0047 0.0045 0.0044 0.0043 0.0041 0.0040 0.0039 0.0038 0.0037 0.0036
-2 .7 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028 0.0027 0.0026
- 2.8 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021 0.0020 0.0019
-2 .9 0.0019 0.0018 0.0018 0.0017 0.0016 0.0016 0.0015 0.0015 0.0014 0.0014
-3 .0 0.0014 0.0013 0.0013 0.0012 0.0012 0.0011 0.0011 0.0011 0.0010 0.0010
-3 .1 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008 0.0008 0.0007 0.0007
-3 .2 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006 0.0005 0.0005 0.0005
-3 .3 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004 0.0004 0.0004 0.0003
-3 .4 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0002
-3 .5 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002
-3 .6 0.0002 0.0002 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
-3 .7 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
-3 .8 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
-3 .9 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
-4 .0 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
706
TABLE 5 con tin u ed
2 0.00 0 .0 1 0.02 0.0 3 0.0 4 0.0 5 0.0 6 0 .0 7 0.0 8 0 .0 9
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1 .1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9986 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
3.5 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998
3.6 0.9998 0.9998 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.7 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.8 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.9 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
4.0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
707
CHAPTER 3
1. U sing E q u a tio n 3 .2 :
S = P (1 +
T h e re fo re :
$6250 = $6000 1+
S o lv in g this e q u a tio n , w e fin d th a t r = 0 . 2 5 3 4 7 2 o r a p p ro x im a te ly 2 5 . 3 5 p e r c e n t p e r a n n u m .
2. The series o f d e p o s its consists o f th e in itia l d e p o s it plus a n o r d in a r y a n n u ity w ith a term o f 1 0 ye a rs.
(a) U sin g E q u a tio n 3 .4 , the fu tu re v a lu e o f th e first d e p o s it is:
S = P (1 + / ] n
= $ 5 0 0 0 ( 1 .0 8 ) 10
= $ 5 0 0 0 x 2 .1 5 8 9 2 4 9 9 7
= $ 1 0 7 9 4 .6 2
U sin g E q u a tio n 3 . 2 8 , the fu tu re v a lu e o f the 1 0 la te r d e p o s its is:
,r - i]
$1000
[( 1 .0 8 ) 10
0 .0 8
= $ 1 0 0 0 x 1 4 .4 8 6 5 6 2 4 7
= $ 1 4 4 8 6 .5 6
T he re fore , w h e n A n g e la has m a d e the last d e p o s it, she w ill h a ve $ 1 0 7 9 4 . 6 2 + $ 1 4 4 8 6 . 5 6 = $ 2 5 2 8 1 .1 8 .

(b) The a m o u n t to b e d e p o s ite d n o w is the p re se n t v a lu e o f $ 2 5 2 8 1 .1 8 in 1 0 y e a rs ' tim e . U sin g E q u a tio n 3 .5 ,
this a m o u n t is:
_ $ 2 5 2 8 1 .1 8
( 1 .0 8 ) 10
$ 2 5 2 8 1 .1 8
_ 2 .1 5 8 9 2 4 9 9 7
= $ 1 1 7 1 0 .0 8 3
3. (b) U sing E q u a tio n 3 .6 :
= 0 .1 0 3 6 1 8
709
A ppendix B S o lutio ns t o self-test problems
(b) The re p a y m e n ts a re a n o r d in a r y a n n u ity fo r 2 5 x 12 = 3 0 0 m onths w ith a m o n th ly interest rate o f

9 9
— p e rc e n t = 0 .8 2 5 p e r ce n t. U sin g E q u a tio n 3 .1 9 :
$75 0 0 0 = — - —
0 .0 0 8 2 5 ( 1 .0 0 8 2 5 )300
$ 7 5 0 0 0 = C x 1 1 0 .9 0 6 4 3 7
c _ $75 000
1 1 0 .9 0 6 4 3 7
= $ 6 7 6 . 2 5 per month
CHAPTER 4
1• The e s tim a te d v a lu e o f o n e sh a re is th e p re se n t v a lu e o f th e d iv id e n d s fo r th e n e x t 2 y e a rs plus th e p re se n t v a lu e o f

the sh a re as a t th e e n d o f 2 y e a rs . The la tte r v a lu e ca n be e stim a te d u sin g E q u a tio n 4 .8 .
p D〇(1 + g') t D〇(l + g')2* | ___ 1 _ D〇(1 + g,)2(l +g)

0 |1 + M (1 + M 2 (1 + M 2 [k e -g ]
_ $ 0 .7 5 (1 .0 8 ) $ 0 .7 5 ( 1 .0 8 )2 1 $ 0 .7 5 ( 1 ,0 8 )2 (1 .04)
1 .1 4 ~ + ~ ( 1 . 1 4 ) 2~ + (1 .1 4 )2 ~ ( 0 .1 4 - 0 .0 4 )
= $ 8 .3 8
2. The in te re st p a y m e n ts o f $ 5 . 5 0 p e r h a lf y e a r a re a n o r d in a r y a n n u ity. The y ie ld is 1 3 / 2 = 6 . 5 p e r c e n t p e r h a lf

y e a r, th e re fo re the c u rre n t p ric e P is:
_ $ 5 .5 0 $100
_ 0 .0 6 5 (1 .0 6 5 )6 (1 .0 6 5 )6
= $ 9 5 .1 6
3. O n th e b a sis o f th e e x p e c ta tio n s th e o ry o f th e term structure o f in te re st rates, w e have:
3
( ] + z 0,3) = 〇 + z 0,l ) 〇 + z l ,2) 〇 + z 2,3)
T h e re fo re , the 1-ye a r z e ro rates in fu tu re y e a rs a re fo u n d as fo llo w s :
In Year 2: (1.,1 170)2 = (1 .1 3 9 0 ) (1 + z ] 2)
Therefore ^ 2 = 9 .5 4 2 %
In Year 3: (1 .1 0 6 0 ) 3 = (1 .1 3 9 0 ) (1 .0 9 5 4 2 ) (1 + z 2 3)
Therefore z 2 3 = 8 .4 3 2 %
(1 .1 0 6 0 )3
Equivalently:
Z2' 3 _ ( 1 . 1 1 7 0 ) 2 _ 1
= 8 .4 3 2 %
710
CHAPTER 5
Q
NPV= J 2
r “ r
= $ 101 8 0 0 + $ 9 0 0 0 0 + $ 8 0 0 0 0 _ $18〇〇〇〇
1.10 (1.10)2 (1.10)3

= $ 9 2 5 4 5 + $ 7 4 3 8 0 + $ 6 0 105 - $ 1 8 0 0 0 0
=$47030
2. $180000= $ 1〇 18 〇〇 + M ^ + M ^
1+r (1 + i ] 2 (1 + r1 3
If w e try a d is c o u n t ra te o f 2 5 p e r cent, w e fin d that:
$ 1 8 0 0 0 0 = $81 4 4 0 + $ 5 7 6 0 0 + $ 4 0 9 6 0
NPV=0
T h e re fo re , the in te rn a l ra te o f return is 2 5 p e r cent.
^ _ r. present value o f net cash flow s

〇• Benerit-cost ratio = ---------------- -----------------------------
in itia l cash outlay
$227030
~ $180000
= $ 1 .2 6
CHAPTER 6
1. The a n n u a l d e p re c ia tio n c h a rg e w ill b e e q u a l to $ 8 4 0 0 0 / 1 2 = $ 7 0 0 0 . The in cre a se in p ro fit e a c h y e a r (ig n o rin g

the e x p e n d itu re on a n o v e rh a u l e v e ry 2 years) is $ 2 0 0 0 0 - $ 7 0 0 0 = $ 1 3 0 0 0 . The c o m p a n y in c o m e ta x rate
is 0 .3 0 % th e re fo re , the in c re a s e in ta x a tio n is $ 1 3 0 0 0 x 0 . 3 0 = $ 3 9 0 0 p e r a n n u m . The net p re se n t v a lu e from
p u rc h a s in g the e q u ip m e n t is th e re fo re e q u a l to the p re se n t v a lu e o f the a n n u a l sa vin g s o f $ 2 0 0 0 0 - $ 3 9 0 0 , less
the p re se n t v a lu e o f the o v e rh a u ls e v e ry 2 y e a rs , less th e in itia l o u tla y.
The n e t p re se n t v a lu e is th e re fo re e q u a l to:
( 1 .1 )12 $ 2 0 0 0 (1 - 0 . 3 0 ) $ 2 0 0 0 (1 - 0 . 3 0 )
($ 2 0 0 0 0 - $ 3 9 00 1
0.1 l.l2 l.l4
$ 2 0 0 0 (1 -0 .3 0 ) $ 2 0 0 0 (1 -0 .3 0 ) $ 2 0 0 0 (1 -0 .3 0 ) t0 /1 ™
-------------a------------------------- 〇------------------------- Tn---------- 4 > «4 U U U
l.l6 l.l8 l . l 10
$21 6 0 4
As the net p re se n t v a lu e is p o s itiv e , th e e q u ip m e n t sh o u ld be p u rc h a s e d .
2. The o p tim u m re p la c e m e n t p o lic y c a n b e c a lc u la te d u sin g th e m e th o d o u tlin e d in S e ctio n 6 . 2 . In th e ca se o f th e TMT,

the o b je c tiv e is to m in im is e the p re se n t v a lu e o f cash o u tflo w s , a ssu m in g th a t o p e ra tin g cash in flo w s re m a in c o n s ta n t
e a ch y e a r. For re p la c e m e n t e v e ry y e a r, the N P V is:
$50000
^ ,= -$ 6 4 0 0 0 -^ °
1 .1 5
-$ 3 0 0 8 7
71 1
A ppendix B S o lutio ns to self-test problems
If the m a c h in e is re p la c e d e v e ry y e a r in p e rp e tu ity, the N P V is:
^ | l , 〇〇 ) = -$ 3 0 0 8 7 ^ ^
= -$ 2 3 0 6 6 7
The net p re se n t v a lu e 3 assu m in g re p la c e m e n t in p e rp e tu ity a t the e n d o f 2 , 3 ; 4 a n d 5 y e a rs a re :
N W (2,oc) ==-$217953
卿 P'ocl := -$220463
NPV[4,oo) -= -$223 708
NPV(5,oo) -= -$240906
T h e re fo re , the m a c h in e s h o u ld b e re p la c e d a t the e n d o f 2 ye a rs.
3. (a) Retain semi-trailers fo r 3 years a n d then replace w ith Flexivans.

W e assum e th a t the F lexivan s a re to b e re p la c e d in p e rp e tu ity.
(i) R e sidual v a lu e o f se m i-tra ile rs:
$ 1 0 0 0 0 ( 1 . 1 )-3 = $ 7 5 1 3
(ii) N e t ca sh flo w s o f se m i-tra ile rs:
(1 + 0 .1 0 )3
$300000 $746056
0.10
C o n s id e r o n e F le xiva n :
In itia l o u tla y = $ 7 0 0 0 0
PV o f net cash flo w s :
(1+0.10 广
$40000 $ 1 5 1 631
0.10
PV o f re s id u a l va lu e :
$ 5 0 0 0 ( 1 . 1)"5 = $ 3 1 0 5
N P V o f o n e F le xiva n :
- $ 7 0 0 0 0 + $ 1 5 1 631 + $ 3 1 0 5 = $ 8 4 7 3 6
(iii) PV o f a p e rp e tu a l c h a in o f six F lexivan s b e g in n in g in 3 ye a rs:
6 ($ 8 4 7 3 6 )
(II)5 ( l . l ) - 3 = $1 0 0 7 6 5 5
.( i.ii5 -
N e t p re se n t v a lu e :
(i) + (ii) + (iii) = $ 7 5 1 3 + $ 7 4 6 0 5 6 + $1 0 0 7 6 5 5 = $1 7 6 1 2 2 4
(b) R eplace se m i-tra ile rs w ith F lexivan s n o w .

(i) S a lv a g e v a lu e o f se m i-tra ile rs: $ 5 0 0 0 0
(ii) PV o f a p e rp e tu a l c h a in o f six F le xiva n s b e g in n in g n o w :
6 ($ 8 4 7 3 6 )
( i. ir $1 3 1 4 1 8 9
.( l.l) 5 - '
712
N e t p re se n t v a lu e :
(i) + (ii) = $1 3 9 1 1 8 9
S in ce the net p re se n t v a lu e o f re ta in in g the CB se m i-tra ile rs fo r 3 y e a rs a n d then re p la c in g them w ith A Z

F lexivan s is g re a te r than the net p re se n t v a lu e o f re p la c in g the CB se m i-tra ile rs w ith the A Z F lexivan s now ,
the CB se m i-tra ile rs sh o u ld be re ta in e d fo r 3 ye a rs .
CHAPTER 7
1. (a) U sin g E q u a tio n 7 .1 , th e e x p e c te d return on th e p o rtfo lio is:
E[Rp) = wx E(Rx) + w yE(Ry)
= (0 .3 1 (0 .1 2 ) + (0 .7 )(0 .1 8)
= 0 .1 6 2 o r 1 6 .2 %
(b) U sing E q u a tio n 7 .4 , the v a ria n c e o f the p o rtfo lio is:
aP = + ^ yg y + ^ w x w y P 0 X0 Y
= (0.3)2(0.2)2 + (0.7)2(0.15)2 + 2(0.3) (0.7) p(0.2) (0.15)
= 0 . 0 0 3 6 + 0 .0 1 1 0 2 5 + 0 . 0 1 2 6 p
jjj p = + 1 .0 , a p = 0 .0 2 7 2 2 5
(ii) p = + 0 .7 , (jp = 0 .0 2 3 4 4 5
jjjjj p = 0, 〇 p = 0 .0 1 4 6 2 5
jjv j p = - 0 . 7 , ap = 0 .0 0 5 8 0 5
These results illu s tra te the fa c t th a t, o th e r th in g s b e in g e q u a l, d iv e rs ific a tio n is m o re e ffe c tiv e the lo w e r the
c o rre la tio n c o e ffic ie n t.
2. The v a ria n c e - c o v a ria n c e m a trix w ill be a 3 x 3 m a trix w ith the v a ria n c e s o f th e th re e se cu ritie s on th e m ain
d ia g o n a l a n d c o v a ria n c e s in a ll o th e r cells. For e x a m p le , the v a ria n c e o f X is ( 0 .2 2 ) 2 = 0 . 0 4 8 4 a n d the c o v a ria n c e
b e tw e e n X a n d Y is (0 .6 ) (0 .2 2 ) (0 .1 5 ) = 0 . 0 1 9 8 . The m a trix is:
X 0 .0 4 8 4 0 .0 1 9 8 0 .0 1 3 2
Y 0 .0 1 9 8 0 .0 2 2 5 0 .0 0 9 0
Z 0 .0 1 3 2 0 .0 0 9 0 0 .0 1 0 0
= + + + 2 w ^ 2 w 2 C 〇y [R x ，Ry) + 2 w ^V V yC Q y R^) + 2w yV V 2C 〇y (Ry>
= (0 .2 )2 (0 .0 4 8 4 ) + (0 .3 )2 (0 .0 2 2 5 ) + (0 .5 )2 (0 .0 1 0 0 ) + 2 (0 .2 )(0 .3 )(0 .0 1 9 8 ) + 2 (0 .2 ) (0.5 ) (0 .0 1 3 2 )
+ 2 (0 .3 ) (0.5) (0 .0 0 9 0 )
= 0 .0 0 1 9 3 6 + 0 .0 0 2 0 2 5 + 0 .0 0 2 5 + 0 .0 0 2 3 7 6 + 0 .0 0 2 6 4 + 0 .0 0 2 7 = 0 .0 1 4 1 7 7
= 0 .0 0 1 9 3 6 + 0 .0 0 2 0 2 5 + 0 .0 0 2 5 + 0 .0 0 2 3 7 6 + 0 .0 0 2 6 4 + 0 .0 0 2 7 = 0 .0 1 4 1 7 7
The s ta n d a rd d e v ia tio n is:
〇 = V 〇 .0 3 8 4 7 7
= 0 .1 9 6 1 5
713
A ppendix B So lu tio n s to self-test problems
3. The C A P M ca n b e used to c a lc u la te the re q u ire d return o n e a c h sh a re . For e x a m p le , fo r C a rlto w n th e re q u ire d return

is c a lc u la te d as fo llo w s :
E iR ^ R ^ p ^ R ^ - R f ]
= 0 . 0 8 + (0.7) (0 .0 6 )
= 0 .1 2 2 o r 1 2 .2 %
The e x p e c te d a n d re q u ire d returns on the fo u r shares a re as fo llo w s :
S h a re Expected return (% ) Required return (% )

C a rlto w n 1 3 .0 1 2 .2
Pivot 1 7 .6 1 7 .6
Forresters 1 4 .0 1 4 .6
B runsw ick 1 0 .4 1 0 .4
Pivot a n d B ru n s w ic k a re c o rre c tly v a lu e d , C a rlto w n is u n d e rv a lu e d a n d Forresters is o v e rv a lu e d .
C H A P T E R 10
1• The p ric e is fo u n d b y d is c o u n tin g the fa c e v a lu e usin g sim p le interest. U sin g E q u a tio n 1 0 .1 , the p ric e is:
1 + (r)(d/365)
= $500000
_ 1 + (0 .0 5 5 ) ( 9 0 /3 6 5 )
$500000
_ 1 .0 1 3 5 61 6 4 3
= $ 4 9 3 3 0 9 .9 1
The b ill is p u rc h a s e d fo r $ 4 9 3 3 0 9 .9 1 .
2. W h e n the b ill is so ld 3 0 d a y s la te r, its term to m a tu rity has b e c o m e 6 0 d a y s . A g a in u sin g E q u a tio n 1 0 .1 , the p ric e is:
1 + (r)[d /3 6 5 )
_ $500000
_ 1 + (0 .0 5 3 ) ( 6 0 /3 6 5 )
$500000
_ 1 .0 0 8 7 1 2 3 2 8
= $ 4 9 5 6 8 1 .4 6
The b ill is so ld fo r $ 4 9 5 6 8 1 . 4 6 . T h e re fo re , th e d o lla r return to th e h o ld e r o v e r the 3 0 -d a y p e rio d is:
$ 4 9 5 6 8 1 . 4 6 - $ 4 9 3 3 0 9 .9 1 = $ 2 3 7 1 . 5 5
The im p lie d in te re st ra te is:
$ 2 3 7 1 .5 5
$ 4 9 3 3 0 9 .9 1
= 0 .0 0 4 8 0 7 4 2 4
714
A ppendix B So lutio ns to self-test problems
T h e re fo re , the e ffe c tiv e a n n u a l in te re st ra te is:
365
(1 .0 0 4 8 0 7 4 2 4 ) 3 0 - 1
= 0 . 0 6 0 0 8 6 152
^6 .0 1 %
C H A P T E R 12
A n n u a l net cash flo w ($) 0 100 0 0 0 200 000
F in a n cin g p la n
(a) A ll equity
Rate on return on $1 0 0 0 0 0 0 (%) 0 10 20
(b) $750 000 equity and $ 2 5 0 0 0 0 loan
Interest p a id ($) 2 5 000 25 000 25 000
P rofit a fte r interest ($) -2 5 000 75 000 175 0 0 0
Rate o f return on $ 7 5 0 0 0 0 (%) -3 .3 3 10 2 3 .3 3
(c) $250 000 equity and $ 7 5 0 0 0 0 loan
Interest p a id ($) 75 000 75 000 75 000
Profit a fte r interest ($) -7 5 000 25 000 125 00 0
Rate o f return on $ 2 5 0 0 0 0 (%) -3 0 10 50
N o te th a t the c h o ic e o f fin a n c in g p la n has n o e ffe c t o n the ra te o f return on B a rry 's in ve stm e n t o n ly w h e n the net
o p e ra tin g cash flo w is $ 1 0 0 0 0 0 p e r a n n u m . For cash flo w s g re a te r th a n o r less th a n $ 1 0 0 0 0 0 p e r a n n u m , the
effects o f fin a n c ia l le v e ra g e a re e v id e n t fo r fin a n c in g p la n s (b) a n d (c).
2. (a) The first step is to use E q u a tio n 1 2 .3 to fin d fc〇

:
ke = k〇 + ( k o - k j)
21.5 = ^0 + (/c0 - 8 ) G )
R e a rra n g in g this e q u a tio n sho w s th a t /c〇= 1 7 p e r cent. A fte r th e n e w lo a n is ta ke n ou t, th e d e b t- e q u ity ra tio

is 1 :1 . U sing E q u a tio n 1 2 .3 a g a in :
/ce = 17 + (17 一 81 ( j )
= 26%
(b) The a v e ra g e co st o f c a p ita l is c a lc u la te d u sing E q u a tio n 1 2 .2 :
W ith the o r ig in a l c a p ita l structure:
U 2i-5(I)+8G)
= 17%
715
A fte r the in c re a s e in le v e ra g e :
U 2 6 ⑷ +8
= 17%
C o n siste n t w ith th e M M p ro p o s itio n s , th e c o m p a n y ’s w e ig h te d a v e ra g e co st o f c a p ita l is n o t c h a n g e d b y the

c h a n g e in its c a p ita l structure.
3. (a) C o s m ic 's v a lu e w ith a ll-e q u ity fin a n c e is:
w $ 6 0 0 0 0 0 (1 - 0 .3 0 )
Vu = ----------------------------
0 .1 5
=$420000
_ 0 .1 5
= $2 800000
(b) (i) Intere st o n the lo a n is $ 1 0 0 0 0 0 p e r a n n u m w h ic h is ta x d e d u c tib le .

A fte r-ta x cash flo w = $ ( 6 0 0 0 0 0 - 1 0 0 0 0 0 ) (1 - 0 .3 0 ) + $ 1 0 0 0 0 0 = $ 4 5 0 0 0 0 w h ic h is a n in c re a s e
o f $ 3 0 0 0 0 p e r an nu m .
(ii) The v a lu e o f the c o m p a n y c a n b e c a lc u la te d u sing E q u a tio n 1 2 .6 :
VL = V U+ tcD
= $ 2 8 0 0 0 0 0 + 0 .3 0 x $ 1 0 0 0 0 0 0
= $ 2 800 0 0 0 + $300 000
= $ 3 100000
C H A P T E R 14
1• (a) The cost o f c a p ita l fo r the p ro je c t fc- ca n b e e s tim a te d u sing E q u a tio n 1 4 .1 :
= 0 .1 2 + 0 .7 5 ( 0 .1 8 - 0 .1 2 )
= 0 .1 6 5
NPV--
Ci
-C,0
1 + kj
$235000
-$200000
1 .1 6 5
$1717
S in ce the N P V is p o s itiv e , the p ro je c t is a c c e p ta b le ,

(b) If Pj =
^• = 0 .1 2 + ( 0 . 1 8 - 0 . 1 2 )
= 0 .1 8
NPV= $ 2 3 5 0 0 0 = $ 2 0 0 0 0 0
1.1 8
= -$ 8 4 7
In this ca se , the p ro je c t is n o t a c c e p ta b le .
716
A ppendix B S olutions to self-test problems
2. (a) U sing the C A P M , th e costs o f c a p ita l fo r the p ro je c ts a re :
M a rs t = 9 + 0 . 7 0 ( 1 6 .5 - 9) = 1 4 .2 5 %
Pluto )c = 9 + 0 . 8 5 ( 1 6 .5 - 9 ) = 1 5 .3 7 5 %
N e p tu n e = 9+ 1 . 2 0 ( 1 6 . 5 - 9 ) = 1 8 .0 %
The p ro je c ts th a t sh o u ld b e a c c e p te d a re M a rs a n d N e p tu n e .
(b) If a ll p ro je c ts w e re e v a lu a te d u sing the c o m p a n y 's co st o f c a p ita l, M a rs w o u ld b e in c o rre c tly re je c te d a n d Pluto
w o u ld b e in c o rre c tly a c c e p te d .
3. The a n n u a l d e p re c ia tio n c h a rg e w ill b e e q u a l to $ 8 4 0 0 0 / 1 2 = $ 7 0 0 0 . The in c re a s e in p ro fit e a ch y e a r (ig n o rin g

the e x p e n d itu re on a n o v e rh a u l e v e ry 2 yea rs) is $ 2 0 0 0 0 - $ 7 0 0 0 = $ 1 3 0 0 0 . The e ffe c tiv e c o m p a n y in c o m e
ta x ra te is 0 .3 0 (1 - 0 .7 5 ) = 0 . 0 7 5 . T h e re fo re , the in c re a s e in ta x a tio n is $ 1 3 0 0 0 x 0 . 0 7 5 = $ 9 7 5 p e r a n n u m .
The net pre sen t v a lu e fro m p u rc h a s in g the e q u ip m e n t is th e re fo re e q u a l to th e p re se n t v a lu e o f the a n n u a l s a vin g s o f
$ 2 0 0 0 0 - $ 9 7 5 , less the p re se n t v a lu e o f the o v e rh a u ls e v e ry 2 y e a rs , less th e in itia l o u tla y.
The net p re se n t v a lu e is th e re fo re e q u a l to:
(1 .1 )2 $ 2 0 0 0 (1 - 0 . 0 7 5 ) $ 2 0 0 0 (1 - 0 . 0 7 5 )
($ 2 0 0 0 0 - $ 9 7 5 )
~〇? i ~ rr1 i.i4
$ 2 0 0 0 (1 - 0 . 0 7 5 ) $ 2 0 0 0 (1 - 0 . 0 7 5 ) $ 2 0 0 0 (1 -0 .0 7 5 ) $8>)〇〇〇
l.l8 l . l 10
=$40217
A s th e n e t p re s e n t v a lu e is p o s itiv e , th e e q u ip m e n t sh o u ld b e p u rc h a s e d .
C H A P T E R 15
1. (a) The N P V o f th e le ase to D o n a sh is th e co st o f th e c o m p u te r ( $ 4 4 0 0 0 0 ) less the p re se n t v a lu e o f th e cash

o u tflo w s fo r the le ase . S in ce D o n a sh w ill n o t b e p a y in g c o m p a n y in c o m e ta x d u rin g th e term o f th e le a se , the
o n ly cash o u tflo w s a re the le a se re n ta ls a n d the d is c o u n t ra te is 1 5 p e r c e n t p e r y e a r. The N P V to D o n a sh is:
NPV= $ 4 4 0 0 0 0 - $ 1 0 0 0 0 0 i 1 + — ' ―
\ 0 .1 5
= $ 4 4 0 0 0 0 -$ 4 3 5 216
=$4784
(b) C o m le a s e w ill p u rc h a s e th e c o m p u te r fo r $ 4 4 0 0 0 0 , re ce ive th e le ase re n ta ls ( $ 7 0 0 0 0 p e r a n n u m a fte r tax)
a n d re c e iv e d e p re c ia tio n ta x s a v in g s (0 .3 x ( 1 / 3 ) x $ 4 4 0 0 0 0 = $ 4 4 0 0 0 p e r an n u m ) in Years 1, 2 a n d 3 .
The a fte r-ta x d is c o u n t ra te is 15(1 - 0 . 3 ) = 1 0 .5 p e r c e n t p e r y e a r. The N P V to C o m le a s e is:
1 1 $44 000
NPV = - $ 4 4 0 0 0 0 + $ 7 0 0 0 0 i 1 + — ' ― [i 1 1
\ 0 .1 0 5 (0 .1 0 5 )5 . J ' 0 .1 0 5 [ (l.l〇 5 )3 J
=$466
(c) The o v e ra ll g a in on the tra n s a c tio n is:
$4784 + $446
=$5250
717
C H A P T E R 17
1• The c u rre n t s itu a tio n is:
S e p te m b e r p ric e : $ 12 6 0
June p ric e : $ 12 0 0
S p re a d : $ 60
The s p re a d is e x p e c te d to w id e n — th a t is, th e S e p te m b e r c o n tra c t w ill b e c o m e re la tiv e ly d e a re r a n d the June c o n tra c t

w ill b e c o m e re la tiv e ly c h e a p e r. T h e re fo re , w e w o u ld b u y th e S e p te m b e r c o n tra c t a n d sell the Jun e c o n tra c t. If the
su b s e q u e n t p ric e s a re $1 3 0 0 (June) a n d $1 3 8 0 (S ep tem be r), the o u tc o m e is:
June Sell at: $1200 (+)
Buy b a ck at: $1300 H
O u tco m e : $100 (loss)
September Buy at: $1260 H
Sell at: $1380 w
O u tco m e : $120 (p ro fit)
O v e ra ll o u tc o m e = - $ 1 0 0 + $120 = $20 (p ro fit). The p ro fit ($ 2 0 ) is e q u a l to th e c h a n g e in the s p re a d

(= $ 8 0 -$ 6 0 ).
2. The sale on 2 S e p te m b e r is a t a q u o te d p ric e o f 9 2 . 0 0 . This p ro v id e s an a n n u a l y ie ld o f 1 0 0 - 9 2 . 0 0 = 8 . 0 0

p e r cent. U sing E q u a tio n 1 7 .1 0 , the c o n tra c t p ric e is:
$1 000000
1 + (0 .0 8 ) ( 9 0 /3 6 5 )
= $ 9 8 0 6 5 5 .5 6
The c lo s in g o u t on 8 S e p te m b e r is a t a q u o te d p ric e o f 9 2 . 5 0 . This p ro v id e s an a n n u a l y ie ld o f 1 0 0 - 9 2 . 5 0 = 7 . 5 0

p e r cent. The c o n tra c t p ric e is:
$1 000000
1 + (0 .0 7 5 ) ( 9 0 /3 6 5 )
= $ 9 8 1 8 4 2 .6 4
H a ro ld w ill m a k e a loss o f $ 9 8 1 8 4 2 . 6 4 - $ 9 8 0 6 5 5 . 5 6 = $1 1 8 7 .0 8 on e a ch c o n tra c t. O n 1 5 co n tra c ts he w ill

lose $ 1 1 8 7 . 0 8 x 15 = $ 1 7 8 0 6 . 2 0 .
C H A P T E R 18
1• (a) The m in im u m th e o re tic a l p ric e is g iv e n b y E q u a tio n 1 8 .3 :
X
Min c = Max 0,s-
In this p ro b le m , c = $ 1 . 7 0 a n d the risk-free in te re st ra te fo r an 8-m o nth p e rio d is (1 .0 0 7 5 )8 6 .1 6
p e r cent. T h e re fo re , the p re se n t v a lu e o f the e x e rc is e p ric e is 丨二: % $ 1 4 .1 3 .
718
A ppendix B S o lutio ns to self-test problems
A/lax = M a x [0 , $ 1 4 . 9 0 - $ 1 4 . 1 3 ]
= M a x [0 , $ 0 .7 7 ]
= $ 0 .7 7
T h e re fo re the c u rre n t c a ll p ric e ( $ 1 .7 0 ) e xce e d s its m in im u m th e o re tic a l p ric e ( $ 0 .7 7 ) .

(b) The d e ta ils o f the a rb itr a g e a re set o u t in th e ta b le b e lo w . The p re se n t v a lu e o f the e x e rc is e p ric e , as c a lc u la te d
in (a), is $ 1 4 .1 3 .
Future ca sh f lo w ($) if
Current transaction Current ca sh f lo w ($) S* > $15 5* <
Buy p u t -0 .8 3 0 + (1 5 -S *)
Sell call + 1 .7 0 -(S *-1 5 ) 0
Buy share -1 4 .9 0 +S* +S*
B o rro w $ 1 4 .1 3 + 1 4 .1 3 -1 5 -1 5
Total + 0 .1 0 0 0
The ta b le sh o w s th a t the su g g e ste d tra n s a c tio n s c re a te a n a rb itra g e : a cash in flo w o f $ 0 . 1 0 p e r o p tio n is

a c h ie v e d to d a y , w h ile th e fu tu re ca sh flo w is g u a ra n te e d to be z e ro .
(c) The a r b itra g e is p o s s ib le b e ca u s e p u t-c a ll p a r ity (E q u a tio n 1 8 .1 ) is v io la te d in this p ro b le m .
P u t-c a ll p a rity is g iv e n b y:
In this p ro b le m , p = $ 0 .8 3 but:
c-S+ = $ 1 . 7 0 - $ 1 4 . 9 0 + $ 1 4 .1 3
1 +〆
= $ 0 .9 3
¥ P
2. The b in o m ia l la ttic e fo r this p ro b le m is:
F ig u re B . l Lattice o f sh a re p ric e s a n d call p ric e s
$ 7 .1 6 6 3
$1.1663
$ 6 .8 2 5 0
5 0 .8 8 4 4 ^ -^
$ 6 .5 0 0 0 $ 6 .5 0 0 0
$0.6354 $0.5000
$0.2922
$ 5 .8 9 5 7
$0.0
N o te th a t s h a re p ric e s a re s h o w n in bold a n d o p tio n p ric e s a re s h o w n in italics.
719
A ppendix B S o lu tio n s to self-test problems
S h a re p ric e c a lc u la tio n s a re :
$ 6 . 5 0 x 1 .0 5 = $ 6 .8 2 5 0
$ 6 . 8 2 5 0 x 1 .0 5 = $ 7 . 1 6 6 3
$ 6 .5 0 /1 .0 5 = $ 6 .1 9 0 5
$ 6 .1 9 0 5 /1 .0 5 = $ 5 .8 9 5 7
The 'u p 7 p r o b a b ility (p) a n d the /d o w n , p r o b a b ility (1 - p) a re g iv e n b y :
$ 6 5〇 = p ($ 6 .8 2 5 ) + ( 1 - p ) ( $ 6 . 1 9 0 5 )
• 一 1.01
w h ic h solves to g iv e p = 0 . 5 9 0 2 a n d 1 - p = 0 . 4 0 9 8 .
The p a y o ffs a t e x p ir y a re :
M a x [$ 0 , $ 7 .1 6 6 3 - $ 6 .0 0 ] = $ 1 .1 6 6 3
M a x [$ 0 , $ 6 . 5 0 - $ 6 . 0 0 ] = $ 0 .5 0
M a x [$ 0 , $ 5 .8 9 5 7 - $ 6 .0 0 ] = $ 0
The o p tio n p ric e c a lc u la tio n s a re :
( 0 .5 9 0 2 )($ 1 .1 6 6 3 ) + (0 .4 0 9 8 )($ 0 .5 0 ) = $〇8 8 4 4

1.01 ~
(0 .5 9 0 2 )($ 0 .5 0 ) + (0 .4 0 9 8 )($ 0 .0 0 ) = $〇2 9 2 2

1.01 一 .
( 0 .5 9 0 2 )($ 0 .8 8 4 4 ) + ( 0 .4 0 9 8 )($ 0 .2 9 2 2 ) = $〇6 3 5 4

1.01 一 •
The c u rre n t p ric e o f the c a ll o p tio n is th e re fo re c a lc u la te d to b e $ 0 . 6 3 5 4 , o r a p p ro x im a te ly 6 4 cents.
3. The B la c k -S c h o le s m o d e l to p ric e c a ll o p tio n s is E q u a tio n 1 8 .5 :
c = SN(d1)- X e - r，
TN(d2)
£n(S/X) + ( / + Acr2^ T
w h e re 山三 ---------------- ^ ^ z----- —
1 oVT
en[S/X\ + ( / + l a 2) 7
d2S------- 〇7f--------
= c/] - a v T
In this p ro b le m , S = $ 1 2 . 1 5 , X = $ 1 2 . 0 0 , 〆 = 0 . 1 0 p e r a n n u m , 7" = 0 . 2 5 y e a rs a n d = 0 . 2 p e r a n n u m . T h e re fo re :
d M 1 2 . 1 5 / 1 2 ) + [0.1 + ( 0 .5 ) ( 0 .2 ) 2](0 .2 5 )
1 0 .2 v /〇
^5
0 . 0 1 2 4 2 2 5 + 0 .0 3
« 0 .4 2 4 2
and
d 2 = 0 . 4 2 4 2 - 0.1
= 0 .3 2 4 2
720
Using Table 5 in Appendix A:
N/(0.4242卜 0.6643
and
N(0.3242) ^0.6271
The present value of the exercise price is given by:
e-(0.1)(0.25)x $ 1 2
=0.975 3099 x $12

« $11.703719
Therefore the call price, c, is given by:
($12.15)(0.6643) - ($11.707371 9)(0.6271)
=$0.7296
~ 73 cents
C H A P T E R 19
1. (a) The value of Beta to Alpha is $750000 = $3 〇〇〇〇〇〇. As there are 2 million shares on issue, Beta is a zero-
0.25
NPV investment at a price of $1.50 per share.
(b) The value of Beta as an independent entity is 丨〇〇= $2 000000.
(c) If $2.6 million cash is paid for Beta, the wealth of its shareholders will increase by $2.6 million - $2000000
=$600000. The answers to (a) and (b) show that the gain from the takeover is $ 1 million. If $600000 of this
gain accrues to Beta's shareholders, then the wealth of Alpha's shareholders must increase by $400000.
2. (a) The increase in the value of B's equity is $380000000 - $320000000 = $60000000. To achieve this
increase B must purchase 10 million shares at $5 each: an outlay of $50000000. Therefore, B's shareholders
benefit by $10000000, so it should proceed with the takeover.
(b) B will have to issue 15 million shares to acquire 50 per cent of C, after which it will have 95 million shares on
, , n , M, , $380000000 。
issue and each B share will be worth —-~ ____ = 》 4.
95 000000
The value of the outlay for the takeover is 15000000 x $4 = $60000000, so the wealth of B’s shareholders
will not be changed by the takeover.
CHAPTER 20
1. Using Equation 20.2:
Q*
/(2)(3000)(500)
V 48
=250 sprockets
where 〇 = $3000 (per run)

D = 500 (units per annum)
c = $48 (per sprocket per annum)
721
A ppendix B S o lutio ns t o seif-test problems
The e c o n o m ic p ro d u c tio n run is 2 5 0 sp ro cke ts, a n d th e re fo re = 2. T w o p ro d u c tio n runs p e r a n n u m a re

in d ic a te d . ^
2. A re o rd e r p o in t o f 2 2 0 0 w ill a c h ie v e a sto cko u t p r o b a b ility o f 5 p e r ce n t. If a re o rd e r p o in t o f 2 0 0 0 is a d o p te d , the

e x p e c te d cu sto m e r-se rvice le vel is:
' 2000 ' —2000 2000

0 . 1 0 + 0 . 2 0 + 0 . 5 0 + (0 .1 5 ) (0 .0 3 ) ( 0 . 02)
2200 .2 4 0 0 . 2600
= 0 .9 7 6 7
A s this e x c e e d s the ta rg e t level o f 9 5 p e r cent, a lo w e r re o rd e r p o in t w ill b e trie d . If a re o rd e r p o in t o f 1 8 0 0 is

a d o p te d , the e x p e c te d cu sto m e r-se rvice level is:
2800' 1800 *1 8 0 0 ' 1800

0 .1 0 + 0 .2 0 + (0 .5 0 ) + (0.15 ) + (0.03 ) + (0 . 02 )
2000 . 2200 .2 4 0 0 . 2600
= 0 .9 0 9 1
The re q u ire d re o rd e r p o in t thus lies b e tw e e n 1 8 0 0 a n d 2 0 0 0 . Let the re q u ire d p o in t e x c e e d 1 8 0 0 b y x units, w h e re

it is k n o w n th a t 0 < x < 2 0 0 . The e x p e c te d cu sto m e r-se rvice le vel is as fo llo w s :
1800 + x 1800 + x "1 8 0 0 + x ' 1800 + x '

0 .9 5 = 0 . 1 0 + 0 .2 0 + (0.50 ) + (0 .1 5 ) + (0.03 ) + ( 0 . 02 )
2000 2200 .2 4 0 0 . 2600 .
0 .1 5 0 .0 3 0 .0 2
= 0 , 0 + 0 .2 0 + 0 .4 5 + 0 , 2 2 7 3 + 0 .0 2 2 5 + 0 . 0 13 8 5 + [ _
2200 2400 + 2600
= 0 .9 0 9 0 8 + 0 .0 0 0 3 3 8 3 7 x
_ 0 .9 5 -0 .9 0 9 0 8
• X 一 0 .0 0 0 3 3 8 37
= 1 2 0 .9 3
=121
A s a result, a re o rd e r p o in t o f 1 8 0 0 + 121 = 1921 sh o u ld a c h ie v e a n e x p e c te d cu sto m e r se rv ic e le vel o f

a p p ro x im a te ly 9 5 p e r cent. This is c o n firm e d in th e fo llo w in g c a lc u la tio n :
1921 1921 1921 — 1921'

0 .1 0 + 0 . 2 0 + (0 .5 0 ) + (0 .1 5 ) (0 .0 3 ) + ( 0 . 02)
2000 2200 2400. .2 6 0 0 .
：0 . 10 + 0.20 + 0.480 25 + 0 . 1 3 0 9 8 + 0 .0 2 4 0 1 + 0 .0 14 7 8
0 .9 5 0 0 2
= 9 5 per cent
C H A P T E R 21
1• (a) The d is c o u n t fo r p a y m e n t 7 d a y s a fte r the in v o ic e d a te is $ 1 5 0 0 x 0 . 0 2 = $ 3 0 .

(b) C u s to m e r X saves $ 3 0 b y p a y in g 2 3 d a y s e a rly. The e ffe ctive a n n u a l in te re st ra te is:
365
/ 3 0 \^ 3 "
(1 + - 1 = 0 . 3 7 7 9 6 o r 3 7 .8 %
V 1470/
722
A ppendix B S olutions to self-test problems
C o n s id e r sales o f $ 1 0 0 0 . The cost o f g o o d s sold w ill be $ 7 5 0 . W ith the o r ig in a l term s, a n d u sing s im p le interest,
the N P V p e r $ 1 0 0 0 o f sales is:
NPV= — $1〇〇° = ^ - - $ 7 5 0
\365J
= $ 2 3 7 .8 3
W ith the revise d term s, th e N P V is:
N p y __ $ 7 0 0 x 0 .9 9 + _ $ 3 0 0 _ $75〇
1 + 〇.i ( i
V365/ V365；
= $ 2 3 0 .5 1
The d iffe re n c e in p ro fita b ility is sm all, b u t the o r ig in a l term s a re m o re p ro fita b le .

GLOSSARY
W
a b n o r m a l re tu rn s re tu rn s in e x c e s s o f th e re tu rn b e n e fi 卜
c o st r a tio in d e x c a lc u la t e d b y d i v id i n g
e x p e c te d fr o m a s e c u r ity th e p r e s e n t v a lu e o f th e fu tu r e n e t c a s h f lo w s
ac ce p to r (o r d r a w e e ) in a b ill o f e x c h a n g e , th e b y th e in it ia l c a s h o u t la y (a ls o k n o w n a s a
p a r t y a g r e e in g t o p a y th e h o ld e r th e b ill's f a c e p ro fita b ility index)

v a lu e o n th e m a t u r ity d a t e ; u s u a lly a b a n k o r o t h e r b e ta m e a s u r e o f a s e c u r ity 's s y s te m a tic ris k ,
f in a n c ia l in s titu tio n d e s c r ib in g th e a m o u n t o f r is k c o n t r ib u t e d b y th e
a c c o u n ts re c e iv a b le su m o f m o n e y o w e d to a s e c u r ity t o th e m a r k e t p o r t f o lio
s e lle r a s a re s u lt o f h a v in g s o ld g o o d s o r s e r v ic e s bill a c c e p ta n c e fa c ility a g r e e m e n t in w h ic h

o n c r e d it o n e e n t it y ( n o r m a lly a b a n k ) u n d e r ta k e s to a c c e p t
a c c o u n tin g ra te o f return e a r n in g s fr o m a n b ills o f e x c h a n g e d r a w n b y a n o t h e r e n t it y (th e
in v e s tm e n t e x p r e s s e d a s a p e r c e n t a g e o f th e b o rro w e r)
in v e s tm e n t o u t la y bill d is c o u n t fa c ility a g r e e m e n t in w h ic h o n e
a c c u m u la tio n p r o c e s s b y w h ic h , t h r o u g h th e e n t it y ( n o r m a lly a b a n k ) u n d e r ta k e s to d is c o u n t
o p e r a t io n o f in te re s t, a p r e s e n t su m b e c o m e s (b u y ) b ills o f e x c h a n g e d r a w n b y a n o t h e r e n t it y (th e
a g r e a t e r s u m in th e fu tu r e b o rro w e r)
a n n u it y s e rie s o f c a s h f lo w s , u s u a lly o f e q u a l bill o f e x c h a n g e m a r k e ta b le s h o rt-te rm d e b t s e c u r it y
a m o u n t, e q u a lly s p a c e d in tim e in w h ic h o n e p a r t y (th e d r a w e r ) d ir e c t s a n o t h e r

p a r t y (th e a c c e p t o r ) to p a y a s ta te d su m o n a s ta te d
a n n u it y -d u e a n n u it y in w h ic h th e f ir s t c a s h f lo w is
fu tu r e d a t e
to o c c u r 'im m e d ia t e ly ' (i.e . o n th e v a lu a t io n d a te )
b o n d d e b t s e c u r ity is s u e d w it h a m e d iu m o r lo n g
a r b it r a g e s im u lta n e o u s t r a n s a c t io n s in d if f e r e n t
te rm to m a t u r ity b y b o r r o w e r s s u c h a s g o v e r n m e n t s ,
m a rk e ts t h a t re s u lt in a n im m e d ia t e r is k - fr e e p r o f it
s ta te a u t h o r itie s a n d c o r p o r a t io n s in r e tu r n f o r c a s h
a t call m o n e y r e p a y a b le im m e d ia te ly , a t th e o p t io n
fr o m in v e s to rs
o f th e le n d e r
b o o k - t o - m a r k e t r a tio b o o k v a lu e o f a
a u th o r is e d d e p o s it -t a k in g in stitu tio n a c o r p o r a t io n
c o m p a n y ’ s e q u it y d i v id e d b y m a r k e t v a lu e o f
t h a t is a u t h o r is e d u n d e r th e B a n k in g A c t 1 9 5 9 to
th e c o m p a n y ’ s e q u it y
a c c e p t d e p o s its fr o m th e p u b lic
b r e a k -e v e n a n a l y s i s a n a ly s is o f th e a m o u n ts b y
b a d d e b ts a c c o u n ts t h a t h a v e p r o v e n to b e w h ic h o n e o r m o r e in p u t v a r ia b le s m a y c h a n g e
u n c o lle c t a b le a n d a r e w r it t e n o f f b e f o r e a p r o je c t c e a s e s to b e p r o f it a b le
b a n k bill ( b a n k a c c e p te d bill) b ill o f e x c h a n g e t h a t b r id g in g fin a n c e s h o rt-te rm lo a n to c o v e r a n e e d
has b e e n a c c e p te d o r e n d o rs e d b y a b a n k o fte n a r is in g f r o m t im in g d iff e r e n c e s b e t w e e n t w o o r

m o r e t r a n s a c t io n s
b a n k r u p tc y c o sts d ir e c t a n d in d ir e c t c o s ts
a s s o c ia te d w it h f in a n c ia l d i f f ic u lt y t h a t le a d s to b u b b le p e r io d in w h ic h p r ic e s ris e s tr o n g ly ,
c o n t r o l o f a c o m p a n y b e in g tr a n s f e r r e d to le n d e r s d e p a r t in g fr o m t h e ir 'tr u e v a lu e ’ ，f r e q u e n t ly f o llo w e d
b y a s u d d e n d e c r e a s e in p r ic e s
b a s is s p o t p r ic e a t a p o in t in t im e m in u s th e fu tu re s
p r ic e (fo r d e liv e r y a t s o m e la te r d a te ) a t t h a t p o in t b u s in e s s r is k v a r i a b ili t y o f fu tu r e n e t c a s h f lo w s
in tim e a t t r ib u t e d t o th e n a tu r e o f th e c o m p a n y ’s o p e r a tio n s .
It is th e r is k s h a r e h o ld e r s f a c e if th e c o m p a n y h a s
b a s is p o in t 0 . 0 1 p e r c e n t, o fte n a b b r e v ia t e d to 1 b p
no d e b t
B B S W B B S W is th e b a n k b ill r e f e r e n c e r a te a n d is
b u y - a n d - h o ld p o lic y in v e s tm e n t s tr a te g y in
th e s t a n d a r d b e n c h m a r k f o r th e f lo a t in g - r a t e c a s h
w h ic h s h a re s a r e b o u g h t a n d th e n r e t a in e d in th e
f lo w s in s h o rt-te rm in te r e s t r a t e s w a p s in A u s t r a lia .
in v e s to r 's p o r t f o lio f o r a lo n g p e r io d
It is a s e t o f r e p r e s e n t a t iv e m a r k e t in te r e s t ra te s f o r
b a n k b ills a n d s im ila r s e c u r itie s , q u o t e d o n a p e r b u y o u t (o r g o in g - p r iv a t e ) tr a n s a c tio n t r a n s f e r
a n n u m b a s is u s in g e x a c t d a y - c o u n ts . S ix B B S W fr o m p u b lic o w n e r s h ip to p r iv a t e o w n e r s h ip o f a
ra te s a r e c a lc u la t e d d a i l y a t a p p r o x im a t e ly c o m p a n y t h r o u g h p u r c h a s e o f its s h a r e s b y a s m a ll
1 0 : 1 0 a m S y d n e y t im e f o r te rm s o f 1 , 2 , 3 , 4 , 5 g r o u p o f in v e s to r s t h a t s o m e tim e s in c lu d e s th e
a n d 6 m o n th s e x is tin g m a n a g e m e n t
725
G lossary
call n o tic e g iv e n b y a c o m p a n y t h a t th e h o ld e r s s e p a r a t e ly — t h a t is, p r o f it p a id a s a d iv id e n d is

o f p a r t ly p a id s h a r e s m u s t m a k e a n a d d it io n a l e f f e c t iv e ly t a x e d t w ic e
c o n t r ib u t io n o f e q u it y co llectio n p o lic y p o lic y a d o p t e d b y a c o m p a n y
call o p tio n r ig h t t o b u y a n u n d e r ly in g a s s e t a t a in r e g a r d to c o lle c t in g d e lin q u e n t a c c o u n ts e ith e r
f ix e d p r ic e in f o r m a lly o r b y th e u s e o f a d e b t c o lle c t io n a g e n c y
ca ll o p tio n o n a fu tu re s c o n tra c t o p t io n t h a t g iv e s c o m m e r c ia l p a p e r (o r p r o m is s o r y n o te ) s h o rt-te rm

th e b u y e r th e r ig h t to e n t e r in to th e fu tu re s c o n t r a c t m a r k e t a b le d e b t s e c u r ity in w h ic h t h e b o r r o w e r
a s a b u y e r a t a p r e d e t e r m in e d p r ic e p r o m is e s t o p a y a s ta te d su m o n a s ta te d fu tu r e
c a p ita l m a r k e t m a r k e t in w h ic h lo n g - te r m fu n d s a r e d a t e . A ls o k n o w n a s one-nom e p a p e r
r a is e d a n d lo n g - te r m d e b t a n d e q u it y s e c u r itie s a r e c o m p a n y s e p a r a te le g a l e n t it y f o r m e d u n d e r th e
tra d e d C o rp o ra tio n s A c t 2 0 0 1 ; s h a r e h o ld e r s a r e th e
c a p ita l m a r k e t lin e e f f ic ie n t s e t o f a ll p o r t f o lio s o w n e rs o f a c o m p a n y
t h a t p r o v id e s th e in v e s t o r w it h th e b e s t p o s s ib le c o m p o u n d in te re st in te r e s t c a lc u la t e d e a c h p e r io d
in v e s tm e n t o p p o r t u n it ie s w h e n a ris k -fre e a s s e t is o n th e p r in c ip a l a m o u n t a n d o n a n y in te r e s t e a r n e d
a v a ila b le . It d e s c r ib e s th e e q u ilib r iu m r is k - r e tu r n o n th e in v e s tm e n t u p t o t h a t p o in t
r e la t io n s h ip f o r e f f ic ie n t p o r t f o lio s , w h e r e th e c o m p o u n d o p tio n o p t io n o n a n o p t io n (e .g . a n
e x p e c t e d re tu r n is a f u n c tio n o f th e ris k -fre e in te r e s t o p t io n to b u y a n o p t io n )
r a te , th e e x p e c t e d m a r k e t r is k p r e m iu m a n d th e
c o n g lo m e r a t e t a k e o v e r t a k e o v e r o f a t a r g e t
p r o p o r t io n a t e ris k o f th e e f f ic ie n t p o r t f o lio to th e ris k
c o m p a n y in a n u n r e la t e d t y p e o f b u s in e s s
o f th e m a r k e t p o r t f o lio
c o n s iste n c y p rin c ip le in a p p l y in g th e N P V m o d e l,
c a p it a 丨
r a tio n in g a c o n d it io n w h e r e a f ir m h a s
th e n e t c a s h f lo w s in th e n u m e r a to r s h o u ld b e
lim it e d re s o u rc e s a v a ila b l e f o r in v e s tm e n t
d e f in e d a n d m e a s u r e d in a w a y t h a t is c o n s is te n t
c a p ita l stru ctu re m ix o f d e b t a n d e q u it y f in a n c e w it h th e d e f in it io n o f th e d is c o u n t r a t e
used b y a c o m p a n y
c o n s ta n t c h a in o f re p la c e m e n t a s s u m p t io n m a y
c a r r y in g c o st c o s t o f h o ld in g a c o m m o d it y f o r a b e u s e d to e v a lu a t e m u t u a lly e x c lu s iv e p r o je c ts o f
s p e c if ie d p e r io d o f tim e u n e q u a l liv e s ; in th is c a s e , e a c h p r o je c t is a s s u m e d
c a s h b u d g e t f o r e c a s t o f th e a m o u n t a n d t im in g o f to b e r e p la c e d a t th e e n d o f its e c o n o m ic lif e b y a n
th e c a s h r e c e ip ts a n d p a y m e n ts t h a t w i ll re s u lt fr o m id e n t ic a l p r o je c t
a c o m p a n y ’s o p e r a t io n s o v e r a p e r io d o f tim e c o n s u m e r cre d it c r e d it e x t e n d e d to in d iv id u a ls b y
c a sh f l o w p a y m e n t (c a s h o u t flo w ) o r r e c e ip t (c a s h s u p p lie r s o f g o o d s a n d s e r v ic e s , o r b y f in a n c ia l
in flo w ) o f m o n e y in s titu tio n s t h r o u g h c r e d it c a r d s
c a te rin g th e o r y t h e o r y t h a t s u g g e s ts t h a t c o n tin g e n t c la im a s s e t w h o s e v a lu e d e p e n d s o n th e
m a n a g e r s c a t e r t o c h a n g e s o v e r t im e in in v e s t o r v a lu e o f s o m e o t h e r a s s e t
d e m a n d f o r d iv id e n d s c o n tin u o u s in te re st m e th o d o f c a lc u la t in g in te r e s t in
c e n tra l b a n k a b a n k t h a t c o n t r o ls th e is s u e o f w h ic h in te r e s t is c h a r g e d s o f r e q u e n t ly t h a t th e tim e
c u r r e n c y , a c ts a s b a n k e r to th e g o v e r n m e n t a n d p e r io d b e t w e e n e a c h c h a r g e a p p r o a c h e s z e r o
th e b a n k in g s y s te m a n d sets th e in te r e s t r a te f o r c o n trib u tin g s h a r e s s h a re s o n w h ic h o n ly p a r t o f
o v e r n ig h t c a s h th e is s u e p r ic e h a s b e e n p a id . A ls o k n o w n a s p o rtly
c e r t a in ty -e q u iv a le n t a p p r o a c h t h a t in c o r p o r a t e s p a id shores
ris k b y a d ju s t in g t h e c a s h f lo w s r a t h e r th a n th e c o n v e r s io n ra tio r e la t io n s h ip t h a t d e t e r m in e s h o w
d is c o u n t r a te m a n y o r d in a r y s h a re s w i ll b e r e c e iv e d in e x c h a n g e
chattel m o r t g a g e a lo a n s e c u r e d b y a m o r t g a g e f o r e a c h c o n v e r t in g s e c u r ity w h e n t h e c o n v e r s io n
o v e r m o v a b le p r o p e r t y o c c u rs
c la s sic a l t a x s y s t e m t a x s y s te m t h a t o p e r a te s c o n v e rtib le s e c u r ity is s u e d f o r a f ix e d te r m ,

in th e U S a n d w h ic h o p e r a t e d in A u s t r a lia u n til u s u a lly a t a f ix e d in te r e s t r a te , w it h t h e a d d it io n a l
3 0 J u n e 1 9 8 7 ; u n d e r th is s y s te m c o m p a n y p r o fits , f e a tu r e t h a t th e h o ld e r h a s th e r ig h t t o c o n v e r t th e
a n d d iv id e n d s p a id fr o m th o s e p r o fits , a r e t a x e d s e c u r it y to o r d in a r y s h a re s o n a s p e c if ie d fu tu re
726
G lossary
d a t e o r d a te s . C o n v e r tib le s is s u e d in A u s t r a lia a r e a ls o a n e x c h a n g e o f lo a n p r in c ip a ls a t th e s ta r t a n d
u s u a lly c a lle d c o n v e r t ib le n o te s b u t m a y b e c a lle d a lm o s t a lw a y s a r e - e x c h a n g e o f p r in c ip a ls a t th e
c o n v e r t ib le b o n d s e n d o f th e a g r e e m e n t .
conve rtin g preference share a p r e fe r e n c e s h a r e cu rren t assets c a s h , in v e n to r y , a c c o u n ts r e c e iv a b le

t h a t w i ll a u t o m a t ic a lly c o n v e r t in to a n o r d in a r y a n d o t h e r a s s e ts t h a t w i l l n o r m a lly b e c o n v e r t e d in to
s h a re o n a s p e c if ie d d a t e u n le s s it is r e d e e m e d c a s h w it h in a y e a r
b y th e is s u e r p r i o r t o t h a t d a t e cu rre n t lia b ilitie s d e b t o r o t h e r o b lig a t io n s d u e f o r
corporate raide rs a g g r e s s iv e c o r p o r a t e o r p a y m e n t w it h in a y e a r
in d iv id u a l in v e s to rs w h o p u r c h a s e a c o m p a n y ’ s
s h a re s w it h th e in te n t io n o f a c h ie v in g a c o n t r o llin g d eb en tu re a t y p e o f f ix e d in te r e s t s e c u r ity is s u e d
in te re s t a n d r e p la c in g th e e x is tin g m a n a g e m e n t b y a c o m p a n y , u s u a lly s e c u r e d b y a c h a r g e o v e r
cost o f ca pita l m in im u m r a te o f re tu rn n e e d e d to t a n g ib le a s s e ts
c o m p e n s a te s u p p lie r s o f c a p it a l f o r c o m m itt in g d e b t f in a n c ia l c o n t r a c t in w h ic h th e r e c e iv e r o f th e
re s o u rc e s to a n in v e s tm e n t in it ia l c a s h (th e b o r r o w e r ) p r o m is e s a p a r t ic u la r
coupon p aym ents p e r io d ic p a y m e n ts o f in te re s t, c a s h f lo w , u s u a lly c a lc u la t e d u s in g a n in te r e s t ra te ,
o fte n a t h a lf - y e a r ly in te r v a ls , o n d e b t s e c u r itie s s u c h to th e p r o v id e r o f fu n d s (th e le n d e r )
a s d e b e n tu r e s a n d b o n d s d e b to r finance o n g o in g f o r m o f f u n d in g in w h ic h
coupons f ix e d in te re s t p a y m e n ts m a d e o n b o n d s a f in a n c e p r o v id e r a d v a n c e s fu n d s to a b o r r o w e r
a n d d e b e n tu r e s u s in g th e b o r r o w e r ’s a c c o u n ts r e c e iv a b le a s s e c u r ity
f o r th e lo a n
covenant p r o v is io n in a lo a n a g r e e m e n t to p r o te c t
le n d e r s ’ in te re s ts b y r e q u ir in g c e r t a in a c t io n s to b e d e b to r finance w ith recourse d e b t o r f in a n c e
ta k e n a n d o th e r s r e f r a in e d f r o m a g r e e m e n t u n d e r w h ic h th e p r o v id e r is r e im b u r s e d
b y th e b o r r o w e r if th e d e b t o r d e fa u lts
credit fo ncie r loan t y p e o f lo a n t h a t in v o lv e s r e g u la r
r e p a y m e n ts t h a t in c lu d e p r i n c ip a l a n d in te r e s t d e b to r finance w ith o u t recourse d e b t o r f in a n c e
a g r e e m e n t u n d e r w h ic h th e p r o v id e r is n o t
credit p e rio d p e r io d b e t w e e n th e d a t e t h a t a
r e im b u r s e d b y th e b o r r o w e r if th e d e b t o r d e f a u lts
p u r c h a s e r is in v o ic e d a n d th e d a t e w h e n p a y m e n t
is d u e d e fa u lt f a ilu r e t o p e r fo r m a c o n t r a c t u a l o b lig a t io n
credit p olicy s u p p lie r ’ s p o lic y o n w h e t h e r c r e d it w ill d e fa u lt ris k th e c h a n c e t h a t a b o r r o w e r w i l l f a i l to
b e o f f e r e d t o c u s to m e rs a n d o n t h e te rm s t h a t w i ll m e e t o b lig a t io n s t o p a y in te r e s t a n d p r i n c ip a l a s
b e o f f e r e d to th o s e c u s to m e r s p r o m is e d
credit risk p o s s ib ilit y o f lo s s b e c a u s e a p a r t y f a ils to d e fa u lt-ris k structure o f interest rates r e la t io n s h ip

m e e t its o b lig a t io n s b e t w e e n d e f a u lt r is k a n d in te r e s t ra te s
cross-border lease (CBL) f in a n c e le a s e , u s u a lly d e fe rre d a n n u ity a n n u it y in w h ic h th e f ir s t c a s h

le v e r a g e d , w h e r e th e le s s o r a n d le s s e e a r e lo c a t e d f lo w is to o c c u r a f t e r a tim e p e r io d t h a t e x c e e d s th e
in d if f e r e n t c o u n tr ie s t im e p e r io d b e t w e e n e a c h s u b s e q u e n t c a s h f lo w
cum rights w h e n s h a re s a r e t r a d e d c u m r ig h ts th e d e la ye d e q u ity c o n v e r t ib le w h ic h is p r e d o m in a n t ly

b u y e r is e n t it le d to p a r t ic ip a t e in th e f o r t h c o m in g e q u it y b u t h a s s o m e d e b t - lik e f e a tu r e s ; t y p ic a lly h a s
r ig h ts issu e a h ig h p r o b a b il it y o f b e in g c o n v e r t e d to e q u it y
cum -dividend p e rio d p e r io d d u r in g w h ic h th e d e lin q u e n t accounts a c c o u n ts w h e r e p a y m e n t h a s

p u r c h a s e r o f a s h a r e is q u a l if ie d to r e c e iv e a n o t b e e n m a d e b y th e d u e d a t e
p r e v io u s ly a n n o u n c e d d i v id e n d . T h e c u m - d iv id e n d disclosure d ocum ent p r o s p e c tu s , p r o f ile s ta te m e n t

p e r io d e n d s o n th e e x - d iv id e n d d a t e o r o f f e r in f o r m a t io n s ta te m e n t t h a t m u s t b e s u p p lie d
currency sw a p a g r e e m e n t b e t w e e n t w o to p o t e n t ia l in v e s to rs to p r o v id e in f o r m a t io n a b o u t
c o u n t e r p a r t ie s t o e x c h a n g e se ts o f in te r e s t p a y m e n ts a n o f f e r o f s e c u r itie s
f o r a s p e c if ic p e r io d , r e la t e d to a g r e e d p r in c ip a l d iscount p e rio d p e r io d d u r in g w h ic h a d is c o u n t f o r
a m o u n ts in t w o d if f e r e n t c u r r e n c ie s . U s u a lly , th e r e is p r o m p t p a y m e n t is a v a ila b le to th e p u r c h a s e r
727
G lossary
d isc o u n t ra te e x p r e s s io n o f th e p r ic e r e d u c t io n a d u r a tio n m e a s u r e o f th e tim e p e r io d o f a n

p u r c h a s e r w i ll r e c e iv e if p a y m e n t is m a d e w it h in th e in v e s tm e n t in a b o n d o r d e b e n t u r e t h a t in c o r p o r a t e s
d is c o u n t p e r io d c a s h f lo w s t h a t a r e m a d e p r i o r to m a t u r ity
d isc o u n te d c a s h f l o w (DCF) m e t h o d s m e th o d s
w h ic h in v o lv e th e p r o c e s s o f d is c o u n t in g a s e rie s
e c o n o m ic o r d e r q u a n t it y (E O Q ) o p t im a l q u a n t it y
o f fu tu r e n e t c a s h f lo w s to t h e ir p r e s e n t v a lu e s
o f in v e n t o r y o r d e r e d t h a t m in im is e s th e c o s t o f
d isc o u n te r (o f a b ill o f e x c h a n g e ) th e in it ia l p u r c h a s in g a n d h o ld in g th e in v e n to r y
p u r c h a s e r o f a b ill o f e x c h a n g e
effective in te re st ra te in te r e s t r a te w h e r e in te re s t
d isc o u n te r (o f c o m m e r c ia l p a p e r ) th e in it ia l is c h a r g e d a t th e s a m e f r e q u e n c y a s th e in te re s t
p u r c h a s e r o f c o m m e r c ia l p a p e r r a te is q u o t e d
d is c o u n t in g p r o c e s s b y w h ic h , t h r o u g h th e efficie nt m a r k e t h y p o t h e s is (E M H ) t h a t th e p r ic e
o p e r a t io n o f in te r e s t, a fu tu r e su m is c o n v e r t e d to its o f a s e c u r ity (s u ch a s a s h a re ) a c c u r a t e ly r e fle c ts
e q u iv a le n t p r e s e n t v a lu e a v a ila b le in f o r m a t io n
d is in te r m e d ia t io n m o v e m e n t o f fu n d s e n d o r s e m e n t th e s e lle r o f a b ill in th e s e c o n d a r y
fr o m a c c o u n ts w i t h d e p o s it - t a k in g f in a n c ia l m a r k e t a c c e p t s r e s p o n s ib ilit y to p a y th e f a c e v a lu e
in t e r m e d ia r ie s a n d th e r e in v e s tm e n t o f th o s e fu n d s if th e r e is d e f a u lt b y th e a c c e p t o r , d r a w e r a n d
in s e c u r itie s e a r lie r e n d o r s e r s
d iv e stitu re (o r se ll-o ff) s a le o f a s u b s id ia r y , d iv is io n e q u iv a le n t a n n u a l v a lu e m e t h o d in v o lv e s
o r c o lle c t io n o f r e la t e d a s s e ts , u s u a lly to a n o t h e r c a lc u la t in g th e a n n u a l c a s h f l o w o f a n a n n u it y t h a t
com pany h a s t h e s a m e lif e a s th e p r o je c t a n d w h o s e p r e s e n t
d iv id e n d clientele g r o u p o f in v e s to r s w h o c h o o s e to v a lu e e q u a ls t h e n e t p r e s e n t v a lu e o f th e p r o je c t
in v e s t in c o m p a n ie s t h a t h a v e d iv id e n d p o lic ie s t h a t E u r o b o n d m e d iu m - to lo n g - te r m in t e r n a t io n a l b e a r e r
m e e t t h e ir p a r t ic u la r r e q u ir e m e n ts s e c u r it y s o ld in c o u n tr ie s o t h e r th a n t h e c o u n t r y o f
d iv id e n d d r o p - o f f ra tio r a t io o f th e d e c lin e in th e t h e c u r r e n c y in w h ic h th e b o n d is d e n o m in a t e d
s h a r e p r ic e o n th e e x - d iv id e n d d a y to th e d iv id e n d e v e n t s t u d y r e s e a r c h m e th o d t h a t a n a ly s e s th e
p e r s h a re b e h a v io u r o f a s e c u r ity 's p r ic e a r o u n d th e tim e o f
d iv id e n d ele ctio n s c h e m e a r r a n g e m e n t m a d e a s ig n if ic a n t e v e n t s u c h a s th e p u b lic a n n o u n c e m e n t
b y a c o m p a n y t h a t g iv e s s h a r e h o ld e r s th e o p t io n o f th e c o m p a n y ’s p r o f it
o f r e c e iv in g t h e ir d iv id e n d s in o n e o r m o r e o f a e x -d iv id e n d d a te d a t e o n w h ic h a s h a r e b e g in s
n u m b e r o f fo r m s t r a d in g e x - d iv id e n d . A s h a r e p u r c h a s e d e x - d iv id e n d
d iv id e n d g r o w t h m o d e l m o d e l e x p r e s s in g th e v a lu e d o e s n o t in c lu d e a r ig h t to th e f o r t h c o m in g d iv id e n d
o f a s h a r e a s th e s u m o f th e p r e s e n t v a lu e s o f fu tu r e paym ent
d iv id e n d s w h e r e t h e d iv id e n d s a r e a s s u m e d to g r o w e x -r ig h t s d a te d a t e o n w h ic h a s h a r e b e g in s
a t a c o n s t a n t r a te t r a d in g e x - r ig h ts . A f t e r th is d a t e a s h a r e d o e s
d iv id e n d re in v e s tm e n t p la n (D R P ) a r r a n g e m e n t n o t h a v e a t t a c h e d to it th e r ig h t to p u r c h a s e a n y
m a d e b y a c o m p a n y t h a t g iv e s s h a r e h o ld e r s a n a d d i t i o n a l s h a re (s ) o n th e s u b s c r ip tio n d a t e
o p t io n o f r e in v e s tin g a ll o r p a r t o f t h e ir d iv id e n d s in
e x c h a n g e - t r a d e d m a r k e t m a r k e t in w h ic h t r a d in g
a d d it io n a l s h a re s in th e c o m p a n y , u s u a lly a t a s m a ll ta k e s p la c e b y c o m p e t it iv e b i d d in g o n a n o r g a n is e d
d is c o u n t fr o m m a r k e t p r ic e
exchange
d iv id e n d y ie ld d iv id e n d p e r s h a r e d iv id e d b y th e
e x e rc ise (o r strik e ) price f ix e d p r ic e a t w h ic h a n
s h a r e p r ic e
u n d e r ly in g a s s e t c a n b e t r a d e d , p u r s u a n t to th e
d iv id e n d - p a y o u t ra tio p e r c e n t a g e o f p r o f it p a id o u t te rm s o f a n o p t io n c o n t r a c t
to s h a r e h o ld e r s a s d iv id e n d s
e x p e c t a tio n s t h e o r y o f th e te rm s tr u c tu r e is t h a t
d iv id e n d s p e r io d ic d is t r ib u t io n s , u s u a lly in c a s h , b y in te r e s t r a te s a r e s e t s u c h t h a t in v e s to r s in b o n d s
a c o m p a n y to its s h a r e h o ld e r s o r o t h e r d e b t s e c u r itie s c a n e x p e c t , o n a v e r a g e ,
d r a w e r in a b ill o f e x c h a n g e , th e p a r t y in it ia t in g to a c h ie v e th e s a m e r e tu r n o v e r a n y fu tu r e p e r io d ,
th e c r e a t io n o f th e b i ll; u s u a lly th e b o r r o w e r r e g a r d le s s o f th e s e c u r ity in w h ic h t h e y in v e s t
728
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W
face va lu e su m p r o m is e d to b e p a id in th e fu tu r e o n fra n k in g p re m iu m t h a t p a r t o f th e re tu r n o n s h a re s
a d e b t s e c u rity , s u c h a s c o m m e r c ia l p a p e r o r a b ill o r a s h a r e m a r k e t in d e x t h a t is d u e to t a x c r e d it s
o f exchange a s s o c ia te d w it h f r a n k e d d iv id e n d s
fa cto rin g fo r m o f d e b t o r f in a n c e in w h ic h th e fre e cash flo w c a s h f lo w in e x c e s s o f t h a t r e q u ir e d

f in a n c e p r o v id e r (th e f a c to r ) ta k e s c o n t r o l o f to fu n d a ll p r o je c ts t h a t h a v e p o s it iv e n e t p r e s e n t
th e b o r r o w e r 's s a le s le d g e r a n d d e b t c o lle c t io n v a lu e s
fu n c tio n s a n d p a s s e s a c c o u n t p a y m e n ts o n to th e fu ll p a y o u t p o licy d is t r ib u t io n o f th e fu ll
b o rro w e r p r e s e n t v a lu e o f a c o m p a n y ’s f r e e c a s h f lo w to
finance lease lo n g - te r m le a s e t h a t e f f e c t iv e ly s h a r e h o ld e r s
tra n s fe rs th e ris k s a n d b e n e fits o f o w n e r s h ip o f a n fu lly d ra w n b ill fa c ility b ill f a c ilit y in w h ic h th e
a s s e t fr o m th e le s s o r to th e le s s e e b o r r o w e r m u s t is s u e b ills so t h a t th e fu ll a g r e e d
fin an cia l agency in stitu tio n a r r a n g e s o r a m o u n t is b o r r o w e d f o r th e p e r io d o f th e f a c ilit y
fa c ilit a t e s th e d ir e c t t r a n s f e r o f fu n d s fr o m le n d e r s to fu tu re s contract a n a g r e e m e n t to t r a d e in a n
b o rro w e rs a s s e t in th e fu tu r e t h a t c a n b e its e lf t r a d e d o n a n
fin an cia l assets a s s e ts s u c h a s s h a re s , b o n d s a n d exchange
b a n k d e p o s its , a s d is tin c t f r o m r e a l a s s e ts fu tu re sum a m o u n t t o w h ic h a p r e s e n t s u m , s u c h a s
fin a n cia l contract a r r a n g e m e n t , a g r e e m e n t o r a p r i n c ip a l , w i ll g r o w ( a c c u m u la te ) a t a fu tu r e d a te ,
in v e s tm e n t t h a t p r o d u c e s c a s h f lo w s t h r o u g h th e o p e r a t io n o f in te re s t
fin an cia l distress s it u a t io n w h e r e a c o m p a n y 's

f in a n c ia l o b lig a t io n s c a n n o t b e m e t, o r c a n b e m e t
gen eral a n n u ity a n n u it y in w h ic h th e f r e q u e n c y o f
c h a r g in g in te re s t d o e s n o t m a tc h th e f r e q u e n c y o f
o n ly w ith d if f ic u lt y
p a y m e n t; th u s , re p a y m e n ts m a y b e m a d e e ith e r m o r e
fin a n cia l in te rm e d ia ry in s titu t io n t h a t a c ts a s a
fr e q u e n tly o r less f r e q u e n tly th a n in te re s t is c h a r g e d
p r in c ip a l in a c c e p t in g f u n d s fr o m d e p o s it o r s o r
in v e s to rs a n d le n d in g th e m t o b o r r o w e r s
g eom etric ra te o f retu rn a v e r a g e o f a s e q u e n c e o f
a r it h m e t ic r a te s o f r e tu r n , f o u n d b y a p r o c e s s t h a t
fin an cia l leve ra g e (g e a rin g ) th e e f f e c t o f c o m p a n y
re s e m b le s c o m p o u n d in g
d e b t o n th e re tu rn s e a r n e d b y s h a r e h o ld e r s .
F in a n c ia l le v e r a g e is m e a s u r e d b y r a t io s s u c h a s
hedge ra tio (or delta) r a t io o f th e c h a n g e in a n
th e d e b t - e q u it y r a t io a n d t h e r a t io o f d e b t to to ta l
o p t io n p r ic e t h a t re s u lts fr o m a c h a n g e in th e p r ic e
a ss e ts
o f th e u n d e r ly in g a s s e t
fin a n cia l ris k ris k a t t r ib u t a b le to th e u se o f d e b t a s
hedgers in d iv id u a ls a n d c o m p a n ie s w h o e n t e r in to
a s o u rc e o f f in a n c e
c o n t r a c t s in o r d e r to r e d u c e ris k
flo o r-p la n (or w h o le sa le ) fin a n ce lo a n , u s u a lly
h ire-purchase a gree m e nt a g r e e m e n t u n d e r w h ic h
m a d e b y a w h o le s a le r to a r e t a ile r , t h a t f in a n c e s a n
a n a s s e t o w n e d b y a f in a n c ie r is h ir e d b y a u s e r
in v e n to r y o f d u r a b le g o o d s s u c h a s m o t o r v e h ic le s
w h o h a s th e r ig h t o r a n o b lig a t io n to p u r c h a s e th e
fo re ig n bond b o n d is s u e d o u t s id e th e b o r r o w e r 's a s s e t w h e n th e a g r e e m e n t e x p ir e s
c o u n t r y a n d d e n o m in a t e d in th e c u r r e n c y o f th e
h o riz o n ta l ta k e o v e r t a k e o v e r o f a t a r g e t c o m p a n y
c o u n t r y in w h ic h it is is s u e d
o p e r a t in g in th e s a m e lin e o f b u s in e s s a s th e
fo rw a rd contract a g r e e m e n t b e t w e e n t w o p a r tie s a c q u ir in g c o m p a n y
th a t, o n a s ta te d fu tu r e d a t e , o n e o f th e p a r tie s w i ll
b u y a n d th e o t h e r p a r t y w i l l s e ll a n u n d e r ly in g a s s e t im m u n is a tio n s tr a te g y d e s ig n e d to a c h ie v e a t a r g e t
a t a p r ic e d e c id e d t o d a y s u m o f m o n e y a t a fu tu r e p o in t in tim e , r e g a r d le s s o f
fra n k e d d ivid e n d d iv id e n d p a id o u t o f A u s t r a lia n in te r e s t r a te c h a n g e s
c o m p a n y p r o fits o n w h ic h c o m p a n y in c o m e t a x h a s im p u ta tio n ta x system s y s te m u n d e r w h ic h
b e e n p a id a n d w h ic h c a r r ie s a f r a n k in g c r e d it in v e s t o r s in s h a r e s c a n u s e t a x c r e d it s
fra n k in g credit c r e d it f o r A u s t r a lia n c o m p a n y t a x a s s o c ia t e d w i t h f r a n k e d d i v id e n d s t o o f f s e t t h e ir
p a id , w h ic h , w h e n d is t r ib u t e d to s h a r e h o ld e r s , c a n p e r s o n a l in c o m e t a x . T h e s y s te m e lim in a t e s th e
b e o ffs e t a g a in s t t h e ir t a x l i a b i lit y d o u b le t a x a t i o n in h e r e n t in t h e c la s s ic a l t a x s y s te m
729
G lossary
ind ep en d en t p ro je ct a p r o je c t t h a t m a y b e d is c o u n t r a te a t w h ic h th e n e t p r e s e n t v a lu e is
a c c e p t e d o r r e je c t e d w it h o u t a f f e c t in g th e e q u a l to z e r o
a c c e p t a b ilit y o f a n o t h e r p r o je c t intrinsic v a lu e v a lu e o f a n o p t io n if e x e r c is e d
in d ica to r rate in te r e s t r a te s e t a n d p u b lis h e d b y im m e d ia t e ly
a le n d e r f r o m tim e to tim e a n d u s e d a s a b a s e in v e n to ry c o m p r is e s r a w m a te r ia ls , w o r k in
o n w h ic h in te r e s t r a te s o n in d iv id u a l lo a n s a r e p r o g r e s s , s u p p lie s u s e d in o p e r a t io n s a n d f in is h e d
d e t e r m in e d , u s u a lly b y a d d in g a m a r g in goods
ind iffe re nce curve c u r v e s h o w in g a s e t o f in v e s tin g in s titu tio n a c c e p t s f u n d s f r o m th e
c o m b in a t io n s s u c h t h a t a n in d iv id u a l d e r iv e s e q u a l p u b lic a n d in v e s ts th e m in a s s e ts ; in c lu d e s
u t ilit y f r o m ( a n d th u s is in d if f e r e n t b e tw e e n ) a n y s u p e r a n n u a t io n f u n d s , lif e in s u r a n c e c o m p a n ie s
c o m b in a t io n s in t h e se t a n d u n it tru s ts
in fo rm a tio n a s y m m e try s it u a t io n w h e r e a ll investm ent h orizo n th e p a r t ic u la r fu tu r e d a t e o n
r e le v a n t in f o r m a t io n is n o t k n o w n b y a ll in te r e s te d w h ic h a n in v e s to r in te n d s to liq u id a t e (se ll) th e ir
p a r tie s . T y p ic a lly , th is in v o lv e s c o m p a n y ’ in s id e r s ’ in v e s tm e n t
( m a n a g e r s ) h a v in g m o r e in f o r m a t io n a b o u t th e
invoice d iscounting f o r m o f d e b t o r f in a n c e in w h ic h
c o m p a n y 's p r o s p e c ts th a n 'o u t s id e r s ’ （
s h a r e h o ld e r s
th e b o r r o w e r r e ta in s c o n t r o l o f its s a le s le d g e r
a n d le n d e rs )
a n d d e b t c o lle c t io n fu n c tio n s a n d p a s s e s a c c o u n t
in fo rm a tio n efficiency s it u a t io n in w h ic h p r ic e s p a y m e n ts o n to th e d is c o u n t e r
a c c u r a t e ly r e fle c t a v a ila b l e in f o r m a t io n
issue costs c o s ts o f r a is in g n e w c a p it a l b y is s u in g
in itia l public o ffe rin g a c o m p a n y 's f ir s t o f f e r in g o f s e c u r itie s , in c lu d in g u n d e r w r it in g fe e s a n d le g a l,
s h a re s to th e p u b lic a c c o u n t in g a n d p r in t in g e x p e n s e s in c u r r e d in
in sta lm e n t receipt m a r k e ta b le s e c u r ity f o r w h ic h p r e p a r in g a p r o s p e c tu s o r o t h e r o f f e r d o c u m e n ts .
o n ly p a r t o f th e is s u e p r ic e h a s b e e n p a id . T h e A ls o k n o w n a s flo ta tio n costs
b a la n c e is p a y a b le in a f in a l in s ta lm e n t o n o r
Ja n u a ry effect o b s e r v a tio n th a t, o n a v e r a g e , s h a re
b e f o r e a s p e c if ie d d a t e
p r ic e s in c r e a s e m o re in J a n u a r y th a n in o th e r m o n th s
in te rb a n k cash ra te th e in te r e s t r a te o n o v e r n ig h t
jo in t test p ro b le m p r o b le m t h a t a n y te s t o f m a r k e t
lo a n s b e tw e e n a b a n k a n d a n o t h e r b a n k ( in c lu d in g
e f f ic ie n c y is s im u lt a n e o u s ly a te s t o f s o m e m o d e l o f
th e R e s e rv e B a n k o f A u s t r a lia )
'n o r m a l’ a s s e t p r ic in g
interest rate r a te o f re tu r n o n d e b t
lessee in a le a s e c o n t r a c t , th e p a r t y u s in g th e a s s e t
in te re s t ra te s w a p a g r e e m e n t b e t w e e n t w o
c o u n t e r p a r t ie s t o e x c h a n g e in te r e s t p a y m e n ts f o r lessor in a le a s e c o n t r a c t , th e p a r t y t h a t o w n s th e
a s p e c if ic p e r io d , r e la t e d to a n a g r e e d p r i n c ip a l asset
a m o u n t. T h e m o s t c o m m o n t y p e o f in te r e s t r a t e le ve ra g ed b u y o u t c o m p a n y t a k e o v e r t h a t is
s w a p in v o lv e s a n e x c h a n g e o f a s e t o f f ix e d - la r g e ly f in a n c e d u s in g b o r r o w e d f u n d s ; th e
in te r e s t p a y m e n ts f o r a s e t o f f lo a t in g - in t e r e s t r e m a in in g e q u it y is p r iv a t e ly h e ld b y a s m a ll g r o u p
p a y m e n ts . A ll p a y m e n t s a r e in th e s a m e c u r r e n c y , o f in v e s to rs
in te re st-o n ly loa n lo a n in w h ic h th e b o r r o w e r is leve ra g ed lease f in a n c e le a s e w h e r e th e le s s o r

r e q u ir e d to m a k e r e g u la r p a y m e n ts to c o v e r in te re s t b o r r o w s m o s t o f th e fu n d s to a c q u ir e th e a s s e t
a c c r u e d b u t is n o t r e q u ir e d to m a k e p a y m e n ts to lim ite d lia b ility le g a l c o n c e p t t h a t p r o te c ts
r e d u c e th e p r i n c ip a l . O n th e m a t u r ity d a t e o f th e s h a r e h o ld e r s w h o s e l i a b i lit y t o m e e t a c o m p a n y ’s
lo a n , th e p r i n c ip a l is r e p a id in a lu m p su m d e b ts is lim it e d to a n y a m o u n t u n p a id o n th e s h a re s
in te rm e d ia tio n p r o c e s s in w h ic h a b a n k o r o th e r th e y h o ld
f in a n c ia l in s titu t io n ra is e s fu n d s fr o m in v e s to rs a n d liq u id assets c o m p r is e c a s h a n d a s s e ts t h a t a r e

th e n le n d s th o s e f u n d s to b o r r o w e r s r e a d ily c o n v e r t ib le in to c a s h , s u c h a s b ills o f
in te rn a l ra te o f re tu rn (IRR) th e d is c o u n t r a te exchange
t h a t e q u a te s th e p r e s e n t v a lu e o f a n in v e s tm e n t’s liq u id ity m a n a g e m e n t in v o lv e s d e c is io n s a b o u t th e

n e t c a s h f lo w s w it h its in it ia l c a s h o u t la y ; it is th e c o m p o s it io n a n d le v e l o f a c o m p a n y 's liq u id a s s e ts
730
G lossary
liq u id ity p r e m iu m (ris k p r e m iu m ) t h e o r y o f th e n o m in a l in te re s t ra te q u o t e d in te r e s t r a te

te rm s tru c tu re is t h a t a lt h o u g h fu tu r e in te r e s t ra te s w h e r e in te r e s t is c h a r g e d m o r e f r e q u e n t ly t h a n
a r e d e t e r m in e d b y in v e s to r s ' e x p e c t a t io n s , in v e s to rs t h e b a s is o n w h ic h th e in te r e s t r a t e is q u o t e d .
r e q u ir e s o m e r e w a r d ( liq u id it y p r e m iu m ) to b e a r th e T h e in te r e s t r a t e a c t u a ll y u s e d t o c a lc u la t e
in c r e a s e d ris k o f in v e s tin g lo n g te rm th e in te r e s t c h a r g e is t a k e n a s a p r o p o r t i o n
lo g price re la tiv e n a t u r a l lo g a r it h m o f th e r a t io o f o f th e q u o t e d n o m in a l r a t e . Note: T h e te r m
s u c c e s s iv e s e c u r ity p r ic e s . Im p lic it ly , it is a s s u m e d 'n o m i n a l in te r e s t r a t e ' a ls o h a s a n o t h e r m e a n in g
t h a t p r ic e s h a v e g r o w n ( o r d e c a y e d ) in a c o n tin u o u s (s e e S e c t io n 3 . 4 . 4 )
fa s h io n b e t w e e n th e t w o d a t e s o n w h ic h th e p r ic e s n o n - b a n k bill b ill o f e x c h a n g e t h a t h a s b e e n
logarithmic rote o f
a r e o b s e r v e d . A ls o k n o w n a s a n e it h e r a c c e p t e d n o r e n d o r s e d b y a b a n k
return and a continuous rote o f return n o n -d e b t t a x s h ie ld s (N D T S s ) t a x d e d u c tio n s f o r
lo n g h e d g e r h e d g e r w h o h e d g e s b y m e a n s o f ite m s s u c h a s d e p r e c ia t io n o n a s s e ts a n d t a x lo s s e s
b u y in g fu tu re s c o n t r a c t s t o d a y c a r r ie d f o r w a r d
n o n -re c o u rse lo a n t y p e o f lo a n u s e d in le v e r a g e d
m a in te n a n c e le a s e o p e r a t in g le a s e w h e r e th e le a s e s w h e r e th e le n d e r h a s n o r e c o u r s e to th e
le s s o r is r e s p o n s ib le f o r a ll m a in t e n a n c e a n d s e r v ic e le s s o r in th e e v e n t o f d e f a u lt b y th e le s s e e
o f th e le a s e d a s s e t
n o t io n a l p r in c ip a l (o r n o t io n a l a m o u n t ) o f a n
m a n a g e m e n t b u y o u t p u r c h a s e o f a ll o f a in te re st ra te s w a p e a c h g r o s s s w a p p a y m e n t
c o m p a n y ’s is s u e d s h a re s b y a g r o u p 丨
ed b y th e is c a lc u la t e d b y m u lt ip ly in g a n in te r e s t r a te
c o m p a n y 's m a n a g e m e n t b y th e n o t io n a l a m o u n t . T h e n o t io n a l a m o u n t
m a r g in call d e m a n d f o r e x t r a fu n d s t o b e d e p o s it e d c o r r e s p o n d s t o th e p r i n c ip a l o f t h e lo a n in te r e s t
in to a t r a d e r ’s a c c o u n t f lo w s t h a t th e s w a p m im ic s . In n e a r ly a ll c a s e s ,
m a r k e t m o d e l tim e s e rie s r e g r e s s io n o f a n a s s e t’s t h e n o t io n a l a m o u n t in a n in te r e s t r a t e s w a p is
re tu rn s n e v e r p a id
m a r k e t o p p o r t u n it y line lin e t h a t s h o w s th e
o p e n a c c o u n t a n a r r a n g e m e n t u n d e r w h ic h g o o d s
c o m b in a t io n s o f c u r r e n t a n d fu tu r e c o n s u m p tio n
o r s e r v ic e s a r e s o ld t o a c u s to m e r o n c r e d it , b u t
t h a t a n in d iv id u a l c a n a c h ie v e fr o m a g iv e n w e a lt h
w it h n o f o r m a l d e b t c o n t r a c t . P a y m e n t is d u e a f t e r
le v e l, u s in g c a p it a l m a r k e t t r a n s a c tio n s
a n a c c o u n t is s e n t t o th e c u s to m e r
m a r k e t p o rtfo lio p o r t f o lio o f a ll r is k y a s s e ts ,
o p e r a t in g le a s e le a s e u n d e r w h ic h th e ris k s a n d
w e ig h t e d a c c o r d in g to t h e ir m a r k e t c a p it a lis a t io n
b e n e fits o f o w n e r s h ip o f th e le a s e d a s s e t r e m a in
m a r k in g - t o - m a r k e t p r o c e s s o f a d ju s t in g t r a d e r s '
w it h th e le s s o r
a c c o u n t b a la n c e s to r e f le c t c h a n g e s in m a r k e t
o p p o r t u n it y c o st h ig h e s t p r ic e o r r a te o f re tu r n
p r ic e s
t h a t w o u ld b e p r o v id e d b y a n a lt e r n a t iv e c o u r s e o f
m o m e n tu m effect e f f e c t in w h ic h g o o d o r b a d
a c t io n . T h e opportunity cost o f capital is th e r a te o f
p e r fo r m a n c e o f s h a re s c o n tin u e s o v e r tim e
r e tu r n t h a t c o u ld b e e a r n e d o n a n o t h e r in v e s tm e n t
m o r t g a g e a t y p e o f s e c u r it y f o r a lo a n in w h ic h
w it h th e s a m e r is k
s p e c ific la n d o r o t h e r t a n g ib le p r o p e r t y is p le d g e d
o p t im a l c a p ita l stru ctu re th e c a p it a l s tru c tu re th a t
b y th e b o r r o w e r ( m o r t g a g o r ) to th e le n d e r
m a x im is e s a c o m p a n y ’s v a lu e
( m o r tg a g e e )
o p tio n th e r ig h t b u t n o t th e o b lig a t io n to b u y o r se ll
m u tu a lly e x c lu s iv e pro je cts a lt e r n a t iv e in v e s tm e n t
u n d e r ly in g a s s e ts a t a f ix e d p r ic e f o r a s p e c if ie d
p r o je c ts , o n ly o n e o f w h ic h c a n b e a c c e p t e d
p e r io d
net p re se n t v a lu e (N P V ) th e d if f e r e n c e b e tw e e n o p tio n to a b a n d o n r ig h t to d is c o n tin u e a n
th e p r e s e n t v a lu e o f th e n e t c a s h f lo w s f r o m a n in v e s tm e n t p r o je c t
in v e s tm e n t d is c o u n t e d a t th e r e q u ir e d r a te o f r e tu r n , o p tio n to d e fe r r ig h t to b e g in a n in v e s tm e n t p r o je c t
a n d th e in it ia l c a s h o u t la y o n th e in v e s tm e n t a t a la te r d a t e
731
G lossary
o p tio n to e x p a n d right to increase the scale o f an poison p ill strategic move by a com pany that may
investment project become a takeover target to make its shares less
o p tio n to reopen rig h t to restart a shut-down attractive to an acquirer by increasing the cost o f a
investment project takeover (e.g. an issue o f securities that w ill convert
o p tio n to stu dy rig ht to gather more inform ation on to shares if a takeover bid occurs)
an investment project p o rtfo lio com bined holding o f more than one asset
o rd in a ry a n n u ity annuity in w hich the time period preference shares shares that rank before o rdinary
from the date o f valuation to the date o f the first shares for the payment o f dividends and, usually, in
cash flo w is equal to the time period between each the event of liquidation o f the issuing company. They
subsequent cash flo w often provide an entitlement to a fixed dividend
o rd in a ry p e rp e tu ity o rdinary annuity with the special present va lu e am ount that corresponds to today's
feature that the cash flows are to continue forever value o f a promised future sum
o rd in a ry shares securities that represent an present va lu e o f a co ntract the value to da y that is
ow nership interest in a com pany and provide equivalent to the stream o f cash flow s promised in a
the ow ner w ith voting rights. Holders o f o rd in a ry financial contract
shares have a residual interest in the net assets of p ric e -e a rn in g s ra tio share price d ivid e d by
the issuing com pany and are therefore exposed to earnings per share
greater risk than other classes o f investors p rim a ry m a rk e t m arket for new issues o f securities
o ver-the -co un te r m a rk e t there is no organised w here the sale proceeds go to the issuer of the
exchange and the m arket consists o f financial securities
institutions that are w illin g to trade w ith a princip al the amount borrow ed at the outset of a loan
counterparty
p rin c ip a 卜 a rid -in te re s t loa n loan repaid by a
o v e rd ra ft lim it level to w hich a com pany is sequence o f equal cash flows, each o f w hich is
permitted to o verdraw its account sufficient to cover the interest accrued since the
o verre octio n biased response o f a price to previous paym ent and to reduce the current balance
inform ation in w hich the initial price movement can o w in g. Therefore, the debt is extinguished when the
be expected to be reversed sequence o f cash flows is com pleted. Also known
as a cre d it foncier loan
p a rtia l ta k e o v e r takeover in w hich a b id de r seeks
p ro d u ctio n p ossibilities curve curve that
to acquire no more than p art o f a com pany's issued
displays the investment opportunities and outcomes
shares
a va ila b le to the com pany; its shape therefore
p a rtn e rs h ip business ow ned by tw o or more people determines the com binations o f current dividends,
acting as partners investments and future dividends that a com pany
p a yb a ck p e rio d the time it takes for the progressive can achieve
accum ulated net cash flows generated by an p ro gressive d iv id e n d p olicy directors aim to
investment to equal the initial cash outlay steadily increase or at least m aintain the dividend at
p a y o ff structure set of future cash flows each paym ent
pecking o rd e r th e o ry theory that proposes that p ro p o rtio n a l b id p artial takeover b id to acquire
com panies fo llo w a hierarchy o f financing sources a specified proportion o f the shares held by each
in w hich internal funds are preferred and, if shareholder
external funds are needed, b o rro w in g is preferred prospectus a docum ent that, am ong other things,
to issuing riskier securities provides details o f the com pany and the terms of
perfect ca p ita l m a rk e t frictionless capital m arket in the issue o f securities, w hich must be provided to
w hich there are no transaction costs and no barriers potential investors by a com pany seeking to issue
to the free flo w o f inform ation shares or other securities
placem ent an issue o f securities direct to chosen pure p la y com pany that operates almost entirely in
investors rather than the general public only one industry or line o f business
732
G lossary
p ut o ptio n r ig h t to s e ll a n u n d e r ly in g a s s e t a t a ris k -s e e k in g in ve sto r a n in v e s to r w h o lik e s ris k

f ix e d p r ic e a n d w h o w i ll c h o o s e a r is k y in v e s tm e n t e v e n if th e
p u t o p tio n on a fu tu re s co ntract o p t io n t h a t g iv e s e x p e c t e d r e tu r n is le ss th a n th e e x p e c t e d r e tu r n o n a
th e b u y e r th e r ig h t to e n t e r in to th e fu tu r e s c o n t r a c t le ss r is k y in v e s tm e n t
a s a s e lle r a t a p r e d e t e r m in e d p r ic e
p u t-ca ll p a rity r e la t io n s h ip t h a t e x is ts b e t w e e n s a fe ty stock a d d i t i o n a l in v e n t o r y h e ld w h e n

d e m a n d is u n c e r t a in , to r e d u c e th e p r o b a b il it y o f a
th e p r ic e o f a c a ll o p t io n a n d th e p r ic e o f th e
s to c k o u t
c o r r e s p o n d in g p u t o p t io n
sale and lease-back agreem ent a g r e e m e n t in
w h ic h a c o m p a n y se lls a n a s s e t a n d th e n le a s e s
rate o f retu rn c a lc u la t io n t h a t e x p r e s s e s th e r a t io o f
it b a c k
n e t c a s h in flo w s to c a s h o u t f lo w s
seasoned e q u ity o ffe rin g o f f e r t o s e ll e q u it y
real interest ra te in te re s t r a te a f t e r t a k in g o u t th e
s e c u r itie s o f a c la s s t h a t is a lr e a d y t r a d e d
e ffe c ts o f in fla t io n
secondary m a rk e t m a r k e t w h e r e p r e v io u s ly is s u e d
real o ptions th e f le x i b il it y t h a t a m a n a g e r h a s
s e c u r itie s a r e t r a d e d
in c h o o s in g w h e t h e r t o u n d e r ta k e o r a b a n d o n a
p r o je c t o r c h a n g e th e w a y a p r o je c t is m a n a g e d
secondary m a rk e t tran sactio n p u r c h a s e o r s a le o f
a n e x is tin g s e c u r ity
real o ptio ns a n a lysis m e t h o d o f e v a lu a t in g a n
in v e s tm e n t o p p o r t u n it y t h a t a c c o u n ts f o r t h e v a lu e
securities in th e c o n t e x t o f f in a n c ia l m a rk e ts ,
f in a n c ia l a s s e ts t h a t c a n b e t r a d e d
a s s o c ia t e d w it h m a n a g e r s h a v in g f l e x i b i l i t y in t h e ir
d e c is io n s a b o u t w h e n t o in v e s t, h o w t o m a n a g e securitisation th e p r o c e s s o f m a k in g a s s e ts
th e in v e s t m e n t a n d w h e n t o d iv e s t t h e m s e lv e s o f m a r k e ta b le b y a g g r e g a t in g in c o m e - p r o d u c in g
th e in v e s t m e n t a s s e t a s s e ts in a p o o l a n d is s u in g n e w s e c u r itie s b a c k e d
b y th e p o o l
redeem able preference share a p r e fe r e n c e s h a re
th a t h a s a f in it e life security m a rk e t line g r a p h ic a l r e p r e s e n t a t io n o f th e
c a p it a l a s s e t p r ic in g m o d e l
rediscounting s e llin g a s h o rt-te rm d e b t s e c u r ity in
th e s e c o n d a r y m a r k e t s e n sitivity a na lysis a n a ly s is o f th e e f f e c t o f
c h a n g in g o n e o r m o r e in p u t v a r ia b le s to o b s e r v e
reset preference share a p r e fe r e n c e s h a r e w h e r e
th e e ffe c ts o n th e re s u lts
th e d iv id e n d r a te c a n b e v a r ie d a t s p e c if ie d
in te r v a ls s h o rt hed ge r h e d g e r w h o h e d g e s b y m e a n s o f
s e llin g fu tu r e c o n tr a c ts t o d a y
residual claim c la im to p r o f it o r a s s e ts t h a t r e m a in
a ft e r th e e n title m e n ts o f a ll o t h e r in te r e s te d p a r tie s sh ort selling p r o c e s s o f f ir s t e n t e r in g in to a c o n t r a c t
ha ve been m et to s e ll a n d la te r e n t e r in g in to a c o n t r a c t t o b u y
residual va lu e d is p o s a l v a lu e o f a p r o je c t ’s a s s e ts s h o rtfa ll fa c ility a m e c h a n is m u n d e r w h ic h a

le ss a n y d is m a n t lin g a n d r e m o v a l c o s ts a s s o c ia te d c o m p a n y m a y is s u e s h o r tf a ll s h a r e s t o e lig i b l e
w it h th e p r o je c t's t e r m in a t io n s h a r e h o ld e r s o r o t h e r in v e s to rs
re vo lvin g cre d it b ill fa c ility b ill f a c il it y in w h ic h s h o rtfa ll shares n e w s h a re s n o t s u b s c r ib e d f o r b y

th e b o r r o w e r c a n is s u e b ills a s r e q u ir e d , u p to th e e l ig i b l e s h a r e h o ld e r s a c c o r d in g to t h e ir e n title m e n ts
a g r e e d lim it u n d e r a r ig h ts is s u e
ris k n e u tra lity s it u a t io n in w h ic h in v e s to r s a r e s im p le a n n u ity a n n u it y in w h ic h th e f r e q u e n c y

in d if f e r e n t to ris k ; a s s e ts a r e t h e r e f o r e p r ic e d o f c h a r g i n g in te r e s t m a t c h e s t h e f r e q u e n c y o f
s u c h t h a t t h e y a r e e x p e c t e d to y ie ld th e ris k -fre e paym ent
in te re s t r a te sim ple interest m e th o d o f c a lc u la t in g in te r e s t in

risk-averse in ve sto r a n in v e s to r w h o d is lik e s ris k w h ic h , d u r in g th e e n t ir e te rm o f th e lo a n , in te r e s t is
a n d w h o w ill o n ly c h o o s e a r is k y in v e s tm e n t if th e c o m p u t e d o n th e o r i g in a l su m b o r r o w e d
e x p e c t e d re tu rn is h ig h e n o u g h to c o m p e n s a t e f o r s im u la tio n a n a ly s is o f th e e f f e c t o f c h a n g in g a ll o f
b e a r in g th e ris k th e in p u t v a r ia b le s w h o s e v a lu e s a r e u n c e r t a in to
ris k -n e u tra l inve sto r a n in v e s to r w h o n e it h e r lik e s o b s e r v e th e e ffe c ts o n th e re s u lts
n o r d is lik e s ris k sole p ro p rie to rs h ip b u s in e s s o w n e d b y o n e p e r s o n
733
G lossary
speculators individuals and com panies w ho enter systematic (market-related or non-diversifiable)

into contracts in ord er to p rofit from correctly risk that com ponent of total risk that is due to
anticipating price movements econom y-w ide factors
spin-off the separation o f certain assets (or a
division) from a com pany upon w hich are issued takeover acquisition o f control o f one com pany by
new shares that are allocated to the com pany’s another
existing shareholders target com pany object o f a takeover bid
spot price price of the com m odity when the ta x loss selling investm ent strategy in w hich
buyer pays im m ediately and the seller delivers the tax rules make it a ttractive fo r an investor
im m ediately to sell certa in shares just before the end o f the
spread long (bought) position in one m aturity tax ye ar
date, paired w ith a short (sold) position in another term structure of interest rates relationship
maturity date between interest rates and term to m aturity for debt
standard deviation square root o f the variance securities in the same risk class
stapled securities tw o or more legally separate terminal value of a contract the value, as at the
instruments, typ ically an o rd in a ry share plus units in date o f the final cash flo w promised in a financial
one or more related trusts, w hich cannot be traded contract, that is equivalent to the stream o f promised
separately cash flows
static trade-off theory theory that proposes that tests for private information research method that
com panies have an optim al capital structure based tests whether systematic profits can be generated by
on a trade-off between the benefits and costs of m aking investment decisions on the basis o f private
using debt inform ation
step-up preference share a preference share tests of return predictability research method
w here the d ivid en d rate is reset at a higher rate designed to detect systematic patterns in asset
on a specified date unless the securities have been prices
re-marketed, redeemed or converted theoretical ex-righfs share price the expected
subordinated debt debt that ranks below other debt price o f one share when shares begin to be traded
in the event that a com pany is w ound up ex-rights
subscription price the price that must be paid to theoretical rights price the expected price o f one
obtain a new share rig h t ca lcu late d on the basis o f the cum-rights
sunk cost cost that has a lre a d y been incurred and share price
is irrelevant to future decision making time value value o f an option in excess o f its
sw a p an agreem ent between tw o counterparties to intrinsic value
exchange sets o f future cash flows time value of m oney principle that a d o lla r is worth
sweetened debt co n ve rtib le w hich is more (less), the sooner (later) it is to be received, all
p re do m in an tly d e b t but has some equity-like other things being equal
features; ty p ic a lly has a lo w p ro b a b ility o f being trade credit arrangem ent in w hich a seller o f goods
converted to equity or services allow s the purchaser a period o f time
syndicated loan loan arranged by one or more before requiring paym ent; it is equivalent to a short
lead banks, funded by a syndicate that usually term loan made by the seller to the purchaser, o f an
includes other banks am ount equal to the purchase price
syne rgy in takeovers, the situation w here the treasury m anagem ent involves the managem ent
perform ance and therefore the value o f a com bined o f financial assets and includes the m anagem ent of
entity exceeds the sum o f the previously separate short-term financial assets, long-term financing and
components risk m anagem ent
734
p
G lossary
treasury stock US term for a com pany's own shares vertical takeover takeover o f a target com pany that
that have been repurchased and held rather than is either a supplier o f goods to, or a consumer of
cancelled goods produced by, the a cqu iring com pany
volatility v a ria b ility o f a share price; can be
underreaction biased response o f a price to measured by the variance (or the standard
inform ation in w hich the initia l price movement can deviation) o f the distribution o f returns on the share
be expected to continue
unsubordinated debt d eb t that has not been w eighted ave rage cost of capital (WACC) the cost
subordinated o f capital determ ined by the w eighted average cost
o f all sources o f finance
unsystematic (diversifiable) risk that com ponent of
total risk that is unique to the com pany and may be w inner’s curse problem that arises in b id d in g
elim inated by diversification because the b id de r w ho 'w in s 7 is likely to be the
one w ho most overestimates the value o f the assets
offered for sale
value at risk worst loss possible under normal
withholding tax the tax deducted by a com pany
market conditions for a given time horizon
from the dividend payable to a non-resident
variable interest rate loan loan w here the lender
shareholder
can change the interest rate charged, usually in line
with movements in the general level o f interest rates yield curve graph o f yield to m aturity against bond
in the economy term at a given point in time
variance measure o f v a ria b ility ; the mean
o f the squared deviations from the mean or zero-coupon bonds (zeros) bonds that pay only
expected value one cash flow, the paym ent at m aturity
735
INDEX
10-year Treasury bond futures A N Z Banking G roup Australian Securities and long-term borrowing from
contracts 5 3 2 -5 2 2 2 , 335 Investments Commission 2 8 5 -9
30-day interbank cash rate APA 2 9 7 -8 (ASIC) 2 1 8 , 2 4 0 , short-term borrowing
futures contract 5 3 5 -6 arbitrage 7, 3 6 5 318, 619 from 2 8 2 -4
90-day bank-accepted bill with bank bill futures Australian Securities Exchange short-term investments
futures contract 5 2 5 -3 2 5 3 1 -2 5 0 8 , 5 1 2 -1 3 674
Asay, M.R. 5 9 4 Australian Small Scale Banksia Financial G roup 296
A Asciano 6 28 O fferings Board 2 1 6 Barber, B. 4 9 4 , 4 9 8
AASB 1 17 Leases 4 5 5 -6 , Asia Pacific Stock Exchange Australian Stock Exchange Ltd Barberis, N . 4 8 2 , 4 9 7
468 216, 242 (ASX) 2 1 6 Barclay, M . 4 0 0 , 4 0 4 -5 , 4 0 8
ABC Com pany 3 22 Asquith, P. 2 6 9 2 0 0 futures contract 5 3 7 Barings 5 3 9
ABC Limited 3 0 7 asset allocation (portfolio and futures trading Bartov, E. 341
abnorm al returns 4 8 0 performance) 198 5 1 2 -1 3 Basel Committee on Banking
Accelerated Non- asset-backed commercial indicies 5 3 6 - 7 Supervision 213
Renounceable Entitlement paper (ABCP) 2 23 listing rules 2 4 2 , 25 9 , basis points 5 4 8
O ffer 2 5 9 asset characteristics 4 1 0 2 6 1 , 2 6 2 , 3 03 basis risk 5 1 9 -2 0
Accelerated Renounceable asset growth 4 8 4 market statistics 2 1 7 Bautista, A. 4 5 8
Entitlement O ffer asset pricing 6 -7 value of share listinqs BBSW 5 4 6
(AREO) 2 5 9 asset risk 179 2 33 beating the market 4 9 9
acceptor (bills of exchange) of an individual asset 1 87 See a lso financial futures Beggs, D. 3 3 1 -2
2 92 assets on the ASX behavioural factors (payout
accounting accruals 4 8 4 current 6 4 7 Australand 2 6 9 policy) 3 3 9
accounting for leases 4 5 5 - 6 liquid 6 4 7 , 6 4 8 , 6 6 7 , authorised deposit-taking behavioural finance and
accounting rate o f return 669 institutions (ADIs) market efficiency 4 9 5 -7
1 1 8 -2 0 valuation based on 2 1 4 -1 5 , 2 1 8 Bellamy, D. 3 3 0
accounts receivable 6 4 7 , 6 4 8 (takeovers) 6 1 9 average collection period 6 9 7 Benartzi, S. 333
definition 6 7 5 S e e a lso short-term asset average inventory turnover benchmark indexes (portfolio
management 6 7 5 —7 management; short period 6 9 6 -7 performance) 199
accumulation 34 term assets Bendigo Bank 6 2 3
acquisition costs 6 5 0 assets, company B benefit-cost ratio (profitability
activity ratios 6 9 3 -4 overvaluation 3 8 5 -6 bad debts 6 7 6 index) 1 1 7 -1 8
Adelaide Bank 623 undervaluation 3 8 3 -5 Baker, H. 106, 124, 6 1 3 Benmelech, E. 4 0 5
adjusted present value at call 282 Baker, M . 3 3 9 , 4 0 4 Berk, J. 3 9 8
(APV) 4 3 6 Australia Balachandran, B. 2 58 Bernardo, A. 3 3 4
agency costs 3 3 5 -8 , 3 4 1 , banks 2 2 0 -2 Ball, R. 4 8 2 beta 1 87
3 7 9 -8 1 , 3 9 9 - 4 0 1 ,4 6 9 capital markets 2 1 2 -1 3 bank accepted bills 2 93 Bettman, j.L. 4 8 1 ,4 8 4
agency relationships 7 -8 equity markets 2 1 6 bank accepted bill futures BHP Billiton 3 2 0 - 1 , 5 6 4 - 5 ,
A g ra w a l, A . 3 9 8 financial institutions, contract 573, 624, 647, 667
Aitken, M . 4 8 8 assets of 2 1 5 hedging 5 2 7 -9 biased price reaction 4 7 9 -8 0
Alesco Corporation 2 6 4 financial markets 2 1 2 -1 3 specification 5 2 6 -7 bill acceptance facility 2 9 4
All Black Ltd 3 2 7 investment banking speculation 5 2 7 bill discount facility 2 9 4
Allen, F. 3 3 4 , 411 2 1 8 -1 9 uses 5 2 7 -3 2 bill facilities 2 9 4 -5
allocated costs (project profit and dividend bank bill futures 5 3 1 -2 Billabong 2 5 9
evaluation) 131 announcements bank bill futures contracts bills o f exchange 2 9 2 -5
Alpert, K. 5 7 7 4 9 1 -2 valuation 5 4 0 -1 binom ial option pricing
Alpha Books 383 securitisation 2 2 3 -4 bank bills 2 9 3 , 5 2 5 -6 5 7 7 -8 2
Annam ay Ltd 5 2 7 -3 0 share repurchases 3 4 3 -5 bank deposits, government Bishop, S. 6 0 6 , 6 3 7
Anderson, D. 4 8 3 , 4 8 4 Treasury’s currency guarantee 222 Black, S. 2 9 8
Anderson, H. 3 3 2 swaps crash 5 53 Bank for International Black-Scholes equation
Andrade, G. 3 9 8 -9 , 6 0 7 , Australian Competition and Settlements (BIS) 5 4 4 5 8 3 -7 , 5 9 4
630, 634 Consumer Commission Bank o f M elbourne 6 2 3 -4 Black-Scholes model o f call
annuities 5 0 - 7 (ACCC) 6 1 0 bank overdraft 2 8 2 -3 option pricing 5 8 2 -8
deferred 5 0 -2 Australian Equipment Lessors bankruptcy costs 3 7 7 -8 Block, S. 1 24
definition 5 0 -2 Association 4 5 1 ,4 5 3 banks Board Ltd 6 1 5 , 6 1 6 , 6 1 7 -1 8
future vale o f 5 6 - 7 Australian Financial Markets as financial Boart Longyear 2 6 9
general 6 3 -5 Association (AFMA) intermediaries bond duration 9 7 -9
ordinary 5 0 218, 544 220-2 bond price changes and
types o f 5 0 -2 Australian Prudential Regulation and global financial duration 100
annuity-date 5 0 Authority (APRA) 213, crisis 222 bond pricing 5 3 2 -3
present value o f an 5 2 -3 218, 221, 225 investment 2 1 7 -2 0 bonds 8 0 - 1 , 2 9 8 - 3 0 0
736
Index
W
convertible 3 0 3 -4 , 5 9 6 and the security market effects o f taxes under a valuation o f contracts
term structure to price line 1 9 2 -4 classical tax system with multiple
8 3 -5 capital market line 3 6 9 -7 4 4 6 -5 0
bonus issues 2 6 8 -9 1 9 1 -2 effects o f taxes under S e e a lso discounted
book building 2 4 4 implementation 1 9 5 -7 an imputation tax cash flo w methods
book-to-market ratio 4 8 5 -6 risk and return 197 system 3 7 4 -7 cash management trusts 6 7 4
Boral 6 4 7 , 6 6 7 capital expenditure evidence o 门 cash payments 671
Bowers, J. 4 8 2 process 104 3 9 5 -4 0 6 cash receipts 6 7 0
Bradley, M . 4 0 2 , 631 tasks and outcomes information costs Cassilis Ltd 4 3 8
Brailsford, T. 192, 1 9 6 ; 198, 1 0 5 -6 4 0 1 -3 catering theory 3 3 9
4 8 1 ,4 8 6 capital gains tax with information Cannavan, D. 331
Brambles 5 7 5 and dividend policy asymmetry 3 8 2 -6 central bank 2 13
Brav, A. 2 5 1 , 3 2 0 , 3 35 with imputation M od ig lia n i and M iller certainty 25
break-even analysis 1 5 1 -2 3 2 8 -9 analysis 3 6 0 , financial asset valuation
break fees and takeovers and im putation 3 2 7 -8 3 6 1 -9 , 3 9 4 , 4 0 8 under 7 5 - 6
624 capital market 1 2 -1 3 , optimal 3 5 7 , 3 8 1 -2 valuation o f shares
bridging finance 2 8 4 1 6 -1 9 , 2 1 0 -3 0 pecking order theory assuming 7 6 - 7
Brock, W . 481 Australia 2 1 2 -1 3 3 8 2 -3 , 3 9 4 , certainty-equivalent 4 3 7
broker and the stock business funding 4 0 1 -3 , 4 0 7 -8 certainty-equivalents to allow
exchange 2 1 6 -1 7 2 1 4 -1 5 principles of 3 5 6 -8 7 for risk 4 3 7 -9
Brooks, R. 2 4 7 , 2 52 definition 21 1 -1 2 priority o f debt 4 0 4 -5 Chan, H.W . 2 6 3 , 481
Brounen, D. 4 0 5 flo w o f funds 21 1 spin-offs 4 0 3 - 4 Chappie, L_ 6 2 4
Brown, C. 3 3 0 , 345 perfect 361 static trade-off theory C harting 4 9 7
Brown, P. 4 8 4 , 4 9 1 ,4 9 4 , types 21 2 394, 403, 4 0 6 -7 chattel mortgages 471
630, 631, 635, 636 capital market efficiency surveys 4 0 5 -6 Chestertheaton Investment
Brown, R. 5 7 7 4 7 7 -5 0 1 taxes 3 9 5 -7 fund 531
Brown, R.L. 263 and behavioural finance capital structure decisions C hicago Board of
Brown, S. 481 4 9 5 -7 3 9 3 -4 1 2 Trade 5 0 8
bubbles 4 9 6 categories 4 8 0 asset characteristics 4 1 0 C hicago Board O ptions
business angels 238 efficient market business risk 4 0 9 Exchange 5 6 6 , 5 8 7
business funding 2 1 4 -1 5 hypothesis company financing Chopra, N. 4 8 2 , 4 9 7
business risk 3 5 7 , 4 0 9 4 7 8 -8 0 3 9 4 -5 Chow, D. 398
business structures 3 -5 event studies 4 8 7 -9 1 financing as a marketing Christensen, B. 6 2 4
buy-and-hold policies 4 9 8 -9 and financial managers problem 4 0 8 -9 C itigroup G lobal Markets
buyouts 6 2 8 -9 4 9 9 -5 0 0 financing strategy Australia 2 6 0
leveraged 6 2 7 investors in securities 4 0 9 -1 1 Clarendon Com pany
management 2 3 6 , 6 2 7 4 9 7 -9 inflation risk 41 1 1 3 7 -9
and the joint test political risk 41 1 Clarke, A. 3 3 0
c problem 4 8 0 reserve borrow ing Clarke's Photography Store
Cabcharge Australia Ltd 3 5 8 macro level 4 9 5 capacity 41 1 6 5 4 , 6 5 7 -8
Cahan, S. 332 test o f return tax position 4 1 0 Clarkson, P. 6 2 4
call 2 3 4 predictability CAPstart Private Equity classical tax system, effects
call option 4 8 1 -6 M arket 2 1 6 on capital structure
current share price tests for private Carhart, M . 198 under a 3 6 9 -7 4
5 6 8 -9 inform ation 4 9 3 -5 carrying costs 5 1 3 , 651 com pany income tax
definition 5 6 4 capital market line 1 9 1 -2 cash budgeting 6 7 0 -3 3 6 9 -7 1
excise price 5 6 9 capital raising regime for cash flows com pany tax and
minimum value 5 7 6 -7 listed companies 2 5 2 -3 definition 29 personal tax
prices, factors affecting capital rationing 1 5 7 -8 estimation in project 3 7 1 -3
5 6 7 -7 1 capital structure evaluation 13 0 -3 M iller's analysis 3 7 3 -4
pricing, Black-Scholes agency costs 3 7 9 -8 1 , free 3 3 6 Claus J . 197
model 5 8 2 -8 3 9 9 -4 0 1 incremental (project Cliff, M . 2 4 9
on a futures contract assessing the theories evaluation) 130-1 CME G roup 5 0 8
513 4 0 6 -8 inform ation in project Coleman, L. 198, 4 0 5
payoff structure 5 6 6 -7 choice o f maturity evaluation with Coles 2 88
single-period 5 7 7 -8 4 0 4 -5 taxes 1 3 7 -9 collection policy 6 8 1 -6
term to expire 5 6 9 -7 0 costs o f financial distress effect of taxes on net Comer, A. 2 5 0
Camp, G. 2 5 0 3 7 7 -9 , 3 9 7 -9 (project evaluation) commercial bills, discounting
capital asset pricing model definition 3 5 7 1 3 4 -7 o f 6 7 4 -5
(CAPM) 6 dual issues 4 0 3 -4 and takeovers 61 1 commercial paper 2 9 0 -2
and cost o f capital effects o f financial timing (project Commonwealth Bank of
4 2 1 ,4 3 1 leverage 3 5 7 -6 1 evaluation) 131 Australia 2 22
737
Index
companies 4 -5 control, effect of debt weighted average cost and com pany cost of
capital raising regime on 2 7 9 of capital (WACC) capital 4 2 9
for listed 2 5 2 -3 conversion ratio 3 0 7 4 2 2 -3 , 4 3 1 ,4 3 5 , cost o f 4 2 4 -7
conflict of interest with convertible notes/bonds 4 3 6 -7 cost o f long-term 4 2 6 -7
employees 401 3 0 3 -4 , 5 9 6 cost of debt 4 2 4 -7 cost o f short-term 4 2 5 -6
m anaging equity converting preference shares cost o f long-term debt 4 2 6 - 7 effect on control 2 7 9
structure 2 6 8 -9 3 0 6 -7 cost of o rd in a ry shares effect on risk 2 7 9
S e e a lso public Cooper, M . 4 8 4 4 2 7 -9 hybrids 3 0 2 -8
company, floating Copperam a 4 7 9 cost o f preference shares interest cost of 2 7 8 -9
company cost of capital 4 2 2 , corporate bonds 2 9 7 -3 0 0 427 long-term borrowing
4 2 9 -3 0 , 4 3 1 -6 corporate (company) cost of short-term debt 4 2 5 -6 2 8 5 -9
company financing 3 9 4 -5 decisions 2 coupon payments 2 9 0 and overinvestment
com pany income tax corporate finance 2 covenants 2 7 7 , 2 8 0 4 0 0 -1
3 6 9 -7 1 corporate governance 3 3 5 -8 Cranfield M anufacturing and preference
company-issued share and takeovers 6 2 4 Ltd 6 5 4 shares 3 08
options 2 6 2 -3 corporate raiders 6 0 9 credit project finance 3 0 1 -2
company managers, corporate restructuring benefits and costs of security for 2 8 0 -1
conflict o f interest with 6 2 7 -9 granting 6 7 6 -7 sweete 门ed 3 0 4
shareholders 3 8 0 -1 buyouts 6 2 8 -9 collection policies short-term borrowing
com pany life cycle and divestures 6 2 7 6 8 2 -6 2 8 2 -4
payout policy 3 4 7 -8 spin-offs 6 2 7 -8 decision to offer 6 7 7 types of 4 2 5
com pany’s financial corporate treasurer 6 7 5 evaluation of alternative and underinvestment
objective 5 C o rp o ra tio n s A c t 2 0 0 1 4, 6 8 2 -6 3 9 9 -4 0 0
Com petition a n d C o n su m e r 2 4 0 , 2 4 1 ,2 5 2 - 3 , 2 5 6 , lim it 6 8 0 debt securities 2 8 9 -3 0 0
A c t 2 0 1 0 6 ] 0 , 623 317, 318, 493, 619, period 6 8 0 bills of exchange
competitive capital markets 621, 622, 625 policy 6 7 7 -8 1 2 9 2 -5
(finance leasing) 4 6 1 -2 C o rp o ra tio n s Legislation risk 5 5 6 commercial paper
compound interest 3 3 -4 5 A m endm ent (S im pler terms 6 8 0 -1 2 9 0 -2
basic idea 3 3 -4 R e gulato ry System ] A c t credit fo n d e r loan 2 8 6 corporate bonds
continuous interest rate 20 0 7 256 credit-worthy customers 2 9 7 -3 0 0
4 2 -4 Correia Da Silva, L. 3 3 7 -8 6 7 7 -8 0 debentures 8 0 -1 ,
definition 33 Corrigan, Chris 6 2 6 creeping takeovers 6 2 2 2 9 5 -6
formula development cost of capital 4 1 7 -4 8 cross-border leasing general principles
3 4 -7 alternative approaches (CBL) 4 5 5 2 8 9 -9 0
qeometric rates of return to estimation CSL Limited 268 unsecured notes 2 9 7
4 4 -5 4 2 1 -3 cumulative average valuation o f 80-1
nominal and effective alternative evaluation abnorm al returns debtor finance 2 8 3 -4
interest rates techniques 4 3 6 - 7 (CAR) 491 debtor finance with
3 7 -4 0 company cost of capital cumulative preference recourse 2 8 3
real interest rate 4 0 -1 422 shares 3 0 5 debtor finance without
compound option 5 9 7 definition 41 8 cum-dividend 31 7 recourse 2 8 3
conglomerate takeovers 6 0 8 direct estimation cum rights 2 53 debtors 6 4 7 , 6 4 8
ConnectEast G roup 3 0 2 approach 4 3 4 -5 currency swaps 5 4 4 , 5 5 1 -5 default risk 2 2 1 , 3 6 6
Conquest Investments 5 9 0 -1 direct use of CAPM 421 current assets 6 4 7 default-risk structure of
Conrad, J. 4 8 1 ,4 8 2 company 4 2 2 , 4 2 9 -3 0 , current ratio 6 9 6 interest rates 82, 8 9 -9 1
conservation of capital 431- 6 customer credit 6 7 5 defaults 2 7 7
(leasing) 4 6 7 -8 estimation 4 2 3 -3 1 deferred annuity 5 0 -1
consistency principle 41 8 formulae 4 4 7 -9 D present value o f an
constant chain of issue costs 4 3 0 -1 Da Silva Rosa, R. 2 4 7 , 5 3 -5
replacement and leasing 4 6 8 -9 2 5 2 , 6 3 0 ,6 3 1 , 6 3 5 , delayed equity 3 0 4
assumption 140 project 4 3 1 -6 636, 638 delinquent accounts 6 7 6
contingent claim 5 6 4 , 5 9 5 - 8 'pure play' approach d a ily return patterns 4 8 2 delta 5 7 8
continuous interest 42 432- 4 day trading 5 1 7 Denis, D. 2 4 9 , 3 3 6
continuous interest rate 4 2 - 4 and risk, return 41 8-1 9 De Angelo, H. & L. 3 2 3 , deposits (futures trading)
contracts risk independence 4 1 9 3 2 4 , 3 2 5 , 3 4 7 —8, 3 7 4 5 1 1 -1 2
present value 4 7 and taxes 4 1 9 -2 1 de Jong, A. 4 0 5 deposits o f funds with
principle-and-interest under alternative decision-tree analysis financial institutions 6 7 4
loan 5 8 -6 3 systems 4 4 7 -8 (projects) 1 5 3 -6 derivative securities 7
terminal value 4 7 using certainty debentures 8 0 - 1 , 2 9 5 - 6 Desai, H_ 2 6 9 , 631
valuation with multiple equivalents to a llow DeBondt, W .F.M. 4 8 2 Diacono Fidelity 5 9 5
cash flows 4 6 - 5 0 for risk 4 3 7 -9 debt 3 0 , 2 7 5 -3 0 9 Dill, D. 4 5 8
contributing shares 2 6 2 characteristics 2 7 7 -8 1 Dimovsky, W . 2 4 7 , 2 52
738
6 Z
CO
— SIOPOE 1 0 0 3 1 1 pl !x p s !> p
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Index
finance companies 223 effects on capital fixed charge 2 8 0 gearing 3 5 7

finance leases 4 5 2 -3 structure 3 5 7 -6 1 fixed-rate term loans 2 8 7 general annuities 6 3 -5
establishing an financial managers 4 9 9 -5 0 0 floating charge 2 8 0 qeometric rates of return
advantage 4 6 2 -3 financial markets, Australia's flotation costs 3 2 5 4 4 -5
evaluation of 4 5 8 -6 4 2 1 2 -1 3 floor-plan (or wholesale) G eorge, TJ. 481
imputation tax financial mathematics finance 2 8 4 global financial crisis
system 4 6 4 cash flows 29 flo w o f funds 211 and bank deposits 2 2 2
leasing and investment fundamental concepts F o re ig n A cq u isitio n s a n d and investment banks
decisions 4 6 0 2 9 - 31 Takeovers A c t 1 9 7 5 2 1 9 -2 0
taxes and the size of interest rate 30 623 G oergen, M . 3 3 7 -8
leasing gains rate of return 2 9 -3 0 foreign bonds 3 0 0 Goetzmann, W . 196
4 6 3 -4 time value of money foreign currency options going-private transaction
valuation in competitive 30- 1 5 8 8 -9 1 6 2 8 -9
capital markets financial ratio analysis, Foreign Investment Review Gompers, P. 2 5 1 -2
4 6 1 -2 usefulness o f 6 9 5 -6 Board (FIRB) 6 2 3 G ong, N. 2 4 7
Financial Accounting financial ratios Fortescue M etals G roup 2 6 8 goods and service tax (GST)
Standards Board measurement and forw ard contract 5 0 9 4 5 8 , 471
(FASB) 4 5 6 interpretation 6 9 0 -2 forw ard rate agreements Goss G old 5 2 3 - 4
financial agency institution and short-term asset (FRAs) 5 4 2 -4 Government Insurance Office
21 4 , 2 1 5 -1 9 management 6 9 6 -7 forw ards 5 9 1 -3 (GIO) 2 4 4
broker and the stock financial risk 2 7 9 Frank, M . 3 9 4 , 4 0 3 , 4 0 8 G oyal, V. 3 9 4 , 4 0 3 , 4 0 8
exchange 2 1 6 -1 7 financial slack 41 1 franked dividends 3 1 7 GPT G roup 2 6 9
investment banks financial statement analysis franking credits 31 8 G raham , J. 3 2 0 , 335,
2 1 7 -2 0 6 9 0 -7 market value of 3 9 6 -7 , 4 0 2 , 4 0 5 ,
financial asset valuation financing as a marketing 3 2 9 -3 2 406, 407
under certainty 7 5 -6 problem 4 0 8 -9 franking premium 421 Gray, S. 3 3 0 -1
financial assets 21 1 financing decisions (Fisher's free cash flow 3 8 1 ,6 1 1 G riffin, J.M. 481
financial contract 29 Separation Theorem) 23 French, K.R. 197, 198, 3 4 2 , G rinblatt, M . 4 8 1 ,4 8 2
financial decisions 2 -3 financing policy, information 403, 482, 485, 486 Grullon, G. 3 3 3 -4 , 3 3 6 ,
short-term 6 4 7 asymmetry for 3 8 6 fully draw n bill facilities 2 9 4 3 4 1 , 343
financial distress 2 7 9 financing strategy (capital fully paid shares 2 3 4 Grundy, B.D. 4 8 2
costs of 3 7 7 -9 , 3 9 7 -9 financinq decision) fund managers 2 3 9 guarantee 281
definition 3 7 7 4 0 9 -1 1 fundamental analysis 4 9 8 Guay, W . 342
financial futures contracts, finished goods inventories future sum 3 1 -2 Gulen, H. 4 8 4
valuation 5 4 0 -2 650, 652 futures 5 9 1 -3 Gup, B.E. 2 13
financial futures on the ASX Finn, F. 3 3 1 ,4 9 1 , 4 9 4 , 6 0 7 options on 5 9 3 -5
10-year Treasury bond Fisher’s Separation Theorem pricing options on 5 9 4 H
futures co 门tracts 1 1 -2 4 futures contract 5 6 6 , 5 9 3 Hall, j. 3 3 0 -1
5 3 2 -5 analysis using rates of call option 5 1 3 H alliwell, J. 4 8 5
30-day interbank cash return 13 definition 5 0 8 , 5 0 9 -1 2 Hameed, A. 491
rate futures contract assumptions 1 1 -1 2 , 14 deposits, margins and Hancock, P. 491
535- 6 com pany’s decision 26 market-to-market Harford J . 3 4 2 , 6 0 7 , 6 1 3
90-day bank-accepted the com pany 15 rule 5 1 1 -1 2 Harris, R.S. 4 3 4
bill futures contract dividend decisions 23 present value 5 12 Harris Scarfe 3 9 5
5 2 5 -3 2 financial decision put option 51 3 Harvey, C. 3 2 0 , 3 3 5 , 4 0 5
share price index S& P/ making 2 2 -4 selectinq the number Harvey N orm an Holdinqs Ltd
ASX 2 0 0 (SPI 200) financing decisions 23 5 2 2 -4 6 9 0 -2
futures contract formal approach 1 4 -2 4 futures market Hathaway, N. 3 3 0
536- 4 0 , 5 9 4 -5 introduction 1 1 hedging 5 1 7 -2 1 H edy, P. 2 6 9 , 3 3 3 ,
financial intermediaries 21 4 , investment decisions 23 organisation 5 0 9 -1 1 637, 638
2 2 0 -4 and net present value regretting 521 Heaney, R. 4 8 5
banks 2 2 0 -2 1 3 -1 4 speculating 5 1 6 -1 7 Heaton, J. 1 97
definition 21 1 optimal policy 19 -2 2 strategies 5 1 5 -2 4 Heavy Haulage Ltd 4 5 8 -9
finance companies 223 shareholders 1 5 -1 6 futures prices hedge ratio 5 7 8
money market shareholders' determinants 51 3 -1 5 hedgers 5 0 8
corporations consumption futures trading hedging 5 1 5 , 5 1 7 -1 8
(MMCs) 2 2 3 opportunities and deposits 51 1 -1 2 with 10-year bond
securitisation 2 2 3 - 4 preferences 12 margins 51 1 -1 2 futures 5 3 2 -5
financial institutions, deposits solution 1 2 -1 3 , 1 6 -1 9 with bank bill futures
of funds with 6 7 4 solution requiring G 5 2 7 -9
financial leverage borrow ing 13 Garm aise, M . 4 0 5 basis risk 5 1 9
definition 358 summary 14 Gaunt, C. 198 currency swaps 5 5 4
740
Index
imperfect convergence undervaluation of interest rate on a term loan investment projects

518 com pany assets 2 8 5 -6 break-even analysis
interest rate swaps 3 8 3 -5 intrinsic value 5 6 9 1 5 1 -2
5 4 7 -8 inform ation costs 4 0 1 -3 inventories o f finished replacement decisions
specification differences inform ation disclosure goods 6 5 2 1 4 7 -9
5 2 0 -1 2 4 0 -2 inventories o f raw retirement decisions
SPI 2 0 0 futures 5 3 7 offer information materials 651 1 4 6 -7
Heemskirk Consolidated 6 4 7 statements 2 4 1 -2 inventory 6 4 7 , 6 4 8 risk analysis 1 4 9 -5 3
hire-purchase agreement 471 offers of unlisted inventory costs selection (qualitative
Hoberg, G. 3 3 9 securities 2 4 0 -1 manufacturing 6 5 1 -2 factors) 156
Hodgson, A. 6 0 7 offers that do not need retailing and selection with resource
Hong, H. 4 8 2 2 4 1 -2 wholesaling 6 5 0 -1 constraints 1 5 7 -8
horizontal takeovers 6 0 7 information efficiency 4 8 0 inventory loans 2 8 4 sensitivity analysis
Hovakimian, A. 4 0 3 -4 inform ation gaps 2 3 7 inventory management 149-51
Hovakimian, G . 4 0 3 -4 information leakage 2 3 7 and /just-in-time, system simulation 1 5 2 -3
How, J. 2 5 0 information problems and 6 6 1 -2 investments 2
hybrids of debt and equity new ventures 2 3 7 overview 6 5 0 independent 1 1 2
3 0 2 -8 initial public offerings (IPOs) inventory management under mutually exclusive
convertible notes/bonds 2 3 3 , 2 3 7 , 2 4 2 , 2 4 6 -7 , certainty 6 5 2 -8 112-17
3 0 3 -4 2 4 8 -5 2 cost estimation 6 5 5 -6 short-term 6 4 8 , 6 7 4 -5
preference shares lonq-term performance economic order quantity investor(s)
3 0 5 -8 2 5 0 -2 (EOQ) model decisions 3
Hwang, C.Y. 481 of o rd in a ry shares 243 6 5 2 -5 information effects and
Inman, Launa 2 5 9 EO Q model with signalling to 3 3 2 -5
I Innovation Investment Fund positive lead time reactions to managers'
Ibbotson, R.G. 196 program 2 3 9 656 decisions 2 4 -5
Ikenberry, D. 341 instalment receipts 2 6 2 EO Q model with risk-averse 6, 176
immunisation 9 7 -1 0 2 insurance companies quantity discounts risk-neutral 176
and duration 1 0 0 -2 2 2 5 -8 6 5 7 -8 risk-seeking 176
imperfect convergence 51 8 interbank cash rate 2 7 8 inventory management under in securities 4 9 7 - 9
imputation tax system futures 5 3 5 -6 uncertainty 6 5 8 -6 1 utility function 1 7 6 -9
317, 369 interest specifying an investing institution 2 1 4
and capital gains tax compound 3 3 -4 5 acceptable invoice discounting 2 83
3 2 7 -8 cost of debt 2 7 8 -9 expected customer irredeemable preference
definition 3 7 4 -5 elasticity and duration service level 6 6 0 -1 shares 3 05
dividend policy 3 2 8 -9 9 9 -1 0 0 specifying an issue costs
and dividends 3 2 5 -7 simple 3 1 -3 acceptable and cost of capital 4 3 0
effects o f tax on capital interest rate risk 8 1 -2 p ro b a b ility of definition 4 3 0
structure 3 7 4 -7 interest rate swaps 5 4 4 -5 2 stockout 6 6 0
and leasing 4 6 4 interest rates 30 investing institutions 2 2 4 -9
Incite Pivot 2 6 8 , 2 6 9 continuous 4 2 -4 insurance companies Jagadeesh, N. 4 8 1 ,
Income Tax Assessment Act default-risk structure of 2 2 5 -8 482, 494
134, 135 82, 8 9 -9 1 investment companies Jagannathan, M . 3 4 2
independent investments 1 12 effective 3 7 -4 0 2 2 8 -9 Jain, P. 2 6 9
independent project 107 nominal 3 7 -4 0 overseas sources and Jameson Ltd 4 3 9
indicator rate 282 real 4 0 -1 markets 2 2 9 January effect 4 8 3
indifference curve 15 structures 91 superannuation funds Jarrell, G . 3 4 1 ,4 0 2 , 631
inflation term structure of 8 2 -9 2 2 5 -8 Jegadeesh, N . 198
chain of replacement interest-only loan 37 unit trusts 2 2 8 -9 Jensen, M ichael 2 0 2 , 3 8 1 ,
methods 145 intermediation 2 7 6 investment banks 2 1 7 -2 0 3 9 4 , 4 0 0 , 4 0 1 ,4 0 2 ,
and project evaluation internal capital rationing 157 Australia 2 1 8 -1 9 6 0 6 , 6 0 7 , 6 1 1 ,6 3 6
1 3 1 -3 internal funds 2 6 6 -7 and the global financial Jensen's alpha (portfolio
and term structure 89 89 internal rate o f return (IRR) crisis 2 1 9 -2 0 performance) 2 0 2 -3
inflation risk 41 1 definition 107 regulation 21 8 Ji, X. 481
information asymmetry 2 3 7 multiple and role of 2 1 7 -1 8 joint test problem 4 8 0
capital structure 3 8 2 -6 indeterminate investment companies Jung, J. 4 7 8
for financing policy 3 8 6 110-12 2 2 8 -9 just-in-time system 6 6 1 -2
overvaluation of project evaluation 10 7 , investment decisions
company assets 1 0 9 -1 2 finance leasing 4 6 0 K
3 8 5 -6 International Accounting Fisher’s Separation Kaplan, S. 3 9 8 -9
pecking order theory Standards Board Theorem 23 Kathmandu Holdings 2 4 4
3 8 2 -3 (IASB) 4 5 6 investment horizons 87 Kaul, G . 4 8 1 ,4 8 2
741
Index
Keswin, A. 4 9 4 Lee, C .M .C . 4 8 2 , 4 9 3 , 4 9 4 Lopez-De-Silanes, F. 3 3 6 -8 Michaely, R. 3 2 0 , 3 3 3 -5 ,

Kim, Y. 3 9 8 , 4 0 2 Lee, P. 2 4 7 , 2 4 8 , 2 5 0 , 2 52 Loughran, T. 2 4 7 , 2 4 8 , 2 4 9 , 3 3 6 , 3 4 0 , 3 4 1 , 343
Kinney, W . 4 8 2 Leeson, N ick 5 3 9 2 5 1 ,6 3 5 M iguel, A.F. 4 9 4
Kiymaz, H. 6 1 3 legal ownership 2 8 0 Lucas, D. 197 Mikkelson, W . 4 0 4
Koedijk, K. 4 0 5 Lehman Brothers 2 1 9 , 222 Lynch, A. 4 8 3 Miller, M (MM) 3 2 0 -5 , 335,
Krishnamurti, C. 3 33 Lehn, K. 6 3 6 3 4 7 , 4 6 1 ,4 6 8 - 9
Kusnadi, Y. 481 lenders, conflict of interest M M iller's analysis
with shareholders M cConnell, J. 6 13 (classical tax
L 3 7 9 -8 0 MacKay, P. 3 95 system) 3 7 3 -4
La Porta, R. 3 3 6 -8 Lerner, J. 2 5 1 -2 MacKie*Mason, J. 3 9 6 , 4 0 7 capital structure analysis
Lakonishok, J. 3 4 1 ; 4 8 1 ; lessee 451 M acKinlay, A.C . 481 3 6 0 , 3 6 1 -9 ,
4 8 1 ,4 8 4 , 4 9 3 lessor 451 M adison Com pany 1 4 4 -5 394, 408
Lancaster Ltd 6 7 1 -3 leverage and pecking order Maher, T.R.B. 481 M itchell, M . 6 3 0 , 6 3 4 , 6 3 6
Lang, L. 3 3 6 , 6 3 6 theory 4 0 2 M aheswaran, K. 196, 198, M o d ig lia n i, F. (MM) 3 2 0 -5 ,
Lanis, R. 3 9 7 leverage ratios 6 9 4 405, 626 3 3 5 , 3 4 7 , 461
lease contracts, types of o f Australia listed maintenance leases 4 5 3 capital structure analysis
4 5 1 -5 companies 3 5 9 Mamaysky, H. 4 8 1 ,4 9 7 3 6 0 , 3 6 1 -9 ,
lease rentals, setting 4 5 6 -7 leveraged buyouts 6 2 7 management buyout (MBO) 394, 408
Leaseurope 451 leveraged leasing 4 5 4 -5 236, 627 momentum effect 481
leasing 4 5 0 -7 2 Levi, M . 6 3 2 managers money
accounting treatment Li, K. 632 conflict of interest with purchasing pow er of 6
455- 6 liabilities, short-term 6 4 9 shareholders 3 8 0 -1 time value o f 5 , 30-1
advantages 4 6 2 -3 , Liang, N . 3 42 and payout money market corporations
4 6 6 -7 0 Lie, E. 3 3 6 decisions 3 2 0 (MMCs) 223
and agency costs 4 6 9 Lieu, D. 5 9 4 managers' decisions, M onlease 4 5 7
and company tax limited lia b ility 4 investors' reactions to monthly return patterns
466- 7 shareholders 2 3 4 2 4 -5 4 8 2 -3
comparative advantage lintner, J. 190 manufacturing (inventory M orck, R. 6 3 6
in asset liquid assets 6 4 7 , 6 4 8 , 6 6 7 costs) 6 5 1 -2 m ortgage 2 8 0
disposal 4 7 0 motives for holding 6 6 9 margin call 51 2 M oskowitz, T. 4 0 5 , 481
conservation o f capital liquidity management margins (futures trading) Mossin, J. 190
467- 8 6 6 7 -7 0 , 6 75 5 1 1 -1 2 Mukherjee, T.K. 6 13
cost of capital 4 6 8 -9 centralisation 6 6 8 market bids (takeovers) 621 mutually exclusive
cross-border 4 5 5 definition 6 6 7 market efficiency 6 - 7 investments 1 1 2 -1 7
decisions 4 6 0 m ajor issues in 6 6 9 -7 0 and behavioural finance ranking 1 1 3 -1 7
disadvantages 4 6 6 -7 0 liquidity (risk) premium 4 9 5 -7 mutually exclusive
finance 4 5 2 -3 85, 87 implications of evidence projects 1 13
finance, evaluation of liquidity ratios 6 9 2 -3 4 9 7 -5 0 0 Myers, S. 3 9 4 , 4 0 2 , 4 0 3 ,
4 5 8 -6 4 listed investment companies at the macro level 4 9 5 4 0 6 -7 , 4 5 8
flexibility and transaction (LICs) 2 2 9 market opportunity line
costs 4 7 0 listed management 17-18 N
and imputation tax investments (LMIs) 2 28 market portfolio 192 N ational Association of
system 4 6 4 listed securities 241 market risk 6 Securities Dealers 251
leveraged 4 5 4 -5 Little, Paul 6 2 6 market risk premium 1 9 6 -7 N ational Australia
off-balance-sheet Litzenberger, R. 3 3 6 market timing (portfolio Bank 2 2 2
finance 4 6 8 Lo, A .W . 4 8 1 ,4 9 7 performance) 1 9 8 -9 N ational Stock Exchange of
operating 4 5 1 ,4 5 3 loan, syndicated 2 8 7 market-tom a rket 51 1- 12 Australia 2 1 6 , 2 42
operating, evaluation of loan repayments 2 8 6 M arket Volatility Index (VIX) negative pledge 2 8 0 -1
4 6 5 -6 loans 587, 588 net present value (NPV)
policy 4 6 9 -7 0 fixed-rate term 2 8 7 M artin, K. 61 3 597, 682
sale and lease back term 2 8 7 , 2 8 8 -9 M artin, S. 4 8 1 ,4 8 2 definition 107
agreements 4 5 3 -4 variable interest rate 62 M artlake Ltd 1 4 6 -7 and Fisher’s Separation
setting lease rentals variable-rate term Masulis, R. 2 5 1 , 3 7 4 Theorem 13 -1 4
456- 7 2 8 6 -7 M athiou, N. 4 8 3 project evaluation 107,
taxation treatment 4 5 6 , long hedge 5 1 7 M atsa, D. 3 9 8 , 401 1 0 8 -9 , 4 1 8
4 6 3 -4 , 4 6 6 - 7 long-term abnorm al returns M a yfa ir Ltd 6 1 5 , 6 1 6 , project evaluation
transaction costs 4 6 7 (takeovers) 6 3 5 6 1 7 -1 8 application 1 3 0 -4
types o f 451 - 5 long-term borrow ing from M egacorp Ltd 6 6 8 net share issues 4 8 4
valuation in competitive banks/financial M ehra, R. 196 new venture finance 2 3 7 -8
capital markets institutions 2 8 5 -9 M ehrotra, V. 4 0 4 new ventures and information
4 6 1 -2 long-term /overnight position M erton, R.C. 5 7 3 problems 2 3 7
LeBaron, B. 481 taking 5 1 7 M etallgesellschaft 5 2 4 N ine Entertainment 2 4 4
742
Index
no liability companies foreign currency partial takeovers 6 2 2 placements (private issues)

2 3 4 -5 5 8 8 -9 1 partly paid shares 2 3 4 2 6 0 -5
nominal amount (concept in on futures 5 9 3 -5 Partington, G . 331 poison pills 6 2 5
finance) 6 risk-free interest partnerships 3 -4 political risk 41 1
nominal interest rates 3 7 -4 0 rate 571 Patrick Corporation 6 2 6 portfolio
definition 3 7 , 4 0 trading 5 6 5 -6 Pattenden, K. 3 9 7 definition 179
non-bank bill 2 93 volatility of the share payback period 1 18, 12 0 -1 performance appraisal
non-debt tax shields 570 payoff structure for calls and 1 9 8 -2 0 3
(NDTSs) 3 9 6 See a lso call options; puts 5 6 6 -7 performance, alternative
non-instantaneous price put options payout policy 3 1 5 -4 9 measures 19 9 -2 0 3
reaction 4 7 9 o rd in a ry annuity 5 0 agency costs 3 3 5 -8 portfolio theory and
non-participating preference present value of an alternative 3 1 9 -2 0 diversification 17 9 - 9 0
shares 305 5 1 -2 , 5 5 -6 behavioural factors 3 3 9 diversification with
non-recourse loan 4 5 4 o rd in a ry perpetuity 51 catering theory 3 3 9 multiple assets
non-votinq preference shares o rd in a ry shares and com pany life cycle 1 8 4 -6
3 0 5 -6 advantages and 3 4 7 -8 efficient frontier 18 9 -9 0
N o rfo lf Ltd 3 3 0 disadvantages constant 3 2 0 risk o f an individual
N o r li, 〇 .2 5 1 2 3 5 -6 corporate governance asset 18 7 -9
Norman, D. 3 45 characteristics 3 3 5 -8 systematic and
notional principle (or notional 2 3 4 -6 dividend declaration unsystematic risk
amount) o f the interest cost o f 4 2 7 -9 procedures 3 1 6 -1 7 1 8 6 -7
rate swap 5 45 definition 2 3 4 dividend election Poulsen, A. 6 3 2
notes, convertible 3 0 3 -4 franked dividends 3 1 7 schemes 3 4 6 -7 Prabhala, N.R. 3 3 9
N ow ra Ltd 3 7 1 , 3 75 franking credits 31 8, dividend reinvestment preference shares 3 0 5 -8
Nufarm Limited 281 3 2 9 -3 2 plans 3 4 6 -7 classification as debt or
franking premium 421 dividends 3 2 5 -3 2 equity 3 0 8
o fully paid and partly flotation costs 3 2 5 cost of 4 2 7
O 'Brien, M . 198, 4 8 1 ,4 8 6 paid 2 3 4 im portance of 323 modern 3 0 6 -8
O ’Brien, TJ. 4 3 4 initial public offerings information effects traditional 3 0 5 - 6
O dean, T. 4 9 8 (IPOs) 2 3 3 , 2 3 7 , 3 3 2 -5 w hy companies issue?
off-balance-sheet finance 2 4 2 , 2 4 3 , 2 4 6 -7 , im portance to 308
(leasing) 4 6 8 2 4 8 -5 2 shareholders Prescott, E.C. 196
off-market bids (takeovers) limited liab ility 2 3 4 3 1 9 -2 4 present value 32
6 2 0 -1 no lia b ility companies introduction 3 1 6 -1 9 present value o f the
Officer, R. 3 3 0 , 6 0 6 , 6 3 7 2 3 4 -5 irrelevance o f 3 2 1 -3 contract 4 7
〇 oi, Y.H. 481 placements (private legal and tax present value of futures
open account 6 7 6 issues) 2 6 0 -1 considerations contract 5 1 2
operating leases 4 5 1 ,4 5 3 pricinq a new issue 3 1 7 -1 8 price-earnings ratio
evaluation of 4 6 5 -6 2 4 3 -4 managers and payout and future returns 4 8 3
Opler, T. 3 98 rights issue 2 5 3 -6 0 decisions 3 2 0 share valuation 7 9 -8 0
opportunity cost 41 8 selling a new in practice 3 2 4 and takeovers
of investments 651 issue 2 4 6 repurchasing shares 612, 618
optimal capital structure shareholder rights 2 3 5 3 18 price stabilisation 2 4 5 -6
definition 3 5 7 subsequent issues of share buybacks pricing a new issue (shares)
static trade-off theory 2 5 2 -6 5 3 3 9 -4 5 2 4 3 -4
3 5 7 ,3 8 1 - 2 underwriting and signalling to investors pricing o f risky assets 1 9 0 -7
option contracts 5 6 6 m anaging a new 3 3 2 - 5, 3 4 0 -1 prim ary markets 21 2
option markets 5 6 4 -7 7 issue 2 4 4 -6 transaction costs 3 2 4 -5 principal 3 1 , 2 7 7
option pricing, binomial See a lso shares taxes 3 2 5 -3 2 principle-and interest loan
5 7 7 -8 2 O rigin Energy 2 6 4 pecking order theory 3 8 2 -3 , 5 8 -6 3 , 2 8 6
option to abandon 5 9 7 Otchere, I. 3 4 5 3 9 4 , 4 0 1 -3 , 4 0 7 -8 balance owing a i any
option to defer 5 9 7 overdraft lim it 2 8 2 Pedersen, L.H. 481 given date 6 0 -1
option to expand 5 9 7 overinvestment and debt Penman, S.H. 61 8 basic features 58
option to reopen 5 9 7 4 0 0 -1 perfect capital market 361 changing the interest
option to study 5 9 7 overreaction 4 7 9 Perco Parts Ltd 4 3 3 -4 rate 6 2 -3
options 2 5 5 -6 , 5 6 4 -7 7 , over-the-counter market 21 2 Perrigo 61 1 definition 58
5 9 1 -3 Pham, T_ 398 loan term required 6 1 -2
company-issued share P Phang, G . 5 7 7 principal and interest
2 6 2 -3 Palepu, K. 2 6 9 , 3 3 3 , Phillips, G .M . 395 components
creation of 5 6 5 -6 637, 638 Pilotte, E. 4 0 2 5 9 -6 0
definition 5 6 4 -5 Paperlinx 6 4 7 , 6 6 7 Pincus, M . 4 8 4 private vs public ownership
expected dividends 571 Partch, M . 4 0 4 Pinder, S. 198, 4 0 5 , 6 2 6 (companies) 2 4 2 -3
743
Index
private equity 2 3 6 -9 tax issues 13 4 -9 Raven Enterprises Ltd (REL) dividend yield 483
definition 2 3 3 , 2 3 6 and W A C C 4 3 6 -7 2 5 4 -5 long-term patterns
from business angles 2 38 project finance 3 0 1 -2 raw materials inventories 481- 2
information projects 6 5 0 , 651 monthly return patterns
problems 2 3 7 mutually exclusive 1 13 real estate investment trusts 482- 3
new ventures 2 3 7 -8 selection (qualitative (REITs) 2 2 7 , 2 2 8 , 2 2 9 net share issues 4 8 4
private equity funds factors) 156 real amount (concept in predictive future returns
2 3 8 -9 selection with resource finance) 6 483- 6
private information, tests for constraints 1 5 7 -8 real interest rate 4 0 -1 presence o f seasonal
4 8 0 , 4 9 3 -5 proportional bid 6 2 2 real options analysis 1 2 3 -4 effects of returns
probability distribution 173 prospectuses 2 4 0 -1 redeemable preference 4 8 2 -3
production possibility public company, floating shares 3 0 5 price-earnings ratio 4 83
curve 15 2 4 2 -5 2 rediscounting (bills of relationship between
profitability index 1 1 7 -1 8 costs 2 4 6 -5 0 exchange) 2 9 2 past and future
profitability ratios 6 9 5 -6 initial public offering regretting 521 returns 481 - 2
progressive dividend of ordinary regulation of a rights short-term patterns 481
policy 3 2 0 shares 2 43 issue 2 5 6 size 4 8 4 -5
project cost o f capital 431 - 6 long-term performance Reinganum, M.R. 4 8 3 revolving credit bill
project evaluation 1 0 3 -2 5 of IPOs 2 5 0 -2 Renneboog, L 3 3 7 -8 facility 2 9 4
accounting rate of return pricing a new issue replacement decisions Rhee, S.G. 481
118-20 2 4 3 -4 (projects) 1 4 7 -9 Richardson, G . 3 9 7
alternative 4 3 6 -7 public vs private repurchasing shares 3 1 8 -1 9 rights issues 2 5 3 -6 0 ,
application 12 9 -5 9 ownership 2 4 2 -3 Reserve Bank o f Australia 5 9 5 -6
benefit-cost ratio selling a new issue 2 4 6 (RBAj 2 1 3 , 2 2 1 , accelerated 2 5 9 -6 0
(profitability index) underwriting and 2 6 6 -7 , 2 7 8 designing a successful
117-18 managing a new reserve borrow ing 2 5 7 -9
capital-expenditure issue 2 4 4 -6 capacity 41 1 disclosure and
process 104 public vs private ownership reset preference shares regulation 2 5 6
cash flows, estimation of 2 4 2 -3 3 0 7 -8 significance 2 5 6 -7
1 3 0 -3 purchasing power of residential mortgage-backed traditional 2 5 9 -6 0
com paring mutually money 6 securities (RMBS) 223 and underwriters 2 6 0
exclusive projects pure plays 4 3 2 residual claim 2 3 4 risk 5
that have different put-call parity 5 7 3 -6 residual dividend policy 3 1 9 analysis (projects)
lives 1 3 9 -4 5 put option residual value (project 1 4 9 -5 3
economic value added definition 5 6 4 evaluation) 131 of assets 179
(EVA) 1 2 1 -2 on a futures contract retailing (inventory costs) business 3 5 7
decision-tree analysis 513 6 5 0 -1 and certainty
1 5 3 -6 minimum value 5 7 6 -7 retirement decisions (projects) equivalents 4 3 7 -9
discounted cash flo w payoff structure 5 6 6 -7 1 4 6 -7 and cost o f capital
methods 1 0 8 -1 7 pricing 5 7 1 -3 return 4 1 8 -1 9
and inflation 1 3 1 -3 PXT Ltd 4 2 0 a dditional factors that independence 4 1 9
methods 1 0 4 -7 explain returns of an individual
and net present value Q 197- 8 asset 187
method 1 3 0 -4 Qantas 2 4 4 , 2 9 7 -8 and cost o f capital interest rate 81 - 2
payback period 1 1 8, qualitative factors (selection 4 1 8 -1 9 investor's utility function
120-1 of projects) 156 portfolio performance 1 7 6 -9
project risk, analysing Queensland Gas Com pany appraisals portfolio theory and
1 4 9 -5 3 (QGC) 261 198- 203 diversification
project selection with quick ratio 6 9 6 portfolio theory and 1 7 9 -9 0
resource constraints Q uintro Electronics Ltd 65 9 , diversification and return 1 7 3 -6
1 5 7 -8 6 6 0 -1 1 7 9 -9 0 return and CAPM 197
qualitative factors QR National 2 4 5 -6 , 2 4 7 and risk 1 7 3 -6 systematic risk 6, 1 8 6 -7
(selection of See also rate o f return unsystematic risk 6,
projects) 156 R return predictability, tests of 1 8 6 -7
and real options 5 9 7 -8 Rajan, R. 3 9 5 , 401 4 8 0 , 4 8 1 -6 risk-averse investor 6, 176
and real options Rajgopal, S. 4 8 4 accounting accruals risk aversion 6
analysis 1 2 3 -4 Ralph Review 623 484 risk-free interest rate
resource constraints Ramos, S.B. 4 9 4 asset growth 4 8 4 195, 571
1 5 7 -8 Rampini, A. 4 6 7 book-to-market ratio risk-neutral investor 176
retire (abandon) or rate o f return 2 9 -3 0 , 173 485— 6 risk neutrality 5 7 9
replace a project accounting 1 18 -2 0 daily return patterns 482 risk premium 8 5 , 87
1 4 6 -9 measuring 4 9 -5 0 definition 4 8 0 risk-seeking investor 176
744
Index
risky assets, pricing of 1 9 0 -7 share buybacks 3 1 8 -1 9 , subsequent issues of Skeels, C. 3 3 1 -2

CAPM and the security 3 3 9 -4 5 2 5 2 -6 5 Skinner, D. 3 2 4 , 3 3 3 ,
market line 1 9 2 -4 in Australia 3 4 3 -4 underwriting and 3 3 4 , 343
capital market line why companies managing a new Smith, C.W . 2 5 1 ,2 5 5 , 4 0 0 ,
1 9 1 -2 repurchase shares issue 2 4 4 -6 , 4 0 2 , 4 0 4 -5 , 4 0 8 ,
implementation of 3 4 0 -3 258, 260 469, 470
CAPM 1 9 5 -7 share consolidations 2 6 9 valuation 7 9 -8 0 Societe Generale 5 4 0
risk, return and share options valuation assuming sole proprietorship 3
CAPM 197 company-issued 2 6 2 -3 certainty 7 6 -7 Soltes, E. 3 3 4
risky coupon-paying debt share price index futures valuation of 7 6 -8 0 special purpose vehicle
5 9 6 -7 contracts valuation valuation under (SPV) 2 23
risky zero-coupon debt 5 9 6 5 4 1 -2 unc^rtai 门ty 7 7 -8 specification differences
Ritter, J.R. 196, 2 4 7 , 2 4 9 , share price index (SPI 200) volatility o f 5 7 0 , 5 7 5 5 2 0 -1
25 0 , 2 5 1 ,2 5 2 futures contract 5 3 6 -4 0 , See a lso ordinary speculation
Rock, K. 2 48 5 9 4 -5 shares; preference 10-year bond futures
Roll, Richard 197, 6 3 2 share price response to new shares 5 3 2 -5
Rose, L 332 financing 4 0 2 share’s systematic risk SPI 2 0 0 futures 5 3 7
Ross, M. 345 share splits 2 6 8 -9 1 9 5 -6 speculators 5 0 8 , 5 1 5
Rozeff, M . 4 8 2 shareholders 4 Sharpe, W illiam 190, speculating 5 1 5 -1 7
Royal Dutch Shell 6 2 7 conflict of interest with 1 9 9 -2 0 0 currency swaps 5 5 2 -3
Ruback, R. 6 3 6 , 6 3 7 lenders 3 7 9 -8 0 Sharpe ratio (portfolio interest rate swaps 5 4 7
Rubenstein, M . 4 9 7 conflict of interest with performance) spin-offs 4 0 3 -4 , 6 2 7 -8
com pany managers 1 9 9 -2 0 0 spot price 5 1 4
S 3 8 0 -1 Shekhar, C. 2 4 7 spreading 5 1 6 -1 7
Saadi, S. 106, 124 and Fisher’s Separation Shleifer, A. 3 3 6 -7 , 4 8 2 , spreads 5 16
safety stock 6 5 8 Theorem 1 5 -1 6 495, 497, 636 stable (or progressive)
Saint, M ichael 5 3 8 -9 limited lia b ility 2 3 4 Shiller, Robert 4 7 8 , 4 9 5 , 4 9 7 dividend policy 3 1 9 -2 0
sale and lease back and payout policy short hedge 5 1 7 Stafford, E. 6 0 6 , 6 0 7 ,
agreements 4 5 3 -4 3 1 9 -2 4 short selling 51 1 630, 634
Sarin, A. 3 3 6 rights 2 35 shortfall facility 258 standard deviation 174
Sault, SJ. 4 8 1 ,4 8 4 shareholders' consumption shortfall shares 2 58 Stanton, R. 3 98
Sawicki, J. 4 8 5 opportunities and short-term asset management stapled securities 2 2 9 , 233
scalping 5 1 6 preferences 12 6 4 8 -9 , 6 6 7 , 6 9 6 -7 static trade-off theory 3 8 1 -2 ,
schemes o f arrangement Sharemarket Research Ltd short-term assets 6 4 9 394, 403, 4 0 6 -7
(takeovers) 6 2 2 -3 (SRL) 4 5 9 -6 0 , 4 6 3 introduction 6 4 7 , 6 6 7 Stein, J.C. 4 8 2
Schwert, G . 6 2 6 shares 5 types 6 4 8 step-up preference shares
seasonal effect on returns bonus issues 2 6 8 -9 short-term borrowing (SPSs) 3 0 8
4 8 2 -3 company-issued options from banks/financial stock exchange 2 1 6 -1 7
seasoned equity offering 2 6 2 -3 institutions 2 8 2 -4 automation of
(SEOs) 251 contributing 262 short-term financial trading 2 1 6
secondary market employee share decisions 6 4 7 stockbrokers 2 1 7
transactions 2 8 9 options 3 42 short-term investments 6 4 8 stockout costs 651
secondary markets 21 2 employee plans 2 6 5 -6 types of 6 7 4 -5 Stoll, H.R. 5 7 3
securities franked dividends 3 1 7 short-term liabilities 6 4 9 straddling 5 1 7
definition 2 7 6 franking credits 31 8, short-term securities 673 strike price 5 6 4
investors in 4 9 7 -9 3 2 9 -3 2 Shyam-Sunder, L 4 0 3 Stulz, R. 6 3 6
listed 241 franking premium 421 signalling to investors subordinated debt 2 7 9
random selection of 4 9 8 fully paid and partly 3 3 2 -5 , 3 4 0 -1 subscription price 2 5 3
short-term 6 7 3 paid 2 3 4 simple annuity 63 Suncorp-Metway 2 6 0
unlisted 2 4 0 -1 placements (private simple interest 3 1 -3 sunk costs (project
securitisation 2 2 3 -4 issues) 2 6 0 -1 applications 3 2 -3 evaluation) 131
security for debt 2 8 0 -1 price-earnings ratio basic idea 31 superannuation funds
security market line and the 7 9 -8 0 , 4 83 definition 31 2 2 5 -8
CAPM 1 9 2 -4 pricing a new issue formula development Swaminathan, B. 3 3 3 -4 ,
security selection (portfolio 2 4 3 -4 3 1 -2 346, 482
performance) 199 purchase plans 262 Simultaneous Accelerated swaps 5 0 8 , 5 4 4 -5 6
self-managed superannuation repurchasing 31 8 -1 9 Renounceable currency 5 4 4 , 5 5 1 -5
funds (SMSFs) 2 25 rights issue 2 5 3 -6 0 Entitlement O ffer definition 5 4 4
Sembawang Kimtrans Ltd 6 28 selling a new (SAREO) 2 5 9 interest rate 5 4 4 -5 2
sensitivity analysis 149-51 issue 2 4 6 simulation 1 5 2 -3 sweetened debt 3 0 4
Seyhun, H. 4 93 shareholder rights 235 Sinclair, N . 4 9 2 Symbion Health 6 2 4
Shapiro 4 0 8 shortfall 2 58 size effect 4 8 4 -5 syndicated loan 2 8 7
745
Index
1
synergy 608 estimating cost for a S e e a lso classical tax Theobold, M . 3 3 3
systematic risk 6, 1 8 6 -7 share-exchange system; imputation Thomas, J. 197
takeover 6 1 7 -1 8 tax system Thomas, S. 6 3 8
T takeovers, reasons for tax issues in project Thorburn, K. 6 2 7 , 6 3 5
takeover defences 6 2 5 -7 6 0 8 -1 4 evaluation 13 4 -9 time value of money 5, 30-1
acquisition by friendly complementary cash-flow information, timing o f cash flows (project
parties 6 2 5 assets 6 0 9 illustration 13 7 -9 evaluation) 131
claims and appeals 6 2 6 cost reductions 6 1 0 effect on net cash flow Titman, S. 198, 3 7 8 -9 , 3 9 8 ,
disclosure of favourable diversification benefits 1 3 4 -7 4 8 1 ,4 8 2 , 4 8 4
inform ation 6 2 5 -6 6 1 0 -1 1 tax loss selling 4 83 Tobin's Q 3 3 6
effects o f 6 2 6 -7 evaluation of 6 0 9 -1 2 Taylor, S. 2 4 7 , 24 8 , Toll Holdings 2 6 8 , 6 2 6 , 6 2 8
poison pills 6 2 5 excess liquidity 61 1 250, 252 Toowomba Resources Ltd
takeovers 6 0 5 -3 9 free cash flo w 61 1 technical analysis 4 9 7 3 0 6 -7
and acquiring company increased earnings per Telstra 2 4 4 , 3 3 6 , 3 3 8 Toyota M otor Corporation
6 3 1 -3 share 61 2 Tehranian, H. 4 0 3 -4 6 6 1 -2
alternative valuation increased market Ten Network Holdings 245 trade credit 6 7 5
approaches power 6 1 0 term loans 2 8 7 , 2 8 8 -9 transaction costs 3 2 4 -5
6 1 8 -1 9 motives 61 3 term structure 8 2 -3 Treasury bond futures
break fees 6 2 4 price-earnings ratio empirical evidence 8 8 -9 contracts 5 3 2 -5
conglomerate 6 08 effects 6 1 2 and inflation 89 treasury stock 31 8
controls 6 2 3 roles 6 1 3 -1 4 o f interest rates 8 2 -9 treasury management
corporate target company to price bonds 8 3 -5 6 6 7 -8
governance 6 2 4 management 6 0 9 theories 8 5 -8 Treasury W in e Estates 651
creeping 6 22 target company term to e xpiry (options) Treasury’s currency swaps
definition 6 0 6 undervalued 6 0 9 5 6 9 -7 0 crash 5 5 3
disclosure requirements tax benefits 61 1 terminal value of the Treynor, Jack 2 0 0
6 2 1 -2 Takeovers Panel 6 1 9 contract 4 7 Treynor ratio (portfolio
distinguishing between target com pany 6 0 6 , tests for private information performance) 2 0 0 -1
good and bad 6 3 6 6 0 9 , 631 4 8 0 , 4 9 3 -5
em pirical evidence management 6 0 9 tests o f return predictability u
6 3 0 -8 valuation 6 0 9 4 8 0 , 4 8 1 -6 uncertainty 25
fluctuations in activity Tasman Industries Ltd accounting valuation o f shares
6 0 6 -7 (TIL) 4 2 4 accruals 4 8 4 under 7 7 -8 0
horizontal 6 0 7 tax asset growth 4 8 4 underinvestment and debt
introduction 6 0 6 -8 benefits o f takeovers 61 1 book-to-market ratio 3 9 9 -4 0 0
long-term abnorm al capital structure 3 9 5 -7 485— 6 underreaction 4 7 9
returns 635 company income d a ily return underwriting a new issue
market bids 621 3 6 9 -7 1 patterns 4 8 2 2 4 4 -6 , 2 5 8 , 2 6 0
net effect o f 6 3 6 - 7 and cost of capital dividend yield 4 8 3 unique risk 6
off-market bids 6 2 0 -1 4 1 9 -2 1 long-term patterns unlisted securities 2 4 0
partial 6 2 2 dividend policy with 481- 2 unit trusts 2 2 8 -9
poor investments? imputation and monthly return patterns unsecured notes 2 9 7
6 3 3 -5 capital gains tax 482- 3 unsubordinated debt 2 7 9
regulation 6 1 9 -2 4 3 2 8 -9 net share issues 4 8 4 unsystematic risk 6, 1 8 6 -7
schemes of arrangement dividends and predictive future returns Upton, C. 4 6 8 -9
6 2 2 -3 imputation tax 483- 6 utility function, inverter's
sources of gains 6 3 7 -8 system 3 2 5 -7 presence o f seasonal 1 7 6 -9
tax effects 6 2 3 -4 effects of takeovers effects of returns Uylangco, K. 4 9 4
types of 6 0 7 -8 6 2 3 -4 4 8 2 -3
valuation based on effects on capital price-earnings ratio 4 83 V
assets 6 1 9 structure under relationship between valuation based on assets
valuation based on a imputation tax past and future (takeovers) 6 1 9
earnings 61 8 -1 9 system 3 7 4 -7 returns 481 - 2 valuation based on
vertical takeovers 6 0 8 im putation 3 1 7 short-term patterns 481 earnings (takeovers)
takeovers, economic im putation and capital size 4 8 4 -5 6 1 8 -1 9
evaluation o f 6 1 4 -1 8 gains tax 3 2 7 -8 Thaler, R. 3 3 3 , 4 8 2 , valuation of bank bill futures
comments on estimation and leases 4 5 6 , 4 6 3 -4 496, 497 contracts 5 4 0 -1
of takeover gains leasing and com pany Theobald, M . 2 58 valuation of contracts with
6 1 5 -1 6 tax 4 6 6 -7 theoretical ex-rights share multiple cash flows
comparing gains and personal 3 7 1 -3 price 2 5 4 4 6 -5 0
costs 6 1 6 -1 7 position 4 1 0 theoretical rights price 2 5 4 formula development 48
746
Index
measuring rate of return variable interest rate loans 62 W ang, J. 4 8 1 ,4 9 7 W oolworths 24 4 ,

4 9 -5 0 variable-rate term loans W arner, J. 3 98 3 4 3 -5 , 6 4 7
present value 4 7 2 8 6 -7 Watts, R. 4 0 0 , 4 0 5 , 4 0 8 w ork in progress inventory
terminal value 4 7 variance 174 weighted average cost of 650
value additivity 4 6 -7 Veda G roup 2 4 4 capital (WACC) W otif.com 395
valuation of debt securities Velayuthen, G . 2 4 7 , 2 5 2 4 2 2 -3 , 4 3 1 ,4 3 5 , W right, S. 3 9 4
80-1 Venkatachalam, M . 4 8 4 4 3 6 -7 W urgler, J. 3 3 9 , 4 0 4 , 631
valuation of financial futures venture capital 2 3 9 Welch, I. 2 4 7 , 2 4 9 , 3 3 4
contracts 5 4 0 -2 Vermaelen, T. 341 Wermers, R. 4 8 2 X
valuation of share price vertical takeovers 6 0 8 Wesfarmers 2 88 Xstrata 6 2 4
index futures contracts Vijh, A. 6 35 Western Computer
5 4 1 -2 Vishney, R. 3 3 6 -8 , 4 8 2 , 6 3 6 Services Ltd (WCS) Y
valuation of shares 7 6 -8 0 Vital 6 2 7 4 6 1 -2 Yan Du, D. 4 8 1 ,4 8 2
valuation of levered shares volatility o f shares 5 7 0 , 5 7 5 Westpac Banking yield curve 84
and risky coupon-paying Corporation 2 2 2 ,
debt 5 9 6 -7 W 5 8 9 -9 0 , 6 2 3 -4 Z
valuation of levered shares W akeman, D. 4 3 4 W haley, Robert 5 8 7 Zechner, J. 3 98
and risky zero-coupon Wakeman, L.M. 4 6 9 ; 4 7 0 W H K G roup 2 68 Zenacom Ptyh Ltd 3 9 9
debt 5 9 6 W a ld , J. 3 9 5 , 4 0 2 wholesaling (inventory costs) zero-coupon bonds 82
value (concept in finance) 5 W alker, S. 331 6 5 0 -1 zero-coupon debt 5 9 6
value additivity 4 6 - 7 W alkling, R. 6 3 6 w ithholding tax 31 8 Zhang, F. 6 3 2
value at risk 18 7 -9 W alter, T. 2 4 7 , 2 4 8 , 2 5 0 , W M C Resources 6 2 4 Zhang, L. 198, 4 8 1 , 4 8 6
Vanguard 4 9 9 252, 638 W om ack, K. 3 33 Zingales, L. 3 9 5 , 4 0 1 ,4 0 2
747
ABBREVIATIONS
APRA... Australian Prudential Regulation Authority
APT … • arbitrage pricing theory
ASIC... Australian Securities and Investments Commission
ASX… Australian Stock Exchange
CAPM . capital asset pricing model
CGT.... capital gains tax
C M L ... capital market line
CPI Consumer Price Index
DCF .... discounted cash flow
DES… dividend election scheme
DRP… dividend reinvestment plan
EAV… equivalent annual value
EBIT..... earnings before interest and tax
EMH …. efficient market hypothesis
E〇Q._. economic order quantity
EPS … earnings per share
EVA… economic value added
FRA… forward-rate agreement
FV....... future value
GST… goods and services tax
IPO ..... initial public offering
IRR…… .internal rate of return
LIBOR.. London interbank offered rate
NIF note issuance facility
NPV.... .net present value
O IS ..... offer information statement
PAR … . .prime assets ratio
PV....... .present value
RBA… .Reserve Bank o f Australia
SEATS.. .Stock Exchange Automated Trading System
SFE … .Sydney Futures Exchange
TLC … .transferable loan certificate
WACC .weighted average cost of capital
Now in its 44th year of publication, this 12th edition of the iconic and
market-leading Business Finance continues to provide rigorous and
authoritative coverage of major corporate finance topics. The only wholly
Australian textbook offered at this level, its strong analytical approach is
well suited to students continuing further studies in corporate finance.
W h a t’s new ?
• Currency：New developments as well as important topics in the field are

incorporated, including revised coverage of behavioural finance and a new
appendix on the Australian taxation system in Chapter 14.
• Real world examples：Covering highly technical concepts, the text
deals with complex theories in conjunction with real world examples in
order to better assist student learning and more adequately prepare
students for future careers in finance.
• Easy navigation：With clear differentiation between the concepts,
cases, questions and worked examples, students can follow the text
with ease.
•Di g i t a l resources：The updated Connect digital package is the perfect
accompaniment to the text. It will not only assist student learning, but will
also provide teaching and assessment support for instructors.
D igita l learning and teaching at its best W a n t to use an eBook? G et C o n n e c t Plus
McGraw-Hill Connect is a digital teaching and Connect Plus includes an integrated eBook
learning environment that improves performance that allows you to review your notes,
over a variety of critical outcomes. It is easy to highlight text, search for specific topics and
use and proven to be effective. engage with interactive resources.
To see how you can access these exceptional digital resources, go to

www.mheducation.com.au/digital/connect

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National Library o f Australia Cataloguing-in-Publication Data

CHAPTER 2 Consumption, investment and the capital market 10

CHAPTER 3 The time value o f money: on introduction to financial mathematics 28

CHAPTER 4 A pplying the time value o f money to security valuation 74

CHAPTER 5 Project evaluation: principles and methods 103

CHAPTER 6 The application o f project evaluation methods 129

CHAPTER 7 Risk and return 772

CHAPTER 8 The capital market 210

CHAPTER 9 Sources o f finance: equity 232

CHAPTER 10 Sources o f finance: debt 275

CHAPTER 11 Payout policy 315

CHAPTER 12 Principles o f capital structure 3 56

CHAPTER 13 C apital structure decisions 3 93

CHAPTER 14 The cost o f capital 417

CHAPTER 15 Leasing and other equipment finance 450

CHAPTER 16 C apital market efficiency 477

CHAPTER 17 Futures contracts and swops 507

CHAPTER 18 Options and contingent claims 5 63

CHAPTER 19 Analysis o f takeovers 605

CHAPTER 2 0 Managem ent o f short-term assets: inventory 646

Publisher's foreword V Digital resources xxx i

ID FINANCE AS AN AREA OF STUDY 2

IQ THE COMPANY'S FINANCIAL OBJECTIVE 5

IB FUNDAMENTAL CONCEPTS IN FINANCE 5

ID OUTLINE OF THE BOOK 8

Chapter 2 Consumption, investment and the capital market 10

^ FISHERY SEPARATION THEOREM: A SIMPLIFIED EXAMPLE 11

2.2.7 Fisher's Separation Theorem and net present value 13

Q | FISHERS SEPARATION THEOREM: A FORMAL APPROACH 14

B | INVESTORS'REACTIONS TO MANAGERS' DECISIONS 24

The time value of money: an introduction to

|B FUNDAMENTAL CONCEPTS OF FINANCIAL MATHEMATICS 29

IB VALUATION OF CONTRACTS WITH MULTIPLE CASH FLOWS 46

3.5.3 Formula development: valuation as at any date 48

IB PRINCIPAL-AND-INTEREST LOAN CONTRACTS 58

Applying the time value of money to security valuation 74

IQ FINANCIAL ASSET VALUATION UNDER CERTAINTY 75

|Q VALUATION OF DEBT SECURITIES 80

EB INTEREST RATE RISK 81

ED THE TERM STRUCTURE OF INTEREST RATES 82

EB THE DEFAULT-RISK STRUCTURE OF INTEREST RATES 89

APPENDIX 4.1 DURATION AND IMMUNISATION 97

I Project evaluation: principles and methods 103

Q THE CAPITAL-EXPENDITURE PROCESS 104

E 9 METHODS OF PROJECT EVALUATION 104

0 3 THE DISCOUNTED CASH FLOW METHODS COMPARED 108

Q OTHER METHODS OF PROJECT EVALUATION 118

Q PROJECT EVALUATION AND REAL OPTIONS ANALYSIS 123

Chapter 6 The application of project evaluation methods 129

APPLICATION 〇 F THE NET PRESENT VAUJE METHOD 130

TAX ISSUES IN PROJECT EVALUATION 134

COMPARING MUTUALLY EXCLUSIVE PROJECTS THAT HAVE DIFFERENT LIVES 139

DECIDING WHEN TO RETIRE (ABANDON) OR REPLACE A PROJECT 146

ANALYSING PROJECT RISK 149

DECISION-TREE ANALYSIS 153

QUALITATIVE FACTORS AND THE SELECTION OF PROJECTS 156

PROJECT SELECTION WITH RESOURCE CONSTRAINTS 157

Chapter 7 Risk and return 172

RETURN AND RISK 173

THE INVESTORS UTILITY FUNCTION 176