ADVANCED FINANCIAL MANAGEMENT

PART 3

CPA SECTION 5

STUDY TEXT

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PAPER NO. 15 ADVANCED FINANCIAL MANAGEMENT
GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will
enable him/her to apply advanced financial management techniques in an organisation
15.0 LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Evaluate capital investment decisions under uncertain economic conditions
• Design an optimal capital structure for an organisation
• Predict corporate failure
• Apply derivatives in financial risk management
• Apply financial management skills in the public sector
CONTENT
15.1 Nature and purpose of financial management
- Introduction to financial management
- Stakeholders theory
- Conflicting stakeholders interests and corporate governance
- Corporate social responsibility (CSR) and financial management.
- Ethical issues in financial management
15.2 The Investment decision
- Investment decision under capital rationing :multiperiod
- Investment decision under inflation
- Investment decision under uncertainty/risk
- Nature and measurement of risk and uncertainty
- Techniques of handling risk: sensitivity analysis; scenario analysis; simulation
analysis; decision theory models; certainty equivalent; risk adjusted discount
rates; utility curves
- Special cases In investment decision: projects with unequal lives; replacement
analysis; abandonment decision
- Real options in investment decisions: types of real options ;evaluation of a
capital project using real options
- Common capital budgeting pitfalls
- Bond refinancing/refunding
15.3 Portfolio theory and analysis
- Portfolio Theory and risk reduction
- Risk return trade off, Mean-Variance Analysis
- Capital Efficient Portfolios
- Capital asset pricing model(CAPM)
- Arbitrage Pricing Models(APT) and other multifactor models
- Beta estimation
- Portfolio performance measurement: Treynor's measure, Sharpe's measure and
Jensen's measure
15.4 The financing decision
- Introduction to financing decision
- Nature and significance of financing decision
- Cost of capital and significance: specific cost of capital, weighted
average cost of capital (WACC), marginal cost of capital (MCC),
MCC - lOS I MCC - IRR schedules
- Capital structure theories: Traditional theories; Net Income (NI)
Approach, Net Operating Income (NO I)
- Franco Modigliani & Merton Miller (MM) propositions :MM without Taxes. MM

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 with corporate taxes, MM with corporate and personal taxes. MM with taxes
and financial distress costs, other capital structure theories
- Special topics in financing: EBIT-EPS analysis, financial and operating
leverage, financial and operating leverage combined, geared and ungeared
betas, lease versus purchase
- Impact of financing on investment decisions - Adjusted present value
- Financial distress: signs of financial distress, forms of distress, predicting
organisational failure ,solutions to financial distress
15.5 Corporate valuation
- Application of valuation models
- Use of free cash flows in valuation
- Use of relative measures; economic value added (EVA)
- Use of enterprise value
15.6 Mergers and acquisitions
- Nature of mergers and acquisitions
- Reasons for mergers and acquisitions
- Acquisition and mergers versus organic growth.
- Valuation of acquisition and mergers.
- Financing acquisitions and mergers
- Takeover and defense tactics
- Regulatory framework for mergers and acquisition.
- Valuation and analysis of corporate restructuring, leveraged buy outs (LBO)
divestitures, strategic alliances, liquidation and recapitalisation.
- Mergers and acquisition in the global context
15.7 Derivatives in financial risk management
- Introduction to financial risk management
- Types of risks: operational risks, political risks, economic risks, fiscal risks,
regulatory risks, currency risks and interest rate risks.
- Foreign currency risk management Types of forex risks, hedging currency
risks: forward contracts, money market hedge, derivatives; currency options
currency futures and currency swaps
- Interest rate risks: Term structure of interest rates, hedging currency risks; forward
rate agreement, interest rate futures, interest rate swaps, interest rate options
- Derivatives in risk management: meaning and purpose of derivatives; types of
derivatives; forwards, options, futures and swaps
- Valuations of derivatives: options;- Black and Scholes options pricing models,
Greeks (definitions)

15.8 International financial management

- International investments
- International financial institutions
- Divided policy for multinationals
- Availability and timing of remittances
- Transfer pricing: impact on taxes and dividends
15.9 Emerging issues and trends

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CONTENT PAGE

Topic 1: Nature and Purpose of Financial Management………………………………………5

Topic 2: The Investment Decision……………......................………………………………17
Topic 3: Portfolio Theory and Analysis …………………………….....................................53
Topic 4: The Financing Decision.................................................................................….............90
Topic 5: Corporate Valuation………… …………………............…………………………148
Topic 6: Mergers and Acquisitions …...................................................................................170
Topic 7: Derivatives in Financial Risk Management……………………….………….….....209
Topic 8: International Financial Management.......................................................................…...241

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 CHAPTER 1
NATURE AND PURPOSE OF FINANCIAL MANAGEMENT

INTRODUCTION TO FINANCIAL MANAGEMENT

Finance is defined as the provision of money at the time when it is required. Every enterprise, whether
big, medium, small, needs finance to carry on its operations and to achieve its target. In fact, finance
is so indispensable today that it is rightly said to be the blood of an enterprise.
Without adequate finance, no enterprise can possibly accomplish its objectives.

Financial management refers to that part of the management activity, which is concerned with the
planning and controlling of firm’s financial resources. It deals with finding out various sources for
raising funds for the firm. Financial management is practiced by many corporate firms and can be
called Corporation finance or Business Finance.

Financial management performs different function for the effective management of funds of any
organization. The functions of financial management are;-

1. Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets. This
activity is also known as capital budgeting. It is important to allocate capital in those long term assets
so as to get maximum yield in future. The two aspects of investment decision
a. Evaluation of new investment in terms of profitability
b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along
with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays
a very significant role in calculating the expected return of the prospective investment. Therefore
while considering investment proposal it is important to take into consideration both expected return
and the risk involved.
Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less profitable and
less productive. It wise decisions to decompose depreciated assets which are not adding value and
utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be
calculating while dissolving such assets.

2. Financial Decision
Financial decision is another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds. Funds
can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and
debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure. A
firm tends to benefit most when the market value of a company’s share maximizes this not only is a
sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt
affects the risk and return of a shareholder. It is more risky though it may increase the return on equity
funds. A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and hence an
optimum capital structure would be achieved. Other than equity and debt there are several other tools
which are used in deciding a firm capital structure.

3. Dividend Decision

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Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits to
the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the
other half in the business. It’s the financial manager’s responsibility to decide a optimum dividend
policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is
calculated. It is a common practice to pay regular dividends in case of profitability.Another way is to
issue bonus shares to existing shareholders.

4. Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability,
liquidity and risk all are associated with the investment in current assets. In order to maintain a
tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets.
But since current assets do not earn anything for business therefore a proper calculation must be done
before investing in current assets. Current assets should properly be valued and disposed of from time
to time once they become non profitable. Currents assets must be used in times of liquidity problems
and times of insolvency.

STAKEHOLDERS THEORY
Stakeholder theory states that a company owes a responsibility to a wider group of stakeholders, other
than just shareholders. A stakeholder is defined as any person/group which can affect/be affected by
the actions of a business. It includes employees, customers, suppliers, creditors and even the wider
community and competitors.
Edward Freeman, the original proposer of the stakeholder theory, recognised it as an important
element of Corporate Social Responsibility (CSR), a concept which recognises the responsibilities of
corporations in the world today, whether they are economic, legal, ethical or even philanthropic.
Nowadays, some of the world’s largest corporations claim to have CSR at the centre of their corporate
strategy. Whilst there are many genuine cases of companies with a “conscience”, many others exploit
CSR as a good means of PR to improve their image and reputation but ultimately fail to put their
words into action.
Within an organisation there are a number of internal parties involved in corporate governance. These
parties can be referred to as internal stakeholders.

A useful definition of a stakeholder, for use at this point, is 'any person or group that can affect or be
affected by the policies or activities of an organization.

The basis for stakeholder theory is that companies are so large and their impact on society so
pervasive that they should discharge accountability to many more sectors of society than solely their
shareholders demonstrated in the diagram below;

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 Stakeholder theory may be the necessary outcome of agency theory given that there is a business case
in considering the needs of stakeholders through improved customer perception, employee
motivation, supplier stability, shareholder conscience investment.
Each internal stakeholder has:
• An operational role within the company
• A role in the corporate governance of the company
• A number of interests in the company (referred to as the stakeholder 'claim').

Stakeholder Operational role Corporate governance Main interests in the

role company
Directors Responsible for the Control company in best - pay
actions of the interest of the - performance linked bonus
corporation. stakeholders - share options
- status
- reputation
- power
Company Ensure compliance with Advise board on
secretary company legislation and corporate governance
regulations and keep matters
board members - pay
informed of their legal
responsibilities.
Sub-board Run business -Identify and evaluate - Job stability
management operations. Implement risks faced by a - career progression
board policies. company. - status
-enforce controls. - working conditions
-monitor success. - performance linked bonus
-reports concerns.
Employees Carry out orders of - Comply with internal
management. controls
-Report breaches
Employee Protect employee Highlight and take - Power
representatives interests action against breaches
in governance

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e.g trade unions requirements e.g. - Status
protection of whistle
blowers.

External corporate governance stakeholders

A company has many external stakeholders involved in corporate governance.
Each stakeholder has:
• a role to play in influencing the operation of the company
• its own interests and claims in the company.

External party Main role Interests and claims in company

Auditors Independent review of company’s
reported financial position.
Regulators Implementing and monitoring
regulations
Government Implementing and maintaining laws
with which all companies must comply
Stock exchange Implementing and maintaining rules
and rules and regulations for
companies listed on the exchange
Small investors Limited power with use of vote
Institutional Through considered use of their votes
investors can (and should) beneficially influence
corporate policy
- Fees
- Reputation
- Quality of relationship
- Compliance with audit
requirements
- Compliance with regulations
- Effectiveness of regulations.
- Compliance with laws
- Payment of taxes
- Levels of employment
- Levels of imports/exports
- Compliance with rules and
regulations
- fees
- Maximisation of shareholder value
- Value of shares and dividend
payments
- Security of funds invested
- Timeless of information received
from company
- Shareholder rights are observed.

CONFLICTING STAKEHOLDERS INTERESTS AND CORPORATE

GOVERNANCE
Agency theory
Agency theory is part of the bigger topic of corporate governance.
It involves the problem of directors controlling a company whilst shareholders own the company. In
the past, a problem was identified whereby the directors might not act in the shareholders (or other
stakeholders) best interests. Agency theory considers this problem and what could be done to prevent
it.

A number of key terms and concepts are essential to understanding agency theory.
• An agent is employed by a principal to carry out a task on their behalf.
• Agency refers to the relationship between a principal and their agent.
• Agency costs are incurred by principals in monitoring agency behaviour because of a lack of
trust in the good faith of agents.

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 • By accepting to undertake a task on their behalf, an agent becomes accountable to the
principal by whom they are employed. The agent is accountable to that principal.

In the field of finance shareholders are the owners of the firm. However, they cannot manage the firm
because:
• They may be too many to run a single firm.
• They may not have technical skills and expertise to run the firm
• They are geographically dispersed and may not have time.

Shareholders therefore employ managers who will act on their behalf. The managers are therefore
agents while shareholders are the principal.
Shareholders contribute capital which is given to the directors which they utilize and at the end of
each accounting year render an explanation at the annual general meeting of how the financial
resources were utilized. This is called stewardship accounting.

• In the light of the above shareholders are the principal while the management are the agents.
• Agency problem arises due to the divergence or divorce of interest between the principal and
the agent. The conflict of interest between management and shareholders is called agency
problem in finance.
• There are various types of agency relationship in finance exemplified as follows:
1. Shareholders and Management
2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary

Agency theory and corporate governance

Agency theory can help to explain the actions of the various interest groups in the corporate
governance debate.
Many companies are managed by directors who do not own the company. Many problems have arisen
due to the separation of ownership and control .e.g. directors having inadequate skills to manage their
area, or awarding themselves large bonuses whilst not meeting targets. Due to the many problems
which have arisen in the past, corporate governance has been developed.

Governance could therefore be described as the system by which companies are directed and
controlled in the interests of shareholders and other stakeholders.
Companies are directed and controlled from inside and outside the company. Good governance
requires the following to be considered:

Direction from within:

• the nature and structure of those who set direction, the board of directors
• the need to monitor major forces through risk analysis
• the need to control operations: internal control.

Control from outside:

• the need to be knowledgeable about the regulatory framework that defines codes of best
practice, compliance and legal statute
• the wider view of corporate position in the world through social responsibility and ethical
decisions.

Providing a business case for governance is important in order to enlist management

support. Corporate governance is claimed to bring the following benefits:

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 • It is suggested that strengthening the control structure of a business increases accountability
of management and maximises sustainable wealth creation.
• Institutional investors believe that better financial performance is achieved through better
management, and better managers pay attention to governance, hence the company is more
attractive to such investors.
• The above points may cause the share price to rise - which can be referred to as the
"governance dividend" (i.e. the benefit that shareholders receive from good corporate
governance).
• Additionally, a socially responsible company may be more attractive to customers and
investors hence revenues and share price may rise (a "social responsibility dividend").

Examples of principal-agent relationships

A. Shareholders and Management

There is near separation of ownership and management of the firm. Owners employ professionals
(managers) who have technical skills. Managers might take actions, which are not in the best interest
of shareholders. This is usually so when managers are not owners of the firm i.e. they don’t have any
shareholding. The actions of the managers will be in conflict with the interest of the owners. The
actions of the managers are in conflict with the interest of shareholders will be caused by:

i) Incentive Problem
Managers may have fixed salary and they may have no incentive to work hard and maximize
shareholders wealth. This is because irrespective of the profits they make, their reward is fixed.
They will therefore maximize leisure and work less which is against the interest of the
shareholders.

ii) Consumption of “Perquisites”

Perquisites refer to the high salaries and generous fringe benefits which the directors might award
themselves. This will constitute directors remuneration which will reduce the dividends paid to
the ordinary shareholders. Therefore the consumption is against the interest of shareholders since
it reduces their wealth.

iii) Different Risk-profile

Shareholders will usually prefer high-risk-high return investments since they are diversified i.e
they have many investments and the collapse of one firm may have insignificant effects on their
overall wealth.
Managers on the other hand, will prefer low risk-low return investment since they have a
personal fear of losing their jobs if the projects collapse. (Human capital is not diversifiable).
This difference in risk profile is a source of conflict of interest since shareholders will forego
some profits when low-return projects are undertaken.

iv) Different Evaluation Horizons

Managers might undertake projects which are profitable in short-run. Shareholders on the other
hand evaluate investments in long-run horizon which is consistent with the going concern aspect
of the firm. The conflict will therefore occur where management pursue short-term profitability
while shareholders prefer long term profitability.

v) Management Buy Out (MBO)

The board of directors may attempt to acquire the business of the principal. This is equivalent to
the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency
relationship and contract between the shareholders and the managers.

vi) Pursuing power and self-esteem goals

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 This is called “empire building” to enlarge the firm through mergers and acquisitions hence
increase in the rewards of managers.

vii) Creative Accounting

This involves the use of accounting policies to report high profits e.g. stock valuation methods,
depreciation methods recognizing profits immediately in long term construction contracts etc.

Solutions to Shareholders and Management Conflict of Interest

Conflicts between shareholders and management may be resolved as follows:
1. Pegging/attaching managerial compensation to performance
This will involve restructuring the remuneration scheme of the firm in order to enhance the
alignments/harmonization of the interest of the shareholders with those of the management e.g.
managers may be given commissions, bonus etc. for superior performance of the firm.

2. Threat of firing
This is where there is a possibility of firing the entire management team by the shareholders due to
poor performance. Management of companies have been fired by the shareholders who have the right
to hire and fire the top executive officers e.g the entire management team of Unga Group, IBM, G.M.
have been fired by shareholders.

3. The Threat of Hostile Takeover

If the shares of the firm are undervalued due to poor performance and mismanagement. Shareholders
can threaten to sell their shares to competitors. In this case the management team is fired and those
who stay on can loose their control and influence in the new firm. This threat is adequate to give
incentive to management to avoid conflict of interest.

4. Direct Intervention by the Shareholders

Shareholders may intervene as follows:
• Insist on a more independent board of directors.
• By sponsoring a proposal to be voted at the AGM
• Making recommendations to the management on how the firm should be run.

5. Managers should have voluntary code of practice, which would guide them in the
performance of their duties.

6. Executive Share Options Plans

In a share option scheme, selected employees can be given a number of share options, each of which
gives the holder the right after a certain date to subscribe for shares in the company at a fixed price.
The value of an option will increase if the company is successful and its share price goes up. The
theory is that this will encourage managers to pursue high NPV strategies and investments, since they
as shareholders will benefit personally from the increase in the share price that results from such
investments.
However, although share option schemes can contribute to the achievement of goal congruence, there
are a number of reasons why the benefits may not be as great as might be expected, as follows:

Managers are protected from the downside risk that is faced by shareholders. If the share price falls,
they do not have to take up the shares and will still receive their standard remuneration, while
shareholders will lose money.
Many other factors as well as the quality of the company’s performance influence share price
movements. If the market is rising strongly, managers will still benefit from share options, even
though the company may have been very successful. If the share price falls, there is a downward

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stock market adjustment and the managers will not be rewarded for their efforts in the way that was
planned.

The scheme may encourage management to adopt ‘creative accounting’ methods that will distort the
reported performance of the company in the service of the managers’ own ends.

Note
The choice of an appropriate remuneration policy by a company will depend, among other things, on:
• Cost: the extent to which the package provides value for money
• Motivation: the extent to which the package motivates employees both to stay with the
company and to work to their full potential.
• Fiscal effects: government tax incentives may promote different types of pay. At times of
wage control and high taxation this can act as an incentive to make the ‘perks’ a more
significant part of the package.
• Goal congruence: the extent to which the package encourages employees to work in such a
way as to achieve the objectives of the firm – perhaps to maximize rather than to satisfy.

7. Incurring Agency Costs

Agency costs are incurred by the shareholders in order to monitor the activities of their agent. The
agency costs are broadly classified into 4.

a) The contracting cost. These are costs incurred in devising the contract between the managers and
shareholders.
The contract is drawn to ensure management act in the best interest of shareholders and the
shareholders on the other hand undertake to compensate the management for their effort.
Examples of the costs are:
• Negotiation fees
• The legal costs of drawing the contracts fees.
• The costs of setting the performance standard,

b) Monitoring Costs: This is incurred to prevent undesirable managerial actions. They are meant to
ensure that both parties live to the spirit of agency contract. They ensure that management utilize
the financial resources of the shareholders without undue transfer to themselves.
Examples are:
• External audit fees
• Legal compliance expenses e.g. Preparation of financial statement according to
international accounting standards, company law, capital market authority
requirement, stock exchange regulations etc.
• Financial reporting and disclosure expenses
• Investigation fees especially where the investigation is instituted by
the shareholders.
• Cost of instituting a tight internal control system (ICS).

c) Opportunity Cost/Residual Loss This is the cost due to the failure of both parties to act optimally
e.g.
• Lost opportunities due to inability to make fast decision due to tight internal control system
• Failure to undertake high risk high return projects by the manager leads to lost profits when
they undertake low risk, low return projects.

d) Restructuring Costs – e.g. new I.C.S., business process reengineering etc.

B. SHAREHOLDERS AND CREDITORS/bond/debenture holders

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Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to
the firm on the strength of the following factors:
• The existing asset structure of the firm
• The expected asset structure of the firm
• The existing capital structure or gearing level of the firm
• The expected capital structure of gearing after borrowing the new debt.
Note
• In raising capital, the borrowing firm will always issue the financial securities in form of
debentures, ordinary shares, preference shares, bond etc.
• In case of shareholders and bondholders the agent is the shareholder who should ensure that the
debt capital borrowed is effectively utilized without reduction in the wealth of the bondholders.
The bondholders are the principal whose wealth is influenced by the value of the bond and the
number of bonds held.
• Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
• An agency problem or conflict of interest between the bondholders (principal) and the
shareholders (agents) will arise when shareholders take action which will reduce the market value
of the bond and by extension, the wealth of the bondholders. These actions include:

a) Disposal of assets used as collateral for the debt in this.

In this case the bondholder is exposed to more risk because he may not recover the loan extended in
case of liquidation of the firm.

b) Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project. However,
this project may be substituted with a high risk project whose cash flows have high standard
deviation. This exposes the bondholders because should the project collapse, they may not recover all
the amount of money advanced.

c) Payment of High Dividends

Dividends may be paid from current net profit and the existing retained earnings. Retained earnings
are an internal source of finance. The payment of high dividends will lead to low level of capital and
investment thus a reduction in the market value of the shares and the bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no returns are
expected. This will reduce the value of the firm and bond.

d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital in the
entire project if there is expectation that most of the returns from the project will benefit the
bondholders. This will lead to reduction in the value of the firm and subsequently the value of the
bonds.

e) Borrowing more debt capital

A firm may borrow more debt using the same asset as collateral for the new debt. The value of the
old bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is
liquidated. This exposes the first bondholders/lenders to more risk.

SOLUTIONS TO AGENCY PROBLEM

The bondholders might take the following actions to protect themselves from the actions of the
shareholders which might dilute the value of the bond. These actions include:

1. Restrictive Bond/Debt Covenant

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In this case the debenture holders will impose strict terms and conditions on the borrower. These
restrictions may involve:
a) No disposal of assets without the permission of the lender.
b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the amount of current assets in relation
to current liabilities.
d) Restrictions on mergers and organisations
e) No borrowing of additional debt, before the current debt is fully serviced/paid.
f) The bondholders may recommend the type of project to be undertaken in relation to the
riskiness of the project.

2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry of the
maturity period if there is breach of terms and conditions of the bond covenant.

3. Transfer of Asset
• The bondholder or lender may demand the transfer of asset to him on giving debt or loan to
the company. However the borrowing company will retain the possession of the asset and the
right of utilization.
• On completion of the repayment of the loan, the asset used as a collateral will be transferred
back to the borrower.
4. Representation
The lender or bondholder may demand to have a representative in the board of directors of the
borrower who will oversee the utilization of the debt capital borrowed and safeguard the interests of
the lender or bondholder.

5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the debt capital
borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its
investments needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.

6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds
into ordinary shares.

C.Agency Relationship between Shareholders and the government

Shareholders and by extension, the company they own operate within the environment using the
charter or licence granted by the government. The government will expect the company and by
extension its shareholders to operate the business in a manner which is beneficial to the entire
economy and the society.

The government in this agency relationship is the principal while the company is the agent. It
becomes an agent when it has to collect tax on behalf of the government especially withholding tax
and PAYE.

The company also carries on business on behalf of the government because the government does not
have adequate capital resources. It provides a conducive investment environment for the company
and share in the profits of the company in form of taxes.

The company and its shareholders as agents may take some actions that might prejudice the position
or interest of the government as the principal. These actions include:

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 • Tax evasion: This involves the failure to give the accurate picture of the earnings or profits of
the firm to minimize tax liability.
• Involvement in illegal business activities by the firm.
• Lukewarm response to social responsibility calls by the government.
• Lack of adequate interest in the safety of the employees and the products and services of the
company including lack of environmental awareness concerns by the firm.
• Avoiding certain types and areas of investment coveted by the government.

Solutions to the agency problem

The government can take the following actions to protect itself and its interests.

1. Incur monitoring costs

E.g. the government incurs costs associated with:
• Statutory audit
• Investigations of companies under Company Act
• Back duty investigation costs to recover tax evaded in the past
• VAT refund audits

2. Lobbying for directorship (representation)

The government can lobby for directorship in companies which are deemed to be of strategic nature
and importance to the entire economy or society e.g directorship in KPLC, Kenya Airways, KCB etc.

3. Offering investment incentives

To encourage investment in given areas and locations, the government offers investment incentives in
form of capital allowances as laid down in the Second schedule of Cap 470.

4. Legislations
The government has provided legal framework to govern the operations of the company and provide
protection to certain people in the society e.g. regulation associated with disclosure of information,
minimum wages and salaries, environment protection etc.

5. The government can in calculate the sense and spirit of social responsibility on the activities
of the firm, which will eventually benefit the firm in future.

D. Agency Relationship between Shareholders and Auditors

Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies Act. The
auditors are supposed to monitor the performance of the management on behalf of the shareholders.
They act as watchdogs to ensure that the financial statements prepared by the management reflect the
true and fair view of the financial performance and position of the firm.

Since auditors act on behalf of shareholders they become agents while shareholders are the principal.
The auditors may prejudice the interest of the shareholders thus causing agency problems in the
following ways:

a) Colluding with the management in performance of their duties whereby their independence is
compromised.
b) Demanding a very high audit fee (which reduces the profits of the firm) although there is
insignificant audit work due to the strong internal control system existing in the firm.
c) Issuing unqualified reports which might be misleading the shareholders and the public and
which may lead to investment losses if investors rely on such misleading report to make
investment and commercial decisions.
d) Failure to apply professional care and due diligence in performance of their audit work.

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 Solutions to the conflict
1. Firing: The auditors may be removed from office by the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors who issue
misleading reports leading to investment losses.
3. Disciplinary Action – ICPAK.
Professional bodies have disciplinary procedures and measures against their members who are
involved in un-ethical practices. Such disciplinary actions may involve:

• Suspension of the auditor

• Withdrawal of practicing certificate
• Fines and penalties
• Reprimand
4. Use of audit committees and audit reviews.
5. Headquarter office and branch /subsidiary.

The cost of agency relationships

Agency costs arise largely from principals monitoring activities of agents, and may be viewed in
monetary terms, resources consumed or time taken in monitoring. Costs are borne by the principal,
but may be indirectly incurred as the agent spends time and resources on certain activities. Examples
of costs include:
• incentive schemes and remuneration packages for directors
• costs of management providing annual report data such as committee activity and risk
management analysis, and cost of principal reviewing this data
• cost of meetings with financial analysts and principal shareholders
• the cost of accepting higher risks than shareholders would like in the way in which the
company operates
• Cost of monitoring behavior, such as by establishing management audit procedures.

CORPORATE SOCIAL RESPONSIBILITY (CSR)

Corporate social responsibility (CSR) may be defined as “the commitment of business to contribute to
sustainable economic development, working with employees, their families, the local community and
society at large to improve their quality of life”
Corporations invest in CSR projects in an attempt to improve their reputation in society and compete
with global corporations. Companies boost about their CSR expenditure in their annual reports to
attract investors and satisfy various stakeholders like employees, customers, suppliers, government,
regulators, distributors etc. Companies use CSR as a marketing tool and to establish good rapport with
the public.

It is also used as a prevention strategy by the companies to protect them from corporate scandals,
unpredicted risks, possible ecological accidents, governmental rules and regulations, protect
noticeable profits, brand differentiation, and better relationship with employees based on volunteerism
terms.
Most corporations are much cognizant to publish their CSR activities on their websites, sustainability
reports and their advertising campaigns. CSR is also practiced because customers as well as
governments today are demanding more ethical behaviors from organizations. In response,
corporations are volunteering themselves to incorporate CSR as part of their business policies,
mission proclamation and values in multiple areas, respecting labor and environmental laws, while
taking care of the differing interest of various stakeholders

16
ETHICAL ISSUES IN FINANCIAL MANAGEMENT
Ethics are principles based on doing the right thing. They are the moral values by which an individual
or business operates. In theory, a business or individual can act ethically and still attain ultimate
success. A history of doing the right thing can be used as a selling point to heighten a person's or
organization's reputation in the community. Not only are ethics morally valued, they are backed by
legal repercussions for failure to act within certain guidelines.

The ethics of a finance manager should be above approach. This includes more than just acting in an
honest, above-board manner. It means establishing boundaries that prevent professional and personal
interests from appearing to conflict with the interest of the employer. A finance manager must provide
competent, accurate and timely information that fairly presents any potential disclosure issues, such as
legal ramifications. The manager is also ethically responsible for protecting the confidentiality of the
employer and staying within the boundaries of law.

Some laws are specifically designed to address unethical actions of finance managers. For example, if
a finance manager is aware of business activity that will affect a stock price and uses that information
to buy or sell stocks for financial again, he has broken a trust with his employer. A finance manager
who is aware that his company may be breaking the law may be held legally responsible for a crime.

The dilemma faced by many finance managers comes in balancing the need to act ethically while
fulfilling the needs of the employer. The employer's ultimate goal is to maximize earnings, and the
drive to make money may cause an employee to act unethically. If a manager believes his company
may have crossed an ethical line, his first step should be to take it up with his employer. If he feels the
actions warrant legal intervention, he should do so without fear of repercussion.

If a discussion with an employer does not resolve the ethical issues facing a finance manager, he can
report the activity to the appropriate government agency for investigation. This is known as
whistleblowing. Under laws, an employee has the right to report suspicious activity without fearing
for his job. While the activity may put a strain on his working relationship, he is protected by law.

CHAPTER 2
THE INVESTMENT DECISION

INTRODUCTION
A financial manager with present investment policies will be concerned with how efficiently the
company’s funds are invested because it is from such investment that the company will survive.
Investments are important because:

i) They influence company’s size

ii) Influence growth
iii) Influence company’s risks

17
 In addition, this investment decision making process also known as capital budgeting, involves the
decision to invest the company’s current funds in viable ventures whose returns will be realised for
long term periods in future.

Capital budgeting as financial planning is characterized by the following:

1. Decisions of this nature are long term i.e. extending beyond one year in which case they are
also expected to generate returns of long term in nature.
2. Investment is usually heavy (heavy capital injection) and as such has to be properly planned.
3. These decisions are irreversible and any mistake may cause the company heavy losses.

Importance of Investment Decisions

a) Such decisions are importance because they will influence the company’s size (fixed assets,
sales, and retained earnings).
b) They increase the value of the company’s shares and thus its credibility.
c) The fact that they are irreversible means that they have to be made carefully to avoid any
mistake which can lead to the failure of such investment.

Due to heavy capital outlay, more attention is required to avoid loss of huge sums of money which in
the extreme may lead to the closure of such a company

INVESTMENT DECISIONS UNDER CAPITAL RATIONING

It is a process of making investment decisions on viable projects where funds are limited. Investments
decisions are made given a fixed amount of capital to be invested in viable projects. If a company
doesn’t have sufficient funds to undertake all projects with a positive NPV, this is a capital rationing
situation.

Causes
1) Hard capital rationing
2) Soft capital rationing

Soft capital rationing

It is caused by internally generated factors of the company. It is a self-imposed capital rationing by
the management of the company. Management may put a maximum budget limit to be spent within a
specific period.
Examples/causes of soft capital rationing
1) A self-imposed budgetary limit where the management puts a ceiling on the maximum amount to
be spent on investments.
2) Management may decide against issuing more equity finance in order to maintain control over the
company’s affairs by existing shareholders.
3) Management may opt not to raise more equity so as to avoid dilution in the Earning per share.
4) Management may decide against raising additional debt due to the following reasons:
a) To avoid increase in interest payment commitment
b) To control the gearing or operating leverage so as to maximize the financial risk.
5) If a company is small or family owned, its managers may limit the investment funds available to
maintain constant growth through retained earnings as opposed to rapid expansion.

Hard capital rationing

18
It is externally imposed by the market and is caused by the factors beyond the control of the company.
It occurs where the company has exhausted all its borrowing limits and is unable to raise funds
externally.
Causes of hard capital rationing
1) Economic factors e.g. high interest rates and high inflation
2) Perception by investors that the company is risky. Where the company is deemed risky e.g. in an
infant industry or operating in a very competitive market, the investors will not provide funds to
that company.
3) High competition for funds by different companies resulting into an increase in the costs of
borrowing.
4) Depressed stock exchange. The company’s share market price is very low and so may find it hard
to raise funds from the stock market.

Example
Investment outlay NPV Profitability index
Project 1 600 300 1.5
Project 2 600 270 1.45
Project 3 200 80 1.4
Project 4 400 100 1.25

If we had an unlimited budget, we would undertake all projects and we would improve shareholder
wealth bysh.750 (sum of the NPVs). With a budget of Sh.1,000 our decisions will be different. We
would choose project 1 and 4. Project 4 is our third best option, but due to constraints of funds, we are
forced to choose it.
Capital rationing has the potential to misallocate resources. Funds should be diverted to the highest
NPV projects.

NPV cannot be correctly used to rank projects with different sizes. For example a project may have an
outlay of 10,000 and an NPV of 6 while another project may have an outlay of 5 and an NPV of 4.
Can you say the first project is better since it has a higher NPV? The second project has had a smaller
outlay and a higher NPV as a percentage of outlay (4/5) than the first project (6/10,000).

We should then use another method which captures the size of the investment. Profitability index is an
especially useful method because it shows the profitability of each investment per currency invested.
When we have capital rationing, projects should be ranked based on Profitability index.

In our above example given by the table, with capital rationing, we should undertake project 1 and 4.
We had a budget of 1000 and we have spent only 800. With the remainder, we can either invest in
part projects e.g. fraction of either project 2 or 3.

Divisible projects
These are projects that can be undertaken in parts or in proportions depending on the capital available
for investment. In capital rationing situations, where funds available are not enough to the entire
project, the remaining funds can be partly invested in the next viable projects.

Single period capital rationing

It is a situation where the company has limited amounts of funds in one investment period only. After
that period, the company can access funds from various sources, e.g. issuing shares, borrowing from
banks or issuing bonds.

ILLUSTRATION
ABC Ltd.is considering investing in the following independent projects

19
 Project PV of cash flow Initial cost NPV P.I
1 230,000 200,000 30,000 1.15
2 141,250 125,000 16,250 1.13
3 194,250 175,000 19,250 1.11
4 162,000 150,000 12,000 1.08

The company has set a capital limit of sh.300000.

Required:
Advice the management on the projects to undertake

SOLUTION
If there was no capital rationing then all the 4 projects would be accepted coz they have positive NPV.
However with capital rationing, the projects have to be compared using PI index. With sh.300,000, we
could have invested in three options. Invest in project 1; invest in projects 2 and 3; invest in projects 2
and 4. We will select the option that gives us the highest weighted average profitability index.

A major assumption made in analysis is that the PI index of all projects is excess of one and the
unused funds PI is equal to one.

Weighted average PI:

For option 1: 1.15(200/300) + 1.0(100/300) = 1.1
For option 2: 1.13(125/300) + 1.11(175/300) = 1.118
For option 3: 1.13(125/300) + 1.08(150/300) + 1(25/300) = 1.094
Decision: Invest in project 2 and 3 since these results in the highest weighted average PI.

Multi-period capital rationing

It occurs where the company has limited amounts of funds for a longer duration of time. The capital
constraints extend beyond one investment period.
If we assume that it’s possible to undertake fractional projects then the problem can be formulated
using linear programming. If the projects are indivisible, however, then integer programming should
be used.

Under the multi-period capital rationing, situation the NPV or PI criterion alone cannot give optimal
solution therefore a mathematical optimization model must be used to generate an optimal solution
subject to a specified constraint.
There are a number of mathematical optimization models;
1) Linear programming (LP) model for divisible model.
2) Integer programming (IP) model for non-divisible model
3) Goal programming (GP) model for project with several goals.
4) Dynamic programming (DP) model for variables that is uncertain.

ILLUSTRATION
A company is considering investing into projects whose cash flows are as shown below:
Year Cash flows Sh. ‘m’
∝ 𝛽𝛽
0 (10) (20)
1 (20) (10)
2 - (30)
3 60 100

20
The company’s cost of capital is 10%. The amounts available for investment are restricted to sh. 20m,
25m and 20m in years 0, 1 and 2 respectively. None of the projects can, be delayed or deferred
however they are divisible.

Required:
a) Formulate a LP model to solve for the optimal soln.
b) Solve the problem using the graphical method.

SOLUTION
a)
Year Factor 10% Cash flows Sh. ‘m’
∝ 𝛽𝛽
0 1.00 (10) (20)
1 0.9091 (20) (10)
2 0.8264 - (30)
3 0.7513 60 100
16.899 21.247

LP Model formulation;

Steps
i) Define the decision variables – DV;
Let XA and XB be the proportions of projects ∝ and 𝛽𝛽 respectively accepted.

ii) State the objective function, O.F

Max. Z = 16.896xA+ 21.247xB

iii) Specify the constraints subject to:

St:
1) 10xA + 20xB≤ 20
2) 20xA + 10xB≤ 25
3) 30xB≤ 20
4) xA≥ 0, xB≥ 0

b) Solution of the problem graphically;

Steps
1. Convert the inequalities into equation and obtain the x co-ordinates.
XA XB
i) xA + 2xB = 2 0 1
2 0
ii) 2xA + xB = 2.5 0 2.5
1.25 0
iii) 3xB = 2 ? ∀ 2/3
iv) xA = 0 0 ∀ ?
v) xB = 0 ? ∀ 0

∀ = For all values of.

2. Plot the equations in the graph to identify the feasible area/region

21
 xB

3•

1•
• ••
Q R
S
• • xA
1 J 2 3

3. Test for optimal solution within the area. The rule of thumb, the optimal solution occurs at the
corner point of the feasible area.

Corner point XA XB Z = 16.896xA + 21.247xB

P 0 0 0
Q 0 2/3 14.165
R 2/3 2/3 25.429
S 1 0.5 27.52
T 1.25 0 21.12

The company should accept ∝ in full and ½ of 𝛽𝛽 to obtain expected NPV of sh. 27.52M.

ILLUSTRATION
Assume that XYZ ltd. is considering the following available projects.
Project1 period 1 outlay Period 2 outlay NPV
1 12000 3000 14000
2 54000 7000 17000
3 6000 600 17000
4 6000 2000 15000
5 30000 35000 40000
6 6000 6000 12000
7 48000 4000 14000
8 36000 3000 10000
9 18000 3000 12000
Assume that fractional projects can be undertaken and that funds cannot be transferred from one
period to another. The company has a capital budget of Sh.50000 in period 1 and Sh.20,000 in period
2.

Required:
Find the set of projects that maximizes the NPV and satisfies the capital constraints.

SOLUTION
Objective function:
Max NPV= ∑ αt NPVt

22
αt is proportion of project t to be undertaken in the optimal solution.

Subject to∑ αt Cti ≤ Bi

Ct is the outlay of project t in period i

Bi is the capital budget in period i

αt Cti≥0

Objective function: (expressed in ‘000’)

Max NPV = 14α1 + 17 α2 + 17α3 + 15α4 + 40α5 + 12α6 + 14α7 + 10α8+ 12α9

Subject to
12α1 + 54α2 + 6α3+ 6α4 + 30α5+6α6+48α7+36α8+18α9 ≤ 50 Period 1 constraint
3α1 + 7α2+6α3+2α4+35α5+6α6+4α7+3α8+ 3α9≤ 20 Period 2 constraint

Solution:
α1=1 α2=0 α3=1 α4=1 α5=0 α6=0.97 α7=0.045 α8=0 α9=1
Max NPV = 70.27
Shadow prices: Period1= 0.136 Period 2 = 1.864

Because it has shadow price then all the funds have been used up.
Project 1,3,4 and 9 are accepted wholly while project 6 and 7 are partially accepted in the optimal
solution. Cash constraints are binding in both periods since they have a shadow price greater than
zero. An additional shilling provided in period 1 will increase the NPV by 0.136 while an additional
shilling provided in period 2 will increase the NPV by 1.8641.

ILLUSTRATION
Management is faced with eight projects to invest in. The capital expenditures during the year has
been rationed to Shs. 500,000 and the projects have equal risk and therefore should be discounted at
the firm's cost of capital of 10%.

Project Cost Project cash flow NPV at the

t = 0(Shs) Life per year 10% cost
1 400,000 20 58,600 98,895
2 50,000 10 55,000 87,951
3 100,000 8 24,000 28,038
4 75,000 15 12,000 16,273
5 75,000 6 18,000 3,395
6 50,000 5 14,000 3,071
7 250,000 10 41,000 1,927
8 250,000 3 99,000 (3,802)

Required:
Determine the optimal investment sets.

Max Z = 98,895 X1 + 87,951 X2 + 28,038 X3 + 16,273 X3 + ... + (3,802) X8

St 1 = 400,000 X1 + 250,000 X2 + 100,000 X3 + ... + 250,000 X8 ≤500,000

2 = 1 < X1, X2, X3 ... X8 > 0

23
The Optimal Budget:
Project Cost NPV
2 250,000 87,951
3 100,000 28,038
4 75,000 16,273
5 75,000 3,395
500,000 135,657

CAPITAL BUDGETING UNDER INFLATION

Inflation refers to either a general increase in prices or general decline in purchasing power of money.
The general effect of inflation in capital budgeting includes:-
(i) Revenues tend to increase in money terms
(ii) Cost (expenses) also tends to increase in money terms.
(iii) The cost of capital (required rate of return must be adjusted to include an inflation premium)
i.e. the money adjusted cost of capital equals to real cost of capital + inflation premium.
MC = rc + ip

ILLUSTRATION
Kenya Bank Ltd lends Kshs. 1M to a borrower for 1 year. The borrower promises to repay the
principal + interest of Kshs. 155,000, in one year time. The bank estimates that rate of inflation during
the forthcoming year will be 5% which has been factored in the interest above.

Required:
a) Compute
(i) The inflation adjusted money rate (m)
(ii) The real interest rate (r)
b) What is the relationship between the money rate (m), real rate (r) and inflation rate (i)
c) What’s the significance of the above relationship in capital budgeting or investment decisions.

SOLUTION
a) Computation of inflation adjusted money rate.
Amount to be repaid in one year’s time= Sh.1,155,000
Amount of the loan = Shs.1,000,000
Money/inflation adjusted = 1,155,000 – 1,000,000
= 15500
Money interest rate (m) = 1,550,000/1000, 000 × 100%
= 15.5%
b) Computation of the real interest rate (r)
Amount to be repaid in 1 years’ time = 1,155,000
Amount required by the bank to maintain purchasing power
1,000,000(1 + 5%)= 1,050,000
Sh.
Real interest 1,155,000
Less Bank’s purchasing power (1,050,000)
Real interest 105,000

Real interest rate = 1,050,000 ×100% = 10%

105,000
Given
m = 15.5%
r = 10%
i=- 5%

24
 Relationship; m = r + i
The relationship is;
(1 + m) = (1 + r) (I + i)

For example
m = 15.5%
i = 5%

Required;-
Compute r%
1+m-1 =r
1+i
1.55 - 1 = r
1.05

Therefore r = 10%

Given r = 10%, I = 5%

Required;-
Calculate m in terms of %

Solution
(1 + m) = 1 + r) (1 + i)
m = (1 + r) (1 + i) – 1 = (1.1) (1.05) – 1

m = 15.5%

Given m = 15.5%, r = 10%

Calculate inflation rate, i

Solution
(1 + m) = (1 + r) (1 + i)

i=1+m -1
1+r
= 1.155 - 1
1.1
i = 5%

Implication of a relationship between m, r and i in capital budgeting

Capital budgeting under inflation (i)
Capital budgeting inflation (i)

Either OR

Use inflation adjusted cash flows SAME NPV Use real cash flows

25 at the inflation adjusted

Discount I + m = (I + r) (I + i) Discount at real rate (r)
money rate (m)
ILLUSTRATION
A company is considering investing in a scout saving project that will involve machinery purchasing
costing Ksh.5m with useful life of 5 years and zero salvage value. Installation of machinery would
result into annual savings of material and labour costs of Sh. 1m and Sh. 0.5m respectively for 5
years. A company forecasted that the material and labour cost savings will be affected by inflation at
the rate of 10% and 5% per annum respectively. A company estimates the inflation adjusted discount
rate to be 15%.
Required;
Compute the expected NPV of the project using:
a) Inflation adjusted cash flows
b) Real cash flows

SOLUTION
a) Computation of NPV – inflation adjusted cash flows
Year Material Labour Total Factor @ Discounted
15% cash flows
1 I(1.1)1 = 1.1 0.5(1.05)1 = 0.525 1.625 0.8696 1.4131
2 I(1.1)2 = 1.21 0.5(1.05)2 = 0.551 1.761 0.7561 1.3314
3 I(1.1)3 =1.331 0.5(1.05)3 = 0.579 1.91 0.6575 1.25582
4 I(1.1)4 =1.464 0.5(1.05)4 = 0.608 2.068 0.5718 1.1824
5 I(1.1)5 =1.611 0.5(1.05)5 = 0.638 2.249 0.4972 6.3011

Therefore;
PV 6.3011
Less initial outlay (5.000)
NPV 1.3011

b) Using Real cashflows

Real material cost saving = Shs. 1m p.a
Money rate (m) = 15%
Inflation rate (i) = 10%
Therefore Real rate (r) = 1+m - 1
I+i
= 1.15 - 1
1.1
r = 4.55%
PVIFA4.55, 5 years = I – (1.0455)-5
0.0455
= 4.3839
Real Labour cost saving = shs. 0.5m p.a
Money rate (m) = 15%
Inflation rate (i) = 5%

Therefore Real rate (r) = 1 + m - 1

1+i

26
 = 1.15 - 1
1.05
r = 9.52%
PVIFA
9.52%, 5 years = 1 - (1.0952)-5
0.0952

=3.8377
PV of real material cost savings
1m × 4.3839= Shs. 4.3839

PV of real labour cost saving= 0.5 × 3.8377 = Shs. 1.9189

PV of the total savings

Material 4.3839
Labour 1.9189
PV 6.3028
Less: initial outlay (5.000)
NPV 1.303

INVESTMENT DECISION UNDER UNCERTAINTY

Capital Investment Appraisal Under conditions of Uncertainty / Risk.
One of the practical problems experienced when evaluating capital investments is to accurately
determine values of a capital investment decision variables such as economic life of an asset, salvage
value of asset, additional investment in working, annual operating cash flows, purchase cost of an
asset, the changes in discounting rates, tax rates etc.

The future is not certain and therefore it is impossible to know with certainty values of decision
variables. Where the future values of decision variables are uncertain and there exists no sufficient
information to assign probabilities of realizing certain values, then investment decisions would be
made in the environment of uncertainty.

However, values of future decision variables are uncertain but there exist information which makes it
possible to assign probabilities of realizing certain values, then capital decisions shall be made in
environment of risk.

The term risk and uncertainty are more often used interchangeably to imply that actual outcomes are
expected to vary from expected outcomes. A capital investment decision variable expected to be
realized in recent future e.g. salvage value are more uncertain compared to decision variable e.g. cost
of equipment and additional investment in working capital.

When incorporating risks / uncertainty in capital investment appraisal, we use the following tools.

Techniques of Analysis
i) Expected monetary value
ii) Standard deviation
iii) Coefficient of variation
iv) Sensitivity analysis

27
 v) Scenario analysis
vi) Use of decision trees
vii) Simulation analysis
viii) Utility analysis
ix) Certainty equivalent and
x) the risk adjusted discounting rate

Expected monetary Value (EMV)

Expected value is an average value which is a weighted average. The weighted average is determined
using probability as weights. Where the expected value is expressed in monetary terms then it is
known as expected monetary value. For example we talk of expected sales, expected profits, expected
economic life of the asset, expected economic life of the assets expected salvage value, expected net
operating cash flows etc.

ILLUSTRATION
A capital project is expected to generate the following cash flows in different economic environment
in each year.

Economic environment Cash flow (Sh Million) Probability distribution of cash flows
Good 20 0.4
Fair 15 0.5
Bad 10 0.1

Required
Determine the expected cash flow in each year.

SOLUTION
This is a probability distribution of the cash flows
Expected cash flow is a weighted average cash flow which is worked out as follows:
Expected Net Cash flow = [𝐶𝐺. 𝑊𝐺] + [𝐶𝐹. 𝑊𝐹] + [𝐶. 𝐵. 𝑊𝐵]

∴ E(NCF) = (20 x 0.4) + (15 x 0.5) + (10 x 0.1)

������
𝑁𝐶𝐹 = Sh 16.5 million p.a.

Where the forecasted cash flows are given in the absence of probabilities, the expected cashflow shall
be a simple arithmetic mean.

𝐶1 + 𝐶2 + …………..𝐶𝑛
E(NCF) = 𝑛

The Standard Deviation

This is an absolute measure of dispersion which is a tool that can be used to measure total risk. The
standard deviation measures variation expected around the expected value i.e. the spread around the
expected value.

Where a probability distribution of variables is given i.e. values corresponding probabilities, the
standard deviation is determined as follows:

𝛿𝑥 = �∑𝑛𝑡=1(𝑥 − 𝑥̅ )2 x𝑃𝑖

𝛿𝑥2 = Variance of variable x

28
𝛿𝑥2 = ∑𝑛𝑡=1(𝑥 − 𝑥̅ )2 x𝑃𝑖

Therefore the standard deviation is the square root of the variance.

������ )2 x 𝑃𝑖
∴ 𝛿 𝑁𝐶𝐹 = �∑𝑛𝑡=1(𝑁𝐶𝐹 − 𝑁𝐶𝐹

(𝑁𝐶𝐹 − ������
𝑁𝐶𝐹 )2 x 𝑃𝑖
(20 − 16.5)2 x 0.4 = 4.9
(15 − 16.5)2 x 0.5 = 1.125
(10 − 16.5)2 x 0.1 = 4.225
Variance of NCF (𝛿 2 𝑁𝐶𝐹) = 10.250

∴ 𝛿 𝑁𝐶𝐹 = √10.25 = Sh 3.2 million

������
𝑁𝐶𝐹 = [𝑆ℎ 16.5 ± 3.2𝑚]
Sh 13.3m ≤ NCF ≤ 19.7m

Where forecasted values are given absence of probabilities, the standard deviation of variable x shall
be determined as follows.

∑𝑛
𝑡=1(𝑥−𝑥̅ )
2
𝑆𝑚𝑎𝑙𝑙 𝑠𝑎𝑚𝑅𝑅𝑙𝑒
𝛿𝑥 = � (𝐼𝑅𝑅 𝑛<30)
𝑛−1

Or

∑𝑛
𝑡=1(𝑥−𝑥̅ )
2
𝐿𝑎𝑟𝑔𝑒 𝑠𝑎𝑚𝑅𝑅𝑙𝑒
𝛿𝑥 = � 𝐼𝑅𝑅 𝑛≥30
𝑛

Coefficient of Variation (C.O.V)

This is a relative of dispersion. Coefficient of variable is a numerical measure of a relative risk i.e.
risk per unit of return.

When evaluating projects of different sizes, projects which have different costs and different cash
flows, coefficient of variation would be preferred to the standard deviation when measuring the risk of
the projects.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑅𝑅 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑥 𝛿𝛿𝑥
C.O.V = =
𝑇ℎ𝑒 𝑒𝑥𝑅𝑅𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑅𝑅 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑥 𝑥

N.B
The higher the standard deviation and coefficient of variation, the greater the risk and vice versa

Risk-adjusted discount rate

This approach uses different discount rates for proposals with different risk levels. A project that carries
a normal amount of risk and does not change the overall risk composure of the firm should be
discounted at the cost of capital. Investments carrying greater than normal risk will be discounted at a
higher discount rate.

The NPV of the project will be given by the following formula.

29
 n

∑(1+ K
Ct
NPV = t
- Io
t=1 )

Where Ct is cashflows at period t

K is the risk adjusted discount rate
Io is initial cash outflow (cost of project)
Note that Kf + φ
Where Kf = the risk-free rate
φ = the risk premium
The following diagram shows a possible risk-discount rate trade off scheme. Risk is assumed to be
measured by the coefficient of variation, C.V)

The normal risk for the firm is represented by a coefficient of variation of 0.30. An investment with this
risk will be discounted at the firm's normal cost of capital of 10%. As the firm selects riskier projects
with, for example, a C.V. of 0.90, a risk premium of 5% is added for an increase in C.V. of 0.60 (0.90 -
0.30). If the firm selects a project with a C.V. of 1.20, it will now add another 5% risk premium for this
additional C.V. of 0.30 (1.20 - 0.90). Notice that the same risk premium was added for a smaller
increase in risk. This is an example of being increasingly risk averse at higher levels of risk and
potential return.

Advantages of Risk-adjusted discount rate

(a) It is simple and can be easily understood.
(b) It has a great deal of intuitive appeal for risk-averse businessmen.
(c) It incorporates an attitude (risk-aversion) towards uncertainty.

Disadvantages of Risk-adjusted discount rate

a) There is no easy way of deriving a risk-adjusted discount rate.
b) It does not make any risk adjustments in the numerate - for the cashflows that are forecast over the
future years.
c) It is based on the assumption that investors are risk averse. (Not all investors are risk averse as
discussed earlier).

30
Certainty Equivalent

Using this method the NPV will be given by the following formula:

α t Ct
n
NPV = ∑(1+ Kf
t=0
t
)
- Io

Where Ct = Forecasted cashflows (without risk adjustment)

αt = the risk-adjusted factor or the certainty equivalent coefficient
Io = Initial cash outflow (cost of project)
Kf = risk-free rate (assumed to be constant for all period).

The certainty equivalent coefficient assumes a value between 0 and 1 and varies inversely with risk.
Therefore, a lower αt will be used if greater risk is perceived and a higher αt if lower risk is anticipated.

The coefficient is subjectively established by the decision maker and represents the decision maker's
confidence in obtaining a particular cashflow in period t.

The certainty equivalent coefficient can be determined by the following formula.

αt = certain net cashflow

risky net cashflow

For example, if an investor expects a risky cashflow of Sh 100,000 in period t and considers a certain
cashflow of Sh 80,000 equally desirable, the αt will be:

αt = 80,000 = 0.8
100,000
ILLUSTRATION

Assume a project costs Sh 30,000 and yields the following uncertain cashflows:

Year Cashflow
1 12,000
2 14,000
3 10,000
4 6,000

Assume also that the certainty equivalent coefficients have been estimated as follows:

α0 = 1.00
α1 = 0.90
α2 = 0.70
α3 = 0.50
α4 = 0.30

The risk-free discount rate is given as 10%

Required;-
Compute the NPV of the project

SOLUTION

31
 α t Ct
n
NPV = ∑(1+ Kf
t=0
t
)
- Io

= 0.9 (12,000) + 0.7 (14,000) + 0.5 (10,000) + 0.3 (6,000) - 30,000

1 + 0.1 (1 + 0.1)² (1 + 0.1)3 (1 + 0.1)4

Using the present value interest factor tables:

Year Certain Cash flows PVIF10% PV

0 (30,000) 1.00 (30,000)
1 0.9 (12,000) 0.909 9,817.2
2 0.7 (14,000) 0.826 8,094.8
3 0.5 (10,000) 0.751 3,755.0
4 0.3 (6,000) 0.683 1,229.4
NPV (7,103.6)

The project has a negative NPV and therefore should not be undertaken.

Note that if risk was ignored the NPV would have been Sh 4,080 and the project would have been
accepted.

Merits of certainty equivalent approach

1. This method explicitly recognises risk.
2. It recognises that cashflows further away into the future are less certain (therefore a lower αt)

Demerits
1. The method of determining αt is subjective and is likely to differ from project to project.
2. The forecaster, expecting the reduction that will be made to his forecasts, may inflate them in
anticipation.
3. When forecasts have to pass through several layers of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra conservative.

DECISION TREES
The decision tree is one of the tools which is used to evaluate capital investments under conditions of
risks. A decision tree is a diagrammatic representation of decision making process showing the
following:
i. Decision alternatives of the course of action which is represented by decision node -
ii. States of nature likely to influence outcomes of decisions made in part (i) above.
This is represented by a chance node/ outcome node –
A decision tree thus shows probable outcome and probabilities of realizing such outcomes.
iii. Conditional pay offs i.e. the net present values or returns of each combination of decision and
various outcomes. When using decision trees in capital investment appraisals, the following
steps would be followed.
a) Define the objective of analysis e.g. enter new market, launch new product, replace all
fixed assets, undertake an expansion programme etc.
b) State all possible decision alternatives e.g. construct a large plant, a medium plant or a
small plant.
c) Identify all the states of nature which are likely to influence the outcome of decisions in
1 and 2 above. E.g. political climate (favorable or unfavorable), weather conditions

32
 (favorable or unfavorable), demand for firm products (high or low), economic
conditions (favorable or unfavorable)
d) Estimate the values and corresponding probabilities which are expected in the different
states of nature.
e) Construct a decision tree to depict decision making process.
f) Calculate the expected monetary value (expected NPV) using the ‘roll back technique’
to determine the optimal decision strategy.

The roll back technique is applicable where there are more than one decision alternatives at different
points.
Note
We can then evaluate the risk inherent in capital investment using standard deviation of NPV and
coefficient of variables.

ILLUSTRATION
A project has the following cashflows
Year 1 Year 2
Cashflow Probability Cashflow Probability
60,000 0.3 50,000 0.3
60,000 0.5
70,000 0.2
80,000 0.4 60,000 0.3
80,000 0.5
100,000 0.2
100,000 0.3 80,000 0.3
100,000 0.5
120,000 0.2
The projects initial cash outlay is Sh 100,000 with a cost of capital of 12%.

Required:
Determine:
(a) The projects expected monetary value (EMV)
(b) The projects NPV

33
34
NPV = 133,850.7 - 100,000 = 33,850.7

Merits of decision tree

1. It clearly brings out the implicit assumptions and calculations for all to see, so that they may be
questioned and revised.
2. The decision tree allows a decision maker to visualise assumptions and alternatives in graphic form,
which is usually much easier to understand than more abstract, analytical form.

Demerits
1. The decision tree can become more and more complicated as more alternatives are included.
2. It cannot be used for dependent variables.

SENSITIVITY ANALYSIS
Sensitivity Analysis is a way of analyzing change in the project's NPV for a given change in one of the
variables affecting the NPV. It indicates how sensitive the NPV is to changes in particular variables.
The more sensitive the NPV, the more critical the variable.

Steps followed in use of Sensitivity Analysis

1. Identification of all those variables which have an influence on the projects NPV.
2. Definition of the underlying (mathematical) relationship between variables.
3. Analysis of the impact of the change in each of the variables on the projects NPV.

Sensitivity Analysis allows the decision maker to ask "what if" questions.

To illustrate let us consider an example. A project has annual cash flows of Sh. 30,000 and an initial
cost of Sh. 150,000. The useful life of the project is 10 years. The cash flows can further be broken as
follows:
Sh. Sh.
Revenue 375,000
Variable costs

35
 Fixed costs 300,000
Depreciation 30,000
Before tax profit 15,000 (345,000)
Tax (50%) 30,000
After tax profits (15,000)
Add back depreciation 15,000
Net annual cash flows 15,000
30,000

The cost of capital is 10% and depreciation method is straight line.

The NPV of the project is:

NPV = 30,000 × PVIFA 10%, 10 years - 150,000

= 30,000 × 6.145 - 150,000

= Sh. 34,350

The NPV is positive and therefore the project is acceptable. However, the investor should consider how
confident he is about the forecast and what would happen if the forecast goes wrong. A sensitivity can
be conducted with regard to volume, price, cost etc. In order to do so we must obtain pessimistic and
optimistic estimates of the underlying variables.

Assume that in the above example, the variables used in the forecasts are:

(a) Volume of sale (= market size × market share)

(b) Unit price
(c) Unit variable costs
(d) Fixed costs

Assume further that the pessimistic, expected and optimistic estimates are:

Variable Pessimistic Expected Optimistic

Market Size 9,000 10,000 11,000
Market Share 0.004 0.01 0.016
Unit price (Sh.) 3,500 3,750 3,800
Unit variable costs (Sh.) 3,600 3,000 2,750
Fixed costs (Sh.) 40,000 30,000 20,000

The resulting NPVs would be:

NPV in shillings
Pessimistic Expected Optimistic
Market size 11,306.25 34,350 57,393.75
Market share -103,912.5 34,350 172,612.5
Unit price -42,462.5 34,350 49,712.5
Unit variable cost -150,000 34,350 11,162.5
Fixed costs 3,625 34,350 65,075

36
 Note that NPV under this category is: Sh

Revenue = 3,750(9,000 x 0.01) = 90 x 3,750 337,500

Variables cost = 3,000 (9,000 x 0.01) = 90 x 3,000 (270,000)
Contribution margin 67,500
Less Fixed costs + Depreciation (45,000)
22,500
Less tax (11,250)
11,250
Add back depreciation 15,000
Net cashflows 26,250

NPV = 26,250 × 6.145 - 150,000

= Sh. 11,306.25

It is important to note that only one variable is allowed to vary at a time and all the others are held
constant (at their expected values).
It has been assumed that a negative pre-tax profit will be reduced by tax credit from the government.
From the project the most dangerous variables appear to be market share and unit variable cost. If the
market share is 0.004 (and all other variables are as expected), then the project's NPV is –Sh. 103,912.5.
If unit variable cost is Sh 3,600 (and all other variables are as expected), then the project has an NPV of
-150,000. Therefore the most sensitive factor is the unit variable cost, followed by market share and unit
price follows. Market size and fixed costs are not very sensitive.

Advantages of Sensitivity Analysis

1. This analysis gives information about riskiness of a project
2. Analysis enables decision makers to analyze how a change in the value of decision variable
affects the projects criterion (NPV or IRR)
3. It enables decision makers to identify decision variables which are sensitive and decision
variables which are insensitive thus critical factors require further analysis.

Weakness of Sensitivity Analysis

1. The analysis is based on assumptions that only a single decision variables will change at a
time all the rest remaining constant which is not the case in reality because there can be a
simultaneous change in the values of decision variables.
2. This analysis is not an optimization technique hence it cannot provide/ yields an optimal
NPV.

SCENARIO ANALYSIS
This analysis is basically a wider case of sensitivity analysis. Scenario analysis addresses or alleviates
some of the drawbacks of sensitivity analysis.
It recognizes the fact that a capital investment decision variables can change simultaneously (at the
same time).

Similarly unlike sensitivity analysis which does not indicate probability of a given change of the key
factor occurring, scenario analysis provides probabilities of the key factor occurring.
Scenario analysis is thus a tool of analysis when making capital investment decisions in environment
of risk. Where this tool is used, decision makers will estimate the values of decision variables in
different economic environment or (in different scenarios)
e.g. – worst scenario/ economic environment
- Most likely scenario
-best case scenario

37
In a most likely scenario we expect low sales, high variable costs, low salvage values, increased
working capital investment, reduced economic life of asset, increased capital investment, increase in
cost of capital.

In a best case scenario, we expect to have high sales, reduce variable costs, reduced fixed costs,
reduced working capital, increase in salvage value etc.
In the best case scenario, we expect to have the most likely values of decision variables.
Once these estimates have been done, the NPV of a project in each case scenario can be determined
using probabilities as weights to determine expected NPV, standard deviation of expected NPV and
coefficient of variation.
SIMULATION ANALYSIS
Simulation analysis is a statistically based behavioral approach which uses or applies predetermined
probability distribution and random numbers to estimate or come up with likely values in each trial or
experiment.

By using different values of cash flow components and mathematical models and repeating the
process several times, decision makers can develop a probability distribution of the project decision’s
criterion.
Simulation analysis is based on experimentation on the model of the actual system. The experiments
are conducted on an organized trial and error basis, results derived and generalization made after
several runs or trials.

Simulation analysis allows decision makers to let all the decision variables (capital investment due to
change at the same time i.e. to vary simultaneously)

The following steps can be followed where this tool is used to evaluate capital investments under
conditions of risks or uncertainties.
i. Define the problem i.e. state the objective of the analysis.
ii. Identify the relevant key decision variables e.g. initial costs, salvage value, economic life of
asset.
iii. Formulate a mathematic model which is relevant to the problem and specifies the relationship
which exists between variables in step (ii) above.
iv. Specifies the values of decision variables to be tested and estimate their probability of
occurrence. In other words develop a probability distribution of the variables.
v. Test the model, i.e. run a simulation experiment. Obtain the values of decision criterion using
random numbers.
vi. Change the parameters randomly and repeat the experiment until a satisfactory solution is
obtained.

Diagrammatically, this can be summarized as follows:

1.
Identify the key decision variables and their inter relationship

2.
Specify possible values of each variable and estimate their probability
of occurrence (probability distribution)

3. Carry out repeated trials using randomly selected values of each key
variable

38
Where there is a large number of decision variables which are uncertain, a simulation analysis shall
provide a satisfactory solution as long as two conditions are made. i.e.
i. A large number of trials are conducted so as to attain a steady state.
ii. The probability distribution of random variables of decision factors is reliable.

Advantages of Simulation Analysis

1. In the process of model buildings construction, this analysis helps manager to fully understand the
project and the key issues to be resolved.
Decision makers can identify critical decision factors and interrelationship and hence understand
the project in totality.
2. Simulation analysis allows decision makers to vary many decision variables simultaneously and
randomly which reflects what is likely to occur in practice.
3. Provides managers with a distribution of the projects outcome and values of decision criterion i.e.
NPV or IRR of each trial which can be used to assess the risk associated with the project.

Weakness of Simulation Analysis

1. Can be costly and time consuming in the absence of computers since to reach a steady state, many
trials will be done.
2. This analysis is based on probability and thus can give misleading results if the probability
distribution is not reliable.
3. A complex simulation problem may require a management scientist to model and resolve and thus
results obtained from the analysis might not be meaningful to finance managers.

UTILITY THEORY

When discussing the expected value and the standard deviation we noted that decision makers can either
be risk seekers, risk averse or risk neutral. Therefore, we cannot be able to tell with certainty whether a
decision maker will choose a project with a high expected return and a high standard deviation, or a
project with comparatively low expected return and low standard deviation.

Utility theory aims at incorporating the decision maker's preference explicitly into the decision
procedure. We assume that a rational decision maker maximises his utility and therefore would accept
the investment project which yields maximum utility to him.

We can graphically demonstrate the three attitudes towards risk as follows:

a) Averse decision maker

39
 Utilities

Wealth (Shs)

b) Risk seeker decision maker

Utilities

Wealth (Shs)

c) Risk seeker decision maker

Note that utiles is a relative measure of utility. For the risk averse decision maker, the utility for wealth
curve is upward-sloping and is convex to the origin. This curve indicates that an investor always prefer
a higher return to a lower return, and that each successive identical increment of wealth is worth less to
him than the preceding one - in other words, the marginal utility for money is positive but declining.

For a risk seeker, the marginal utility is positive and increasing. For a risk neutral decision maker, the
marginal utility is positive but constant. To derive the utility function of an individual, we let him
consider a group of lotteries within boundary limits.

ILLUSTRATION
Derivation of utility functions

40
Assume that utiles of 0 and 1 are assigned to a pair of wealth representing two extremes (say, Sh. 0 and
Sh. 100,000 respectively). To determine the utility function of a decision maker, we offer him a lottery
with 0.5 chance of receiving no money and 0.5 chance of receiving Sh. 100,000. Assume he is willing
to pay Sh. 33,000 for this lottery. (Therefore 0.5 utile = (0.5 x 0) + (0.5 x 1) = Sh. 33,000.

Next, consider a lottery providing a 0.4 chance of receiving Sh. 33,000 and a 0.6 chance of receiving Sh.
100,000. Assume that the decision maker is willing to buy this lottery at Sh. 63,000. The utile value of
Sh. 63,000 is

U(Sh. 63,000) = 0.4 U(Sh. 33,000) + 0.6 U(Sh. 100,000)

= 0.4 x 0.5 + 0.6 × 1
= 0.8

Assume also a lottery providing a 0.3 chance of receiving Sh. 0 and a 0.7 chance of receiving Sh. 33,000
is also offered. The decision maker is willing to pay Sh. 21,000 for this lottery. The utile value for Sh.
21,000 can be computed as follows.

U (Sh. 21,000) = (0.3 U(Sh. 0) + 0.7 U(Sh. 33,000)

= 0.3 × (0) + 0.7(0.5)
= 0.35

Note that other lotteries can be provided to the decision maker until we have enough points to construct
his utility function.

Expected utility of an investment

Once your utility function is specified, we can calculate the expected utility of an investment.
This calculation involves multiplying the utile value of a particular outcome by the probability of its
occurrence and adding together the product for all probabilities.

ILLUSTRATION
Consider two investments that have cash flow streams and assonated probabilities.

Project A
Cashflows Utiles Probability
Shs
-20,000 -0.20 0.10
0 0 0.10
60,000 0.60 0.60
80,000 0.80 0.20

Project B
Cashflows Utiles Probability
Sh.
-25,000 -0.25 0.10
0 0 0.20
50,000 0.50 0.50
100,000 1.00 0.20

The expected monetary value for Project A is

41
-20,000 (0.10) + 0(0.10) + 60,000 x (0.6) + 80,000 (0.20)= Sh. 50,000

For Project B

-25,000 (0.10) + 0 (0.20) + 50,000 (0.50) + 100,000 (0.20)= Sh. 42,500

Using the expected monetary value, Project A is preferred then Project B.

Using the utility values (utiles) the expected utility value is computed as follows:

Project A Project B
Utile Prob. Weighted Utile Prob. Weighted
Utility Utility
-0.20 0.10 -0.02 -0.25 0.10 -0.025
0 0.10 0 0 0.20 0
0.60 0.60 0.36 0.50 0.50 0.25
0.80 0.20 0.16 1.00 0.20 0.20
Expect utility value 0.54 0.425

Using utility values Project A should be accepted since it has a higher utility value.

Advantages of utility approach

1. The risk preferences of the decision maker are directly incorporated in the capital budgeting
analysis.
2. It facilitates the process of delegating the authority for decision.

Limitations
1. It is hard to determine the utility function (it is subjective).
2. The derived utility function is only valid at a point of time.
3. If the decision is taken by a group of people it is hard to determine the utility functions since
individuals differ in their risk preferences.

SPECIAL CASES IN INVESTMENT DECISIONS

INVESTMENTS DECISION FOR PROJECTS WITH UNEQUAL USEFUL LIVES

Occasionally, a firm may be confronted with two or more mutually exclusive projects that are carried
out to meet a continuity need but would have differences in their life spans (useful lifes)
In such situations it’s possible that by undertaking a project with a shorter life span. Funds will be
released sooner or faster to be re-invested elsewhere for a return than if the project with a longer life
were accepted.

The basic NPV criterion however ignores any future re-investment opportunities available to a firm. It
assumes that projects are only undertaken once while in real life there are possibilities for re-
investment
There are 2 criterions that we can use to evaluate projects with unequal projects with unequal useful
lives
1. Replacement chain method
2. Equivalent annuity method

42
ILLUSTRATION
A company is considering investing in 2 projects whose cash flows are as shown below:
Year Cash flow in Sh ‘m’
A B
0 (99) (140)
1 50 80
2 70 60
3 - 30

The company cost of capital is 10% none of the projects can be delayed or deferred

Required;-
a) Compute the NPV’s of the two project.
b) Which project (s) will you recommend if the projects were
i. Independent.
ii. Mutually exclusive
c) Assuming that the projects are mutually exclusive but that the firm can reinvest indefinitely in
each project. Which project would you recommend? Why?

SOLUTION
a)
Year Factor 10% Cash flow in Sh ‘m’
A B
0 1.00 (99) (140)
1 0.9091 50 80
2 0.8264 70 60
3 0.7513 - 30
NPV 4.303 4.851
b) i) If independent both project are recommended because their NPV’s are positive.
ii) However, if mutually exclusive project B would be recommended as it has the higher NPV
over the one of time invested
c) I would recommend project A because it has a shorter life thus cashflow will be realized soon.

Replacement Chain method

It assumes that the firm would re-invent indefinitely in the same or similar project (s) as they mature
thus the project form a replacement chain.
The NPV of the competing projects are then computed and compared over the shortest common
period of time and the project with the higher NPV recommended.

Equivalent annuity method

An annuity to equal cash flow received paid each year for a given number of years.
This method therefore converts the NPV’s of the projects into an annuity stream/pattern over their
useful lives and the project (s) that has that highest equivalent annuity recommended.

ILLUSTRATION
Consider two projects whose details are as shown below
Project
X Y
Life n 3 5
NPV Shs.’m’ 5 6
Required

43
Using both the replacement chain and equivalent annuity method, determine what project is
recommended. Assume cost of capital for both projects is 10%

SOLUTION
Replacement Chain
LCM of 3 and 5 years solution =15
Computing the NPV‘s over 15 years

0 3 6 9 12 15

5M
5M
5M
5M
5M
NPV

NPV/15 years = 5[1+1.1-3+1.1-6+1.1-9+1.1-12]

= 15.2926M

NPV/15 years = 6[1+1.1-5+1.1-10]

= 12.0388M

Equivalent annuity method

𝑵𝑷𝑽
Project N NPV 𝑷𝑽𝟏𝑭𝑨𝒓=𝟏𝟎%
𝒓,𝒏 EA=
𝑷𝑽𝟏𝑭𝑨𝒓,𝒏
X 3 5 2.4869 2.0106
Y 5 6 3.7908 1.5828

Therefore Project X is recommended

ILLUSTRATION

ABC Ltd. is contemplating a replacement cycle for new machinery. This new machinery will cost Sh.
100 million purchase. The operating and maintenance costs for the future years are as follows:

Year 0 1 2 3
Operating and maintenance
costs (Sh. “000”) 0 120000 130000 140000

The resale values of the machinery in the second hand market are as follows:
Year 0 1 2 3
Resale value(Sh. “000”) 0 80000 65000 35000

Assume:
1. The replacement is by an identical machine
2. There is no inflation, tax or risk
3. The cost of capital is 11%

44
Required:
Advise ABC Ltd. on whether to replace this new machine on a one, two or three – year cycle

SOLUTION

Computation of NPV of costs

Cash flow in Year Year of Replacement Factor 11%

1 2 3
0 (100) (100) (100) 1.000
1 (40) (120) (120) 0.9009
2 - (65) (130) 0.8116
3 - - (105) 0.7445
(136.036) (260.862) (391.789) NPV
0.9009 1.7125 2.4437 Factor @ 11% n(PV1FA)
(151.000) (152.609) (160.720) 𝑁𝑃𝑉
Equivalent cost =𝑃𝑉𝐼𝐹𝐴

Recommendation;
The company should replace the machinery after every 1 year as it’s the cheapest replacement option
i.e. Sh. (151,000)

REPLACEMENT PROBLEM
This problem occurs whenever one productive asset is replaced with another whose usefulness has
become inadequate or obsolete usually the same product may be produced with the new assets
although the output may change and the quality of produce may also be changed.
The replacement analysis and the historical /sunk costs are ignored as they cannot be changed whether
or not the old assets are replaced
It is only that cash flow that can change that is considered in replacement analysis.

ILLUSTRATION
A company is considering replacing old machinery that has been used in production for a number of
years. The relevant facts regarding the two assets are as follows:
Old Proposed
Cost 8M 10.8M
Salvage 0.5M 0.8M
Current market value 2.8M 10.8M
Expected PBIT
Years 1-3 1.5M 3.0M
4-6 1.0M 2.5M

The total useful life of old asset is 10years and 6 years respectively. The old asset is 4 years old. The
company depreciates its non-current assets using the straight line method. Corporate tax rate is 30 % .
Required rate of return is 12 %. Assume that depreciation is allowed for tax purposes and that capital
gains (losses) are taxable (tax allowable)

Required;
Should that old asset be replaced with the new one?

SOLUTION

45
Computation of the increment out lay Sh. ‘000”
Purchase cost of new asset (10,800)
Expected proceed from disposal old asset 2,800
(8,000)
Tax saving on disposal 660
Net cost outlay (7,340)

Computation of gain/loss of disposal

Proceeds of disposal 2,800
Cost of old machinery 8,000
8000−500 3,000 (5,000)
Account Depreciation [ 10
] ×4
NPV (2,200)
Tax saving on disposal =30% ×2200=660

Computation of increment annual cash flows

Years Sh. ‘000’
1-3 4-6
Incremental P.BIT 1500 1500

Depreciation on new machinery

10800−500
6
= 1666

Depreciation on old machinery

8000−800 (750)
10
= 916
Tax Shield =30% × 916 275 275
1,775 1,775

Incremental terminal cash flow

Sh ‘000’
Salvage value of new asset 800 800
Salvage value of old asset (500)
300

Computation of NPV (Incremental)

Year Fact 12% Cash flow (Sh ‘000)
0 1.000 (7,340)
1-6 4.1114 1,775
6 0.5066 300
NPV 109.715

Since the expected NPV of the replacement is positive the proposed replacement is recommended as it
increases the shareholders wealth by Sh. 109,715

ABANDONMENT DECISION
It has been assumed so far that the firm will operate a project over its full physical life. However, this
may not be the best option - it may be better to abandon a project prior to the end of potential life. Any
project should be abandoned when the net abandonment value is greater than the present value of all

46
cash flows beyond the abandonment year, discounted to the abandonment decision point. Consider the
following example:

ILLUSTRATION
Project A has the following cashflows over its useful life of 3 years. The market value (Abandonment
value) has also been given.

Year Cash Abandonment

flow value
Sh`000' Sh`000'
0 (4,800) 4,800
1 2,000 3,000
2 1,875 1,900
3 1,750 0

Required:
Determine when to abandon the project assuming a discount rate of 10%.

SOLUTION
If the project is used over its life, the NPV is negative as shown below:

NPV = 2,000 × PVIF 10%, 1year + 1,875 × PVIF 10%, 2years + 1,750 × PVIF 10%, 2 years - 4,800

= 2,000 x 0.909 + 1,875×0.826 + 1,750 x 0.751 - 4,800

= Sh. -119

The project should not be accepted. However, if the project is abandoned after 1 year the NPV would be

NPV = 2,000 × 0.909 + 3,000×0.909 - 4,800

= Sh. -255

If abandoned after 2 years

NPV = 2,000 × 0.909 + 1,875×0.826 + 1,900 × 0.826 - 4,800

= Sh. 136
The NPV is positive if the project is abandoned after 2 years and therefore this is the optimal decision.

Note that abandonment value should be considered in the capital budgeting process because, as our
example illustrates, there are cases in which recognition of abandonment can make an otherwise
unacceptable project acceptable. This type of analysis is required to determine projects economic life.

REAL OPTIONS IN INVESTMENT DECISIONS

Real options can include opportunities to expand and cease projects if certain conditions arise,
amongst other options. They are referred to as "real" because they usually pertain to tangible assets
such as capital equipment, rather than financial instruments. Taking into account real options can
greatly affect the valuation of potential investments. Oftentimes, however, valuation methods, such as
NPV, do not include the benefits that real options provide.

47
The real options approach to the analysis of capital investment projects can be found in many areas,
for example the development of natural oil fields, the valuation of high-tech companies, the valuation
of manufacturing flexibility, and the valuation of entry to or exit from a market. The nature of the
optionality may take a number of forms. Examples are:

• The option to make follow-on investments if an immediate project is successful;

• The option to abandon a project if the immediate project is not successful;
• The option to wait before investing, and;
• The option to vary a firm’s output or production methods.

Traditional NPV approach to the valuation of projects

The traditional net present value (NPV) approach to the valuation of capital investment projects is to
calculate the expected present value of future cash flows (V) and then to subtract the present value of
the cost of investment (I). The discounting is performed using a risk-adjusted discount rate, e.g capital
asset pricing model (CAPM).
Projects are treated as independent and an immediate accept or reject decision is often made based on
the value of the NPV (= V-I).
This approach does not allow for the management flexibility that is often present. Management can
add value by reacting to changing conditions, e.g by expanding operations if the outlook seems
attractive or reducing the scope of activities if the future outlook is unattractive. The traditional NPV
approach also ignores the strategic value of projects, such as the opportunity to expand into a new
market, to develop natural resources, or technology.
When considering uncertainty and managerial flexibility, NPV does not properly capture the non-
linear nature of the cash flow distribution or the changing risk profile over time.
Many investment opportunities have options embedded in them and the traditional NPV misses this
extra value because it treats investors as passive.

The real options approach to the valuation of projects

The real options approach to the capital investment decision provides a different insight into the
valuation of projects. Real options can capture the value of managerial flexibility and strategic value,
and provide intuition that may be contrary to popular thinking.

Example; the embedded options nature of a project.

Consider the development of a new personal computer (PC1) with an initial investment of Sh.200m
and an expected present value of future cashflows using the risk-adjusted discount rate equal to
Sh.175m. Using a traditional approach, the NPV = - Sh.25m. Now consider the value of the option to
make a follow-on investment in a superior PC (PC2) in three years’ time (this investment in PC2
being too expensive unless an entry is made with PC1). This follow-on investment may either be a
good investment or a bad one. This further investment also requires Sh.600m in three years’ time and
will produce an expected present value of future cashflows equal to Sh.500m at that time, which is
equivalent to a value of Sh.290m now. Using a traditional NPV approach, the value of this additional
investment in three years’ time is - Sh.100m.
As these future cashflows are very uncertain, they have a high standard deviation of 40% pa. The
value of the cashflows of Sh.290m can be viewed as a stock that evolves over time with a standard
deviation of 40% pa.
If the expected value of these future cashflows in three years’ time is greater than Sh.600m then the
option to invest in PC2 proceeds. If it is less than Sh.600m then no further investment will take place.
This assumes that there are no further embedded options present, i.e options on PC3 or PC4, as a
result of developing PC2. This option to invest further has the features of a European call option,
exercisable in three years’ time with an exercise price of Sh.600m.

48
The valuation of this option, using Black-Scholes (assuming the underlying conditions hold) turns out
to be equal to Sh.35m. This now produces an overall project NPV of - Sh.30m plus Sh.35m, which is
equal to Sh.5m. So entering the market to develop PC1 begins to look attractive, even though under a
traditional approach the NPV is negative for PC1 on a stand-alone basis.
The real options approach implicitly assumes that each real investment opportunity has a ‘double‘, a
security or portfolio with identical risk characteristics to the capital investment being evaluated.

The real options valuation approach can be summarized as follows:

Real options NPV = traditional NPV + real option value

Call options stock options v real options

The valuation of options on stocks is a function of certain parameters; the analogous relationships in
the valuation of real options are as follows:
– Stock price PV of expected project cash flows.
– Exercise price investment cost.
– Expiry date date until which the investment opportunity remains open.
– Stock return uncertainty project value uncertainty.
– Dividends operating cashflow or competitive erosion.
The riskless interest rate is the same for both stock and real options.

Different forms of optionality

Option to expand
Sometimes there is a strategic value in taking on negative NPV projects, in that the project’s payoff
may contain call option features, as connected future project opportunities, in addition to the
immediate negative NPV, the value of these call options being greater than the negative NPV.

Option to abandon
The option to abandon a project can be viewed as a put option against the failure of a project. The
exercise price is equal to the value of the project’s assets if sold or if used for alternative purposes.
The exercise of this put option would occur if this were greater than the expected present value of
future cash flows.

Option to wait
Sometimes it may be beneficial to defer the start of a project that currently has a positive NPV. This is
because there is more value in waiting. This is analogous to the valuation of American call options (i.e
early exercise is allowable). Investing in a project immediately can be viewed as exercising an option,
but sometimes it pays to wait and keep the option alive. The value of waiting is greatest when the cash
flows forgone by waiting are small and there is greater volatility over future cash flows.

Real options approach complexities

Real options are more often complex in practice:
- Cost of further investment or the price of abandonment is likely to vary over time.
- Abandonment of a project may occur at any time in a project and the reinstatement of a
project may be possible.
- Postponement of a project and missing out on the first year’s cash flows in the anticipation of
learning from them may sometimes provide no additional information.

COMMON CAPITAL BUDGETING PITFALLS

49
− The failure to account for economic reactions. If a company introduces a highly profitable
product to the market, then competitors will enter the market and future profitability will
deteriorate.
− Standard approaches for different capital projects. A company may use a common model to
analyze all of its capital projects despite differences across all the capital projects that it considers.
− Focusing on accounting results. A company’s management may be incentivized to initiate
projects that show positive short term accounting results at the expense of long term projects with
high net present values.
− Utilizing IRR over NPV. IRR may not lead to optimal decision making when evaluating mutually
exclusive projects. NPV is considered the superior approach.
− Pet projects. Influential company managers may initiate projects which advance their own
interests but do not create company value (or even destroy it).
− Cash flow errors. Many estimates and assumptions go into forecasting cash flows and these are
subject to error.
− Inappropriate discount rate. A company might use too low of a discount rate for a high risk
project and overstate the project’s NPV.
− Misunderstanding sunk costs and opportunity costs. A company may incorrectly include sunk
costs into its capital budgeting analysis, but exclude opportunity costs.

BOND REFINANCING/REFUNDING
Bond Refinancing
The issuance of new bonds to replace outstanding bonds, either at maturity or prior to maturity.

Favorable market conditions or the strengthening of a company's credit rating may lead to the
refinancing of corporate debt. The two primary factors for influencing a company to refinance are
decreases in the interest rate or improvements in the company's credit quality.
When a company issues debt, usually in the form of long-term bonds, it is agreeing to pay a periodic
interest charge, known as a coupon, to the bondholders. The coupon rate reflects the current market
interest rates and the company's credit rating.
When interest rates drop, the company will want to refinance its debt at the new rate. Because the debt
was issued during a time of higher interest rates, the company is paying a larger interest rate than what
current market conditions would specify. In this case, the company may refinance by issuing new
bonds at the lower coupon rate and use the proceeds to buy back the older bonds. This allows the
company to capitalize on the lower interest rate, which allows it to pay a smaller interest charge.
A company's credit rating is reflected in the coupon rate on newly issued debt. A risky company will
need to offer lenders a larger return, to compensate them for the additional risk of investing in that
company. When a company's credit quality improves, investors won't require such a high return
because that company's bonds will be a safer investment. If lenders are requiring a lower return than
before, a company will probably want to refinance its older debt at the new rate.

Refunding Bonds
A bond refund or call occurs after the issuer takes advantage of a lower interest rate. By offering a
refund, the issuer buys back the bond from the investor, at its current rate, no matter where it is in the
maturity process. This essentially puts the investor at a disadvantage; since there is no way of
knowing if the interest rates will drop, making the bond a risky investment. A company that wishes to
have the option of refunding a bond must put it in writing before the initial sale.
Refinancing a bond is different from refunding one since it involves the restructuring of the bond
instead of a complete reversal of funds to the investor. It’s a great way for a business to save money
by taking advantage of a new interest rate while keeping the investor on board for the refinanced
bond.

Advantage for the Investor

50
While a refinance is a risky investment, it does offer the chance of a better return than a full refund.
The bond issuer buys back the original bond and puts that money into an escrow account. In return,
the investor will receive a new bond at the new interest rate. When the new bond matures, the investor
will have both the amount of the mature bond and the amount of money left over in escrow.

PRACTICE QUESTIONS (Solutions on page 272)

QUESTION 1
a) The Better Shoe Company is considering a major investment in a new product area, novelty
umbrellas. It hopes that this product will become a fashion icon. The following information has
been collected:
1) The project will have a limited life of 11 years.
2) The initial investment in plant and machinery will be Sh. 10 million and a marketing budget
of Sh. 2 million will be allocated to the first year.
3) The net cash flows before depreciation of plant and machinery and before marketing
expenditure for each umbrella will be Sh. 100.
4) The products will be introduced both in Kenya and Uganda.
5) The marketing costs in years 2 to 11 will be Sh. 5 million per annum.
6) If the product catches the imagination of the customers in both countries, then sales in the first
year are anticipated at 1 million umbrellas.
7) If the fashion press ignores the new products in one country but become enthusiastic in the
other, sales will be 700,000 umbrellas in year 1.
8) If the marketing launch is unsuccessful in both countries, first year sales will be 200,000
umbrellas.
The probability of each of these events occurring is:
1 million sales = 0.3
0.7 million sales = 0.4
0.2 million sales = 0.3

i. If the first year is successful in both countries then two possibilities are envisages.
• Sales levels are maintained at 1 million units per annum for the next 10 years –
probability of 0.3.
• The product is seen as a temporary fad and sales fall to 100,000 units for the
remaining 10 years – probability of 0.7.
ii. If success is achieved in only one country in the first year, then for the remaining 10
years there is:
• A 0.4 probability of maintaining the annual sales at 700,000 units and
• A 0.6 probability of sales immediately falling to 50,000 units per year.
If the marketing launch is unsuccessful in both countries, the production will cease and the project
will be scraped with zero value. The annual cash flows and marketing costs will be payable at
each year end.

Assume:
• Cost of capital is 10 per cent per annum.
• No inflation or taxation.
• No exchange rate charges.

Required:
(i) Calculate the expected net present value for the project.
(ii) Calculate the standard deviation for the project.

51
b) If the project produces a net present value of less that Sh. 10 million, the directors fear that the
company will be vulnerable to a hostile takeover. Calculate the probability of the firm avoiding a
hostile takeover. Assume normal distribution

QUESTION 2
Matibabu Pharmacia Ltd. recently carried out clinical trials on a new drug which was developed to
reduce the effects of diabetes.

The research and development costs incurred on the drug amount to Sh.160 million. In order to
evaluate the market potential of the drug, an independent research firm conducted a market research at
a cost of Sh.15 million. The independent researchers submitted a report indicating that the drug is
likely to have a useful life of 4 years (before new advanced drugs are introduced into the market). It
is projected that in the year the drug is launched it could be sold to authorised drug stores (chemists
and hospitals) at Sh.20 per 500mg capsule. After the first year, the price is expected to increase by
20% per annu
For each of the four years of the drug’s life, the sales have been estimated stochastically as shown
below:

Number of Capsules sold Probability

11 million 0.3
14 million 0.6
16 million 0.1

If the company decides to launch the new drug, it is possible for production to commence
immediately. The equipment required to produce the drug is already owned by the company and
originally cost Sh.150 million. At the end of the drug life, the equipment could be sold for Sh.35
million. If the company decides against the launch of the new drug, the equipment will be sold
immediately for Sh.85 million as it will be of no further use to the company.
The new drug requires two hours of direct labour for each 500 mg capsule produced. The cost of
labour for the new drug is Sh.4 per hour. New workers will have to be recruited to produce the new
drug. At the end of the life, the workers are unlikely to be offered further employment with the
company and redundancy costs of Sh.10 million are expected. The cost of ingredients for the new
drug is Sh.6 per 500mg capsule. Additional overheads arising from the production of the drug are
expected to be Sh.15 million per annum. Additional work capital of Sh.2 million will be required
during the drug’s 4-year life.

The drug has attracted interest of the company’s main competitors and if the company decides not to
produce the drug, it could sell the patent right to Welo Kam (K) Ltd., its competitor, at Sh.125
million. The cost of capital is estimated to be 12%.

Required:
a) The expected Net Present Value of the new drug.
b) State with reasons whether the company should launch the new drug.

Ignore Taxation

52
 CHAPTER 3
PORTFOLIO THEORY AND ANALYSIS

53
RISK AND RETURN
When considering a prospective investment the financial manager, or any rational investor, will be
concerned not only with the volume and timing of its expected future cash flows but also with their
riskiness, by which in finance we mean their tendency to vary from some expected or mean value.
The greater the range or spread of possible returns from an investment, the greater its risk. Thus both
the return and the risk dimension of investment decisions must be evaluated.

Risk and return are intimately related and we shall spend some time exploring this fundamental
relationship (or in technical terms the correlation), between risk and return. We will see how the
notion of return cannot be considered in isolation from risk - the two variables are inseparable. We
will also examine risk and return in the context of modern portfolio theory and see how risk can be
reduced by diversification.

For the financial manager the goal of investment decisions is to maximise shareholder wealth, and
making sound investment decisions that enhance shareholder wealth lies at the very heart of the
financial manager's job. Wealth-enhancing investment decisions (corporate or personal) cannot be
made without an understanding of the interplay between investment returns and investment risk. The
risk-return relationship is central to investment decision making, whether evaluating a single
investment or choosing between alternative investments

Potential investors, for example, will assess the risk-return relationship or trade-off in deciding
whether to invest in company securities such as shares or bonds. Investors will evaluate whether, in
their view, the securities provide a return commensurate with their level of risk.

The risk – return relationship

Every financial decision contains an element of risk and an element of return. The relationship
between risk and return exists in the form of a risk-return trade-off, by which we mean that it is only
possible to earn higher returns by accepting higher risk. If an investor wishes to earn higher returns
then the investor must appreciate that this will only be achieved by accepting a commensurate
increase in risk. Risk and return arc positively correlated, an increase in one is accompanied by an
increase in the other.

The implication for the financial manager in evaluating a prospective investment project is that an-
effective decision about the: project's value to the firm cannot be made simply by focusing on its
expected level of returns: the project's expected feral of risk must also be simultaneously considered.
This risk-return trade-off is central to investment decision-making.

Risk diversification
It is unlikely that the financial manager or corporate treasurer will be involved with investing the
entire firm's capital resources in only a single project or asset, this would be very risky. As the old
adage goes, all the firm's eggs would be in one basket. More probable resources will be invested in a
collection or portfolio of investment projects as totals will be reduced through diversification.
This means risk will be spread and therefore not all the firm's investment eggs will be in the one
basket. From the shareholder's perspective, the firm itself can be viewed as a portfolio of assets or
investment projects managed by a professional team - the firms managers.

Holding a group of diversified assets (that is, assets that do not move in the same direction at the same
time) in a portfolio reduces overall risk and risk reduction through diversification is a key aspect of
the corporate treasury risk management role.

54
Thus the financial manager's concern is not just with the relative timing of investment returns but also
with their relative risks, (that is, the potential variability of their future returns) and how together these
will impact on the firm's market value and shareholder wealth.

Shareholder wealth maximisation means maximising the value of the share price while risk and return
are two key determinants of share price. We will begin our study of risk and return by first
considering return; it is the easier of the two to understand.

Return
An investment's return can be actual or expected and is measured in terms of cash-flows, positive or
negative. Measuring actual return is usually a retrospective and comparatively easier exercise than
measuring expected return. In calculating actual return the relevant data is historic and is known with
certainty: determining expected return is altogether a more problematic exercise as we are dealing
with the future and the future is uncertain.
An investment's expected return - usually denoted E(r) or f (referred to as 'r bar')-is the
Investment's most likely return and is measured in terms of the future cash flows, positive and
negative, it is expected to generate. It represents the investor's best estimate of the investment's future
returns.

As a general rule the rate of return (actual or expected) on any investment over a defined period of
time can be calculated simply as:

𝐼𝑛𝑐𝑜𝑚𝑒
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
×100 = %

A refinement to the above would be to allow for changes in the value of the investment over the
period, such as the capital gain on a share.

(𝐸𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 − 𝑠𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒) + 𝐼𝑛𝑐𝑜𝑚𝑒

𝑠𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒

For example, if you bought a security such as a share for shs.10.00 which one year later was valued at
shs.11.00 and it paid you a shs.0.50 dividend during the year, your return would be:

(𝑠ℎ𝑠.11.00−𝑠ℎ𝑠.10.00)+𝑠ℎ𝑠.0.50 𝑠ℎ𝑠.1.50
×100 = %= ×100 = 15%
𝑠ℎ𝑠.10.00 𝑠ℎ𝑠.10.00

If you invested in a security such as a bond, the income is the cash you receive in the form of interest
plus any principal repayments and/or changes in the market price of the bond. The above is an
example of actual or realized returns where the relevant variables (cash income, beginning value and
ending value) are known. They are calculated after the event, are thus sometimes referred to as ex post
returns.
In contrast, when faced with making an investment decision the relevant variables are not known with
certainty, and consequently they have to be estimated. In making investment decisions for the firm,
the financial manager will need to make estimates of the returns (cash flows) expected from an
investment.
The expected return is determined ex ante, (before the event) that is before the investment is made,
and is calculated by the same method as before only this time expected values are substituted in the
formula for the actual values.

(𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑛𝑑𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒 − 𝑠𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒) + 𝐼𝑛𝑐𝑜𝑚𝑒

𝑠𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑣𝑎𝑙𝑢𝑒

55
For example, you know that your share is currently valued at shs.11.00. If you expect its most likely
value to be shs.12.00 one year from now and expect it to pay you a dividend of shs.0.75 during the
year, your expected return E(r) would be:

(𝑠ℎ𝑠.12.00−𝑠ℎ𝑠.11.00)+ 𝑠ℎ𝑠.0.75
E(r) = × 100 = %
𝑠ℎ𝑠.11.00

𝑠ℎ𝑠.1.75
= × 100 = 15.9%
𝑠ℎ𝑠.11.00

Clearly, in one year's time the actual return from this investment may be very different )in the
expected return. However, at the present point in time, the expected return is our best guess of the
share’s future return.
The determination of return, actual or expected, in general can be expressed mathematically as:

𝑉𝑡 −𝑉𝑡−1 +𝐶𝐹1
r1 =
𝑉𝑡−1
Where;
rt = actual or expected rate of return during period t
vt = value of asset at time tn
Vt -1 = value of asset at time t-1
CF = cash flow from investment over the period t-1 to t

Frequently in finance we will be measuring returns over the period of a year, so rt often represent the
annual rate of return. Where an investment is held for a period greater or less than a year it is best to
convert the return to an annual return, as this makes reviewing and comparing investment
performance easier.
For example, if you bought a share six months ago for shs.100 and sold it today for shs 106, and in the
meantime received a dividend of shs.3 your- return over the six- month holding period (known as the
holding period return) would be calculated as:
Holding period return = (shs.106 – shs.100 + shs.3)/shs.100 = 9%
To convert this to an annual rate of return we can divide the six-month holding period return by 0.5,
thus the annualized return is: 9/0.5 = 18%. For any investment we convert its holding period return to
an annual return by dividing the holding period by the number of holding periods, expressed in terms
of years, thus:

Annual return - holding period return/number of holding periods (in years)

18% = 9%/0.5

We have previously defined expected return as the most likely future return. When considering a
potential investment an investor is likely to determine a range of possible future returns for the
investment before deciding on the most likely return.
Returning to our previous share example, if you wish to estimate the share's future return, you may
intuitively consider a number of possible future values.
For example assume there is a 25 per cent share of the future return remaining at 15 per cent, a 50
percent chance of it increasing to 16 per cent and a 25 percent chance that it might be 17 percent. You
could then compile a probability distribution of future returns as follows:

Probability (p) Return (r) (p) × (r)

0.25 15% 3.75
0.50 16% 8.00

56
 0.25 17% 4.25
E(r) = 16.00%

The expected return E(r) is therefore defined as: a weighted average of possible returns where the
weightings are the respective probabilities of each possible return occurring. All the relative
weightings will add up to 1.0.

The expected return E(r) is derived mathematically as:1

E(r) = r1P(r1) + r2P(r2) + ... + rnP(rn)

Where,
r1 = rate of return for the identified ith outcome J
P(r1) = probability of earning return i for the identified outcome/
n = number of possible outcomes

ILLUSTRATION – Expected return, E(r)

The financial manager of Manifested Technologies wishes to determine the expected rate of return
from a proposed investment projects. The expected returns from the project are related to future
performance of the economy over the period as follows:

Economic scenario Probability of occurrence (p) Rate of return (r)

Strong growth 0.25 15%
Moderate growth 0.50 12%
Low growth 0.25 8%

The expected return E(r) is calculated as:

E(r) = 0.25(15%) + 0.50(12%) + 0.25(8%)
= 11.75%

The expected return E(r) is the weighted average of the range of possible returns where the weightings
are the respective probabilities of each return in the range being realized. In this case the probability
weightings will have been determined subjectively by the firm’s management.

Required rate of return

The required rate of return is the minimum rate of return an investor requires an investment to earn,
given its risk characteristics, for the investment to be considered worthwhile. The required rate of
return is equal to the rate of return given by a risk free or safe, investment- such as a government
treasury bill-plus a risk premium. The risk premium is necessary to compensate the investor for
undertaking a risky investment.

Required rate of return, R(r) = risk-free return + risk premium.

Once determined, the required return can then be used as a benchmark against which an investment's
expected return can be compared.
An investment's expected return may or may not be the same as the investor's required return. If the
return which an investment is expected to yield is greater than the return the investor requires then the

57
investment will be considered worthwhile. Should the expected return be less than the required return,
then the investor will not consider the investment to be beneficial.
For instance, if in the illustration above the financial manager of Manifested Technologies normally
required a return of 15 per cent from investments of similar risk, then investment project would be
rejected as its expected return of 11.75 per cent significantly less than its required return of 15 per
cent.
We can now turn to the other member of the inseparable duo - risk.

Risk
Generally speaking, risk can be defined as: the chance that the actual outcome will differ from the
expected outcome or in our current context the chance that the actual return will differ from the
expected return. Clearly there is a chance that the actual return will be greater than, equal to, or less
than the expected return. In finance it is this potential variability of returns that we call risk.

Attitudes to risk
Investment decisions will be influenced by the investor's risk propensity or the investor's attitude to
risk. Investors who have a low risk propensity, in other words they have preference for less risk are
said to be risk-averse.

Investors who have a high risk propensity or a positive desire for risk arc referred to as risk-takers or
risk-seeking. Other individuals may be risk-indifferent or risk-neutral, that is for an increase in risk,
and they do not necessarily require an increase in return.
It should be noted that risk aversion is a preference for less risk, it does not imply complete risk
avoidance; it is simply a reference for less risk rather than more risk. Different investors will also
differ in their degrees of risk aversion. Individuals and corporations are risk-averse in the sense that
they are willing to reduce their risk burden" by paying others to assume some of their risks.

For example, they will pay premiums to insurance companies to accept their everyday personal and
business risks. Of course insurance underwriters will only assume the risk for a price. This is another
way of saying that investors must be paid or compensated for assuming more risk.
Shareholders and managers are generally considered to be risk-averse, that is, for an increase in risk
they require a commensurate increase in return. It is common practice in finance to assume that all
investors are risk-averse and that is similarly our assumption throughout this text.

Measuring risk
Before making an investment decision we would certainly wish to have some indication of the level
of risk associated with our investment, so how can we measure or quantify risk?

Standard deviation
The standard deviation, 𝜎, is a statistical measure of the dispersion or deviation of possible outcomes
around an expected or mean value; we use it to measure an asset's or investment's total risk. As we
shall see, total risk consists of two elements, diversifiable i and non-diversifiable risk, but more of this
later.
The standard deviation is defined as the square root of the variance. The variance is defined as the
weighted average of the squared deviations of possible outcomes from the expected value or mean.
The variance and standard deviation are expressed mathematically as follows:
𝑛
Variance, Var (r) = ∑ (𝑟𝑖 − 𝑟̅ )2 × P(𝑟𝑖 )
𝑡=1

And
3
Standard deviation 𝜎𝑟 = � ∑ (𝑟𝑖 − 𝑟̅ )2 × P(𝑟𝑖 )
𝑡=1

58
Where,
Var (r) = the variance of returns
𝜎𝑟 = the standard deviation of returns
𝑟̅ = the expected or mean value of a return
ri = return of the ith outcome
P(r1) = probability of occurrence of the ith outcome
n = number of outcomes considered

The higher the variance and consequently the standard deviation, the greater is the degree of
dispersion and therefore the higher is the asset's or investment's total risk. In cases where all the
outcomes, r1 are knows and their respective probability occurrence, P(ri), are all the same, the
expected return, 𝑟̅ , is calculated as the simple-value of all the outcomes, thus:
3
∑
𝑖=1
r=
𝑛

Given the same conditions (all the outcomes, ri are known and their respective probabilities of
occurrence, P (ri), are all equal), the standard deviation of returns, 𝜎𝑟 is given by:

3 2
∑ (𝑟𝑖 − 𝑟̅ )
𝜎𝑟 = � 𝑖=1
𝑛−1

ILLUSTRATION– Standard deviation as a measure of asset3 risk

Having determined the expected rate of return on a proposed investment the financial manager of
Future Spec Technologies now wishes to calculate the standard deviation as an indicator of the
investment's total risk. The expected returns from the project arc related to the future, performance of
the economy over the period as follows:

Economic scenario Probability of occurrence (p) Rate of return (r)

Strong growth 0.25 15%
Moderate growth 0.50 12%
Low growth 0.25 8%

The expected return E(r) was calculated as:

E(r) = 0.25(15%) + 0.50 (12%) 0.25(8%)
= 11.75%

To find the standard deviation of returns, 𝜎, we first have to determine the variance. The
Variance is found by: (1) subtracting each individual return from rise-mean return (column
4 in the-table below); (2) squaring each difference to remove any negative values, (column. 5 ); and
(3) multiplying each squared deviation by its respective probability

Weighting (column7)
The variance is the sum of the squared deviations times their respective probabilities. The standard
deviation is then the square root of the variance.

Thus the standard deviation of return, 𝜎, is the derived as follows.

(2) – (3) (4) × (4) (5) ×(6)
(1) (2) (3) (4) (5) (6) (7)
I 𝑟𝑖 𝑟̅ 𝑟̅𝑖 − 𝑟̅ (𝑟̅𝑖 − 𝑟̅ )2 P(𝑟𝑖 ) (𝑟̅𝑖 − 𝑟̅ )2 x P(𝑟𝑖 )
1 15% 11.75% 3.25% 10.56% 0.25 2.64

59
 2 12 11.75 0.25 0.06 0.50 0.03
3 8 11.75 -3.75 14.06 0.25 3.53

3
Variance = ∑ (𝑟𝑖 − 𝑟̅ )2 x P(𝑟𝑖 ) = 6.19%
𝑖=1

3
𝜎𝑟 = � ∑ (𝑟𝑖 − 𝑟̅ )2 x P(𝑟𝑖 ) = √6.19 = 2.49%
𝑖=1

Thus the standard deviation for this proposed investment is 2.49%

Comparing alternative investments

In choosing between two alternative investments which have the same expected returns but different
standard deviations, a rational, risk-averse investor would select the investment with the lower
standard deviation (total risk). Conversely, in choosing between two investments which have identical
risk but different expected returns, the investment with the higher return would usually be selected.
For example consider the following choice between two alternative investment opportunities, Asset C
and Asset D:

Asset C Asset D
Expected return, (E) r 10% 12%
Standard deviation, 𝜎 5% 5%

Which investment would you choose?

Both investments have the same degree of risk, but Asset D promises a higher return than Asset
C. Given this information, rational, risk-averse investors would choose Asset D. In the language of
financial management Asset D is said to dominate because all rational investors would select Asset D
in preference to Asset C, if this was their only choice.

Asset pricing
This illustrates an important feature of the way asset pricing, or valuing, works in financial markets. If
two such investment opportunities were to exist simultaneous: a competitive market, all rational
investors would invest their funds in Asset D in preference to Asset C. If, for illustration, we assume
that both assets are company shares trading in the stock market, the competitive activity between
profit-seeking investors would increase the demand for Asset D, which would in turn bid up its price
in market.

An increase in an investment's market price will result in a reduction in its return. For example, if the
price of Asset D in the market was currently £10.00 and it is expected to pay a dividend of sh. 1.20,
the expected return would be: (sh. 1.20/ sh. l0.00) x 100 = 12 %. Should the competitive demand for
Asset D bid its price up to sh. 12.00 the expected return would then be reduced to: (sh. 1.20/ sh.12.00)
× 100 = 10 per cent.

Moreover, investors who owned Asset C would try to sell and invest their cash in Asset D, thus
bidding down the price of Asset C and conversely increasing its return expected return from Asset C
will continue to increase, while that of Asset D will continue to decrease until eventually competition
will force the market for the shares into equilibrium.

At this point both investments will then yield the same expected returns for the same level of risk.
In a competitive financial market there cannot exist simultaneously two investment opportunities
which have equal risk but offer different returns, or alternatively offer equal returns but have different
risks - the continual competitive activity of profit-seeking investors will prevent it.

60
The key point is that in a competitive market rational investors competing with each other for profits
will ensure that similar risk investments offer similar returns.

Also in an efficient market expected return will equal required return, for the very same, competitive
reasons. In an efficient market if an investment's expected return is greater; than its required return
investors will seek to buy it. This will push its price up and its expected return down, until expected
return and required return are in equilibrium.

Conversely should an asset's expected return be less than its required return, then investors will seek
to sell forcing the price down and expected return up, until the two are again equal. Notice to the
nature of the relationship between price and return, there is an inverse, relationship between an
investment's return and its price in the market. When price increases, return will fall and vice versa.

So how can we choose between two alternative investments each of which has different risk/return
characteristics? Is there any way of making a rational comparison between two investments. We can
draw on another statistical measure which is useful in such a case, the coefficient of variation.

Coefficient of variation (CV)

Consider the following investment choice.
Asset X Asset Y
Expected return 10% 20%
Standard deviation 5% 8%

Both assets have different expected rates of return and different standard deviations. Asset Y with the
higher expected return also has the higher level of risk. This is what risk-averse investors would
expect in a competitive market, the higher risk investment carries-a higher risk premium, in the form
of a higher rate of return.
The risk premium is the amount by which the return from a risky investment exceeds that of a
risk-free investment. A risk premium is necessary to entice risk-averse investors to invest. In the
above example is Asset Y therefore the more risky investment?
Expected return and standard deviation are absolute measures, to make a valid comparison between
two such investments we need a relative measure of risk and return. This is where the coefficient of
variation (CV) is helpful. The coefficient of variation is a relative measure, or ratio, of dispersion and
is particularly useful in comparing assets that have different risk-return characteristics.
Basically the higher the CV, the higher the risk. The coefficient of variation is measured as the ratio
of the standard deviation to the expected return:

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝜎𝑟
=
𝐸𝐸𝑥𝑅𝑅𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑟̅

For Assets X and Y the coefficient of variation is calculated as

Asset X Asset Y
Expected return, r 10% 20%
Standard deviation, 𝜎 5% 8%
Coefficient of variation (CV) = 5 ÷10 8 ÷20
= 0.50 0.40

We can see that although Asset Y has the higher absolute risk measure, 𝜎, it has the lower coefficient
of variation, which means that it actually has lower risk per unit of return. The returns from Asset X

61
are relatively more volatile (risky) compared to those from Asset. For a rational, risk-averse investor
the preferred choice in this case' would be Asset Y. Although as always, the final decision rests with
the investor and depends on investor's risk propensity or attitude to risk.

Risk and time

Risk is often viewed as an increasing function of time the further into the future project, the greater
the potential variability of returns. In developing a financial model of an investment's future cash flow
returns, the more distant the cash flows are projects into the future, the more risky they become.
We will now move on to explore what happens to risk and return when we wish to combine assets or
investments together into a portfolio.

PORTFOLIO THEORY
So far we have explored the risk-return relationship in the context of a single asset. Now we are going
to explore the effect on risk and return when an investor is managing a portfolio of assets, rather than
just a single asset. A portfolio is simply a collection for a group of assets, and, as we shall see later,
preferably a diverse group of assets.
Portfolios can consist of, at one extreme, just a few investments held by individuals or, at the extreme,
of hundreds or even thousands of investments managed by the giant1 investment management funds.
Now suppose, 'just for an instant', that you had a Shs.l million windfall on the lottery what would you
do with the money?

Probably you would invest some of your new found wealth. Invest it in what kind of assets?
Perhaps a proportion would go into a bank or building society deposit account(s). You may decide to
invest" in a new house, you may also decide to invest a proportion in a range of shares on the stock
market. Another proportion you may decide to invest in a long-term savings scheme, purchase a work
of art, and so forth.

This diverse group of investments would be your asset or investment portfolio. It is unlikely that you
would invest all your money in a single asset, as this would be the high risk strategy.
Rather, your objective should be to create an efficient portfolio, which is one which will maximize
your return for a certain level of risk, or alternatively minimize your risk for a required level of return.
You would also be concerned with how future changes to your portfolio through; disposals and/or
acquisitions of individual assets would affect the overall level of risk and return on your portfolio.

Thus the risk of any single prospective asset or investment should not be viewed in isolation; it should
be viewed in the context of its impact on the risk and return of the existing portfolio of assets.

The same investment principles apply for financial managers of commercial firms, as they essentially
managing a portfolio of assets in die form of investment projects, financial managers will also be
concerned with achieving an efficient investment portfolio their firms and with assessing how changes
in a firm's portfolio will impact on its levels of risk and return, and ultimately on its share price in the
financial markets. But before discovering how changes to a portfolio will affect its risk and return we
must first be able calculate the risk and return of a portfolio. We will deal with portfolio return first.

Portfolio return
To find the expected return of a portfolio E(rp), or 𝑟̅ p, we can apply what we have learned previously
about the expected return being a weighted average of possible outcomes. However, when dealing
with a portfolio of assets the expected return is calculated as the weighted average of the expected
returns of all the individual assets making up the portfolio and this applies in all cases to portfolios of
all sizes, not just two-asset portfolios.

62
The individual asset weightings are simply the respective proportion of the portfolio invested in each
asset and, as with our previous probability weightings, all the proportionate weightings will sum to
1.0 (or 100 per cent). The, expected return on a portfolio is represented mathematically as follows:
E(rp) = w1r1 + w2r2 + ….. + wnrn

Where
E(rp) = the expected return of the portfolio
w1 = weights of the individual assets (where i=1,2…..n)
r1 = expected return of the individual assets (where i = 1,2,..n)
n = number of assets in the portfolio

For example, if you decided to invest Shs.10,000 of your lottery winnings in a two-asset portfolio in
the following proportions:

Security 1 Security 2
Expected return on security, E(r) 20% 16%
Amount invested Shs.6,000 Shs.4,000
Proportion invested 0.6 0.4

The expected return on this portfolio would be:

E(rp) = 0.6 (20%) + 0.4 (15%)
= 12% + 6%
= 18%

Portfolio risk
As we are about to learn, calculating portfolio risk is a more complex task than calculating portfolio
return, so do not be discouraged if some of the concepts at first seem difficult grasp, with a little
practice they will soon become familiar.

Based on our knowledge of portfolio return it would seem logical to measure the risk of our two
security portfolio in a similar manner, by simply calculating a weighted average of the respective
standard deviations of the two securities, where the weightings are against the portfolio proportions.
For example, assuming the standard deviations of the two securities 1 and 2 above to be 9% and 7%,
respectively, the standard deviation of the portfolio, 𝜎 p, would calculated as:

Security 1 Security 2
Expected return on security, E(r) 20% 16%
Amount invested Shs.6,000 Shs.4,000
Proportion invested 0.6 0.4
Standard deviation of security, 𝜎 9% 7%
Standard deviation of the portfolio, 𝜎 = w1𝜎1+w2𝜎2
= 0.6(9%) + 0.4(7%)
= 5.4% + 2.8%
= 8.2%

A word of warning, however, calculating the portfolio's risk by simply taking a weighted average of
the two standard deviations assumes a very special condition: namely that the two assets are perfectly
positively correlated.

Unfortunately, except for this very special case of perfect positive correlation, portfolio risk is a
measured by simply calculating a weighted average of the standard deviations of all the individual
assets in the portfolio, some more work is required.

63
To hold a portfolio of only two assets, both of which are perfectly positively correlated is not a good
investment strategy, for reasons we are shortly to explain. It is a much bet strategy to diversity and
invests in two assets which are not perfectly positively correlated. Can you think why? Consider this
for a moment before proceeding.

To appreciate why it is better to diversify, that is invest in assets which are less than perfectly
positively correlated, it is necessary first to understand the statistical concepts correlation and
covariance and how they relate to portfolio diversification. Students who are familiar with these
concepts can proceed to the 'Asset Correlation' section without loss of continuity.

CORRELATION, COVARIANCE AND PORTFOLIO DIVERSIFICATION

CORRELATION
Correlation is a statistical technique which is used to measure the relationship between data variables
or data series management correlation is used to measure the direction of the relationship between two
assets or investments. Correlation measures both the degree and direction of the relationship. Broadly
speaking there are three categories or states of correlation as follows:
i. Positive correlation. This is the state which exists when two variables move in the same
direction at the same direction e.g. sales and profits. Under normal business conditions one
would expect sales and profits to be positively correlated. An increase in sales would normally be
expected to produce an increase in profits, and a fall in sales: reduction in profits.
ii. Negative correlation. This state occurs when two variables move in the opposite direction at the
same time that is they are inversely related. Assuming normal; business conditions, one would
expect the price and demand for a company's products be negatively correlated. An increase in
price is likely to produce a decrease in demand and vice versa.
iii. Zero correlation. This applies when there is no relationship between variables, a change in one
variable is independent of a change in the other.
The correlation coefficient
The degree to which two variables, or the returns from two assets, are correlated is measured by
correlation coefficient, p (Greek letter 'rho') which ranges from +1.0 for perfect positive correlation to
-1.0 for perfect correlation. A correlation coefficient of 0 suggests no relationship between variables.
Perfect positive correlation (P = +1.0) exists where two variables move together in exactly the same
direction at the same rime and by the same relative degree of magnitude.

For example, if we have two perfectly correlated variables A and B and variable A increases by 10 per
cent, then β will also increase by a constant amount or proportion of this 10 per cent. The increase for
B could be less than, equal to, or greater than 10 per cent.

The key point is that the relative change between the variables remains constant over time. In the case
of perfect negative correlation (p = -1.0), this occurs when two variables move in exactly opposite
direction at the same time and by the same relative degree of magnitude. Again the proportionate
relationship between the variables must remain constant over time.

A correlation coefficient lying between 0 and +1.0 suggests that there is a generally positive, but not
necessarily a precise predictable, relationship between variables and the closer p is to 0, the weaker
tine positive relationship. Similarly a correlation coefficient lying between 0 and -1.0 suggests a
generally negative, but not necessarily a precise predictable, relationship between variables, and
similarly the closer p is to 0, the weaker the negative relationship.

It is important to appreciate that the correlation coefficient is an expression of an average relationship.

There can be temporary or short-term deviations in the relationship, but correlation is concerned with
the average nature of the relationship over the longer term.

64
Asset correlation
Figure below illustrates three broad types of possible correlation states between of two assets in a
portfolio and indicates .their respective correlation coefficient. Correlation was perfectly positive in
diagram (a), or perfectly negative in all the points would lie in a straight line; the line would slope
upwards to and downwards to the right in (b).

Types of correlation: two-asset portfolios.

Asset C, rate of return

•
Asset A, rate of return

•
• •
•
• •
• •
•
Asset D, rate of return
Asset B, rate of return (b) Negative correlation
(a) Positive correlation P < 0.0
P > 0.0
Asset Y, rate of return

• •
•
• •
• •
• •
•
• • •

Asset X, rate of return

(c) Zero correlation
P = 0.0

The returns on most securities in the stock market arc positively correlated, but not perfectly
positively correlated. This is because the returns on most assets tend to follow the movements in the
general economy. If the financial markets anticipate a good economic outlook then expected share
returns tend to go up, and conversely if the markets take a very gloomy view of future economic
conditions then expected returns tend to go down.

Risk of a two-asset portfolio

We can now return to quantifying the risk of a two-asset portfolio-by using the statistical measures of
variance and standard deviation. We will look first at the variance of return for a two-asset portfolio
which is given by the following formula:
Varp = (w1)2 (𝜎1)2 + (w2)2(𝜎 2)2 + 2(w1wℓ1,2 𝜎1 𝜎2)
Varp = the variation of returns for a two-asset portfolio.
Wi = weights or proportions of the individual portfolio assets (i = 1, 2)
𝜎 = standard deviations of the individual portfolio assets (i = 1, 2)
P12 = correlation coefficient of returns between assets 1 and 2

65
To find the standard deviation for a two-assets portfolio we simply take the square root of the variance
as follows:

𝜎1 = �(𝑤1 )2 (𝜎1 )2 + (𝑤2 )2 (𝜎2 )2 + 2(𝑤1 𝑤2 𝑝12 𝜎1 𝜎2 )

= �𝑣𝑎𝑟𝑅𝑅
If you are new to the topic do not be deterred by these complex-looking formulae: they are not as
formidable as they look.
If you will note that calculating both the variance and standard deviations of a portfolio for more
complex than simply calculating a weighted average of the variances or standard deviations of the two
separate assets. Although both formulae include the weighted average of the variances of the two
separate assets they also incorporate a third term, 2(𝑤1 𝑤2 𝑝12 𝜎1 𝜎2 ), which represents a weighted
measure of the covariance of the asset returns.

COVARIANCE
The variance of a portfolio is described as: the weighted sum of the individual asset variances plus
twice their covariance (COV) and the standard deviation of a portfolio is defined as the square root of
the weighted sum of the individual asset variances plus twice their covariance (COV).
The covariance term in the above equations is represented by (p12)(𝜎1, 𝜎2) and notice that, as for the
standard deviations of the respective assets, it is weighted by the product of the respective proportions
of each asset (w1w2) in the portfolio.

Covariance (COV) is a measure of how two assets move together in terms of the degree and
magnitude of the movement. Remember correlation measures degree and direction s of movement.

The covariance of two securities', Security 1 and Security 2, denoted COV12, is simply the product of
the standard deviations of the two securities 𝜎1, 𝜎2 multiplied by their correlation coefficient (pl2), that
is, (p12)(𝜎1, 𝜎2). The correlation coefficient of the two securities (p12) is equal to the covariance of the
two securities, COV12, divided by the product of their standard deviations (𝜎1, 𝜎2).

The relationship between covariance and correlation can be seen more clearly from the following:

Covariance, COV12, = (p12)(𝜎1, 𝜎2)

Therefore
𝐶𝑂𝑉12
Correlation coefficient (p2) = (𝜎1,𝜎2)

You will note that covariance includes correlation. Covariance is an absolute measure of how two
variables move together and depends on the units in which the variables are measured - this is one of
its difficulties.
For example, if the two variables were (a) the height, and (b) the weight of people the value of
covariance would depend on whether the variables were measured imperially (i.e in feet and stones,
or even inches and pounds), or metrically (i.e. in metres and kilograms, or simply centimetres and
grams).

Correlation, on the other hand, is an improved covariability concept; it is a relative measure of

covariability and is completely independent of the units of measurement either variable. Whereas
covariance can assume any value however, large or correlation can only assume values ranging

66
between -1.0 and +1.0 and this makes more convenient measure to work with; consequently,
covariance is converted into a correlation coefficient.

Calculating the risk of a two-asset portfolio

If we now return to the two-asset portfolio consisting of Security 1 and Security 2, and this time
determine the portfolio risk (variability of returns) 𝜎p, by applying the previous equation and
assuming perfect negative correlation between asset returns.

Security 1 Security 2
Expected return on security, E(r) 20% 16%
Amount invested £6,000 £4,000
Proportion invested 0.6 0.4
Standard deviation of returns 9% 7%
= w1𝜎1+w2𝜎2
= 0.6(9%) + 0.4(7%)
= 5.4% + 2.8%
= 8.2%

𝜎1 = �(𝑤1 )2 (𝜎1 )2 + (𝑤2 )2 (𝜎2 )2 + 2(𝑤1 𝑤2 𝑝12 𝜎1 𝜎2 )

= �(0.6)2 (9%)2 + (0.4)2 (7%)2 + 2[(0.6)(0.4)(−1.0)(9%)(7%)]

= �29.16 + 7.84 + 2(−15.12)

= √37.0 − 30.24

= √6.76

= 2.6%

You will notice that the risk of the two-asset portfolio has reduced significantly with perfect negative
correlation (pl2 = -1.0) compared with our previous calculation of 8.2 per cent, when we assumed that
the two assets were perfectly positively correlated (p!2 -+1.0). For practice you may wish to verify the
original calculation of 𝜎p = 8.2 per cent by applying the above equation and substituting p12 = +1.0.

It is important to remember that portfolio variances and standard deviations are now just simple
weighted averages of the individual asset variances and standard deviations. When correlation is less
than perfectly positive, the risk of the portfolio will be less than a weighted average of the risks of the
individual assets.

Portfolios consisting of more than two assets

When more than two assets are included in a portfolio the expected return is always, a weighted
average of the expected returns of all the individual assets, no matter how many assets comprise the
portfolio.

Unfortunately the process of computing variance and standard deviations for more than two asset
portfolios is not so simple, it becomes an increasingly complex task as more assets are added to the
portfolio. The covariance of each additional asset with each existing asset in the portfolio must be
computed and the number of covariance terms actually increases exponentially.

67
For example, if we were to add a third security, Security 3 to our two security portfolio above we now
need to calculate three pairs of covariance (COV12,.COV13 and COV23) rather than just one, COVl2, as
before. If a fourth security is added you get six covariance combinations and so on.
Fortunately, as we are about to explain, once a portfolio reaches 20 to 30 assets randomly selected, the
scope for increasing risk reduction by including additional assets diminishes dramatically.

Portfolio diversification
We have just seen that if we combine negatively correlated assets the overall variability (i.e. risk) of
portfolio returns can be substantially reduced. This is the principle of diversification, which is,
reducing risk by holding a portfolio of diverse assets. In other words not holding all your investment
eggs in one basket. Although, as we shall discover later, total risk can be significantly reduced by
diversifying asset holdings in a portfolio, it cannot be completely eliminated.

We can examine the effects on the risk of our two-asset portfolio if the correlation between the two
securities is zero:

𝜎1 = �(0.6)2 (9%)2 + (0.4)2 (7%)2 + 2[(0.6)(0.4)(0)(9%)(7%)]

= √29.16 + 7.84 + 0
= 6.1%

This time portfolio risk has been reduced below the weighted average of the two individual securities
when they were perfectly correlated, but you will notice that the reduction in risk is not as substantial
as with perfect negative correlation.

The effects of portfolio weightings

What do you think would happen to the risk of the portfolio if you decided to change the weightings
of your investment in each security? Observe the effect of changing the portfolio weightings to a
50/50 split, still assuming perfect negative correlation:

𝜎1 = �(0.5)2 (9%)2 + (0.5)2 (7%)2 + 2[(0.5)(0.5)(−1.0)(9%)(7%)]

= 1.0%

The risk of the portfolio has reduced as there is now a lesser proportion invested in the more risky
asset, Security 1.

To summarise our correlation findings so far see table below:

Portfolio risk for various two-asset combinations and correlations

Asset combination Correlation coefficient of returns Portfolio risk,

W1 W2 𝝈1 𝝈1
0.8 0.4 + 1.0 8.2%
0.6 0.4 0.0 6.1%
0.6 0.4 -1.0 2.6%
0.5 0.5 -1.0 1.0%
0.4 0.6 -1.0 0.6%

We can now summarise some of the key points about the effect of correlation portfolio risk.

68
1. If there is perfect positive correlation of returns between two assets, portfolio equal to the
weighted average of the standard deviations (individual risks) of assets. No reduction in risk is
achieved.
2. If there is perfect negative correlation of returns between two assets, portfolio may be virtually
eliminated when the optimum combination of assets is achieved.
3. If the correlation of returns between two assets is less than 1.0, portfolio risk can reduced by
diversification. The less the degree of positive correlation, the greater will be the risk reduction
effects. However, combining assets which are negative will reduce risk further.

Remember that the investor or financial manager's goal is to achieve an efficient portfolio, that is one
which yields the highest expected return for a given level of risk (standard deviation), or minimises
risk (standard deviation) for a given level of return.

Diversified firms
A common practical application of diversification is for corporate firms to engage in countercyclical
operations, or businesses. The objective is to counteract cyclic economic, seasonal and market
conditions, by investing in a portfolio of businesses which respond differently to the same, economic
or seasonal circumstances e.g. economic recession or economic boom.

For example, diversification in its most simple form would be a retailing company smoothing out
seasonal fluctuations in sales and earnings by selling different product lines at different times of the
year e.g. in swim suits and sweaters in winter.

A retailing company could take diversification a stage further and develop activities in other business
areas such as the hotel and leisure industry or property development, international diversifications
may be considered, particularly investing in foreign markets which have economic cycles negatively
correlated to the firm's domestic cycle.

ILLUSTRATION
Return.
Calculate the rate of return earned (realized) on each of the following investments over the past year.
Investment Opening value (shs) Closing value (shs) Cash flow (shs.)
1 10,000 11,000 500
2 20,000 19,000 500
3 3,500 3,800 -100
4 123,000 131,000 9,000
5 65,000 63,000 1,100

SOLUTION
The rate of return, rt, earned on an investment is given by:
𝑉𝑡 −𝑉𝑡−1 + 𝐶𝐹𝑡
𝜋𝑡 =
𝑉𝑡−1

Investment
𝑟𝑡
1 [(11,000 – 10,000) + 500]/10,000 15.0%
2 [(19,000 – 20,000) + 500]/20,000 -2.5%
3 [(3,800 – 3,500) - 100]/3,500 5.7%
4 [(131,000 – 123,000) + 900]/123,000 13.8%
5 [(63,000 – 65,000) + 1,100]/55,000 -1.4%

ILLUSTRATION
Risk and return.

69
Calculate the expected return and risk (standard deviation) of the following investment. If the return
on a risk-free investment (e.g. a Treasury bill) is currently 7 per cent should the following investment
be undertaken?

Return Probability
5% 0.10
6% 0.20
7% 0.40
8% 0.30

SOLUTION
a) Expected return, E(r)
Return, r1 Probability, P(r1) r1 x P (r1)
5% 0.10 0.5
6% 0.20 1.2
7% 0.40 2.8
8% 0.30 2.4
E(r) = 6.9%

b) Standard deviation of return, 𝜎𝑟

(2) – (3) (4) × (4) (5) ×(6)
(1) (2) (3) (4) (5) (6) (7)
I 𝑟̅𝑖 𝑟̅ 𝑟̅𝑖 − 𝑟̅ (𝑟̅𝑖 − 𝑟̅ )2 P(𝑟𝑖 ) (𝑟̅𝑖 − 𝑟̅ )2 x P(𝑟𝑖 )
1 5% 6.9% 1.9% 3.61% 0.10 0.36
2 6 6.9 0.9 0.81 0.20 0.16
3 7 6.9 -0.1 0.01 0.40 0.00
4 8 6.9 -1.1 1.21 0.30 0.36

3
Varr = ∑ (𝑟̅𝑖 − 𝑟̅ )2 × P(𝑟𝑖 ) = 0.68%
𝑖=1

3
𝜎r = � ∑ (𝑟̅𝑖 − 𝑟̅ )2 × P(𝑟𝑖 ) = √0.88% = 0.94%
𝑖=1

The proposed investment has an expected return of 6.9 per cent and a standard deviation 0.94 per
cent. Compared with the return on the risk-free investment of 7 per cent, this investment would not be
worthwhile. The expected return is marginally lower at 6.9 per cent and it is a risky investment.

THE CAPITAL ASSET PRICING MODEL (CAPM)

Overview
We continue our theme of exploring the nature of the risk-return relationship in modern financial
management. We shall see how the risk-return relationship is used in the financial markets to
determine the price or value of financial assets. In an efficient market the value and price of an asset
will be equal.

70
This task of asset pricing, or asset valuing, is central to the functioning of financial markets and it is
clearly of fundamental importance for the financial manager to understand the principles and
processes which lie behind it.

For example, when raising long-term finance such as through equity or debt issues, the asset pricing
models enable the financial manager to understand how these securities will be priced in the markets
also how to choose between alternative sources of corporate financing. In this connection we will
study one of the most influential concepts in recent financial management history, the asset pricing
model (CAPM)

The Investor's Risk-Adjusted Required Rate of Return

Up until now in valuing investment cash flows we have simply accepted discount rates as a given
figure. We have described the discount rate as the investor's opportunity cost of capital by which we
mean that it represents the minimum rate of return the investor requires an investment to cam for it to
be considered worthwhile. The opportunity cost capital reflects the rate of return an investor can earn
elsewhere on an investment risk.

If a proposed investment is expected to yield less than the return the investor requires from
investments of equal risk, money will not be invested and the investor- will seek other alternative
investments. In such circumstances the firm will find it very difficult to attract funding for its
investment projects.

The rate at which expected cash flow returns are discounted represents the investor’s risk-adjusted
required rate of return. This is the rate of return required by an investor' to compensate for a given
investment's level of risk. In this chapter we will explore the determination of risk-adjusted required
rates of return, that is, discount rate.

The Capital Asset Pricing Model (CAPM)

In the chronological development of modern financial management, portfolio theory came first with
Markowitz in 1952. It was not until 1964 that William Sharper derived the Capital Asset Pricing
Model (CAPM) based on Markowitz's portfolio theory. For example, a key assumption of the CAPM
is that investors hold highly diversified portfolios and thus can eliminate a significant proportion of
total risk.

The CAPM was a breakthrough in modern finance because for the first time a model became available
which enabled academics, financiers and investors to link the risk and return for an asset together, and
which explained the underlying mechanism of asset pricing in capital markets.

For anyone making an investment decision and trying to determine what return they should require for
assuming a given level of risk the CAPM seemed to have come up with the answer. The capital asset
pricing model (CAPM) demonstrated how risk and return could be linked together and specified the
nature of the risk-return relationship for any security or asset. Impact of the capital asset pricing
model (CAPM) has been immense and it is one of the most influential financial concepts in recent
financial-management history. It is basic theory which links together relevant risk and expected return
for any security, "though Sharpe originally developed the CAPM in the context of pricing ordinary
shares in the stock market, the model has been subsequently extended and applied to evaluate the
decisions by firms to invest-in corporate assets. Indeed, one way of viewing the firm is as a 'portfolio
of tangible assets and investment projects.

We know that all financial decisions contain a risk element and a return element and that there is
always a trade-off between these two elements: the higher the perceived risk, the higher will be the

71
required return and vice versa. The CAPM was the first method of formally expressing this risk-return
relationship: it brought together systematic risk for all assets.
However, before analysing the basic constructs of the CAPM we need to understand little more about
the various types of investment risk.

Types of Investment Risk

We have seen how the total risk (as represented by the standard deviation, 𝜎) of a two-security
portfolio can be significantly reduced by combining securities whose returns are negatively correlated,
or at least have a low positive correlation - the principle of diversification.

The principle of diversification can be extended to larger portfolios of securities. The greater the
volume of securities which are combined in a portfolio, the greater will be the reduction in risk, up to
a point, providing that the securities are not closely correlated.

Unfortunately, as we shall soon explain, it is not possible to eliminate all portfolio risk through
diversification, no matter how many securities arc contained in a portfolio. Even the large financial
institutions and investment funds, which may have hundreds or possibly even thousands of securities
to manage, cannot eliminate total risk. However, "managing such large portfolios becomes
progressively more complex. We now know that as the number of securities in a portfolio increases
there is a geometric increase in the number of calculations required to determine portfolio risk -
remember that correlation and covariance must be calculated for each pair of assets.

According to the CAPM, the total risk of a security or portfolio of securities can be split into two
specific types, systematic risk and unsystematic risk. This is sometimes referred to as risk partitioning,
as follows:
Total risk = Systematic risk + Unsystematic risk

Systematic (or market) risk cannot be diversified away: it is the risk which arises from market
factors and is also frequently referred to as undiversifiable risk. It is due to factors which
systematically impact on most firms, such as general or macroeconomic conditions (e.g. balance of
payments, inflation and interest rates). It may help you remember which it type it is if you think of
systematic risk as arising from risk factors associated with the general economic and financial system.

Unsystematic (or specific) risk can be diversified away by creating a large enough portfolio of
securities: it is also often called diversifiable risk or company-unique risk. It is the risk which relates,
or is unique, to a particular firm. Factors such as winning a new contract, an industrial dispute, or the
discovery of a new technology or product would contribute to unsystematic risk.

The relationship between total portfolio risk, 𝜎, and portfolio size can be shown diagrammatically as
in below. Notice that total risk diminishes as the number of assets or securities in the portfolio
increases, but also observe that unsystematic risk disappears completely and that systematic risk
remains unaffected by portfolio size.
Portfolio risk op

Total risk

Unsystematic
risk
Systematic risk

1 5 10 15 20
Number of securities in portfolio

72
There is research which indicates that a portfolio consisting of 15 to 20 securities chosen at random, is
sufficient to produce most of the risk reduction benefits of diversification (Wagner and Lau 1971;
Klemosky and Martin 1975). Thus only a very small fraction of all the infinitely possible investment
portfolios available in the market will be necessary to construct an efficient portfolio. Understanding
these two types of risk is fundamental to an understanding of the CAPM.

The CAPM Model

We have previously described the CAPM as a method of expressing the risk-return relationship for a
security or portfolio of securities: it brings together systematic (undiversifiable) risk and return. After
all, for any rational, risk-averse investor it is, only systematic risk which is relevant, because if the
investor creates a sufficiently portfolio of securities, unsystematic or company-specific risk can be
virtually eliminated through diversification.
It is therefore the measurement of systematic risk which is of primary importance for" rational
investors in identifying those securities which possess the most desired risk-return characteristics. It is
the measurement of systematic risk which becomes critical in the CAPM because the model relies on
the assumption that investors will only hold well diversified portfolios, so only systematic risk
matters.

The CAPM is quite a complex concept so if you find it difficult to grasp at first do not become
disillusioned, stick with it.

For reasons of presentation and ease of understanding we will approach our study of the CAPM by
breaking it down into five key components as follows:
1. The beta coefficient, (𝛽𝛽 );
2. The CAPM equation;
3. The CAPM graph - the security market line (SML);
4. Shifts in the SML - inflationary expectations and risk aversion;
5. Comments and criticisms of the CAPM.
We will examine each component in turn, beginning with the key concept of beta, 𝛽𝛽 .

The beta coefficient (𝜷)

Recall that the standard deviation, 𝜎, is used to measure an asset or share's total risk, while the beta
coefficient, 𝛽𝛽 , in contrast is used to measure only part of a share or portfolio risk, namely the part that
cannot be reduced by diversification, that is the systematic or market risk of an individual share or
portfolio of shares.

Systematic or market risk can be further subdivided into business risk and financial risk.
Business risk arises from the nature of the firm's business environment and the particular
characteristic of the type of business or industry in which it operates. For example the competitive
structure of the industry, its sensitivity to changes in macroeconomic variances such as interest, rates
and inflation and the stability of industrial relations all combine to determine a firm's business risk.
The level of business risk in some industries, for example catering and construction, is higher than in
others and is a variable which lies largely outside management's control.

Financial risk in contrast represents the risk which arises from a firm’s level of gearing 'or leverage
and is a variable, which is directly under management’s control. Basically the ore debt a firm has, the
greater the level of financial risk (that is, the risk of the firm not being able to meet its financial
obligations). As the level of debt increases, the greater will be the firm's burden of interest and
principal payments and the greater the return the equity shareholders require to compensate for the
additional financial risk.

73
Beta is a measure of the sensitivity or volatility of an individual security's or portfolio's [mum (capital
gains plus dividends) in relation to changes in the overall capital or stock market return. In the capital
asset pricing model, market return is the return (capital gains plus dividends) from the market
portfolio.
The market portfolio is a theoretical concept which, in theory, should include every conceivable
security traded in the capital market in proportion to its market value. It may help to view the market
portfolio as a giant weighted average of the market values of all the possible investment assets
available in the capital market.

Returning to the beta coefficient, 𝜷, it is important to note that beta can apply in the context of an
individual share or a portfolio of shares. However to avoid undue repetition k will for the time being
confine our discussion of beta to the context of an individual pet or share.

The beta coefficient is like a share's market sensitivity indicator. For example, if the average rate of
return on the stock market rises or falls by 10 per cent, how does the rate return on an individual share
respond? If the share's rate of return similarly rises or falls by 10 per cent in exact harmony with the
market, then we say that the share has a beta efficient of 1.0; it is just as risky as the 'average' share in
the market.
Should the rate of return on the share rise or fall by only 5 per cent in response to a corresponding 10
per cent rise or fall in the market, then its beta is 0.5:
On the other hand, the share's rate of return changed by 20 per cent in response to a matching 10 per
cent change in the market return, its beta would be 2.0; the share would be twice as risky as the
market average.
Shares or securities can be broadly classified as aggressive, average or defensive according to their
betas. Shares with a beta 1.0 are described as aggressive; they are risky than the market average,
although they will tend to perform well in a rising oil-market. Consequently investors would require
a- rate of return from the share which greater than the market average.

Shares with a beta = 1.0 are described as average or neutral as their rate of return move in exact
harmony with movements in the stock market average return; they are of average risk and yield
average returns. In contrast, shares with a beta < 1.0 are classed as defensive. A defensive share does
not perform well in a bull market but conversely it does not much as the average share in a falling or
bear market.

BETA DETERMINATION
A share's beta is determined from the historical values of the share's returns relative to market returns.
It is important to appreciate therefore that beta is a relative, not an absolute, measure of risk. As each
individual beta is derived from a common base, that is, the return on the market portfolio or a suitable
stock index substitute, then beta is a standardised risk measure, i.e. this makes the beta of one share
directly comparable with the beta of another.

One way of determining the beta for a share is to plot on a graph the historic (ex post) relationship
between the movement in the share's returns and the market (or stock index) returns over a defined
period of time. For example, if a stock market analyst considers that the share's actual performance
over' the past five years also gives a fair indication of the share's likely future performance, and then
deriving its beta is a matter of:

1. Computing both the average individual share's return and the average market return (utilising an
appropriate stock market index) for each month of the five-year period. Sometimes betas are also
computed using daily averages.

74
2. Plotting on a graph the coordinates for each monthly set of returns. Conventionally the market's or
index's returns are plotted on the horizontal (x) axis and the individual-share's returns on the
vertical (y) axis. The results will probably appear in the form of a scatter gram and a statistical
technique called regression analysis can then be used to derive the regression or characteristic line
for the data.
The characteristic line is the straight line that best represents or fits the relationship between the
share's return from the market over the period.

Characteristic line
• •
• • •
• 𝛽𝛽 = slope of line
• • •
• •
• •
• •
• •
0
Market return

Beta is the slope of this characteristic line for the share as illustrated in the figure above. Shares with
high betas will have steeper sloped characteristic lines than those with low betas, and the steeper the
slope of the line the more volatile (risky) are the returns from the share in relation to the returns from
the market.

The figure below illustrates the respective characteristic lines for two different risk securities, A and
B. Security A has a beta of 1.5 and is represented by the steeper sloped line,, .compared with Security
B which has a beta of 0.7. Security A's higher beta suggests that its return is more sensitive to changes
in the market return: it is thus a more risky investment than Security B.

Characteristic lines for two different risk securities, A and B

Characteristic lines
50-

40-
Beta = 1.5 = A
30-
20-
Beta = 0.7 = B
10-
0
-10 -5 5 10 15 20 25 30
-10-
-20-
Market return (%)
Security A
Security B

Alternative derivation of beta

Using past data on individual share and market returns over a sufficiently lengthy period, say, the
most recent four to five years, betas can also be calculated statistically. For sample the beta ( β) of a
share (S) is equal to the covariance between the share's returns and the market's returns (COVsm)

75
divided by the variance of the market's returns (Varm) which in turn is the standard deviation of the
market returns squared, that is;-

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝑠𝑚𝑚 𝐶𝑂𝑉𝑠𝑚𝑚 𝐶𝑂𝑉𝑠𝑚𝑚

Beta, 𝛽𝛽𝑠 = = ==
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝑚𝑚 𝑉𝑎𝑟𝑚𝑚 𝜎 2 𝑚𝑚

The returns on a suitable stock market index can be used as a proxy for the returns. For example,
substituting the FTSE 100 Share Index, the beta (β) of a share would be calculated as:-

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝐹𝑇𝑆𝐸100 𝐶𝑂𝑉𝐹𝑇𝑆𝐸100 𝐶𝑂𝑉𝐹𝑇𝑆𝐸100

Beta, 𝛽𝛽𝑠 = = ==
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒𝐹𝑇𝑆𝐸100 𝑉𝑎𝑟𝐹𝑇𝑆𝐸100 𝜎 2 𝐹𝑇𝑆𝐸100

As the covariance of each individual share is divided by a common denominator the variance of the
market (Varm) or a suitable surrogate market index, we end up standardised measure of risk, that is,
the share's beta.

Being a standardised measure we are able to directly compare the beta of one share with the beta of
another.

Portfolio betas
We have learned that a share's beta represents only part of a share's risk, namely element of systematic
or market risk, which is the risk element that cannot be diversified away.
When it comes to including a share in a portfolio we are only concerned with-impact of that share's
market risk on the portfolio risk. In a portfolio context market is also the only relevant risk and beta is
its best measure.
The portfolio beta measures the portfolio's responsiveness to macroeconomic variables such as
inflation and interest rates.
To determine the systematic risk for a portfolio, that is the portfolio beta, we shaft] calculate a
weighted average of the betas of the individual securities making up the portfolio, as follows:
Portfolio beta, 𝛽𝛽 p = w1, 𝛽𝛽 1 + w2P2 + w3P3 ... + wnpn
where,
𝛽𝛽 p = the portfolio beta (i.e. risk of the portfolio relative to the market)
w1, = portfolio weightings of the individual securities (where i = 1, 2,... n)
𝛽𝛽 1 = beta of the individual security (where i = 1, 2, ... n)
n = number of securities in the portfolio

ILLUSTRATION – Portfolio beta

Set out below is the relevant data for a four security portfolio.

Security Beta, 𝜷1 Weighting, w1

1 2.0 0.10
2 1.5 0.20
3 0.8 0.30
4 0.5 0.40
1.00

The portfolio beta would be computed as:

𝛽𝛽 p = 2.0(0.10) + 1.5(0.20) + 0.8 (0.30) + 0.5(0.40)

= 0.94

76
The beta of this portfolio is very close to the market beta of 1.0. Remember that altering the portfolio
weightings or the proportions invested in each security would alter the portfolio’s risk.
Clearly the systematic risk (beta) of the portfolio will depend on the betas of the individual securities
making up the portfolio. If all the individual securities in the portfolio have high betas then the
portfolio beta for an individual security. Being aware of this allows investors to create portfolios that
match their risk-return preferences.
For example, investment fund managers use this knowledge to create different port-folios with
different risk-return characteristics to meet their clients' differing investment needs.

Betas - a cautionary note

We will end this section on betas with a few cautionary notes. It is Important to appreciate that
deriving betas is not an exact science; there are some important limitations in both the determination
and in the application of betas. We can summarise these cautionary notes about betas as follows,
essentially they:
• rely extensively on historic data;
• can and do change over time;
• have been seriously challenged as a useful risk measure;
• are essentially average measures; and
• are available from different sources.

We have seen for example that betas have been derived using historical data, and as such, they are
primarily indicators of past relationships between a security's return and the average market return.
Past relationships may or may not be relevant to future relationships, therefore to use beta as a
predictor of future relationships is clearly problematic.

Betas can and do change over time as most companies' risk-return character change over time as a
result of, for example, changes in products, markets, technology financing.
Beta has in recent years has been seriously challenged as a useful measure of risk. Eugene Fama and
Kenneth French both from the University of Chicago (Fama French 1992). Based on their research
these two authors have essentially concluded that beta is an inappropriate measure of risk. Their
research failed to find any significantly relationship between historic betas and historic returns on
over 2,000 shares over the period 1963 to 1990. However, the jury is still out on this and their
research findings are still being rigorously debated in the academic community.
Beta is an expression of the average relationship between a share's returns and the return from the
market. Averages are simply that, averages, (like the average family size). There are not hard and fast
rules so there will be variations and no share will maintain a constant relationship with ‘the market’
over time.

The CAPM equation

We will now examine the actual equation for the capital asset price model. It is one of the most
famous equations in financial management. The CAPM equation links together risk and the required
return for a share. It shows, for example, that the return a rational investor would require on a
particular share, R(r), is a function of the share’s market or systematic risk (beta), 𝛽𝛽 , and risk
premium to compensate for investing in the risky market. Thus the higher the risk, the higher the
return the investor will require and vice versa.
Simply stated, the underlying precept of the CAPM is that the expected return on a security is
composed of two elements as follows:

Expected return, E(r) = a risk free interest rate + a risk premium

Using the capital asset pricing model (CAPM) this relationship is expressed more formally as:

77
E(r) = Rf + 𝛽𝛽 1(ERm – Rf)

Where,
E(r) = required return on asset/share i
Rf = risk free rate of return
𝛽𝛽 1 = beta coefficient for asset/share i
ERm = expected market return, that is the return expected on the market portfolio of shares.

As we have seen above, the CAPM equation can be split into two segments:
1. the risk-free rate of return, Rf; and
2. the risk premium, 𝛽𝛽 1(ERm – Rf)

We will discuss the risk-free rate of return, Rf first.

The risk-free rate of return, Rf

The risk-free rate of return, Rf is the rate of return that can be earned on a security which has zero risk;
its beta equals 0 and the return is certain. Why should a security offer a return if there is no risk? In
short, the risk-free rate of return is the rates that must be offered compensate the investor for deferring
consumption; it reflects the time value of money.

Although no security or investment can be considered absolutely risk-free, securities issued by some
governments, such as UK and US government bonds or 3-months. Treasury bills (Tbs), are for all
practical purposes risk-free investments. In this case the risk of default, that either the US or UK
government will not be able to redeem the bonds or bills when they fall due for redemption in 90
days’ time

Treasury bills are about as close as one can get to a risk-free investment because their maturity is very
short term, they are easily liquidated (i.e. cashed-in without significant loss in value) and they are
government backed. The current rate of return or yield on Treasury bills is quoted daily in the
financial media.

From a practical point of view there are other investments which could be considered virtually risk-
free. These are short-term, easily liquidated deposit accounts held with the major banks and building
societies. This is a more universally held with the investment than Treasury bills. However, the
convention in financial management is to use Treasury bill rates as the risk-free rate benchmark.
Adding a risk-free security to an investment portfolio will reduce an investor’s risk and the proportion
of portfolio will reduce an investment held in the form of risk-free securities on the investor's attitude
to risk and the returns expected from securities.

The risk premium, P,(ERm -R,)

A market risk premium is the second key component of the CAPM equation. This market risk
premium is the difference between the expected market return, rate of return, ERm. The market risk
premium is converted to a risk individual share by multiplying it by the share's beta, 𝛽𝛽1. The risk
premium therefore for an individual share is a function of the individual share's beta, 𝛽𝛽1, and the risk
premium for the market.

The market risk premium represents the additional return, over and above the risk which the investor
expects for assuming the risk comparable with risky market portfolio of shares.
The increase in required return is proportional to the amount of risk the amount of risk the investor is
willing to assume.

78
Unlike the risk-free return which is known with certainty, it should be appreciated that in relation to
the market return we are dealing with the notion of expected return and consequently the market risk
premium is an expected risk premium. Investing in the market is risky and there are no guaranteed
returns. Actual returns may turn out to be greater, equal to, or less than those which the investor
initially requires.

Required return may also differ from expected return. Before investing, an investor can use available
data about a security to calculate its expected return, E(r), however this may not match the investor's
required return, R(r), when calculated using the capital asset pricing model equation.

For example, in relation to the share of a quoted company, information is available on share price, the
expected dividend, and so forth. From this an expected return can be calculated. By using the CAPM
equation, the investor can then compare the expected return E(r) with the required return R(r): if E(r)
> R(r) then the investment would seem worthwhile. Conversely, if E(r) < R(r) then this would not be a
good investment.

The illustration below demonstrates how the CAPM equation can be utilised to calculate the expected
rate of return for an investor.

ILLUSTRATION
Using CAPM to calculate the expected rate of return
J Kutuny is considering a number of investment opportunities. Assuming that the risk-free rate is
currently 5 per cent and the expected return from the market is 12 percent calculate, using the CAPM,
the rates of return that J Kutuny should expect each investment to earn.

Security Beta
A 0.9
B 1.3
C 0.6
D 1.5

The expected return on each security is computed as follows:

Security Ri + Bi(ERm – Ri) = E(r)
A 5 + 0.9(13-5) = 11.3%
B 5 + 1.3(12-5) = 14.1%
C 5 + 0.6(12-5) = 9.2%
D 5 + 1.5(12-5) = 15.5%
Negative betas
In theory betas can be negative, implying that a share’s expected return will go up as the market goes
down and vice versa, but in practice negative betas are extremely rare. If the share’s beta is negative,
the risk premium for the share will also be negative and the expected return will be less than the risk-
free rate.

The effect of a negative beta stock can be best explained with an example. If we assume that a share
has a beta of -0.33, the risk-free rate is 7 per cent, the market return is 16 per cent, giving a market
risk premium of 9 per cent, then the investor’s required return would be:
R(r) = 7% + -0.33 (16% - 7%) = 4%

The CAPM graph – the security market line (SML)

Having now had some practice in using the CAPM to calculate expected returns you will have noticed
that the CAPM equation is in fact a straight line equation. Conventionally the equation for a straight
line is usually given as: y = ax + c.

79
When the CAPM equation is shown in graph form, the resultant straight line is referred to as the
security market line (SML). It is the line which exhibits the positive relationship (correlation) between
the systematic risk of a security and its expected return.
On the security market line (SML) the risk-free rate, Rf is a constant and represents the vertical
intercept, i.e. the point where the SML crosses the vertical axis, it is equivalent to the constant c in the
straight line equation above.

The coordinate x represents the systematic or market risk of the share as measured by its beta, 𝛽𝛽, and
coordinate y represents the expected market return. Observe that the slope or gradient of the line, a, is
represented by the market risk premium (ERm – Rf), not beta and indicates the level of risk aversion
in the economy.
The SML represents the level of return expected in the market for each level of the share’s beta
(market risk).

Interpreting the security market line (SML)

A few comments about the SML will facilitate its interpretation. First, notice that the beta associated
with the risk-free security is 0, reflecting the security’s freedom from risk and its immunity from
changes in the market return.
Second, point M on the SML represents the market portfolio. The return on the market portfolio (i.e.
the average return from a securities on the entire market or a proxy index) is given by ERm and its
corresponding level of risk is shown by 𝛽𝛽m, where 𝛽𝛽 = 1.0

Expected return, E(r) %

SML

ERM M •
Market risk premium (ERM – Rf)

Risk-free rate (Rf)

𝛽𝛽m
0 0.5 1.0 1.5 2.0

Market risk 𝛽𝛽

The beta for the market portfolio must be 1.0 because the market's correlation with itself is 1.0; thus a
security with a beta of 1.0 has risk equal to that of the market.
Third, the difference between ERm and Rf (ERm - Rf) is the market risk premium, thus the risk
premium for an individual asset, i, equals the market risk premium multiplied by the share's beta,
𝛽𝛽,(ERm - Rf).

As it is a straight line the slope or gradient, a, of the SML is given by ∆y/∆x, which substituting
equals (ERm - Rf)/(1.0 - 0.0) giving ERm - Rf. Thus the greater the market risk premium, the steeper
the SML slope and thus the greater the rate of return required by investors (as we shall see later). For
example, supposing the expected return on the market ERm is 12 per cent and the risk-free rate, Rf is 7
per cent, the slope of the SML would be calculated as:

∆y/∆x = (ERm-Rf)/(1.0-0.0) = (12 - 7)/(1.0 - 0.0)

= ERm-Rf = 12-7
=5

80
In this instance, the expected rate of return would increase by 5 per cent for each 1.0 increase in beta.
Thus assuming beta initially equals 0.5 and then increases to 1.5 the change in the expected return
would be an increase of 5 per cent, thus:
1) E(r) = 7% + 0.5 (12-7) = 9.5%
2) E(r) = 7% + 1.5(12-7) = 14.5%

To construct the SML the only data needed are the risk-free rate of return and the expected return on
the market portfolio.

Market equilibrium
Earlier we drew a distinction between the expected return E(r) and the required return R(r) on a share
and noted that it is possible for the two to differ.
Given an individual share's risk characteristics, the CAPM specifics what the return on t share should
be, that is, its required return. In market equilibrium (when supply equal demand and prices remain
stable) expected return and required return for the share would be equal, K(r) s R(r) and its price
would be stable. However, consider the respective positions of the two shares A and B in relation to
the SML in the figure below.

Expected return, E(r) %

Share A SML

ERM M •
Share B

Risk-free rate (Rf)

𝛽𝛽m
0 0.5 1.0 1.5 2.0

Market risk 𝛽𝛽
Share A has a beta of between 1.0 and 1.5, yet, as it lies above the SML at this point it is expected to
offer a return greater than that required by the market for that level of risk its expected return is
greater than its required return as specified by the CAPM. Alternatively, Share B has a beta of
between 1.5 and 2.0 but is expected to provide a return below that required by the market for that
corresponding level of risk.

An astute rational investor will soon realise that both assets are mispriced: Share A is undervalued; it
is a bargain as it offers a higher return for the given level of risk. In Share B is overvalued, it offers to
provide a return lower than that required by the market for its level of risk. What do you think may
happen next?

In an efficient market these anomalies will not obtain for very long. Rational profit investors will seek
to buy Share A driving its price up and its return down remember inverse relationship between price
and return) until it gravitates to the SML.

Conversely, with Share B rational investors will wish to sell but may find it dime the current price as
it is overvalued. They will only find buyers when the price drops' increasing return.
This share will also gravitate towards the SML where its expected return equals its required return.
You may wish to think of the SML, via an efficient market, as acting like the force of gravity which1
pulls aberrant shares back equilibrium.

81
 Remember that the SML is based on the CAPM, which as we shall sec is in turn based on a number of
assumptions, many of them unrealistic. There are also practical difficulties in specifying beta and the
market portfolio.

The CAPM, and therefore its graph the SML, like any other model, is only as good as the quality of
the data on which it is based. If poor quality or erroneous data is used, in constructing the SML then
what appear to be aberrant stocks may only be a mirage. In short, the SML may be badly constructed.

Shifts in the security market line (SML)

We noted above that the slope of the SML is given by the market risk premium (ERm - Rf), not beta
and that it reflects the general level of risk aversion in the economy. The security market line is not
static; it is an expression or snapshot of the risk-return relationship at a particular point in time. In
dynamic capital markets, which are constantly responding to new information, risk-return factors
change continually, thus the SML and shift over time. Here we will explore the impact of two specific
major changes, effects on SML - (1) inflation and (2) risk aversion.

The inflation shift

The risk-free rate of return is composed of several elements: a real interest rate, a liquidity or maturity
premium and an inflation premium (IP). However, as we are primarily concerned with understanding
inflation effects, we will simplify matters by assuming that liquidity premium is subsumed within the
real interest rate, which we will denote r* thus risk-free interest rate is made up as follows:
Rt = r* + IP

When expectations in the financial markets about the future rate of inflation change, is will essentially
move the risk-free rate, Rp up or down depending on the market's Expectations about the direction of
inflation. As the risk-free rate the base line ingredient for all rates of return, any change in the risk-
free rate as a result of changes in inflation expectations will be applied to all required rates of return as
implied by the CAPM.

For example, suppose the risk-free rate is currently 7 per cent and this is made up of a real underlying
interest rate, r* of 3 per cent and an inflation premium, IP, of 4 per cent, the financial markets expect
inflation to rise to 6 per cent (perhaps as a result of creased consumer spending or changes in
government policy), this will cause the risk-free rate to correspondingly increase to 9 per cent [r*
(3%) + IP (6%)]

Under CAPM this will result in a parallel shift upwards of 2 per cent in the SML owing that an
increase in the risk-free rate, Rf, affects the rate of return on all risky assets equally.

The effect of an inflationary increase on the SML is illustrated below. Notice that the market risk
premium itself remains unchanged, that is (ERm1-Rm) = (ERm2 - R2) = 2 per cent. The original risk-free
rate, Rfl, was 7 per cent and the original market return Rm-l) was 9 per cent (it was originally located
at the point where the new risk-free rate, R12 , is now positioned) yielding an expected market risk
premium of 2 per cent. The new market risk premium (ERm2 – R12) = (11% - 9%) = 2 per cent, the
same as before.
Expected return, E(r) % SML2

SML1
ERM2, 11% •
M2
ERM1, 9%
Now risk-free rate (Rf2) 9% M1 Increase in expected inflation, ∆IP = 2%
Original risk-free rate (Rf1) 7%

𝛽𝛽m
0 0.5 1.0 1.5 2.0
82 Market risk 𝛽𝛽
The risk aversion shift
As we have explained, the slope of the SML represents the market risk premium the steeper the slope,
the greater the risk premium in the market. This reflects the extent which investors in the market are
risk-averse, that is for an increase in risk they require commensurate increase in return as indicated by
the upward slope of the SML. If market risk did not exist there would be no risk premium and the
SML would be a flat extending from the Rf vertical intersection.

However, in reality market risk does exist and it is a variable which can change primarily as a result
of economic, political and social factors such as general strikes, widespread civil unrest, stock market
crashes, wars or greater political or economic uncertainty and instability.
Should market risk increase, for example because investors perceive greater economic uncertainty or
instability- ahead, then this will be reflected in a rise in the slope of; SML, Note that in this instance
the risk-free rate remains unchanged, it is the risk premium which now changes. Observe also how the
increase in the risk premium become more prominent as the riskiness of the security (its 𝛽𝛽) increases.

The increase in the risk premium is significantly greater for a security with a beta of 1.5 (an
aggressive share) than it is in relation to a security with a beta of 0.5 (a defensive share). The effect of
an increase in risk aversion on the SML is illustrated in Figure below.

SML2
Expected return, E(r) %

SML1
ERM2, 12% • M2

ERM1, 9%
M1 Additional market risk premium (ERm2 – ERm)

Risk-free rate (Rf1) 7%

𝛽𝛽m
0 0.5 1.0 1.5 2.0

Market risk 𝛽𝛽

If we adopt the same figures as before, that is Rf1, equals 7 per cent and ERm1 equals 9 per cent the
original market risk premium was ERm1 – Rf1 = 9% - 7% = 2%. If we assume that ERm2, has now
moved to 12 per cent, the new market risk premium is ERm2- Rf2, = 12% - 7% = 5%. Thus the market
risk premium has increased by an additional 3 per cent; Em2 – ERm1 = 12% - 9% = 3%: the risk-free
rate remains unaffected.

UNDERLYING ASSUMPTIONS AND LIMITATIONS OF THE CAPM

83
The CAPM is a model, and like any model it is mere representation of reality. All models(business,
economic and financial,etc) are constructed from a set of underlying assumptions about real world;
they inevitably have their limitations. The CAPM is built on the following set of assumptions and
limitations.

1. Historical data. CAPM is a future-oriented model yet it essentially relies on historic data predict
future returns. Betas, for example, are calculated using historic data; consequently they may or
may not be appropriate predictors of the variability or risk of future returns- Thus the CAPM is
not a deterministic model, the required returns suggested by the model can only be viewed as
approximations.
2. Investor expectations and judgements. The model includes the expectations and subjective
judgements of investors about future asset or security returns and these are very difficult to
quantify. In addition the model also assumes that investors expectations and judgements are'
homogeneous, i.e. identical. If investors have heterogeneous (i.e. varied) expectations about
future returns they will essentially have different SMLs, rather than a common SML as implied by
the model.
3. A perfect capital market. CAPM assumes an efficient or perfect capital market, An efficient
capital market is one where all securities and assets are always correctly priced and where it is not
possible to outperform the market consistently except by luck . An efficient capital market implies
that there are many small investors (all are price-takers), all of whom are rational and risk-averse;
they each possess the same information and the same future expectations about securities. It also
assumes that in the financial markets there are no transaction costs, no taxes and no limitations on
investment.
4. Investors fully diversified. The CAPM also assumes that investors are fully diversified. In
practice many investors, particularly small investors, do not hold highly diversified asset
portfolios.
5. Practical data measurement problems. There are also practical problems associated with the
model such as difficulties with specifying the risk-free rate, measuring beta and measuring the
market risk premium.
6. One-period time horizon. CAPM assumes investors adopt a one-period time horizon. In practice
investors are likely to have differing time horizons and again this would imply varying SMLs.
7. Single factor model. CAPM is a single factor model: it relies on-the-market portfolio to explain
security returns. The rate of return on a security is a function of the security's beta times a risk
premium, that is, β(ERM-R4). Both beta and the risk premium are determined in relation to the
market portfolio. Recall that each security's beta (risk factor) is derived; by linear regression,
plotting its return against the return from the market portfolio - 'the characteristic line.

FURTHER ILLUSTRATION
The capital asset pricing model (CAPM). As financial manager of Kapambo Enterprises you are
required, using the capital asset pricing model (CAPM), to calculate the required rate of return and the
risk premium for the following list of potential investment projects.

Project Systematic risk, 𝜷

A 0.90
B 0.00
C 1.25
D 1.50
E -0.75

You have also determined that the risk-free rate is 7 per cent and that the return on the market
portfolio is 16 per cent.

84
The capital asset pricing model (CAPM). Using the capital asset pricing model (CAPM) equation
calculate the following:
a) The required return on share A, R (rA), if the risk-free rate Rf, is 5 per cent, the market return,
ERM is 10 per cent and the share’s beta BA, is 1.25.
b) The market return ERm, if the risk-free rate Rf is 7 per cent, the required return on share B is 16
per and the share’s beta, 𝛽𝛽B, is 0.75.
c) The beta on share C, 𝛽𝛽c, if the risk-free rate Rf, is 8 per cent, the market return ERm is 17 per
cent and the required return R(rc) is 20 per cent.
d) The risk-free rate Rf if the required return on share D, R(rD), is 17 per cent, the market return,
ERm is 18 per cent and the share’s beta, 𝛽𝛽D, is 0.9

SOLUTION
a) R(rA) = 5 + 1.25 (10 – 5) = 5 + 6.25 = 11.25%

b) 16 = 7 + 0.75 (ERm – 7)
16 – 7 = 0.75 (ERm – 7)
9 = 0.75ERm – 5.25
9 + 5.25 = 0. 75ERm
14.25/0.75 = ERm = 19%

c) 20 = 8 + 𝛽𝛽𝑐 (17 – 8)
20 – 8 = 17𝛽𝛽𝑐 - 8𝛽𝛽𝑐
12 = 9𝛽𝛽𝑐
𝛽𝛽𝑐 = 12/9 = 1.33

d) 17 = Rf + 0.9 (18 – Rf)

17 = Rf + 16.2 – 0.9Rf
17 – 16.2 = 0.1Rf
Rf = 8%

ARBITRAGE PRICING MODELS (APT) AND OTHER

MULTIFACTOR MODELS
The fundamental foundation for the arbitrage pricing theory (APT) is the law of one price, which
states that two identical items will sell for the same price, for if they do not, then a riskless profit
could be made by arbitrage—buying the item in the cheaper market then selling it in the more
expensive market. This principle also applies to financial instruments, such as stocks and bonds.
For instance, if Microsoft stock is selling for $30 on one exchange, but $30.25 on another
exchange, then an arbitrageur could simultaneously buy the stock on the cheaper exchange and sell
it short on the more expensive exchange for a riskless profit. (The arbitrage is done simultaneously
because the price discrepancy must be taken advantage of immediately; otherwise it will probably
disappear by the time of settlement.) The arbitrageur would continue doing this until the price
discrepancy disappeared, since buying on the cheaper exchange would increase the demand, and
therefore the price, on that exchange, while the short selling on the more expensive exchange
would increase supply, thereby reducing its price.

There is another law of one price used in arbitrage pricing theory that is slightly different from the
above examples. It is predicated on the fact that 2 financial instruments or portfolios—even if they
are not identical—should cost the same if their returns and risks are identical. The justification for
this is that the only reason that a financial instrument is purchased is to earn an expected return in
exchange for accepting a certain amount of risk—no other aspect of the financial instrument
matters. Hence, the law of one price requires that any two financial instruments or portfolios that

85
have the same return-risk profile should sell for the same price. If this is not true, then a profit
could be made through risk arbitrage — selling short the security or portfolio with the lower return,
and buying the higher return portfolio. This coheres with the capital asset pricing model (CAPM),
which postulates that the expected return of an asset is proportional to its risk.

Macroeconomic factor risks

Investment risk is composed of systematic risk and firm-specific risk. Systematic risk derives from
macroeconomic factors, which affects all investments, including the general state of the economy,
the stage of the business cycle, interest rates, inflation, and so on. Firm-specific risk affects only
particular firms, such as the death of key employees or the quality of management. APT considers
only macroeconomic risks, since these risks cannot be eliminated by through diversification. On
the other hand, firm-specific risks can be eliminated through diversification. Therefore, the market
offers no risk premium for taking on firm-specific risk, since it can be easily eliminated. However,
systematic risk cannot be eliminated through diversification. Therefore, investors will only hold
assets that have an expected return commensurate with their systematic risk.

Different assets have different sensitivities to systematic risk, which is the beta of the asset. By
definition, the beta of the market is equal to 1. Some assets will have a higher beta, meaning that
their percentage change in price will usually be greater than that of the market, and some assets will
have a lower beta, where the percentage change in price will usually be less than the market.

A factor beta (aka factor sensitivity, factor loading) can also be calculated for each type of
macroeconomic factor risk, equal to the percentage change in the expected return for each unit
change in the macroeconomic risk factor. So if the expected return declined by 1.5% for each 1%
increase in interest rates, then the beta for interest rate risk for that particular firm is -1.5.
Generally, factor betas can be found through regression analysis of historical changes in the
expected return for a given change in the systematic risk factor.

The expected rate of return is equal to the risk-free rate + the risk premium for taking on any
systematic risk. Since different systematic risk factors have different risk premiums, the expected
rate of return can be further decomposed into the risk-free rate plus the premium for each risk
factor multiplied by the beta for that risk factor.
The simplest form of the APT is the one macroeconomic factor model for the security or portfolio:
E(ri) =rf + F1b1
A graph of this line is the arbitrage pricing line for 1 risk factor. Not that this is similar to
the capital allocation line (CAL), with rf as the proportion of the portfolio consisting of the risk-
free security and F1b1 representing the proportion of the risky asset, with F1 representing the risk
premium for the macroeconomic factor and b1 representing the sensitivity of the return compared
to a unit change in the risk factor, just as beta represents the volatility of a stock compared to the
market in the CAPM.
The APT is similar to the CAPM. Both models assume that investors:
• prefer more wealth to less;
• are risk-averse;
• have similar expectations;
• and that capital markets are efficient.
However, APT has more general applicability, since it does not assume:
• a 1-period horizon;
• a market portfolio;
• that returns are normally distributed;
• that investors can borrow or lend at the risk-free rate;
• nor is there any need for utility functions.
Additionally, APT assumes unrestricted short-selling, since the arbitrage of portfolios requires this.

86
Example
Consider the following 2 portfolios: Pa has an expected return of 20% and Pb has an expected
return of 17%. Both have a beta of 1.8. Thus, a riskless profit could be made with no net
investment by buying Pa and selling short Pb. The proceeds of selling short Pb can be used to buy
Pa, so the sh.30 income earned for each sh.1,000 requires no net investment. Note that the betas are
equal and opposite, so there is no risk.

Portfolio Initial Cash Flow Beta

Payments
Pa (long) Sh.-1000 Sh.200 1.8
Pb (short) Sh.1000 Sh.-170 -1.8
0 30 0

Continuing to short Pb and buying Pa will eliminate the arbitrage profits since the demand for
Pa will increase, thus increasing its price while the supply of Pb will increase, thus decreasing its
price, until the returns of Pa and Pb are equalized, which is as it should be, since they have the
same risk. This is the essence of the arbitrage pricing theory and the law of one price.

Multi factor arbitrage

Implicit to the APT as well as the CAPM is that only macroeconomic risk factors, such as
unanticipated changes in interest rates or inflation, or unemployment rates that affect every firm are
the cause of systematic risk, and have pricing value. Microeconomics factors, such as the death of
key employees or the firm's credit rating, that cause firm-specific risk have no pricing power
because such risk can be reduced to zero through diversification. Although the simplest form of the
arbitrage pricing theory assumes that there is only 1 macroeconomic factor causing systematic risk,
the theory can easily be extended to include any number of macroeconomic factors with associated
betas for each factor:
E(ri) =rf + F1bi1+ F2bi2 +…………………………………+ Fnbin

Where Fn is the risk premium for that factor and bin is the factor beta for that risk factor.

The general solution to solving these multi-factor equations is to solve for these factors
simultaneously to see what they equal for a given set of portfolios.

PORTFOLIO PERFORMANCE MEASUREMENT

There are three composite measures which have been developed by scholars to measure the
performance of a portfolio relative to the performance of market portfolio. This evaluation is done to
ascertain if the performance of a portfolio is superior, inferior or average when compared to that of
market portfolio. These composite measures are:
i. Trenor’s measure (TJ)
ii. Sharpe’s measure (SJ)
iii. Jensen’s measure ( a )

Trenor’s measure
Trenor was the first scholar to develop a composite measure of portfolio performance. This measure is
based on the background of CAPM and therefore it operates effectively under the assumptions of
CAPM. This means that the weaknesses/ drawbacks of Trenor’s measures are similar to weakness of
CAPM.

Trenor’s measure of portfolio performance involve computing a T value portfolio.

𝑅𝑅𝑅𝑅−𝑅𝑅𝑅𝑅
TJ =
𝐵𝐵𝐵𝐵 TJ = Trenor’s measure of portfolio

87
Where Rp = Expected return of portfolio J.
Rf = Risk free rate of return.
BJ = Beta coefficient of portfolio J.

This measure is compared with equivalent Trenor’s measure of market portfolio (TM)

𝐸𝐸𝑅𝑅𝑚𝑚 −𝑅𝑅𝑅𝑅
Tm =
𝐵𝐵𝑚𝑚

Where Tm = Trenor’s measure of market portfolio

But Bm = 1

∴ Tm = ERm – Rf = Market Risk Premium.

If TJ Is more than Tm, it means that performance of portfolio J is superior compared to that of market
portfolio.
If TJ< TM implies that performance of portfolio J is inferior compared to that of market portfolio
If TJ=TM means performance of portfolio J is similar to that of market portfolio.

Sharpe’s measure portfolio performance (SJ)

This measure is based on background of portfolio theory and therefore it operates effectively under
the assumptions of portfolio theory implying that weakness of Sharpe’s measure are similar to
limitation of portfolio theory.
Sharpe’s measure portfolio performance is determined the same way as Trenor’s measure except risk
is measured in terms of total risk and this is measured using standard deviation of returns.

𝑅𝑅𝑅𝑅−𝑅𝑅𝑅𝑅
SJ =
𝛿𝛿𝐽𝐽

Where 𝛿𝐽 = Total risk of portfolio J

This measure is compared with Sharpe’s measure of market portfolio given as follows:

𝐸𝐸𝑅𝑅𝑀𝑀 −𝑅𝑅𝑅𝑅
SJ =
𝛿𝛿𝑀𝑀

If SJ > Sm = Superior performance

SJ < Sm = Inferior performance
SJ – Sm = Average / Efficient performance

Jensen’s measure
This is an improvement of Trenor’s measure of portfolio performance. Jensen’s carried out a
regression analysis on a security market line in order to obtain an equation which is a linear equation
in the form:
𝑦 = 𝑎 + 𝑏𝑥
Using the historical data. The linear equation which he came up with is given as follows.

ERJ – RF = a + BJ (ERM – RF)

y a x
b

88
Where a = Jensen’s measure of portfolio performance
i.e. a = E(RJ) - RJ

If a is positive, the performance of a portfolio is superior.

If a is negative, the performance of a portfolio is inferior.
If a =0, indicates efficient.
Jensen’s measure of portfolio performance operates effectively under the assumptions of linear
regression analysis and therefore the weaknesses of this measure are similar to that of linear
regression analysis. e.g.
i). Use of historical data
ii). Assumption that a linear relationship will exist between variables which may not be the case all
the times.

PRACTICE QUESTIONS (Solutions on page 275)

QUESTION 1
Butere Sugar Company Ltd. Has been enjoying a substantial net cash inflow. Before the surplus
funds are needed to meet tax and dividend payments, and to finance further capital expenditure in
several months’ time, they are invested in a small portfolio of short-term equity investments.
Details of the portfolio, which consist of shares of four companies listed on the stock exchange are as
follows:

Company Number of Beta equity Market price Latest Expected return

shares coefficient per share dividend yield on equity in the
next year
Sh. % %
A Ltd 60,000 1.16 42.90 6.1 19.5
B Ltd 80,000 1.28 29.20 3.4 24.0
C Ltd 100,000 0.90 21.70 5.7 17.5
D Ltd 125,000 1.50 31.40 3.3 23.0

The current market return is 19% a year and treasury bill yield is 11% a year.

Required:
On the basis of the data given above, calculate the risk of Butere Sugar Company Ltd.’s short-term
investment portfolio relative to that of the market.
QUESTION 2
An investor has an investment fund of Sh. as 1,000,000.he intends to apportion this fund into two
securities. A and B. as follows; sh. 200,000 in security A and sh.800, 000 in security B
The return on each security is dependent on the state of the economy as how below:

State of economy Probability Return on security A Return on security B

Boom 0.4 18% 24%
Average 0.5 14% 22%
Recession 0.1 12% 21%

Required:
(i) Expected returns on the portfolio
(ii) Standard deviation of each security
(iii) Correlation coefficient between security A and security B
(iv) Assess the extent of risk diversification by the investor through the portfolio holdings

89
 CHAPTER 4
THE FINANCING DECISION

INTRODUCTION
The financing decisions are decisions regarding the methods that are used to raise funds which would
be used for making acquisitions. The financing decisions are decisions concerning the liabilities and
stockholders' equity side of the firm's balance sheet, such as a decision to issue bonds.
The financing decisions involve various factors. They are determining the proper amount of funds to
employ in a firm, selecting projects and capital expenditure analysis, raising funds on the most
favorable terms possible and finally managing working capital such as inventory and accounts
receivable. The goals of corporate finance can be achieved only when the corporate investment is
financed appropriately. The financing mix will make an impact the valuation.

The company should therefore identify an optimal mix of financing i.e. the one which results in
maximum value.
The sources of finance are usually comprised of a combination of debt and equity financing. A project
that is financed through debt results in a liability and obligation. When the projects are financed
through equity, it is less risky with respect to cash flow commitments. The cost of equity is always
higher than the cost of the debt. The equity financing may result in an increased hurdle rate which

90
will offset any reduction in the cash flow risk. The management of the company must match the
financing mix to the asset that is being financed.

One of the theories as to how the firms make their financing decisions is the Pecking Order
Theory. Under this theory the firms should avoid external financing if they have an availability
of internal financing option. They also avoid equity financing if they have an option of debt financing
at lower interest rates. Another theory which helps firms in financial decision is the Trade-off
theory where firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt
when making their decisions.

NATURE AND SIGNIFICANCE OF THE FINANCING DECISION

The nature of financial decisions varies from one firm to the other. It may also be different for the
same firm over a period of time. The reason is that the nature of financial decisions is influenced by
the prevailing microeconomic and macroeconomic conditions. These factors are explained below;-

Microeconomic Factors
Microeconomic factors are related to the internal conditions of the firm. Important among these
conditions are:
1. Nature and size of the enterprise;
2. Level of risk and stability in earnings;
3. Liquidity position;
4. Asset structure and pattern of ownership;
5. Attitude of the management.

Nature and size of the enterprise;

If a firm is engaged in manufacturing operations or in the provision of public utility services, its
investment in fixed assets is large and hence the capital structure has a large share of long-term
capital. The share of long-term capital in the capital structure is also large in firms producing capital
goods. On the other hand, in trading concerns, a greater part of the investment is found in current
assets. With a greater ratio of current assets, the ratio of current liabilities rises. Similarly, companies
that is larger in size need a large capital. Small firms may obtain their fixed assets on lease, but large
firms would need to construct their own building and assemble their own plant. Small firms have
lower goodwill in the capital market and so their financing decisions are different from that of large
firms. It is because of the lack of sufficient goodwill in the capital market that small firms are largely
dependent on internal finances and this is one of the reasons that their dividend decisions are different
from that of large firms.

Level of risk and stability in earnings;

Risk is another important factor influencing financial decisions. The greater the risk, the higher the
discount factor. Thus, risk influences the long-term investment decision or capital budgeting decision.
Again, if risk is higher or income is not stable, the finance manager tries to impress on the
shareholders for more retention of earnings rather than adopting a liberal dividend policy. But with
stable income or lower risk, the financial decision will be just the reverse. In such cases, the fixed-cost
capital, such as preference shares and debentures, may be preferred and also the firm may adopt a
liberal dividend policy.

Liquidity position
The third factor influencing financial decisions is the liquidity position. Since dividend is normally
paid out of cash, firms with a sound liquidity position adopt a liberal dividend policy. But if, in such
cases, the working capital requirements are very large or the firm has to meet significant past
obligations, it will have to follow a conservative dividend policy. Any tilt towards illiquidity will alter
the nature of financing and dividend decisions.

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Asset structure and pattern of ownership
Again, in a closely-held company where the ownership lies in a few hands, the management does not
find it difficult to persuade the owners to accept a conservative dividend policy in the interests of the
firm. But in cases where there are many shareholders, their wishes matter considerably.
Attitude of the management
Last but not least is the management’s attitude. A conservative finance manager will attach greater
importance to liquidity rather than to the profitability. On the other hand an aggressive finance
manager will stress on the latter, and financial decisions will be taken accordingly. For example, a
conservative finance manager attempts to tread a beaten path, preferring to avoid fixed obligations for
raising additional capital even if debt financing is advantageous. The preference is to maintain a large
volume of current assets. However, an aggressive finance manager is ready to bear the risk involved
in debt financing or that involved in maintaining lower current assets. However, a prudent finance
manager would prefer a compromise between risk and return or between profitability and liquidity.

Macroeconomic Factors
Macroeconomic factors are the environmental factors that are beyond the control of the firm’s
management. They relate primarily to:
1. The state of the economy;
2. Governmental policy.

The state of the economy

The state of the economy changes from time to time and the financial decisions of a firm conform to
these changes. When the economy is growing or proceeding towards recovery, the finance manager
should be eager to avail investment opportunities. But when the economy is facing a slump, the
finance manager should proceed with care. For example, in such a situation it would not be advisable
to go for an expansion programme. Similarly, when the economy is experiencing an uptrend, the
finance manager can opt for trading on equity as larger profits are assured. But in times of a
downtrend, the stress should be on internal financing. Again, during an uptrend, higher dividends can
be declared, but during a downtrend conservation of cash is necessary and therefore a strict dividend
policy should be followed.

The state of economy is also denoted by the structure of capital and money markets. If the capital
market is well developed having a multitude of financial institutions and venturesome investors, the
finance manager will find it easy to select the proportion-mix of capital structure and, accordingly,
financing decisions will be broader. He can manage with a comparatively lower amount of cash as he
can get funds whenever he desires. The dividend policy too is broad in such cases as the shareholders
are not necessarily interested in regular and large dividends. But if the investors are not venturesome,
they will wish for large dividends and the finance manager will have to adopt a liberal dividend
policy, and will not be able to opt for trading on equity to any great extent. Similarly, if the financial
institutions provide concessional assistance for priority projects, the investment decisions will be
influenced in favour of such projects. Moreover, if the financial institutions stress on a particular debt-
equity ratio, the financing decisions will be so influenced.

Governmental policy
Apart from the state of economy, governmental policy is no less significant in influencing corporate
financial decisions. State intervention or state regulation is found in almost all countries. Thus
corporate investment decisions are governed by the nature and extent of state regulations.

SIGNIFICANCE OF THE FINANCING DECISION

There are two fundamental types of financial decisions that the finance team needs to make in a
business i.e investment and financing. The two decisions boil down to how to spend money and how

92
to borrow money. The overall goal of financial decisions is to maximize shareholder value, so every
decision must be put in that context.

Investment
An investment decision revolves around spending capital on assets that will yield the highest return
for the company over a desired time period. In other words, the decision is about what to buy so that
the company will gain the most value.
To do so, the company needs to find a balance between its short-term and long-term goals. In the very
short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't
investing in things that will help it grow in the future. On the other end of the spectrum is a purely
long-term view. A company that invests all of its money will maximize its long-term growth
prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon.
Companies thus need to find the right mix between long-term and short-term investment.
The investment decision also concerns what specific investments to make. Since there is no guarantee
of a return for most investments, the finance department must determine an expected return. This
return is not guaranteed, but is the average return on an investment if it were to be made many times.

The investments must meet three main criteria:

1. It must maximize the value of the firm, after considering the amount of risk the company is
comfortable with (risk aversion).
2. It must be financed appropriately (we will talk more about this shortly).
3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder
in order to maximize shareholder value.

Financing
All functions of a company need to be paid for one way or another. It is up to the finance department
to figure out how to pay for them through the process of financing.
There are two ways to finance an investment: using a company's own money or by raising money
from external funders. Each has its advantages and disadvantages.

There are two ways to raise money from external funders: by taking on debt or selling equity. Taking
on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of
borrowing. Selling equity is essentially selling part of your company .When a company goes public,
for example, they decide to sell their company to the public instead of to private investors. Going
public entails selling stocks which represent owning a small part of the company. The company is
selling itself to the public in return for money.
Every investment can be financed through company money or from external funders. It is the
financing decision process that determines the optimal way to finance the investment.
Among different financial decisions, the one relating to investment in fixed assets or capital budgeting
is of special significance. While taking this decision financial manager has to take special precautions.

These decisions are relatively more important because of the following reasons:
(1) Long-term Growth and Effect:
These decisions are concerned with long-term assets. These assets are helpful in production. Profit is
earned by selling the goods so produced. It can, therefore, be said the more correct these decisions are,
the greater will be the growth of business in the long run. In addition to that, these affect future
possibilities of the business.
(2) Large Amount of Funds Involved:
Decisions regarding fixed assets are included in the preview of capital budgeting. Large amount of
capital is invested in these assets. If these decisions turn out to be wrong, there occurs heavy loss of
capital which is a scarce resource.

(3) Risk Involved:

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Capital budgeting decisions are full of risk. There are two reasons for it. First, these decisions refer to
a long period, and as such expected profits for several years are to be anticipated. These estimates
may turn out to be wrong. Second, because of heavy investment involved, it is very difficult to change
the decision once taken.

(4) Irreversible Decisions:

Nature of these decisions is such as cannot be changed so quickly. For instance, if soon after setting
up a cotton mill, it is thought of changing it, then the old machinery and other fixed assets will have to
be sold at throwaway price. In doing so, heavy loss will have to be incurred. Changing of these
decisions, therefore, is very difficult.

COST OF CAPITAL AND ITS SIGNIFICANCE

Cost of capital is the price the company pays to obtain and retain finance. To obtain finance a
company will pay implicit costs which are commonly known as floatation costs. These include:
Underwriting commission, Brokerage costs, cost of printing a prospectus, Commission costs, legal
fees, audit costs, cost of printing share certificates, advertising costs etc. For debt there is legal fees,
valuation costs (i.e. security, audit fees, Bankers commission etc.) such costs are knocked off from:

i) The market value of shares if these has only been sold at a price above par value.
ii) For debt finance – from the par value of debt.

I.e. if flotation costs are given per share then this will be knocked off or deducted from the market
price per share. If they are given for the total finance paid they are deducted from the total amount
paid.

Cost of Retaining Finance

This will include dividends for share capital and interest for debt finance (tax deducted) or effective
cost of debt. However, when computing the cost of finance apart from deducting implicit costs,
explicit costs are the most central elements of cost of finance.

Importance of Cost of Finance

The cost of capital is important because of its application in the following areas:
i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the cost
of capital is used to discount the cash flows. Under IRR method the cost of capital is compared
with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is
determined by the cost of each capital component.
iii) Evaluation of performance of management – A high cost of capital is an indicator of high risk
attached to the firm. This is usually attributed to poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is low compared to the cost
of new ordinary share capital, the firm will retain more and pay less dividend. Additionally, the
use of retained earnings as an internal source of finance is preferred because:
• It does not involve any floatation costs
• It does not dilute ownership and control of the firm, since no new shares are issued.
v) Lease or buy decisions – A firm may finance the acquisition of an asset through leasing or
borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt (interest rate
on loan borrowed) is used as the discounting rate.

Factors That Influence the Cost of Finance

1. Terms of reference – if short term, the cost is usually low and vice versa.

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 2. Economic conditions prevailing – If a company is operating under inflationary conditions, such
a company will pay high costs in so far as inflationary effect of finance will be passed onto the
company.
3. Risk exposed to venture – if a company is operating under high risk conditions, such a
company will pay high costs to induce lenders to avail finance to it because the element of risk
will be added on the cost of finance which may compound it.
4. Size of the business – A small company will find it difficult to raise finance and as such will
pay heavily in form of cost of finance to obtain debt from lenders.
5. Availability – Cost of finance (COF) prices will also be influenced by the forces of demand and
supply such that low demand and low supply will lead to high cost of finance.
6. Effects of taxation – Debt finance is cheaper by the amount equal to tax on interest and this
means that debt finance will entail a saving in cost of finance equivalent to tax on interest.
7. Nature of security – If security given depreciates fast, then this will compound implicit costs
(costs of maintaining that security).
8. Company’s growth stage – Young companies usually pay less dividends in which case the cost
of this finance will be relatively cheaper at the earlier stages of the company’s development.

Usually the cost of debt is lower than the cost of equity. This is so because debt is a fixed obligation
while equity is not. However, firms cannot operate on debts alone since this will subsequently increase
the risk of bankruptcy (that is the firm being unable to meet its fixed obligations). This risk of
bankruptcy is also associated with the stability of sales and earnings. A firm with relatively unstable
earnings will be reluctant to adopt a high degree of leverage since conceivably it might be unable to
meet its fixed obligations at all.

Note: Financial leverage is the change in the EPS induced by the use of fixed securities to finance a
company's operation.

COMPONENTS OF COST OF CAPITAL

The components of cost of capital have been discussed below. They includes;-

COST OF DEBT
The cost of debt capital (i.e. debentures or long-term loans) is the rate of return required by lenders. It
is the interest that has to be paid on it. For example, if a company issues debentures of Shs.100 each at
par at 15%, in this case the cost of one debenture will be 15% p.a.

In the case of debt capital, the effective cost is taken into consideration for the purposes of calculating
weighted cost of capital. As the interest on debt or loan capital is an allowable expense for tax
purposes, it therefore reduces the profit of a company. The charge for interest is thus offset by the
reduction in the tax payable.

Thus, the effective cost of debt capital is calculated as:

Effective cost of debt capital = Actual cost - Tax benefit

Cost of Bank Loan

Unlike securitized debt, bank borrowings do not have a market price with which to relate interest and
payments to in order to calculate their cost. Its cost can only be approximated. To approximate the
cost of bank borrowings the interest rate paid on the loan should be taken, making the appropriate
calculation to allow for the tax deductibility of the interest payments. Therefore the cost of loan
finance is given by:
CL = i (1 – t)
Where:
CL= cost of loan

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 i = interest rate on loan finance
t = Corporation tax.
ILLUSTRATION
Maendeleo ltd has acquired a bank loan of Ksh 1,250,000 to expand its operations. The corporate tax
is 30%, and the bank charges 16% interest on the loan. The cost of this finance is:
CL= 0.16(1-0.30)

CL= 0.16 × 0.70

CL= 0.112 or 11.2%

Cost of irredeemable debt

The formulae for calculating cost of irredeemable debt is;-

𝑰 (𝟏−𝒕)
Kd =
𝑷

Where;
Kd=cost of debt capital
I is the annual interest
P is the current market price
t is the rate of corporation tax

Cost of redeemable debt

Redeemable debt is one that matures after a certain time.
The cost of is given by;-

kd=I + 1/n(P – Nd)

½(P+ Nd)

P = actual value/par value/face value

Nd = net proceed from sale of debt instrument
I = annual interest charged
n = number of years to maturity of instrument

ILLUSTRATION
A ten year debenture of a firm can be sold at a rate of Ksh 9,000. The face value of the debenture is
Ksh 10,000 and the coupon rate of interest is 8%. If a 50% tax bracket is assumed, calculate;
i. Before tax cost of debenture
ii. The after tax cost of the debenture
iii. Explain your results in i) and ii) above

SOLUTION
P = Ksh 10,000
Nd = Ksh 9,000
R = 8% of 10,000 = 800
n = 10

Before tax cost of debenture

kd =800 + 1/10(10,000 – 9,000) = 900 = 0.095 or 9.5%

½(10,000+ 9,000) 9,500

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After tax cost of debenture
kda = kd (1-t)
kda = 0.095(1-0.5)
kda = 0.0475 or 4.75%

Explanation of the results in i) and ii) above

Interest charged on debt is tax deductible expense. The after tax cost of debt is lower than before tax
cost of debt.

COST OF PREFERENCE SHARE CAPITAL

preference share capital represents a special type of ownership interest on the firm. It gives preferred
share owners the right to receive their stated dividends before any earnings can be distributed to
ordinary shareholders. The cost of preferred share capital is the ratio of preferred dividends to the net
proceeds from the sale of preferred share capital.

The preference dividend is not an expense of business and it does not reduce the profits which are
taxed. The cost to a company of 12% preference share is thus 12%. A company rarely fails to pay its
preference dividend. In recent years, preference shares have formed a negligible part of new capital
issues.
The main reason for this is that these dividends, unlike interest on loans, are not allowable for
Corporation tax. From the point of view of the investor, they are less attractive than loan stock as they
cannot be secured on the company assets. The cost of preference share capital can be calculated as
under:

Cost of preference share capital is given by:

Kp = DP×100
PO
Where
Kp = cost preference share capital
DP= dividends per preference share
Po = market price per preference share

ILLUSTRATION
Chamji Corporations’ preferred stock is selling at Ksh 115 per share and pays a dividend of 6% of par
value (Ksh 100). Find the cost of preferred stock.

SOLUTION
6 × 100
DP = = sh.6
100

6 × 100
Kp = = 5.2%
115

COST OF EQUITY
The equity capital consists of ordinary share capital and retained earnings. The cost of equity capital is
the amount of dividend payable plus a specific growth in equity. The ordinary share holders expect a
certain rate of return on their investment and they also expect that their investment must grow at a
specific rate. This growth rate is expressed as a percentage of the total equity. There are two models
used to obtain the cost of equity for a firm. The Gordon’s model and the Capital Asset Pricing Model
(CAPM).

Gordon’s Model (The Constant Dividend Growth Model)

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Myron Gordon has developed a simple formula which combines current dividend yield with the
growth factor to produce the cost of equity capital.

Newly Issued Common Stock

For a newly issued common stock, the model is as follows;

𝐷1
Ke = ×100 + g
𝑃𝑜−𝑅𝑅

Where:
Ke = cost of ordinary shares (new)
D1 = Expected dividend per share
P0 = market price per share
g% = growth in equity per annum
f = floatation cost per share

Note: Retained earnings are not a costless source of finance. If these funds were given to the common
stock holders in form of dividends, they could have achieved an equivalent return by re-investing the
funds at a personal level. Therefore they bear an opportunity cost equivalent to the on going cost of
equity. It should be noted that the presence of floatation costs raise the cost of new equity capital. Po –
f represents the firm’s net proceeds per share.

ILLUSTRATION
UshindiLtd expects a dividend of Ksh 2 per share. The growth rate of dividends is 7% and is expected
to remain constant. Its market price per share is Ksh 40 while floatation costs per share are Ksh 1.50.
Find the cost of issuing new equity common stock.

SOLUTION
2
Ke = ×100 + 7%
40−1.5

Ke = 12.2%

Old Common Stock

It is important to note that while computing the cost of a newly issued equity capital, Gordon’s model
factored in floatation costs. However for an old stock, the floatation cost is zero. Thus the adjusted
model is as follows;

𝐷1
Ke = ×100 + g %
𝑃𝑜−𝑅𝑅

Since f = 0, the model reduces to;

𝐷1
Ke = ×100 + g %
𝑃𝑜

In the example above, assuming that Ushindi’s common stock had been issued earlier then floatation
costs is zero. Thus its cost of equity capital would be;

2
Ke = ×100 + 7 %
40

Ke = 12%

The Capital Asset Pricing Model

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The CAPM model is given by the following formula;

Ke = krf + (km - krf)*β

Where:
Ke = cost of equity
krf = the risk free rate of interest
km = the expected return on the market
β = a measure of the firm’s stock returns sensitivity relative to those of the market assuming
risk is not diversifiable.

ILLUSTRATION
Ushindi’s stock returns sensitivity relative to those of the market is 0.5%. The central bank’s treasury
bill rate is 8% while the market rate of return is 12%. Compute Ushindi’s cost of equity.

SOLUTION
Ke = 8 + (12 - 8) ×0.5

Ke = 10%

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

This is also called the overall or composite cost of capital. Since various capital components have
different percentage cost, it is important to determine a single average cost of capital attributable to
various costs of capital. This is determined on the basis of percentage cost of each capital component.

Market value weight or proportion of each capital component

E P D
W.A.C.C = K e   + K p   + K d (1 − T ) 
V V V
Where:
Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital respectively
E, P and D = Market value of equity, preference share capital and debt capital respectively.
NB: Market value = Market price of a security × No. of securities.
V = Total market value of the firm = E + P + D.

ILLUSTRATION
Pick Ltd has the following cost structure which is considered optimal
Particulars Kshs”000”
Debt (Par @ Kshs.100) 250,000
Preference stock (par @ Kshs.100) 150,000
Common stock (par@ Kshs.100) 600,000

Additional information
The investor of Pick Ltd expect earnings and dividends to grow at a constant rate of 9% p.a. in future .
The company has just paid a dividend of Kshs.3.60 per share and its stock currently sells at Kshs.60
per share. Treasury bonds yield 11% and the return on the market is 14% Pick Ltd beta is 1.51. New
preferred stock can be sold at Kshs.100 per share with a dividend of Kshs.11 per share and floatation
cost of Kshs.5 per share.
The company tax rate is 30% and it pays out all its earnings as dividends. 12% debentures with a
maturity of 10 years can be sold at Kshs.92 per debenture.

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Required;-
The weighted average cost of capital (WACC) using market value weights

SOLUTION
1. Cost of common stock
ke =(D1/P0+ g)100

D0 = 3.60 g=9% P0 = 60
D1 = 3.60(1+0.09)
= 3.924
= (3.924/60+0.09)×100%

= 15.54%

CAPM
ke = Rf +(Rm-Rf)β = 11+ (14-11) ×1.51 = 11 + (3×1.51) = 15.53%

Preferred stock
𝐷𝑃𝑆 11
Kps= ×100 = ×100 =11.58%
𝑃𝑜−𝑅𝑅 100−5

Cost of debt

kd =R + 1/n(P – Nd)
½(P+ Nd)
P = actual value/par value/face value
Nd = net proceed from sale of debt instrument
R = annual interest charged
n = number of years to maturity of instrument

12
R= ×100 = sh.12
100

12+ (100-92)/10 = 12.8

12.8/0.5(100+92) (1-.3) =0.93333 =9.3%

Computation of market value

a) Debenture In sh. ‘000’= (Initial capital × Market value)/ par value

= (250,000×92)/100

= Kshs.230, 000

b) Preferred stocks In sh. ‘000’ = (Initial capital × Market value)/ par value

= (150,000×100)/100 = Kshs.150, 000

c) Common stock In sh. ‘000’= (Initial capital × Market value)/ par value

= (600,000×60)/100 = Kshs.360, 000

Total market value in sh. ‘000’ = Debentures+ Preference shares + Common stock
= 230,000+150,000+360,000

100
 = Kshs.740,000

Computation of weights
a) Debentures = Debenture / Overall= 230,000/740,000 =0.31

b) Preferred stock = Preferred stock / Overall = 150,000/740,000 =0.20

c) Common stock = Common stock / Overall = 360,000/740,000 =0.49

Weighted average cost of capital (WACC) = kewe+kdwd+kpswps

= (15.53×.49)+(11.58×0.2)+(0.31×9.33)= 12.82%

ILLUSTRATION
The following is the capital structure of XYZ Ltd as at 31/12/2002.
Sh. Million
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par value 100
12% debenture Sh.100 par value 200
900
Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to grow at
5% p.a. in future. The current MPS is Sh.40.

Required;-
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
c) What are the weaknesses associated with WACC when used as the discounting rate, in project
appraisal.

SOLUTION
a) i) Compute the cost of each capital component
Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth rate
dividend model to determine the cost of equity.

d0 = Sh.5 P0 = Sh.40 g = 5%

d0 (1 + g ) 5(1 + 0.05)
Ke = +g = + 0.05 = 0.18125 = 18.13%
P0 40

Cost of perpetual preference share capital (Kp) – preference shares are still selling at par thus MPS =
par value. If this is the case, Kp = coupon rate = 10%.

MPS = Par value = Sh.20

Dp = 10% x Sh.20 = Sh.2

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 DPS dp Sh.2
Kp = = = = 10%
MPS Pp Sh.20

Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a redeemable fixed
return security thus the cost of debt is equal to yield to maturity.
kd =R + 1/n(P – Nd)
½(P+ Nd)
P = actual value/par value/face value
Nd = net proceed from sale of debt instrument
R = annual interest charged
n = number of years to maturity of instrument

Interest charges p.a. = 12% x Sh.100 par value = Sh.12

Maturity period (n) = 10 years
Maturity value (m) = Sh.100
Current market value (Vd) = Sh.90
Corporate tax rate (T) = 30%

kd =12 + 1/10(100 – 90)

½(100+ 90)
=13.6% (1-0.3)=9.58%

ii) Compute the market value of each capital component

Market value of Equity (E) = MPS x No. of ordinary shares
Sh.400 MDSC
= Sh.40 x = 1,600
Sh.10parvalue

Market value of preference share capital (P)

= Par value, since MPS = Par value per share = 100

Market value of debt (D) = Vd x No. of debentures

Sh.200 Mdebentures
= Sh.90 x = 180
Sh.100parvalue

E + P + D = V = total Market Value = 1,880

iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%

a) Using weighted average cost method,, WACC =

E P D
= K e   + K p   + K d (1 − T ) 
V V V

1,600 100 180

=18.13% ( ) + 10% ( ) + 9.58 %( ) = 15.43 + 0.5319 + 0.9172
1,880 1,880 1,880

≈ 16.88%

b) By using percentage method,

WACC = Total monetary cost
Total market value (V)

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 Where: Monetary cost = % cost x market value of capital

Sh. ‘m’
Monetary cost of E = 18.13% × 1,600 290.08
Monetary cost of P = 10% × 100 10.00
Monetary cost of D = 9.58% × 180 17.244
317.324

Therefore WACC = 317.324 = 16.88%

x100
1,880

In computation of the weights or proportions of various capital components, the following values may
be used:
• Market values
• Book values
• Replacement values
• Intrinsic values

Market Value – This involves determining the weights or proportions using the current market
values of the various capital components. The problems with the use of market values are:
The market value of each security keep on changing on daily basis thus market values can be
computed only at one point in time.
The market value of each security may be incorrect due to cases of over or under valuation in the
market.
Book values – This involves the use of the par value of capital as shown in the balance sheet. The
main problem with book values is that they are historical/past values indicating the value of a security
when it was originally sold in the market for the first time.

Replacement values – This involves determining the weights or proportions on the basis of amount
that can be paid to replace the existing assets. The problem with replacement values is that assets can
never be replaced at ago and replacement values may not be objectively determined.

Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic value of a
given security. Intrinsic values may not be accurate since they are computed using historical/past
information and are usually estimates.

e) Weaknesses of WACC as a discounting rate

WACC/Overall cost of capital has the following problems as a discounting rate:

• It can only be used as a discounting rate assuming that the risk of the project is equal to the
business risk of the firm. If the project has higher risk then a percentage premium will be
added to WACC to determine the appropriate discounting rate.
• It assumes that capital structure is optimal which is not achievable in real world.
• It is based on market values of capital which keep on changing thus WACC will change over
time but is assumed to remain constant throughout the economic life of the project.
• It is based on past information especially when determining the cost of each component e.g in
determining the cost of equity (Ke) the past year’s DPS is used while the growth rate is
estimated from the past stream of dividends.
Note;-
When using market values to determine the weight/proportion in WACC, the cost of retained
earnings is left out since it is already included or reflected in the MPS and thus the market value of

103
equity. Retained earnings are an internal source of finance thus, when they are high there is low
gearing, lower financial risk and thus highest MPS.

MARGINAL COST OF FINANCE

This is cost of new finances or additional cost a company has to pay to raise and use additional
finance is given by:

Total cost of marginal finance×100

Cost of finance (COF)

Cost of finance may be computed using the following information:

i) Marginal cost of each capital component.
ii) The weights based on the amount to raise from each source.

Investors usually compute their return basing their figures on market values or cost of investment.
Investors purchase their investment at market value and as such, the cost of finance to the company
must be weighted against expectations based on the market conditions.
Investments appreciate in the stock market and as such the cost must be adjusted to reflect such a
movement in the value of an investment.

1. Marginal cost of equity

D1
MCE = x100 (for zero growth firm)
Po − f
Also cost of equity
D1
Ke = (for normal growth firm)
Po − f
Where: d1 = expected DPS = d0(1+g)
P0 = current MPS
f = floation costs
g = growth rate in equity

2. Cost of preference share capital:

Dp
Kp = x100
Po − f
Where: Kp = Cost of preference
Dp = Dividend per share
Po = MPS (Market price per share)
F = Flotation costs

3. Cost of debenture
Int(1 − T)
Kd =
Vd − f

Where: Kd = Cost of debt

Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate

4. Just like WACC, weighted marginal cost of capital can be computed using:
i) Weighted average cost method
ii) Percentage method

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ILLUSTRATION
XYZ Ltd wants to raise new capital to finance a new project. The firm will issue 200,000 ordinary
shares (Sh.10 par value) at Sh.16 with Sh.1 floatation costs per share, 75,000 12% preference shares
(Sh.20 par value) at Sh.18 with sh.150,000 total floatation costs, 50,000 18% debentures (sh.100 par)
at Sh.80 and raised a Sh.5,000,000 18% loan paying total floatation costs of Sh.200,000. Assume
30% corporate tax rate. The company paid 28% ordinary dividends which is expected to grow at 4%
p.a.

Required;-
a) Determine the total capital to raise net of floatation costs
b) Compute the marginal cost of capital

SOLUTION
a)
Sh. ‘000’
Ordinary shares 200,000 shares @ Sh.16 3,200,000
Less floatation costs 200,000 shares @ Sh.1 (200,000) 3,000
Preference shares 75,000 shares @ Sh.18 1,350,000
Less floatation cost (150,000) 1,200
Debentures 50,000 debentures @ Sh.80 4,000,000
Floatation costs -____ 4,000
Loan 5,000,000
Less floatation costs (200,000) 4,800
Total capital raised 13,000

b) Marginal cost of equity Ke

d0 (1 + g)
Ke +g
P0 − f
d0 = 28% x Sh.10 par = Sh.2.80
g = 4%
f = Sh.1.00
P0 = Sh.16
2.80(1.04)
Therefore marginal = Ke = + 0.04 = 0.234 = 23.4%
16 − 1

Marginal cost of preference share capital Kp

Kp = dp
P0-f

dp = 12% x Sh.20 par = Sh.2.40

P0 = Sh.18
f = Floatation cost per share= Sh.150,000 = Sh.2.00
75,000 shares
Kp = 2.40 = 0.15 = 15%
18 – 2

Marginal cost of debenture Kd:

Kd = Int (1-t)
Vd-f

105
 f = 0
Vd = Sh.80
Int = 18% x Sh.100 par = Sh.18
T = 30%

Kd = 18(1-0.3) = 0.1575 = 15.75%

80

Marginal cost of loan Kd

Kd = Int (1-t)
Vd-f

T = 30%
Vd = Sh.5 million
f = Sh.0.2 million
Int = 18% x Sh.5M = Sh.0.9M

Kd = 0.9 (1-0.3) = 0.13125= 13.13%

5 – 0.2

Source Amount to raise % marginal Maturity cost

before fixed costs cost Sh. ‘000’
Sh. ‘000’
Ordinary shares 3,200 23.4% 748.8
Preference shares 1,350 15.0% 202.5
Debenture 4,000 15.75% 472.5
Loan 5,000 13.13% 656.5
12,550 2,237.8

Weighted marginal cost = 2,237.8 x 100 = 16.52%

12,550

MCC -IOS / MCC - IRR SCHEDULES

THE MARGINAL COST OF CAPITAL (MCC)

MCC refers to the cost of raising marginal /additional incremental funds from the specific sources or
from the available new sources
MCC may vary over time depending on the volume of financing that the firm plans to raise. MCC is
calculated within financial bracket/ranges as determined by the break points.

A Break Point in MCC

A break point occurs every time the cheapest fund from a particular source is exhausted and additional
fund have to be raised at a higher cost.

𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑅𝑅𝑢𝑛𝑑 𝑅𝑅𝑟𝑜𝑚 𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝑗

Break point =
𝑊𝑗 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑎𝑅𝑅𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒`

INVESTMENT OPPORTUNITY SCHEDULE (IOS)

At any given time a firm has a certain set of investment opportunities available to it. These
opportunities differ in term of returns. Therefore IOS is the graphical ranking of investments
possibilities from the best return to the worst / lowest return as measured by IRR.

106
 Typically, the more capital a company wants to raise, the more expensive it will be for each additional
increment; i.e., as its capital budget grows, its marginal cost of capital (MCC) increases. Because a
company will undertake a project only when that project’s internal rate of return (IRR) is greater than
the cost of capital needed to fund the project (alternatively: only when that project’s net present value
(NPV) is positive when discounted at the cost of capital needed to fund that project), it is important
for the company to know how its marginal cost of capital relates to its overall capital budget.

Generally, the MCC doesn’t rise smoothly as the capital budget increases (though we often draw it
that way, mainly out of laziness): the MCC will be constant for a certain range of total capital budget
amounts, then will step up to a higher level, where it will remain constant for a certain range, then
step up to an even higher level, and so on

ILLUSTRATION
The finance manager of STN Ltd is planning new year’s capital budget. STN ltd expects its net
income to be Sh 2,700,000 next year and its current dividend payout ratio is 30%. The company’s
earnings and dividends are expected to grow at a constant rate of 8% per annum. The last divided paid
by the company was Sh 1.00 per share and the current equilibrium share price is Sh 16 STN Ltd can
raise up to Sh 1,800,000 of debt at 11% before tax cost, the next Sh 1,800,000 will cost 12% and all
debt above Sh 3,600,000 will cost13%. If STN Ltd issues new ordinary shares, a 12% underwriting
cost will be incurred. STN Ltd can sell the first Sh 200,000 of new ordinary shares at the current
market price, but to sell any additional new shares, STN Ltd must lower the price to Sh 14. STN Ltd
is at its optimal capital structure, which is 60% debt and 40% equity and the firm’s corporation tax
rate is 40%. STN Ltd has the following independent, indivisible and equally risky investment
opportunities.

Project Cost “Sh” Internal rate of return (IRR) %

A 3,200,000 13.0
B 1,300,000 10.7
C 1,750,000 12.0
D 450,000 11.2

Required;-
a) The break points in the marginal cost of capital (MCC) schedule.
b) The cost of each component of the capital structure.
c) The weighted average cost of capital (WACC) in the interval between each break in the MCC
schedule.
d) The MCC/IOS graph clearly indicating the projects to be undertaken.
e) STN Ltd’s optimum capital budget.

SOLUTION

Available Proportion Available Break-point Rank Cost of capital

funds (limit) Column
source 𝑨𝑭𝒔
= 𝑾𝒋

R/E 0.4 2700 (1-0.3) = 1890 2 𝑏0(1+𝑔)

0.4
= 4,725 R/e= 𝑃𝑜
+ 𝑔
1890

107
 1(1.08)
16
+ 0.08

= 14.75%
1800 1800
= 3,000
0.6
Kd 0.6 1
Kd = 𝐾𝑑 (𝐼 − 𝑇)

= 11(0.6)

= 6.6%
3600 3600
= 6000
0.6
Kd 0.6 4
12(0.6)

= 7.2%
No limit
No break
Kd 0.6
13 (0.6)

= 7.8%
1890 + 200 =
2090
2090 = 5225
Ke 0.4 0.4
𝐷0(1+𝑔)
Ke = 𝑃𝑜 − 𝑅𝑅
+ 𝑔
3

1(1.08)
16−1.92
+ 0.08

= 15.67%

No limit No break 1(1.08)

Ke 0.4 Ke = 14−1.68
+ 0.08

= 16.77%

MCC Schedule
Financial Ranges Ke0.4 Kd (I-T)0.6 MCC/WACC

0 – 3,000 14.75 6.6 9.9

3,000 – 4,725 14.75 7.2 10.2

4,725 – 5,225 15.67 7.2 10.6

5,225 – 6,000 16.77 7.2 11.0

Above 6,000 16.77 7.8 11.4

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 Recall: MCC = WeKe + WdKd(I-T)

13.1- A
12.9
12.7
MCC/IRR

12.5
12.3
12.1 C Optimal Point
11.9
11.7
11.5
11.3 D MCC Graph
11.1
10.9
B
10.7
10.5
10.3
105
10.1 Graph
9.9-

X
1000 2000 3000 4000 5000 6000 7000

Financial
Requirements
Accept all projects that are plotting above the MCC and reject projects that are plotting below the
MCC.

Therefore accept A, C, D and reject project B.

The optimal capital budget is the point of intersection between MCC and 10S graphs i.e. Sh 5,400,000

CAPITAL STRUCTURE
In finance, capital structure refers to the way a corporation finances its assets through some
combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or
'structure' of its liabilities. For example, a firm that sells Sh.20 million in equity and Sh.80 million in
debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total
financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be
highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital
employed of the firm which come from outside of the business finance, e.g. by taking a short term
loan etc.

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ELEMENTS OF CAPITAL STRUCTURE
A company formulating its long-term financial policy should, first of all, analyse its current financial
structure. The following are the important elements of the company’s financial structure that need
proper scrutiny and analysis:

Capital Mix
Firms have to decide about the mix of debt and equity capital. Debt capital can be mobilized from a
variety of sources. How heavily does the company depend on debt? What is the mix of debt
instruments? Given the company’s risks, is the reliance on the level and instruments of debt
reasonable? Does the firm’s debt policy allow it flexibility to undertake strategic investments in
adverse financial conditions? The firms and analysts use debt ratios, debt-service coverage ratios, and
the funds flow statement to analyse the capital mix.

Maturity and Priority

The maturity of securities used in the capital mix may differ. Equity is the most permanent capital.
Within debt, commercial paper has the shortest maturity and public debt longest. Similarly, the
priorities of securities also differ. Capitalized debt like lease or hire purchase finance is quite safe
from the lender’s point of view and the value of assets backing the debt provides the protection to the
lender. Collateralized or secured debts are relatively safe and have priority over unsecured debt in the
event of insolvency. Do maturities of the firm’s assets and liabilities match? If not, what trade-off is
the firm making? A firm may obtain a risk-neutral position by matching the maturity of assets and
liabilities; that is, it may use current liabilities to finance current assets and short-medium and long-
term debt for financing the fixed assets in that order of maturities. In practice, firms do not perfectly
match the sources and uses of funds. They may show preference for retained earnings. Within debt,
they may use long-term funds to finance current assets and assets with shorter life.

Terms and Conditions

Firms have choices with regard to the basis of interest payments. They may obtain loans either at
fixed or floating rates of interest. In case of equity, the firm may like to return income either in the
form of large dividends or large capital gains. What is the firm’s preference with regard to the basis of
payments of interest and dividend? How do the firm’s interest and dividend payments match with its
earnings and operating cash flows? The firm’s choice of the basis of payments indicates the
management’s assessment about the future interest rates and the firm’s earnings. Does the firm have
protection against interest rates fluctuations?
The financial manager can protect the firm against interest rates fluctuations through the interest rates
derivatives. There are other important terms and conditions that the firm should consider.
Most loan agreements include what the firm can do and what it can’t do. They may also state the
schemes of payments, pre-payments, renegotiations etc. What are the lending criteria used by the
suppliers of capital? How do negative and positive conditions affect the operations of the firm? Do
they constraint and compromise the firm’s operating strategy? Do they limit or enhance the firm’s
competitive position? Is the company level to comply with the terms and conditions in good time and
bad time?

Currency
Firms in a number of countries have the choice of raising funds from the overseas markets. Overseas
financial markets provide opportunities to raise large amounts of funds. Accessing capital
internationally also helps company to globalize its operations fast. Because international financial
markets may not be perfect and may not be fully integrated, firms may be able to issue capital
overseas at lower costs than in the domestic markets. The exchange rates fluctuations can create risk
for the firm in servicing its foreign debt and equity. The financial manager will have to ensure a

110
system of risk hedging. Does the firm borrow from the overseas markets? At what terms and
conditions? How has firm benefited – operationally and/or financially in raising funds overseas?
Is there a consistency between the firm’s foreign currency obligations and operating inflows?

Financial innovations
Firms may raise capital either through the issues of simple securities or through the issues innovative
securities. Financial innovations are intended to make the security issue attractive to investors and
reduce cost of capital. For example, a company may issue convertible debentures at a lower interest
rate rather than non-convertible debentures at a relatively higher interest rate. A further innovation
could be that the company may offer higher simple interest rate on debentures and offer to convert
interest amount into equity. The company will be able to conserve cash outflows. A firm can issue
varieties of option-linked securities; it can also issue tailor-made securities to large suppliers of
capital. The financial manager will have to continuously design innovative securities to be able to
reduce the cost. An innovation introduced once does not attract investors any more. What is the firm’s
history in terms of issuing innovative securities? What were the motivations in issuing innovative
securities and did the company achieve intended benefits?

Financial market segments

There are several segments of financial markets from where the firm can tap capital. For example, a
firm can tap the private or the public debt market for raising long-term debt. The firm can raise short-
term debt either from banks or by issuing commercial papers or certificate deposits in the money
market. The firm also has the alternative of raising short-term funds by public deposits. What
segments of financial markets have the firm tapped for raising funds and why? How did the firm tap
and approach these segments?

FRAMEWORK FOR CAPITAL STRUCTURE

A financial structure may be evaluated from various perspectives. From the owners’ point of view,
return, risk and value are important considerations. From the strategic point of view, flexibility is an
important concern. Issues of control, flexibility and feasibility assume great significance. A sound
capital structure will be achieved by balancing all these considerations:
• Flexibility
The capital structure should be determined within the debt capacity of the company, and this
capacity should not be exceeded. The debt capacity of a company depends on its ability to
generate future cash flows. It should have enough cash to pay creditors’fixed charges and
principal sum and leave some excess cash to meet future contingency. The capital structure should
be flexible. It should be possible for a company to adapt its capital structure with a minimum cost
and delay if warranted by a changed situation. It should alsobe possible for the company to
provide funds whenever needed to finance its profitable activities.
• Risk
The risk depends on the variability in the firm’s operations. It may be caused by the macro
economic factors and industry and firm specific factors. The excessive use of debt magnifies the
variability of shareholders’ earnings, and threatens the solvency of the company.

• Income
The capital structure of the company should be most advantageous to the owners(shareholders) of
the firm. It should create value; subject to other considerations, it should generate maximum
returns to the shareholders with minimum additional cost.
• Control
The capital structure should involve minimum risk of loss of control of the company.The owners
of closely held companies are particularly concerned about dilution of control.
• Timing

111
 The capital structure should be feasible to implement given the current and future conditions of
the capital market. The sequencing of sources of financing is important. The current decision
influences the future options of raising capital.

CAPITAL STRUCTURE THEORIES

Under favourable economic conditions, the earnings per share increase with financial leverage.
But leverage also increases the financial risk of shareholders. As a result, it cannot be stated definitely
whether or not the firm’s value will increase with leverage. The objective of a firm should be directed
towards the maximization of the firm’s value. The capital structure or financial leverage decision
should be examined from the point of its impact on the value of the firm. If capital structure decision
can affect a firm’s value, then it would like to have a capital structure, which maximizes its market
value. However, there exist conflicting theories on the relationship between capital structure and the
value of a firm. The traditionalists believe that capital structure affects the firm’s value while
Modigliani and Miller (MM), under the assumptions of perfect capital markets and no taxes, argue
that capital structure decision is irrelevant. MM reverse their position when they consider corporate
taxes. Tax savings resulting from interest paid on deb creates value for the firm. However, the tax
advantage of debt is reduced by personal taxes and financial distress. Hence, the trade-off between
costs and benefits of debt can turn capital structure into a relevant decision. There are other views also
on the relevance of capital structure. We first discuss the traditional theory of capital structure
followed by MM and other views

TRADITIONAL THEORIES
Traditional approach to capital structure suggests that there exist an optimal debt to equity ratio where
the overall cost of capital is the minimum and market value of the firm is the maximum. On either
side of this point, changes in the financing mix can bring positive change to the value of the firm.
Before this point, the marginal cost of debt is less than cost of equity and after this point vice-versa.
Capital Structure Theories and its different approaches put forth the relation between the proportion of
debt in financing of a company's assets, the weighted average cost of capital (WACC) and the market
value of the company. While Net Income Approach and Net Operating Income Approach are the two
extremes Approach are the two extremes, traditional approach, advocated by Ezta Solomon and Fred
Weston is a midway approach also known as “intermediate approach”.

Traditional Approach to Capital Structure:

Traditional approach to capital structure advocates that there is a right combination of equity and debt
in the capital structure, at which the market value of a firm is maximum. As per this approach, debt
should exist in the capital structure only up to a specific point, beyond which, any increase in leverage
would result in reduction in value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest
and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to
equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold,
the WACC increases and market value of the firm starts a downward movement.
Assumptions under Traditional Approach:
1. The rate of interest on debt remains constant for a certain period and thereafter with increase in
leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase gradually. After that the
equity shareholders starts perceiving a financial risk and then from the optimal point and the
expected rate increases speedily.
3. As a result of activity of rate of interest and expected rate of return, the WACC first decreases and
then increases. The lowest point on the curve is optimal capital structure.

NET INCOME (NI) APPROACH

Net income approach was developed by Durand, in this he has portrayed the influence of the leverage

112
on the value of the firm, which means that the value of the firm is subject to the application of debt
i.e., leverage.
In this approach, the cost of debt is identified as cheaper source of financing than equity share capital.
The more application of debt in the capital structure brings down the overall capital, more particularly
100% application of debt finance leads to resemble the overall cost of capital as cost of debt. The
weighted average cost of capital will come down due to more application of leverage in the capital
structure, only with reference to cheaper cost of raising than the equity share capital cost.

The essence of the NI approach is that the firm can increase its value or lower the overall cost of capital
by increasing the proportion of debt in the capital structure. The crucial assumption of this approach
are:
(a) The use of debt does not change the risk perception of the investor. Thus Kd and Ke remain
constant with changes in leverage.
(b) The debt capitalization rate is less than equity capitalization rate (i.e. Kd< Ke).

The implications of these assumptions are that with constant Kd and Ke, increased use of debt, by
magnifying the shareholders earnings will result in a higher value of the firm via higher value of equity.
The overall cost of capital will therefore decrease. If we consider the equation for the overall cost of
capital,
D
Ko= Ke -( Ke - Kd )
V

Ko decreases as D/V increases because Ke and Kd are constant as per our assumptions and Kd is less than
Ke. This also implies that Ko will be equal to Ke if the firm does not employ any debt (i.e. when D/V =
0) and that Ko will approach Kd as D/V approaches 1. This argument can be illustrated graphically as
follows.

According to N.I, Value of firm = Ve + Vd

i.e. Value of equity (Ve)+ Value of debt (Vd)

𝐸𝐵𝐼𝑇
𝑉𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 (𝑢) =
𝐾𝑒𝑢

Keuis the cost of equity of unlevered firm

EBIT is the earnings before interest and tax

𝐸𝐸𝐵𝐵𝐼𝑇
𝐾𝑒𝑢 =
𝑉𝑒𝑢

V.Fu = Veu + o ∴ V.F.u = Veu

𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐾𝑒𝑙 = V.L = where kd is cost of debt
𝑉𝑒𝑙 𝐾𝑑

Proof that always a livered firm will always command the highest value i.e. an increase in debt lead to
an increase in the V.F hence capital structure is relevant.

ILLUSTRATION
Consider two firms i.e. Levered and Unlevered firm that are similar in all aspects except their capital
structure. Both have an EBIT of Sh. 900,000 and Ke = 10%

113
The Unlevered firm is all equity financed while the other has debt of sh 4m whose interest rate is
7.5%

Required;-
a) Using N.I determine the value of both firms and WACC.
b) Suppose the amount of debt increased to 5 M, 7.5M, 9M and 12M. Recalculate VF and WACC.
What is your observation?

SOLUTION
a) Value of a firm (V.F) = Ve + Vd

𝐸𝐸𝐵𝐵𝐼𝑇 900,000
𝑉𝑒𝑢 = = = 9,000 000
𝐾𝑒𝑢 0.1

𝑉. 𝐹𝑢 = 𝑉𝑒𝑢 = 9,000,000

𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 900,000−300,000
𝑉𝑒𝑙 = = = 6,000, 000
𝐾𝑒𝑙 0.1

𝐼𝑛𝑡 7.5 𝑥 4,000,000

𝑉𝑙 = = = 4,000, 000
𝐾𝑑 7.5

V.F.L = 6000 000 + 4,000, 000 = 10,000 000

WACCu = WeKe + WdKd

= 1 × 10 + 0 = 10%

∴ WACCu = Keu = 10%

6 4
WACCL = x 10M + x 7.5M = 9%
10 10

∴ An increase in debt in capital structure will lead to:

• Increase in value of firm
• Decrease in WACC.

Hence a capital structure decision is relevant

b)
Unlevered 4M 5M 7.5M 9M 12M
EBIT (in ksh.) 900 000 900,000 900 000 900 000 900,000 900,000
Int. 0 (300,000) (375,000) (562,500) (675,000) (900,000)
EAT& Int, 900 000 600 000 525000 337,500 225,000 0
Cost of equity
(Ke) 10% 10% 10% 10% 10% 0
𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 9,000,000 6,000,000 5,250,000 3,375,000 2,250,000 0
𝑉𝑒 =
𝐾𝑒

𝐼𝑛𝑡
𝑉𝑑 = 0 4,000,000 5,000,000 7,500,000 9,000,000 12,000,000
𝐾𝑑
Value of firm - - - - - -
(V.F (in ksh.) 9,000,000 10,000,000 10,250,000 10,875,000 11,250,000 12,000,000

114
 Unlevered firm At 4M debt At 5M debt
9 6 4 5.25 5
× 10% ×10 + × 7.5 ×10 +10.25×7.5
9 10 10 10.25
WACC
=10% =9% =8.8%

Observation:
• As the amount of debt increases, the Value of firm (V.F) increases
• As the amount of debt increases, WACC reduces
• As the amount of debt increases, value of equity (Ve) decreases

Therefore, the maximum value of the firm (V.F) is found when 100% debt is used.

The effect of change in the capital structure (increase in debt capital)

Let as assume that the firm decides to retire Kshs.100,000.00 worthy of equity by using the proceeds
of new debt issue worthy the same amount. The cost of debt and equity would remain the same as per
the assumptions of the net income approach

Required;-

Determine the value of the firm and the overall cost of capital

SOLUTION

Particulars Ksh. ‘000’

EBIT 50,000
Less: Interest (10% of 300,000) (30,000)
EBT 20,000
Less: Tax @ 0 rate (0)
EAT 20,000

Valuation of the firm (Ksh. ‘000’)

i) Valuation of equity = EAT/ke
= 20,000/0.125
= 160,000
ii) Valuation of debt = 30,000
Total value of the firm = Equity + Debt
=160,000+300,000
= 460,000

Overall cost of capital (WACC)= kewe + kdwd

= (0.35×160) + (10×0.65)

= 10.88%

Weights
i) Equity = 160,000/460,000 = 0.35

ii) Debt = 1- Equity = 1-0.35 = 0.65

Alternative formula

115
 = EBIT / Valuation of the firm
- This proves that the use of additional financial leverage (debt) causes of the value of the firm to
increase and the overall cost of capital to decrease.

ILLUSTRATION
The following extract of balance sheet of Mapato Ltd shows the capital structure of the company as at
31/12/2007
Particulars Kshs”000”
Ordinary share capital (par value Kshs.125) 62,500
Reserves 121,500
Shareholders’ equity 184,000
Long term liabilities
14% debenture stock(par value Kshs.500) 118,500
Capital employed 302,500
The management of the company consider the above capital structure to be optimal additional
information
Additional information;-
1. The company’s EBIT average Kshs.75 Million per year. These earnings are expected to be
maintained in the foreseeable future.
2. The ordinary shares are currently trading at Kshs.400 per share.
3. The market price of debenture is Kshs.525 per debenture.
4. The corporate tax rate is 30%

Required;-
Using the net income approach (incorporating taxes), calculate the company’s
1. Cost of equity
2. After tax cost of debt (Market value weighted)
3. Market weighted average cost of capital.

SOLUTION
1. Cost of equity (ke) = EAT / Value of equity = 40,887/0.2044 = 200,034
Particulars Kshs”000”
EBIT 75,000
Less: Interest (14% of 118,500) (16,590)
EBT 58,410
Less: Tax @ 30% (17,523)
EAT 40,887

Cost of equity (ke) = 100(EAT / market value) = 100 (40,887/200,000) = 20.44%

Market value of share

= No. of share outstanding × market price per share
= (62,500,000/125) × sh.400 = 200million

After tax cost of debt

= I(1-T)×100
B0
= 0.14×500(1-0.3) ×100
525
=9.33%

Weighted average cost of capital (WACC)

116
 = kewe +kdwd

Market value in sh. ‘000’

Equity = (62,500/125) ×100 = Kshs.200 million

Debt = (118,500/500) ×525

= Kshs.124, 425

Weights
Equity = 200,000/(200,000+124,425) = 0.62
Debt = 1-Equity = 1-0.61 = 0.38

Hence, WACC = (0.61×20.44) + (0.38×9.33) = 16.4%

NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that the application of
leverage do not have any influence on the value of the firm through the overall cost of capital. The
more application of leverage leads to bring down the explicit cost of capital on one side and on the
other side implicit cost of debt is expected to go up.
How the implicit cost of debt will go up? The more application of debt leads to increase the financial
risk among the investors that warranted the equity share holders to bear additional financial risk of the
firm. Due to additional financial risk, the shareholders are requiring the firm to pay additional
dividends over the existing. The increase in the expectations of the shareholders with reference to
dividends hiked the cost of equity.
Under this approach, no capital structure is found to be an optimum capital structure. The major
reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing
but remains constant.

The critical assumptions of this approach are:

i. The market capitalizes the value of the firm as a whole.
ii. Cost of equity depends on the business risk. If the business risk is assumed to remain constant, then
cost of equity will also remain constant.
iii. The use of less costly debt increases the risk of the shareholders. This causes cost of equity to
increase and thus offset the advantage of cheaper debt.
iv. Cost of debt is assumed to be constant.
v. Corporate income taxes are ignored.

The implications of the above assumptions are that the market value of the firm depends on the business
risk of the firm and is independent of the financial mix. This can be illustrated as follows:

According to this theory, a capital structure decision is irrelevant irrespective of the capital structure
adopted i.e. two firms that are similar in all aspects except the capital structure must command the
same value since;-

𝐸𝐸𝐵𝐵𝐼𝑇
Value of the firm (VF) =
𝑊𝐴𝐶𝐶

Therefore, the value of equity is a residue i.e.

117
 Value of equity (Ve) = VF – Vd

N/B:
WACC will be known in advance and is expected to remain constant. Using the illustration above,
prove whether that according to NOI approach a capital structure/ mix is irrelevant.

𝐸𝐸𝐵𝐵𝐼𝑇
Recall: Value of the firm -V.F =
𝑊𝐴𝐶𝐶

By referring to the previous illustration

WACC=10%
Unlevered Kd=4M Kd=5M Kd=7.5M
EBIT 900 000 900 000 900 000 900 000
WACC 0.1 0.1 0.1 0.1
VF (value of firm) 9M 9M 9M 9M

Ve = VF – Vd 9M 5M 4M 1.5M

𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 10% 12% 13.13% 22.5%

𝐾𝑒 = 𝑉𝑒

Kd=4M Kd=5M Kd=7.5M

Computation of Ke 900,000 − 7.5% 𝑥 4𝑀 900,000 − 7.5% 𝑥 5𝑀 900,000 − 7.5% 𝑥 7.5𝑀
5𝑀 4𝑀 1.5 𝑀

12% 13.13% 22.5%

Prove that weighted average cost of capital (WACC) = 10%

5𝑚 4
WeKe + WdKd = 10%× 𝑥 12% + 𝑥 7.5% = 10%
9𝑀𝑀 9

Observation
As debt increases, value of firm (V.F) remains constant hence a capital structure decision/mix is
irrelevant.
As value of debt increases, value of equity decreases i.e. Ve is a residue.
WACC is always constant irrespective of the capital structure adopted.

Hence a capital structure decision is irrelevant i.e. there exists no optimum capital structure.

FRANCO MODIGLIANI AND MERTON MILLER (MM)

PROPOSITIONS
The MM, in their first paper (in 1958) advocated that the relationship between leverage and the
cost of capital is explained by the net operating income approach.
They argued that in the absence of taxes, a firm's market value and the cost of capital remains
invariant to the capital structure changes. The arguments are based on the following assumptions:
a) Capital markets are perfect and thus there are no transaction costs.
b) The average expected future operating earnings of a firm are represented by subjective random
variables.
c) Firms can be categorized into "equivalent return" classes and that all firms within a class have the
same degree of business risk.
d) They also assumed that debt, both firms and individual's is riskless.

118
e) Corporate taxes are ignored.
Proposition I
The value of any firm is established by capitalizing its expected net operating income (If Tax = 0)

VL = VU = EBIT = EBIT
WACC KO

1. The value of a firm is independent of its leverage.

2. The weighted cost of capital to any firm, levered or not is
(a) Completely independent of its capital structure and
(b) Equal to the cost of equity to an unlevered firm in the same risk class.

Proposition II
The cost of equity to a levered firm is equal to
a) The cost of equity to an unlevered firm in the same risk class plus
b) A risk premium whose size depends on both the differential between the cost of equity and debt to
an unlevered firm and the amount of leverage used.

D
K el = K eu + Risk premium = K eu + ( K eu - K d )
E

As a firm's use of debt increases, its cost of equity also rises. The MM showed that a firm's value is
determined by its real assets, not the individual securities and thus capital structure decisions are
irrelevant as long as the firm's investment decisions are taken as given. This proposition allows for
complete separation of the investment and financial decisions. It implies that any firm could use the
capital budgeting procedures without worrying where the money for capital expenditure comes from.
The proposition is based on the fact that, if we have two streams of cash, A and B, then the present value
of A +B is equal to the present value of A plus the present value of B. This is the principle of value
additivity. The value of an asset is therefore preserved regardless of the nature of the claim against it.
The value of the firm therefore is determined by the assets of the firm and not the proportion of debt and
equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to substitute personal for
corporate leverage, thereby replicating any capital structure the firm might undertake. They used the
arbitrage process to show that two firms alike in every respect except for capital structure must have the
same total value. If they don't, arbitrage process will drive the total value of the two firms together.

ILLUSTRATION
Assume that two firms the levered firm (L) and the unlevered firm (U) are identical in all important
respects except financial structure.
Firm L has Sh 4 million of 7.5% debt, while Firm U uses only equity. Both firms have EBIT of Sh
900,000 and the firms are in the same business risk class.
Initially assume that both firms have the same equity capitalization rate Ke(u) = Ke(L) = 10%.
Under these conditions the following situation will exist.

Firm U

Value of Firm U's Equity = EBIT - KD = 900,000 - 0

Ke 0.1

119
 = Sh 9,000,000
Total market value = Du + Eu
= 0 + 9,000,000
= Sh 9,000,000

Firm L
Value of Firm L's Equity = EBIT - KdD = 900,000- 0.075(4,000,000)
Ke 0.10

= Sh. 6m

Total market value = DL + EL

= 4m + 6m
= Sh 10,000,000

Thus the value of levered firm exceeds that of unlevered firm. The arbitrage process occurs as
shareholders of the levered firm sell their shares so as to invest in the unlevered firm.

Assume an investor owns 10% of L's stock. The market value of this investment is Sh. 600,000. The
investor could sell this investment for Sh. 600,000, borrow an amount equal to 10% of L's debt (Sh.
400,000) and buy 10% of U's shares for Sh. 900,000. The investor would remain with Sh 100,000
which he can invest in 7.5% debt. His income position would be:

Sh. Sh.
Old income 10% of L's Sh. 600,000 equity income 60,000
New income 10% of U's income 90,000
Less 7.5% interest on 400,000 (30,000) 60,000
Plus 7.5% interest on extra Sh. 100,000 7,500
Total new investment income 67,500

The investor has therefore increased his income without increasing risk.

As investors sell L's shares, their prices would decrease while the purchaser of U will push its prices
upward until an equilibrium position is established.

Conclusion;-
Taken together, the two MM propositions imply that the inclusion of more debt in the capital structure
will not increase the value of the firm, because the benefits of cheaper debt will be exactly offset by an
increase in the riskiness, and hence the cost of equity.

MM theory states that in a world without taxes, both the value of a firm and its overall cost of capital are
unaffected by its capital structure.

Criticism of the MM Hypothesis

The arbitrage process is the behavioral foundation for MM’s hypothesis.
The shortcomings of this hypothesis lie in the assumption of perfect capital market in which arbitrage
is expected to work. Due to the existence of imperfections in the capital market, arbitrage may fail to
work and may give rise to discrepancy between the market values of levered and unlevered firms. The
arbitrage process may fail to bring equilibrium in the capital market for the following reasons:

Lending and borrowing rates discrepancy

120
The assumption that firms and individuals can borrow and lend at the same rate of interest does not
hold in practice. Because of the substantial holding of fixed assets, firms have a higher credit
standing. As a result, they are able to borrow at lower rates of interest than individuals. If the cost of
borrowing to an investor is more than the firm’s borrowing rate, then the equalization process will fall
short of completion.

Non-substitutability of personal and corporate leverages

It is incorrect to assume that “personal (home-made) leverage” is a perfect substitute for “corporate
leverage.” The existence of limited liability of firms in contrast with unlimited liability of individuals
clearly places individuals and firms on a different footing in the capital markets. If a levered firm goes
bankrupt, all investors stand to lose to the extent of the amount of the purchase price of their shares.
But, if an investor creates personal leverage, then in the event of the firm’s insolvency, he would lose
not only his principal in the shares of the unlevered company, but will also be liable to return the
amount of his personal loan. Thus, it is more risky to create personal leverage and invest in the
unlevered firm than investing directly in the levered firm.

Transaction costs
The existence of transaction costs also interferes with the working of arbitrage. Because of the costs
involved in the buying and selling securities, it would become necessary to invest a greater amount in
order to earn the same return. As a result, the levered firm will have a higher market value

Institutional restrictions
Institutional restrictions also impede the working of arbitrage. The “home-made” leverage is not
practically feasible as a number of institutional investors would not be able to substitute personal
leverage for corporate leverage, simply because they are not allowed to engage in the “home-made”
leverage.

Existence of corporate tax

The incorporation of the corporate income taxes will also frustrate MM’s conclusions. Interest
charges are tax deductible. This, in fact, means that the cost of borrowing funds to the firm is less than
the contractual rate of interest. The very existence of interest charges gives the firm a tax advantage,
which allows it to return to its equity and debt holders a larger stream of income than it otherwise
could have.

FRANCO MODIGLIANI AND MERTON MILLER (MM) WITHOUT TAXES

According to this theory, two firms that are similar in all aspects except their capital structure must
command the same value and if this does not happen, there will be some disequilibrium in the market
that cannot continue forever as the investors would identify an opportunity to earn a profit by selling
the shares in the over-value firm and buying in the under-value firm. This profit is referred to as an
arbitrage profit and the process of selling and buying is referred to as the arbitrage process.
This theory operates the same way as the N.I approach.

Arbitrage process
It is the process facilitates the individual investors to buy the investments at lower price at one market
and sells them off at higher price in another market. With the help of arbitrage process, the investors
are permitted to shift holding of the Levered firm to the unlevered firm which is known as
undervalued. These two firms are identical in business risk except in the application of debt finance in
the levered firm. In order to maintain the similar amount of the financial risk of the firm, the investor
is required to undergo for personal leverage or homemade leverage to maintain the same proportion of
investment in the unlevered firm. During this process, the investor could save something and this
continuous arbitrage process will level the value of the both firms. It means that the value of the firm
is unaffected by the application of leverage which is explained through the arbitrage process, nothing

121
but behavioural pattern of the investors.

The same thing could be applied in the case of reverse arbitrage process in between the Unlevered and
levered. This also another kind of process in which the investor could gain through the transfer of the
holdings from the unlevered firm to levered firm.
This theory operates the same way as the N.I approach

Recall:
Value of firm (V.F) = Ve + Vd
𝐸𝐸𝐵𝐵𝐼𝑇−𝐼
Value of equity of levered firm (VE L)=
𝐾𝑒𝑙

Where;-
EBIT is earnings before interest and tax
I- is the interest
K el- is cost of equity of a levered firm

ILLUSTRATION
Consider firm. L and U that are identical in all aspects except that firm U if all equity financed while
firm L is partly financed by a debt sh. 4,000,000, 7.5%. Both firms have EBIT of sh. 900,000 and cost
of equity (Ke) in both firms is 10%.

Required;-
i. Using the net income (N.I) approach, determine the value of both firms.
ii. Conduct and arbitrage process of an investor who owns 10% of the share capital in firm L

SOLUTION
V.F = Ve + Vd
U L
EBIT 900 000 900 000
Interest 0 (300,000)
900 000 600,000
Cost of equity (Ke) 10% 10%
Value of equity (Ve) 9000 000 6,000 000
Value of debt (Vd) 0 7.5 𝑥 4𝑀 4,000 000
Value of firm (V.F) 9000 000 7.5 10,000, 000

According to MM1, investors will sell their shares/control in the over-valued firm (L) and buy in
under-valued firm (U). This is called arbitrage process.

Arbitrage Process
Proceeds from sale of shares/control in L
Shs
10%×6,000,000 = 600,000
10% ×4,000,000 = 400,000
Funds available for investment in U 1,000,000

1000 000 1
The new control in the firm U, = =
9000 000 9

Shs
1 100,000
Share of profits in U, = x 900,000
9
(30,000)
Interest on debt 7.5% x 400,000

122
 70,000
Profit foregone 10% × 600 000 (60,000)
Arbitrage profit 10,000

Therefore, if this activity / process is carried on continually, the share capital in firm U will increase
while that of firm L will reduce leading to the equalization of the values:

FRANCO MODIGLIANI AND MERTON MILLER (MM) WITH CORPORATE

TAXES
Two firms that are similar in all aspects will always command different prices since the interest on
debt in the Levered firm will always be allowable for tax purposes.

𝐸𝐸𝐵𝐵𝐼𝑇(1−𝑇)
The 𝑉𝑒𝑢 =
𝐾𝑒𝑢

𝑉𝑒𝑙 = Vu + BT

Where; VU = Value of Unlevered firm

BT = Tax shield on the entire debt

𝐷
𝐾𝑒𝑙 = Keu+(Keu – Kd) (I-TC)
𝑡

Or

𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 (𝐼−TC))
Kel =
𝑉𝑒𝑙
ILLUSTRATION
Using the previous illustration where EBIT was sh. 900,000. Determine the value of both the levered
and unlevered firm given a tax rate of 40%

U(unlevered) L(levered)
EBIT 900 000 900 000
Cost of equity (Ke) 10% -

Corporate tax rate 40%

𝐸𝐸𝐵𝐵𝐼𝑇−𝐼 (𝐼−𝑇
𝑉. 𝐹𝑢 =
𝐾𝑢

900,000 (1−0.4)
𝑉𝑢 = = 5, 400,000
0.1

𝑉𝑙 = Vu + BT

𝑉. 𝐹𝐿 = 5, 400,000 + 4, 000,000×40% = Shs.7, 000,000

WACCu = Keu = 10%

𝐷 4
But Ke = Keu + (Keu – Kd) (I – T) = 10 + (10 – 7.5) ×0.6 = 12%
𝐸𝐸 3

3 4
∴ WACCL = × 12 + × 7.5 × 0.6= 7.7%
7 7

123
Conclusion
According to MM2, an optimum capital structure exists since an increase in debt leads to an increase
in the value of the firm (V.F) and a decrease in WACC hence a capital structure decision is relevant.

FRANCO MODIGLIANI AND MERTON MILLER (MM) WITH CORPORATE AND

PERSONAL TAXES
MM argued that the investors will be taxed on their personal incomes they receive from the company
i.e. they will be paying both personal taxes on the dividend and interest incomes alongside corporate
taxes.
The benefit to the providers of funds/investors will be the after tax divides and interest.
This theory is an extension of MM with corporate taxes that stated

𝐸𝐸𝐵𝐵𝐼𝑇(𝐼−𝑇)(𝐼−𝑇𝑃𝑠)
𝑉𝑢 =
𝐾𝑒𝑢

Where; TPs – Personal tax on the stock income (dividends)

(I−T)(I−TPs)
VL = Vu + B �I − �
I−TPd

Where, TPs – Person tax on stock income (Dividends)

TPd – Personal tax on debt income (interest)

ILLUSTRATION
Given that
EBIT =shs 900,000
Corporate tax rate = 30%
TPs = 15%

TPd = 5%

Debt (B) = sh. 4,000,000, 7.5% interest rate.

Cost of equity of unlevered firm (Keu) = 10%

Required;-
Determine the value of the unlevered firm X value of levered firm and the conclusion.

SOLUTION

𝐸𝐸𝐵𝐵𝐼𝑇 (𝐼−𝑇)(𝐼−𝑇𝑃𝑆)
𝑉𝑢 =
𝐾𝑒𝑢

900,000 𝑥 0.7 𝑥 0.85

= = 5355000
0.1

(I−Tc)(I−TPs)
VL = Vu + B �I − �
I−TPd

0.7x 0.85)
VL = 5,355,000+ 4,000,000 �1 − �
0.95

= shs 6,849,737

124
Conclusion
The capital structure decision is relevant since an increase in leverage leads to an increase in the value
of the firm hence 100% debt in the capital structure is encouraged.

FRANCO MODIGLIANI AND MERTON MILLER (MM) WITHTAXES AND FINANCIAL

DISTRESS COSTS

According to this theory, 100% debt cannot be adopted in the capital structure due to the financial
distress cost in the form of bankruptcy cost and agency cost/monitory cost.
Agency costs are costs that are incurred to ensure that the firm adheres to its contracted commitments.
They are also referred to as supervisory costs.
Bankruptcy costs refer to the indirect or direct cost associated with the impending bankruptcy.
One of the major contributions of bankruptcy/financial distress is the use of excessive debit to finance
the project.
An increase in debt leads to an increase in a financial distress cost.

Conclusion
100% debt in the capital structures cannot be used although increase in debt leads to the increase in
the value of the firm.
This theory is an extension of MM with corporate taxes that stated

ILLUSTRATION
Dalton Ltd an unlevered firm generates EBIT of Kshs.20 million pa. The market value of the
company as at 31/10/2007, the company’s financial year and was Kshs.120million. The management
of the company is considering the use of debt finance and has provided the following additional
information.
i. The estimated present value of any future financial business costs is Kshs.80 million.
ii. The probability of financial distress would increase with leverage according to the following
schedule.

Value of debt Prob. of financial distress

25M 0.000
50M 0.0125
75M 0.025
100M 0.0625
125M 0.0125
150M 0.3125
200M 0.750

Required;-
i. The company’s cost of equity and weighted average cost of capital as at 31/10/2007 (2 Marks)
ii. The company’s optimum level of debt finance using the Modigliani & Miller with tax model
(excluding financial distress costs) 2 Marks
iii. The company’s optimum level of debt finance using “MM” model interpreting financial
distress costs.

SOLUTION
i.
Particulars Kshs.M
EBIT 20
Less: interest @ Zero rate (0)

125
 EBT 20
Less: Tax@ 30% (6)
EAT 14

Ke = EAT/Value of equity
= (14/120)*100
= 11.67%
Since the firm is ungeared the cost of equity is the same as WACC since WACC is 11.67%

ii.
VL = VU+TD
Debt “M” VU TD=Tc× D VL=VU+TD
25 120 7.5 127.5
50 120 15 135
75 120 22.5 142.5
100 120 30 150
125 120 37.5 157.5
150 120 45 165
200 120 60 180

The optimal level of debt is Kshs.200 million. This is because it is at this level when the value of
the firm is high.

iii.
Debt “M” VU TD PV(FD) VL=VU+TD-PV(FD)
25 120 7.5 0 127.5
50 120 15 1 134
75 120 22.5 2 140.5
100 120 30 5 145
125 120 37.5 10 147.5
150 120 45 25 140
200 120 60 60 120

Note;-
PV(FD) = PV×Prob. FD

Comments
The company optimal level of debt is 125million. It is at this point when the firm has the highest
value.

OTHER CAPITAL STRUCTURE THEORIES

Pecking order theory
This theory states that company prioritizes their source of financing (from internal financing to
equity). Hence, internal funds are used first and when that is depleted, debt is issued and when it is not
sensible to issue any more debt, equity is used.
Peeking order theory starts with asymmetric information as managers know more about their
company’s prospects, risk and value than outside investors.

126
Asymmetric information affects the choice between internal and external financing and between the
issue and equity.
There therefore exists a taking order of new financing project. Asymmetric information save us the
issue of debt over equity signals the board confidence that an investment is profitable and that the
current stock price is undervalued (where stock price is overvalued, the issue of equity will be
favoured)

Trade off theory

This refers to the idea that a company chosen how much debt finance and how much equity finance to
use by balancing the costs and benefits.
An important purpose of the theory is to explain the fact that corporate usually are financed partly
with debt and partly with equity.
It states that there is an advantage to financing with debt, the tax benefit of debt and there is a cost of
financial distress including bankruptcy, cost of debt and non-bankruptcy costs (e.g. staff leaving,
suppliers demanding, disadvantageous payment tax, bond /stockholders infighting)
The marginal benefit of further increasing debt declines as debt increases, why the marginal cost
increases, so that a firm that is optimizing its overall value will focus on this trade off when choosing
how much debt and equity to use for financing.

SPECIAL TOPICS IN FINANCING

EBIT –EPS ANALYSIS
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of
financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial
leverage on the EPS with varying levels of EBIT or under alternative financial plans.
It examines the effect of financial leverage on the behavior of EPS under different financing
alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of the
combination and of the various sources. It helps select the alternative that yields the highest EPS.
We know that a firm can finance its investment from various sources such as borrowed capital or
equity capital. The proportion of various sources may also be different under various financial plans.
In every financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis

EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various
financing plans with varying levels of EBIT. Thus it helps a firm in determining optimum financial
planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

Financial planning: Use of EBIT-EPS analysis is indispensable for determining sources of funds. In
case of financial planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evalu-
ates the alternatives and finds the level of EBIT that maximizes EPS.

Comparative analysis: EBIT-EPS analysis is useful in evaluating the relative efficiency of depart-
ments, product lines and markets. It identifies the EBIT earned by these different departments,
product lines and from various markets, which helps financial planners rank them according to
profitability and also assess the risk associated with each.

Performance evaluation: This analysis is useful in comparative evaluation of performances of

various sources of funds. It evaluates whether a fund obtained from a source is used in a project that
produces a rate of return higher than its cost.

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Determining optimum mix: EBIT-EPS analysis is advantageous in selecting the optimum mix of
debt and equity. By emphasizing on the relative value of EPS, the analysis determines the optimum
mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest
value of EPS as the most profitable financing plan or the most profitable level of EBIT as the case
may be.

Limitations of EBIT-EPS analysis

Finance managers are very much interested in knowing the sensitivity of the earnings per share with
the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this technique
also suffers from certain limitations, as described below

No consideration for risk: Leverage increases the level of risk, but this technique ignores the risk
factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt,
any financial planning can be accepted irrespective of risk. But in times of poor business the reverse
of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS
analysis.

Contradictory results: It gives a contradictory result where under different alternative financing
plans new equity shares are not taken into consideration. Even the comparison becomes difficult if the
number of alternatives increase and sometimes it also gives erroneous result under such situation.

Over-capitalization: This analysis cannot determine the state of over-capitalization of a firm. Beyond
a certain point, additional capital cannot be employed to produce a return in excess of the payments
that must be made for its use. But this aspect is ignored in EBIT-EPS analysis

ILLUSTRATION
Wazalendo Ltd., has an EBIT of Sh. 3,200,000. Its capital structure is given as below:
Sh.
Equity share capital at sh.10 4,000,000
13% preference share capital 1,000,000
9% debentures 2,000,000

The corporate tax rate is 50%

Required;-
Compute the EPS.
Sh.
EBIT 3,200,000
Interest (9/100×2,000,000) (180,000)
EBT 3,020,000
Less tax at 50% 1,510,000
EAT 1,510,000
Less; Preference dividend (13/100×1,000,000) (130,000)
Earnings available to equity shareholders 1,380,000

4,000,000
Number of equity shares is = 400,000
10

1,380,000
Earnings per share is = sh.3.45
400,000
Indifference Point
The indifference point, often called as a breakeven point, is highly important in financial planning
because; at EBIT amounts in excess of the EBIT indifference level, the more heavily levered financ-

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ing plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference
points the financing plan involving less leverage will generate a higher EPS.
i) Concept:
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial
plans. Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt
equity mix. The management is indifferent in choosing any of the alternative financial plans at this
level because all the financial plans are equally desirable. The indifference point is the cut-off level of
EBIT below which financial leverage is disadvantageous. Beyond the indifference point level of EBIT
the benefit of financial leverage with respect to EPS starts operating.
The indifference level of EBIT is significant because the financial planner may decide to take the debt
advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will be able to
magnify the effect of increase in EBIT on the EPS.
In other words, financial leverage will be favorable beyond the indifference level of EBIT and will
lead to an increase in the EPS. If the expected EBIT is less than the indifference point then the
financial planners will opt for equity for financing projects, because below this level, EPS will be
more for less levered firm.

ii) Computation:
We have seen that indifference point refers to the level of EBIT at which EPS is the same for two
different financial plans. So the level of that EBIT can easily be computed. There are two approaches
to calculate indifference point: Mathematical approach and graphical approach.

Mathematical Approach:
Under the mathematical approach, the indifference point may be obtained by solving equations.

Sh.
EBIT X
Less; Interest I
EBT X -I
Less; tax (X –I)t
EAT (X –I) (X –t)
Less; Preference dividend Pd
Earnings available to equity shareholders (X –I) (X –t) - Pd

(𝑋−𝐼)(𝑋−𝑡)−𝑃𝑑
Earnings per share will be
𝑁

Where, N represents number of equity shares.

In case of financing, three types of sources may be opted: Equity, debt and preference shares.
Therefore the four possible combinations will be;-
• Equity
• Equity - Debt
• Equity - Preference Shares
• Equity - Debt - Preference Shares.
So, EPS under various alternatives will be as follows:

(𝑋−𝐼)(1−𝑡)
Equity – Debt; EPS = 𝑁

𝑋(1−𝑡)−𝑃𝑑
Equity - Preference Shares; EPS =
𝑁

(𝑋−1) (1−𝑡)−𝑃𝑑
Equity - Debt - Preference Shares; EPS =
𝑁

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ILLUSTRATION
Daraja Co. Ltd., is planning an expansion programme. It requires Sh. 20,000,000 of external financing
for which it is considering two alternatives. The first alternative calls for issuing 15,000 equity shares
of Sh. 1000 each and 5,000 10% Preference Shares of Sh. 1000 each; the second alternative requires
10,000 equity shares of Sh. 100 each, 2,000 10% Preference Shares of Sh. 100 each and Sh.
8000,000 Debentures carrying 9% interest. The company is in the tax bracket of 50%.

Required;-
Calculate the indifference point for the plans and verify your answer by calculating the EPS.

SOLUTION
Plan 1 Plan 2
Sh. Sh.
Equity share capital at sh.10 15,000,000 10,000,000
10% preference share capital 5,000,000 2,000,000
9% debentures - 8,000,000
Total 20,000,000 20,000,000
Number of equity shares 15,000 10,000

Let X level of EBIT, the EPS under both the plan be the same

𝑋(1−𝑡)−𝑃𝑑 𝑋(1−0.5)−500,000
EPS under 1st alternative = =
𝑁 15000

(𝑋−𝐼) (1−𝑡)−𝑃𝑑 (𝑋−72,000) (1−0.5)−20,000

EPS under 2nd alternative = =
𝑁 10,000

Equalizing Both the EPS, it will be as follows;-

𝑋(1−0.5)−500,000 (𝑋−720,000) (1−0.5)−200,000

=
15000 10,000

0.5𝑋−500,000 0.5𝑋−360000−200,000
=
15000 10,000

0.5𝑋−500,000 0.5𝑋−560,000
=
3 2

0.5𝑋−500,000 0.5𝑋−560,000
=
3 2

1.5X – 1,680,000 = X -1,000,000

680,000
X= =1,360,000
0.5

Computation of EPS under different plans

Plan 1 Plan 2

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EBIT 1,360,000 1,360,000
Less; Interest - (720,000)
EBT 1,360,000 640,000
Less; tax 680,000 320,000
EAT 680,000 320,000
Less; Preference dividend 500,000 200,000
Earnings available to equity shareholders 180,000 120,000

180,000 120,000
EPS 15000 10000

12 12

FINANCIAL & OPERATIONAL GEARING

FINANCIAL GEARING
In financial management the term financial gearing (leverage) is used to describe the way in which
owners of the firm can use the assets of the firm to gear up the assets and earnings of the firm.
Employing debt allows the owner to control greater volume of assets than they could if they invested
their own money only. The higher the debt equity ratio, the higher the firm equity and therefore the
firm level of financial risk. Financial risk occurs due to the higher proportion of financial obligations
in the firms cost structure. The degree to which the firm is financially geared can be measured by the
degree of financial gearing given by:

Degree of Financial Gearing (DFG) = (% ∆ in EPS)

(% ∆ in EBIT)

The degree of financial gearing indicates how sensitive a firm’s E PS is to changes in earnings before
changes in interest and taxes (EBIT).

ILLUSTRATION
The financial manager of ABC Ltd expects earnings before interest and taxes of sh.50,000 in the
current financial year and pays interest of 10% as long-term loan of sh.200 000. The company has
100 000 ordinary shares and the tax rate is 20%. The finance manager is currently examining 2
scenarios.
A case where EBIT is 25% less than expected
A case where EBIT is 25% more than expected.

Required;-
Compute the EPS under the 3 cases and the degree of financial gearing for both scenario 1 and 2.

SOLUTION
Scenario 1 Base Case Scenario 2
(-25%) sh. (+25%)
EBIT 37 500 50 000 62 500
Interest (20,000) (20 000) (20 000)
EBT 17 500 30 000 42 500
Tax (20%) (3 500) (6 000) 8 500
EAT 14 000 0.24 34 000
EPS 0.14 24 000 0.34

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DFG = %∆ in EPS
%∆ in EBIT

Scenario 1 DFG = (0.24 – 0.14) / 0.24 = 1.67

0.25

Scenario 2 DFG = (0.34 – 0.24) / 0.24 = 1.67

0.25
The degree of financial gearing can be calculated more easily using the following formulae.
DFG = EBIT
EBT

= 50 000 = 1.67
30 000

Note that this formula should be used for the base case only.

A degree of financial gearing greater than one indicates that the firm is financially geared. The higher
the ratio, the more vulnerable the firm’s earnings available to shareholders are to changes in firm’s
EBIT.

OPERATING GEARING
Financial gearing is related to the proportion of fixed financial cost in the firm’s overall cost structure.
Operating gearing however relate to the proportion of fixed operating cost in the firm’s overall cost
structure. Operating gearing mainly considers the relationship between changes in EBIT and changes
in sales. The degree to which a firm is operationally geared can be measured as follows:
D.O.G. = %∆ in EBIT
%∆ in Sales

D.O.G. therefore measures the sensitivity or vulnerability of EBIT to changes in sales. It can also be used
to measure Business Risk. If D.O.G is more than one, then the business is operationally geared.

ILLUSTRATION
Assume that the finance manager of ABC Ltd expects to generate sales of sh.50 000 in the current
financial year. Analysis of the firms operating cost structure reveals that variable operating cost is
40% of sales and fixed operating cost at sh.250 000.

The manager wishes to explore the effect of changes in sales and has developed 2 scenarios.
Sales revenue is 10% less than expected
Sales revenue is 10% greater than expected

Required;-
Compute EBIT for each of the scenarios and the degree of operating gearing.
Scenario 1 Base Case Scenario 2
(-10%) sh. (+10%)
Sales 450 000 500 000 550 000
Variable cost (180 000) (200 000) (220 000)
Contribution 270 000 300 000 330 000
Fixed cost (250 000) (250 000) (250 000)
20 000 50 000 80 000

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 D. O. G. = (50 000 – 20 000) / 50 000 =6
(500 000 – 450 000) / 500 000

For the Base Case the degree of operating gearing can be given by the following formulae:
D.O.G. = Contribution
EBIT

= 300 000
50 000 = 6

COMBINED GEARING
It’s possible to obtain an assessment of the firms total gearing by combining its financial gearing and
operating gearing so that the degree of total gearing (D.T.G) is equal to degree of operating gearing
multiplied by degree of financial gearing.

D.T.G. = D.O.G. × D. F. G.
= %∆ in EPS
%∆ in sales

D.T.G. therefore measures the sensitivity (vulnerability) of EPS to changes in company’s sales.
ILLUSTRATION
Consider the ABC illustration and compute the degree of total gearing.

SOLUTION
Base case Scenario 2
Sh. +10%
Sales 500 000 550 000
Variable cost 200 000 220 000
Contribution 300 000 330 000
Fixed cost 250 000 250 000
EBIT 50 000 80 000
Interest 20 000 20 000
EBT 30 000 60 000
Less Tax(10%) 6 000 12 000
EAT 24 000 48 000
EPS 0.24 0.48

D.T.G = (0.48 – 0.24) / 0.24 = 10

(550 000 – 500 000) / 500 000)

For the base case,

D.T.G = Contribution
EBT

= 300 000 = 10
30 000

GEARED AND UNGEARED BETAS

Firms must provide a return to compensate for the risk faced by investors, and even for a well-
diversified investor, this systematic risk will have two causes:

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 • the risk resulting from its business activities
• the finance risk caused by its level of gearing.

Consider therefore two firms A and B:

• both are identical in all respects including their business operations but
• A has higher gearing than B:
o A would need to pay out higher returns
o any beta extrapolated from A's returns will reflect the systematic risk of both its
business and its financial position and would therefore be higher than B's.

Therefore there are two types of beta:

Β Asset reflects purely the systematic risk of the business area.

Β Equity reflects the systematic risk of the business area and the company-specific financial structure.

Using betas in project appraisal

It is critical in examination questions to identify which type of beta you have been given and what risk
it reflects. The steps to calculating the right beta and how to use it in project appraisal are;-

(1) Find an appropriate asset beta.

This may be given to you in the question. If not, you will need to calculate it by de-gearing a
given equity beta. You can do this using the asset beta formula given to you in the exam.

However, in many exams, ßd will be assumed to be zero. This means that the asset beta
formula can be simplified to:

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Where:
Ve = market value of equity
Vd = market value of debt
T = corporation tax rate.
When using this formula to de-gear a given equity beta, Ve and Vd should relate to the company or
industry from which the equity beta has been taken.
If using the adjusted present value (APV) approach, then this asset beta can be used to calculate a Ke
to determine the base case NPV.

If needing a risk adjusted WACC, then the following steps need to be followed as well.

(2) Adjust the asset beta to reflect the gearing levels of the company making the investment
Re-gear the asset beta to convert it to an equity beta based on the gearing levels of the company
undertaking the project. The same asset beta formula as given above can be used, except this time
Ve and Vd will relate to the company making the investment.

(3) Use the re-geared beta to find Ke. This is done using the standard CAPM formula.

Remember that CAPM just gives you a risk-adjusted Ke, so once a company has found the relevant
shareholders' required return for the project it could combine it with the cost of debt to calculate a risk
adjusted weighted average cost of capital. This is discussed in further detail he

LEASE VERSUS PURCHASE

An entity's non-financial assets can be acquired either through outright purchase or leasing
arrangements. When making a ‘lease or buy’ decision an entity must not only consider the financial
implications of the options including the government's procurement criterion relating to ‘value for
money’, but consideration must also be given to long-term strategic priorities and to qualitative
factors. It is important to understand the implication of both options for the service delivery needs of
the entity when determining the most appropriate option.

When leasing an asset the entity only pays for the use of the asset over the term of the lease and
ownership of the asset does not pass to the entity at any stage unless the lease contract specifically
states it. Leases where substantially all the risks and rewards incidental to ownership are transferred
are usually classified as finance leases. When buying an asset, the entity pays the full cost of the asset
at acquisition date and has full ownership over the asset.
A finance lease is recorded as an asset when the transaction (contract) is entered into and, similar to
the outright purchase option, will give rise to depreciation expense as would be the case of other
assets controlled by the entity. If there is no reasonable certainty that the lessee will obtain ownership
by the end of the lease term, the asset is required to be fully depreciated over the lease term or its
useful life, whichever is shorter.
An operating lease on the other hand, will usually specify a period over which an entity will have the
right to use the goods, and have them replaced if they stop working during the lease period, but will
then return the goods to the lessor at the end of the lease.
Better practice entities will usually undertake a risk assessment and cost benefit analysis to assess the
implication of the operating lease vs finance lease vs outright purchase decision when considering key
asset acquisitions.

Advantages of purchase

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• Outright asset ownership
• Assets can be modified at any stage to suit changing business requirements.
• Asset can be replaced or disposed of at any time.
Disadvantages of purchase
• Major capital outlay up-front.
• Entity incurs maintenance and repairs costs which typically increase as assets age.
• Entity incurs costs for the replacement or disposal of assets at the end of their useful lives.

Advantages of leasing
• Cash-flow effective method for gaining access to assets as no major capital outlay up-front.
• Entity may not incur repair and maintenance costs as assets may fall under the warranty of the
lessor over the term of the lease.
• The entity may not incur costs associated with disposal and replacement of assets at the end of
their useful lives
• Assets may be replaced more frequently, allowing the entity access to latest technology for no
additional cost.

Disadvantages of leasing
• No asset ownership.
• Assets may not be able to be modified to suit changing business requirements without lessor
approval and attracting fees.
• Lease terms are generally fixed so asset replacements and early terminations at the request of the
entity may attract penalties and fees.
• Potential capital outlay at the end of the lease term if purchasing the asset at the end of the lease.

The decision to either lease an asset or purchase it outright not only requires consideration of the
broad advantages and disadvantages outlined above, but also requires an analysis of the financial
implications of the decision. Financial parameters, such as the interest rate which may be charged on
the financed amount as well as the implied opportunity cost of using the entity's own cash resources,
may have a significant impact on the lease versus purchase decision.

IMPACT OF FINANCING ON INVESTMENT DECISIONS -

ADJUSTED PRESENT VALUE
Adjusted present value is an investment appraisal technique similar to net present value method.
However, instead of using weighted average cost of capital as the discount rate, ungeared cost of
equity is used to discount the cash flows from a project and there is an adjustment for the tax shield
provided by related debt capital.

This approach separates the investment element of the decision from the financing element and
appraises them independently.

APV is also recommended when there are complex funding arrangements (e.g. subsidized loans).

Calculation
Basic principle
The APV method evaluates the project and the impact of financing separately. Hence, it can be used if
a new project has a different financial risk (debt-equity ratio) from the company, i.e. the overall
capital structure of the company changes.

APV consists of two different elements:

136
1. The investment element (Base case NPV)
The project is evaluated as though it were being undertaken by an all equity company with all
financing side effects ignored. The financial risk is quantified later in the second part of the APV
analysis. Therefore:
• ignore the financial risk in the investment decision process
• Use a beta that reflects just the business risk

In finance, the beta (β) of an investment is a measure of the risk arising from exposure to general
market movements as opposed to idiosyncratic factors.

Procedure for Calculating Base Case NPV

2. The financing impact

Financing cash flows consist of:
• Issue costs.
• Tax reliefs.

As all financing cash flows are low risk they are discounted at either:
• the Kd i.e cost of debt or
• The risk free rate.

Issue costs
A firm will know how much finance is required for the investment. Issue costs of finance will usually
be quoted on top. It will therefore be necessary to gross up the funds to be raised. Issue costs for debt
will be eligible for tax relief so this must be incorporated.

Tax reliefs
Since interest cost is allowable as tax deduction therefore, when calculating taxable income it
provides tax savings (also called tax shield).

This gives the following overall calculation:

Sh.

137
Base case NPV XX

PV of the issue costs

Equity (XX)
Debt (XX)
PV of the tax shield XX
XX

Basically in the adjusted preset value (APV) approach the value of the firm is estimated in following
steps.
1. The first step is to estimate the value of a company with no leverage by calculating a NPV at the
cost of equity as the discount rate.
2. The next step is to calculate the expected tax benefit from a given level of debt financing. These
can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the
tax effects. The NPV of the tax effects is then added to the base NPV.
3. The last step is to evaluate the effect of borrowing the amount on the probability that the firm will
go bankrupt, and the expected cost of bankruptcy.

ILLUSTRATION
A project costing sh.50 million is expected to generate after tax cash flows of sh.10 million a year
forever. Risk free rate is 3%, asset beta is 1.5, required return on market is 12%, cost of debt is 8%,
annual interest costs related to project are sh.2 million and tax rate is 40%.
Required;-
Calculate the adjusted present value of the project.

SOLUTION

Adjusted Present Value = Present Value of Cash Flows + Present Value of financing effects.

Ungeared Cost of Equity = Risk Free Rate+ Asset beta × (Market Return − Risk Free Return)

We need to find ungeared cost of equity which is 3% + 1.5× (12% − 3%) = 16.5%.

Sh. million
Present value of cash flows= sh.10 million/0.165 60.61
Less; initial investment cost 50
value of a company with no leverage 10.61

Present value of tax savings (sh.2 million × 0.4 / 0.08) 10

Adjusted Present Value 20.61
Decision Rule
The decision rule for adjusted present value is the same as net present value: accept positive APV
projects and reject negative APV projects. The project has an APV of sh.20.61 which is positive
hence the company should undertake the project.

Debt capacity
Debt finance benefits a project because of the associated tax shield. If a project brings about an
increase in the borrowing capacity of the firm, it will increase the potential tax shield available.
A project's debt capacity denotes its ability to act as security for a loan. It is the tax relief available on
such a loan, which gives debt capacity its value.
When calculating the present value of the tax shield (tax relief on interest) it should be based on the
project's theoretical debt capacity and not on the actual amount of the debt used.

138
The tax benefit from a project accrues from each pound of debt finance that it can support, even if the
debt is used on some other project. We therefore use the theoretical debt capacity to match the tax
benefit to the specific project.

For example, if a question stated that actual debt raised is sh.800, 000 but you are told in the question
"The investment is believed to add sh.1 million to the company's debt capacity." The present value of
the tax shield is based on the sh.1 million - the theoretical amount.

The APV technique has practical advantages and theoretical disadvantages.

Advantages
− Step by step approach gives clear understanding of the elements of decision making
− Can evaluate any type of financing package
− More straight forward than adjusting the WACC which can be very complex

Disadvantages
Based on MM theory with tax theory. Therefore ignores;
• Bankruptcy risk
• Tax exhaustion
• Agency costs
Based on MM theory with taxes. Therefore assumes debt is risk free and irredemable

FINANCIAL DISTRESS
Financial Distress is a condition where a company cannot meet or has difficulty paying off its
financial obligations to its creditors. The chance of financial distress increases when a firm has high
fixed costs, illiquid assets, or revenues that are sensitive to economic downturns
A company under financial distress can incur costs related to the situation, such as more expensive on
financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing
additional capital will usually increase, making it more difficult and expensive to raise the much
needed funds. In an effort to satisfy short-term obligations, management might pass on profitable
longer-term projects. Employees of a distressed firm usually have lower morale and higher stress
caused by the increased chance of bankruptcy, which would force them out of their jobs. Such
workers can be less productive when under such a burden.

Sources of Financial Distress

We can divide the sources of financial distress into three categories:
a) Firm level causes of financial distress
b) Industry level causes
c) Macro level factors causing financial distress

a) Firm Level Causes

These factors are specific to a particular firm and include
• ownership and governance,
• operating risk and
• Leverage.
For example, agency costs connected with managerial discretion and debt, depending on the extent
that they are not mitigated through contracting devices can affect a firm's operational efficiency,
leverage, profitability and risk. However, if a firm is observed to be in financial distress, and even if
the cause of the distress can be traced explicitly to bad decisions by management, it may be difficult
to distinguish whether the decisions that contributed to distress are due to management's self-serving
behavior or to incompetence.

139
b) Industry Level Causes
Five forces of industry competition are useful for identifying possible industry level causes of
financial distress. These forces are;-
i). Entry / exit barriers.
ii). bargaining power of vendors
iii). bargaining power of buyers
iv). threat of substitute products and
v). Rivalry among competing firms.

A negative shock to an industry's product demand or costs especially if it is sustained over time, will
eventually force a shakeout of firms in the industry. The weakest firm will be forced into liquidation
or must consider being acquired by a stronger firm in the industry.

The leverage helps boost a firm's sales growth relative to that of its industry rivals because the firm
commits to aggressive competitions in the product markets, which leads less aggressive competitors
to yields part of their market share. The firm may deliberately choose low leverage so as to be able to
pursue predatory market strategies to squeeze a high-levered rival, perhaps to the point of bankruptcy.
The industry shocks contribute to the frequency of takeover and restructuring activity. Shocks include
deregulation, changes in input costs, and innovations in financing technology that induce or enable
alterations in industry structure. The inter-industry patterns in the rate of takeovers and restructurings
are directly related to the economic shocks borne by the sample industries.

Financial researchers and thinkers have investigated the effect of a bankruptcy announcement by one
firm on the values of other firms in the industry. There are two conflicting effects. On one hand, there
may be contagion effect. The market may lower the value of other firms in the industry because the
bankruptcy announcement reveals new negative information about the status of the industry as a
whole. On the other hand, the market may raise the values of other firms in the industry because on of
their rival has failed.

The deregulation of an industry can induce financial distress in many firms within the industry as the
economic structure of the industry changes.

c) Macro-Level Causes
Recessions create financial distress by narrowing the margin between cash flow and debt service.
When the flow constraint is relevant, a principal effect of drop in current income is the reduction of
expenditure on illiquid and long-lied assets. There are two reasons for this. First, lower current
income increases the short run probability that the flow constraint will have to be satisfied through
costly means, for example, the distress sales of assets, borrowing at unfavorable terms, sever
reduction in current living standard, or as the last resort, bankruptcy. Secondly, a drop in current
income typically has ambiguous implications for the consumers' estimates of future income flows and,
hence, for the level of durables holdings consistent with maintenance of solvency in the long run.
Because durables are illiquid, it is more costly to correct an over purchase than an under purchase.
Assuming that waiting for new information will tend to resolve the ambiguity created by the initial
income fall even a risk neutral consumer will be motivated to defer durables purchases until the
uncertainty is resolved.

Effects of Financial Distress

Loss of Tax Benefit: if a levered firm fails to make profits on a chronic basis, it looses the value of
the tax shield provided by debt interest and depreciation. Depending on the firm's initial leverage and
depreciation base, these losses alone can place the firm at a competitive and strategic disadvantage.

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Transaction Costs: the cost of transacting in the financial markets is much higher for firms in
financial distress. In some cases, the capital markets may be effectively closed to a firm that is in
severe distress, in part because, given the effort required by an investment bank that float the firm's
equity or debt securities, the required underwriter spread would be prohibitively high.

Increase in Illiquidity: significant losses in the market value of a firm's equity can have several
negative liquidity effects. First, the firm may lose some professionals who play vital role is
supporting the flow of information about a stock, which is critical to liquidity. Secondly, the investors'
interest in trading that stock may reduce resulting in increase in the bid-ask spread. Third, there are
chances that stock exchange may de-list that stock, but this will depend on the regulations of stock
exchange.
At this point, the firm has lost most of its potential to raise equity funds; raising debt funds will be
more difficult as well. Moreover, this may come at a time when the firm is most in need of external
funds to survive.

SIGNS OF FINANCIAL DISTRESS

Many businesses often show symptoms of having impaired cash flow but fail to recognize the
warning signs until it are too late. There are some warning signs all business owners must look out for
which will provide crucial insight into the financial viability of a business. Of these, a lack of up-to-
date financial information (especially reports related to taxation) should always set alarm bells
ringing, as it indicates limited control and vision of where the business is headed.
• Continued erosion of margins, suggesting an inability to maintain market share and, ultimately,
remain solvent;
• Expansion beyond a business’s financial means, so that the cost of resultant over-borrowing
becomes a drain on the overall operation;
• Over-reliance on borrowed funds, resulting in a significant proportion of gross profits being
directed at servicing the loan;
• Inadequate capital base, creating problems in financing ongoing operations and growth;
• Lack of cash flow forecasting, in particular the absence of a cash budget;
• Difficulty paying creditors
• Continual capital/loans injection, for if a business is not structured for recovery then any over-
capitalization will be impossible to service from internal generation of funds.
• Lack of accountability
• Internal borrowing from restricted funds. This can be done in a disciplined, board-approved way,
but not in desperation.
• Lack of investment expertise and policies. They must be present or built.
• Untimely financial reporting. A board that does not receive timely reports is at risk.
• Poor credit. Creditworthiness and ability to borrow are signs of strength.
• Spending down cash reserves. This s usually done by default, not design.

PREDICTING ORGANISATIONAL FAILURE

REVISITING THE Z-SCORE

Traditional Ratio Analysis

The detection of company operating and financial difficulties is a subject which has been particularly
amenable to analysis with financial ratios. Prior to the development of quantitative measures of
company performance, agencies were established to supply a qualitative type of information assessing
the credit-worthiness of particular merchants. (For instance, the forerunner of the well-known Dun &
Bradstreet, Inc. was organized in 1849 in Cincinnati, Ohio, in order to provide independent credit
investigations). Formal aggregate studies concerned with portents of business failure were evident in
the 1930’s.

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One of the classic works in the area of ratio analysis and bankruptcy classification was performed by
Beaver (1967). In a real sense, his univariate analysis of a number of bankruptcy predictors set the
stage for the multivariate attempts, by this author and others, which followed.
Beaver found that a number of indicators could discriminate between matched samples of failed and
non-failed firms for as long as five years prior to failure. He questioned the use of multivariate
analysis, although a discussant recommended attempting this procedure. The Z-Score model did just
that. A subsequent study by Deakin (1972) utilized the same 14 variables that Beaver analyzed, but he
applied them within a series of multivariate discriminant models.
The aforementioned studies imply a definite potential of ratios as predictors of bankruptcy. In general,
ratios measuring profitability, liquidity, and solvency prevailed as the most significant indicators. The
order of their importance is not clear since almost every study cited a different ratio as being the most
effective indication of impending problems.

Although these works established certain important generalizations regarding the performance and
trends of particular measurements, the adaptation of the results for assessing bankruptcy potential of
firms, both theoretically and practically, is questionable. In almost every case, the methodology was
essentially univariate in nature and emphasis was placed on individual signals of impending problems.
Ratio analysis presented in this fashion is susceptible to faulty interpretation and is potentially
confusing. For instance, a firm with a poor profitability and/or solvency record may be regarded as a
potential bankrupt. However, because of its above average liquidity, the situation may not be
considered serious. The potential ambiguity as to the relative performance of several firms is clearly
evident. The crux of the shortcomings inherent in any univariate analysis lies therein. An appropriate
extension of the previously cited studies, therefore, is to build upon their findings and to combine
several measures into a meaningful predictive model. In so doing, the highlights of ratio analysis as an
analytical technique will be emphasized rather than downgraded. The questions are;
i) which ratios are most important in detecting bankruptcy potential
ii) what weights should be attached to those selected ratios, and
iii) How the weights should be objectively established.

Discriminant Analysis

Multiple discriminant analysis (MDA) seems to be an appropriate statistical technique.

Although not as popular as regression analysis, MDA has been utilized in a variety of disciplines
since its first application in the 1930’s. During those earlier years, MDA was used mainly in the
biological and behavioral sciences. In recent years, this technique has become increasingly popular in
the practical business world as well as in academia. Altman, et.al. (1981) discusses discriminant
analysis in-depth and reviews several financial application areas.

MDA is a statistical technique used to classify an observation into one of several a priority groupings
dependent upon the observation’s individual characteristics. It is used primarily to classify and/or
make predictions in problems where the dependent variable appears in qualitative form, for example,
male or female, bankrupt or no bankrupt. Therefore, the first step is to establish explicit group
classifications. The number of original groups can be two or more.

Some analysts refer to discriminant analysis as “multiple” only when the number of groups exceeds
two. We prefer that the multiple concepts refer to the multivariate nature of the analysis.

After the groups are established, data are collected for the objects in the groups; MDA in its most
simple form attempts to derive a linear combination of these characteristics which “best”
discriminates between the groups. If a particular object, for instance, a corporation, has characteristics
(financial ratios) which can be quantified for all of the companies in the analysis, the MDA
determines a set of discriminant coefficients. When these coefficients are applied to the actual ratios, a
basis for classification into one of the mutually exclusive groupings exists.

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The MDA technique has the advantage of considering an entire profile of characteristics common to
the relevant firms, as well as the interaction of these properties. A univariate study, on the other hand,
can only consider the measurements used for group assignments one at a time.

Another advantage of MDA is the reduction of the analyst’s space dimensionally, that is, from the
number of different independent variables to G-1 dimension(s), where G equals the number of
original a priori groups. This analysis is concerned with two groups, consisting of bankrupt and non-
bankrupt firms. Therefore, the analysis is transformed into its simplest form: one dimension. The
discriminant function, of the form Z = V1X1 + V2X2 +…+ VnXn transforms the individual variable
values to a single discriminant score, or z value, which is then used to classify the object where V1,

X2, . . . . . . Vn = discriminant coefficients, and

V1, X2, . . . . Xn = independent variables

The MDA computes the discriminant coefficient; Vi while the independent variables Xi are the actual
values.

When utilizing a comprehensive list of financial ratios in assessing a firm’s bankruptcy potential,
there is reason to believe that some of the measurements will have a high degree of correlation or
collinearity with each other. While this aspect is not serious in discriminant analysis, it usually
motivates careful selection of the predictive variables (ratios). It also has the advantage of potentially
yielding a model with a relatively small number of selected measurements which convey a great deal
of information. This information might very well indicate differences among groups, but whether or
not these differences are significant and meaningful is a more important aspect of the analysis.

Perhaps the primary advantage of MDA in dealing with classification problems is the potential of
analyzing the entire variable profile of the object simultaneously rather than sequentially examining
its individual characteristics. Just as linear and integer programming have improved upon traditional
techniques in capital budgeting, the MDA approach to traditional ratio analysis has the potential to
reformulate the problem correctly. Specifically, combinations of ratios can be analyzed together in
order to remove possible ambiguities and misclassifications observed in earlier traditional ratio
studies.

As we will see, the Z-Score model is a linear analysis in that five measures are objectively weighted
and summed up to arrive at an overall score that then becomes the basis for classification of firms into
one of the a priori groupings (distressed and non-distressed).

DEVELOPMENT OF THE Z-SCORE MODEL

Sample Selection

The initial sample is composed of 66 corporations with 33 firms in each of the two groups. The
bankrupt (distressed) group (Group 1) is manufacturers that filed a bankruptcy petition under Chapter
X of the National Bankruptcy Act from 1946 through 1965. A 20-years period is not the best choice
since average ratios do shift over time. Ideally, we would prefer to examine a list of ratios in time
period t in order to make predictions about other firms in the following period (t+1). Unfortunately, it
was not possible to do this because of data limitations.

Recognizing that this group is not completely homogeneous (due to industry and size differences),
careful selection was made of no bankrupt (non-distressed) firms.

Group 2 consists of a paired sample of manufacturing firms chosen on a stratified random basis.

The firms are stratified by industry and by size, with the asset size range restricted to between $1and
$25 million. The mean asset size of the firms in Group 2 ($9.6 million) was slightly greater than that

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of Group 1, but matching exact asset size of the two groups seemed unnecessary. Firms in group 2
were still in existence at the time of the analysis. Also, the data collected are from the same years as
those compiled for the bankrupt firms. For the initial sample test, the data are derived from financial
statements dated one annual reporting period prior to bankruptcy. The data were derived from
Moody’s Industrial Manuals and also from selected annual reports. The average lead-time of the
financial statements was approximately seven and one-half months.

An important issue is to determine the asset-size group to be sampled. The decision to eliminate both
the small firms (under $1 million in total assets) and the very large companies from the initial sample
essentially is due to the asset range of the firms in Group 1. In addition, the incidence of bankruptcy in
the large-asset-size firm was quite rare prior to 1966. This changed starting in 1970 with the
appearance of several very large bankruptcies.

A frequent argument is that financial ratios, by their very nature, have the effect of deflating statistics
by size, and that therefore a good deal of the size effect is eliminated. The Z-Score model, discussed
below, appears to be sufficiently robust to accommodate large firms.

Variable Selection

After the initial groups are defined and firms selected, balance sheet and income statement data are
collected. Because of the large number of variables found to be significant indicators of corporate
problems in past studies, a list of 22 potentially helpful variables (ratios) was compiled for evaluation.
The variables are classified into five standard ratio categories, including liquidity, profitability,
leverage, solvency, and activity. The ratios are chosen on the basis of their popularity in the literature
and their potential relevancy to the study, and there are a few “new” ratios in this analysis. The Beaver
study (1967) concluded that the cash flow to debt ratio was the best single ratio predictor. This ratio
was not considered in my 1968 study because of the lack of consistent and precise depreciation and
cash flow data. The results obtained, however, were still superior to the results Beaver attained with
his single best ratio

From the original list of 22 variables, five are selected as doing the best overall job together in the
prediction of corporate bankruptcy. This profile did not contain the entire most significant variable
measured independently. This would not necessarily improve upon the univariate, traditional analysis
described earlier. The contribution of the entire profile is evaluated and, since this process is
essentially iterative, there is no claim regarding the optimality of the resulting discriminant function.
The function, however, does the best job among the alternatives which include numerous computer
runs analyzing different ratio profiles.

In order to arrive at a final profile of variables, the following procedures are utilized:

1. observation of the statistical significance of various alternative functions, including determination

of the relative contributions of each independent variable;
2. evaluation of inter-correlations among the relevant variables;
3. observation of the predictive accuracy of the various profiles; and
4. Judgment of the analyst.
The final discriminant function is as follows:

Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 +0.999X5

Where X1 = working capital/total assets,

X2 = retained earnings/total assets,

X3 = earnings before interest and taxes/total assets,

X4 = market value equity/book value of total liabilities,

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X5 = sales/total assets, and

Z = overall index.

Note that the model does not contain a constant (Y-intercept) term. This is due to the particular
software utilized and, as a result, the relevant cutoff score between the two groups is not zero. Other
software program, like SAS and SPSS, have a constant term, which standardizes the cutoff score at
zero if the sample sizes of the two groups are equal.

X1, Working Capital/Total Assets (WC/TA).

The working capital/total assets ratio, frequently found in studies of corporate problems, is a measure
of the net liquid assets of the firm relative to the total capitalization. Working capital is defined as the
difference between current assets and current liabilities. Liquidity and size characteristics are
explicitly considered. Ordinarily, a firm experiencing consistent operating losses will have shrinking
current assets in relation to total assets. Of the three liquidity ratios evaluated, this one proved to be
the most valuable. Two other liquidity ratios tested were the current ratio and the quick ratio. There
were found to be less helpful and subject to perverse trends for some failing firms.

X2, Retained Earnings/Total Assets (RE/TA).

Retained earnings is the account which reports the total amount of reinvested earnings and/or losses of
a firm over its entire life. The account is also referred to as earned surplus. It should be noted that the
retained earnings account is subject to "manipulation" via corporate quasi-reorganizations and stock
dividend declarations. While these occurrences are not evident in this study, it is conceivable that a
bias would be created by a substantial reorganization or stock dividend and appropriate readjustments
should be made to the accounts.

This measure of cumulative profitability over time is what I referred to earlier as a “new” ratio. The
age of a firm is implicitly considered in this ratio. For example, a relatively young firm will probably
show a low RE/TA ratio because it has not had time to build up its cumulative profits. Therefore, it
may be argued that the young firm is somewhat discriminated against in this analysis, and its chance
of being classified as bankrupt is relatively higher than that of another older firm, ceteris paribus. But,
this is precisely the situation in the real world. The incidence of failure is much higher in a firm’s
earlier years. In 1993, approximately 50% of all firms that failed did so in the first five years of their
existence (Dun & Bradstreet, 1994).

In addition, the RE/TA ratio measures the leverage of a firm. Those firms with high RE, relative to
TA, have financed their assets through retention of profits and have not utilized as much debt.

X3, Earnings Before Interest and Taxes/Total Assets (EBIT/TA).

This ratio is a measure of the true productivity of the firm’s assets, independent of any tax or leverage
factors. Since a firm’s ultimate existence is based on the earning power of its assets, this ratio appears
to be particularly appropriate for studies dealing with corporate failure.

Furthermore, insolvency in a bankrupt sense occurs when the total liabilities exceed a fair valuation of
the firm’s assets with value determined by the earning power of the assets. As we will show, this ratio
continually outperforms other profitability measures, including cash flow.

X4, Market Value of Equity/Book Value of Total Liabilities (MVE/TL).

Equity is measured by the combined market value of all shares of stock, preferred and common, while
liabilities include both current and long term. The measure shows how much the firm’s assets can
decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets
and the firm becomes insolvent. For example, a company with a market value of its equity of $1,000
and debt of $500 could experience a two-thirds drop in asset value before insolvency. However, the

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same firm with $250 equity will be insolvent if assets drop only one-third in value. This ratio adds a
market value dimension which most other failure studies did not consider. The reciprocal of X4 is a
slightly modified version of one of the variables used effectively by Fisher (1959) in a study of
corporate bond yield-spread differentials. It also appears to be a more effective predictor of
bankruptcy than a similar, more commonly used ratio; net worth/total debt (book values). At a later
point, we will substitute the book value of net worth for the market value in order to derive a
discriminant function for privately held firms (Z’) and for non-manufacturers (Z”).

More recent models, such as the KMV approach, are essentially based on the market value of equity
and its volatility. The equity market value serves as a proxy for the firm's asset values.

X5, Sales/Total Assets (S/TA).

The capital-turnover ratio is a standard financial ratio illustrating the sales generating ability of the
firm’s assets. It is one measure of management’s capacity in dealing with competitive conditions. This
final ratio is quite important because it is the least significant ratio on an individual basis. In fact,
based on the univariate statistical significance test, it would not have appeared at all. However,
because of its unique relationship to other variables in the model, the sales/total assets ratio ranks
second in its contribution to the overall discriminating ability of the model.

SOLUTIONS TO FINANCIAL DISTRESS

The solutions to financial distress include;-
• Debt restructuring
• Loan modifications
• Full or partial debt settlement
• Extension of payment terms

Debt restructuring is a process that allows a private or public company, or a sovereign entity facing
cash flow problems and financial distress to reduce and renegotiate its delinquent debts in order to
improve or restore liquidity so that it can continue its operations.

A Loan Modification is a permanent change in one or more of the terms of a Borrower's loan, allows
the loan to be reinstated, and results in a payment the Borrower can afford.

Extension of payment terms; this is an act or instance of extending the payment period or lengthening,
stretching out.

PRACTICE QUESTIONS (Solutions on page 276)

QUESTION 1
(a) Highlight four uses of the cost of capital to a limited liability company.
(b) The Finance Manager of Mapato Limited has compiled the following information regarding the
company’s capital structure.

Ordinary shares
The company’s equity shares are currently selling at Shs. 100 per share. Over the past five years, the
company’s dividend pay-outs which have been approximately 60% of the earnings per share were as
follows:
Year ended 30 September Dividend per share
Shs.
2004 6.60
2003 6.25
2002 5.85

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 2001 5.50
2000 5.23

The dividend for the year ended 30 September 2004 was recently paid.
The average growth rate of dividend is 6% per annum.
To issue additional ordinary shares, the company would have to issue at a discount of Shs. per share
and it would cost Shs. 5 in floatation cost per share.
The company can issue unlimited number of shares under the above terms.

Preference shares
The company can issue an unlimited number of 8% preference shares of Shs.10 par value at a
floatation cost of 5% of the face value per share.

Debt
The company can raise funds by selling Shs.100, 8% coupon interest rate, 20 year bonds, on which
annual interest will be made.
The bonds will be issued at a discount of Shs.3 per bond and a floatation cost of an equal amount per
bond will be incurred.

Capital structure
The company’s current capital structure, which is considered optimal, is:
Shs.
Long term debt 30,000,000
Preference shares 20,000,000
Ordinary shares 45,000,000
Retained earnings 5,000,000
100,000,000

The company is in the 30% tax bracket.

Required:
(i) The specific cost of each source of financing.
(ii) The level of total financing at which a break-even point will occur in the company’s weighted
marginal cost of capital.

QUESTION 2
Zatex Ltd. had the following capital structure as at 31 March 2005:
Shs.
Ordinary share capital (200,000 shares) 4,000,000
10% Preference share capital 1,000,000
14% Debenture capital 3,000,000
8,000,000
Additional information:
1. The market price of each ordinary share as at 31 March 2005 was Shs. 20.
2. The company paid a dividend of Shs. 2 for each ordinary share for the year ended 31 March
2005.
3. The annual growth rate in dividends is 7%.
4. The corporation tax rate is 30%.

Required:

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 (i) Compute the weighted average cost of capital of the company as at 31 March 2005.
(ii) The company intends to issue a 15% Shs. 2 million debenture during the year ending 31
March 2006. The existing debentures will not be affected by this issue. The dividend per
share for the year ending 31 March 2006 is expected to be Shs. 3 while the average market
price per share over the same period is estimated to be Shs. 15. The average annual growth
rate in dividends is expected to remain at 7%.

Compute the expected weighted average cost of capital as at 31 March 2006.

CHAPTER 5
CORPORATE VALUATION

INTRODUCTION
Several valuation methods are available, depending on a company’s industry, its characteristics (for
example, whether it is a start-up or a mature company), and the analyst’s preference and expertise. In
this chapter, we focus on the mainstream valuation methods. These methods are classified into two
categories, based on two dimensions. The first dimension distinguishes between direct (or absolute)
valuation methods and indirect (or relative) valuation methods

As their name indicates, direct valuation methods provide a direct estimate of a company’s
fundamental value. In the case of public companies, the analyst can then compare the company’s
fundamental value obtained from that valuation analysis to the company’s market value. The
company appears fairly valued if its market value is equal to its fundamental value, undervalued if its
market value is lower than its fundamental value, and overvalued if its market value is higher than its
fundamental value.

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In contrast, relative valuation methods do not provide a direct estimate of a company’s fundamental
value: They do not indicate whether a company is fairly priced; they indicate only whether it is fairly
priced relative to some benchmark or peer group. Because valuing a company using an indirect
valuation method requires identifying a group of comparable companies, this approach to valuation is
also called the comparable approach.
These two approaches to valuation are broken down as follows;-

Present Value of Cash Flows (PVCF) /direct valuation methods

i) Present value of dividends (DDM)
ii) Present value of free cash flow to equity (FCFE)
iii) Present value of free operating cash flow to the firm (FCFF)

Relative Valuation Techniques

i) Price/earnings ratio (P/E)
ii) Price/cash flow ratio (P/CF)
iii) Price/book value ratio (P/ BV)
iv) Price/sales ratio (PIS)
APPLICATION OF VALUATION MODELS

ABSOLUTE VALUE MODELS/ DISCOUNTED CASH FLOW VALUATION

TECHNIQUES
The discounted cash flow techniques are based on the basic valuation model which asserts that the
value of an asset is the present value of its expected cash flows and can be expressed as follows:

𝐶𝐹𝑡
Vj = ∑
(1+k)𝑡

Where Vj Value of stock j

n Life of the asset
CFt Cash flow in period t
k The discount rate that is equal to the investors required rate of return for asset j,
which is determined by the uncertainty (risk) of the assets cash flows

Under the discounted cash flow techniques we have the following techniques:
i. The dividend discount model-DDM ( Present value of dividends)
ii. Present value of operating free cash flows (Pv OFCE)
iii. Present value of free cash flow to equity ( Pv FCFE)

i) The dividend discount model(DDM)

According to this model, the value of a share is the present value of all future dividends.
This is given by:

𝐷𝑡
Vj = ∑
(1+k)𝑡

𝐷1 𝐷2 𝐷𝑛
+ +…………+
(1+k)1 (1+k)2 (1+k)𝑛

Where Vj is the value of a common stock/share

Dn Dividend during period t
k Required rate of return on stock j
n number of periods

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This formula assumes that a share is held indefinitely. However, this is not usually the case since
securities could be held for a period (year), several years (multiple periods) or for an infinite period of
time.

a) Single period model (One year holding period)

In a single period model, an investor’s intention is to purchase a share now, hold it for one year and
sell it off at the end of one year. The investor therefore would be expected to receive an amount of
dividend as well as the selling price after one year.
To calculate the value of the share, we must estimate the dividends to be received during this period,
the expected sale price at the end of the holding period as well as the investor’s required rate of
return.

The Present value of the share will be expressed as:

𝐷1 𝑆1
Vj = (𝐼+𝑘)1 + (𝐼+𝑘)1

Where
D1 = Amount of dividend expected to be received at the end of one year.
S1 = Selling price expected to be realised on sale of the share at the end of one year.
k=Rate of return required by the investor

ILLUSTRATION
An investor expects to invest in a company and to get shs 1.50 as dividends from a share next year
and hopes to sale off the share at 30 shillings after holding it for 1 year. His required rate of return is
20%
i) What is the present value of the share
ii) How much should he be willing to buy a share of this company

𝐷1 𝑆1 1.50 30
Value of share =
(1+𝑘)1
+ (𝐼+𝑘)1 = (1+0.2)1 + (1+0.2)1

1.50 30
= (1.2)1 + (1.2)1

= 1.25 + 25 = Shs. 26.25

The value he should be willing to pay the share should be shs. 26.25 or less
Shs. 26.25 is the intrinsic value of the share. The investor would buy this share only if its current
market price is lower than or equal to this value.

b) Multiple period model ( Multiple-year Holding period)

An investor may hold a share for a certain number of years and sell it off at the end of his holding
period. In this case, he would receive annual dividends each year and the sale price of the share at the
end of the holding period. The present value of the share will be expressed as:

𝐷1 𝐷2 𝐷3 𝐷𝑛+𝑆𝑛
Vj = + + …………+
(1+k)1 (1+k)2 (1+𝑘)3 (1+k)𝑛

Where

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D1, D2, D3,…Dn = Annual dividends to be received each year.
Sn = Sale price at the end of the holding period
k = Investor’s required rate of return.
n = Holding period in years.

ILLUSTRATION
An investor intends to invest in XYZ Company and expects to get sh. 3.5, sh.4 and sh. 4.5 as
dividends from a share during the next three years and hopes to sale it off at sh. 75 at the end of the
third year. His required rate of return is 25%

Required;-
What is the present value of the share of XYZ company.

3.5 4 4.5+75
Value of the share =
(1+0.25)1
+ (1+0.25)3 + (1+0.25)3

= 2.8 + 2.56 + 40.70 = sh.46.06

However, to use the dividend discount model, an investor has to forecast the future dividends as well
as the selling price of the share at the end of his holding period. This is a major limitation since it is
not possible to forecast these variables accurately. For this reason, the model is practically infeasible.
In the case of most equity shares, the dividend per share grows because of the growth in earnings of a
company. It also follows that dividends grow and are not constant over time. The growth rate pattern
of equity dividends have to be estimated.

To overcome this major limitation, assumptions about growth rate patterns can be made and
incorporated into the valuation models. The assumptions include:
1. Dividends grow at a constant rate in future, i.e the constant growth rate assumption.
2. Dividends grow at varying rates in future, i.e multiple growth assumption.

Infinite period model (constant growth model) (Gordon’s share valuation model)
This model assumes that the value of a share is the present value of all future dividends. If the future
stream of cash flow will grow at a constant rate for an infinite period, then:

𝐷𝑜(1+𝑔)1 𝐷𝑜(1+𝑔)2 𝐷𝑜(1+𝑔)𝑛

Then Vj = (𝐼+𝑘)1
+ (𝐼+𝑘)1
………………….. (𝐼+𝑘)ℎ

Where,
Vj is the value of stock j
Do Dividend payment in the current period
g Constant growth of dividends
k Required rate of return on stock j
n Number of periods

Three basic assumptions are made when using the model and they include:
- Dividends will grow at a constant rate (g)
- An infinite time period (indefinite future)
- The discount rate (k) is greater than the dividend growth rate (g) i.e k>g

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The model can be reduced to:
Vj = D1 or Do (1+g)
k-g k-g

Where D1 is equal to = Do (1+g)

Do current dividend
k required rate
g is the growth rate

ILLUSTRATION
A company has declared a dividend of sh. 2.5 per share for the current year. The company has been
following a policy of enhancing its dividends by 10% every year and it is expected to continue with
the policy into the future. The required rate of return is 15%.
What the value of the share.
𝐷𝑜(1+𝑔)
Vj =
𝑘−𝑔
Do = shs 2.5
g = 10%
k = 15%

2.5 (1+0.1) 2.5 (1.1) 2.75

= = = Sh 55
0.15−0.1 0.05 0.05

ILLUSTRATION
Consider a company with current dividend of sh 1 per share. Over the long run the company earnings
and dividends will grow at 7%. The long run required rate of return is 11%.

Required;-
a) What is the value of a stock of the firm
𝐷𝑜(1+𝑔) 1(1+0.07) 1(1.07)
Vj = = =
𝑘−𝑔 0.11−0.07 0.04
Sh. 26.75

b) What is the required rate of return if the cost of capital changes to 12%
1(1+0.07)
= Sh. 21.40
0.12−0.07

c) What is the growth rate increases to 8%

1(1+0.08)
= Sh. 36
0.11−0.08

Summary
Required rate of Growth rate in Spread (k-g) Value of the share
return dividend
11% 7% 4% Sh. 26.75

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12% 7% 5% Sh. 21.40
11% 8% 3% Sh. 36.00

NOTE;-
• A small change in growth rate/required rate of returns produces a large difference in estimated
value of the stock
• An important relationship in determining value of a share is the spread between the required rate
of return and the growth rate in dividend.
• A decline in spread causes an increase in the computed value and vice-versa

ILLUSTRATION
ABC Company earned sh. 10 per share last year and paid sh. 6 per share dividend. Next year ABC is
expected to earn sh. 11 per share and continue its payment ratio. An investor would wish to sell the
share for sh. 132 per share a year from now and requires 12% rate of return.

Required;-
How much will he be willing to pay for it.

SOLUTION
𝐷1 𝑆𝑃
Vj = (1+𝑘)1 + (1+𝑘)1

11 × 6
Payment ratio is 10: 6 = = shs 6.6
10

∴ Next year 11: ?

6.6 132
(1+0.12)
+ (1+0.12)

5.893 + 117.857= Sh. 123.75

Super-normal growth model (multiple growth models)

There are certain instances when the constant growth assumption may not be realistic. This is more so
when the growth in dividends may be at varying rates. This could be as a result of new prospects, new
products, superior management, etc.

When this occurs, a company may have a period of extraordinary growth that will prevail for a certain
number of years, after which growth will change to a level at which it is expected to continue
indefinitely.
According to this model, the future time period can be divided into two different growth segments.
The initial extraordinary growth period (Growth rates are variable from year to year) and the
subsequent constant growth period (Growth rate remains constant from year to year)

ILLUSTRATION
A company paid a dividend of sh. 2 per share during the current year. It is expected to pay a dividend
of Sh. 3 per share and sh. 3.50 per share respectively during the two subsequent years. After that
annual dividends will grow at 10% per year into an indefinite future. The investors required rate of
return is 20%.

153
Required;
Calculate the investor’s intrinsic value

SOLUTION

Year Dividend PVIF @ 20% Present Value

1 2 0.8333 1.666
2 3 0.6944 2.0832
3 3.5 0.5787 2.0254
End of year 3 38.5 0.5787 22.2799
Present value 28.0455

𝐷𝑜(1+𝑔) 3.5(1+0.1)
= 38.5
𝑘−𝑔 0.2−0.1

ILLUSTRATION
Toleo ltd is experiencing a period of abnormal growth. It has a current dividend (Do) of shs 2 per
share. The following are the expected annual growth rates for dividends.
Year Dividend growth rate (%)
1-3 25
4-6 20
7-9 15
10 and so on 9
The required rate of return for stock of Toleo Ltd is 14%.
Required:
What is the value of the stock of Toleo Ltd?

SOLUTION

Year Dividends PV1F 14% Present Value

1 2(1+0.25) = 25 0.8772 2.193
2 2.5(1+0.25) = 3.125 0.7645 2.389
3 3.125 (1 + 0.25) = 3.91 0.6750 2.639
4 3.91 (1 + 0.20) = 4.69 0.5921 2.776
5 4.69(1 + 0.2) = 5.63 0.5174 2.9242
6 5.63 (1 + 0.2) = 6.76 0.4556 3.0798
7 6.76 (1 + 0.15) = 7.77 0.3996 3.1048
8 7.77(1 + 0.15) = 8.94 0.3605 3.1334
9 8.94 (1 + 0.15) = 10.28 0.3075 3.1611
End of year 9 10.28(1.09) = 224.104 0.3075 68.911
94.3113

𝐷𝑜(1+𝑔) 10.28(1+0.09)
= 224.104
𝑘−𝑔 0.14−0.09

FREE CASH FLOW MODELS

Decisions to invest can be made based on simple analysis such as finding a company you like with a
product you think will be in demand in the future. The decision might not be based on scouring the
financial statements, but the underlying reason for picking this type of company over another is still
sound. Your underlying prediction is that the company will continue to produce and sell high-demand

154
products and thus will have cash flowing back to the business. The second, and very important, part of
the equation is that the company's management knows where to spend this cash to continue
operations. A third assumption is that all of these potential future cash flows are worth more today
than the stock's current price.

FREE CASH FLOW TO EQUITY (FCFE)

This technique resembles a present value of earnings concept except that it considers the capital
expenditures required maintaining and growing the firm and the change in working capital required
for a growing firm (that is, an increase in accounts receivable and inventory). The specific definition
of free cash flow to equity (FCFE) is:

Net Income + Depreciation Expense - Capital Expenditures - change in Working Capital - Principal
Debt Repayments + New Debt Issues

Computation of free cash flows to equity

Sh
Net income xxx
Less capital expenditures (xxx)
Add depreciation expenses Xx
Less working capital (xx)
Less principal debt repayments (xx)
Add any new debt issued xx
Free cash flow to equity xx

This technique attempts to determine the free cash flow that is available to the stockholders
after payments to all other capital suppliers and after providing for the continued growth of
the firm. Given the current FCFE values, the alternative forms of the model are similar to those
available for the DDM, which in turn depends on the firm's growth prospects. Specifically, if the firm
is in its mature, constant-growth phase, it is possible to use a model similar to the reduced form DDM:

𝑭𝑪𝑭𝑬
Value =
𝑲−𝑮 𝒇𝒄𝒇𝒆
Where
FCFE = the expected free cash flow to equity in Period 1
k = the required rate of return on equity for the firm
Gfcfe = the expected constant growth rate of free cash flow to equity for the firm

Free cash flow to equity is derived after the operating cash flows have been adjusted for debt
payments (Interest and principle) but include dividends to shareholders.
They are referred to as free because they are what are left after providing funds needed to maintain
firm’s assets base and free cash flow to equity because they adjust for debt payments to debt holders
and any payments to preferred stockholders.

ILLUSTRATION
Upendo Ltd has been in operation for a few years and have estimated for the next 6 years they expect
to continue with a growth rate of 8% into the future. Their net income for the year 2012 was 35
million shillings. Depreciation expense12.5 million, capital expenditure 35.5million and their changes
in working capital was 7.5 million.

They also paid principle repayment of 1.5million. In order to increase it opportunities in the market.
Upendo Ltd issued bond of 10 million. The required rate of return on equity is 9% and the outstanding
shares are 25million.

155
Required;-
i) What is the intrinsic value of a share of Upendo Ltd.
ii) What would be your advice for an investor who intends to invest in Upendo Ltd if their share is
Shs 60.50

SOLUTION
i) Intrinsic value of a share of Upendo
Step 1: Free cash flows to equity
Shs ‘million’
Net income 35.0
Less capital expenditure (35.5)
Less working capital (7.5)
Less debt repayment (1.5)
Add new debt 10
Add depreciation 12.5
13

Assume constant growth rate

𝐹𝐶𝐹𝐸(1 + 𝑔)
(𝑘 − 𝑔)

13,000,000(1+0.08)
= 1,404, 000,000
(0.09−0.08)

𝑉𝑗
Value of a share =
𝑁𝑜 𝑜𝑅𝑅 𝑠ℎ𝑎𝑟𝑒𝑠
1,404,000,000
∴= = sh 56.16
25,000,000

ii) An investor shouldn’t invest in the company since the price of the share sh. 60.50 is overvalued
when compared with the intrinsic value which is sh. 56.16

ILLUSTRATION
The following example uses a three-stage growth model as follows;-
g1 = 13 percent for the five years after 2008
g2 = a constantly declining growth rate to 6 percent over seven years
k = 8 percent cost of equity
The specific estimates of annual FCFE, beginning with the estimated value of shs.780 million in 2008
are as follows;-

HIGH GROWTH PERIOD

YEAR GROWTH RATE million 8% PV Factor PV @ 8%
2009 13% 881 0.855 753
2010 13% 996 0.794 791
2011 13% 1,125 0.735 827
2012 13% 1,271 0.680 864
2013 13% 1,437 0.629 904
4,139

DECLINING GROWTH PERIOD

YEAR GROWTH RATE million 8% PV Factor PV @ 8%
2014 12% 1,609 0.585 941

156
2015 11% 1,786 0.541 966
2016 10% 1,965 0.500 982
2017 9% 2,142 0.463 992
2018 8% 2,313 0.429 992
2019 7% 2,475 0.397 983
2020 6% 2,624 0.368 966
6,822

𝟐,𝟔𝟐𝟒(𝟏.𝟎𝟔) 𝟐,𝟕𝟖𝟏
Constant Growth Period value = = =139,050
𝟎.𝟎𝟖−𝟎.𝟎𝟔 𝟎.𝟎𝟐

PV at 8%=sh. 139,050× 0.368=sh. 51,170

Sh. million
Present value of high-growth FCFEs 4,139
Present value of declining-growth FCFEs 6,822
Present value of constant-growth FCFEs 51,170
Total present value of FCFE 62,131

The outstanding shares in 2007 were approximately 1,006 million. Therefore, the per share
value, based on the present value of FCFE is sh.61.76 (62,131/1,006). Again, the estimated value
is above the prevailing market price of about sh.37.00. This estimated value implies a Price earnings
ratio of about 28 times estimated 2008 earnings of sh. 2.20 per share.

FREE CASH FLOW TO FIRM (FCFF) MODEL

The object is to determine a value for the total firm and subtract the value of the firm's debt
obligations to arrive at a value for the firm's equity.
Notably, in this valuation technique, we discount the firm's operating free cash flow to the firm
(FCFF) at the firm's weighted average cost of capital (WACC) rather than its cost of equity.

Operating free cash flow or free cash flow to the firm (FCFF) is equal to

EBIT (1 - Tax Rate) + Depreciation Expense - Capital Expenditures - change in Working Capital -
change in other assets

This is the cash flow generated by a company's operations and available to all who have pro-
vided capital to the firm-both equity and debt. As noted, because it is the cash flow available
to all capital suppliers, it is discounted at the firm's WACC.
Again, the alternative specifications of this operating FCF model are similar to the DDM-
that is, the specification depends upon the firm's growth prospects. Assuming an expectation
of constant growth, you can use the reduced form model:

𝑭𝑪𝑭𝑭𝟏 𝑶𝑭𝑪𝑭𝟏
Firm Value = or
𝑾𝑨𝑪𝑪−𝑮 𝒇𝒄𝒇𝒇 𝑾𝑨𝑪𝑪−𝑮 𝑶𝒇𝒄𝒇

Where:
FCFF 1 = the free cash flow for the firm in Period 1
OFCF1 = the firm's operating free cash flow in Period 1
WACC = the firm's weighted average cost of capital
Gfcff = the constant infinite growth rate of free cash flow for the firm
Gofcf = the constant infinite growth rate of operating free cash flow

157
COMPUTING THE WACC
This is also called the overall or composite cost of capital. Since various capital components have
different percentage cost, it is important to determine a single average cost of capital attributable to
various costs of capital. This is determined on the basis of percentage cost of each capital component.

Market value weight or proportion of each capital component

E P D
W.A.C.C = K e   + K p   + K d (1 − T ) 
V V V
Where:
Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital respectively
E, P and D = Market value of equity, preference share capital and debt capital respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.

ILLUSTRATION
The following is the capital structure of XYZ Ltd as at 31/12/2012.
Sh. M
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par value 100
12% debenture Sh.100 par value 200
900
Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to grow at
5% p.a. in future. The current MPS is Sh.40.

Required;-
a) Determine the WACC of the firm.
b) Explain why market values and not book values are used to determine the weights.
c) What are the weaknesses associated with WACC when used as the discounting rate, in project
appraisal.

SOLUTION
a) i) Compute the cost of each capital component
Cost of equity (Ke) – Since the growth rate in dividends is given, use the constant growth rate
dividend model to determine the cost of equity.

d0 = Sh.5 P0 = Sh.40 g = 5%

d0 (1 + g ) 5(1 + 0.05)
Ke = +g = + 0.05 = 0.18125 = 18.13%
P0 40

Cost of perpetual preference share capital (Kp) – preference shares are still selling at par thus MPS =
par value. If this is the case, Kp = coupon rate = 10%.

MPS = Par value = Sh.20

Dp = 10% × Sh.20 = Sh.2

158
 DPS dp Sh.2
Kp = = = = 10%
MPS Pp Sh.20

Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a redeemable fixed
return security thus the cost of debt is equal to yield to maturity.

Redemption yield:
Interest charges p.a. = 12% x Sh.100 par value = Sh.12
Maturity period (n) = 10 years
Maturity value (m) = Sh.100
Current market value (Vd) = Sh.90
Corporate tax rate (T) = 30%

Int(1 − T ) + (M − Vd )
1
K d = YTM = RY = n
(M + Vd )½

1
Sh.12(1 − 0.3) + (100 − 90)
= 10 = 9.9% ≈ 10%
(100 + 90)½

ii) Compute the market value of each capital component

Market value of Equity (E) = MPS × No. of ordinary shares
Sh.400 MDSC
= Sh.40 x = 1,600M
Sh.10parvalue

Market value of preference share capital (P)

= Par value, since MPS = Par value per share = 100M

Market value of debt (D) = Vd × No. of debentures

Sh.200 Mdebentures
= Sh.90 x = 180M
Sh.100parvalue

E + P + D = V = total Market Value = 1,880M

iii) Compute W.A.C.C using Ke = 18.13%, Kp = 10%, Kd(1-T) = 10%

a) Using weighted average cost method,, WACC =

E P D
= K e   + K p   + K d (1 − T ) 
V
  V
  V

 1,600   100   180 

= 18.13%  + 10%  + 10% 
 1,880   1,880   1,880 

= 15.43 + 0.5319 + 0.9574

= 0.169193

≈ 16.92%

b) By using percentage method,

159
 WACC = Total monetary cost
Total market value (V)

Where: Monetary cost = % cost x market value of capital

Monetary cost of E = 18.13% x 1,600 = 290.08
Monetary cost of P = 10% x 100 = 10.00
Monetary cost of D = 10% x 180 = 18.00
318.08

Total market value (V) 1,880

318.08
Therefore WACC = x100 = 16.92%
1,880

COMPUTATION OF PRESENT VALUE OF FREE CASHFLOWS TO THE FIRM(FCFF)

Assuming WACC of 7.5 percent in the demonstration and the following growth estimates for a three-
stage growth model:
gl = 13 percent for four years
g2 = a constantly declining rate to 6 percent over seven years then grows constantly.
The specific estimates for future OFCF (or FCFF) are as follows, beginning from the 2008 value
of shs 700 million.

HIGH-GROWTH PERIOD
Year Growth rate FCFF PV Factor @ PV @ 7.5%
7.5%
2008 - 700
2009 (13%) 791 0.930 736
2010 (13%) 894 0.865 773
2011 (13%) 1,010 0.805 813
2012 (13%) 1,141 0.749 855
3,177

DECLINING-GROWTH PERIOD
Year Growth rate FCFF PV Factor @ 7.5% PV @ 7.5%
2013 (12%) 1278 0.697 891
2014 (11%) 1419 0.648 920
2015 (10%) 1560 0.603 935
2016 (9%) 1701 0.561 954
2017 (8%) 1837 0.522 959
2018 (7%) 1966 0.486 955
2019 (6%) 2083 0.452 942
Total 6,556

𝟐,𝟎𝟖𝟑(𝟏.𝟎𝟔) 𝟐,𝟐𝟎𝟖
Constant Growth Period value = = = Shs.147, 200
𝟎.𝟎𝟕𝟓−𝟎.𝟎𝟔 𝟎.𝟎𝟏𝟓

PV at 7.5% = Sh. 147,200 × 0.452 = Sh.66, 534

This growth rate assumption implies that we do not believe that FCFF can grow as long at 13 percent
as FCFE. Given a beginning growth rate of 13 percent for only four years and a long- run rate of 6
percent means that the growth rate will decline by 0.01 per year as shown in the following example.
Thus the total value of the firm is;-
Shs million

160
 Present value of high-growth cash flows 3,177
Present value of declining-growth cash flows 6,556
Present value of constant-growth cash flows 66,534
Total present value of operating FCF(FCFF) 76,267

MEASURES OF RELATIVE VALUE

Relative valuation is a business valuation method that compares a firm's value to that of its
competitors to determine the firm's financial worth. Relative valuation models are an alternative to
absolute value models, which try to determine a company's intrinsic worth based on its estimated
future free cash flows discounted to their present value. Like absolute value models, investors may
use relative valuation models when determining whether a company's stock is a good for buying.

Relative valuation is not as straightforward as it might appear on the surface. Which companies are
chosen as comparable companies and which multiples are used to determine value will have a
significant outcome on a company's relative valuation. When performing a relative valuation, a
company's sector should be used to determine the most logical multiple to use. For example, price to
cash flow for real estate and price to sales for retail.

PRICE-TO-EARNINGS (P/E) RATIO

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

Market Value per Share

Earnings per Share (EPS)

For example, if a company is currently trading at shs.43 a share and earnings over the last 12 months
were sh.1.95 per share, the P/E ratio for the stock would be 22.05 (shs.43/shs.1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the
estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation
uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future
compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by
itself. It's usually more useful to compare the P/E ratios of one company to other companies in the
same industry, to the market in general or against the company's own historical P/E. It would not be
useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a
technology company (high P/E) to a utility company (low P/E) as each industry has much different
growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing
to pay per shilling of earnings. If a company were currently trading at a multiple (P/E) of 20, the
interpretation is that an investor is willing to pay shs.20 for sh.1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid
basing a decision on this measure alone. The denominator (earnings) is based on an accounting
measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as
good as the quality of the underlying earnings number.

161
The price/earnings ratio (P/E) is the best known of the investment valuation indicators. The P/E ratio
has its imperfections, but it is nevertheless the most widely reported and used valuation by investment
professionals and the investing public. The financial reporting of both companies and investment
research services use a basic earnings per share (EPS) figure divided into the current stock price to
calculate the P/E multiple (i.e. how many times a stock is trading (its price) per each dollar of EPS).

It's not surprising that estimated EPS figures are often very optimistic during bull markets, while
reflecting pessimism during bear markets. Also, as a matter of historical record, it's no secret that the
accuracy of stock analyst earnings estimates should be looked at skeptically by investors.

Draw backs of using the P/E ratio

1. Earnings can be negative which produces useless P/E ratio.
2. Management discretion within allowed accounting practices can distort reported earnings and
thereby lessen the comparability of P/E ratio across firms.
3. The volatility portion of earnings makes the interpretation of P/E difficult for analysts.

We can define versions of P/E ratio as trading and leading P/E ratio. The difference between the two
is how earning (the denominator) are calculated.
Trading P/E ratios use earnings over the most recent 12 months in the denominator. The leading P/E
ratio (also known as forward or prospective P/E) uses next year expected earnings which is defined as
either expected EPS for the next four quarters or expected EPS for the next fiscal year

a) Trading P/E ratio

= Market price per share/ EPS over the previous 12 months
b) Leading P/E ratio
= Market price per share/ Forecast EPS over the next 12 months

ILLUSTRATION
Biron Ltd. reported Kshs.32 million in earnings during the fiscal year 2006. An analyst forecast an
EPS over the next 12 months of Kshs.1. Biron has 40 million shares outstanding at a market price of
Kshs.18 per share.

Required;-
Calculate Biron’s trading & leading P/E ratio

SOLUTION
MPS = 18
EPS over the previous 12 months

Reported earnings 32
= = = Kshs.0.80
Outstanding number of shares 40

Trading price earnings ratio

𝑚𝑎𝑟𝑘𝑒𝑡 𝑅𝑅𝑟𝑖𝑐𝑒 𝑅𝑅𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 18

= = = 22.5
𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑅𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 0.80

Leading P/E ratio

𝑚𝑎𝑟𝑘𝑒𝑡 𝑅𝑅𝑟𝑖𝑐𝑒 𝑅𝑅𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 18

= = = 18
𝑅𝑅𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑅𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 1

162
PRICE-TO-BOOK (P/B) RATIO

A ratio used to compare a stock's market value to its book value. It is calculated by dividing the
current closing price of the stock by the latest quarter's book value per share.
Also known as the "price-equity ratio"

Calculated as:
𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑛𝑑 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Price-to-book value (P/B) is the ratio of market price of a company's shares (share price) over its book
value of equity. The book value of equity, in turn, is the value of a company's assets expressed on the
balance sheet. This number is defined as the difference between the book value of assets and the book
value of liabilities.

Assume a company has shs.100 million in assets on the balance sheet and shs.75 million in liabilities.
The book value of that company would be shs.25 million. If there are 10 million shares outstanding,
each share would represent shs.2.50 of book value. If each share sells on the market at shs.5, then the
P/B ratio would be 2 (5/2.50).

First of all, the ratio is really only useful when you are looking at capital-intensive businesses or
financial businesses with plenty of assets on the books. Thanks to conservative accounting rules, book
value completely ignores intangible assets like brand name, goodwill, patents and other intellectual
property created by a company. Book value doesn't carry much meaning for service-based firms with
few tangible assets. Companies like Microsoft, whose bulk asset value is determined by intellectual
property rather than physical property; its shares have rarely sold for less than 10 times book value.
This means, Microsoft's share value bears little relation to its book value.

Book value doesn't really offer insight into companies that carry high debt levels or sustained losses.
Debt can boost a company's liabilities to the point where they wipe out much of the book value of its
hard assets, creating artificially high P/B values. Highly leveraged companies - like those involved in,
say, cable and wireless telecommunications - have P/B ratios that understate their assets. For
companies with a string of losses, book value can be negative and hence meaningless.
Behind-the-scenes, non-operating issues can impact book value so much that it no longer reflects the
real value of assets. For starters, the book value of an asset reflects its original cost, which doesn't
really help when assets are aging. Secondly, their value might deviate significantly from market value
if the earnings power of the assets has increased or declined since they were acquired. Inflation alone
may well ensure that book value of assets is less than the current market value.

At the same time, companies can boost or lower their cash reserves, which in effect changes book
value, but with no change in operations. For example, if a company chooses to take cash off the
balance sheet, placing it in reserves to fund a pension plan, its book value will drop. Share buy backs
also distort the ratio by reducing the capital on a company's balance sheet.

Advantages of price to book value

i. Book value is a cumulative amount that is usually positive even when a firm reports a loss and
earnings per share is negative. Thus price to book value can typically be used when the P/E
ratio cannot.
ii. Book value is more stable than EPS, so it may be more useful than P/E ratio, when EPS is
particularly high, low or volatile.

163
 iii. Book value is an appropriate measure of net asset value for firms that primarily hold liquid
assets. Examples include finance, investment, insurance and banking firms.
iv. Price to book value can be useful in valuing companies that are expected to go out of business.
v. Empirical research shows that price to book value ratios help explain differences in long run
average returns.

Limitations

i. Price to book value ratio do not recognize the value of non- physical asset such as human
capital.
ii. Price to book value ratios can be misleading when they are significant differences in the asset
intensity of production markets among the firms under consideration.
iii. Different accounting conventions can obscure the time investment in the firm made by
shareholders which reduces the comparability of price to book value ratios across firms and
countries.
iv. Inflation and technological changes can cause the book market value of asset to differ
significantly so book value is not an accurate measure of the shareholders investment. Thus
makes it more difficult to compare price to book value ratios across firms.

Note
Market value of equity
Price to book value=
Book value of equity

Where
Book value of equity is derived as
= Total assets – (Current liabilities+ Long term liabilities + Preference share capital)

Note
It is advisable to use tangible book value which is equal to book value of equity less intangible assets.
ILLUSTRATION
Based on the information in the following table, calculate the current price to book value for A and B
Corporations
Company Book value Shares o/s Current price
of equity
A 28,039 7,001 17.83
B 6,320 5,233 12.15

SOLUTION
Price / Book value = Market price per share / Book value of equity shares outstanding
a) A = 28,039/7,001 = 4.0049

b) B = 6,320/5,233 = 1.2077

Price / Book value = Price current/ Book value of equity shares outstanding
a) A = 17.83/4.005 = 4.452
b) B = 12.15/1.2077 = 10.06

PRICE TO CASH FLOW (P/CF) RATIO

It is a measure of the market's expectations of a firm's future financial health. Because this measure
deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to
the price-earnings ratio, this measure provides an indication of relative value.

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This ratio is similar to the price/earnings ratio, except that the price/cash flow ratio (P/CF) is seen by
some as a more reliable basis than earnings per share to evaluate the acceptability, or lack thereof, of a
stock's current pricing. The argument for using cash flow over earnings is that the former is not easily
manipulated, while the same cannot be said for earnings, which, unlike cash flow, are affected by
depreciation and other non-cash factors.

Calculated by:
𝑺𝒉𝒂𝒓𝒆 𝑷𝒓𝒊𝒄𝒆
Price to Cash flow ratio =
𝑪𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

The price/cash flow ratio has grown in prominence and use because many observers contend that a
firm's cash flow is less subject to manipulation than its earnings per share and because cash flows are
widely used in the present value of cash flow models discussed earlier.

Just as many financial professionals prefer to focus on a company's cash flow as opposed to its
earnings as a profitability indicator, it's only logical that analysts in this case presume that the price to
cash flow ratio is a better investment valuation indicator than the P/E ratio.

Investors need to remind themselves that there are a number of non-cash charges in the income
statement that lower reported earnings. Recognizing the primacy of cash flow over earnings leads
some analysts to prefer using the price to cash flow ratio rather than, or in addition to, the company's
P/E ratio

ILLUSTRATION
The closing stock price for Zimmer Man Holdings as of December 30, 2005 was reported in the
financial press as sh. 67.44. The reported net cash provided by operating activities (cash flow
statement) is 878.2 and the weighted average number of common shares outstanding (income
statement) is 247.1. Compute the price to cash flow ratio

SOLUTION
𝟔𝟕.𝟒𝟒 𝟔𝟕.𝟒𝟒
Price to cash low ratio= = =19
𝟖𝟕𝟖.𝟐/𝟐𝟒𝟕.𝟏. 𝟑.𝟓𝟓

The cash flow per share is calculated by dividing the reported net cash provided by operating
activities (cash flow statement) by the weighted average number of common shares outstanding
(income statement) to obtain the sh. 3.55 cash flow per share figure. By simply dividing, the equation
gives us the price/cash flow ratio that indicates as of Zimmer Man Holdings' 2005 fiscal year-end, its
stock (at sh. 67.44) was trading at 19.0-times the company's cash flow of sh. 3.55 per share

PRICE TO SALES (P/S) RATIO

The price-to-sales ratio (P/S) has had a long but generally neglected existence followed by a recent
reawakening. Phillip Fisher (1958), suggested this ratio as a valuable tool when considering
investments, including growth stocks. Subsequently, his son Kenneth Fisher (1984) used the ratio as a
major stock selection variable. In the late 1990s, P/S was suggested as a valuable tool by Leibowitz
(1997), and this ratio was espoused by O'Shaughnessy (1997), in his book that compared several stock
selection techniques. Leibowitz makes the point that sales growth drives the growth of all subsequent
earnings and cash flow. Those who are concerned with accounting manipulation point out that sale is
one of the purest numbers available. Notably, this ratio is equal to the P/E ratio times the net profit
margin (earnings/sales), which implies that it is heavily influenced by the profit margin of the entity
being analyzed in addition to sales growth and sales volatility (risk).

Formula:

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 𝑠𝑡𝑜𝑐𝑘 𝑅𝑅𝑟𝑖𝑐𝑒 𝑅𝑅𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Price to sales ratio =
𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 (𝑟𝑒𝑣𝑒𝑛𝑢𝑒)𝑅𝑅𝑒𝑟𝑠ℎ𝑎𝑟𝑒

Advantages
1. Price to sales ratio is meaningful even for distressed firm since sales revenue is always positive.
This is not the case for price to earnings ratio and price to book ratio which can be negative.
2. Sales revenue is not easy to manipulate or distort as EPS and book value which are significantly
affected by accounting conventions.
3. Price to sales ratio is not volatile as P/E multiples. This may make Price to sales ratio more
reliable in valuation analysis.
4. Price to sales ratio is particularly appropriate for valuing stock in mature cyclical industries and
Startup Company with no records of earnings.
5. Like the price to earnings and price to book ratios empirical research find that differences are
Price to sales ratio is significantly related to differences in long term average returns.

Limitations
1. High growth in sales does not necessarily indicate operating profits as measured by earnings and
cash flow.
2. Price to sales does not capture differences in cost structures across companies.
3. While less subject to distortion than earnings and cash flow, revenue recognition practices can
still distort sales forecast. For instance, an analyst should look for company practices that speed
up revenue recognition. For instance, sale on a bill and hold basis which involves selling products
and delivering them at a later date. This practice accelerates sales into an earlier reporting
production and distorts the P/S ratio
Note
Market value of equity
Price / Sales ratio (P/S) =
Total sales

ILLUSTRATION
Based on the following information in the table below, calculate the price to sales ratio for A & B
Company Sales Shares outstanding Price Current
A 18,878 7,001 17.83
B 9,475 5,233 12.15

Solution
a) A
Sales per Share = Total sales / Number of shares outstanding
= 18,878/7,001 = 2.696
Price / Sales ratio= Market price per share / SPS= 17.85/2.696= 6.6209

b) B
Sales per Share = Total sales / Number of shares outstanding
= 9,475/5,233
= 1.8106
Price / Sales ratio= Market price per share / SPS = 12.15/1.8106
= 6.7104

ECONOMIC VALUE ADDED

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Economic value added is the incremental difference in the rate of return over a company's cost of
capital. In essence, it is the value generated from funds invested in a business. If the economic value
added measurement turns out to be negative, this means a business is destroying value on the funds
invested in it. It is essential to review all of the components of this measurement to see which areas of
a business can be adjusted to create a higher level of economic value added. If the total economic
value added remains negative, the business should be shut down.

To calculate economic value added, determine the difference between the actual rate of return on
assets and the cost of capital, and multiply this difference by the net investment in the business.

Additional details regarding the calculation are:

• Eliminate any unusual income items from net income that do not relate to ongoing operational
results.
• The net investment in the business should be the net book value of all fixed assets, assuming that
straight-line depreciation is used.
• The expenses for training and R&D should be considered part of the investment in the business.
• The fair value of leased assets should be included in the investment figure.
• If the calculation is being derived for individual business units, the allocation of costs to each
business unit is likely to involve extensive arguing, since the outcome will affect the calculation
for each business unit.

The formula for economic value added is:

(Net investment) × (Actual return on investment – Percentage cost of capital)

Calculating EVA
A company has reported operating profits of sh. 21million. This was after charging sh. 4 million for the
development and launch costs: of: a new product that is expected to generate profits for four years.
Taxation is paid at the rate of 25% of the operating profit.
The company has-a risk adjusted weighted average cost of capital of 12% per annum and is paying
interest at 9% per annum on a substantial long term loan.
The company's non-current asset value is sh. 50 million and the net current assets have a value of sh. 22
million. The replacement cost of the non-current assets is estimated to be sh. 64 million.

Required;
Calculate the company's EVA for the period.

Solution
Calculation of NOPAT
Sh. million
:
Operating profit 21
Add back development costs 4
Less one year's amortization of development costs (Sh. 4 million/4) (1)
24
Taxation at 25% (6)
NOPAT 18

Calculation of economic value of net assets

Sh. million
Replacement cost of net assets (Sh. 22 million + Sh. 64 million) 86
Add back investment in new product to benefit future 3
Economic value of net assets 89

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Calculation of EVA
The capital charge is based on the weighted average cost of capital which takes account of the cost of
share capital as well as the cost of loan capital. Therefore the correct interest rate to use is 12%.
Sh. million
NOPAT 18.00
Capital charge (12% x sh.89 million) (10.68)
EVA 7.32
ILLUSTRATION
B division of Z Co has operating profits and assets as below:
Sh. million
Gross profit 156
Less: Non-cash expenses (8)
Amortization of goodwill (5)
Interest at 10% (15)
Profit before tax 128
Tax at 30% (38)
Net profit 90
Total equity 350
Long-term debt 150
500

Z Co has a target capital structure of 25% debt/75% equity. The cost of equity is estimated at 15%. The
capital employed at the start of the period amounted to Sh. 450,000. The division had non-capitalized
leases of Shs.20, 000 throughout the period. Goodwill previously written off against reserves in
acquisitions in previous years amounted to Sh. 40,000.

Required;
Calculate EVA for B division and comment on your results.

SOLUTION

Sh. million Sh. million

NOPAT
Net profit 90
Add back:
Non-cash expenses 8
Amortization of goodwill 5
Interest (net of 30% tax) 15 × 0.7 10.5 23.5
113.5
Assets
At start of period 450
Non-capitalized leases 20
Amortized goodwill 40
510

WACC
Equity 15% ×75% 0.1125
Debt (10% × 0.7) ×25% 0.0175
WACC 0.13

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 EVA Sh. Million
NOPAT 113.5
Capital charge;13%×Sh. 510 (66.3)
47.2
RI Sh. million
Net profit 90
Capital charge; 13% × Sh. 500 (65)
25

The EVA for B division is Sh. 47.2 M, higher than its RI. This is despite the higher net asset value and is
caused by treating expenses, such as amortization, in line with economic, not accountancy, principles.
The business is creating value as its return (however calculated) is greater than the group's WACC. The
division's ROI is 18% vs. WACC of 13% (based on target not actual capital structure).

USE OF ENTERPRISE VALUE IN VALUATION

Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were to
acquire it. Enterprise value is a more accurate estimate of takeover cost than market
capitalization because it takes includes a number of important factors such as preferred stock, debt,
and cash reserves that are excluded from the latter metric.

Enterprise value is the total value of a company. Whereas multiples that use the stock price look only
at the equity side of a stock, enterprise value includes a company's debt, cash and minority interests. It
is calculated as market capitalization (stock price times shares outstanding) plus net debt (total debt
minus cash and equivalents) plus minority interest. Investors use enterprise value to determine how
debt financing, corresponding interest payments and joint ventures impact a company's value

How is Enterprise Value Calculated?

Enterprise value is calculated by adding a corporation’s market capitalization, preferred stock, and
outstanding debt together and then subtracting out the cash and cash equivalents found on the balance
sheet. (In other words, enterprise value is what it would cost you to buy every single share of a
company’s common stock, preferred stock, and outstanding debt. The reason the cash is subtracted is
simple: once you have acquired complete ownership of the company, the cash becomes yours). Let’s
examine each of these components individually, as well as the reasons they are included in the
calculation of enterprise value:

Market Capitalization:
Frequently called “market cap”, market capitalization is calculated by taking the number of
outstanding shares of common stock multiplied by the current price-per-share. If, for example, Billy
Bob’s Tire Company had 1 million shares of stock outstanding and the current stock price was shs 50
per share, the company’s market capitalization would be shs50 million (1 million shares x shs50 per
share = shs50 million market cap).

Preferred Stock: Although it is technically equity, preferred stock can actually act as either equity or
debt, depending upon the nature of the individual issue. A preferred issue that must be redeemed at a
certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stock may
have the right to receive a fixed dividend plus share in a portion of the profits (this type is known as
“participating”). Regardless, the existence represents a claim on the business that must be factored
into enterprise value.

Debt

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Once you’ve acquired a business, you’ve also acquired its debt. If you purchased all of the
outstanding shares of a chain of ice cream stores for shs10 million (the market capitalization), yet the
business had shs5 million in debt, you would actually have expended shs15 million; shs10 million
may have come out of your pocket today, but you are now responsible for repaying the shs5 million
debt out of the cash flow of the business – cash flow that otherwise could have gone to other things.

Cash and Cash Equivalents:

Once you’ve purchased a business, you own the cash that is sitting in the bank. After acquiring
complete ownership, you can simply take this cash and put it in your pocket, replacing some of the
money you expended to buy the business. In effect, it serves to reduce your acquisition price; for that
reason, it is subtracted from the other components when calculating enterprise value.

Why Is Enterprise Value Important?

Some investors, particularly those that follow a value philosophy, will look for companies that are
generating a lot of cash flow in relation to enterprise value. Businesses that tend to fall into this
category are more likely to require little additional reinvestment; instead, the owners can take the
profit out of the business and spend it or put it into other investments.

Enterprise value multiple

This valuation metric is calculated by dividing a company's "enterprise value" by its earnings before
interest expense, taxes, depreciation and amortization (EBITDA).

Overall, this measurement allows investors to assess a company on the same basis as that of an
acquirer. As a rough calculation, enterprises value multiple serves as a proxy for how long it would
take for an acquisition to earn enough to pay off its costs (assuming no change in EBITDA).

Formula:

𝒆𝒏𝒕𝒓𝒆𝒑𝒓𝒊𝒔𝒆 𝒗𝒂𝒍𝒖𝒆
Enterprise value multiple =
𝐄𝐁𝐈𝐓𝐃𝐀

CHAPTER 6

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 MERGERS AND ACQUISITIONS

DEFINITION OF TERMS
Acquiring Effective Control
This means the acquisition of shares in the offeree which together with shares if any, already held by
the offeror or by any other person that is deemed to be associated or a company or by any other
company that is deemed by virtue of being a related company to the offeror or by persons acting in
concert with the offeror carry the right to exercise or control the exercise of not less than twenty-five
percent of the votes attached to the ordinary shares of the offeree provided that such person already
holding twenty five percent or more but less than fifty percent of the voting shares may acquire no
more than five percent of the shares of a listed company in any one year.

Acting in concert
This refers to persons who pursuant to a formal or informal agreement or understanding actively co-
operate through the acquisition by any of them of shares having voting rights in a public listed
company to obtain or consolidate control of that company.

Competing take-over offer

This means an offer made by a person with respect to the offeree’s voting shares in response to an
offer that has already been made and such other person shall be deemed to be the competing offeror.

Counter offer
It’s a take-over offer made by an offeree to an offeror;

Effective control
This is where a person or a company makes an offer for the acquisition of effective control of an
offeree which holds shares which together with shares, if any, already held by such person or an
associate person or a company or by any other company that is deemed by virtue of being a related
company or by persons acting in concert with such person carry the right to exercise or control the
exercise of not less than twenty five percent of the votes attached to the ordinary shares of an offeree
which shall be deemed to be a take-over and the provisions of these Regulations shall apply except
where that person or associate person or related company or persons acting in concert with the person,
already hold shares carrying more than ninety percent voting rights in the offeree;
Merger
This refers to an arrangement whereby the assets of two or more companies become vested in or
under the control of one company;

Offeror
In relation to a take-over scheme or a take-over offer means any person who acquires or agrees to
acquire effective control in the offeree either directly or with any associated person or related
company or any person acting in concert with the offeror but does not include a person who holds
shares carrying more than ninety percent voting rights in the offeree

Offeree
In relation to a take-over scheme or a take-over offer means a listed company on a securities exchange
with shares to which the scheme or offer relates;

Offer period
This refers to the means the period commencing from the date the offeror sends an offeror’s statement
until -
(a) The first closing date of the take-over offer; or

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 (b) The date when the take-over offer becomes or is declared unconditional as to acceptances,
lapses or is withdrawn.

Press notice
This means to announce or publish information on the take-over through the print or `electronic
media;

Related company

This refers to a company which is -

(a) The holding company of another company;
(b) A subsidiary of another company; or
(c) A subsidiary of the holding company of another company; and for purposes of ascertaining the
relation, that first mentioned company and the other company shall be deemed to be related to
each other;

Reverse take-over offer

This means a situation where an offeror makes a take-over offer for the voting shares of an offeree by
means of an exchange of shares such that if the take-over offer is accepted, the shareholders of the
offeree would control the offeror;

“Take-over offer”
This means a general offer to acquire all voting shares in the offeree company and includes a take-
over scheme;

Take-over scheme
This means a scheme involving the making of offers for acquisition by or on behalf of a person of (a)
all voting shares in the offeree;

(a) such shares in any company which results in an offeror acquiring effective control in an offeree;
(b) any shareholding of twenty five percent or more in a subsidiary of a listed company that has
contributed fifty percent or more to the average annual turnover in the latest three financial
years of the listed company preceding the acquisition; or
(c) any acquisition deemed by the Authority to constitute a take-over scheme.

Ultimate offeror

This includes a person -

(a) in accordance with whose directions and instructions the proposed offeror or any person
acting in concert with the proposed offeror is accustomed to act; or
(b) having an interest in the proposed take-over offer pursuant to an agreement, arrangement or
understanding with the proposed offeror.

NATURE OF MERGERS AND ACQUISITION

Definition of merger
When we use the term "merger", we are referring to the joining of two companies where one new company
will continue to exist.
The term "acquisition" refers to the purchase of assets by one company from another company. In an
acquisition, both companies may continue to exist.

However, throughout this topic we will loosely refer to mergers and acquisitions (M & A) as a business
transaction where one company acquires another company. The acquiring company (also referred to as the
predator company) will remain in business and the acquired company (which we will sometimes call the

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Target Company) will be integrated into the acquiring company and thus, the acquired company ceases to
exist after the merger.

TYPES OF MERGERS
Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services. Horizontal mergers are often used as
a way for a company to increase its market share by merging with a competing company. For example, the
merger between Total and ELF will allow both companies a larger share of the oil and gas market.

Vertical: Two firms are merged along the value-chain, such as a manufacturer merging with a supplier.
Vertical mergers are often used as a way to gain a competitive advantage within the marketplace. For
example, a large manufacturer of pharmaceuticals may merge with a large distributor of pharmaceuticals, in
order to gain an advantage in distributing its products.

Conglomerate: Two firms in completely different industries merge, such as a gas pipeline company
merging with a high technology company. Conglomerates are usually used as a way to smooth out wide
fluctuations in earnings and provide more consistency in long-term growth. Typically, companies in mature
industries with poor prospects for growth will seek to diversify their businesses through mergers and
acquisitions.

There are two types of mergers that are distinguished by how the merger is financed. Each has certain
implications for the companies involved and for investors:

Purchase Mergers
As the name suggests, this kind of merger occurs when one company purchases another. The purchase
is made with cash or through the issue of some kind of debt instrument; the sale is taxable.

Acquiring companies often prefer this type of merger because it can provide them with a tax benefit.
Acquired assets can be written-up to the actual purchase price, and the difference between the book
value and the purchase price of the assets can depreciate annually, reducing taxes payable by the
acquiring company. We will discuss this further in part four of this tutorial.

Consolidation Mergers

With this merger, a brand new company is formed and both companies are bought and combined
under the new entity. The tax terms are the same as those of a purchase merger.

REASONS FOR MERGERS AND ACQUISITIONS

a. Synergy
Every merger has its own unique reasons why the combining of two companies is a good business decision.
The underlying principle behind mergers and acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of
Company A is Sh. 2 billion and the value of Company B is Sh. 2 billion, but when we merge the two
companies together, we have a total value of Sh. 5 billion. The joining or merging of the two companies
creates additional value which we call "synergy" value.

Synergy value can take three forms:

1. Revenues: By combining the two companies, we will realize higher revenues than if the two companies
operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses than if the two companies
operate separately.
3. Cost of Capital: By combining the two companies, we will experience a lower overall cost of capital.

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For the most part, the biggest source of synergy value is lower expenses. Many mergers are driven by the
need to cut costs. Cost savings often come from the elimination of redundant services, such as Human
Resources, Accounting, Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include:
i) Positioning - Taking advantage of future opportunities that can be exploited when the two companies
are combined. For example, a telecommunications company might improve its position for the future
if it were to own a broad band service company. Companies need to position themselves to take
advantage of emerging trends in the marketplace.
ii) Gap Filling - One company may have a major weakness (such as poor distribution) whereas the
other company has some significant strength. By combining the two companies, each company fills-
in strategic gaps that are essential for long-term survival.
iii) Organizational Competencies - Acquiring human resources and intellectual capital can help
improve innovative thinking and development within the company.
iv) Broader Market Access - Acquiring a foreign company can give a company quick access to
emerging global markets.

b. Bargain Purchase
It may be cheaper to acquire another company than to invest internally. For example, suppose a company
is considering expansion of fabrication facilities. Another company has very similar facilities that are idle.
It may be cheaper to just acquire the company with the unused facilities than to go out and build new
facilities on your own.

c. Diversification
It may be necessary to smooth-out earnings and achieve more consistent long-term growth and
profitability. This is particularly true for companies in very mature industries where future growth is
unlikely. It should be noted that traditional financial management does not always support diversification
through mergers and acquisitions. It is widely held that investors are in the best position to diversify, not
the management of companies since managing a steel company is not the same as running a software
company.

d. Short Term Growth

Management may be under pressure to turnaround sluggish growth and profitability. Consequently, a
merger and acquisition is made to boost poor performance.

e. Undervalued Target
The Target Company may be undervalued and thus, it represents a good investment. Some mergers are
executed for "financial" reasons and not strategic reasons. A company may, for example, acquire poor
performing companies and replace the management team in the hope of increasing depressed values.

ACQUISITION AND MERGERS VERSUS ORGANIC GROWTH

Organic Growth is the rate of a business expansion through a company’s own business activity, while
Inorganic Growth means that the company has grown by merger, acquisitions or takeovers. When a
company with help of its efficient management enhances its growth rate it is referred to as organic
growth which is also known as Internal Growth whereas inorganic growth is attained when a company
acquires a technology developing company in order to enhance its competitive advantage and growth
rate and is also known as External Growth. Most business enterprises are constantly faced with the
challenge of prospering and growing their businesses. Growth is generally measured in terms of
increased revenue, profits or assets. Businesses can choose to build their in-house competencies,
invest to create competitive advantages, differentiate and innovate in the product or service line
(Organic Growth) or leverage upon the market, products and revenues of other companies (In-organic
Growth). Simply put, business expansion with the help of the businesses’ core-competencies and sales
refers to Organic Growth and is in contrast with Inorganic growth approach where expansion
objectives are met through Mergers and Acquisition (M&A).

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Acquisitions provide the following benefits to the business:
- Helps reduce competition in the market place
- Instantly adds new brands and product/ service lines to the acquiring company
- Provides access to fresh customer base and adds new geographical locations
- In many cases, an established marketing channel also becomes available
- Economies of scale are achieved over a period of time.
- A fresh breath of management skills
- Most importantly, time-to-market is substantially reduced which gives businesses a
significant competitive edge.

Industry and economic factors play a crucial role in motivating companies to adopt the Inorganic
route for growth. Slowing industry growth rate, fragmented industry, too many competitors fighting
for the same market share are some compelling reasons which push businesses towards the M&A
route. Other than that, economic slump creates opportunities for cash rich companies to get hold of
unutilized capacities of loss making competitors at attractive valuations.
The success of Organic Growth is a sure-fire test of the management’s ability to share a common
vision and deliver the vision. Companies growing organically not only measure their success on
financial metrics alone but take careful note of other metrics like customer satisfaction metrics,
product quality metrics, logistics and supply chain metrics etc. Some of the typical characteristics of
businesses which believe in the benefits of Organic Growth are:
- Customer centricity
- Ability to deliver unique value propositions.
- Building brands and marketing channels to serve customers better
- Discipline and focus for Growth strategies. The management is willing to take risks for which
they prepare and plan well.

To conclude, both Organic and In -Organic Growth options offer intrinsic value in their own way and
the choice is dependent on the market and industry scenario as well as the strategic vision of the
business. In fact, a good management principle would be to use a combination of both methods to
gain a steady growth pattern in the business. Using Organic Growth options for things which one does
best, and using In-Organic growth measures for expanding the business potential is a potent mix when
it comes to gearing up for growth.

THE OVERALL MERGER PROCESS

The Merger & Acquisition Process can be broken down into five phases:

Phase 1 - Pre Acquisition Review:

The first step is to assess your own situation and determine if a merger and acquisition strategy should be
implemented. If a company expects difficulty in the future when it comes to maintaining core competencies,
market share, return on capital, or other key performance drivers, then a merger and acquisition (M & A)
program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to protect its valuation, it may
find itself the target of a merger. Therefore, the pre-acquisition phase will often include a valuation of the
company - Are we undervalued? Would an M & A Program improve our valuations?
The primary focus within the Pre-Acquisition Review is to determine if growth targets (such as 10% market
growth over the next 3 years) can be achieved internally. If not, an M & A Team should be formed to
establish a set of criteria whereby the company can grow through acquisition. A complete rough plan should
be developed on how growth will occur through M & A, including responsibilities within the company,
how information will be gathered, etc.

Phase 2 - Search & Screen Targets:

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The second phase within the M & A Process is to search for possible takeover candidates. Target companies
must fulfill a set of criteria so that the Target Company is a good strategic fit with the acquiring company.
For example, the target's drivers of performance should complement the acquiring company. Compatibility
and fit should be assessed across a range of criteria - relative size, type of business, capital structure,
organizational strengths, core competencies, market channels, etc.
It is worth noting that the search and screening process is performed in-house by the Acquiring Company.
Reliance on outside investment firms is kept to a minimum since the preliminary stages of M & A must be
highly guarded and independent.
Phase 3 - Investigate & Value the Target:
The third phase of M & A is to perform a more detailed analysis of the target company. You want to
confirm that the Target Company is truly a good fit with the acquiring company. This will require a more
thorough review of operations, strategies, financials, and other aspects of the Target Company. This detail
review is called "due diligence." Specifically, Phase I Due Diligence is initiated once a target company has
been selected. The main objective is to identify various synergy values that can be realized through an M &
A of the Target Company. Investment Bankers now enter into the M & A process to assist with this
evaluation.
A key part of due diligence is the valuation of the target company. In the preliminary phases of M & A, we
will calculate a total value for the combined company. We have already calculated a value for our company
(acquiring company). We now want to calculate a value for the target as well as all other costs associated
with the M & A.

Phase 4 - Acquire through Negotiation:

Now that we have selected our target company, it's time to start the process of negotiating a M & A. We
need to develop a negotiation plan based on several key questions:
- How much resistance will we encounter from the Target Company?
- What are the benefits of the M & A for the Target Company?
- What will be our bidding strategy?
- How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both companies to reach agreement
concerning the M & A; i.e. a negotiated merger will take place. This negotiated arrangement is sometimes
called a "bear hug." The negotiated merger or bear hug is the preferred approach to a M & A since having
both sides agree to the deal will go a long way to making the M & A work. In cases where resistance is
expected from the target, the acquiring firm will acquire a partial interest in the target; sometimes referred to
as a "toehold position." This toehold position puts pressure on the target to negotiate without sending the
target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the acquiring company will make a
tender offer directly to the shareholders of the target, bypassing the target's management. Tender offers are
characterized by the following:
- The price offered is above the target's prevailing market price.
- The offer applies to a substantial, if not all, outstanding shares of stock.
- The offer is open for a limited period of time.
- The offer is made to the public shareholders of the target.
A few important points worth noting:
- Generally, tender offers are more expensive than negotiated M & A's due to the resistance of target
management and the fact that the target is now "in play" and may attract other bidders.
- Partial offers as well as toehold positions are not as effective as a 100% acquisition of "any and all"
outstanding shares. When an acquiring firm makes a 100% offer for the outstanding stock of the target, it
is very difficult to turn this type of offer down.

Another important element when two companies merge is Phase II Due Diligence. As you may recall,
Phase I Due Diligence started when we selected our target company. Once we start the negotiation process
with the target company, a much more intense level of due diligence (Phase II) will begin. Both companies,
assuming we have a negotiated merger, will launch a very detailed review to determine if the proposed

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merger will work. This requires a very detail review of the target company - financials, operations, corporate
culture, strategic issues, etc.
Phase 5 - Post Merger Integration:
If all goes well, the two companies will announce an agreement to merge the two companies. The deal is
finalized in a formal merger and acquisition agreement. This leads us to the fifth and final phase within the
M & A Process, the integration of the two companies.

Every company is different - differences in culture, differences in information systems, differences in

strategies, etc. As a result, the Post Merger Integration Phase is the most difficult phase within the M & A
Process. Now all of a sudden we have to bring these two companies together and make the whole thing
work. This requires extensive planning and design throughout the entire organization.

The integration process can take place at three levels:

i) Full: All functional areas (operations, marketing, finance, human resources, etc.) will be merged into
one new company. The new company will use the "best practices" between the two companies.
ii) Moderate: Certain key functions or processes (such as production) will be merged together. Strategic
decisions will be centralized within one company, but day to day operating decisions will remain
autonomous.
iii) Minimal: Only selected personnel will be merged together in order to reduce redundancies. Both
strategic and operating decisions will remain decentralized and autonomous.
If post-merger integration is successful, then we should generate synergy values. However, before we
embark on a formal merger and acquisition program, perhaps we need to understand the realities of
mergers and acquisitions.

SUCCESS AND FAILURE OF MERGERS

Mergers and acquisitions are extremely difficult. Expected synergy values may not be realized and
therefore, the merger is considered a failure. Some of the reasons behind failed mergers are:

Poor strategic fit

The two companies have strategies and objectives that are too different and they conflict with one another.

Cultural and Social Differences

It has been said that most problems can be traced to "people problems." If the two companies have wide
differences in cultures, then synergy values can be very elusive.

Incomplete and Inadequate Due Diligence

Due diligence is the "watchdog" within the M & A Process. If you fail to let the watchdog do his job, you
are in for some serious problems within the M & A Process.

Poorly Managed Integration

The integration of two companies requires a very high level of quality management. In the words of one
CEO, "give me some people who know the drill." Integration is often poorly managed with little planning
and design. As a result, implementation fails.

Paying too much

In today's merger frenzy world, it is not unusual for the acquiring company to pay a premium for the Target
Company. Premiums are paid based on expectations of synergies. However, if synergies are not realized,
then the premium paid to acquire the target is never recouped.

Overly Optimistic
If the acquiring company is too optimistic in its projections about the Target Company, then bad decisions
will be made within the M & A Process. An overly optimistic forecast or conclusion about a critical issue
can lead to a failed merger.

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DUE DILIGENCE
There is a common thread that runs throughout much of the M & A Process. It is called Due Diligence. Due
diligence is a very detailed and extensive evaluation of the proposed merger.
An over-riding question is - Will this merger work? In order to answer this question, we must determine
what kind of "fit" exists between the two companies. This includes: Investment Fit - What financial
resources will be required, what level of risk fits with the new organization, etc.

Strategic Fit
What management strengths are brought together through this M & A? Both sides must bring something
unique to the table to create synergies.

Marketing Fit
How will products and services complement one another between the two companies? How well do various
components of marketing fit together - promotion programs, brand names, distribution channels, customer
mix, etc

Operating Fit
How well do the different business units and production facilities fit together? How do operating elements
fit together - labor force, technologies, production capacities, etc.

Management Fit
What expertise and talents do both companies bring to the merger? How well do these elements fit together
- leadership styles, strategic thinking, ability to change, etc.

Financial Fit
How well do financial elements fit together - sales, profitability, return on capital, cash flow, etc.?
Due diligence is also very broad and deep, extending well beyond the functional areas (finance, production,
human resources, etc.).

This is extremely important since due diligence must expose all of the major risk associated with the
proposed merger. Some of the risk areas that need to be investigated are:
- Market - How large is the target's market? Is it growing? What are the major threats? Can we improve
it through a merger?
- Customer - Who are the customers? Does our business compliment the target's customers? Can we
furnish these customers new services or products?
- Competition - Who competes with the target company? What are the barriers to competition? How
will a merger change the competitive environment?
- Legal - What legal issues can we expect due to an M & A? What liabilities, lawsuits, and other claims
are outstanding against the Target Company?

Another reason why due diligence must be broad and deep is because management is relying on the creation
of synergy values. Much of Phase I Due Diligence is focused on trying to identify and confirm the existence
of synergies between the two companies. Management must know if their expectation over synergies is real
or false and about how much synergy can we expect? The total value assigned to the synergies gives
management some idea of how much of a premium they should pay above the valuation of the Target
Company. In some cases, the merger may be called off because due diligence has uncovered substantially
less synergies then what management expected.

MAKING DUE DILIGENCE WORK

Since due diligence is a very difficult undertaking, you will need to enlist your best people, including
outside experts, such as investment bankers, auditors, valuation specialist, etc. Goals and objectives should
be established, making sure everyone understands what must be done. Everyone should have clearly defined

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roles since there is a tight time frame for completing due diligence. Communication channels should be
updated continuously so that people can update their work as new information becomes available; i.e. due
diligence must be an iterative process. Throughout due diligence, it will be necessary to provide summary
reports to senior level management.
Due diligence must be aggressive, collecting as much information as possible about the target company.
This may even require some undercover work, such as sending out people with false identities to confirm
critical issues. A lot of information must be collected in order for due diligence to work. This information
includes:
Corporate Records
Articles of incorporation, by laws, minutes of meetings, shareholder list, etc.

Financial Records
Financial statements for at least the past 5 years, legal council letters, budgets, asset schedules, etc.

Tax Records
Federal, state, and local tax returns for at least the past 5 years, working papers, schedules, correspondence,
etc. Regulatory Records: Filings with the NSE, reports filed with various governmental agencies, licenses,
permits, decrees, etc.

Debt Records
Loan agreements, mortgages, lease contracts, etc.

Employment Records
Labor contracts, employee listing with salaries, pension records, bonus plans, personnel policies, etc.

Property Records
Title insurance policies, legal descriptions, site evaluations, appraisals, trademarks, etc.

Miscellaneous Agreements
Joint venture agreements, marketing contracts, purchase contracts, agreements with Directors, agreements
with consultants, contract forms, etc.

Good due diligence is well structured and very pro-active; trying to anticipate how customers, employees,
suppliers, owners, and others will react once the merger is announced. When one analyst was asked about
the three most important things in due diligence, his response was "detail, detail, and detail." Due diligence
must very in-depth if you expect to uncover the various issues that must be addressed for making the merger
work.
VALUATION OF ACQUISITIONS AND MERGERS
Valuation related to mergers and acquisitions employ three methods. Namely
− The income based procedure.
− The asset based procedure.
− The market based procedure.

There are many factors that determine whether a particular company ought to be bought or not, such
as the financial soundness of the subject company. Along with that, the financial trends over the past
couple of years and the trends manifested in the macroeconomic indicators also need to be judged.

Valuation related to mergers and acquisitions usually follow these three methods: market based
method, asset based method and income based method. It may be felt that the market based method is
the most relevant, but all three methods are significant depending upon the situation prevailing during
the course of the mergers as well as acquisitions.

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Market based method
Valuation related to mergers and acquisitions estimated by the market based method, compares
various aspects of the target company with the same aspects of the other companies in the market.
These companies (not the target company) usually possess a market value, which has been established
previously.

There are a few things to be kept in mind prior to comparing the various aspects, such as which
factors need to be compared and which are the companies that will serve as comparable companies to
the target one. Public companies, belonging to similar industries (of the target company) may be opted
for as comparable, but if the target company is not listed on the stock exchange or if it is
comparatively smaller in size than the public companies, comparison with the public companies may
not be of much help. In such cases, private as well as public databases are available, which are
commercial in nature.

Other aspects that need to be compared include book value and earnings, or total revenue. Once all the
data is collected, an extensive comparison is made to find the value of the target/subject company.

Asset based method

Valuation related to mergers and acquisitions employ this method when the subject or the target
company is a loss making company. Under such circumstances, the assets of the loss making
company are calculated. Along with this method, the market based method and the income based
method may also be employed. Valuations obtained from this method may generate very small value,
however it is more likely to generate the actual picture of the assets of the target company.

Income based method

Valuation related to mergers and acquisitions employing the income based method take the net
present value into consideration. The net present value of income, which is likely to be in the future, is
taken into account by the application of a mathematical formula.

FINANCIAL TERMS OF EXCHANGE

When two companies are combined, a ratio of exchange occurs, denoting the relative weighting of the
firms. The ratio of exchange can be considered in respect to earnings, market prices and the book values
of the two companies involved.

a. Earnings
In evaluating possible acquisition, the acquiring firm must at least consider the effect the merger will
have on the earnings per share of the surviving company. We can discuss this through an illustration:

ILLUSTRATION
Company A is considering the acquisition by shares of Company B. The following information is also
available.
Company A Company B
Present earnings Sh. 20,000,000 Sh. 5,000,000
Shares 5,000,000 2,000,000
Earnings per share Sh. 4 Sh. 2.50
Price/earning ratio 16 12
Price of shares Sh. 64 Sh. 30

Company B has agreed to an offer of Shs 35 a share to be paid in Company A shares.

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Required:
Consider the effect of the acquisition to the earnings per share.

SOLUTION
The exchange ratio = 35/64 = 0.546875 shares of Company A's stock for each share of
Company B's stock.

The total number of shares needed to acquire company B's share

= 0.546875 X 2,000,000 = 1,093,750 shares of Company A

The earnings per share therefore can be computed as follow:

EPS combined = Earnings of A + Earnings of B

Companies Total No. of shares

= 20,000,000 + 5,000,000
5,000,000 + 1,093,750

= 25,000,000
6,093,750

= Shs 4.10

Therefore the earnings for share of the combined firm is Shs 4.10.
There is therefore an immediate improvement in earnings per share for Company A as a result of the
merger.
However, Company B's former shareholders experience a reduction in earnings per share. These EPS
will be given by

0.546875 × 4.10 = Sh. 2.24 from Sh. 2.50

b. Future Earnings
If the decision to acquire another company were based solely on the initial impact on earnings per share,
an initial dilution in earnings per share would stop any company from merging with another. However,
due to synergetic effects discussed earlier, the merger may result in increased future earnings and
therefore a high EPS in future.

c. Market Value
The major emphasis in the bargaining process is on the ratio of exchange of market price per share. The
market price per share reflects the earnings potential of the company, dividends, business risk, capital
structure, asset values and other factors that bear upon valuation. The ratio of exchange of market price
is given by the following formula:

Market price ratio = Market price per share of acquiring company X No. of shares offered
of exchange Market price per share of the acquired company

Considering the previous example (example 4.1)

Market price ratio = 64 × 0.546875 = 1.167.

30

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Therefore, Company B receive more than its market price per share. It is common for the company
being acquired to receive a little more than the market price per share. Shareholders of the acquired
company would therefore benefit from the acquisition because their shares were originally worth Shs 30
but they receive Sh. 35.

ILLUSTRATION
The following information relates to Company X and Y.

Company X Company Y
Present earnings Shs 20,000,000 Shs 6,000,000
No. of shares 6,000,000 2,000,000
Earnings per share Shs 3.33 Shs 3.00
Market price per share Shs 60.00 Shs 30.00
Price/earning ratio 18 10

Company X offers 0.667 shares for each share of Company Y to acquire the company.

The market price exchange ratio = 60 ×0.667 = 1.33

30

Shareholders of Y are being offered a share with a market value of Sh. 40 for each share they own (i.e.
1.333 × 30). They benefit from acquisition with respect to market price because their shares were
formerly worth Sh.30. We can consider the combined effect.
Combined Effect
Total earnings Shs 26,000,000
No. of shares 7,333,333
Earnings per share Shs 3.55
Price/earning ratio 18
Market price per share Shs 63.90

Note:
Both companies tend to benefit due to the merger. This can be seen by the increased market price per
share for both company. This is due to the assumption that the price earnings ratio of the combined
company will remain 18. If this is the case, companies with high price/earning ratios can be able to
acquire companies with lower price/earnings ratio to obtain an immediate increase in earnings per share
(even if they pay a premium for the share.)

d. Book value
Book value per share is not a useful basis for valuation in most mergers. However, it may be important
if the purpose of an acquisition is to obtain the liquidity of another company. The ratio of exchange of
book value per share of the two companies are calculated in the same manner as is the ratio for market
values computed above. The application of this ratio in bargaining is usually restricted to situations in
which a company is acquired for its liquidity and asset values rather than for its earning power.

VALUING THE TARGET FIRM

To determine the value of the target firm, two key items are needed:
a) A set of proforma financial statements which develop the incremental cashflows expected from
the merger, and
b) A discount rate or cost of capital, to apply to these projected cash flows.

CASH FLOW STATEMENTS

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In a pure financial merger, the post-merger cash flows are simply the sum of the expected cash flows of
the two firms if they were to continue operating independently. If the two firm's operations are to be
integrated however, forecasting future cash flows is a more complex task.

The following illustration can be used to determine the value of Target Company

ILLUSTRATION
XYZ Ltd. is considered acquiring ABC Ltd. The following information relates to ABC Ltd. for the next
five years. The projected financial data are for the post-merger period. The corporate tax rate is 40%
for both companies.
Amounts are in Shs `000'
1994 1995 1996 1997 1998
Net sales 1,050 1,050 1,260 1,510 1740 1,910
Cost of sales 735 882 1,057 1,218 1,337
Selling & admn. expenses 100 120 130 150 160
Interest expenses 40 50 70 90 110
Other information
a) After the fifth year the cash flows available to XYZ from ABC is expected to grow by 10% per
annum in perpetuity.
b) ABC will retain Sh. 40,000 for internal expansion every year.
c) The cost of capital can be assumed to be 18%.

Required:
i) Estimate the annual cash flows.
ii) Determine the maximum amount XYZ would be willing to acquire ABC.

SOLUTION
i) Projected post-merger cash flows for ABC ltd.
Amounts in Sh. `000'
1994 1995 1996 1997 1998
Net sales 1,050 1,260 1,510 1,740 1,910
Less cost of sales 735 882 1,057 1,218 1,337
315 378 453 522 573
Less selling and admn. costs 100 120 130 150 160
EBIT 215 258 323 372 413
Less interest 40 50 70 90 110
EBT 175 208 253 282 303
Less tax 40% 70 83.2 101.2 112.8 121.2
Net income 105 124.8 151.8 169.2 181.8
Less Retention by ABC 40 40.0 40.0 40.0 40.0
Cash available to XYZ 65 84.8 91.8 129.2 141.75
Add terminal value . . . 1,949.75
Net cash flows 65 84.8 91.8 129.2 2,091.55

Computation of terminal value

TV = 141.8 (1 + 0.1) = Sh. 1,949.75

0.18 - 0.10

ii) Assuming the discount rate of 18%, the maximum price of ABC can be determined by computing
the PV of the projected cashflows.

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 Year Cashflow PVIF18% PV
1 65 0.847 55.055
2 84.8 0.718 60.886
3 91.8 0.607 55.723
4 129.2 0.516 66.667
5 2,091.55 0.437 914.24
1,152.57

The maximum price will therefore be Shs 1,152,570

THE ROLE OF INVESTMENT BANKERS IN MERGERS

The investment banking community is involved with mergers in a number of ways:
1. They help arrange mergers
The bankers will identify firms with excess cash that might want to buy other firms, companies that
might be willing to be bought and companies which might be attractive to others.

2. They help target companies develop and implement defensive techniques

Target firms that do not want to be acquired generally enlist the help of an investment banking firm,
along with a law firm that specializes in helping to block mergers.

Defensive techniques include:

a) Changing the by-laws e.g require special resolution (75%) to approve mergers.
b) Trying to convince the target firm's shareholders that the price being offered is too low.
c) Raising antitrust issues between shareholders of the two firms.
d) Repurchasing shares in an open market in an effort to push the prices above that being offered by
the potential acquirer.
e) Being acquired by a more friendly firm.
f) Taking a poison pill (commiting economic suicide) e.g. borrowing on terms that require
immediate repayment of all loans if the firm is acquired, selling off at a bargain the assets that
originally made the firm a desirable target, heavy cash overflows in dividends, executive benefits
etc.

3. Establishing a fair value

Investment bankers are experts that can help the firms determine a fair ratio of exchange that is
beneficial (if possible) to both shareholders.

4. They help finance mergers

If the acquiring company has cash flow problems, then investment bankers will provide required finance
for the merger. They speculate in the shares of potential merger candidates and thereby make arbitrage
gains.

ANTI-TAKEOVER DEFENSES
Throughout this entire lesson we have focused our attention on making the merger and acquisition process
work. In this final part, we will do just the opposite; we will look at ways of discouraging the merger and
acquisition process. If a company is concerned about being acquired by another company, several anti-
takeover defenses can be implemented. As a minimum, most companies concerned about takeovers will
closely monitor the trading of their stock for large volume changes.

a) Poison pill
One of the most popular anti-takeover defenses is the poison pill. Poison pills represent rights or options
issued to shareholders and bondholders. These rights trade in conjunction with other securities and they
usually have an expiration date. When a merger occurs, the rights are detached from the security and

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exercised, giving the holder an opportunity to buy more securities at a deep discount. For example, stock
rights are issued to shareholders, giving them an opportunity to buy stock in the acquiring company at an
extremely low price. The rights cannot be exercised unless a tender offer of 20% or more is made by
another company. This type of issue is designed to reduce the value of the Target Company. Flip-over rights
provide for purchase of the Acquiring Company while flip-in rights give the shareholder the right to acquire
more stock in the Target Company. Put options are used with bondholders, allowing them to sell-off bonds
in the event that an unfriendly takeover occurs. By selling off the bonds, large principal payments come due
and this lowers the value of the Target Company.

b) Golden Parachutes
Another popular anti-takeover defense is the Golden Parachute. Golden parachutes are large compensation
payments to executive management, payable if they depart unexpectedly. Lump sum payments are made
upon termination of employment. The amount of compensation is usually based on annual compensation
and years of service. Golden parachutes are narrowly applied to only the most elite executives and thus, they
are sometimes viewed negatively by shareholders and others. In relation to other types of takeover defenses,
golden parachutes are not very effective.

c) Changes to the Corporate Charter

If management can obtain shareholder approval, several changes can be made to the Corporate Charter for
discouraging mergers. These changes include:

Staggered Terms for Board Members: Only a few board members are elected each year. When an
acquiring firm gains control of the Target Company, important decisions are more difficult since the
acquirer lacks full board membership. A staggered board usually provides that one-third are elected each
year for a 3 year term. Since acquiring firms often gain control directly from shareholders, staggered boards
are not a major anti-takeover defense.

Super-majority Requirement: Typically, simple majorities of shareholders are required for various
actions. However, the corporate charter can be amended, requiring that a super-majority (such as 80%) is
required for approval of a merger. Usually an "escape clause" is added to the charter, not requiring a super-
majority for mergers that have been approved by the Board of Directors. In cases where a partial tender
offer has been made, the super-majority requirement can discourage the merger.

Fair Pricing Provision: In the event that a partial tender offer is made, the charter can require that minority
shareholders receive a fair price for their stock. Since many countries have adopted fair pricing laws,
inclusion of a fair pricing provision in the corporate charter may be a moot point. However, in the case of a
two-tiered offer where there is no fair pricing law, the acquiring firm will be forced to pay a "blended" price
for the stock.

Dual Capitalization: Instead of having one class of equity stock, the company has a dual equity structure.
One class of stock, held by management, will have much stronger voting rights than the other publicly
traded stock. Since management holds superior voting power, management has increased control over the
company.

d) Re-capitalization
One way for a company to avoid a merger is to make a major change in its capital structure. For example,
the company can issue large volumes of debt and initiate a self-offer or buy back of its own stock. If the
company seeks to buy-back all of its stock, it can go private through a leveraged buyout (LBO). However,
leveraged re-capitalization require stable earnings and cash flows for servicing the high debt loads. And the
company should not have plans for major capital investments in the near future. Therefore, leveraged recaps
should stand on their own merits and offer additional values to shareholders. Maintaining high debt levels
can make it more difficult for the acquiring company since a low debt level allows the acquiring company to
borrow easily against the assets of the Target Company.

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Instead of issuing more debt, the Target Company can issue more stock. In many cases, the Target
Company will have a friendly investor known as a "white squire" which seeks a quality investment and does
not seek control of the Target Company. Once the additional shares have been issued to the white squire, it
now takes more shares to obtain control over the Target Company.

Finally, the Target Company can do things to boost valuations, such as stock buy-backs and spinning off
parts of the company. In some cases, the target company may want to consider liquidation, selling-off assets
and paying out a liquidating dividend to shareholders. It is important to emphasize that all restructuring
should be directed at increasing shareholder value and not at trying to stop a merger.

e) Other Anti-Takeover Defenses

Finally, if an unfriendly takeover does occur, the company does have some defenses to discourage the
proposed merger:

1. Stand Still Agreement:

The acquiring company and the target company can reach agreement whereby the acquiring
company ceases to acquire stock in the target for a specified period of time. This stand still period
gives the Target Company time to explore its options. However, most stand still agreements will
require compensation to the acquiring firm since the acquirer is running the risk of losing synergy
values.
2. Green Mail: If the acquirer is an investor or group of investors, it might be possible to buy back
their stock at a special offering price. The two parties hold private negotiations and settle for a
price. However, this type of targeted repurchase of stock runs contrary to fair and equal treatment
for all shareholders. Therefore, green mail is not a widely accepted anti-takeover defense.

3. White Knight: If the target company wants to avoid a hostile merger, one option is to seek out
another company for a more suitable merger. Usually, the Target Company will enlist the services
of an investment banker to locate a "white knight." The White Knight Company comes in and
rescues the Target Company from the hostile takeover attempt. In order to stop the hostile
merger, the White Knight will pay a price more favorable than the price offered by the hostile
bidder.

4. Litigation: One of the more common approaches to stopping a merger is to legally challenge the
merger. The Target Company will seek an injunction to stop the takeover from proceeding. This
gives the target company time to mount a defense. For example, the Target Company will
routinely challenge the acquiring company as failing to give proper notice of the merger and
failing to disclose all relevant information to shareholders.

5. Pac Man Defense: As a last resort, the target company can make a tender offer to acquire the
stock of the hostile bidder. This is a very extreme type of anti-takeover defense and usually
signals desperation.
One very important issue about anti-takeover defenses is valuations. Many anti-takeover defenses
(such as poison pills, golden parachutes, etc.) have a tendency to protect management as opposed
to the shareholder. Consequently, companies with anti-takeover defenses usually have less upside
potential with valuations as opposed to companies that lack anti-takeover defenses. Additionally,
most studies show that anti-takeover defenses are not successful in preventing mergers. They
simply add to the premiums that acquiring companies must pay for target companies.

Corporate Alliance
Mergers are one way for two companies to completely join assets and management but many companies
enter into corporate deals which fall short of merging. Such deals are called corporate alliances and they
take many forms, from straight forward marketing agreements to joint ownership of world scale
operations. Joint venture is one method of corporate alliance. In a joint venture parts of companies are

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joined to achieve specific limited objectives. A joint venture is controlled by management teams
consisting of representation of both the two or more parent companies.

REGULATORY FRAMEWORK FOR MERGERS AND ACQUISITIONS

Takeovers & Mergers of listed companies are regulated by The Capital Markets (Takeovers and
Mergers) Regulations, 2002 (“the Takeovers and Mergers Regulations”).

A takeover offer is defined under the Takeovers and Mergers Regulations as a general offer to acquire
all voting shares in the Offeree company (“Target Company”). A reference to a takeover offer
includes a takeover scheme.
A takeover scheme involves making an offer for the acquisition by or on behalf of a person of:
− all voting shares in the Target Company;
− such shares in a company which results in the Offerer acquiring effective control in a Target
Company (namely 25% of the voting rights except where such person already holds 90%
personally or by persons acting in concert or by related or associated parties);
− a shareholding of 25% or more in a subsidiary of a listed company that has contributed 50% or
more to the average annual turnover in the latest three financial years of the listed company prior
to the acquisition; or
− an acquisition deemed by the CMA to constitute a takeover scheme.

Where a person proposes to acquire shares or voting rights of a listed company, which together with
shares and voting rights (if any) held by such person (or by persons acting in concert or by an
associate person or related company) entitle such person to exercise effective control in the listed
company (as defined above), such an acquisition constitutes a takeover, requiring such person to
comply with the takeover procedures provided for under Regulation 4 of the Takeovers and Mergers
Regulations.

In determining whether an acquisition will result in “Effective Control” being exercised, consideration
needs to be given to the following definitions:

“A related company” is defined as:

 a holding company of another company;
 a subsidiary of another company;
 a subsidiary of the holding company of another company.
Persons “acting in concert” is defined as persons who, pursuant to a formal or informal agreement or
understanding, actively co-operate through the acquisition, by any of them, of shares having voting
rights in a public listed company to obtain or consolidate control of that company.

THE STATUTORY AND REGULATORY FRAMEWORK IN KENYA

The legal provisions on takeovers and mergers in Kenya are found in three pieces of legislation:
− The Capital Markets Act (Cap 485A);
− The Capital Markets (Takeovers & Mergers) Regulations, 2002; and
− The Competition Act No. 12 0f 2012.

The Capital Markets Act (Cap 485a)

The Capital Markets Act (“the CM Act”) establishes the Capital Markets Authority (“the CMA”),
which is mandated to regulate, promote and facilitate the development of an orderly, fair and efficient
capital market in Kenya.
The CMA is the principal regulator and supervisor of the securities and capital market in Kenya.

Objectives of the CMA

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The main objectives of the CMA are stated to be:-
− the development of all aspects of capital markets with particular emphasis on the removal of
impediments to, and the creation of incentives for longer term investments in productive
enterprises;
− to facilitate the existence of a nationwide system of stock market and brokerage services so as to
enable wider participation of the general public in the stock market;
− the creation, maintenance and regulation of a market in which securities can be issued and traded
in an orderly, fair and efficient manner, through the implementation of a system in which the
market participants are self-regulatory to the maximum practicable extent;
− the protection of investor interests;
− the operation of a compensation fund to protect investors from financial loss arising from the
failure of a licensed broker or dealer to meet his contractual obligations; and
− the development of a framework to facilitate the use of electronic commerce for the development
of capital markets in Kenya.

Under the CM Act, the CMA is mandated to grant licences to persons wishing to carry on business as
stockbrokers, dealers, investment bankers, fund managers, investment advisers or authorised
securities dealers.
Various regulations and guidelines have been enacted by the CMA in exercise of its power to issue
rules, regulations and guidelines as may be required for the purpose of carrying out its objectives.
Among these rules, regulations and guidelines are regulations that control offers of securities to the
public, licensing of stockbrokers, dealers, investment advisers and the procedures to be followed in
undertaking any proposed takeover of a listed company.

The Nairobi Stock Exchange

Part III of the CM Act empowers the CMA to approve applications of persons wishing to carry on
business as a securities exchange. The Nairobi Stock Exchange (“the NSE”), a limited liability
company, has been licensed as a securities exchange under the foregoing provisions. The NSE, as a
securities exchange, is required to make rules governing certain aspects of the regulation and
supervision of the securities market.
In takeovers of listed companies, the NSE does not play any role in the approval of the takeover.
Nevertheless, the takeover procedure requires an Offerer to serve certain mandatory notices on the
NSE.

The Capital Markets Tribunal

The CM Act also establishes the Capital Markets Tribunal, which handles appeals from decisions,
directions and actions of the CMA.

The Capital Markets (Takeovers And Mergers) Regulations, 2002

The Takeovers and Mergers Regulations outline the procedure that is followed in takeovers and
mergers and spells out the obligations of the Offerer and the Offeree with respect to a takeover offer
by way of purchase of shares.

TAKE-OVER PROCEDURE
No person shall make an offer to acquire shares or effective voting rights of a listed company which
together with shares or control voting rights if any held by such person or by persons acting in concert
or by associated person or related company entitle such person to exercise effective control in the
listed company without complying with the take-over procedure.
Where a person –
(a) holds more than twenty five percent but less than fifty percent of the voting shares of a listed
company, and who acquires in any one year more than five percent of the voting shares of such
company; or

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 (b) holds fifty percent or more of the voting shares of the listed company and who acquires
additional voting shares in the listed company;
(c) acquires a company that holds effective control in the listed company or together with the
shares already held by associated persons or related company or persons acting in concert with
such person, will result in acquiring effective control of the listed company; or
(d) acquires any shareholding of twenty five percent or more in a subsidiary of a listed company
that has contributed fifty percent or more to the average annual turnover in the latest three
financial years of the listed company preceding the acquisition, the person shall be presumed to
have a firm intention to make a take-over of such listed company and shall be required to
comply with the take-over procedures.

Provided that a company that is already in control of twenty five percent but less than fifty percent of
the voting shares of the listed company may acquire up to five percent in any one year in such listed
company up to a maximum of fifty percent.

A company or person who intends or proposes to notice acquire effective control in a listed company
shall not later than and twenty four hours from the resolution of its board to acquire statement.
effective control in the company or not later twenty four hours prior to making a decision to acquire
effective control in the company in the case of any other person announce the proposed offer by press
notice and serve a notice of intention, in writing of the take-over scheme containing the

(a) Proposed offeree at its registered office;

(b) Securities exchange at which the offeree’s voting shares are listed;
(c) Authority; and
(d) The Commissioner of Monopolies and Prices appointed under the Restrictive Trade Practices,
Monopolies and Price Control Act, where the offeror is engaged in the same business as the
offeree.

The press notice shall-

(a) Be made in at least two English language dailies of national circulation;
(b) Be made after the notice of intention has been served on the proposed offeree;
(c) State that the person intends to acquire or has acquired effective control in the company and has
at a stated date served a notice of intention to make a take-over offer to the company or has
made an application to the Authority for exemption from the take-over requirements, in
compliance with these Regulations;
(d) Include the following information where applicable -
(i) The identity of the proposed offeror and all companies related to or persons associated or
acting in concert with the proposed offeror;
(ii) the identity of the proposed offeree and the exchange at which its shares are listed;
(iii) whether the proposed offeror intends to make a take-over offer or apply to the Authority,
for exemption from making a take-over offer;
(iv) the type and total number of voting shares of the offeree;
- Which have been acquired, held or controlled directly or indirectly by the
proposed offeror or any related companies or any person associated or acting in
concert with the proposed offeror;
- In respect of which the proposed offeror or any related company or any person
associated or acting in concert with the proposed offeror has received an
irrevocable undertaking from other holders of voting shares to which the take-
over relates to accept the take-over offer; and
- In respect of which the proposed offeror or any related company or any person
associated or acting in concert with the proposed offeror has an option to acquire;

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 (v) where applicable, the details of any existing or proposed agreement, arrangement or
understanding relating to voting shares referred to in (iv) between the proposed offeror or
any related company or person associated or acting in concert with the proposed offeror
and the holders of the voting shares to which the take-over relates; and
(vi) the conditions of the take-over offer, including conditions relating to acceptances, listing
and increase of capital.

Where a person has acquired effective control in a listed company and has no intention of making a
take-over offer, that person shall make a public announcement including the broad reasons for
exemption, immediately after having served the notice in writing to the parties. The person shall apply
to the Authority for exemption from the take-over requirements under regulation.
The offeror shall serve on the offeree within ten days from the date of the notice of intention, an
offeror’s statement of the take-over scheme containing the information specified in the First Schedule
to the Regulations. Such statement shall be approved by the Authority.
Where a notice of an intention to make a take-over offer or an offeror’s statement has been served
upon the offeree, the proposed offeror shall not amend or withdraw the intention or the statement
without the prior written consent of the Authority.
The Authority shall on application of the offeror, permit the offeror at any time prior to the offeror
serving the take-over document upon the offeree, to –

(a) Amend in writing any notice or statement lodged by the offeror

(b) Substitute in writing a fresh notice or statement for an earlier notice or statement lodged with the
offeree in such manner and subject to terms as the offeror may consider as justified by the
circumstances of the case. Such notice or statement shall be approved by the Authority;
The computation of time shall be as from the date when the first written notice or offeror’s statement
is lodged by the proposed offeror.

The Authority may in writing grant an exemption from complying with the provisions of regulation 4
to any particular person or take-over offer or to any particular class, category, description of persons
or take-over offers subject to such conditions as may be imposed by the Authority. The granting of an
exemption shall serve the wider interests of the shareholders and the public.Such circumstances shall
include -

(a) an acquisition for the purpose of a strategic investment in a listed company that is tied up with
management or any other technical support relevant to the business of such company;
(b) a management buy-out involving a majority of the employees of the offeree;
(c) a restructuring of the listed company’s share capital including acquisition, amalgamation and
any other scheme approved by the Authority;
(d) an acquisition of a listed company in financial distress;
(e) an acquisition of effective control arising out of disposal of pledged securities;
(f) the maintenance of domestic shareholding for strategic reason(s); and
(g) any other circumstances which in the opinion of the Authority serves public interest.

Nothing shall require any person to comply with the take-over procedure provided under regulation 4
if such person at the commencement of these Regulations holds -

(a) twenty five percent or more of the voting shares of a listed company; or
(b) twenty five percent or more of the voting shares in an issuer applying for listing, at the date of
listing whichever is later.
The Authority shall make a public announcement through the print and electronic media of its
decisions on the exemptions granted pursuant to this regulation.

Offeree Obligation

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Upon receiving the offeror’s statement in accordance with the obligation, the offeree shall inform the
relevant securities exchange and the Authority and make an announcement by a press notice of the
proposed take-over offer within twenty four hours of receipt of the offeror’s statement.

The press notice referred shall be made in at least two English language dailies of national circulation
and shall include all material information contained in the offeror’s statement.

Take-over 7

The offeror shall within fourteen days from the offer. date of serving the offeror’s statement submit to
the Authority, for approval, the take-over offer document in relation to the take-over offer which shall
include the information contained in the Second Schedule and such other information that the
Authority may require.

The Authority shall approve the take-over offer document within thirty days where the document is in
compliance with the requirements or within such other time as may be determined by the Authority
provided that where the Authority has determined it is not possible to grant approval within thirty
days, it shall advice the offeror of this fact.

The take-over offer document approved by the Authority shall include a statement in the following
words “Approval has been obtained from the Capital Markets Authority for the compliance with the
requirements relating to the take-over offer document under the Capital Markets (Take-overs and
Mergers) Regulations, 2002. As a matter of policy, the Capital Markets Authority assumes no
responsibility for the correctness of any statements or opinions made in this take-over offer document.
Approval of this take-over offer is not to be taken as an indication of the merits of this offer or
recommendation by the Authority to the offeree’s shareholders”.

The take-over offer document shall be served by the offeror on the offeree within five days from the
date of approval of the take-over offer document by the Authority.

The offeree shall within fourteen days from the date of receipt of the approved take-over document
circulate it to its shareholders to whom the take-over offer relates, together with the independent
adviser’s circular.

Requirements for a take-over offer

The take-over offer shall be dated and shall state that it will remain open for acceptance by the offeree
for thirty days from the date of service of the take-over offer document by the offeror.

The offer shall not be conditional upon the offeree approving or consenting to any payment or other
benefit being made or being given to any director of the offeree or to any other person that is deemed
to be related to the offeree, as compensation for loss of office or as consideration for, or in connection
with, his retirement from the office.

The offer shall state-

(a) Whether the offer is conditional upon acceptance of the offer under the take-over scheme, being
received in respect of a minimum number of issued voting shares of the offeree and if so, the
percentage;
(b) Where the shares are to be acquired in whole or in part for cash, the period within which
payment will be made and the method of such payment;
(c) Where the shares are to be acquired through a share swap, the proportion of the share swap and
the period within which the offeree’s shareholders shall receive the new shares;
(d) Whether the offeror is engaged in the same line of business as the offeree, and whether the offer
is conditional upon receiving approval under the Restrictive Cap. 504 Trade Practices,
Monopolies and Price Control Act or other regulatory approval outside Kenya where the
transaction involves companies incorporated outside Kenya;

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 (e) Whether the offer is conditional upon maintenance of a minimum percentage of share holding
by the general public to satisfy the continuing eligibility requirements for listing; and
(f) The circumstances that shall apply in the event the conditions in (a) to (e) are not fulfilled.

Every take-over offer document shall contain the following words which shall be prominently
displayed on the first page of the take-over offer document;

“If you are in any doubt about this offer, you should consult the independent adviser appointed by
your board of directors, or your stockbroker, investment bank or other professional investment
adviser”.

Offeree comments on the statement and take-over offer

Subject to the independent the Board of directors of the offeree shall within fourteen days after the
receipt of the take-over offer issue a circular to the holders of voting offer.

The board of directors of the offeree shall disclose in the circular to every holder of the voting rights
to which the take-over offer relates all such information as the holders of such voting shares and their
professional advisers would reasonably require or expect to find in such a circular or for the purpose
of making an informed assessment as to the merits of accepting or rejecting the take-over offer and
the extent of the risks involved in such action.

Without prejudice to the statement shall include, but is not limited to information on -

(a) the offeror’s stated intentions regarding the continuation of the business of the offeree;
(b) the offeror’s stated intentions regarding major changes to be introduced in the business, including
plans to liquidate the offeree, sell its assets, re-deploy the fixed assets of the offeree or make any
other major change in the structure of the offeree;
(c) the offeror’s stated long term commercial justification for the proposed take-over offer;
(d) the offeror’s stated intentions with regard to the continued employment of the board of directors,
management and employees of the offeree and of its subsidiaries;
(e) the reasonableness of the take-over offer, including, the reasonableness and accuracy of profit
forecasts for the offeree, if such forecast is included by the offeror in the offer document; and
(f) any other information relevant for the informed assessment of the holders of voting shares and
their professional advisers.

Independent Adviser
The board of directors of the offeree shall appoint an independent adviser. The independent adviser
shall be an investment bank or a stockbroker licensed by the Authority. The substance of the
independent adviser’s advice must be made known to the holders of the class of the voting shares to
which the take-over offer relates, in a circular by the offeree to its shareholders.
The board of directors of the offeror shall appoint an independent adviser where the take-over offer
being made is a reverse take-over or where the board of directors of the offeror is faced with a conflict
of interest situation. The substance of any advice given to the board of directors of the offeror under
shall be made known to all the holders of voting shares of the offeror.
In the case of a reverse take-over, the board of directors of the offeror shall obtain approval of the
holders of voting shares of the offeror to which the reverse take-over relates prior to serving the take-
over offer document to the offeree.

Where the offeror has convertible securities outstanding, the appointed independent adviser shall
make known its advice to the holders of such securities, together with the views of the board of
directors of the offeror or of the offeree, as the case may be, on the take-over offer or proposal.
The independent adviser appointed by the Board of directors of the offeree shall send a circular to the
board of directors of the offeree and the Authority prior to the circular being served on the offeree’s
holders of voting shares to which the take-over offer relates.

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The circular required to be sent by the board of directors of the offeree to the offeree shareholders
shall be posted to the relevant holders of voting shares within fourteen days from the date of the take-
over offer document being served in accordance to regulation 7.

The independent adviser shall disclose all such information in the independent adviser’s circular as
the holders of the voting shares of the offeror, the board of directors of the offeree and all holders of
voting shares to which the take-over offer relates and their professional advisers would reasonably
require or expect to be informed about, in an independent advice or for the purpose of making an
informed assessment as to the merits of accepting or rejecting the take-over offer and the extent of the
risks involved in such action.

The information required to be disclosed must be that which –

(a) is within the knowledge of the Board of directors and of the independent adviser; and
(b) the independent adviser would be able to obtain by making such enquiries as were reasonable in
the circumstances.

A person shall, unless the contrary is proved, be presumed to have been aware at a particular time of a
fact or occurrence of which, an employee or agent of the person having duties or acting on behalf of
the employer or principal was aware of at the time.
An independent adviser shall include in the circular to the board of directors of the offeree and the
offeree shareholders all the information and statements specified in the Fourth Schedule.

Requirements for an independent adviser

No person shall be eligible to be appointed as an independent independent adviser where such a
person -
(a) has an interest in ten percent or more of the voting shares of an offeror or offeree at the present
time or at any time during the twelve months preceding the date of announcement of the
offeror’s intention of the take-over scheme;
(b) has a substantial business relationship with the offeror or offeree at the material time or at any
time during the twelve months preceding the date of announcement of the offeror’s intention of
the take-over scheme.
(c) being a company, has a director on its board of directors who is also a director on the board of
directors of the offeror if the offeror is a company or on the board of directors of the offeree, as
the case may be;
(d) is involved in financing the offer by the offeror;
(e) is a substantial creditor of either the offeror or the offeree.
(f) has a financial interest in the outcome of the take-over offer than that specified in (a) to (d); or
(g) has been an adviser in planning or restructuring of the offeror or offeree including acquisitions,
at any time during the period of twelve months preceding the date of announcement of the
offeror’s intention of the take-over scheme.

A person is deemed a “substantial creditor” if-

i) the loan extended represents more than ten percent of the loan outstanding in the offeror or
the offeree; or
ii) the loan extended to either the offeror or the offeree represents more than ten percent of the
shareholders’ funds of the person based on the latest audited accounts; or
iii) the person is a lead banker in a syndicated loan extended to either the offeror or the offeree in
the preceeding three years;

Offer to dissenting shareholders

Where a take-over results in the offeror acquiring ninety percent of the offeree’s voting shares, the
offeror shall offer the remaining shareholders a consideration that is equal to the prevailing market

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price of the voting shares or the price offered to the other holders, whichever is higher and the Cap.
486. provisions of the Companies Act shall apply.

Competing take over

Where a decision has been reached to make a take-over offer, all provisions in these regulations
relating to the take-over procedures shall apply mutatis mutandis except the notice period to the
competing offer.

The competing offeror shall serve a competing take-over offer document required at least ten days
prior to the closure of the offer period and this period shall also apply to revisions that may be made
to the competing offer.

Offer Period
An offeror must keep a take-over offer open for acceptances for a period of thirty days from the date
the take-over offer document is first served or such period as may be determined by the Authority.

Conditional offer
Where the offer is conditional upon acceptances in respect of a minimum percentage of shares being
received, the offer shall specify a date not being a date later than thirty days from the date of service
of the take-over offer or such later date as the Authority may in a competitive situation or in special
circumstances allow as the latest date on which the offeror can declare the offer to have become free
from that condition.

Variation of take-over offer

An offeror may vary the terms and conditions of a take-over offer including increasing the
consideration offered in relation to the whole or part thereof provided such variation shall be made at
least five days prior to the closure of the offer period.

The varied take-over offer document shall set out in an appropriate form particulars of such
modification of the offeror’s statements and information required under the Second Schedule as are
necessary having regard to the variations.

The offeror shall serve the varied take-over offer document on the offeree, the Authority and the
securities exchange within twenty four hours of making the decision to vary the take-over offer, and
simultaneously make a public announcement by press notice in at least two English language dailies
of national circulation disclosing material variations to the offer.

Withdrawal of take-over offer

An offeror shall not withdraw a take-over offer without the prior written approval of the Authority.

Where a take-over offer has been withdrawn the offeror and all related companies or all persons
acting in concert or associated with the offeror shall not within twelve months from the date on which
the take-over offer was withdrawn –
(a) make a take-over offer for the voting shares that had been the subject of the take-over offer that
has been withdrawn; or
(b) acquire any additional voting shares of the offeree .

The offeror and all related companies or persons acting in concert or associated with the offeror shall
furnish the Authority with details of any acquisition by the offeror and related companies or persons
acting in concert or associated with the offeror of any share of the offeree including any option to
acquire any share in the offeree each month for a period of twelve months from the date on which the
take-over offer was withdrawn.

Withdrawal of a take-over offer may occur where-

(a) The offeree shareholders have rejected the take-over offer;

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 (b) The offeror has not obtained an approval Cap. 504 under the Restrictive Trade Practices,
Monopolies and Price Control Act or any other regulatory approval as may be required;
(c) Events, satisfactory to the Authority occur, rendering either the offeror or offeree or both
incapable of fulfilling their obligations under the take-over offer; or
(d) A counter offer is accepted by the offeror.

Closing of take-over offer

A take-over offer shall be deemed to close on the last day of the offer period.
A holder of the voting shares in the offeree may withdraw acceptance out of his own volition at any
time before the closing of the offer.

Pro-rata acceptances
Where an offeror receives acceptance by the offeree shareholders in excess of the total number of
shares to which the take-over offer relates, the offeror shall undertake pro- rata acceptance.
“Pro-rata acceptance” means an allocation of acceptance by the offeror in the proportion of the total
number of shares accepted by each offeree shareholder in relation to the percentage upon which the
offer was conditional.

Announcement of acceptances
The offeror shall inform the Authority and the securities exchange within ten days of the closure of
the offer and announce by way of press notice in at least two English language dailies of national
circulation the total number of voting shares to which the take-over offer relates-
(a) For which acceptances of the take-over offer have been received after having been served
with the take-over offer document by the offeror to offeree shareholders.
(b) Held by the offeror and all persons acting in concert with the offeror at the time of serving the
offer document to the offeree shareholders.
(c) acquired or agreed to be acquired during the offer period; and
(d) The shareholding structure of the offeree subsequent to the take-over offer.

OBLIGATIONS OF OFFEROR IN RELATION TO OFFER

i) Identity of offeror
No person shall initiate discussions or negotiations with any person in relation to a take-over offer
without disclosing the identity of the;-
(a) proposed offeror and all related companies or persons acting in concert or associated with the
proposed offeror;
(b) Ultimate offeror, where applicable.

ii) Evidence of ability to implement the take-over offer

A person who is required to make an announcement under regulation 20 shall ensure and the person’s
financial adviser shall be reasonably satisfied that –
(a) the take-over offer would not fail due to insufficient financial capability of the offeror; and
(b) every offeree shareholder who wishes to accept the take-over offer will be paid in full.
A person who has no intention of making an offer in the nature of a take-over offer shall not give
notice or publicly announce the intention to make a take-over offer.

A person shall not make a take-over offer or give notice or publicly announce that it intends to make
such an offer if it has no reasonable or probable grounds for believing that it will be able to perform
its obligations if the offer is accepted.

iii) Favourable deals

The offeror shall not enter into any agreement, arrangement or understanding to deal in or make
purchases or sales of voting shares of the offeree, either during a take-over offer or when such a take-

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over offer is reasonably in contemplation by the offeror where the agreement, arrangement or
understanding contain favourable conditions which are not being extended to all offeree shareholders.

iv) Convertible securities

Where a take-over offer is made for the voting shares of an offeree and the offeree has issued
convertible securities, the offeror shall make a take-over offer to purchase the securities and shall
make appropriate arrangements to ensure that the interests of holders of convertible securities are
safeguarded.

The offeror shall serve the take-over offer document to purchase the securities to the holders of the
convertible securities at the same time as when the take-over offer document is served on the offeree
shareholders.

The take-over offer to holders of convertible securities may be affected by way of a take-over scheme
approved at a meeting of the holders of the convertible securities.

For the purposes of these Regulations, “convertible securities” of the offeree means securities that are
convertible to ordinary shares of the offeree”.

v) Sales and disclosure by the offeror during the offer

The offeror shall not sell any voting shares to which the take-over offer relates during an offer period.

A related company or a person associated or period acting in concert with the offeror shall not sell
any voting shares to which the take-over offer relates other than to the offeror.

The following persons shall disclose the total number and price of all voting shares of the offeror and
the offeree which are dealt in for their own account –

(a) the offeror and all related companies or persons associated to or acting in concert with the
offeror;
(b) the chief executive, a director or an officer of the offeror who occupies or acts in a senior
managerial position in the offeror, by whichever name called;
(c) a person who is an associated person in relation to persons referred to in a) and (b); and
(d) a person who is accustomed to act in accordance with directions or instructions of the persons
referred to in (a), (b) or (c).
The disclosure shall be made to the relevant securities exchange where the securities of the offeror are
listed and to the Authority, within twenty four hours of the transaction.

All dealings in voting shares of the offeror and offeree made by an associated person for the account
of investment clients who are not themselves associated persons shall be disclosed to the relevant
securities exchange and the Authority.

OBLIGATIONS OF OFFEREE IN RELATION TO OFFER

i) Information by offeree
An offeree shall provide the offeror with the following information -

(a) a list and addresses of the offeree’s holders of voting shares in the offeree to which the take-
over offer relates;
(b) published annual accounts and reports including the latest half-yearly results of the offeree
and its subsidiaries; and
(c) a copy of the competing offeror’s statement where there is a competing offer.

ii) Frustrations of offers by offeror

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The offeree shall not after contact with the or its agent or on receipt of the notice of intention of the
take-over offer, if the offeree has reason offeree to believe that a bona fide take-over is imminent, or
during the course of a take-over offer-

(a) issue any authorized but un-issued shares of the offeree;

(b) issue or grant options in respect of any un-issued shares of the offeree;
(c) create or issue or permit the creation or subscription of any shares of the offeree;
(d) sell, dispose of or acquire or agree to sell, dispose of or acquire assets of the offeree or of any
of it’s subsidiary; or
(e) enter into or allow contracts for or on behalf of the offeree to be entered into otherwise than in
the ordinary course of business of the offeree.
The above does not apply where a bona fide contract has been entered into prior to contact with the
offeror or its agent or on receipt of the notice of intention of the take-over notice which is not
designed to frustrate a take-over offer or change the activity of the offeree.

iii) Disclosure of dealings

During the offer period the total number and by price of all voting shares of the offeror and the offeree
which offeree. are dealt in by the following persons shall be disclosed by them respectively –

(a) the offeree;

(b) substantial shareholders of the offeree;
(c) any chief executive, a director of the offeree;
(d) any officer of the offeree who occupies or acts in a senior managerial position in the offeree, by
whatever name called;
(e) a person who is an associated person in relation to persons referred to in (a), (b), (c) and (d);
(f) a person who is accustomed to act in accordance with directions or instructions of the persons
referred to in (a), (b), (c), (d) or (e).
The disclosure shall be made to the relevant securities exchange and the Authority within twenty four
hours of the transaction, outside trading hours.

All dealings of voting shares of the offeror or the offeree made by an associated person for the
account of investment clients who are not themselves associated persons shall be disclosed to the
relevant securities exchange and the Authority.

iv) Transfer to the offeror

On completion of the take-over offer, the offeree shall ensure prompt transfer of the accepted voting
shares to the offeror in the register of members maintained as required

GENERAL INFORMATION
False or misleading information

No person shall -
(a) provide or cause to be provided to the holders of voting shares or their professional advisers any
document or information in a take-over offer that is false or misleading;
(b) provide or cause to be provided to holders of voting shares or their professional advisers any
document or information in a take-over offer in which there is a material omission; or
(c) engage in conduct relating to a take-over offer that is misleading or deceptive or is likely to
mislead or deceive holders of voting shares or their professional advisers.

Where information or a document has been circulated or provided to holders of voting shares or their
professional advisers and the person who provided the information or document, or engaged in the
conduct becomes aware that the document or information was false or misleading or contains a
material omission or the conduct in question was misleading or deceptive, the person shall
immediately disclose the fact to the Authority and the relevant securities exchange and make an

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announcement by way of press notice in at least two English language dailies of national circulation
containing such matters as are necessary to correct the false or misleading information omission, or
conduct, as the case may be.

Submission of information to the Authority

A person involved in a take-over scheme, merger or compulsory acquisition, shall submit such
information to the authority as it may from time to time require.

Suspension of during trading take-over

In the event of a take-over the trading of shares of the security of the offeree shall not be suspended
unless for the purpose of enabling the offeree to disclose information on the takeover offer or as may
be directed by the Authority for the purpose of obtaining material information on the offer.

Issuance of shares in a subsidiary

No issuance of shares of a subsidiary of a listed in a company comprising-
(a) twenty five percent or more of the share capital of that subsidiary; or
(b) ten percent or more of the share capital of the subsidiary, that has contributed to twenty five
percent or more to the average turnover in the latest three financial years of the listed company
(preceding the proposed issuance of shares), shall be made without full disclosure through an
information circular to the shareholders of the listed company, of all relevant information relating
to the transaction for which the shares are being issued subject to the prior approval of the
issuance of such shares by the Authority.
The information circular shall be subject to prior approval by the Authority

Establishment of take-over Committee

The Authority may establish a sub-committee of the board that shall consist of the Board members
and such other qualified persons as shall be appointed by the Authority, for the purpose of advising on
the take-over on a case by case basis.

Where a subcommittee has been established the chief executive of the Nairobi Stock Cap. 504
Exchange and the Commissioner of Monopolies and Prices appointed under the Restrictive Trade
Practices, Monopolies and Price Control Act shall be invited to the subcommittee meetings.

The subcommittee in exercise of its delegated responsibility may invite the offeror, the offeree, the
independent adviser or any other person whose input is deemed necessary for the purposes of
facilitating the take-over.

The decision of the subcommittee shall be subject to ratification by the Board.

INFORMATION REQUIRED TO BE INCLUDED IN THE OFFEROR’S STATEMENT

The statement shall -

(a) be dated and signed by two directors of the offeror;
(b) specify the names, descriptions, addresses of all directors of the offeror;
(c) contain a summary of the principal activities of the offeror company;
(d) contain a list of major shareholders and subsidiaries of the offeror;
(e) contain a summary of the latest audited financial statements including -
i) balance sheet;
ii) income statement;
iii) statement of the changes in equity;
iv) cash flow statement; and
v) earnings per share (prior to the take-over offer and post take-over).
(f) specify the number, description and amount of marketable securities in the offeree held by or on
behalf of the offeror, or if none are so held contain a statement to that effect;

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Where the consideration for the acquisition of shares under the take-over scheme is to be satisfied in
whole or in part by the payment of cash, the statement shall contain details of the arrangements that
have been, or will be made to secure payment of the cash and, if there are no such arrangements a
declaration shall be made in the statement to this effect.

Where the consideration for the acquisition of shares under the take-over scheme is to be satisfied in
whole or in part by a share swap, the statement shall contain details of the arrangements that have
been, or will be made to transfer the shares and the proportion of the shares being swapped, and if
there are no such arrangements, a declaration shall be made in the statement to this effect.

The statement shall state whether -

(a) it is proposed in connection with the take-over scheme that a payment or any other benefit shall
be made or be given to any director of the offeree or of any company which is a related
company to the offeree as a consideration for, or in connection with, his retirement from office
and if so the particulars of the proposed payment or benefit;
(b) there is any agreement or arrangement made between the offeror and any of the directors of the
offeree in connection with or conditional upon the outcome of the scheme, and if so the
particulars of such agreement or arrangement;
(c) there has been within the knowledge of the offeror any material change in the financial position
or prospects of the offeree since the date of the latest balance sheet laid before the offeree’s
general meeting and if so, the particulars of such change; and
(d) there is an agreement or arrangement by which shares acquired by the offeror in pursuance of
the scheme will or may be transferred to any other person, and if so-
i) the names of the persons who are party to the agreement or arrangement and the number and
description of the shares which will or may be so transferred; and
ii) the number, if any, description and amount of shares of the offeree company held by or on
behalf of each person, or if no such shares are so held, a statement to that effect.
Where the marketable securities are quoted or dealt in on a securities exchange, the statement shall
state this fact and specify the securities exchange concerned and indicate-

(a) the latest available market sale price prior to the date on which notice of the take-over scheme is
given to the offeree;
(b) the highest and lowest market sale price during the three months immediately preceding that
date and the respective dates of the relevant sales including the latest market sale price
immediately prior to the public announcement;
Where the securities are listed on more than one securities exchange, it shall be sufficient compliance
with the law. If information with respect to the securities is given in relation to the securities exchange
at which there have been the greatest number of recorded dealings in the securities in the three months
immediately preceding the date on which notice of the take-over scheme is served upon the offeree.

INFORMATION REQUIRED TO BE INCLUDED BY THE OFFEROR IN A TAKEOVER

OFFER DOCUMENT
The offeror shall disclose in the offer document all such information as the offeree shareholders and
their professional advisers would reasonably require.

The offeror shall state the following in the offer document -

(a) the identity of the ultimate offeror
(b) information regarding the offeror including the names of its directors and shareholders who hold
notifiable interest in the offeror and the extent of their holdings;
(c) whether the offeror has any intentions regarding the continuation of the business of the offeree
and if so, stating the offeror’s intentions;
(d) the offeror’s stated intentions regarding major changes to be introduced in the business, or
strengthening the financial position of the offeree, whether such plans include a merger, or
liquidating the offeree, selling its assets or re-deploying its fixed assets or making any other

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 major change in the structure of the offeree or its subsidiaries and if so, stating the offeror’s
intentions;
(e) whether there are any long term commercial justifications for the proposed take-over offer, and if
so, stating the long term commercial justifications; and
(f) whether the offeror has any intentions with regard to the continued employment of the
employees of the offeree company and of its subsidiaries and if so, stating the offeror’s
intentions.

Where the take-over offer is for cash, either in part or in whole, the offer must include a confirmation
by a financial adviser of the offeror that the offeror has the financial capability to accept and carry out
the take-over offer in full.

In addition, the offer document should also include a statement that the offeror and the offeror’s
financial advisers are satisfied that-

(a) the take-over offer would not fail due to insufficient financial capability of the offeror; and

(b) every shareholder who wishes to accept the take-over offer will be paid in full.

The offer document shall contain a statement as to whether -

(a) any agreement, arrangement or understanding exists between the offeror or any person acting in
concert with it and any of the directors, past directors, holders of voting shares or past holders of
voting shares having any connection with or dependence upon the take-over offer, and full particulars
of any such agreement, arrangement or understanding.

“past directors” or “past holders of voting shares” means such person who was during the period of
six months immediately prior to the date of the written notice of the take-over offer, a director or a
holder of the voting shares, as the case may be;

(b) any voting shares acquired in pursuance of the take-over offer will be transferred within a
foreseeable period from the date of the offer document to any other person, together with the names of
the parties to any such agreement, arrangement or understanding and the particulars of all securities in
the offeree held by such persons, or a statement that no such securities are held; and

(c) any settlement of the consideration to which any holder is entitled under the take-over offer will be
implemented in full in accordance with the terms of the take-over offer without regard to lien, right of
set off, counter claim or other analogous rights to which the offeror may otherwise be or claim to be
entitled as against the holder.

The offer document shall state as at the latest practicable date, the number of and percentage holding
of voting shares and convertible securities (if any) which -

(a) the offeror and directors of the offeror hold, directly or indirectly, in the offeree;
(b) persons associated or acting in concert with the offeror or related companies to the offeror hold
directly or indirectly in the offeree together with the names of such persons acting in concert; and
(c) persons who, prior to the sending of the take-over offer document, have irrevocably committed
themselves to accept the take-over offer hold directly or indirectly in the offeree together with the
names of such persons.
In the event that there are no holdings of the nature the offer document shall contain a statement to
this effect.

The take-over offer document shall state the names and shareholdings of the ultimate shareholders, if
any, and of the persons acting in concert with the offeror.

Where any party whose holdings are required to be disclosed has dealt in the voting shares in question
during the period commencing six months prior to the beginning of the offer period and ending with

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the latest practicable date prior to the sending of the offer document, the details, including the number
of shares, dates and prices, must be stated. If no such deals have been made this fact should be so
stated.

The take-over offer document shall state, whether the emoluments of the offeror’s directors shall be
effected by the acquisition of the offeree, except in the case of an offeror making a cash offer only.
The offeror shall state whether the offeree’s securities shall continue to be listed at the securities
exchange after the take-over offer has been successfully concluded.

The offer document shall contain particulars of all service contracts of any directors or proposed
director of the offeror or any of its subsidiaries (unless expiring or determinable by the employing
company without payment of compensation within twelve months) and where there are no such
contracts, this fact should be so stated.
Where the contracts have been entered into or amended within six months of the date of the
documents, the particulars of the contracts amended or replaced should be given and where there have
been no new contracts or amendments this fact should be so stated.

INFORMATION REQUIRED IN THE CIRCULAR ISSUED BY THE OFFEREE TO

ITS SHAREHOLDERS
The circular shall state-
(a) the number, description and amount of marketable securities in the offeree company held by or
on behalf of each director of the offeree company, or in the case where no such securities are
held, a statement to that effect;
(b) in respect of each director of the offeree company by whom or on whose behalf shares to which
the take-over scheme relates are held-
i) whether the present intention of the director is to accept any take-over offer that may be made
in pursuance of the take-over scheme in respect of the shares; or
ii) whether the director has decided not to accept such a take-over offer;
(c) whether any marketable securities of the offeror company are held by, or on behalf of, any
director of the offeree company and, if so, the number, description and amount of the marketable
securities so held;
(d) whether it is proposed in connection with the take-over scheme that any payment or other benefit
shall be made or be given to any director of the offeree or of any other company related to the
offeree as consideration, or in connection with, its retirement from office and if so, particulars of
the proposed payment or benefit.
(e) whether there is any other agreement or arrangement made between the director or the offeree
and any other person in connection with or conditional upon the outcome of the take-over scheme
and if so the particulars of such agreement or arrangement;
(f) whether a director of the offeree has an direct or indirect interest in any contract entered into by
the offeror and if so, the particulars of the nature and extent of such interest; and
(g) whether there has been any material change in the financial position of the offeree since the date
of the last balance sheet laid before the company in general meeting, and if so, the particulars of
such change.

INFORMATION AND STATEMENTS REQUIRED TO BE INCLUDED IN AN

INDEPENDENT ADVISER’S CIRCULAR

An independent adviser’s circular whether recommending acceptance or rejection of the take-over

offer, must contain comments and advice on the -

(a) offeror’s stated intentions regarding the continuation of the business of the offeree;
(b) offeror’s stated intentions regarding any major changes to be introduced in the business, including
any plans to liquidate the offeree, sell its assets, re-deploy its fixed assets or make any other major
change in the structure of the offeree;

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(c) offeror’s stated long term commercial justification for the proposed take-over offer;
(d) offeror’s stated intentions with regard to the continued employment of the employees of the
offeree and of its subsidiaries; and
(e) reasonableness of the take-over offer, including the reasonableness and accuracy of profit
forecasts for the offeree, if any, contained in the offer document.
The independent adviser’s circular shall, in so far as is reasonable, contain comments on the -

(a) outlook, for the next twelve months, of the industry in which the offeree has its core or major
business activities; and
(b) prospects, for the next twelve months, of the offeree in terms of financial performance as well
as positioning in the industry including competitive advantage, threats and opportunities -
The independent adviser’s circular shall also state -

(a) whether the offeree holds directly or indirectly, any voting shares or convertible securities in the
offeror and if so, the number and percentage holding of such voting shares and convertible
securities;
(b) whether the directors of the offeree hold, directly or indirectly any voting shares or convertible
securities in the offeror or the offeree and if so, the number and percentage holding of such
voting shares and convertible securities so held; and
(c) whether the directors of the offeree intend, in respect of their own beneficial holdings to accept
or reject the take-over offer.
In the event that there are no holdings of the nature required to be stated. The independent adviser’s
circular shall contain a statement to this effect.

The independent adviser’s circular must also contain a statement from the directors of the offeree
stating any other interest held by them in the offeror and in the offeree.

Where any party whose holdings are required to be disclosed pursuant to the Act has dealt in the
voting shares in question during the period commencing six months prior to the beginning of the offer
period and ending with the latest practicable date prior to the sending of the offer document, the
details, including the number of shares, dates and prices, must be stated and where such deals have
been made, this fact should be so stated.

The independent adviser’s circular shall contain particulars of all service contracts of any director or
proposed director with the offeree or any of its subsidiaries (unless expiring or determinable by the
employing company without payment of compensation within twelve months from the date of the
offer document) and where there are no such contracts, this fact shall be so stated.

Where the service contracts have been entered into or amended within six months of the date of the
document, the particulars of the contracts or amendments shall be given and where there have been no
new service contracts or amendments, this fact shall be so stated.

THE COMPETITION ACT NO. 12 OF 2010

The Act seeks to promote and safeguard competition in the national economy, to protect consumers
from unfair and misleading market conduct and to provide for the establishment, powers and
functions of the

Competition Authority and the Competition Tribunal

In a bid to safeguard competition in the Kenyan economy, the Act bestows the Competition Authority
with the function and power to control mergers. Accordingly, no person, individually or jointly may
implement a proposed merger unless the proposed merger is approved by the Authority and
implemented in accordance with the conditions attached to that approval.

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For the purposes of the Competition Act and indeed for the need for authorization, a merger occurs
when one or more undertakings directly or indirectly acquire or establish direct or indirect
control over the whole or part of the business of another undertaking.

Acquisition or establishment of control can occur through various ways including:

− the purchase or lease of shares, acquisition of an interest, or purchase of assets of the other
undertaking in question;
− the acquisition of a controlling interest in a section of the business of an undertaking capable
of itself being operated independently
− the acquisition of an undertaking under receivership by another undertaking either situated
inside or outside Kenya
− acquiring by whatever means the controlling interest in a foreign undertaking that has got a
controlling interest in a subsidiary in Kenya;
− vertical integration;
− exchange of shares between or among undertakings which result in substantial change in
ownership structure; and
− amalgamation, takeover or any other combination with the other undertaking.

On the other hand a person / entity controls an undertaking if that person:

− beneficially owns more than one half of the issued share capital of the undertaking;
− is entitled to vote a majority of the votes that may be cast at a general meeting of the
undertaking, or has the ability to control the voting of a majority of those votes, either directly
or through a controlled entity of that undertaking;
− is able to appoint, or to veto the appointment of, a majority of the directors of the undertaking;
and
− is a holding company, and the undertaking is a subsidiary of that company as contemplated in
the Companies Act (Cap. 486);
− in the case of the undertaking being a trust, has the ability to control the majority of the votes
of the trustees or to appoint the majority of the trustees or to appoint or change the majority of
the beneficiaries of the trust;
− in the case of the undertaking being a nominee undertaking, owns the majority of the
members’ interest or controls directly or has the right to control the majority of members’
votes in the nominee undertaking; or
− has the ability to materially influence the policy of the undertaking in a manner comparable to
a person who, in ordinary commercial practice, can exercise an element of control referred to
in the preceding paragraphs.

Consummating a merger or takeover as contemplated in the Act without having obtained approval
renders the merger or takeover null and void and constitutes an offence.
Offender(s) may be liable to imprisonment for a term not exceeding five years or to a fine not
exceeding ten million shillings.

VALUATION AND ANALYSIS OF CORPORATE RESTRUCTURING

Corporate restructuring is a process through which a company changes the contractual relationship
which exists among its creditors, shareholders, employees and other stakeholders. It can be pre-
emptive or forced.

Portfolio restructuring includes significant changes in the mix of assets owned by a firm or the lines
of business in which a firm operates, including liquidation, divestitures, asset sales and spin-offs.
Company management may restructure its business in order to sharpen focus by disposing of a unit
that is peripheral to the core business and in order to raise capital or rid itself of a languishing

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operation by selling-off a division. Moreover, a company can entail on an aggressive combination of
acquisitions and divestitures to restructure its portfolio.

Financial restructuring includes significant changes in the capital structure of a firm, including
leveraged buyouts, leveraged recapitalizations and debt for equity swaps. Financial structure refers to
the allocation of the corporate flow of funds-cash or credit-and to the strategic or contractual decision
rules that direct the flow and determine the value-added and its distribution among the various
corporate constituencies.

Organizational restructuring includes significant changes in the organizational structure of the firm,
including redrawing of divisional boundaries, flattening of hierarchic levels, spreading of the span of
control, reducing product diversification, revising compensation, streamlining processes, reforming
governance and downsizing employment. The findings of Bowman et al. [1999] indicated that lay-
offs unaccompanied by other organizational changes tend to have a negative impact on performance.
Downsizing announcements combined with organizational restructuring are likely to have a positive,
though small effect on performance

Need for corporate restructuring

The various needs of undertaking the scheme of corporate restructuring in this modern competitive
business / corporate world are discussed briefly as follows:-
a) To focus on core strengths, operational synergy , and efficient allocation of managerial
capabilities and infrastructure
b) Consolidation and economies of scale by expansion and diversion to exploit the extended
domestic and international markets
c) Revival and rehabilitation of sick unit by adjusting the losses of such sick units with profits of
healthy company
d) Acquiring the constant supply of raw materials and access to scientific research and
technological development
e) Capital restructuring by appropriate mix up of loans and equity capital to reduce cost of
servicing and to increase return on capital employed
f) Improve the corporate performances to bring it at par with competitors.

LEVERAGED BUY OUTS (LBO)

A leveraged buyout (LBO) is an acquisition of a company or a segment of a company funded mostly
with debt. A financial buyer (e.g. private equity fund) invests a small amount of equity (relative to the
total purchase price) and uses leverage (debt or other non-equity sources of financing) to fund the
remainder of the consideration paid to the seller. The LBO analysis generally provides a "floor"
valuation for the company, and is useful in determining what a financial sponsor can afford to pay the
for target and still realize an adequate return on its investment

Transaction structure
Below is a simple diagram of an LBO structure. The new investors (e.g. and LBO firm or
management of the target) form a new corporation for the purpose of acquiring the target. The target
becomes a subsidiary of New Company, or New Company and the target can merge.

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Applications of LBO Analysis
• Determine the maximum purchase price for a business that can be paid based on certain
leverage(debt) levels and the equity return parameters
• Develop a view of the leverage and equity characteristics of a leveraged transaction at a given
price.
• Calculate the minimum valuation for a company since; in the absence of strategic buyers, an LBO
firm should be a willing buyer at a price that delivers an expected equity that meets the firms
hurdle rate.

Steps in LBO Analysis

• Develop operating assumptions and projections for the stand-alone company to arrive at EBITDA
and cash flow available for debt repayment over the investment horizon.
• Determine key leverage levels and capital structure that result in realistic financial coverage and
credit statistics.
• Estimate the multiple at which the sponsor is expected to exit the investment (should generally be
similar to the entry multiple
• Calculate equity returns (IRRs) to the financial sponsor and sensitize the results to a range of
leverage and exit multiples as well as investment horizons.

DIVESTITURES
Divestitures are a way for a company to manage its portfolio of assets. As companies grow they may
find they are trying to focus on too many lines of business, and that they must close some operational
business units in order to focus on more profitable lines
Firms may have several motives for divestitures:
1. A firm may divest (sell) businesses that are not part of its core operations so that it can focus on
what it does best.
2. To obtain funds. Divestitures generate funds for the firm because it is selling one of its businesses
in exchange for cash.
3. A firm's "break-up" value is sometimes believed to be greater than the value of the firm as a
whole. In other words, the sum of a firm's individual asset liquidation values exceeds the market
value of the firm's combined assets. This encourages firms to sell off what would be worth more
when liquidated than when retained.
4. divesting a part of a firm may enhance stability
5. Divesting a part of a company may eliminate a division which is under-performing or even
failing.
6. Regulatory authorities may demand divestiture, for example in order to create competition.
7. Pressure from shareholders for social reasons (sometimes also called disinvestment).
STRATEGIC ALLIANCES
A strategic alliance is an agreement between two or more parties to pursue a set of agreed upon
objectives needed while remaining independent organizations. This form of cooperation lies
between mergers and acquisitions and organic growth. Strategic alliances occurs when two or more
organizations join together to pursue mutual benefits.

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Partners may provide the strategic alliance with resources such as products, distribution channels,
manufacturing capability, project funding, capital equipment, knowledge, expertise, or intellectual
property. The alliance is a cooperation or collaboration which aims for a synergy where each partner
hopes that the benefits from the alliance will be greater than those from individual efforts. The
alliance often involves technology transfer (access to knowledge and expertise), economic
specialization, shared expenses and shared risk.

There are several ways of defining a strategic alliance. Some of the definitions emphasize the fact that
the partners do not create a new legal entity, i.e. a new company. This excludes legal formations like
Joint ventures from the field of Strategic Alliances. Others see Joint Ventures as possible
manifestations of Strategic Alliances. Some definitions are given here:
Definitions excluding Joint Ventures
• An arrangement between two companies that have decided to share resources to undertake a
specific, mutually beneficial project. A strategic alliance is less involved and less permanent than
a joint venture, in which two companies typically pool resources to create a separate business
entity. In a strategic alliance, each company maintains its autonomy while gaining a new
opportunity. A strategic alliance could help a company develop a more effective process, expand
into a new market or develop an advantage over a competitor, among other possibilities.
• Agreement for cooperation among two or more independent firms to work together toward
common objectives. Unlike in a joint venture, firms in a strategic alliance do not form a new
entity to further their aims but collaborate while remaining apart and distinct.

Some types of strategic alliances include;

• Horizontal strategic alliances, which are formed by firms that are active in the same business area.
That means that the partners in the alliance used to be competitors and work together In order to
improve their position in the market and improve market power compared to other competitors.
• Vertical strategic alliances, which describe the collaboration between a company and its upstream
and downstream partners in the Supply Chain, that means a partnership between a company its
suppliers and distributors. Vertical Alliances aim at intensifying and improving these
relationships and to enlarge the company´s network to be able to offer lower prices. Especially
suppliers get involved in product design and distribution decisions. An example would be the
close relation between car manufacturers and their suppliers.
• Intersectional alliances are partnerships where the involved firms are neither connected by a
vertical chain, nor work in the same business area, which means that they normally would not get
in touch with each other and have totally different markets and know-how.
• Joint ventures, in which two or more companies decide to, form a new company. This new
company is then a separate legal entity. The forming companies invest equity and resources in
general, like know-how. These new firms can be formed for a finite time, like for a certain project
or for a lasting long-term business relationship, while control, revenues and risks are shared
according to their capital contribution.
• Equity alliances, which are formed when one company acquires equity stake of another company
and vice versa. These shareholdings make the company stakeholders and shareholders of each
other. The acquired share of a company is a minor equity share, so that decision power remains at
the respective companies. This is also called cross-shareholding and leads to complex network
structures, especially when several companies are involved. Companies which are connected this
way share profits and common goals, which leads to the fact that the will to competition between
these firms is reduced. In addition this makes take-overs by other companies more difficult.
• Non-equity strategic alliances, which cover a wide field of possible cooperation between
companies. This can range from close relations between customer and supplier, to outsourcing of
certain corporate tasks or licensing, to vast networks in R&D. This cooperation can either be an
informal alliance which is not contractually designated, which appears mostly among smaller
enterprises, or the alliance can be set by a contract.
Further kinds of strategic alliances include:

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• Cartels: Big companies can cooperate unofficially, to control production and /or prices within a
certain market segment or business area and constrain their competition
• Franchising: a franchiser gives the right to use a brand-name and corporate concept to a frachisee
who has to pay a fixed amount of money. The franchiser keeps the control over pricing,
marketing and corporate decisions in general.
• Licensing: A company pays for the right to use another companies´ technology or production
processes.
• Industry Standard Groups: These are groups of normally large enterprises that try to enforce
technical standards according to their own production processes.
• Outsourcing: Production steps that do not belong to the core competencies of a firm are likely to
be outsourced, which means that another company is paid to accomplish these tasks.
• Affiliate Marketing: Affiliate marketing is a web-based distribution method where one partner
provides the possibility of selling products via its sales channels in exchange of a beforehand
defined provision

LIQUIDATION AND RECAPITALISATION

LIQUIDATION
In law and business, liquidation is the process by which a company (or part of a company) is brought
to an end, and the assets and property of the company are redistributed. Liquidation is also sometimes
referred to as winding-up or dissolution, although dissolution technically refers to the last stage of
liquidation. The process of liquidation also arises when customs, an authority or agency in
a country responsible for collecting and safeguarding customs duties, determines the final
computation or ascertainment of the duties or drawback accruing on an entry.[1]
Liquidation may either be compulsory (sometimes referred to as a creditors' liquidation) or voluntary
(sometimes referred to as a shareholders' liquidation, although some voluntary liquidations are
controlled by the creditors.

Compulsory liquidation
The parties who are entitled by law to petition for the compulsory liquidation of a company vary from
jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the compulsory
liquidation of a company by:
• The company itself
• Any creditor who establishes a prima facie case
• Contributories: Those shareholders who may be required to contribute to the company's assets on
liquidation.
• The Official Receiver
Voluntary liquidation
Voluntary liquidation occurs when the members of a company resolve to voluntarily wind up its
affairs and dissolve. Voluntary liquidation begins when the company passes the resolution, and the
company will generally cease to carry on business at that time (if it has not done so already).

A creditors’ voluntary liquidation (CVL) is a process designed to allow an insolvent company to close
voluntarily. The decision to liquidate is made by a board resolution, but instigated by the director(s).
If a limited company’s liabilities outweigh its assets, or the company cannot pay its bills when they
fall due, the company becomes insolvent.
If the company is solvent, and the members have made a statutory declaration of solvency, the
liquidation will proceed as a members' voluntary winding-up. In that case the general meeting will
appoint the liquidator(s). If not, the liquidation will proceed as a creditors' voluntary winding-up, and
a meeting of creditors will be called, to which the directors must report on the company's affairs.
Where a voluntary liquidation proceeds as a creditors' voluntary liquidation, a liquidation committee
may be appointed.

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Where a voluntary winding-up of a company has begun, a compulsory liquidation order is still
possible, but the petitioning contributory would need to satisfy the court that a voluntary liquidation
would prejudice the contributors.
In addition, the term "liquidation" is sometimes used when a company wants to divest itself of some
of its assets. This is used, for instance, when a retail establishment wants to close stores. They will sell
to a company that specializes in store liquidation instead of attempting to run a store closure sale
themselves.

RECAPITALIZATION
Recapitalization is a type of corporate reorganization involving substantial change in a
company's capital structure. Recapitalization may be motivated by a number of reasons. Usually, the
large part of equity is replaced with debt or vice versa. In more complicated transactions, mezzanine
financing and other hybrid securities are involved.

Leveraged Recapitalization
One example of recapitalization is a leveraged recapitalization, wherein the company issues bonds to
raise money, and then buys back its own shares. Usually, current shareholders retain control. The
reasons for this sort of recapitalization include:
• Desire of current shareholders to partially exit the investment
• Providing support of falling share price
• Disciplining the company that has excessive cash
• Protection from a hostile takeover
• Rebalancing positions within a holding company
• Help to improve the stock of the company during a time of poor economic marker

Leveraged Buyout
Another example is a leveraged buyout, essentially a leveraged recapitalization initiated by an outside
party. Usually, incumbent equity holders cede control. The reasons for this transaction may include:
• Getting control over the company via a friendly or hostile takeover
• Disciplining the company with excessive cash
• Creating shareholder value via gradual debt repayment
Nationalization
Another example is a nationalization, wherein the nation in which the company is headquartered buys
sufficient shares of the company to obtain a controlling interest. Usually, incumbent equity holders
lose control. The reasons for nationalization may include:
• Saving a very valuable company from bankruptcy
• Confiscation of assets
• Executing the eminent domain right

MERGERS AND ACQUISITION IN THE GLOBAL CONTEXT

The opening up of the European countries to international mergers and acquisitions and the
economic reforms in developing countries provided major boost to international mergers and
acquisitions since the 1990s.
Foreign investment gets major impetus from international mergers and acquisitions. While there are
various advantages of international mergers and acquisitions, certain impediments in the form of
regulatory restrictions also exist.

The adoption of economic reforms in many countries in the last two decades of the 20th century
opened up opportunities of international mergers and acquisitions. With different countries
opening up their economies to foreign investors, international mergers and acquisitions has grown.
The European economy also opened up to foreign mergers and acquisitions in the 1990s, which
resulted in merger and acquisition activities of large volumes taking place across Europe.

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There are various benefits that accrue to firms that undertake international mergers and acquisitions.
Cross border mergers and acquisitions are effective in boosting Foreign Direct Investment (FDI). For
international investors, it is easier to invest through a merger or an acquisition. International mergers
and acquisitions provide access to infrastructure and customer base in a country which is quite
difficult to build from the scratch. Moreover an existing brand name in a country provides strong
business edge. Access to local markets of different countries is possible through international mergers
and acquisitions.

With the developing countries adopting liberal economic policies, the incentives of firms in the
developed nations to indulge in mergers and acquisitions in these countries are huge. International
mergers and acquisitions provide a way to tap the markets of these countries. On the other hand, for
these developing countries international mergers and acquisitions provide them access to improved
technologies and more productive operative mechanisms.

However there are certain impediments to international mergers and acquisitions. Regulations of
different countries play an important role. In some countries certain sectors are prohibited from
international mergers and acquisitions, while for some other sectors certain conditions need to be
fulfilled. In China, for instance, laws regarding international mergers and acquisitions are quite
stringent

CHAPTER 7
DERIVATIVES IN FINANCIAL RISK MANAGEMENT

INTRODUCTION
Risk can be defined as the chance of loss or an unfavorable outcome associated with an action.
Uncertainty does not know what will happen in the future. The greater the uncertainty, the greater the
risk. For an individual farm manager, risk management involves optimizing expected returns subject
to the risks involved and risk tolerance.

Risk is what makes it possible to make a profit. If there was no risk, there would be no return to the
ability to successfully manage it. For each decision there is a risk-return trade-off. Anytime there is a
possibility of loss (risk), there should also be an opportunity for profit. Growers must decide between
different alternatives with various levels of risk. Those alternatives with minimum risk may generate
little profit. Those alternatives with high risk may generate the greatest possible return but may carry
more risk than the producer will wish to bear. The preferred and optimal choice must balance
potential for profit and the risk of loss.

Financial risk encompasses those risks that threaten the financial health of the business and has four
basic components:
1) The cost and availability of capital;
2) The ability to meet cash flow needs in a timely manner;
3) The ability to maintain and grow equity;
4) The ability to absorb short-term financial shocks.

TYPES OF RISKS

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1. Interest rate risk
Firms are exposed to interest rate risk in two ways:
• The cost of existing borrowings (or the yield on deposits) may be linked to interest rates in the
economy. This risk exposure can be eliminated by using fixed rate products.
• Cash flow forecasts may indicate the need for future borrowings/deposits. Interest rates may
change before these are needed and thus affect the ultimate cost/yield

2. Foreign exchange risk

Firms may be exposed to three types of foreign exchange risk:

Transaction risk
• The risk of an exchange rate changing between the transaction date and the subsequent
settlement date on an individual transaction. i.e. it is the gain or loss arising on conversion.
• Associated with exports/imports.

Economic risk
• Includes the longer-term effects of changes in exchange rates on the market value of a
company (PV of future cash flows).
• Looks at how changes in exchange rates affect competitiveness, directly or indirectly.

Translation risk
• How changes in exchange rates affect the translated value of foreign assets and liabilities (e.g.
foreign subsidiaries).

3. Political risk
Political risk is the risk that a company will suffer a loss as a result of the actions taken by the
government or people of a country. It arises from the potential conflict between corporate goals and
the national aspirations of the host country.
This is obviously a particular problem for companies operating internationally, as they face political
risk in several countries at the same time.
Whilst at one extreme, assets might be destroyed as the result of war or expropriation, the most likely
problems concern changes to the rules on the remittance of cash out of the host country to the holding
company. Typical issues include the following:

Exchange control regulations, which are generally more restrictive in less developed countries for
example:
• Rationing the supply of foreign currencies which restricts residents from buying goods abroad
• Banning the payment of dividends to foreign shareholders such as holding companies in
multinationals, who will then have the problem of blocked funds.
Import quotas to limit the quantity of goods that subsidiaries can buy from its holding company to
sell in its domestic market.
Import tariffs could make imports (from the holding company) more expensive than domestically
produced goods.
Insist on a minimum shareholding, i.e. that some equity in the company is offered to resident
investors.
Company structure may be dictated by the host government - requiring, for example, all investments
to be in the form of joint ventures with host country companies.
Super-taxes imposed on foreign firms, set higher than those imposed on local businesses with the aim
of giving local firms an advantage. They may even be deliberately set at such a high level as to
prevent the business from being profitable.
Restricted access to local borrowings by restricting or even barring foreign-owned enterprises from
the cheapest forms of finance from local banks and development funds. Some countries ration all

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access for foreign investments to local sources of funds, to force the company to import foreign
currency into the country.
Expropriating assets whereby the host country government seizes foreign property in the national
interest. It is recognized in international law as the right of sovereign states provided that prompt
consideration at fair market value in a convertible currency is given. Problems arise over the
exact meaning of the terms prompt and fair, the choice of currency, and the action available to a
company not happy with the compensation offered.

4. Regulatory risk
Regulatory risk is the potential for laws related to a given industry, country, or type of security to
change and affect:
• how the business as a whole can operate
• the viability of planned or ongoing investments.

Regulations might apply to:

• businesses generally (for example, competition laws and anti-monopoly regulations)
• specific industries (for example, catering and health and safety regulations, publishing and
copyright laws).

5. Fiscal risk
Fiscal risk from a corporate perspective is the risk that the government will have an increased need to
raise revenues and will increase taxes, or alter taxation policy accordingly. Changes in taxation will
affect the present value of investment projects and thereby the value of the company.

The primary requirement of a fiscal risk management strategy is an awareness of the huge impact tax
can make to the viability of a project. Tax should be factored in to the calculations for all significant
investment appraisal projects.

It is important not only to ensure that the tax rules being applied are up-to-date, but that any potential
changes in the tax rules are also considered. Investment projects may be intended to run for many
years and future changes (particularly those intended to close 'loopholes' in the taxation system) could
wipe out the expected benefits from the project.

Many larger firms will maintain a full time taxation team within the finance function to deal with the
tax implications of investment plans. Smaller companies are more likely to employ external tax
experts. In either case, a relevant tax expert should always be involved in the analysis of the project
and its sensitivity to the taxation assumptions should be carefully modeled.

6. Operational risk
Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for
inadequate or failed internal processes, people and systems, or from external events (including legal
risk), differ from the expected losses".
It can also include other classes of risk, such as fraud, security, privacy protection, legal risks,
physical (e.g. infrastructure shutdown) or environmental risks.
Operational risk is a broad discipline, close to good management and quality management.

In similar fashion, operational risks affect client satisfaction, reputation and shareholder value, all
while increasing business volatility.

Contrary to other risks (e.g. credit risk, market risk and insurance risk) operational risks are usually
not willingly incurred nor are they revenue driven. Moreover, they are not diversifiable and cannot be

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laid off; meaning that, as long as people, systems and processes remain imperfect, operational risk
cannot be fully eliminated.

Operational risk is, nonetheless, manageable as to keep losses within some level of risk tolerance (i.e.
the amount of risk one is prepared to accept in pursuit of his objectives), determined by balancing the
costs of improvement against the expected benefits.

FOREIGN CURRENCY RISK MANAGEMENT

Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in
exchange rates - and will seek to manage their risk exposure. This page looks at the different types of
foreign exchange risk and introduces methods for hedging that risk.

TYPES OF FOREX RISKS

1. Transaction risk
This is the risk of an exchange rate changing between the transaction date and the subsequent
settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on
credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the
foreign exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose to
hedge against such exposure. Measuring and monitoring transaction risk is normally an important
component of treasury risk management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.

The corporate risk management policy should state what degree of exposure is acceptable. This will
probably be dependent on whether the Treasury Department is been established as a cost or profit
centre.

2. Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure
encompasses these plus the long-term effects of changes in exchange rates on the market value of a
company. Basically this means a change in the present value of the future after tax cash flows due to
changes in exchange rates.

There are two ways in which a company is exposed to economic risk.

Directly:
If a firm's home currency strengthens then foreign competitors are able to gain sales at the expense of
the firm because its products have become more expensive (or it has reduced its margins) in the eyes
of customers both abroad and at home.

Indirectly:
Even if the home currency of a firm does not move vis-a -vis its customer's currency the firm may
lose competitive position. For example suppose a South African firm is selling into Hong Kong and
its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong
dollar the South African firm has lost some competitive position.

Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify

internationally, in terms of sales, location of production facilities, raw materials and financing. Such

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diversification is likely to significantly reduce the impact of economic exposure relative to a purely
domestic company, and provide much greater flexibility to react to real exchange rate changes.

3. Translation risk
The financial statements of overseas subsidiaries are usually translated into the home currency in
order that they can be consolidated into the group's financial statements. Note that this is purely a
paper-based exercise - it is the translation not the conversion of real money from one currency to
another.
The reported performance of an overseas subsidiary in home-based currency terms can be severely
distorted if there has been a significant foreign exchange movement.

If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then
the UK parent company will anticipate a balance sheet value of £500,000 for the subsidiary. A
depreciation of the US dollar to $/£2.00 would result in only £250,000 being translated.

Unless managers believe that the company's share price will fall as a result of showing a translation
exposure loss in the company's accounts, translation exposure will not normally be hedged. The
company's share price, in an efficient market, should only react to exposure that is likely to have an
impact on cash flows.

HEDGING CURRENCY RISKS

Hedging is a risk management strategy used in limiting or offsetting probability of loss from
fluctuations in the prices of commodities, currencies, or securities.
Hedging is a strategy, usually some form of transaction, designed to minimize exposure to an
unwanted business risk, commonly arising from fluctuations in exchange rates, commodity prices,
interest rates etc.

Hedging employs various techniques but, basically, involves taking equal and opposite positions in
two different markets (such as cash and futures markets). Hedging is used also in protecting one's
capital against effects of inflation through investing in high-yield financial instruments (bonds, notes,
shares), real estate, or precious metals.
A perfect hedge will eliminate the prospects of any future gains or losses and put the company into a
risk-free position in respect of the hedged risk. This strategy may be chosen where the downside risk
would have serious negative consequences for the firm, and the costs of hedging (including the
chance to participate in any upside) are outweighed by the benefits of certainty

THE INTERNAL TECHNIQUES

Internal techniques to manage/reduce forex exposure should always be considered before external
methods on cost grounds. Internal techniques include the following:
1. Invoice in home currency
One easy way is to insist that all foreign customers pay in your home currency and that your company
pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your
customer may not be too happy with your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive environment this is an
unrealistic approach.

2. Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to
delay payment. This may be achieved by agreement or by exceeding credit terms.

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If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three
months it may try to obtain payment immediately. This may be achieved by offering a discount for
immediate payment.
The problem lies in guessing which way the exchange rate will move.

3. Matching and netting

When a company has receipts and payments in the same foreign currency due at the same time, it can
simply match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total
transactions.
An extension of the matching idea is setting up a foreign currency bank account.

Netting and matching is a feature of foreign exchange risk management and are carried out to reduce
the scale of external hedging required.

For example, Group X is expecting to receive sh.10 million in one subsidiary and pay sh.6 million at
the same time in another subsidiary. Clearly the group only has a net exposure of a receipt of $4
million.

The terms 'netting' and 'matching' are often used interchangeably but strictly speaking they are
different:
• Netting refers to netting off group receipts and payments, as in the example above.
• Matching extends this concept to include third parties such as external suppliers and customers.

Normally netting/matching only occurs in one currency at a time - in the above example sh. were
matched against sh.. However, if an agreement exists to do so, groups can also match different
currencies against each other. This is the topic of this page.

Calculations
The calculations can be presented in one of two ways: the tabular method and the diagrammatical
method. Both are explained below.

Tabular method
Step 1: Set up a table with the name of each company down the side and across the top.
Step 2: Input all the amounts owing from one company to another into the table and convert them into
a common (base) currency (at spot rate).
Step 3: By adding across and down the table, identify the total amount payable and the total amount
receivable by each company.
Step 4: Compute the net payable or receivable, and convert back into the original currency.

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Diagrammatical method
Step 1: Convert all currency flows to a common (base) currency using spot rates (NOT forward or
future rates).
Step 2: Clear the overlap of any bi-lateral indebtedness.
E.g.

Step 3: Clear the smallest leg of any 3 way circuits.

E.g.

Step 4: Clear the smallest leg of any 4 way circuits (then 5, etc).
E.g.

Step 5: Convert back into original currencies.

Step 6: Use the simplified figures for:

A Settlement
B Setting up appropriate hedging tools.

4. Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if
hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.

THE EXTERNAL TECHNIQUES

Transaction risk can also be hedged using a range of financial products.

FORWARD CONTRACTS
Forward Contracts
Forward contracts are a commonly-used method for hedging foreign exchange risk.
The forward market is where you can buy and sell a currency, at a fixed future date for a
predetermined rate, i.e. the forward rate of exchange.
Forward rates may be given explicitly or quoted as an adjustment (either a 'discount' or 'premium') to
the spot rate:
Forward rate = spot rate MINUS a premium
Forward rate = spot rate PLUS a discount

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Availability and use
Although other forms of hedging are available, forward cover represents the most frequently
employed method of hedging.
However, the existence and depth of forward markets depends on the level of demand for each
particular currency.
For major trading currency like the $, £, Yen or Euro it can be up to 10 years forward. Normally
forward markets extend six months into the future. Forward markets do not exist for the so-called
exotic currencies.

Advantages and disadvantages

Forward exchange contracts are used extensively for hedging currency transaction exposures.
Advantages include:
• fixes the future rate, thus eliminating downside risk exposure
• flexibility with regard to the amount to be covered
• relatively straightforward both to comprehend and to organize.

Disadvantages include:
• contractual commitment that must be completed on the due date (option date forward contract
can be used if uncertain)
• no opportunity to benefit from favourable movements in exchange rates.
• availability - see above

MONEY MARKET HEDGE

The money markets are markets for wholesale (large-scale) lending and borrowing, or trading in
short-term financial instruments. Many companies are able to borrow or deposit funds through their
bank in the money markets.

Instead of hedging a currency exposure with a forward contract, a company could use the money
markets to lend or borrow, and achieve a similar result.
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate
instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial
transaction cash flows occur.

Since forward exchange rates are derived from spot rates and money market interest rates, the end
result from hedging should be roughly the same by either method.
Setting up the hedge

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In effect a foreign currency asset is set up to match against a future liability (and vice-versa).

If you are hedging a future payment:

• buy the present value of the foreign currency amount today at the spot rate
• the foreign currency purchased is placed on deposit and accrues interest until the transaction
date.
• the deposit is then used to make the foreign currency payment.
If you are hedging a receipt:
• borrow the present value of the foreign currency amount today
• the foreign loan accrues interest until the transaction date
• the loan is then repaid with the foreign currency receipt

Advantages and disadvantages

Forward exchange contracts are used extensively for hedging currency transaction exposures.

Advantages include:
• fixes the future rate, thus eliminating downside risk exposure
• flexibility with regard to the amount to be covered
• money market hedges may be feasible as a way of hedging for currencies where forward
contracts are not available.

Disadvantages include:
• more complicated to organize than a forward contract
• Fixes the future rate - no opportunity to benefit from favourable movements in exchange rates.

DERIVATIVES

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A derivative is an asset whose performance (and hence value) is derived from the behaviour of the
value of an underlying asset (the "underlying").
The most common underlying’s commodities (e.g. tea, pork bellies), shares, bonds, share indices,
currencies and interest rates.
Derivatives are contracts that give the right and sometimes the obligation, to buy or sell a quantity of
the underlying or benefit in some other way from a rise or fall in the value of the underlying.

Derivatives include the following:

• Forwards.
• Forward rate agreements ("FRAs").
• Futures.
• Options.
• Swaps.
Forwards, FRAs and futures effectively fix a future price. Options give you the right without the
obligation to fix a future price.
The legal right is an asset with its own value that can be bought or sold.

Derivatives are not fixed in volume of supply like normal equity or bond markets. Their existence and
creation depends on the existence of counter-parties, market participants willing to take alternative
views on the outcome of the same event.

Some derivatives (esp. futures and options) are traded on exchanges where contracts are standardized
and completion guaranteed by the exchange. Such contracts will have values and prices quoted.
Exchange-traded instruments are of a standard size thus ensuring that they are marketable.
Other transactions are over the counter ("OTC"), where a financial intermediary puts together a
product tailored precisely to the needs of the client. It is here where valuation issues and credit risk
may arise

1. Currency Options
A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a
future date. If there is a favourable movement in rates the company will allow the option to lapse, to
take advantage of the favourable movement. The right will only be exercised to protect against an
adverse movement, i.e. the worst-case scenario.
Terms
Holder: The buyer of an option is called the holder.

Writer: The seller of an option is called a writer or a grantor.

Call: A call is an option to buy foreign currency.

Put: A put is an option to sell foreign currency.

Strike Price: The strike price or exercise price is the price at which the foreign currency can be
purchased or sold.

Premium: The premium or option price is the cost, price, or value of the option.

American Option: An American option gives the holder the right to exercise the option at any time
between the date of writhing and the expiration or maturity date.

European Option: A European option gives the holder the right to exercise the option only at the
expiration date.

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At-the-Money (ATM): An option whose exercise price is the same as the spot price of the underlying
currency is said to be at-the-money

In-the-Money (ITM): An option that would be profitable if exercised immediately is said to be in-
the-money.

Out-of-the-Money (OTM): An option that would not be profitable to exercise immediately is said to
be out-of-the-money.

Exchange-Traded Options: Options traded in organized exchanges

Types of currency options

Basics
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures.
A European option can only be exercised on the expiry date whilst an American option can be
exercised at any time up to the expiry date.
Foreign Currency Options Markets
Foreign currency options are available on the over-the-counter market and on organized exchanges.

Over-the-Counter (OTC) Market

Over-the-counter options are written by financial institutions. These OTC options are more liquid than
forward contracts. At any moment, the holder can sell them back to the original writer, who quotes
tow-say prices.
The main advantage of OTC options is that they are tailored to the specific needs of the firm:
Financial institutions are willing to write or buy options that vary by contract size, maturity, and strike
price. As a consequence, the bid-ask spread in the OTC market is higher than in the traded-options
market.

Firms buying and selling currency options as part of their risk management program do so primarily
in the OTC market.

In OTC market, most of the options are written at a strike price equal to the spot price of that moment
(at-the-money options).

A firm wishing to purchase an option in the OTC market normally places a call to the currency option
desk of a major money center bank, specifies the currencies, maturity, strike price(s), and asks for an
indication (a bid-ask quote). The bank normally takes a few minutes to a few hours to price the option
and return the call.

Exchange Trade Options

Options on the underlying currency are traded on a number of organized exchanges worldwide,
including the London International Financial Futures Exchange (LIFFE).
An organized option exchange, like a futures market, has an organized secondary market, with a
clearing-house as a guarantor. That is, exchange traded options are settled through a clearing-house,
so buyers do not deal directly with sellers. The clearing-house is the counterpart to every option
contract and it guarantees fulfillment

2. Currency Futures

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Futures contracts are, in principle, contracts to deliver a given amount of currency on a given date and
at a pre-specified price to be paid later on.
Like forward contracts, futures contracts have a zero initial market value: neither the buyer nor the
seller has to pay anything when a contract is initiated at the going market rate

Hedging is achieved by combining a futures transaction with a market transaction at the prevailing
spot rate.

Futures contracts are standard sized, traded hedging instruments. The aim of a currency futures
contract is to fix an exchange rate at some future date.

Key features of futures contracts are:

• Terms and conditions are standardized.
• Trading takes place on a formal exchange wherein the exchange provides a place to engage in
these transactions and sets a mechanism for the parties to trade these contracts.
• There is no default risk because the exchange acts as counterparty, guaranteeing delivery and
payment by use of a clearing house.
• The clearing house protects itself from default by requiring its counterparties to settle gains and
losses or mark to market their positions on a daily basis.
• Futures are highly standardized, have deep liquidity in their markets and trade on an exchange.
• An investor can offset his or her future position by engaging in an opposite transaction before the
stated maturity of the contract.

3. Currency Forwards
A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy
an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time,
but the price is determined at the time of purchase.

Key features of forward contracts are:

• Highly customized - Counterparties can determine and define the terms and features to fit their
specific needs, including when delivery will take place and the exact identity of the underlying
asset.
• All parties are exposed to counterparty default risk - This is the risk that the other party may not
make the required delivery or payment.
• Transactions take place in large, private and largely unregulated markets consisting of banks,
investment banks, government and corporations.
• Underlying assets can be stocks, bonds, foreign currencies, commodities or some combination
thereof. The underlying asset could even be interest rates.
• They tend to be held to maturity and have little or no market liquidity.
• Any commitment between two parties to trade an asset in the future is a forward contract.

Example: Forward Contracts

Let’s assume that you have just taken up sailing and like it so well that you expect you might buy
your own sailboat in 6 months. Your sailing buddy, John, owns a sailboat but expects to upgrade to a
newer, larger model in 6 months. You and John could enter into a forward contract in which you
agree to buy John's boat for sh.1,500,000 and he agrees to sell it to you in 6 months for that price. In
this scenario, as the buyer, you have entered a long forward contract. Conversely, John, the seller will
have the short forward contract. At the end of one year, you find that the current market valuation of
John's sailboat is sh.1, 650,000. Because John is obliged to sell his boat to you for only sh.1500, 000,
you will have effectively made a profit of sh.150, 000. (You can buy the boat from John for $150,000
and immediately sell it for sh.1650, 000.) John, unfortunately, has lost sh.15, 000 in potential
proceeds from the transaction.

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4. Currency Swaps
A currency swap (or a cross currency swap) is a foreign exchange derivative between two institutions
to exchange the principal and/or interest payments of a loan in one currency for equivalent amounts,
in net present value terms, in another currency.

Characteristics of swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-
swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is
agreed between the parties in advance. Thus it is called a "fixed rate/fixed rate" swap.

The main objectives of a forex swap are:

• To hedge against forex risk, possibly for a longer period than is possible on the forward
market.
• Access to capital markets, in which it may be impossible to borrow directly.

Forex swaps are especially useful when dealing with countries that have exchange controls and/or
volatile exchange rates.

ILLUSTRATION
For example, assume that a corporation needs to borrow $10 million euros and the best rate it can
negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a comparable loan. The
corporation could take the U.S. loan and then find a third party willing to swap it into an equivalent
euro loan. By doing so, the firm would obtain its euros at more favorable terms. Cash flow streams are
often structured so that payments are synchronized, or occur on the same dates. This allows cash
flows to be netted against each other (so long as the cash flows are in the same currency). Typically,
the principal (or notional) amounts of the loans are netted to zero and the periodic interest payments
are scheduled to occur on that same dates so they can also be netted against one another.

INTEREST RATE RISKS

Financial managers face risk arising from changes in interest rates, i.e. a lack of certainty about the
amounts or timings of cash payments and receipts.
Many companies borrow, and if they do they have to choose between borrowing at a fixed rate of
interest (usually by issuing bonds) or borrow at a floating (variable) rate (possibly through bank
loans).There is some risk in deciding the balance or mix between floating rate and fixed rate debt. Too
much fixed-rate debt creates an exposure to falling long-term interest rates and too much floating-rate
debt creates an exposure to a rise in short-term interest rates.

In addition, companies face the risk that interest rates might change between the point when the
company identifies the need to borrow or invest and the actual date when they enter into the
transaction.
Managers are normally risk-averse, so they will look for techniques to manage and reduce these risks.

Interest rate risk is the risk that an investment's value will change due to a change in the absolute level
of interest rates, in the spread between two rates, in the shape of the yield curve or in any other
interest rate relationship. Such changes usually affect securities inversely and can be reduced by
diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an
interest rate swap).

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a
change in the asset's value resulting from the variability of interest rates.

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A company might borrow at a variable rate of interest, with interest payable every six months and the
amount of the interest charged each time varying according to whether short-term interest rates have
risen or fallen since the previous payment.
Some companies borrow by issuing bonds. If a company foresees a future requirement to borrow by
issuing bonds, it will have an exposure to interest rate risk until the bonds are eventually issued.
Some companies also budget to receive large amounts of cash, and so budget large temporary cash
surpluses that can be invested short-term. Income from those temporary investments will depend on
what the interest rate happens to be when the money is available for depositing.
Some investments earn interest at a variable rate of interest (e.g. Money in bank deposit accounts) and
some short-term investments go up or down in value with changes in interest rates (for example,
Treasury bills and other bills).
Some companies hold investments in marketable bonds, either government bonds or corporate bonds.
These change in value with movements in long-term interest rates.

Interest rate risk can be significant. For example, suppose that a company wants to borrow sh.100
million for one year, but does not need the money for another three weeks. It would be expensive to
borrow money before it is needed, because there will be an interest cost. On the other hand, a rise in
interest rates in the time before the money is actually borrowed could also add to interest costs. For
example, a rise of just 0.25% in the interest rate on a one-year loan of sh.100 million would cost an
extra sh.250, 000 in interest over the course of a year.

TERM STRUCTURE OF INTEREST RATES

The term structure reflects expectations of market participants about future changes in interest rates
and their assessment of monetary policy conditions. The term structure of interest rates is also known
as a yield curve and it plays a central role in an economy. It is the relationship between interest rates
or bond yields and different terms or maturities.

There are three main theories that try to describe the future yield curve:
1. Pure Expectation Theory: Pure expectation is the simplest and most direct of the three theories.
The theory explains the yield curve in terms of expected short-term rates. It is based on the idea
that the two-year yield is equal to a one-year bond today plus the expected return on a one-year
bond purchased one year from today. The one weakness of this theory is that it assumes that
investors have no preference when it comes to different maturities and the risks associated with
them.
2. Liquidity Preference Theory: This theory states that investors want to be compensated for
interest rate risk that is associated with long-term issues. Because of the longer maturity, there is a
greater price volatility associated with these securities. The structure is determined by the future
expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk
increases with maturity, the yield premium will also increase with maturity. Also known as the
Biased Expectations Theory.
3. Market Segmentation Theory: This theory deals with the supply and demand in a certain
maturity sector, which determines the interest rates for that sector. It can be used to explain just
about every type of yield curve an investor can came across in the market. An offshoot to this
theory is that if an investor wants to go out of his sector, he'll want to be compensated for taking
on that additional risk. This is known as the Preferred Habitat Theory.

Implications of the Yield Curve for the Yield-Curve Theories

1. Pure Expectation Theory
According to this theory, a rising term structure of rates means the market is expecting short-term
rates to increase. So if the two-year rate is higher than the one-year rate, rates should rise. If the curve
is flat, the market is expecting that short-term rates will remain low or hold constant in the future. A
declining rate-term structure indicates the market believes that rates will continue to decline.

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2. Liquidity Preference Theory
Under this theory, the curve starts to get a little bit more bent. With an upward sloping yield curve,
this theory really has no opinion as to where the yield curve is headed. It could continue to be upward
sloping, flat, or declining, but the yield premium will increase fast enough to continue to produce an
upward curve with no concerns about short-term interest rates. When it comes to a flat or declining
term structure of rates, this suggests that rates will continue to decline in the short end of the curve
given the theory's prediction that the yield premium will continue to increase with maturity.

3. Market Segmentation Theory

Under this theory, any type of yield curve can occur, ranging from a positive slope to an inverted one,
as well as a humped curve. A humped curve is where the yields in the middle of the curve are higher
than the short and long ends of the curve. The future shape of the curve is going to be based on where
the investors are most comfortable and not where the market expects yields to go in the future.

HEDGING INTEREST RATE RISKS

The common tools for hedging interest rate risk are;-
• Forward rate agreement
• Interest rate futures
• Interest rate swaps
• Interest rate options

Forward Rate Agreements (FRAs)

An FRA is based on the idea of a forward contract, where the determinant of gain or loss is an interest
rate. Under this agreement, one party pays a fixed interest rate and receives a floating interest rate
equal to a reference rate. The actual payments are calculated based on a notional principal amount and
paid at intervals determined by the parties. Only a net payment is made - the loser pays the winner, so
to speak. FRAs are always settled in cash.

FRA users are typically borrowers or lenders with a single future date on which they are exposed to
interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in a swap all
payments are at the same rate. Each FRA in a series is priced at a different rate, unless the term
structure is flat.

When an FRA reaches its settlement date (usually the start of the notional loan or deposit period), the
buyer and seller must settle the contract:

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Interest rate futures
An interest rate future is a financial derivative (a futures contract) with an interest-bearing instrument
as the underlying asset. It is a particular type of interest rate derivative.

There are two broad types of interest rate futures:

• Short-term interest rate futures (STIRs). These are standardized exchange-traded forward
contracts on a notional deposit (usually a three-month deposit) of a standard amount of principal,
starting on the contract's final settlement date.
• Bond futures. These are contracts on a standard quantity of notional government bonds. If they
reach final settlement date, and a buyer or seller does not close his position before then, the
contracts must be settled by physical delivery.

Short-term interest rate futures are traded on a number of futures exchanges. For example:
• STIRs for sterling (three-month LIBOR) and the euro (three-month euribor) are traded on
Euronext.liffe (formerly LIFFE), the London futures exchange.
• A STIR contract for the US dollar (eurodollar) is traded on the Chicago Mercantile Exchange
(CME).

Interest rate futures are used to hedge against the risk that interest rates will move in an adverse
direction, causing a cost to the company.

For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship
between interest rates and bond prices to hedge against the risk of rising interest rates. A borrower
will enter to sell a future today. Then if interest rates rise in the future, the value of the future will fall
(as it is linked to the underlying asset, bond prices), and hence a profit can be made when closing out
of the future (i.e. buying the future).

It is important to note that interest rate futures are not directly correlated with the market interest rates.
When one enters into an interest rate futures contract (like a bond future), the trader has ability to
eventually take delivery of the underlying asset. In the case of notes and bonds this means the trader
could potentially take delivery of a bunch of bonds if the contract is not cash settled. The bonds which
the seller can deliver vary depending on the futures contract. The seller can choose to deliver a variety
of bonds to the buyer that fit the definitions laid out in the contract. The futures contract price takes
this into account therefore prices have less to do with current market interest rates, and more to do
with what existing bonds in the market are cheapest to deliver to the buyer.

Interest rate swaps

An interest rate swap is an agreement whereby the parties agree to swap a floating stream of interest
payments for a fixed stream of interest payments and via versa. There is no exchange of principal:
• The companies involved are termed 'counter-parties'.
• Swaps can run for up to 30 years.
• Swaps can be used to hedge against an adverse movement in interest rates. Say a company has a
$200m floating loan and the treasurer believes that interest rates are likely to rise over the next
five years. He could enter into a five-year swap with a counter party to swap into a fixed rate of
interest for the next five years. From year six onwards, the company will once again pay a
floating rate of interest.
• A swap can be used to obtain cheaper finance. A swap should result in a company being able to
borrow what they want at a better rate under a swap arrangement, than borrowing it directly
themselves.

ILLUSTRATION

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Company A wishes to raise $10m and to pay interest at a floating rate, as it would like to be able to
take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a
floating rate of 1% above LIBOR.
Company B also wishes to raise $10m. They would prefer to issue fixed rate debt because they want
certainty about their future interest payments, but can only borrow for one year at 13% fixed or
LIBOR + 2% floating, as it has a lower credit rating than company A.
Calculate the effective swap rate for each company - assume savings are split equally.

Solution
Step 1: Identify the type of loan with the biggest difference in rates.
• Answer: Fixed
Step 2: Identify the party that can borrow this type of loan the cheapest.
• Answer: Company A
• Thus Company A should borrow fixed, company B variable, reflecting their comparative
advantages.
Step 3:
• Company A has cheaper borrowing in both fixed and variable. Interest rate differentials are
3% for fixed and 1% for variable. The difference between these (2%) is the potential gain
from the swap.
• Splitting this equally between the two counter parties, each should gain by 1%.

One way of achieving this is for A to pay B LIBOR (variable) and for B to pay A 10%.

Summary

Calculations involving quoted rates from intermediaries

In practice a bank normally arranges the swap and will quote the following:
• The 'ask rate' at which the bank is willing to receive a fixed interest cash flow stream in
exchange for paying LIBOR.
• The 'bid rate' that they are willing to pay in exchange for receiving LIBOR.

The difference between these gives the bank's profit margin and is usually at least 2 basis points.
Note: LIBOR is the most widely used benchmark or reference rate for short-term interest rates
worldwide.

Interest rate options

Interest rate options are options to buy or sell interest rate futures contracts. An Interest rate option is
a specific financial derivative contract whose value is based on interest rates. Its value is tied to an
underlying interest rate, such as the yield on 10 year treasury notes.

Similar to equity options, there are two types of contracts: calls and puts. A call gives the bearer the
right, but not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but
not the obligation, to profit from a decrease in interest rates.

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A grouping of interest rate calls is referred to as an interest rate cap; a combination of interest rate
puts is referred to as an interest rate floor. In general, a cap is like a call and a floor is like a put.

MEANING AND PURPOSE OF DERIVATIVE

A derivative is a term that refers to a wide variety of financial instruments or "contract whose value is
derived from the performance of underlying market factors, such as market securities or indices,
interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative
transactions include a wide assortment of financial contracts including structured debt obligations and
deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof." In
practice, it is a contract between two parties that specifies conditions (especially the dates, resulting
values and definitions of the underlying variables, the parties' contractual obligations, and the notional
amount) under which payments are to be made between the parties. The most common underlying
assets include: commodities, stocks, bonds, interest rates and currencies.

There are two groups of derivative contracts, the privately traded Over-the-counter (OTC) derivatives
such as swaps that do not go through an exchange or other intermediary and Exchange-traded
derivative contracts (ETD) that are traded through specialized derivatives exchanges or other
exchanges.
Derivatives may broadly be categorized as “lock” or “option” products. Lock products (such as
swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract.
Option products (such as interest rate caps) provide the buyer the right, but not the obligation to enter
the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to “hedge” by providing offsetting
compensation in case of an undesired event, “insurance”) or for speculation (i.e. making a financial
"bet"). This distinction is important because the former is a legitimate, often prudent aspect of
operations and financial management for many firms across many industries; the latter offers
managers and investors a seductive opportunity to increase profit, but not without incurring additional
risk that is often undisclosed to stakeholders.

Usage
Derivatives are used by investors for the following:
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose value
moves in the opposite direction to their underlying position and cancels part or all of it out;
• create option ability where the value of the derivative is linked to a specific condition or event
(e.g. the underlying reaching a specific price level);
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather
derivatives);
• provide leverage (or gearing), such that a small movement in the underlying value can cause a
large difference in the value of the derivative;[
• speculate and make a profit if the value of the underlying asset moves the way they expect (e.g.,
moves in a given direction, stays in or out of a specified range, reaches a certain level).

Common derivative contract types

Some of the common variants of derivative contracts are as follows:
1. Forwards: A tailored contract between two parties, where payment takes place at a specific time in
the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. A
futures contract differs from a forward contract in that the futures contract is a standardized
contract written by a clearing house that operates an exchange where the contract can be bought
and sold; the forward contract is a non-standardized contract written by the parties themselves.

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3. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a
call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is
known as the strike price, and is specified at the time the parties enter into the option. The option
contract also specifies a maturity date. In the case of a European option, the owner has the right to
require the sale to take place on (but not before) the maturity date; in the case of an American
option, the owner can require the sale to take place at any time up to the maturity date. If the owner
of the contract exercises this right, the counter-party has the obligation to carry out the transaction.
Options are of two types: call option and put option. The buyer of a Call option has a right to buy a
certain quantity of the underlying asset, at a specified price on or before a given date in the future,
he however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put
option has the right to sell a certain quantity of an underlying asset, at a specified price on or
before a given date in the future, he however has no obligation whatsoever to carry out this right.
4. Binary options are contracts that provide the owner with an all-or-nothing profit profile.
5. Warrants: Apart from the commonly used short-dated options which have a maximum maturity
period of 1 year, there exists certain long-dated options as well, known as Warrant (finance).
These are generally traded over-the-counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the
underlying value of currencies exchange rates, bonds/interest rates, commodities exchange,
stocks or other assets. Another term which is commonly associated to Swap is Swaption which
is basically an option on the forward Swap. Similar to a Call and Put option, a Swaption is of
two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver
Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on
the other hand is an option to pay fixed and receive floating.

Swaps can basically be categorized into two types:

• Interest rate swap: These basically necessitate swapping only interest associated cash flows in
the same currency, between two parties.
• Currency swap: In this kind of swapping, the cash flow between the two parties includes both
principal and interest. Also, the money which is being swapped is in different currency for
both parties.

Futures contract
Futures is a standardized contract between two parties to buy or sell a specified asset of standardized
quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and
payment occurring at a specified future date, the delivery date. The contracts are negotiated at a
futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy
the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party
agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The
terminology reflects the expectations of the parties—the buyer hopes or expects that the asset price is
going to increase, while the seller hopes or expects that it will decrease in near future.

In many cases, the underlying asset to a futures contract may not be traditional commodities at all –
that is, for financial futures the underlying item can be any financial instrument (also including
currency, bonds, and stocks); they can be also based on intangible assets or referenced items, such as
stock indexes and interest rates.

A closely related contract is a forward contract. A forward is like futures in that it specifies the
exchange of goods for a specified price at a specified future date. However, a forward is not traded on
an exchange and thus does not have the interim partial payments due to marking to market. Nor is the
contract standardized, as on the exchange.

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Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The
seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is
transferred from the futures trader who sustained a loss to the one who made a profit. To exit the
commitment prior to the settlement date, the holder of a futures position can close out its contract
obligations by taking the opposite position on another futures contract on the same asset and
settlement date. The difference in futures prices is then a profit or loss.

Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short
term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional amount of
bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the
deposit over which the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered.
In the case of physical commodities, this specifies not only the quality of the underlying goods
but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil
contract specifies the acceptable sulphur content and API specific gravity, as well as the
pricing point—the location where delivery must be made.
• The delivery month.
• The last trading date.
• Other details such as the commodity tick, the minimum permissible price fluctuation.

To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically
5%-15% of the contract's value.
To minimize counterparty risk to traders, trades executed on regulated futures exchanges are
guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to
each Buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This
enables traders to transact without performing due diligence on their counterparty.
Margin requirements are waived or reduced in some cases for hedgers who have physical ownership
of the covered commodity or spread traders who have offsetting contracts balancing the position.

Clearing margin: are financial safeguards to ensure that companies or corporations perform on their
customers' open futures and options contracts. Clearing margins are distinct from customer margins
that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

Customer margin: Within the futures industry, financial guarantees required of both buyers and
sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract
obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts.
Margins are determined on the basis of market risk and contract value. Also referred to as
performance bond margin

Initial margin: is the equity required to initiate a futures position. This is a type of performance bond.
The maximum exposure is not limited to the amount of the initial margin, however the initial margin
requirement is calculated based on the maximum estimated change in contract value within a trading
day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by
the exchange concerned.

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In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call
in order to restore the amount of initial margin available. Often referred to as “variation margin”,
margin called for this reason is usually done on a daily basis, however, in times of high volatility a
broker can make a margin call or calls intra-day.

Calls for margin are usually expected to be paid and received on the same day. If not, the broker has
the right to close sufficient positions to meet the amount called by way of margin. After the position is
closed-out the client is liable for any resulting deficit in the client’s account.
Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much
the value of the initial margin can reduce before a margin call is made. However, most non-US
brokers only use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities'
Initial Margin (which is set by the Federal Reserve in the U.S. Markets).
A futures account is marked to market daily. If the margin drops below the margin maintenance
requirement established by the exchange listing the futures, a margin call will be issued to bring the
account back up to the required level.

Maintenance margin: A set minimum margin per outstanding futures contract that a customer must
maintain in his margin account.

Margin-equity ratio: is a term used by speculators, representing the amount of their trading capital
that is being held as margin at any particular time. The low margin requirements of futures results in
substantial leverage of the investment. However, the exchanges require a minimum amount that varies
depending on the contract and the trader. The broker may set the requirement higher, but may not set
it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls.

Performance bond margin: The amount of money deposited by both a buyer and seller of a futures
contract or an options seller to ensure performance of the term of the contract. Margin in commodities
is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

Return on margin: (ROM) is often used to judge performance because it represents the gain or loss
compared to the exchange’s perceived risk as reflected in required margin.

Settlement - physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified
per type of futures contract:

• Physical delivery - the amount specified of the underlying asset of the contract is delivered by
the seller of the contract to the exchange, and by the exchange to the buyers of the contract.
Physical delivery is common with commodities and bonds. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a
contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier
purchase (covering a long). The Nymex crude futures contract uses this method of settlement
upon expiration
• Cash settlement - a cash payment is made based on the underlying reference rate.Cash settled
futures are those that, as a practical matter, could not be settled by delivery of the referenced item
- i.e. how would one deliver an index? A futures contract might also opt to settle against an index
based on trade in a related spot market. ICE Brent futures use this method.

Expiry is the time and the day that a particular delivery month of a futures contract stops trading, as
well as the final settlement price for that contract. For many equity index and interest rate futures

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contracts (as well as for most equity options), this happens on the third Friday of certain trading
months. On this day the t+1 futures contract becomes the t futures contract.

Pricing
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a
futures contract is determined via arbitrage arguments. This is typical for stock index futures, treasury
bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops
after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does
not yet exists - for example on crops before the harvest or on Eurodollar Futures or Federal funds rate
futures (in which the supposed underlying instrument is to be created upon the delivery date) - the
futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price,
which is simple supply and demand for the asset in the future, as expressed by supply and demand for
the futures contract.

Arbitrage arguments
Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply,
or may be freely created. Here, the forward price represents the expected future value of the
underlying discounted at the risk free rate—as any deviation from the theoretical price will afford
investors a riskless profit opportunity and should be arbitraged away.
Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by
compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.

or, with continuous compounding

This relationship may be modified for storage costs, dividends, dividend yields, and convenience
yields.
In a perfect market the relationship between futures and spot prices depends only on the above
variables; in practice there are various market imperfections (transaction costs, differential borrowing
and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price
in fact varies within arbitrage boundaries around the theoretical price.

Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational
pricing cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is
determined by today's supply and demand for the underlying asset in the futures.
In a deep and liquid market, supply and demand would be expected to balance out at a price which
represents an unbiased expectation of the future price of the actual asset and so be given by the simple
relationship.

By contrast, in a shallow and illiquid market, or in a market in which large quantities of the
deliverable asset have been deliberately withheld from market participants (an illegal action known as
cornering the market), the market clearing price for the futures may still represent the balance between
supply and demand but the relationship between this price and the expected future price of the asset
can break down.

Relationship between arbitrage arguments and expectation

The expectation based relationship will also hold in a no-arbitrage setting when we take expectations
with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to

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the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the
futures market fairly prices the deliverable commodity.

Contango and backwardation

The situation where the price of a commodity for future delivery is higher than the spot price, or
where a far future delivery price is higher than a nearer future delivery, is known as contango. The
reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far
future delivery price is lower than a nearer future delivery, is known as backwardation.

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the
underlying asset (which could include an intangible such as an index or interest rate) and are seeking
to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting
market moves and opening a derivative contract related to the asset "on paper", while they have no
practical use for or intent to actually take or make delivery of the underlying asset. In other words, the
investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures
contract.

Hedgers
Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets
subject to certain influences such as an interest rate.
For example, in traditional commodity markets, farmers often sell futures contracts for the crops and
livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly,
livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed
cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative
products will use financial futures or equity index futures to reduce or remove the risk on the swap.
Those that buy or sell commodity futures need to be careful. If a company buys contracts hedging
against price increases, but in fact the market price of the commodity is substantially lower at time of
delivery, they could find themselves disastrously non-competitive.

Speculators
Speculators typically fall into three categories: position traders, day traders, and swing traders (swing
trading), though many hybrid types and unique styles exist. With many investors pouring into the
futures markets in recent year’s controversy has risen about whether speculators are responsible for
increased volatility in commodities like oil, and experts are divided on the matter.

Options on futures
In many cases, options are traded on futures, sometimes called simply "futures options". A put is the
option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option
strike price is the specified futures price at which the future is traded if the option is exercised. Futures
are often used since they are delta one instruments. Calls and options on futures may be priced
similarly to those on traded assets by using an extension of the Black-Scholes formula, namely the
Black–Scholes model for futures.
Investors can either take on the role of option seller/option writer or the option buyer. Option sellers
are generally seen as taking on more risk because they are contractually obligated to take the opposite
futures position if the options buyer exercises his or her right to the futures position specified in the
option. The price of an option is determined by supply and demand principles and consists of the
option premium, or the price paid to the option seller for offering the option and taking on risk.

Futures versus forwards

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Futures differ from forwards in several instances:
1. A forward contract is a private transaction - a futures contract is not. Futures contracts are
reported to the future's exchange, the clearing house and at least one regulatory agency. The price
is recorded and available from pricing services.
2. A future takes place on an organized exchange where the all of the contract's terms and
conditions, except price, are formalized. Forwards are customized to meet the user's special
needs. The future's standardization helps to create liquidity in the marketplace enabling
participants to close out positions before expiration.
3. Forwards have credit risk, but futures do not because a clearing house guarantees against default
risk by taking both sides of the trade and marking to market their positions every night. Mark to
market is the process of converting daily gains and losses into actual cash gains and losses each
night. As one party loses on the trade the other party gains, and the clearing house moves the
payments for the counterparty through this process.
4. Forwards are basically unregulated, while future contract are regulated at the federal government
level. The regulation is there to ensure that no manipulation occurs, that trades are reported in a
timely manner and that the professionals in the market are qualified and honest.

OPTIONS
In finance, an option is a contract which gives the owner the right, but not the obligation, to buy or
sell an underlying asset or instrument at a specified strike price on or before a specified date. The
seller incurs a corresponding obligation to fulfill the transaction that is to sell or buy, if the long
holder elects to "exercise" the option prior to expiration. The buyer pays a premium to the seller for
this right. An option which conveys the right to buy something at a specific price is called a call; an
option which conveys the right to sell something at a specific price is called a put. Both are
commonly traded, though in basic finance for clarity the call option is more frequently discussed, as it
moves in the same direction as the underlying asset, rather than opposite, as does the put.

Contract specifications
Every financial option is a contract between the two counterparties with the terms of the option
specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they
usually contain the following specifications:

• whether the option holder has the right to buy (a call option) or the right to sell (a put option)
• the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B stock)
• the strike price, also known as the exercise price, which is the price at which the underlying
transaction will occur upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset on exercise,
or may simply tender the equivalent cash amount
• the terms by which the option is quoted in the market to convert the quoted price into the
actual premium – the total amount paid by the holder to the writer

Types of Options
The Options can be classified into following types:

Exchange-traded options
Exchange-traded options (also called "listed options") are a class of exchange-traded derivatives.
Exchange traded options have standardized contracts, and are settled through a clearing house with
fulfillment guaranteed by the Options Clearing Corporation (OCC). Since the contracts are
standardized, accurate pricing models are often available. Exchange-traded options include
o stock options,
o bond options and other interest rate options

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 o stock market index options or, simply, index options and
o options on futures contracts
o callable bull/bear contract

Over-the-counter
Over-the-counter options (OTC options, also called "dealer options") are traded between two private
parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be
individually tailored to meet any business need. In general, at least one of the counterparties to an
OTC option is a well-capitalized institution. Option types commonly traded over the counter include:
1. interest rate options
2. currency cross rate options, and
3. options on swaps or swaptions.

Other option types

Another important class of options, particularly in the U.S., are employee stock options, which are
awarded by a company to their employees as a form of incentive compensation. Other types of
options exist in many financial contracts, for example real estate options are often used to assemble
large parcels of land, and prepayment options are usually included in mortgage loans. However, many
of the valuation and risk management principles apply across all financial options.

Option styles
Naming conventions are used to help identify properties common to many different types of options.
These include:
• European option – an option that may only be exercised on expiration.
• American option – an option that may be exercised on any trading day on or before expiry.
• Bermudan option – an option that may be exercised only on specified dates on or before
expiration.
• Asian option – an option whose payoff is determined by the average underlying price over
some preset time period.
• Barrier option – any option with the general characteristic that the underlying security's price
must pass a certain level or "barrier" before it can be exercised.
• Binary option – An all-or-nothing option that pays the full amount if the underlying security
meets the defined condition on expiration otherwise it expires worthless.
• Exotic option – any of a broad category of options that may include complex financial
structures.
• Vanilla option – any option that is not exotic.

Historical uses of options

Contracts similar to options are believed to have been used since ancient times. In the real estate
market, call options have long been used to assemble large parcels of land from separate owners; e.g.,
a developer pays for the right to buy several adjacent plots, but is not obligated to buy these plots and
might not unless he can buy all the plots in the entire parcel. Film or theatrical producers often buy the
right — but not the obligation — to dramatize a specific book or script. Lines of credit give the
potential borrower the right — but not the obligation — to borrow within a specified time period.

Many choices, or embedded options, have traditionally been included in bond contracts. For example
many bonds are convertible into common stock at the buyer's option, or may be called (bought back)
at specified prices at the issuer's option. Mortgage borrowers have long had the option to repay the
loan early, which corresponds to a callable bond option.
In London, puts and "refusals" (calls) first became well-known trading instruments in the 1690s
during the reign of William and Mary.

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Privileges were options sold over the counter in nineteenth century America, with both puts and calls
on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off market price
on the day or week that the option was bought, and the expiry date was generally three months after
purchase. They were not traded in secondary markets.
Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher
Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be
larger than usual, and during the off-season he acquired the right to use a number of olive presses the
following spring. When spring came and the olive harvest was larger than expected he exercised his
options and then rented the presses out at much higher price than he paid for his 'option'

SWAPS
In finance, a swap is a derivative in which counterparties exchange cash flows of one party's financial
instrument for those of the other party's financial instrument. The benefits in question depend on the
type of financial instruments involved. For example, in the case of a swap involving two bonds, the
benefits in question can be the periodic interest (or coupon) payments associated with the bonds.
Specifically, the two counterparties agree to exchange one stream of cash flows against another
stream. These streams are called the legs of the swap. The swap agreement defines the dates when the
cash flows are to be paid and the way they are calculated.[1] Usually at the time when the contract is
initiated at least one of these series of cash flows is determined by a random or uncertain variable
such as an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an
option, the notional amount is usually not exchanged between counterparties. Consequently, swaps
can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the
expected direction of underlying prices.

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap
agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total
amount of interest rates and currency swaps outstanding is more thаn $347 trillion in 2010, according
to Bank for International Settlements (BIS).

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps,
currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types of
swaps.

Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay
floating. By entering into an interest rate swap, the net result is that each party can 'swap' their
existing obligation for their desired obligation. Normally, the parties do not swap payments directly,

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but rather each sets up a separate swap with a financial intermediary such as a bank. In return for
matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed
rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The
reason for this exchange is to take benefit from comparative advantage. Some companies may have
comparative advantage in fixed rate markets, while other companies have a comparative advantage in
floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the
market where they have comparative advantage. However, this may lead to a company borrowing
fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes
in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For
example, party B makes periodic interest payments to party A based on a variable interest rate of
LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of
8.65%. The payments are calculated over the notional amount. The first rate is called variable because
it is reset at the beginning of each interest calculation period to the then current reference rate, such as
LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency. Just like
interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps
entail swapping both principal and interest between the parties, with the cashflows in one direction
being in a different currency than those in the opposite direction. It is also a very crucial uniform
pattern in individuals and customers.

Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a
fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Credit default swaps

A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments
to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into
default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company
undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts
have been compared with insurance, because the buyer pays a premium and, in return, receives a sum
of money if one of the events specified in the contract occur. Unlike an actual insurance contract the
buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no
direct exposure.

Other variations
There are myriad different variations on the vanilla swap structure, which are limited only by the
imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic
structures.
• A total return swap is a swap in which party A pays the total return of an asset, and party B
makes periodic interest payments. The total return is the capital gain or loss, plus any interest or
dividend payments. Note that if the total return is negative, then party A receives this amount
from party B. The parties have exposure to the return of the underlying stock or index, without
having to hold the underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.
• An option on a swap is called a swaption. These provide one party with the right but not the
obligation at a future time to enter into a swap.

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 • A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks
associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix
the duration of received flows on a swap.
• An Amortizing swap is usually an interest rate swap in which the notional principal for the
interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of
a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers
of banks who want to manage the interest rate risk involved in predicted funding requirement, or
investment programs.
• A Zero coupon swap is of use to those entities which have their liabilities denominated in
floating rates but at the same time would like to conserve cash for operational purposes.
• A Deferred rate swap is particularly attractive to those users of funds that need funds
immediately but do not consider the current rates of interest very attractive and feel that the rates
may fall in future.
• An Accrediting swap is used by banks which have agreed to lend increasing sums over time to
its customers so that they may fund projects.
• A Forward swap is an agreement created through the synthesis of two swaps differing in
duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred
to as a forward start swap, delayed start swap, and a deferred start swap.

VALUATION
The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth
zero when it is first initiated, however after this time its value may become positive or negative. There
are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received
and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-
rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest
payments), and a short position in a floating rate note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite
positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond
to those in the swap. Thus, the home currency value is:

Where ,is the domestic cash flows of the swap, is the foreign cash flows of the
LIBOR is the rate of interest offered by banks on deposit from other banks in the Eurocurrency
market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months
deposits, etc.
LIBOR rates are determined by trading between banks and change continuously as economic
conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a
reference rate of interest in the international market.

Arbitrage arguments

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As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of
these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.
For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed
rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the
present value of future fixed rate payments by Party A are equal to the present value of the expected
future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C,
could:
1. assume the position with the lower present value of payments, and borrow funds equal to this
present value
2. meet the cash flow obligations on the position by using the borrowed funds, and receive the
corresponding payments - which have a higher present value
3. use the received payments to repay the debt on the borrowed funds
4. pocket the difference - where the difference between the present value of the loan and the
present value of the inflows is the arbitrage profit. This section requires additional example

Subsequently, once traded, the price of the Swap must equate to the price of the various
corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly
short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument,
pocket the difference, and then use payments generated to service the instrument which he is short.

VALUATION OF OPTIONS
The value of an option can be estimated using a variety of quantitative techniques based on the
concept of risk neutral pricing and using stochastic calculus. The most basic model is the Black–
Scholes model. More sophisticated models are used to model the volatility smile. These models are
implemented using a variety of numerical techniques. In general, standard option valuation models
depend on the following factors:
• The current market price of the underlying security,
• the strike price of the option, particularly in relation to the current market price of the
underlying (in the money vs. out of the money),
• the cost of holding a position in the underlying security, including interest and dividends,
• the time to expiration together with any restrictions on when exercise may occur, and
• an estimate of the future volatility of the underlying security's price over the life of the option.

More advanced models can require additional factors, such as an estimate of how volatility changes
over time and for various underlying price levels, or the dynamics of stochastic interest rates.
The following are some of the principal valuation techniques used in practice to evaluate option
contracts.

The Black and Scholes Model:

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out
working to create a valuation model for stock warrants. This work involved calculating a derivative to
measure how the discount rate of a warrant varies with time and stock price. The result of this
calculation held a striking resemblance to a well-known heat transfer equation. Soon after this
discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option
pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an
improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the
University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a
proof that the risk-free interest rate is the correct discount factor, and with the absence of assumptions
regarding investor's risk preferences.

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In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the
expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second
part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration
day. The fair market value of the call option is then calculated by taking the difference between these
two parts.

ILLUSTRATION
Assume that the following information has been obtained:
P = Sh 20
X = Sh 20
t = 3 months (0.25 years)
KRF = 12%
δ² = 0.16
Determine the value of the option

SOLUTION
Ln (20/20) + [0.12 + (0.16/2)] 0.25
d1 =
0.4 ×√0.25

0+0.05
=0.25
0.2

d2 = d1 - 0.20 = 0.05

N (d1) = N (0.25) = 0.5987 Using the standard normal table

N (d2) = N (0.05) = 0.5199

-(0.12)(0.25)
V = 20(0.5987) — 20e (0.5199)

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= 20(0.5987) — 20(0.9704)(0.5199)

= 11.97 — 10.09 = Sh. 1.88

GREEKS
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of
derivatives such as options to a change in underlying parameters on which the value of an instrument
or portfolio of financial instruments is dependent. The name is used because the most common of
these sensitivities are denoted by Greek letters (as are some other finance measures). Collectively
these have also been called the risk sensitivities.
The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the value of a
portfolio to a small change in a given underlying parameter, so that component risks may be treated in
isolation, and the portfolio rebalanced accordingly to achieve a desired exposure; see for example
delta hedging.

The Greeks in the Black–Scholes model are relatively easy to calculate, a desirable property of
financial models, and are very useful for derivatives traders, especially those who seek to hedge their
portfolios from adverse changes in market conditions. For this reason, those Greeks which are
particularly useful for hedging--such as delta, theta, and vega--are well-defined for measuring changes
in Price, Time and Volatility. Although rho is a primary input into the Black–Scholes model, the
overall impact on the value of an option corresponding to changes in the risk-free interest rate is
generally insignificant and therefore higher-order derivatives involving the risk-free interest rate are
not common.

The most common of the Greeks are the first order derivatives: Delta, Vega, Theta and Rho as well as
Gamma, a second-order derivative of the value function. The remaining sensitivities in this list are
common enough that they have common names, but this list is by no means exhaustive.

Delta

Delta, , measures the rate of change of the theoretical option value with respect to changes in the
underlying asset's price. Delta is the first derivative of the value of the option with respect to the
underlying instrument's price

Vega

Vega measures sensitivity to volatility. Vega is the derivative of the option value with respect to the
volatility of the underlying asset.
Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu ( ).
Presumably the name vega was adopted because the Greek letter nu looked like a Latin vee, and vega
was derived from vee by analogy with how beta, eta, and theta are pronounced in American English.
Another possibility is that it is named after Joseph De La Vega, famous for Confusion of Confusions,
a book about stock markets and which discusses trading operations that were complex, involving both
options and forward trades.

Vega is typically expressed as the amount of money per underlying share that the option's value will
gain or lose as volatility rises or falls by 1%. All options (both calls and puts) will gain value with
rising volatility.

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Vega can be an important Greek to monitor for an option trader, especially in volatile markets, since
the value of some option strategies can be particularly sensitive to changes in volatility. The value of
an option straddle, for example, is extremely dependent on changes to volatility.

Theta

Theta, , measures the sensitivity of the value of the derivative to the passage of time: the "time
decay."
The mathematical result of the formula for theta is expressed in value per year. By convention, it is
usual to divide the result by the number of days in a year, to arrive at the amount of money per share
of the underlying that the option loses in one day. Theta is almost always negative for long calls and
puts and positive for short (or written) calls and puts. An exception is a deep in-the-money European
put. The total theta for a portfolio of options can be determined by summing the thetas for each
individual position.

Rho

Rho, , measures sensitivity to the interest rate: it is the derivative of the option value with respect to
the risk free interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free
interest rate than to changes in other parameters. For this reason, rho is the least used of the first-order
Greeks.
Rho is typically expressed as the amount of money, per share of the underlying, that the value of the
option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum (100 basis
points).

Lambda

Lambda, , omega, , or elasticity is the percentage change in option value per percentage change
in the underlying price, a measure of leverage, sometimes called gearing.

Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's life
Most companies pay dividends to their shareholders, so this might seem a serious limitation to the
model considering the observation that higher dividend yields elicit lower call premiums. A common
way of adjusting the model for this situation is to subtract the discounted value of a future dividend
from the stock price.
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the expiration date. American
exercise term allow the option to be exercised at any time during the life of the option, making
American options more valuable due to their greater flexibility. This limitation is not a major concern
because very few calls are ever exercised before the last few days of their life. This is true because
when you exercise a call early, you forfeit the remaining time value on the call and collect the
intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the
intrinsic value is the same.

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3) Markets are efficient
This assumption suggests that people cannot consistently predict the direction of the market or an
individual stock. The market operates continuously with share prices following a continuous Itô
process. To understand what a continuous Itô process is, you must first know that a Markov process is
"one where the observation in time period t depends only on the preceding observation." An Itô
process is simply a Markov process in continuous time. If you were to draw a continuous process you
would do so without picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders
pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more
substantial and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In
reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury
Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly
changing interest rates, these 30 day rates are often subject to change, thereby violating one of the
assumptions of the model.

6) Returns are log normally distributed

This assumption suggests, returns on the underlying stock are normally distributed, which is
reasonable for most assets that offer options.

CHAPTER 8
INTERNATIONAL FINANCIAL MANAGEMENT

INTRODUCTION
International financial management, also known as international finance, is the management of
finance in an international business environment; that is, trading and making money through the
exchange of foreign currency.

Compared to national financial markets international markets have a different shape and analytics.
Proper management of international finances can help the organization in achieving same efficiency
and effectiveness in all markets, hence without IFM sustaining in the market can be difficult.

Companies are motivated to invest capital in abroad for the following reasons
• Efficiently produce products in foreign markets than that domestically.
• Obtain the essential raw materials needed for production.
• Broaden markets and diversify
• Earn higher returns

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 • foreign investment

INTERNATIONAL INVESTMENTS
International investing is a type of investment that involves purchasing securities that originate in
other countries. This type of investment is popular because it can provide diversification and
opportunities for superior growth. There are many different ways to invest internationally including
through mutual funds, exchange traded funds (ETFs) and American depository receipts.
International investing is a procedure that many investors choose to get involved in by investing
money outside of their domestic market. For example, instead of holding a portfolio of only domestic
stocks and bonds, an investor could purchase some stocks from a foreign country or buy shares of a
mutual fund that specializes in international investment.

Types of international investments

There are several ways that you could choose to invest internationally. Mutual funds and exchange
traded funds are one of the most common methods.

Exchange-Traded Funds (ETFs);-These investments offer a wide variety of international flavors.

You can buy ETFs that track most of the major foreign indexes, and they allow investors to obtain a
return based on a specific foreign market without having too great of an exposure. Also, because they
trade and work like any other ETF, they aren't expensive to trade and are relatively liquid.

International Funds;-International stock funds are comparable to international ETFs as they also
provide for diversification but have same drawbacks and benefits that are associated with regular
funds and ETFs. In these international funds, a hired professional portfolio manager is in charge and
decides what to place in the portfolio.

Foreign Securities;-many brokerage firms will offer investors the ability to buy investments from
different countries directly from the brokerage's international trading desk.

Benefits of international investments

There are a few benefits that can be realized by investing internationally that may not come with
traditional investments. By investing internationally;
− Potential for higher rates of growth abroad.
− International stocks are becoming a larger share of the investment universe.
− Potential to lower overall risk in your portfolio.
− Multiple currencies can provide an added layer of diversification
It has to be noted that there are some risks associated with international investing. One of the most
prominent risks is the risk of changes in the exchange rate. If you invest in a foreign bond, for
example, by the time you get your principal back, the exchange rate could have moved against you
and your investment may not be as profitable as you had hoped. Many foreign companies also do not
put out as much information for investors, so making an educated decision can be difficult.

INTERNATIONAL FINANCIAL INSTITUTIONS

International financial institutions (IFIs) are financial institutions that have been established (or
chartered) by more than one country, and hence are subjects of international law. Their owners or
shareholders are generally national governments, although other international institutions and other
organizations occasionally figure as shareholders. The most prominent IFIs are creations of multiple
nations, although some bilateral financial institutions (created by two countries) exist and are
technically IFIs. Many of these are multilateral development banks (MDB).

Types
o Multilateral development bank

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 o Bretton Woods institutions
o Regional development banks
o Bilateral development banks and agencies
o Other regional financial institutions

Multilateral development bank

A multilateral development bank (MDB) is an institution, created by a group of countries, that
provides financing and professional advising for the purpose of development. MDBs have large
memberships including both developed donor countries and developing borrower countries. MDBs
finance projects in the form of long-term loans at market rates, very-long-term loans (also known as
credits) below market rates, and through grants.
The following are usually classified as the main MDBs:
• World Bank
• European Investment Bank
• African Development Bank
• Asian Development Bank
• European Bank for Reconstruction and Development
• Inter-American Development Bank Group

There are also several "sub-regional" multilateral development banks. Their membership typically
includes only borrowing nations. The banks lend to their members, borrowing from the international
capital markets. Because there is effectively shared responsibility for repayment, the banks can often
borrow more cheaply than could any one member nation. These banks include:
• Caribbean Development Bank (CDB)
• Central American Bank for Economic Integration (CABEI)
• East African Development Bank (EADB)
• West African Development Bank (BOAD)
• Black Sea Trade and Development Bank (BSTDB)
• Eurasian Development Bank (EDB)

There are also several multilateral financial institutions (MFIs). MFIs are similar to MDBs but they
are sometimes separated since they have more limited memberships and often focus on financing
certain types of projects.
• European Commission (EC)
• International Finance Facility for Immunization (IFFIm)
• International Fund for Agricultural Development (IFAD)
• Islamic Development Bank (IDB)
• Nordic Investment Bank (NIB)
• OPEC Fund for International Development (OPEC Fund)

Bretton Woods’s institutions

The best-known IFIs were established after World War II to assist in the reconstruction of Europe and
provide mechanisms for international cooperation in managing the global financial system .

They include the World Bank, the IMF, and the International Finance Corporation. Today the largest
IFI in the world is the European Investment Bank which lent 61 billion euros to global projects in
2011.

Regional development banks

The regional development banks consist of several regional institutions that have functions similar to
the World Bank group's activities, but with particular focus on a specific region. Shareholders usually
consist of the regional countries plus the major donor countries.

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The best-known of these regional banks cover regions that roughly correspond to United Nations
regional groupings, including the Inter-American Development Bank, the Asian Development Bank;
the African Development Bank; and the European Bank for Reconstruction and Development.

Bilateral development banks and agencies

Bilateral development banks are financial institutions set up by individual countries to finance
development projects in developing countries and emerging markets. Examples include:
• The Netherlands Development Finance Company FMO, headquarters in The Hague; one of
the largest bilateral development banks worldwide.
• The DEG German Investment Corporation.
Other regional financial institutions
Several regional groupings of countries have established international financial institutions to finance
various projects or activities in areas of mutual interest. Examples are listed in the table below;-

Founded Name Notes HQ

1998 ECB European Central Bank Frankfurt am Main

1958 EIB European Investment Bank Created by European Union Luxembourg
member states to provide long-
term finance, mainly in the EU
17/5/1930 Bank of International The bank of central banks Bâle
Settlements
24/1/97 BSTDB-Black Sea Trade and Governed by United Nations
Development Bank registered treaty - Region
covered corresponds to the
Organization of the Black Sea
Economic Cooperation
10/7/70 International Investment Bank established by the countries of Moscow
of Comecon the former Soviet Union and
Eastern Europe
1975 Islamic Development Bank established in pursuance of the Jeddah, Saudi
Declaration of Intent issued by Arabia
the Conference of Finance
Ministers of Muslim Countries
held in Jeddah in December
1973
NIB Nordic Investment Bank The NIB has lending Helsinki, Finland
operations in its member
countries and in emerging
markets on all continents.

DIVIDED POLICY FOR MULTINATIONALS

When deciding how much cash to distribute to shareholders, company directors must keep in mind
that the firm's objective is to maximize shareholder value.
The dividend payout policy should be based on investor preferences for cash dividends now or capital
gains in future from enhanced share value resultant from re-investment into projects with a positive
NPV.

Many types of multinational company shareholder (for example, institutions such as pension funds
and insurance companies) rely on dividends to meet current expenses and any instability in dividends
would seriously affect them.

An additional factor for multinationals is that they have more than one dividend policy to consider:

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 • Dividends to external shareholders.
• Dividends between group companies, facilitating the movement of profits and funds within
the group.

Alternative dividend policies used by MNCs

Probably the most common policy adopted by multinationals for external shareholders is a variant on
stable dividend policy. Most companies go for a stable, but rising, dividend per share:
• Dividends lag behind earnings, but are maintained even when earnings fall below the
dividend level, as happens when production is lost for several months during a major
industrial dispute. This was referred to as a 'ratchet' pattern of dividends.
• This policy has the advantage of not signaling 'bad news' to investors. Also if the increases in
dividend per share are not too large it should not seriously upset the firm's clientele of
investors by disturbing their tax position.

A policy of a constant payout ratio is seldom used by multinationals because of the tremendous
fluctuations in dividend per share that it could bring:
• Many firms, however, might work towards a long-run target payout percentage smoothing out
the peaks and troughs each year.
• If sufficiently smoothed the pattern would be not unlike the ratchet pattern demonstrated
above.
The residual approach to dividends contains a lot of financial common sense:
• If positive NPV projects are available, they should be adopted, otherwise funds should be
returned to shareholders.
• This avoids the unnecessary transaction costs involved in paying shareholders a dividend and
then asking for funds from the same shareholders (via a rights issue) to fund a new project.
• The major problem with the residual approach to dividends is that it can lead to large
fluctuations in dividends, which could signal bad news to investors.

As for any company, dividend capacity is a major determinant of dividend policy for multinationals.
Key factors include:

AVAILABILITY AND TIMING OF REMITTANCES

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The additional factor for multinationals is remittance 'blocking'. This is where if, once a foreign direct
investment has taken place, the government of the host country imposes a restriction on the amount of
profit that can be returned to the parent company, this is known as a 'block on the remittance of
dividends':
• Often done through the imposition of strict exchange controls.
• Limits the amount of centrally remitted funds available to pay dividends to parent company
shareholders (i.e. restricts dividend capacity).
Blocked remittances may be avoided by one of the following methods:
• Increasing transfer prices paid by the foreign subsidiary to the parent company
• Lending the equivalent of the dividend to the parent company.
• Making payments to the parent company in the form of royalties, payments for patents, and/or
management fees and charges.
• Charging the subsidiary company additional head office overheads.
• Parallel loans (currency swaps), whereby the foreign subsidiary lends cash to the subsidiary of
another a company requiring funds in the foreign country. In return the parent company
would receive the loan of an equivalent amount of cash in the home country from the other
subsidiary's parent company.
The government of the foreign country might try to prevent many of these measures being used.

TRANSFER PRICING: IMPACT ON TAXES AND DIVIDENDS

Transfer pricing is the pricing procedure whereby there is a mutual transfer of product and services. It
happens whenever two related companies –that is, a parent company and a subsidiary, or two
subsidiaries controlled by a common parent –trade with each other, as when a US-based subsidiary of
Coca-Cola, for example, buys something from a French-based subsidiary of Coca-Cola. When the
parties establish a price for the transaction, they are engaging in transfer pricing. This can be either
market based, that is equivalent to what is being charged in the outside market for similar goods, or it
can be non-market based.

It is a mechanism for distributing revenue between different divisions which jointly develop,
manufacture and market products and services. Transfer pricing refers to the setting, analysis,
documentation, and adjustment of charges made between related parties for goods, services or the use
of property (including intangible property)
Transfer pricing is portrayed as a technique for optimal allocation of cost and revenues amongst
divisions, subsidiaries and joint ventures within a group of related entities such practice of transfer
pricing simultaneously acknowledge and include how it is deeply implicated in process of wealth
retentiveness that enable the companies to avoid taxes and facilitate the flight of capital. Transfer
pricing practices are responsive to opportunities for determining values in way that are consequential
for enhancing private gains and thereby contributing to relative social impoverishment, by avoiding
the payment of public taxes. Transfer pricing policies are highly related to the organizational structure
of the company, characterized by degree of autonomy of divisions.

There are four main reason company use transfer pricing:

− Saving on taxes,
− Facilitating performance measurement,
− Providing relevant information for trade off decisions,
− Inducing goal congruent decision.
The price at which two unrelated parties would agree to a transaction, this is most often an issue in the
case of companies with international operations whose international subsidiaries trade with each
other. For such companies, there is often an incentive to reduce overall tax burden by manipulation of
inter-company prices.

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Tax authorities want to insure that the inter-company price is equivalent to arm’s length price, to
prevent the loss of tax revenue.

There are different methods to determine the arm’s length price. They are;-
− Resale price method
− Cost plus method
− Profit split method
− Transactional net margin method

Reasons for Using Transfer Pricing

The four main reasons which induce the company to use transfer pricing are;-
Saving on taxes;-The best known inducement to the use of transfer pricing is difference in taxes
among the countries. If taxes rates on profit are higher in country B than in country A and the parent
transactional corporation from A supplies imports to the subsidiary in B, it would pay the firm to
overprice these transactions and transfer profits to A as long as the difference in effective tax rates
exceeds the tariff in B on those imports.

Remittance of dividend, royalties, interest on loan, technical and management fees etc. ;-
Transfer pricing is only one of the way by which a transactional corporations can transfer funds. Other
avenues to transfer funds that a transnational corporation may consider are dividends, royalties,
interest on loans, technical and management fees, etc. Limits imposed on remittance of dividends etc.
can be a contributing factor to the use of transfer pricing.

Changes in exchange rate;-Transfer pricing may constitute an important element of the monetary
and financial management of a transnational corporation. For instance, when devaluation is believed
to be imminent, it is likely that a corporation will, to the extent possible, shift profits and cash
balances out of country via transfer pricing mechanism.

Inducing goal congruent decision- Producing a product internally may not be the most economical
decision for the company. The purchasing division may be able to obtain a similar product for a lower
cost than the transfer price, while the supplying division may be able to use the capacity to produce
something more profitable. However, there could be strategic reasons to buy internally.

SOLUTIONS TO PRACTICE QUESTIONS

CHAPTER 2
THE INVESTMENT DECISION
QUESTION 1
(a) The various sales revenue are as follows

1m units x 100 = 100m

0.7m units x 100 = 70m
0.2m units x 100 = 20m
0.1m units x 100 = 10m

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 0.05 units x 100 = 5m

Marketing costs
Year 1 = sh 2m
Year 2 – 11 = sh 5m p.a
PVIF10%, 1 – 11 = 0.909
For year 2 – 11, PVAF = (PVAF10% 11 – PVAF10% , 1) = 5.586

Let SB = Success in both countries

SO = Success in one country
SZ = Success in none of the countries

Year 0 Year 1 Year 2 - 11

0.3 100 – 5 = 95

0.3 100 – 2 = 98

0.4 70 –5 =65

0.4 70 – 2 = 68
(10m)
.6 05 – 5 = 0
0.3

20 – 2 = 18
1.0

Outcome NPVn J.P ENPV

1 (98 x 0.909) + (95 x 5.586) - 10 6.09.8 0.09 54.9
2 (98 x 0.909) + (5 x 5.586) - 10 107.0 0.21 22.5
3 (68 x 0.909) + (65 x 5.586) - 10 414.9 0.16 66.4
4 (68 x 0.909) + (0 x 5.586) - 10 5.8 0.24 12.4
5 (18 x 0.909) + (0 x 5.586) – 10 6.4 0.30 1.9
Overall NPV 1,189.9 ENPV
158.1

(ii) SNPV = ∑ (NPNn − ENPV ) 2 J.P

(609.8 – 158.1)2 0.09 = 18 363.0

(107.0 – 158.1)2 0.21 = 548.4
(414.9 – 158.1)2 0.16 = 10 551.4
(51.8 – 158.1)2 0.24 = 2 711.9
(6.4 – 158.1)2 0.03 = 6903.9
39078.6

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 SNPV = 39078.6 = 197.7M

X - ENPV
(b) Z value=
SNPV

10 - 158.1
= = - 0.749
197.7

Normal distribution table not given

-0.75
QUESTION 2
Cost
i. Research and Development Cost Sh. 100m – sunk
ii. Market Research cost Sh. 15 m – Sunk
iii. Original cost of equipment Sh. 150m – Sunk
iv. Selling price of equipment Sh. 85m opportunity cost
v. Additional working Capital (changes) Sh. 2m
vi. Patent right cost Sh. 125m opportunity cost

NPV = PVCIF -PVCOF

PVCOF
Opportunity costs of Equipment 85m
Charges in working Capital 2m
Opportunity cost of patent rights 125m
Total PVCOF 212m
n
Expected number of Capsules = ∑ Capsules × p
i =1
i

= 11m x 0.3 + 14m x 0.6+16m x 0.1 = 13.3m

Cash flow Statement

1 Shs 12 Shs 3 Shs 4 Shs
Selling Price 20 24 28.8 3456

Shs 000 Shs 000 Shs 000 Shs 000

Sales Revenue 266,000 319,200 383,040 459,648

Less Cost
Labour Cost (106,400) (106,400) (106,400) (106,400)
Redundancy - - - (10,0000
costs

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Ingredient Cost (79,800) (79,800) (79,800) (79,800)
Overheads (15,000) (15,000) (15,000) (15,000)
64,800 118,000 181,840 248,448
Add Terminal
Benefits
Salvage value - - - 35,000
Release of W. - - - 2,000
capital
Total Cash 64,800 118,000 181,840 285,448
Inflow
PVIF 12% 0.8929 0.7972 0.7118 0.6355
PVCIF 57,860 94,070 129,434 181,402

a) Shs, 000
Total PVCIF 462,766
Total PVCOF (212,000)
250,766
b) Decision
The project has a positive Expected NPV signifying its economical Viable.
However the number of Capsules each year has been estimated using probabilities this signifies it is a
Risky project whose acceptance or rejections will depend on the Risk attitude of individual investor.

CHAPTER 3
PORTFOLIO THEORY AND ANALYSIS
QUESTION 1
Rs = Rf + (ERm + Rf )Bs
Bp = Wa Ba + Wb + Bb + Wc Bc + Wd Bd

Company Total Market Value Wi proportions

A 60,000 x 42.9 = 2,574,000 0.23
B 80,000 x 29.20 = 2,336, 000 0.21
C 100,000 x 21.70 = 3,925,000 0.20
D 125,800 x 31.40 = 3,925,000 0.36
11,005,000 1.0

B p = (0.23 × 1.16) + 0.212 × 1.28) + (0.197 × 0.9) + (0.357 × 1.5)

= 1.2556
However the Beta of the market = 1 and since the Beta of the portfolio is greater than the Beta of the
market, it is an aggressive portfolio.

QUESTION 2
i) WA = 200,000 = 0.2 WB = 800,000 = 0.8
1m 1m

ERp = Weighted Average = WA ERA + WB ERB

ERA = 18 ×0.4 + 14 × 0.5 + 12×0.1 = 15.4

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ERB = 24 ×0.4 + 22 x 0.5 + 21×0.1 = 22.7

ERp = 0.2 × 15.4 + 0.8 × 22.7 = 21.24%

(ii)
n
δi = ∑ CR − ER )
i =1
i 1
2
P1

A B
(18 - 15.4)2 0.4 = 2.704 (24 - 22.7)2 0.4 = 0.676
(14-15.4)2 0.5 = 0.98 (22-22.7)2 0.4 = 0.245
(12-15.4)2 0.1 = 1.156 (21-22.7)2 0.4 = 0.289
Variance 4.84 Variance 1.21
δ = 4.84 = 2.2 δ = 1.21 = 1.1

iii) Correlation Co-efficient between discounting A&B

Cov AB
VAB =
δAδB
n
COAB = ∑
i =1
=( RA − ER A )( RB − ERB ) Pi

= (18 - 15.4)(24 - 22.7)0.4 = 1.352

= (14 - 15.4)(22 - 22.7)0.5 = 0.49
= (12 - 15.4)(24 - 22.7)0.1 = 0.578
Cov AB = 2.42 = 1
COAB
VAB = = 2.42
δAδB
2.2 ×1.1

=1

weighted δp − weighted δp
Percentage Risk diversification = × 100
weighted δp

Weighted δp = WA δ A + WB δ B= 0.2 ×2.2 + 0.8 × 1.1 = 1.32

Actual δp = w2 AδA2 + w2 BδB 2 + 2 wAδACOAB

= 0.22 × 2.22 + 0.82 × 1.12 + 2 × 0.8 × 2.5 = 1.32

% Risk diversification > 1.32 − 1.32 × 100% = 0%

1.32
Thus there will be no risk minimization because the securities are perfectly positively co-related.

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CHAPTER 4
THE FINANCING DECISION
QUESTION 1
(a) Uses of cost of capital
- In determining the optimal mix of debt and equity.
- Using in project appraisal in computing N.P.V.
- Evaluating managerial performance on ability to generate % return above the cost of securing
capital.
- Dividend decisions – do we retain more profits (pay low dividends) since retained profits is a
cheaper source of finance compared to issue of shares?
- In make lease or buy decisions.
(b)
(i) * Cost of equity, ke

do(1 + g)
Ke = = fg
po − fc
do = 6.60
fc = fluctuation costs = 5
po = 100 – 3, discount = 97
g = 6%
6.6(1.06)
ke = + 0.06 = 0.136 = 13.6%
97 − 5

* Cost of preference shares, kp

d.p.s 8%x10 0.8

Kp = x100 = = x100 = 8.42%
po 10 − (5%x10) 9.5
* Cost of debt, kd
Par value = Sh. 100
Mkt price/issue price = 100 – 3 discount – Sh. 3 f.cost = 94
n = 20 years
Int = interest = 8% x 100 = Sh. 8

1
8(1 − 0.3) + (100 − 94) 20 5.9
Kd = 1 = x100 = 6.08% ≈ 6%
(100 + 94) 2 97

* Cost of retained earnings, kr

do(1 + g) 6.60(1.06)
Kr = +g = + 0.06 = 13.2%
po 97

(ii) Breakeven = Source with lowest cost (Amount)

Weight of the source

= Sh. 30m long term debt (lowest cost)

Sh. 30m ÷ 100m

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 = Sh. 30m = Sh. 100m
0.3

QUESTION 2
(b)
Capital % cost Market value Weight

Equity do(1 + g) 2(1.07) Sh.. 20 × 200,000 = 0.50

+g = + 0.07 = 17.7% 4,000,000
po 20

Preference share Coupon rate = 10% 1,000,000 0.125

capital

Debt Coupon rate = 14(1-0.3) = 9.8% 3,000,000 0.375

8,000,000 1.000

WACC = (17.7 × 0.5) + (10 × 0.125) + (9.8 × 0.375) = 13.775%

(ii)
Capital % cost Amount Weight

Equity 3(1.07) 15 × 200,000 = 3,000,000 0.34

+ 0.07 = 28.4
15

New debt 15% (1-0.3) = 10.5 2,000,000 0.22

Old debt 14% (1-03) = 9.8 3,000,000 0.33

Pref. s. c 10 1,000,000 0.11

9,000,000 1.00

WACC = (0.34 × 28.4) + (0.22 × 10.5) + (0.33 × 9.8) + (0.11 × 10) = 16.3%

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