Book Answers

Instructor’s Manual
Corporate Finance and

Investment
Sixth edition
Richard Pike
Bill Neale
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ISBN-978-0-273-71551-1
 Pearson Education Limited 2009

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First published 1999

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Third edition 2006
Sixth edition 2009
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2
Contents
Chapters Pages
Preface 4
1. An overview of financial management 5

2. The financial environment 13
3. Present values, and bond and share valuation 21
4. Investment appraisal methods 24
5. Project appraisal – applications 33
6. Investment strategy and process 45
7. Analysing investment risk 46
8. Identifying and valuing options 54
9. Relationships between investments: portfolio theory 56
10. Setting the risk premium: the Capital Asset Pricing Model 59
11. The required rate of return on investment 61
12. Enterprise value and equity value 63
13. Treasury management and working capital policy 67
14. Short-term asset management 75
15. Short- and medium-term finance 84
16. Long-term finance 88
17. Returning value to shareholders: the dividend decision 95
18. Capital structure and the required return 101
19. Does capital structure really matter? 109
20. Acquisitions and restructuring 120
21. Managing currency risk 130
22. Foreign investment decisions 135
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Richard Pike and Bill Neale, Corporate Finance and Investment, 6th Edition, Instructor’s Manual
PREFACE
This manual accompanies the sixth edition of Corporate Finance and Investment, and is
designed to assist instructors in the use of the text on their courses. For each chapter of the text,
the following three elements are provided.
• A note of the key learning objectives.
• A summary of those chapter end exercise questions whose solutions are to be found in this
manual.
• Solutions to the exercises not given in Appendix B of the text. It should be remembered that
there is often no single correct solution to a particular exercise; alternative solutions may be
equally appropriate because the information given is not always complete, or because there
is more than one possible approach to the problem.
Separately available on the web site are some additional questions with solutions thereto. There
is a also a selection of more complex case studies with relevant teaching notes
Richard Pike
Bill Neale
4
CHAPTER 1
An overview of financial management
Learning objectives
By the end of the first chapter, the reader should have gained a better appreciation of:
• What corporate finance and investment decisions involve.
• How financial management has evolved.
• The finance function and how it relates to its wider environment and to strategic planning.
• The central role of cash in business.
• The central goal of shareholder wealth-creation and how investors can encourage managers
to adopt this goal.
• The underlying principles of finance.
Question summary
2. Go4it plc explores the ideas behind the classical ‘maximise shareholder value’ approach to
finance, and how this can best be measured.
3. These questions address the wider fields of ‘stakeholder’ and ‘agency’ theory.
4. This question asks student to evaluate benefits and problems of ESOP in solving the
‘agency’ dilemma.
5. Zedo plc assesses various remuneration packages for senior management in relation to
encouraging managers to pursue shareholder goals.
6. This question examines shareholder goals and social objectives.
7. The role and characteristics of the financial management function are examined.
8. In the Cleevemoor Water Authority, stakeholder goals and performance measures of a

public utility are considered.
5
Answers to questions
2. Go4it plc
Maximising earnings per share will focus the company’s decision-making on profit after tax
and equity capital investment. These are two important elements of shareholder value, but
they ignore:
• Cash flow – depreciation policy will affect profits but not cash while capital investment
affects cash but not profits.
• Risk.
• Cost of capital.
3.
(a) Managers and owners may have different interests because ownership and management are
separate in many firms. Shareholders have little direct influence on the day-to-day
management. Managers are typically more risk averse than shareholders, who can diversify
much of the risk by holding an investment portfolio.
Examples of possible conflicts include:

• The level of perquisites that managers may look for.
• The time horizon for decision – managers may not expect to stay with the firm for more
than a few years.
• Take-over situations – managers may be reluctant to support a bid if it means new
management and redundancy.
(b) Corporate social responsibility refers to the way in which companies need to be aware of the
needs of the wider community. Such responsibility includes:
• Employees – fair wages and a safe working environment.
• Customers – providing a quality product at an appropriate price.
• Public – safety and support to the local community.
• Suppliers – prompt payment of bills.
• Government – proper payment of taxes and compliance with regulations.
(c) ‘Value for Money’ (VFM), as its name infers, is getting the best possible service at the least
possible cost. With regard to public services this would imply that the taxpayers
requirements are being served by the most efficient use of resources. VFM has three
aspects:
• Economy – acquiring the necessary inputs at the lowest cost.
• Efficiency – gaining more output from given inputs.
• Effectiveness – the extent to which a service meets its declared goals.
4.
Executive share option plans (ESOPs) have become popular in recent years, partly to aid
goal congruence within companies. Goal congruence arises when goals of different groups
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coincide. The two main groups are the shareholders (principals) and the managers (agents).
Other groups include the employees, the creditors, the government and the local community.
ESOPs enable managers to buy a company’s shares at a fixed price over a specified period.
The aim is to give managers a stake in the firm so that they will make decisions consistent
with shareholder’s interests. However, share options typically form only a limited part of
the remuneration package. If share prices fall, managers may decide not to take up the
option. Once they have taken up the option, managers may feel that share price movements
may have little to do with their efforts, but reflect the external market movements. ESOPs
are viewed as a useful instrument for encouraging congruence between the shareholder and
the manager, but which is by no means perfect.
5. Zedo plc
(a) The management of Zedo plc, under the control of the board of directors, is probably a very
different group of individuals, with different requirements and aspirations, from the
company’s shareholders. For the majority of quoted companies, there is a clear separation of
ownership and control. The owners (shareholders) must therefore seek to ensure that their
agents (managers) act in their best interests.
Shareholders seek to maximise their wealth by maximising the market value of their
investment and by the dividends received. Managers, on the other hand, might seek to
maximise their personal wealth or satisfaction through higher salaries, better ‘perks’
(company cars, better offices, etc.) and increased leisure time. They may have a different
attitude to corporate risk, profitability and growth than shareholders, which would lead to
the development of strategies and policies inconsistent with shareholders goals.
One approach shareholders frequently adopt is to introduce a remuneration scheme designed
to motivate managers to take actions consistent with shareholders goals.
Factors to be considered in devising a remuneration package
• Linking management compensation to changes in shareholder wealth.
• Reflecting manager’s contribution to increased wealth i.e. rewarding efficiency rather
than managerial luck.
• Matching the time horizon for decisions of managers with that of shareholders. Many
managers look towards maximising only short-term profits.
• Encouraging the same risk attitude as for shareholders. This is not easy as shareholders,
unlike managers, can reduce risk through holding investment portfolios.
• Making the scheme easy to monitor and incapable of manipulation by the managers.
• Operating a cost-effective scheme.
(b) Advantages and disadvantages of the three schemes.
(i) A bonus based upon achieving a minimum pre-tax profit level.
The danger with such a scheme is that it emphasises short-term profits at the expense of
longer-term profitability. Investment decisions often have a negative-profit impact in the
short-term. This scheme may discourage vital investment decision-making. At the same
time, it encourages the use of ‘creative accounting’ methods to manipulate year-end results,
for example, companies have sold properties and regarded the gains made as part of trading
profit. Another trick is to issue new shares and invest the proceeds in the bank, and the
interest accrued is shown as an increase in the year’s profits.
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(ii) A bonus based on turnover growth.

While this has obvious merits for companies with strong growth goals, it emphasises growth
at the expense of profitability and may not increase shareholders wealth. Investment
decisions and acquisitions might be taken on the basis of turnover rather than wealth-
creation. Prices may be reduced to increase sales at the expense of margins.
(iii) A share-option scheme.
These schemes are long-term compensation arrangements, which are dependent upon the
company’s share performance. Managers can buy a given number of shares at a given price
over a set period of time. Such share options only have value when the actual share price
exceeds the option price. This offers managers, who take up the scheme, the incentive to
take actions consistent with wealth-creation over a longer time period.
While in theory the scheme is attractive, it is often difficult for managers to see a clear
relationship between their efforts and share prices. For example, inefficient managers could
be rewarded in times of a generally rising stock market, as in the early 1980s, and vice
versa.
6. The primary financial objective of companies and the potential conflict with environmental
and social goals is discussed in Sections 1.6–1.8.
Many of the techniques used in financial decision-making are based upon the assumption of
shareholder wealth maximisation. This might be the main objective of shareholders, but it is
unlikely to be the only objective. Environmental and social considerations are only two of a
number of possible objectives of shareholders, some of which may conflict with wealth
maximisation. Maximisation of shareholder wealth, to the exclusion of other objectives, is
therefore, neither desirable nor possible in many companies. This does not negate its
usefulness as a financial objective. A company might seek to maximise shareholder wealth
after taking into account agreed environmental, social or other factors.
Possibly, more serious concerns are the ‘agency’ conflicts that might exist within
organisations. In large companies, in particular, shareholders own the company but control
is exercised by management, especially the board of directors.
Managers acting as ‘agents’ of the shareholders might in part take decisions, which
maximise their own utility, for example, through high salaries, perks or job security, rather
than maximise shareholder wealth. Decisions are sometimes argued to be satisfying rather
than maximising, with managers of all levels concerned with taking decisions that will
satisfy the next higher level of authority, while at the same time fulfilling their own personal
objectives. If shareholders wish managers to make decisions that are consistent with
shareholders wealth maximisation they will need to incur costs to monitor managers
‘actions’, and to introduce incentives for managers to seek wealth maximisation, for
example, through the introduction of share-option schemes whereby managers also benefit
from good market performance of a company’s shares.
Shareholder wealth maximisation is a realistic objective for a profit-seeking organisation,
but it is unlikely to be achieved because of imperfect information, the existence of additional
objectives and the lack of goal congruence between shareholders and the company’s
employees, especially its managers.
8
7. (a) Quoted high-growth company.

• A large amount of time devoted to statutory and listing requirements, particularly if the
company is growing by acquisition.
• Strong focus on management and accounting, for example, evaluation of strategic
opportunities including mergers and acquisitions.
• Strong treasury skills to secure both the short- and long-term financing for the company.
• Development of management information and accounting systems to meet the needs of
the business.
(b) Quoted low-growth company.
• Focus on improvement of profit by means of cost control, and therefore the financial
management must be able to select and implement appropriate budgetary and cost-
control systems and to provide management information in a concise and relevant form.
• The department must be capable of dealing efficiently with the statutory and listing
requirements.
• If the slower rate of growth means that the company generates cash, the financial
management will be concerned with the best ways in which to use the funds, for
example, investment in new business opportunities or repayment to shareholders in the
form of dividends or a buy-back of shares.
(c) Unquoted company aiming for a stock exchange listing.
• If the flotation is being made due to the need for access to a wider pool of funds to
finance expansion, then many of the points made in part (a) would also be relevant.
• The financial management must understand the listing requirements and be able to liaise
with the banks and institutions advising on the flotation.
• If the purpose of the flotation is to enable the owners to realise the value of their
investment then the financial managers must be able to persuade potential investors that
the company will be as successful under a new ownership and control structure as it was
as a private company.
• The managers must be good at communicating information about the company to the
wider public, and must be able to present financial information in a clear and accessible
format.
(d) Small family-owned business.
• The financial manager must be able to communicate effectively with a wide range of
people, including the owners of the business, providers of finance, tax officers and
shopfloor workers.
• The role of the financial manager will depend on the position and nature of the
company. For instance, is it growing or is it facing competitive pressure and liquidity
problems? Different business situations will place different demands upon the financial
managers.
• In a small company, the financial manager must be able to turn his hand to a much
wider range of activities than in a large company. He must therefore be much more of a
generalist and understand the details of a wide range of financial specialisms.
9
(e) Non-profit-making organisation, for example, a charity.

• The main difference between a non-profit-making organisation and a commercial
business is that resources are allocated not on the basis of cash-flow generation, but on
the basis of value to those providing the funds. Thus, the financial manager will be
more concerned with providing an appropriate way of measuring ‘value’ in the context
of the aims of the organisation than with measuring cash flow.
• Since funds are donated, there is likely to be a strong emphasis on cost control and the
efficient use of allocated resources.
• The financial manager will need to be involved in the fund-raising process. This is quite
different from the way in which a commercial organisation raises funds in the form of
equity and debt.
(f) Public sector, for example, a government department.
• In terms of expenditure, the work of the financial manager is likely to be similar to that
in a non-profit-making organisation, the emphasis being on ‘value’ rather than cash
flow. This is likely to demand an understanding of the techniques of cost-benefit
analysis.
• The financial manager will have little or no concern with the way in which the funds are
raised since there is generally a separation in the public sector between sourcing of
funds and expenditure.
• Unlike the private organisation where some attempt will be made to look at the longer
term, most of the budgeting in a government department is concerned with the one-year
time span and is framed in revenue terms.
8. Cleevemoor Water Authority

(a) The main function of public enterprise is to serve the public interest – in the case of a water
undertaking, it would be responsible for ensuring a safe and reliable supply of water to
households at an affordable price, which would also require close attention to control of
operating and distribution costs. Prior to privatisation, UK public enterprises were also
expected to achieve a target rate of return on capital, which struck a balance between the
going rate in the private sector and the long-term perspective involved in such operations.
The authority would also have faced political constraints on achieving its objectives in the
form of pressure to keep water charges down and also periodic restrictions on capital
expenditure.
One problem faced by such enterprises was their inability to generate sufficient funds
necessary to finance the levels of investment required to maintain water supplies of
acceptable quality.
Once privatised, NW would be required to generate returns for shareholders, allowing for
risk, at least, as great as comparable enterprises of equivalent risk. Moreover, it would be
expected to generate a stream of steadily rising dividends to satisfy its institutional investors
with their relatively predictable stream of liabilities.
Any capital committed to fixed investment would have to achieve efficiency in the use of
resources and to achieve the level of returns required by the stock market. In the United
Kingdom, it is alleged that there is an over-concern with short-term results, both to satisfy
existing investors and to preserve the stock market rating of the company. Although this
may safeguard future supplies of capital, it has militated against infrastructure projects and
activities such as R&D, which may generate their greatest returns in the more distant future.
10
(b)
(i) Shareholders
In financial theory, companies are supposed to maximise the wealth of shareholders, as
measured by the stock market value of the equity. In the absence of perfect information, it is
not possible to measure the relationship between achieved shareholder wealth and the
outright maximum. However, good indicators of the benefits received by shareholders are
the returns they receive in the form of dividend payments and share price appreciation.
Dividends
The pro forma dividend was 7p and by 2006 the dividend per share had grown by 186% to
20p, an average annual (compound) growth of around 19%. The pro forma payout ratio was
33%, falling to 31% by 2006. This suggests dividend per share has grown by slightly less
than earnings per share. The pro forma EPS was 21p rising by 210% to 65p, an average
annual increase of about 21%. This suggests the company broadly wishes to align dividend
increases to increases in EPS over time.
Share Price
The flotation price was £1, rising to £1.60 on the first day of dealing. By 2002, the EPS had
become 29p. Given a P:E ratio of 7, this implies a market price of 203p per share. By 2006,
the EPS had risen to 65p, and with a P:E ratio of 7.5, this corresponds to a market price of
488p. Compared to the close of first day’s dealings, the growth rate was 205% (or just over
20% as an annual average), and over the period 2002–6, growth occurred at the accelerated
rate of 140% (an annual average of about 24%).
Although information about returns in the market in general, and those enjoyed by
shareholders of comparable companies are not available to act as a yardstick, these figures
suggest considerable increases in shareholders’ wealth, and at a rate substantially above the
increase in the RPI.
(ii) Consumers
Although NW’s ability to raise prices is ostensibly restrained by the industry regulator,
turnover has risen by 38% over the period, an annual average of 5.5%. This is above the rate
of inflation over this period (about 2% p.a.) and also above the trend rate of increase in
demand (also 2% p.a.). This suggests relatively weak regulation, perhaps reflecting the
industry’s alleged need to earn profits in order to invest, or perhaps that NW has diversified
into other, unregulated activities, which can sustain higher rates of product price inflation.
However, before accusing NW of exploiting the consumer, one would have to examine
whether it did lay down new investment, and also how productive it had been, especially
using indicators like purity and reliability of water supply.
(iii) Workforce
Numbers employed have fallen from 12,000 to 10,000 (i.e. by 17%). The average
remuneration has risen from £8,333 to £8,600, corresponding to a mere 1% in nominal
terms, but about – 8% in real terms, after allowing for the 9% inflation in retail prices over
this period. This suggests a worsening of the returns to the labour force, although a shift in
the skill mix away from skilled workers and/or a change in conditions of employment away
from full time towards part time and contract working might explain the figures recorded.
Certainly, the efficiency of the labour force as measured by sales per employee (up from
£37,500 to £62,000 – an increase of 65%) has outstripped movements in pay. However,
apparently greater labour efficiency could be due to product price inflation and/or the
impact of new investment.
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The directors, however, seem to have benefited greatly. It is not stated whether the number
of directors has increased, but as a group, their emoluments have trebled. Arguably, this
might have been necessary to bring hitherto depressed levels of public sector rewards in line
with remuneration elsewhere in the private sector in order to retain competent executives.
Conversely, the actual remuneration may be understated as it does not appear to include
non-salary items such as share options, which would presumably be very valuable given the
share price appreciation that has occurred over this period.
(iv) Macroeconomic objectives
There are numerous indicators whereby NW’s contribution to the achievement of
macroeconomic policies can be assessed. Among these are the following:
1. Price stability
(i) Via its pricing policy. As noted, NW’s revenues have risen by 38% in nominal terms
and 29% in real terms. This questions the company’s degree of responsibility in cooperating
with the government’s anti-inflationary policy.
(ii) Via its pay policy. There is evidence that NW has held down rates of pay, but if this has
not been reflected in a restrained pricing policy, then, the benefits accrue to shareholders
rather than to society at large. Moreover, the rapid increase in directors’ emoluments is
hardly anti-inflationary, providing signals to the labour force, which are likely to sour
industrial relations.
2. Economic growth
(i) Via its capital expenditure. Higher profitability has been implicitly condoned by the
regulator in order to allow NW to generate funds for new investment. This appears to have
been achieved. Capital expenditure has nearly quadrupled. As well as benefiting the
industry itself, this will have provided multiplier effects on the rest of the economy to the
extent that equipment has been domestically sourced.
(ii) Via efficiency improvements. It is not possible to calculate non-financial indicators of
efficiency, but there are clear signs of enhanced financial performance. The sharp increase
in sales per employee has been noted. In addition, the return on capital as measured by
operating profit to long-term capital has moved steadily upwards as follows:
2000 2002 2004 2006
6.5% 8.4% 12.2% 15.3%
3. Tax payments. Although NW’s average rate of taxation has fallen from 19% in 2000 to 13%
by 2006, this may be due to the impact of capital expenditure, generating significant tax
breaks.
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CHAPTER 2
The financial environment
Learning objectives
By the end of this chapter, the reader should appreciate the nature of financial markets and the
main players within them. A clear understanding is required of the following topics:
• The function of financial markets.
• The operation of the stock exchange.
• The extent to which capital markets are efficient.
• How taxation affects corporate finance.
• Improved skills in reading the financial pages in a newspaper should also be achieved.
Question summary
1. This question invites students to define and discuss the role of merchant banks in providing
corporate finance advice.
2. (a) & (b) require discussion of the role and operation of capital markets, and especially the
place and form of the EMH within these operations. (c) has a solution in the textbook.
3. Buntam plc/Zellus plc asks students to calculate some common ‘market’ indicators and
comment on the issues to be considered and advice to obtain when investing in the stock
market.
4. Beta plc examines the merits of a stock exchange listing.
5. Collingham plc considers the issues involved in gaining a listing.
1. (a) See Section 2.3 in Chapter 2 – wholesale banks.
2. (a) See Section 2.2 in Chapter 2

(b) See Section 2.5 in Chapter 2
3. Report to Clients: Buntam plc/Zellus plc
Subject: Traded Investments
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(a) Traded investment refers to an investment asset, which is traded in the financial markets.
Examples include government and company bonds, ordinary shares, preference shares,
warrants and options or futures contracts. The range of such investments is therefore wide,
and it is important to recognise that each type of investment has unique characteristics in
terms of its cost, rate of return and risk. All of these factors must be taken into account
when selecting an investment.
The price of bonds and shares will vary, depending upon economic conditions and the
financial performance of the individual companies. Interest rates directly affect the price of
gilt-edged stock and corporate bonds, such as rise in interest rates and fall in the price of
bonds. This represents a capital risk to the investor, who cannot be certain of the price at
which the bond can be sold. The return earned on bonds will generally be higher than that
available through interest-bearing deposit accounts. Ordinary shares present a much riskier
form of investment, particularly for private individuals, who may incur high charges from
the purchase and sale of shares. The price of ordinary shares varies daily, depending on
factors within the market in general, and also specific to the company. An investor may earn
a return via dividends and/or capital gains. The amount of dividends receivable is
dependent, among other things, upon the profits of the company, and hence is not
predictable with certainty. Individual share prices are definitely not predictable with any
level of certainty. Consequently, investment in ordinary shares is relatively risky, but may
offer good returns, which historically have been shown on average to be higher than the
returns on bonds.
In conclusion, when comparing the different traded investments, it is essential that the
composition of the investment portfolio matches both the liquidity and risk needs of each
individual investor.
(b) Financial intermediaries are important to the efficient functioning of the financial markets,
as they play a crucial role in bringing the borrowers/companies and lenders/equity providers
together. Financial intermediaries include pension funds, insurance companies, retail and
merchant banks, and unit trust companies. In relation to private investors, their functions
include:
(i) The provision of investment advice and information.
(ii) Reduction of risk via aggregation of funds.
(iii) Maturity transformation. Financial intermediaries play a role here in performing the
function of maturity transformation. For example, a building society will lend out money for
a period of 20–30 years, but their investors would still wish to be able to withdraw cash that
they have in deposit accounts at random intervals. By taking advantage of the constant
turnover of cash between borrowers and lenders, the building society can lend long term
while holding short-term deposits. It is this process that is referred to as maturity
transformation.
Financial intermediaries can therefore be seen to be extremely useful to the private investor,
as they may provide useful advice and make it easier for the individual to take advantage of
the returns that can be earned in the financial markets (via, for example, personal pension
funds), while at the same time leaving investors with a wide range of opportunities as a
result of maturity transformation, aggregation and reduced risk.
14
(c)
(i) Gross dividend
At the end of the financial year, companies will announce the profits or losses that they have
earned, and a figure for net profit after tax. A company can choose to pay out any profit in
dividends or to reinvest it in the business. Dividends are paid out per share, and so the more
shares that you own in a business, the more dividend income that you will receive. Using
the example of Buntam plc, the figures indicate a gross dividend yield of 5%. This means
that the dividend paid equals 5% of the share price, or 8 pence, in this case. The term ‘gross’
means that this is the dividend paid before tax. The equivalent calculation for Zellus plc
means that the dividend yield of 3.33% is equivalent to a gross dividend payment of 9
pence. If an individual shareholder in Buntam plc pays tax at 20% on investment income,
then he will collect a net dividend of 6.40 pence per share. The company pays this basic rate
of tax to the government as an advance payment of its corporation tax liability, when it pays
out its dividends, and so investors receive the dividend after deduction of the basic tax
payable.
The gross dividend figure is of relevance to an investor as it facilitates direct comparison of
the dividend figure and dividend yield paid out by different companies, as well as comparison
with interest yields on fixed-return investments.
The tax liability is determined by the individual circumstances of each investor, and so its
inclusion would serve only to confuse any comparative analysis. The dividend figure is also
relevant to an investment decision because it is a way of earning income from investments,
as opposed to capital gains, which can only be realised when the investment is sold.
(ii) Earnings per share
Earnings per share (EPS) is calculated as profit attributable to equity dividend by the
number of shares in issue and ranking for dividends. EPS thus represents what is available
to be paid out as dividends.
Clearly, therefore, if the number of shares in issue remains fixed, the EPS will rise as the net
profit attributable to equity increases.
The value or EPS can be calculated by dividing the share price by the P/E ratio. For
Buntam, this means EPS equals 8 pence. In other words, the earnings per share is equal to
the gross dividend payable. For Zellus, the EPS is equal to 18 pence (270/15), in
comparison with a gross dividend of 9 pence. On first sight, therefore, it is tempting to view
Zellus as a better investment because its EPS is higher. On the other hand, an investor has to
pay 270 pence per share to get earnings of 18 pence, compared with 160 pence to get
earnings of 8 pence. The EPS figure is of limited value on its own; it needs to be judged in
conjunction with the share price, and hence the P/E ratio.
(iii) Dividend cover
Dividend cover measures the relationship between earnings per share and net dividends per
share. The higher the level of dividends (for any given level of EPS), the lower will be the
level of profit retained and reinvested within the business. This can have an effect on the
balance of returns available to an equity investor.
The returns from investing in shares may take the form of either income, i.e. dividends,
which are paid twice yearly, or capital gain/loss which is earned when the shares are sold.
Some investors may prefer one type of return to the other, often for tax reasons.
Dividend cover is measured as follows: earnings per share (net)/dividend per share (net).
15
Using the example of Zellus plc, the net EPS is 18 pence. The gross dividend is 9 pence,
and so if tax is payable at 20%, then the net dividend equals 7.2 pence. Using this formula,
the dividend cover equals 18/7.2, which gives a dividend cover of 2.5.
In other words, Zellus’ earnings are sufficient for the company to be able to pay out
dividends at a rate 2.5 times their current level. By comparison, Buntam has an EPS of 8
pence and a net dividend per share of 6.4 pence, giving a dividend cover of just 1.25.
Investors need to understand the relationship between dividend cover and investment
returns. As a general rule, the greater the level of retention (and dividend cover), the greater
the likelihood that a share will yield capital gain rather than income. From the examples
given above, it would thus appear for Buntam plc (paying out almost all their earnings as
dividends), there is limited scope for capital growth in the share price. By contrast, Zellus
has a relatively high dividend cover, and so the reinvestment of profits should generate capital
gains.
As with all investor ratios, dividend cover has to be interpreted with caution, and alongside
a number of other measures.
4. Beta plc
(a) The advantages of obtaining a listing on a stock exchange for a company and its
shareholders are as follows:
Cost of capital. The fact that listed shares are easily marketable means that listed shares are
usually viewed as being less risky than unlisted shares. This may help lower the cost of
capital for the company.
Ready price. The fact that a ready price is available for listed shares should help avoid any
uncertainties which occur when shares are being valued for certain purposes such as merger
and take-over bids or for calculating liability for taxation.
Efficient market price. Shares listed on a stock exchange are usually valued in an efficient
manner. This means that the price of the shares reflects fully the available information
concerning the company and its prospects. This should give potential investors greater
confidence when trading in the company’s shares.
Transferability of shares. Existing shareholders will be able to transfer shares more easily,
as listed shares are more marketable than unlisted shares. This increase in the marketability
of shares should also make it easier for the company to raise new share capital when
required.
Credit rating. A listed company may be seen as more creditworthy than an unlisted
company. This may make it easier for the company to raise loans when required.
High profile. When the company is listed, it will become more widely known and will be
the subject of greater interest by the investment and business community. This may help the
company in developing and exploiting market opportunities.
The disadvantages of obtaining a stock exchange listing are as follows:
Market expectations. A listed company may be under considerable pressure to meet with
market expectations. Failure to do so is likely to have an adverse effect on the share price.
Sometimes, market expectations for profit in the short term may conflict with the longer-
term strategies which the company wishes to pursue.
Cost. The cost of floating a company on the stock exchange can be very high. These costs
will usually include substantial legal and accountancy fees.
16
Administration and disclosure requirements. A listed company must comply with various
stock exchange rules and regulations and these may represent an administrative burden. The
company must also meet additional financial disclosure requirements imposed by the stock
exchange, for example, the London Stock Exchange requires that interim (half-yearly)
accounts be published.
Dilution of control. Existing shareholders will have their control over the company diluted
as a result of widening ownership in the company’s shares.
Risk of take-over. As shares in a listed company are easy to acquire, there is a greater risk
that another company will acquire its shares with a view to a takeover.
Public scrutiny. Listed companies are subject to a great deal of scrutiny from financial analysts,
the financial press and investors. This may be a problem if Beta plc is engaged in activities which
require sensitive handling or which may arouse criticism from certain quarters.
(b) When attempting to place an issue price on shares in a company which is to be floated on a
stock exchange, the following factors should be taken into account:
Risk. The level and type of risk associated with the business will be identified and assessed
by investors. For certain types of business, associated risks may be identified and evaluated
more easily than for others. Investors will take account of the risks and compare these with
expected returns when evaluating the share price.
Maintainable profits. The level of maintainable profits will be an important determinant of
share price. The degree of confidence investors have in the reliability of profit forecasts
produced will also be important.
Similar companies data. If there are companies operating in the same industry that are already
listed on the stock exchange, it may be possible to obtain a guide price from the data available.
The P/E ratio of similar companies can be multiplied by the earnings per share of the company
to be floated in order to arrive at a market valuation. However, care must be taken in using the
P/E ratio of other companies as they may not have the same risk and growth characteristics.
Furthermore, the P/E ratio can be influenced by particular accounting policies being adopted
by a company. Other investment ratios, such as the dividend yield and dividend cover of
similar companies may also be used in developing a guide price.
Investor interest. A company may wish to create a good impression among investors by
having a fully subscribed issue of shares. This may be particularly important for a company,
which expects to make further issues in the foreseeable future. Thus, the shares to be issued
may be offered at a discount on what is considered to be their true market value, in order to
attract investor interest. Research suggests that small companies must usually offer a larger
discount than large companies when issuing shares for the issue to be successful. An
immediate premium will accrue to investors who subscribe to the issue for which a discount
is offered.
5. Collingham plc
(a) Seeking a quotation places many strains on a company; in particular, the need to provide
more extensive information about its activities. However, the costs involved in doing this
may seem worthwhile in order to pursue the following aims:
(i) To obtain more capital to finance growth. Companies which apply for a market listing are
often fast-growing firms, which have exhausted their usual supplies of capital. Typically,
they rely on retained earnings and borrowing, often on a short-term basis.
17
A quotation opens up access to a wider pool of investors. For example, large financial
institutions are more willing to invest in quoted companies whose shares are considerably
more marketable than those of unlisted enterprises.
Companies with a listing are often perceived to be financially stronger and hence may enjoy
better credit ratings, enabling them to borrow at more favourable interest rates.
(ii) To allow owners to realise their assets. After several years of successful operation, many
company founders own considerable wealth on paper. They may wish to liquefy some of
their holdings to fund other business ventures or simply for personal reasons, even at the
cost of relinquishing some measure of voting power. Most flotations allow existing
shareholders to release some of their equity as well as raising new capital.
(iii) To make the shares more marketable. Existing owners may not wish to sell out at
present, or to the degree that a flotation may require. A quotation, effected usually by means
of a Stock Exchange Introduction, is a device for establishing a market in the equity of a
company, allowing owners to realise their wealth as and when they wish.
(iv) To enable payment of managers by stock options. The offer of payment to senior
managers partially in the form of stock options may provide powerful incentives to improve
performance.
(v) To facilitate growth by acquisition. Companies whose ordinary shares are traded on the
stock market are more easily able to offer their own shares (or other traded securities, such
as convertibles) in exchange for those of target companies whom they wish to acquire.
(vi) To enhance the company’s image. A quotation gives an aura of financial respectability,
which may encourage new business contracts. In addition, as long as the company performs
well, it will receive free publicity when the financial press reports on their performance and
discusses the results in future years.
(b) The table below compares Collingham’s ratios against the industry averages:
Industry Collingham
Return on (long-term) Capital Employed 22% 10/33 = 30.3%
Return on Equity 14% 6/28 = 21.4%
Net Profit Margin 7% 10/80 = 12.5%
Current Ratio 1.8:1 23/2 = 1.15:1
Acid Test 1.1:1 13/20 = 0.65:1
Gearing (Total Debt/Equity) 18% 10/28 = 35.7%
Interest Cover 5.2 10/3 = 3.33
Dividend Cover 2.6 6/0.5 = 12 times
Collingham’s profitability, expressed in terms of both ROCE (Return on Capital Employed)
and ROE (Return on Equity), compares favourably with the industry average. This may be
inflated by the use of a historic cost base, insofar as assets have never been revalued.
Although a revaluation might depress these ratios, the company appears attractive compared
to its peers. The net profit margin of 12.5% is well above that of the overall industry,
suggesting a cost advantage, either in production or in operating a flat administrative
structure. Alternatively, it may operate in a market niche where it is still exploiting first-
comer advantages. In essence, it is this aspect which is likely to appeal to investors.
Set against the apparently strong profitability is the poor level of liquidity. Both the current
and the acid test ratios are well below the industry average, and suggest that the company
18
should be demonstrating tighter working capital management. However, the stock turnover
of (10/70 × 365) = 52 days and the debtor days of (10/80 × 365) = 46 days do not appear
excessive, although industry averages are not given. It is possible that Collingham has
recently been utilizing liquid resources to finance fixed investment or to repay past
borrowings.
Present borrowings are split equally between short term and long term, although the level of
gearing is well above the market average. The debenture that is due for repayment shortly
will exert further strains on liquidity, unless it can be re-financed. Should interest rates
increase in the near future, Collingham is exposed to the risk of having to lock-in higher
interest rates on a subsequent long-term loan or pay (perhaps temporarily) a higher interest
rate on overdraft. The high gearing is reflected also in low interest cover, markedly below
the industry average. In view of high gearing and poor liquidity, it is not surprising that the
pay-out ratio is below 10%, although Collingham’s managers would presumably prefer to
link high retentions to the need to finance ongoing investment and growth rather than to
protect liquidity.
(c) It is common for companies in Collingham’s position to attempt to ‘strengthen’ or to ‘tidy
up’ their balance sheets in order to make the company appear more attractive to investors.
Very often, this amounts to ‘window dressing’, and if the company were already listed, it
would have little effect in an information-efficient market. However, for unlisted
companies, about whom little is generally known, such devices can improve the financial
profile of the company and enhance the prospects of a successful flotation.
(i) Some changes in the balance sheet that Collingham might consider prior to flotation are as
follows:
• Revalue those fixed assets which now appear in the accounts at historic cost. The
freehold land and premises are likely to be worth more at market values, although the
effect of time on second-hand machinery values is more uncertain. If a surplus emerges,
a revaluation reserve would be created, thus increasing the book value of shareholders’
funds, and hence the Net Asset Value per share. The disadvantage of this would be to
lower the ROCE and the ROE, although these are already well above the industry
averages. Asset revaluation would also reduce the gearing ratio.
• Dispose of any surplus assets in order to reduce gearing and/or to increase liquidity
which is presently low, both absolutely and also in relation to the industry.
• Examine other ways to improve the liquidity position, by reducing stocks, speeding
up debtor collection or slowing payment to suppliers, although it already appears to be a
slow payer with a trade credit period of (15/70 × 365) = 78 days.
• Conduct a share split, because at the existing level of earnings per share, the shares
promise to have a ‘heavyweight’ rating. Applying the industry P:E multiple of 13 to the
current EPS of (£6m/£4m × 2) = 75p, yields a share price of (13 × 75p) = £9.75. While
there is little evidence that a heavyweight rating is a deterrent to trading in already listed
shares, it is likely that potential investors, certainly small-scale ones, will be deterred
from subscribing to a highly priced new issue. A one-for-one share split whereby the
par value is reduced to 25p per share and the number of shares issued correspondingly
doubles, and would halve the share price, although other configurations are possible.
• It will have to enfranchise the non-voting ‘A’ shares, because, under present stock
exchange regulations, these are not permitted for companies newly entering the market.
(ii) Following the flotation, Collingham would probably have to accept that a higher dividend
payout is required to attract and retain the support of institutional investors. If it wishes to
19
persist with a high level of internal financing, a compromise may be to make scrip issues of
shares, especially if the share price remains on the ‘heavy’ side.
Scrip issues are valued by the market because they usually portend higher earnings and
dividends in the future.
Finally, if the company has not already done so, it might consider progressively lowering the
gearing ratio. It might begin this by using part of the proceeds of the flotation to redeem the
debenture early. However, it must avoid the impression that it requires a flotation primarily to
repay past borrowings as that might cast doubts on the company’s financial stability.
20
CHAPTER 3
Present values, and bond and share valuation
Learning objectives
Having completed the chapter, students should have a sound grasp of the time-value of money
and discounted cash flow concepts. In particular, students should appreciate:
• Why the value of money changes with time.
• The financial arithmetic underlying compound interest and discounting.
• Present value formulae for single amounts, annuities, perpetuities and bonds.
• The net present value (NPV) approach and why it is consistent with shareholder goals.
Skills developed in discounted cash flow analysis, using both formulae and tables, will help the
reader enormously in subsequent chapters.
Question summary
5. Construction of a yield curve and discussion of the relevance of yield curves to private
investors.
6. Practice in calculating net present values at different rates showing how the preference
between projects can change as discount rates alter.
7. Basic net present value question demonstrating how NPV falls as the discount rate increases.
9. Leyburn plc. This question involves the valuation using the dividend valuation model where
the company alters its dividend policy to invest in a series of new projects.
Answers to Questions
5.
(a) The yield curve has the following shape:
The yield curve clearly shows that as the years to maturity increase, the yield earned on the
gilt investment falls.
The shape of the curve drawn above is contrary to that which would be expected from
liquidity preference theory. Theory suggests that investors require increasing levels of
compensation as the time to maturity lengthens – the curve drawn above shows the exact
opposite. The reason for the difference between the theoretical and the observed shape of
the curve is market expectations. The market believes that over the long term interest rates
21
will fall, and the effect of market expectations is currently greater than the effects of
liquidity preference.
The slope of the yield curve shows not only how much an investor can expect as investment
returns, but also the cost of debt finance to the government.
(b) The term ‘gilts’ refers to government issued bonds that are ‘gilt’ edged because the associated
risk of default is negligible.
For the private investor, gilts are an attractive form of investment because they offer fixed
rates of return, they may be index-linked, and the investment risks are low. Gilts have a
nominal value of £100 but they may trade at prices above or below that value depending on
the current level of interest rates. If the current interest rate exceeds the coupon rate payable
on the gilt, then it will sell for a price below its nominal value, and vice versa.
Yield curves are relevant to the private investor because they give an indication of interest
rate expectations and trends. A downward-sloping yield curve, such as that shown above,
indicates a long-term downward trend in interest rates. For a gilt investor, this means that he
can expect gilt prices to rise over the same time period.
6. NPV (£)
Discount rate A B Advice

0% 400 600 B
10% 197 213 B
20% 38 (63) A
At the 10% discount rate, project B is marginally superior, but at 20% only project A offers
a positive NPV. The changes in ranking between projects arise because they have very
different cash flow profiles. The correct approach is to decide upon the required rate of
return and assess, which project offers the higher NPV.
7. Brosnan plc
Free cash flow after adding back depreciation, but deducting an equivalent amount for
re-investment is as state i.e. £5m p.a.
(i) Assuming full distribution, and hence no growth:

Value of equity = £5m/12% = £41.67m
Share price = £41.67m/10m = £4.167 (£4.2).
(ii) With 50% retentions, dividends = £2.5m

Growth = (retention rate × return on investment) = (50% × 15%) = 7.5%
Value of equity = [£2.5m(1 + 7.5%)] (12% – 7.5%)
= £2.69m/4.5% = £59.72, and thus £5.97, or £6 per share.
(iii) With 50% retentions, dividends again = £2.5m

Growth = retention rate × return on investment) = (50% × 10%) = 5.0%
Value of equity = [£2.5m(1 + 5%)] (12% – 5%)
= £2.625m/7% = ££37.5m and thus £3.75, per share.
22
(iv) Assuming again 50% retentions:

Cash flows are:
Year Cash flows growing at 7.5% PV at 12%
1. 2.5(1.075) = £2.69m £2.40m
2. = £2.89m £2.30m
= £3.11m £2.21m
PV of years 1 – 3 = £6.91m
PV of years 4 – infinity inclusive:
[£3.11m(1.05)]/(125 – 5%)
= £33.20m
(1.12)3
PV of equity = £40.11m
i.e. £4 per share
9. Leyburn
(a) Value of equity now
D1 £4m(1 + 8%) £4.32m
= = =
Ke − g (14% − 8%) 0.06
= £72m
Allowing for cash of £4m → = £4m
= £76m
(b) This year’s earnings after tax

= £10m (1 − 30%) = £7m
Retention rate now = 3/7 = 43%
Proposed retention rate = 4/7 = 57%
Growth rate = (57% × 20%) = 11.4%
Do (1+ g)
Value of equity = Do +
(k e - g)
 3(1.114) 
= £1m +  
14% – 11.4% 
 £3.342 
= £1m +   = £1m + £128.5m
 0.026 
= £129.5m
(N.B. The reader might consider the feasibility of this result, i.e. the critical assumptions.)
23
CHAPTER 4
Investment appraisal methods
Learning objectives
Having read the chapter, the reader should have a good grasp of the investment appraisal techniques
which are commonly employed in business, and should have developed the skills in applying them
to problems. Particular attention should be devoted to the following:
• The net present value approach and why it is consistent with shareholder goal.
• The three discounted cash flow approaches – net present value, internal rate of return and
profitability index.
• The underlying strengths and limitations of the above methods.
• How net present value and internal rate of return methods can be reconciled when they
conflict.
• Non-discounting methods.
• Analysing investments when capital availability is an important constraint.
Question summary
1. Yorkshire Autopoints is a basic NPV problem.
4. Mylo plc employs various appraisal methods to compare alternatives.
5. Mr.Cowdrey analyses the relationship between NPV and IRR both computationally and
graphically.
6. XYZ plc is a capital rationing problem involving the profitability index.
7. Raiders Ltd. has a more advanced capital budgeting problem under capital rationing
conditions, requiring a mathematical formulation of the problem.
24
1. Yorkshire Autopoints
(a)
Year Cash flow Discount rate 30% Present value
1 30,000 0.769 23,070

2 50,000 0.592 29,600
3 60,000 0.455 27,300
4 60,000 0.350 21,000
5 30,000 0.269 8,070
6 20,000 0.207 4,140
7 20,000 0.159 3,180
270,000 116,360
Less initial cost and setting-up expenses 140,000
Net present value (23,640)

The car-washing project produces a negative net present value of £23,640 when discounted at
the appropriate rate for the risks involved. It is not wealth creating and should not be installed.
(b) The most popular errors in this type of evaluation are:
(i) To fail to discount cash flows. In money terms the project will generate £130,000 (i.e.
£270,000 – £140,000)
(ii) To deduct depreciation as an expense. Depreciation is a non-cash item.
(iii) To include fixed costs. Only relevant, incremental costs should be included.
(iv) To discount cash flows at a rate other than that associated with the project’s degree of
risk.
4. Mylo plc
(a)
(i) Net present value
Project 1 – Incremental cash flows
Year
0 1 2 3
£ £ £ £
Cash flows* (100,000) 60,000 30,000 40,000
Discount rate 10% 1.0 0.91 0.83 0.75
Present value (100,000) 54,600 24,900 30,000
Net present value 9,500
* Calculated by adding the depreciation charge (i.e. capital outlay less residual value spread
over 3 years) to the profit.
25
Year
0 1 2 3
£ £ £ £
Cash flows (60,000) 36,000 16,000 28,000
Discount rate 10% 1.0 0.91 0.83 0.75
Present value (60,000) 32,760 13,280 21,000
(ii) Internal rate of return
Year
0 1 2 3
£ £ £ £
Cash flows (100,000) 60,000 30,000 40,000
Discount rate 18% 1.0 0.85 0.72 0.61
Present value (100,000) 51,000 21,600 24,400
Net present value at
10% 9,500
18% (3,000)
Difference 12,500
By interpolation the internal rate of return is 10% + (8% × (9,500/12,500)) = 16%
Year
0 1 2 3
£ £ £ £
Cash flows (60,000) 36,000 16,000 28,000
Discount rate 18% 1.0 0.85 0.72 0.61
Present value (60,000) 30,600 11,520 17,080
Net present value 800
10% 7,040
18% (800)
Difference 7,840
By interpolation the internal rate of return is 10% + (8% × (7,040/7,840)) = 17%
26
(iii) Profitability index

Present value
Profitability index =
Initial investment
109, 500
Project 1 =
100, 000
= 1.095
67, 040
Project 2 =
60, 000
= 1.117
(iv) Payback period
Project 1 = 60,000 (Year 1) + 30,000
(Year 2) + 10,000 (Year 3)
= 2.25 years
Project 2 = 36,000 (Year 1) + 16,000

(Year 2) + 8,000 (Year 3)
= 2.29 years
(b) Based on the information given, Project 1 should be chosen in preference to Project 2 as it
has a higher positive net present value. Given that the net present value of Project 1 is only
slightly higher, it would be useful to undertake some assessment of the degree of risk
associated with each project.
(c) The net present value method is the most appropriate method for evaluating investment
projects because:
(i) It takes account of all relevant information unlike the payback method, for example, that
ignores cash flows beyond the payback period.
(ii) It is directly related to the objective of wealth maximisation which is the assumed goal of a
business enterprise.
(iii) It employs a discount rate based on the cost of capital.
(iv) It takes account of the time value of money by discounting future receipts and payments.
27
5. Mr.Cowdrey
WORKINGS
Project A DISCOUNTED CASH FLOWS NPV
Discount rate Year 0 Year 1 Year 2 Year 3 £

(£000s)
0% –100 60 40 30 30
6% –100 × 60 × 40 × 30 ×
1.0 0.943 0.890 0.840
–100 56.58 35.60 25.20 17.38
12% –100 × 60 × 40 × 30 ×
1.0 0.893 0.797 0.712
–100 53.58 31.88 21.36 6.82
18% –100 × 60 × 40 × 30 ×
1.0 0.847 0.718 0.609
–100 50.82 28.72 18.27 –2.19
Project B DISCOUNTED CASH FLOWS NPV
Discount rate Year 0 Year 1 Year 2 Year 3 £

(£000s)
0% –100 10 20 110 40
6% –100 × 10 × 20 × 110 ×
1.0 0.943 0.890 0.840
–100 9.43 17.80 92.4 19.63
12% –100 × 10 × 20 × 110 ×

1.0 0.893 0.797 0.712
–100 8.93 15.94 78.32 3.19
18% –100 × 10 × 20 × 110 ×

1.0 0.847 0.718 0.609
–100 8.47 14.36 66.99 –10.18
(b) Internal rates of return (IRR) estimated from the graph in part (a):
PROJECT A 16.4%
PROJECT B 13.2%
28
(c) On the basis of the figures calculated in the workings,

PROJECT A PROJECT B
£000 £000
(i) NPV @ 6% 17.38 19.63
(ii) NPV @ 12% 6.82 3.19
Mr Cowdrey should consider accepting Project B if the discount rate is 6% or Project A if
the discount rate is 12%.
(d) The following additional information would assist Mr Cowdrey in his selection:
(i) An assessment of the degree of accuracy of the estimated cash flows.
(ii) The risk category of each project.
(iii) The cut-off rates i.e. required rates of return relative to the risk category.
(iv) The impact of taxation upon each project’s cash flows.
(v) What happens if things go wrong?
(vi) Non-financial factors, for example, social, political, practical, technological etc., many
of which are of a qualitative nature.
(vii) Details of other projects/opportunity costs.
(e) The relative merits of NPV and IRR as methods of investment
It must be remembered at the outset that the financial data is just one component part of the
capital investment decision-making process. It must also be remembered that methods such
as NPV and IRR depend upon the estimation of cash flows and the selection of an
appropriate discount rate. The NPV method discounts the cash flows at an appropriate rate
and recommends acceptance/strong consideration of all projects that yield a positive NPV.
With the IRR method, all projects whose IRRs exceed the required rate should be accepted
as worthy of further consideration. Both methods give the same decision rule in simple
accept/reject situations.
In a simple accept/reject situation, knowledge of the project’s NPV is sufficient to ensure
that the shareholder’s wealth will be maximised when the present value of the future stream
of cash flows received by the shareholder is maximised. However, knowledge of a project’s
IRR is not in itself sufficient for optimal investment decisions.
The two methods may give different decision rules when selecting between two mutually
exclusive investments. This difference stems from the different assumptions made regarding
the reinvestment rates of intermediate cash flows. The NPV approach assumes that positive
intermediate cash flows can be reinvested at a rate of interest equivalent to that used as the
discount rate. The IRR method assumes that they can be reinvested and earn a return equal to
the project’s IRR. Of the two, it appears that the NPV assumption is more realistic. The NPV
method tends to be more flexible and can be adjusted to include multiple discount rates.
From a ranking point of view, the NPV approach assumes that the discount rate reflects the
opportunity cost of capital. The opportunity cost concept under the IRR method is less valid
because of the IRR’s reinvestment assumption.
However, it is argued that the theoretical difficulties of the IRR method are outweighed by
its practical advantages, such as allowing management to adjust for risk, and that, being
based on the rate of return concept the method is more easily understood and accepted. It
also relieves the decision-makers from having to work out the firm’s cost of capital, which
is quite a complex task. The NPV method, on the other hand, requires the decision-makers
to determine the discount rate to be used right from the word go.
29
(a)
30
6. XYZ plc
(a)
(i)
Year 0 Year 1 Year 2 Year 3 Total P/I
(NPV/Outlay)
1.000 0.870 0.756 0.658
15% discount factors
£000 £000 £000 £000 £000
Project cashflow (350.0) 104.5 133.1 266.2

A: discounted (350.0) 90.9 100.6 175.2 16.7 1.05
Project cashflow (105.0) 49.5 54.5 59.9

B: discounted (105.0) 43.1 41.2 39.4 18.7 1.18
Project cashflow (35.0) (44.0) (30.2) 166.4

C: discounted (35.0) (38.3) (22.8) 109.5 13.4 1.38
(ii) With a limit of £400,000, the choice is restricted to A + C or B + C. B + C has the highest
NPV with £32,100.
The fact that the company can invest for 10% per annum constant in the money market is
not relevant to this particular decision, since this is below its cost of capital.
(b) The higher the borrowings, the greater the volatility of returns to the shareholders. This
inversely influences the value placed on prospective returns to the shareholder, thus partly
offsetting the apparent benefit of the lower cost of borrowing. However, the fact that
interest is tax deductible usually reduces the offset. The decision to borrow depends on a
number of factors:
• the volatility of prospective returns to the entity as a whole;
• interest rate expectations, relative to the perceived cost of equity capital;
• the tax position of the company, notably any unused allowances.
7. Raiders Ltd
(a)
Capital Rationing Ranking of Projects:
Project A B C D
£000 £000 £000 £000
NPV of cash flows +157.0 +150.0 +73.5 159.5
Immediate outflow –400 –300 –300 –
Therefore benefit/cost
ratio (profitability index) 0.39 0.50 0.25 ∞
Ranking 3 2 4 1
31
Project D is ranked first because it has a positive NPV and it did not require an immediate
outlay. The £500,000 will therefore be applied as follows:
NPV OUTLAY
£000 £000
Project D 159.5 –
Project B 150.0 300
Project A (50% × 157) 78.5 200 (max)
388.0 500
(b) Max: 157 A + 150 B + 73.5 C + 159.5 D
subject to:
Year 0 400 A + 300 B + 300 C + DEP ≤ 500
Year 1 200 B + 300 D ≤ 300 + 50 A + 150 C + 1.07 DEP
A,B,C,D ≥ 0, ≤ 1
(c) The formulation of the above problem into a linear programme assumes infinite divisibility
of the unknown and the existence of linear relationships.
Thus, this means that insignificant limitations will exist in situations where the output has
elements of indivisibility and scale economies and/or diseconomies.
Another further area of problem relates to the quality of the data used. The linear
programme can only be relied upon to provide an optimal solution where the investment
opportunities are fully and correctly specified, together with all the respective constraints,
conditions and limitations. Another limitation is that the linear programme does not
effectively take risk into account.
Finally, it must be remembered that the DCF analysis is carried out on the assumption of a
perfect capital market and that the discount rate used reflects the market rate of interest for
the particular level of risk. However, in a situation where capital is being rationed, if the
company is being denied funds by the market then there is a capital market imperfection and
it will be difficult to determine an appropriate discount rate.
(d) The view that capital is always available, but at a price has over the years been the subject
of frequent debate.
The MacMillan Committee, in 1931 identified ‘the MacMillan Gap’, a shortfall in the supply
of funds to small and medium-sized companies. However, the Bolton Committee which
reported in 1971 was of the opinion that the capital market (including government sources
of funds) was efficiently meeting demand. This view was supported by the Wilson
Committee, in 1981. One of the real problems of this area is not so much a shortage of
funds on the supply side but the existence of a ‘communication gap’. The providers of funds
have not always been able to communicate their offerings to those who are in need of the
finance.
It is quite appropriate to use the mathematical capital rationing technique when capital has
been rationed by management (i.e. soft capital rationing) – rather than by the market – as a
control device.
32
CHAPTER 5
Project appraisal – applications
Learning objectives
Having read the chapter, the reader should be well equipped to handle most capital investment
decisions found either on an examination paper or in business. Skills should be developed in the
following areas:
• Identifying the relevant information in investment analysis.
• Evaluating replacement and other investment decisions.
• Handling inflation.
• Assessing the effects of taxation on investment decisions.
• Investment appraisal practices, strengths and limitations.
• Identifying the appropriate discount rate.
Question summary
3. Handling the IRR method when comparing mutually exclusive projects.
6. Argon Mining plc considers the appropriate investment appraisal method.
7. Consolidated Oilfields plc looks more difficult than it really is. It raises the issue of
identifying incremental cash flows and the problems posed by inflation.
8. Deighton plc covers relevant cash flows, taxation and NPV.
9. Howden plc addresses inflation issues.
Assignment
Engineering Products is a mini-case study in investment appraisal and its application. The
main issues addressed are: (i) distinguishing between relevant and non-relevant information;
and (ii) dealing with taxation issues.
33
3. This question requires the student to calculate the IRRs and NPVs for both projects.
PROPOSAL L (Try 25% for IRR)

£
£20,000 × 3.1699 63,398
less outlay 47,232
NPV 16,166
IRR (trial and error) 25%
PROPOSAL M (Try 22% for IRR)

£
Year 0 Outlay (47,232)
1– –
2 £10,000 × 0.8264 8,264
3 £20,000 × 0.7513 15,026
4 £65,350 × 0.6830 44,634
NPV 20,692
IRR 22%
The above analysis reveals that proposal M offers the higher net present value but the
lower internal rate of return. To overcome this problem, two approaches are available:
1. Differential IRR approach
This calculates the IRR on the incremental cash flows between the two options.
If the IRR is above the discount rate, accept the option with the smaller IRR.
Cash flows (£)

0 1 2 3 4
Proposal L –47,232 20,000 20,000 20,000 20,000
Proposal M –47,232 0 10,000 20,000 65,350
M–L 0 –20,000 –10,000 0 +45,350
This produces an IRR of approximately 17%. As this is greater than the 10% discount rate,
select proposal M (with the lower IRR), thus, concurring with the net present value advice.
2. Modified IRR Method (MIRR)
This approach was introduced in Chapter 5. It involves calculating the terminal value at year
4 using the cost of capital of 10% and determining the IRR which equates this figure with
the initial cost.
34
PROPOSAL L
Terminal value Yr 4
Year £ £
1 20,000 × (1.1)3 26,620
2 20,000 × (1.1)2 24,200
3 20,000 × (1.1) 22,000
4 20,000 × 1.0 20,000
92,820
47, 232
PVIF(x %,4yrs) = = 0.509
92,820
Using tables, x = 18% (approximately)
PROPOSAL M
Year £ £
1 – –
2 10,000 × (1.1)2 12,100
3 20,000 × (1.1) 22,000
4 65,350 × 1.0 65,350
99,450
47, 232
PVIF( x %,4yrs) = = 0.475
99, 450
Using tables, x = 20%, approximately

The MIRR for proposal M is greater than for proposal L that gives a decision signal
consistent with the net present value rule.
35
6. Argon Mining plc

(a) INCREMENTAL CASH FLOWS
Years
0 1 2 3 4 5
£m £m £m £m £m £m
Sales 9.4 9.8 8.5 6.3
Wages and salaries (1.8) (2.5) (2.6) (1.8)
Selling and distribution
costs (1.3) (1.2) (1.5) (0.6)
Materials and
consumables (0.3) (0.4) (0.4) (0.2)
Survey costs (0.2)
Site repair (0.4)
Head office expenses (0.2) (0.2) (0.2) (0.2)
Purchase of mine (2.5)
Working capital (0.5) 0.5
Equipment and vehicles (12.5) 2.5
(15.5) 5.6 5.5 3.8 6.5 (0.4)
Discount factor @12% 1.00 0.89 0.80 0.71 0.64 0.57
Present value (15.5) 4.98 4.40 2.70 4.16 (0.23)
NPV £0.51m
(b) The project is expected to produce a positive NPV, its acceptance will enhance the wealth
of shareholders of the company. However, the NPV is small in relation to the initial outlay
required and a careful assessment of both the risks involved and the accuracy of the
estimates should be undertaken before final acceptance.
(c) The net present value method of investment appraisal was selected due to the following
reasons:
(i) It is based on the concept of shareholder wealth maximisation which is assumed to be
the primary objective of a business.
(ii) It takes account of the time value of money.
(iii) It takes account of all cash flows which are relevant to a consideration of the project’s
profitability.
(iv) It uses a discount rate which reflects the returns required by investors.
(v) It provides clear decision rules.
36
7. Consolidated Oilfields plc

(a) INCREMENTAL CASH FLOWS
Years
0 1 2 3 4 5
£000 £000 £000 £000 £000 £000
Sales 7,400 8,300 9,800 5,800
Equipment (5,200) (5,200) 2,000
Working capital (650) 650
Licence fee (300) (300) (300) (300) (300)
Wages (550) (580) (620) (520)
Materials (340) (360) (410) (370)
Overheads (100) (100) (100) (100)
Hire of tools _____ _____ (150) _____ ____ _____
Net cash flow (5,200) (6,150) 5,960 6,960 8,370 7,160
Discount factor 1.00 0.91 0.83 0.75 0.68 0.62
Discounted cash flows (5,200) (5,597) 4,947 5,220 5,692 4,439
NPV +9,501
(b) The above analysis indicates that the Australian Oilfield project offers a positive net present
value of £9,501,000. Acceptance of this project will increase shareholder wealth.
(c) Problems posed by inflation:
(i) Inflation can affect revenues and various expenditures differently. For example, prices
are subject to competitor actions and wages are subject to negotiation etc.
(ii) Some costs do not change: for example, capital allowances for tax purposes are based
on the original cost, not the inflated cost of the project; rent may be fixed for a five-year
period etc.
(iii) Inflation adds to the uncertainty surrounding project cash flows.
(iv) Interest rates are likely to rise during a period of inflation, making it difficult to estimate
the appropriate discount rate.
Two possible approaches are available to deal with inflation in investment analysis:
• adjust future cash flows to take account of the inflation and discount them at the money
rate of interest; or
• convert the money cash flows into real terms and discount at the real rate of interest.
8. Deighton plc
REPORT SUBMITTED TO: Finance Director, Deighton plc.
FROM: An(n) Accountant.
DATE: 12th of Never.
SUBJECT: Investment Project NTI7
The above investment project was rejected by the former management of Linton Ltd, but it
appears that the evaluation (attached) was flawed. This report identifies these flaws and
reevaluates the proposal which appears to be worthwhile. As the market opportunity is still
open, I recommend acceptance of the project.
37
(a) Mistakes made by Linton

1. The initial investment in working capital should be offset by a working capital release in the
final year, assuming a constant level of stock-holding until the last year.
2. The interest cost, although a cash outflow in reality, should be subsumed in the overall cost
of the capital. Linton’s evaluation confused the investment decision with the financing
decision. If the project were evaluated by the new owners, the return of 20% required by
Deighton’s shareholders would be the correct rate of discount.
3. At the end of four years, no scrap value is shown for either new equipment or the old
machine.
4. Depreciation is not a cash outflow. By deducting the depreciation charge, Linton has double
counted for the capital cost (and used the wrong outlay as a basis).
5. However, the annual depreciation allowances (WDA) do affect the tax outflow.
These were ignored.
6. No tax delay is allowed.
7. The overhead charge is overstated. Only half of the amount charged appears to be
incremental.
8. The market research cost, whatever it relates to, is irrelevant (i.e. it is sunk, unless a buyer
could be found for the report).
(b) In the following solution, the tax allowances in relation to the initial outlay on equipment
are evaluated separately. Other approaches are acceptable.
(i) The tax-adjusted cost of the capital expenditure can be found by deducting the present value
of the tax savings generated by exploiting the writing-down allowance from the initial
outlay. It is assumed that the available allowances can be set off against profits immediately
(i.e. beginning in the financial year in which the acquisition of the asset occurs). This yields
five sets of WDAs as the project straddles five tax years.
Years
Item (£000) 0 1 2 3 4 5
Allowance
Claimed at 25% 225 169 126 95 285
Written down value 675 506 380 285 0
Tax saving @ 33% 74 56 42 31 94
Discount factor @
20% 0.833 0.694 0.579 0.482 0.402
Present value 62 39 24 15 38
Present value of tax savings = 178, i.e. £178,000.
The effective cost of the equipment is:
Nominal outlay – present value of tax savings

= [£900,000 – £178,000]
= £722,000.
38
(ii) The cash flow profile is:
Years
Item (£000) 0 1 2 3 4 5
Equipment/Scrap (722) 0
Working capital (100) 100
Sales 1,400 1,600 1,800 1,000
Materials (400) (450) (500) (250)
Direct labour (400) (450) (500) (250)
Overheads (50) (50) (50) (50)
Operating cash
flow 550 650 750 450 100
Tax @ 33% – (182) (215) (248) (149)
Net cash flow (872) 550 468 535 202 (49)
Discount factor @ 20% 0.833 0.694 0.579 0.482 0.402
Present Value (872) 458 325 310 97 (20)
NPV = + 298, i.e. £298,000.
Recommendation
Thus, the purchase of equipment is acceptable and should be undertaken, although an
analysis of its risk is also recommended.
9. Howden plc
(a) Investors advance capital to companies expecting a reward for both the delay in waiting for
their returns (time value of money) and also for the risks to which they expose their capital
(risk premium). In addition, if prices in general are rising, shareholders require
compensation for the erosion in the real value of their capital.
If, for example, in the absence of inflation, shareholders require a company to offer a return
of 10%, the need to cover 5% price inflation will raise the overall required return to about
15%. If people in general expect a particular rate of inflation, the structure of interest rates
in the capital market will adjust to incorporate these inflationary expectations. This is
known as the ‘Fisher Effect’.
More precisely, the relationship between the real required return (r) and the nominal rate
(m) (the rate which includes an allowance for inflation), is given by: (1 + r) (1 + p) = (1 + m)
where p is the expected rate of inflation.
It is essential when evaluating an investment project under inflation that future expected
price-level changes are treated in a consistent way. Companies may correctly allow for
inflation in two ways, each of which computes the real value of an investment project:
(i) Inflate the future expected cash flows at the expected rate of inflation (allowing for
inflation rates specific to the project) and discount at m, the fully inflated rate – the
‘money terms’ approach.
(ii) Strip out the inflation element from the market-determined rate and apply the resulting
real rate of return r, to the stream of cash flows expressed in today’s or constant prices –
the ‘real terms’ approach.
(b) First, the relevant set-up cost needs identification. The offer of £2m for the building, if
rejected, represents an opportunity cost, although this appears to be compensated by its
predicted eventual resale value of £3m. The cost of the market research study has to be met
irrespective of the decision to proceed with the project or not and thus is not incremental.
39
Second, incremental costs and revenues are identified. All other items are avoidable except
the element of apportioned overhead, leaving the incremental overhead alone to include in
the evaluation.
Third, all items of incremental cash flow, including this additional overhead, must be
adjusted for their respective rates of inflation. Because (with the exception of labour and
variable overhead) the inflation rates differ, a disaggregated approach is required.
The appropriate discount rate is given by:
(1 + p) (1 + r) – 1 = m = (1.06) (1.085) – 1 = 15%
Cash flow profile (£ m)

Years
Item 0 1 2 3 4 5
Equipment (10.50) 2.00
Forgone sale of
building (2.00)
Residual value of
building 3.00
Working capital* (0.50) 0.50
Revenue 5.04 5.29 5.56 5.83 6.13
Materials (0.62) (0.64) (0.66) (0.68) (0.70)
Labour and
variable overhead (0.43) (0.46) (0.49) (0.52) (0.56)
Fixed overhead (0.53) (0.55) (0.58) (0.61) (0.64)
Net cash flows (13) 3.46 3.64 3.83 4.02 9.73
Present value at
15% (13) 3.01 2.75 2.52 2.30 4.84
NPV = +£2.42m; therefore, the project appears to be acceptable.
However, the financial viability of the project depends quite heavily on the estimate of the
residual value of the building and equipment.
*
Note: the working capital cash recovery towards the end of the project is equal to the initial
investment in stocks because the rate of material cost inflation is cancelled out by the JIT-
induced reduction in volume, leading to constant stock-holding in value terms throughout
most of the project lifespan.
Case study: Engineering Products plc
Issues addressed
Roger Davis is faced with the type of problem that many a young manager may face: trying
to justify a line of action when the financial analysis provided by the ‘experts’ suggests
otherwise. The problem is essentially one of distinguishing between relevant and non-
relevant information and analysing it in a proper fashion.
Although a short case, it provides students with a practical exercise for capital budgeting
analysis and raises several pedagogical issues for class discussion.
40
For example:
(i) how project risk can be assessed;
(ii) whether investment and financing decisions should be separated;
(iii) the non-quantifiable benefits of advanced manufacturing technology; and
(iv) the appropriate discount rate.
Analysis
The following pieces of information are not relevant to the DCF analysis:
(i) depreciation (non-cash);
(ii) apportioned fixed overheads (incurred regardless of the decision);
(iii) loss on disposal of existing plant (a non-cash item, although in practice profit impact
cannot be ignored);
(iv) interest costs (regarded as part of the financing decision).
All relevant incremental cash flows are then identified. As taxation can be a little complex, it is
preferable to analyse the decision first on a no-tax basis. This is given in Exhibit 1. Attention
should be drawn to the effects of the new decision on other parts of the business:
(i) an existing machine is no longer required, giving rise to an immediate benefit (sale
proceeds), a continuing benefit (cost savings), and an eventual benefit forgone (scrap
value in Year 4) treated as a cash outflow;
(ii) the marketing manager must incur additional advertising;
(iii) another product will lose customers (lost sales less variable costs).
The proposal offers a payback period of 2.8 years – just within the 3-year requirement.
However, the limitations of this method of analysis (ignores the time value of money and
cash flows beyond the payback period) lead us to question whether a project of this size
should be judged solely by such a simple technique. The project offers an IRR of 20%,
before tax, and an NPV of £106K when discounted at the risk-free rate. In a situation such
as this, where there is no clearly defined discount rate, we see the practical benefit of the
IRR method. The question is whether 20% is good enough, and although no two individuals
may agree upon the precise hurdle rate, they may well agree that a 20% IRR is sufficiently
high to submit to the next level in the organisation for consideration and approval.
Exhibit 2 presents the after-tax analysis. This involves calculating the taxable profits and
capital allowances, assessing the tax payable (usually a year later), and adjusting the pre-tax
cash flows accordingly. The impact of taxation is generally far less than it was in the early
1980s when allowances of 100% were given on industrial plant. In our case the payback is
unchanged, while the NPV and IRR have fallen somewhat. However, the discount rate of 10%
has not been tax adjusted. Clearly, the actual hurdle/discount rate should be reduced for tax
when cash flows are after-tax. When so adjusted, the NPV is very similar to the pre-tax NPV.
41
Exhibit 1 CNC MILLING MACHINE APPRAISAL (£000)
Year 0 1 2 3 4
Purchase machine (240)
Residual value 20
Sales 400 600 800 600
Less costs:
Materials (40) (260) (300) (360) (240)
Labour (80) (120) (120) (80)
Other production (Note A) (64) (66) (68) (84)
Sale of existing machine 20
Operating savings 18 18 18 18
Scrap value forgone (8)
Advertising (40) (8) (8) (8) (8)
Less contribution on
competing product (15) (15) (15) (15)
Net cash flow (300) (9) 109 247 203
Discount rate 10% 1.0 0.909 0.826 0.751 0.683
PV (300) (8.2) 90.0 185.5 138.6
Payback period: 2.8 years
NPV at 10% £105.9
IRR: 20%
Note A Year
1. 80,000 – 0.2 × 80,000 = £64,000
2. 90,000 – 0.2 × 120,000 = £66,000
3. 92,000 – 0.2 × 120,000 = £68,000
4. 100,000 –0.2 × 80,000 = £84,000
42
Exhibit 2 TAXABLE PROFIT CALCULATION
Year 1 2 3 4
Sales 400 600 800 600
Cost of sales 220 300 380 300
180 300 420 300

Labour (80) (120) (120) (80)
Other production (64) (66) (68) (84)
Operating savings 18 18 18 18
Advertising (48) (8) (8) (8)
Lost contribution (15) (15) (15) (15)
Operating profit (9) 109 227 131

Sale of existing machine 20
Scrap value forgone (8)
Taxable profits 11 109 227 123
Assume the existing machine has a taxable written-down value of zero. Assume also that
tax is paid a year after the cash flow to which it relates.
CAPITAL ALLOWANCES
£000
Investment 240
Yr 1 WDA 25% 60
180
Yr 2 WDA 25% 45
135
Yr 3 WDA 25% 33.75
101.25
Yr 4 Sale proceeds 20.00
Balancing charge 81.25
43
TAX PAYABLE
Taxable Capital Taxable Tax payable

Year profits allowances amounts at 30%
1 11 60 (49) (15)
2 109 45 64 19
3 227 34 193 58
4 123 81 42 13
NPV CALCULATION
Year Net cash flow Tax paid Post-tax NCF 10% PV
0 (300) (300) 1.0 (300)

1 (9) (9) 0.909 (8)
2 109 (15) 124 0.826 102
3 247 19 228 0.751 171
4 203 58 145 0.683 99
5 – 13 (13) 0.621 (8)
NPV 56K
44
CHAPTER 6
Investment strategy and process
Learning objectives
This chapter examines strategic issues in investment and the investment process:
• How strategy shapes investment decisions.
• Evaluating new technology and environmental projects.
• The investment decision and control process.
• Post-audit reviews.
Question summary
4. Discussion on the appropriate capital investment process for a company.
4. The capital investment process is discussed fully in the text. The main stages may be
summarised as:
(i) preliminary investigation;
(ii) detailed evaluation;
(iii) authorisation;
(iv) project maintaining;
(v) post-completion audit.
45
CHAPTER 7
Analysing investment risk
Learning objectives
For some readers, this and the subsequent two chapters on risk will be somewhat more difficult
to grasp. The main learning objectives are to:
• Understand how uncertainty affects investment decisions and that most managers are risk-
averse.
• Explore managers risk attitudes.
• Appreciate the levels at which risk can be viewed (project, business or investor’s portfolio).
• Be able to measure the expected NPV and its variability.
• Appreciate and apply the main risk-handling techniques in capital budgeting problems.
Question summary
5. Mikado plc requires the calculation of a break-even NPV and a sensitivity analysis in
graphical form.
6. Devonia (Laboratories) Ltd provides more practice in basic project appraisal plus the
calculation of the expected net present value.
7. Plato Pharmaceuticals Ltd involves sensitivity analysis and key assumptions.
8. Tigwood Ltd is a more comprehensive question on risk analysis involving sensitivity

analysis.
9. Zedland covers many of the issues included in earlier chapters (e.g. taxation and inflation).
The second part centres on a discussion on Monte Carlo simulation in assessing investment
risk.
5. Mikado plc
(a) Annual sales 6,000 × (£60 – £36) = £144,000
Additional fixed costs £50,000
Annual benefit £94,000
46
1
Discount factor: = 0.89 Yr 1
(1.125) n
0.79 Yr 2
0.70 Yr 3
0.63 Yr 4
Present value of annuity
4 yrs at 12.5% 3.01
NPV = £94,000 × 3.01 – £180,000 = £102,940
(b) Break-even analysis
The present value of benefits can fall to £180,000
(the cost of the investment) to give zero NPV.
i.e. £180,000/3.01 = £59,800 cash receipts each year.
A deterioration of £94,000 – £59,800 = £34,200
Fixed costs can increase by £34,200 or 68.4%
Selling price:
Break-even contribution = £50,000 + £59,800 = £109,800
Selling price can fall by £34,200 or £5.70 a unit, a decline of 9.5%
Variable cost would increase by £5.70 a unit (15.8%)
Volume can decrease by (£144,000 – £109,800)/£24 = 1,425 units or 23.7%
6. Devonia (Laboratories) Ltd
(a) Expected cash flows (£)

Year
0 1 2 3 4
Sales revenue (see note) 266,000 266,000 266,000 266,000
Labour (13,300 × £8) (106,400) (106,400) (106,400) (106,400)
Ingredients (13,300 × £6) (79,800) (79,800) (79,800) (79,800)
Redundancy costs (10,000)
Overheads (15,000) (15,000) (15,000) (15,000)
Sales of equipment (85,000) 35,000
Sale of patent rights (125,000)
(210,000) 64,800 64,800 64,800 89,800
Discount factor 12% 1.00 0.89 0.80 0.71 0.64
Expected NPV (210,000) 57,672 51,840 46,008 57,472
+2,992
Note : Expected annual sales = (11,000 × 0.3) + (14,000 × 0.6) + (16,000 × 0.1)
= 13,300 units
Sales revenue = 13,300 × £20 £266,000
47
(b) Devonia’s expected net present value is positive, which suggests that the new product
should be produced as it will increase shareholder wealth. However, the expected NPV is
fairly low and a relatively small downward adjustment to forecast sales demand or the
forecast sales price could produce a negative figure. It should also be recognised that there
is a 30% chance that the sales will be much lower, giving a negative NPV. Would the
company be able to withstand this possible eventuality? The validity of the forecast figures
should, therefore, be checked carefully before proceeding. In addition, any negative effects
arising from the sale of the patent rights to a major competitor should be taken into account,
if they exist.
(c) The expected net present value approach gives a single figure outcome upon which
decisions concerning acceptance or rejection of a project can be based. It is a convenient
way of dealing with the problems of risk and uncertainty as it provides a clear usable result.
However, this method does have certain drawbacks. It represents an average figure, which
may not be capable of occurring. When employing averages there is a risk that important
information will be obscured. The expected value method assumes it is possible to identify
each possible outcome relating to a project and to assign appropriate levels of probability to
each outcome. This may be difficult to do in practice. Given the information available, it is
also advisable to calculate standard deviation of the project’s NPV to gain a clearer measure
of the uncertainty involved.
7. Plato Pharmaceuticals Limited

(a) Annual operating cash flows
£000 £000
Sales (150,000 × £5) 750
Less
Variable costs (150,000 × £3) 450
Fixed costs 160 610
140
NPV
Annual cash flows (£140,000 × 3.60) 504
Residual value of machinery and equipment
(£100,000 × 0.57) 57
561
Less: initial outlay 520
NPV 41
(b) Sensitivity analysis
(i) If the discount rate was 18%, the NPV of the project would be:
£000
Annual cash flows (£140,000 × 3.13) 438.2
Residual value of machinery and equipment (£100,000 × 0.44) 44.0
_____
482.2
Less: initial outlay 520.0
NPV (37.8)
48
By interpolation we can derive the IRR

12% + [41/(41 + 37.8) × 6%]
= 15.1% (approximately)
This represents an increase of 26% on the cost of capital figure given in the question.
(ii) The increase required to the initial outlay, to make the project no longer viable, will be
equal to the NPV of the project (i.e. £41,000). This represents an increase of 7.9% on the
initial outlay figure given in the question.
(iii) Change in the net cash flows from operations necessary to make the project no longer
viable:
Let C = the annual operating cash flows
(C × annuity factor for a five-year period) – NPV = 0
which can be rearranged:
(C × annuity factor for a five-year period) = NPV
C × 3.60 = £41,000
C = £41,000/3.60
C = £11,389
This represents a decrease of 8.1% on the estimated cash flows.
(iv) Change in the residual value to make the project no longer viable:
Let R = the required residual value
(R × discount factor at end of five years)
– NPV of project = 0
which can be rearranged:
(R × discount factor at the end of five years) = NPV of project
R × 0.57 = £41,000
R = £41,000/0.57
R = £71,930
This represents a fall of 28.1% in the estimated residual value of the machinery and
equipment.
(c) Sensitivity analysis considers the key factors influencing an investment project to see by
how much the estimated figures used must change before the investment ceases to be viable
(i.e. produce an NPV of zero). It is a simple form of risk analysis, which helps managers to
gain a ‘feel’ for the downside risk associated with a project. It helps them to identify, which
of the key factors are most sensitive to change and this information can be used as a basis
for control.
Sensitivity analysis is a static form of analysis. It involves the examination of only one
factor at a time while all others are held constant. More sophisticated forms of simulation
would be required to cope with simultaneous changes in two or more factors. Sensitivity
analysis does not give managers an indication of the probability of a change in a key factor
arising. To make an informed decision, managers need to know both the degree to which a
factor must change to affect the viability of the project and the likelihood of that change
occurring.
Sensitivity analysis does not provide managers with clear decision rules concerning whether
to accept or reject a proposed project. Thus, no single figure outcome is provided, as with
49
certain other methods of risk analysis. Managers must rely on judgement, and different
managers may interpret the results of sensitivity analysis differently.
(d) On the basis of the calculations in (a) above, the NPV of the project is positive. This
indicates the project should be accepted as it would result in an increase in shareholder
wealth. The sensitivity analysis undertaken in (b) above reveals that the percentage change
in the discount rate and residual value would have to be substantial before the project ceased
to be viable. The percentage changes to the initial outlay and the annual operating cash
flows, however, would have to be much smaller before the project ceased to be viable.
Nevertheless, this does not suggest that the project should be rejected. Subject to additional
information concerning the range of possible outcomes or the likelihood of changes
occurring to the key factors, the project should go ahead.
8. Tigwood Ltd
(a) Microbooks project analysis
Assumptions and workings
• Life of project: 6 years
• Market research is a sunk cost
• Cost of finance is accounted for in the discount rate
• Variable costs per unit:
Copyright £3.95 × 20% = £0.79
Purchases £1.50 × 40% = £0.60
Additional variable costs = £0.20
£1.59
• Sales each year 1.5 million units
Year 0 1–6
£000 £000
Outlay (1,500)
Sales (1.5m × £2) 3,000
Variable (1.5m × £1.59) 2,385
Taxable cash flow 615
Taxation (35%) 215
(1,500) 400
Discounting at 8%, the expected NPV is:

(£1,500) + (£400 × 4.623) = £349.2 or £349,200
where 4.623 is the present value interest factor of an annuity (PVIFA) for 6 years at 8%.
The project is wealth-creating.
(b) A number of potential discount rates are listed, probably to seek to confuse the student!
Because cash flows are expressed in real terms, without inflation adjustment, the real
weighted average cost of capital of 8% is probably most relevant. (Cost of capital is
discussed in a later chapter so we will not expand on this issue here).
50
(c)
(i) In sensitivity analysis, all variables except the one under consideration are held constant,
and an estimate is made of the value for the variable under consideration that produces a net
present value of zero.
Initial outlay: As the present value of net cash inflows is £1,849.2, the value of the initial
outlay would have to be £1,849.2 to result in a zero NPV.
349.2
This represents a change of × 100% = 23.28%
1500
Contribution: The zero NPV annual contribution can be estimated by solving the following
equation for x (the zero contribution):
–1,500 + (0.65) 4.623x = 0
NB (0.65) is the after-tax cash flow that is dependent upon the unknown contribution.
Solving 3.005x = 1,500, x = £499.16, which is the zero NPV annual contribution.
The present annual contribution is £615, so this represents a decline of:
115.84
× 100% = 18.83%
615
Life of agreement: The zero-NPV life has a present value of annuity factor at 8% of:
–1,500 + 400x = 0, x = 3.75
From the annuity table:
PV annuity for four years is 3.312
PV annuity for five years is 3.993
Extrapolating, the zero-NPV life is
3.75 − 3.312
4 years + × 1 year = 4.643 years
3.993 − 3.312
This is a reduction of 1.357 years or 22.61%.
Discount rate: The zero-NPV rate is where the present value of a six-year annuity of 400 is
zero.
Solving, –1,500 + 400x = 0, where x is the required rate
x = 3.75
From the present value of annuity tables, 15% has a PV annuity factor of 3.784, and 16% a
factor of 3.685.
Extrapolating, the zero-NPV rate is
3.784 − 3.75
15% + × 1% = 15.34%
3.784 − 3.685
7.34
This represents a change of = 91.75%.
8
51
Sensitivity analysis suggests that the decision is most sensitive to a change in the annual
contribution. The analysis does not, however, establish how sensitive the decision is to the
sales price alone, or any of the elements of variable costs.
(ii) Sensitivity analysis has several limitations:
(i) There is no measure of the probability of changes in any of the variables occurring.
(ii) It treats variables as if they are independent and does not consider the interrelationships
that might exist between variables.
(iii) No decision rule is implied for managers. Managers do not know whether their
decisions should be altered because of the level of sensitivity of a variable.
(d) Further information might include:
(i) How accurate are the estimated cash flows?
(ii) What is the effect of inflation on the cash flows?
(iii) What is the risk of the project?
(iv) Is the agreement likely to be renewed after six years?
(v) If successful, can it be extended to more books?
(vi) Is it possible to obtain patent protection on the microbooks?
9. Zedland postal service proposal

(a) The question asks for a report. This is not provided here but the main points to cover are:
(i) The government normally expects nationalised industries to earn an average after-tax
return of 5% on average investment and break-even in net present value terms.
(ii) This proposal achieves a 17.6% return on investment, but a negative NPV of $162,000.
(iii) Consideration should be given to:
• pricing, depending on the price elasticity of demand (presumably it has a monopoly);
• cost-reduction opportunities;
• whether the risk is similar to that of the rest of the business. If not, the discount rate
needs reconsideration.
• Is a five-year planning horizon appropriate?
Notes
1. Sales = daily sales × 260 days × rate. The result is then adjusted for inflation at 5% p.a.
2. Because, all cash expenses are subject to inflation at 5% p.a., it is convenient to calculate
total expenses on the basis of current prices and then adjust the annual total for inflation.
52
($000)
Year 1 2 3 4 5
Wages 2,340 2,340 2,340 2,340 2,340
Premises 150 150 150 150 150
Running costs: Vans
$2,000 × 100 + 20% from Yr 2 200 240 288 345 414
Trucks 80 96 115 138 166
Advertising 500 250
3,270 3,076 2,893 2,973 3,070
Inflation adjustment 1.05 (1.05)2 (1.05)3 (1.05)4 (1.05)5
Expenses 3,433 3,391 3,349 3,614 3,918
3. It is assumed that the whole postal service makes profits in excess of $500,000. All
incremental income is therefore taxed at 40%.
4. Market research is a sunk cost.
5. The salaries of the five managers are payable regardless of this proposal.
Incremental cash flows ($000)

Year 1 2 3 4 5 6
Sales: Letters(1) 2,048 2,867 3,010 3,160 3,318

Parcels 682 1,075 1,129 1,185 1,244
2,730 3,942 4,139 4,345 4,562
Expenses(2) (3,433) (3,391) (3,349) (3,614) (3,918)
Pre-tax cash flows (703) 551 790 731 644
Taxation(3) 374 (127) (223) (200) (165)
(703) 925 663 508 444 (165)
Discount factor 14% 0.877 0.769 0.675 0.592 0.519 0.456
Present values (617) 711 448 301 230 (75)
PV future cash flows 998
Initial cost (1,160)
NPV (162) i.e. ($162,000)
Pre-tax cash flows (703) 551 790 731 644
Depreciation (232) (232) (232) (232) (232)
Taxable profit (935) 319 558 499 412
Taxation 374 (127) (223) (200) (165)
Post-tax profit (561) 192 335 299 247
(561) + 192 + 335 + 299 + 247

Average annual profit = = $102,000
5
Average investment = 1,160/2 = $580,000
102,000
Annual after-tax return on investment = = 17.6%
580,000
53
CHAPTER 8
Identifying and valuing options
Learning objectives
By the end of the chapter, the reader should possess a clear understanding of:
• The basic types of options and how they are employed.
• The main factors determining option values.
• How option values can be estimated.
• How option values can be used to reduce risk.
• The various applications of options theory to investment and corporate finance.
• Why conventional net present value analysis is not sufficient for appraising projects.
Question summary
4. This question examines the factors underlying option pricing.
5. Marmaduke plc is an exercise in assessing option profit performance.
11. Enigma Drugs plc is an exercise in identifying various types of option.
4. Factors influencing the price of a traded option:

• Underlying share price. For a call option, the greater the share price, the greater the
option value. Where the share price is below the exercise price of the call option, the
option will have no intrinsic value, but will have a time value.
• Time to expiry. For a call option, the longer the time to expiry, the greater the present
value of the option because it gives greater opportunity for the share price to reach the
exercise price.
• Risk-free interest rate. The higher the interest rate, the lower the present value of the
exercise price and the greater the value of a call option.
• Volatility in underlying share price. Options on shares that are stable are worth less than
on shares that are highly volatile.
Volatility of a company’s share-option price is not necessarily a sign of financial weakness. It

suggests that the market’s view on the above factors influencing the option price is unclear.
54
5. Marmaduke plc
Pence
Current share price 135
Exercise price 120
Profit on exercise 15
Less premium 10
Profit 5
(a/b) The profit on 100 shares is £15 on exercise, or £5 after deducting the premium. The option
should therefore be exercised.
(c) Had he invested £10 (i.e. 100 × 10p premium) for 6 months in a bank offering 10% p.a. the
interest would be £10 @ 5% = 50p
The option therefore gives a 10-fold greater return.
11. Enigma Drugs plc
This mini-case incorporates five options. Take another look at the case to identify the type
of option, its length and exercise price. Recall that American options offer the holder the
right to exercise at any time up to a certain date, while a European option is exercised on
one particular date. The solution to this is given below. The order of the options follows
those in the case.
Enigma Drugs plc options
Option Type Length Exercise price
To the company:
Investment timing American call 2 years £50m investment outlay
Abandonment American put 5 years Resale value of ‘know-how’
Follow-on project European call 4 years £120m investment
Default on loans European call 8 years £40m face value of the loan
To the loanstock holder:

Convertible loan American call 4 years 360p
55
CHAPTER 9
Relationships between investments: portfolio

theory
Learning objectives
A basic axiom of life is ‘do not put all your eggs into one basket’. The chapter is designed to
explore the financial equivalent of this maxim. In particular, it aims to:
• Give the reader an understanding of the rationale behind the diversification decisions of
both shareholders and companies.
• Illustrate the mechanics of portfolio construction with a user-friendly approach to statistics

using several numerical examples.
• Emphasise that optimum portfolio selection is a matter of personal choice.
• Examine the drawbacks of portfolio analysis as an approach to project appraisal.
A good grasp of the principles of portfolio analysis is an essential underpinning to understanding

the Capital Asset Pricing Model covered in Chapter 10.
Question summary
5. Gawain plc. This question requires the construction of a two-asset portfolio to achieve a
targeted expected return, calculation of the correlation between the two assets and the effect
of portfolio formation on company risk.
5. Gawain plc
(a) Project A
Expected return = (0.3 × 0.27) + (0.4 × 0.18) + (0.3 × 0.05)
= 0.081 + 0.072 + 0.015
= 0.168 i.e. 16.8%
Project B
Expected return = (0.3 × 0.35) + (0.4 × 0.15) + (0.3 × 0.20)
= 0.105 + 0.06 + 0.06
= 0.225 i.e. 22.5%
56
To achieve an expected return of 20%

Let α = % weighting in A
(1 – α) = % weighting in B
0.20 = α ERA + (1 – α) ERB
0.20 = α (0.168) + (1 – α) (0.225)
0.20 = 0.168α + 0.225 – 0.225α
Hence,
−0.025 = −0.057α
0.025
α = = 0.44
0.057
Therefore, 44% of the portfolio should be invested in Project A and 56% in Project B.
(b) Portfolio risk = α 2σ 2

A
+ (1 − α ) 2 σ 2
B
+ 2α (1 − α )σ AB
where σAB = rAB σA σB

σ AB
hence, rAB =
σ Aσ B
Standard deviations
Weighted
Outcome Deviation Squared squared
(%) from ER deviation Probability deviation
Project A 27 +10.2 104.04 0.3 31.21
18 +1.2 1.44 0.4 0.58
5 –11.8 139.24 0.3 41.77
= 73.56
σA = 73.56 = 8.58
Project B 35 +12.5 156.25 0.3 46.88
15 –7.5 56.25 0.4 22.50
20 –2.5 6.25 0.3 1.88
= 71.26
σB = 71.26 = 8.44
Covariance
Product of Weighted
RA RB (ERA–RA) (ERB–RB) deviations Probability product
27 35 +10.2 +12.5 127.5 0.3 +38.25
18 15 +1.2 –7.5 –9.0 0.4 –3.60
5 20 –11.8 –2.5 29.5 0.3 +8.85
Covariance = +43.50
Correlation coefficient 43.5 = +0.60

=
(8.58) (8.44)
57
The risk of the new project is thus:
σ p = (0.44) 2 (8.58) 2 + (0.56) 2 (8.44) 2 + 2(0.44)(0.56)(43.50)

= (14.25) + (22.34) + (21.44)
= 58.03 = 7.62 i.e. 7.62%
(c) Any new configuration of activities would involve a 50% weighting for existing operations
and 50% for the new venture (whatever the combination of projects A and B). Given the
standard deviation of existing operations of 10%, the new venture appears to lower the
overall risk of Gawain. The extent of the risk reduction would depend on the correlation
between the parent and the new venture. For illustration, if we assume the relevant
correlation coefficient is 80%, the risk of the expanded operation becomes:
δ p = (0.5) 2 (10) 2 + (0.5) 2 (7.62) 2 + 2(0.5)(0.5)(10)(7.62)(0.8)

= 25 + 14.52 + 30.48
= 70 = 8.37
Obviously, the lower the correlation, the lower will become the risk of the expanded
enterprise.
58
CHAPTER 10
Setting the risk premium: The Capital

Asset Pricing Model
Learning objectives
The chapter deals with the rate of return required by shareholders in an all-equity financed
company by extending the treatment of portfolio theory to the analysis of the Capital Asset
Pricing Model (CAPM). Its specific aims are to:
• Explain what type of risk is relevant for valuing capital assets.
• Explain what a ‘Beta coefficient’ is.
• Enable the reader to determine the appropriate risk premium to incorporate into a discount
rate.
• Question whether corporate diversification is always desirable.
• Examine some criticisms of the CAPM.

An understanding of the significance of Betas is particularly important in appreciating how a
financial manager should view risk. Betas will reappear in later chapters!
Question summary
7. Z plc. This question requires an assessment of the advantages and disadvantages of a

particular portfolio held by a company wishing to finance future investment.
7. Z plc
Observations on the portfolio

• Over 44% in UK equities, 62% in UK and US equities – a high proportion for a
company that may need to liquidate its holdings in the short term.
• The average Beta of the UK component is 1.5, possibly inflated by the AIM
(Alternative Investment Market) shares. Suggests a high level of risk, i.e. exposure to a
falling market.
• The portfolio is an unbalanced mixture of equities and short-term marketable securities.
• US stocks give rise to exchange-rate risk, although if the expansion is to take place in
the United States, then this may provide a hedge.
59
• The high average return in the past year is unlikely to be repeated in future years or so
the Efficient Market Hypothesis would argue.
The conventional wisdom is that equities will show a higher return than government
securities in the long term, but will be subject to wider fluctuations. This means there is a
danger that, when an investors wish to liquidate their holding, the prices could be at the
bottom of the range. Hence, as one draws near the time when the funds are required for
some specific purpose, the advice is to move into the less volatile securities. However, with
the expansion still up to two years away, it is perhaps too early to be in marketable
securities such as the government debt and three-month bonds.
Over the last 12 months, the return on the specific equities held by Z plc has been greater
than that on their respective markets. On the surface, this was beneficial but those who
believe that markets are efficient would suggest that this higher return must imply greater
uncertainty, reinforcing the point made in the previous paragraph. If this is the case, was it
deliberate policy on the part of the Z plc treasury?
If the proposed expansion is in the United States or countries whose currencies move in line
with the dollar, then the investment in US equities could be said to provide something of a
hedge against the fall in the dollar/sterling rate. Otherwise, it could be said to have opened
up an exchange-rate risk.
60
CHAPTER 11
The required rate of return on

investment
Learning objectives
This chapter applies the models developed in earlier chapters to the issue of measuring the
required rate of return on investment projects. After reading it, the reader should:
• Understand how the DGM (Dividend Growth Model) is used to set the hurdle rate.
• Understand how the CAPM (Capital Asset Pricing Model) is also used for this purpose.
• Be able to apply the required rate of return to firm valuation.
• Appreciate that different rates of return may be required at different levels of an organisation.
• Be aware of the practical difficulties in specifying discount rates for particular activities.
• Appreciate how taxation may influence discount rates.
Question summary
7. PFK plc. This question requires calculation of the risk–return characteristics of a proposed
diversification project, and assessment of the impact of accepting it on the parent
company’s risk profile.
7. PFK plc
(a) Expected IRR = (0.2 × –5%) + (0.3 × 8%) + (0.3 × 12%) + (0.2 × 30%)
= (1% + 2.4% + 3.6% + 6%
= 11%
Standard deviation:
Squared Weighted
Outcome Prob ER Deviation deviation by
probability
–5 0.2 11 –16 256 51.2
8 0.3 11 –3 9 2.7
12 0.3 11 +1 1 0.3
30 0.2 11 +19 361 72.2
Variance = 126.4
St. dev. = 11.24%
61
(b) (i)
σ p = (0.75) 2 (20) 2 + (0.25) 2 (11.24) 2 + 2(0.75)(0.25)(40)

= 225 + 7.9 + 15
= 247.9 = 15.75
i.e. total risk = 15.75%, reduced from 20%
cov jm 120 120
(ii) β j = = = = 0.83
122 144
σ 2
m
(iii) New Beta

= (¾ × existing Beta) + (¼ × Beta of project)
0.83 = (¾ × 1.05) + (¼ × Beta of project)
 0.83 − 0.7875 
Beta of project =   = 0.17
 0.25 
(iv) ER = 5% + 0.17 [10% – 5%] = 5.85%
(c) The new project lowers the total risk and the overall company Beta. This might please a
highly risk-averse shareholder, but as investors are able to achieve their desired risk/return
combinations by portfolio formation, some may resent the company’s interference with
their preferences.
62
CHAPTER 12
Enterprise value and equity value
Learning objectives
The ultimate effectiveness of financial management is judged by its contribution to the value of
the enterprise. The chapter aims to:
• Provide the reader with an understanding of the main ways of valuing companies and
shares, and the limitations of these.
• To stress that valuation is an imprecise art, requiring a blend of theoretical analysis and
practical skills.
A sound grasp of the principles of valuation is essential for many other areas of financial
management.
Question summary
1. Amos Ltd. This question involves simple valuations of an unlisted company in a trade sale
using various approaches.
2. Rundum plc. This question requires valuation of a take-over target, again using a variety of
approaches.
4. Vadeema plc. This question involves valuation of a company operating in the pharmaceutical
sector, where valuations are notoriously difficult.
1. Amos Ltd
(i) Book value = £670,000 or £1.34 a share since there are 500,000 shares issued.
63
Pike and Neale, Corporate Finance and Investment, 6th edition, Instructor’s Manual
(ii) Current value:

£
Premises 780,000
Equipment 50,000
Investments 90,000
Debtors 108,000
Stock 85,000
Bank 25,000
1,138,000
Less Creditors (65,000)
Dividends (85,000)
Loan (85,000)
903,000 = £1.806 a share
2. Rundum plc
(a) Net assets from the accounts are £6.6m, allowing for both short- and long-term debt.
However, the debtors and stocks figures are suspect.
‘Realistic’ value of debtors
= £3.0m – [l/3 × £3m × 50% chance of payment]
= £2.5m
‘Realistic’ value of stocks
= £1.5m – [½ × £1.5m] + £50,000
= £0.8m
These adjustments reduce the NAV to £5.4m
(b) A weighted average ‘surrogate’ P:E ratio for Carbo would be
(50% × 8) + (50% × 12) = 10 (10:1)
Earnings are £2.0m [1–33%] post tax = £1.34m
(ignoring any stock or debtors write-off)
However, if the existing MD was paid off, earnings after tax would increase by
£60,000 (1–33%) = £40,200
Adjusted earnings would be [£1.34m + £0.0402m] = £1.3802m
Applying a 10:1 P:E ratio, this yields a value of
[10 × £1.3802m] = £13.802m
Adjusting for the MD’s pay off, this reduces to £13.602m, say £13.6m.
64
4. Vadeema plc
(a) (i) Net asset value
• From the accounts, the basic NAV = £205m.
• Adjustments
(i) revaluation surplus (£65m – £50m) = £15m
(ii) patent = (£20m)
(iii) discount on outstanding work in progress (WIP) for which no contract signed, say
(£40m)
= (£40m)
Net adjustments = (£45m)
Adjusted NAV = (£205m – £45m) = £160m
(ii) Price: Earnings ratio
With no adjustments:
Current sales = £300m
Operating profit margin (£300m × 25%) = £75m

(assuming depreciation all tax-allowable)
Interest (20 × 12% + 40 × 10%) (£10 m)
Tax @ 33% = (£21.45m)
Profit after tax = £43.55
Value of equity = P:E ratio × PAT
= 20 × £43.55 = £871 m
(using the current P:E for Vadeema, this is the current market capitalisation of the company)
Adjustments:
Sales volatility
• reduce sales to mid-range i.e. £250m
Patent expiry
• assume lose half of protected sales
i.e. 50% × 20% × £250m = (£25m)
Adjusted sales = £225m
Operating profit margin @ 25% = £56.25m
Interest (20 × 12% + 40 × 10%) (10 m)
Tax @ 33% = (£15.25m)
Profit after tax = £31m
65
Value of equity = P:E ratio × PAT

 22 + 14 
= Average   = 18 × £31m = £558m
 2 
(iii) Discounted cash flow
Use maintainable profits from above i.e. = £56m
Add back depreciation (£5m + £25m) = £30m
Deduct taxation = (£15m)
Deduct replacement capex = (£5m)
Free cash flow before interest = £66m
Using the perpetuity formula (and assuming discount rate reflects required return for all
providers of capital-see Chapter 18)
1
Value of enterprise (EV) = £66m × = £330m
20%
Value of equity = EV − debt (overdraft + loan stock) = 330 − (20 + 40) = £270m
For a more ‘realistic’ life span, say ten years:
Value of enterprise = £66m × PVIFA20,10
= £66m × 4.1925
= £276.7m
Value of equity = 276.7m – 60 = £216.7m
(c) There is no such thing as a ‘correct’ valuation. The market can only take a view on the long-
term prospects of a company in conjunction with the information provided by the directors.
There are various reasons why Vadeema is difficult to value:
• Volatile sales.
• The uncertain impact of the patent expiry.
• The development programme has an uncertain outcome, in terms of both the results
obtained and also whether clients will take up options.
• Pharmaceutical companies are notoriously cash-hungry when developing prospective
‘winners’.
• The development programmes can be knocked off-balance by departure of key
personnel – it takes time to build up an effective research capability.
• Directors of these companies are often sparing in their release of information to the
market for understandable commercial reasons.
• Due to insufficient expertise of their own, market professionals often fail to fully
understand the significance of information when it is released.
For these reasons, valuation of a company like Vadeema is largely a guesswork, which helps
explain why market values of such companies are so volatile.
66
CHAPTER 13
Treasury management and working capital policy
Learning objectives
The reader should, after reading the chapter, appreciate the following:
• The purpose and structure of the treasury function.
• Treasury funding issues.
• How to manage banking relationships.
• Risk management, hedging and the use of derivatives.
• Working capital policies.
• The cash operating cycle and overtrading problems.
Question summary
1. The question debates the pros and cons for a company of centralising/decentralising the
finance function.
2. A simple question asking the student to identify interest-rate risks and suggest two possible
hedging instruments for their reduction.
3. ABC plc examines the responsibilities of a treasury department and the merits and
drawbacks of establishing it as a profit centre.
4. Addresses issues concerning prediction of corporate failure and appropriate response to
such detection.
5. Delcars plc defines the working capital cash cycle and examines the effect of a specific
working capital management proposal.
7. Micrex Computers Ltd analyses a number of ratios to examine the overtrading problem.
1. See Section 13.2 in text and also answer 7(c) below
2. See Section 13.6 in text (pp 324—334)
3. ABC plc
(a) Treasury management is ‘the corporate handling of all financial matters, the generation of
external and internal funds for business, the management of currencies and cash flows, and
67
the complex strategies, policies and procedures of corporate finance’ Chartered Institute of
Management Accountants (CIMA). The main responsibilities of such a department in a
service-based multinational company are likely to include the following:
Policy – It will make a significant contribution to the definition of corporate financial
objectives, including strategies, policies and systems.
Liquidity management – Ensuring that the company has the liquid funds it needs and that it
invests any surplus funds. This will involve:
• Managing working capital and the transmission of funds within the group;
• Maintaining banking relationships and arrangements for short-term borrowings and
investments;
• Money management.
Funding management – Funding policies and procedures, and the sources and types of funds
to be used.
Currency management –
(i) Exposure policies and procedures;
(ii) Exchange dealing, including futures, options and derivative products;
(iii) International monetary economics and exchange regulations.
Corporate finance decisions such as the following:
• Dividend policy
• Equity capital management
• Mergers, acquisitions and divestments
• Financial information for management
• Project finance
• Corporate taxation
• Risk management and insurance
• Pension fund investment management.
The benefits of a separate centralised treasury function are likely to include the following:
(1) Centralisation of cash surpluses means that larger amounts are available for short-term
investment, thus giving better investment opportunities.
(2) Liquidity management can be improved by allowing bulk cash flows and therefore lower
bank charges, and by avoiding the proliferation of small local surpluses and overdrafts.
(3) Borrowings can be arranged in bulk at lower interest rates than for smaller amounts.
(4) A specialist department can employ experts with knowledge and experience of
corporate treasurership, derivative products and so on.
(5) The centralised precautionary balance is likely to be lower than the sum of the local
precautionary balances.
(6) Foreign currency risk management is likely to be improved because it will be possible
to match receipts and payments made in a given currency across all the subsidiaries.
68
(b) The benefits of operating a separate treasury department as a profit centre include the
following:
• Some companies, particularly those with a high level of foreign exchange transactions,
may be able to make significant profits from their treasury activities.
• Recognition of the department as a profit centre may allow the company to introduce an
element of performance-related pay, should it wish to do so.
The possible disadvantages of operating the treasury department as a profit centre include
the following:
• Operating the department as a profit centre may encourage a more aggressive attitude to
risk which may be difficult to reconcile with the directors’ requirements. In addition, it
means that a good system of controls must be in place to prevent speculation.
• It is difficult to set prices to be charged for the treasury service to other departments. It
may be difficult to put realistic prices on some services such as the arrangement of
finance or general financial advice. If the charges are viewed as too high by the
subsidiaries, they may be tempted to seek outside advice instead and thus the
advantages of a centralised treasury function will be lost.
• Even with a profit centre approach it may be difficult to measure the success of a
treasury department because successful treasury activities sometimes involve avoiding
the incurring of costs. For example, a successful currency hedge during a period of
strong currency movements may prevent the company from incurring a substantial loss.
4. See Section 13.8 in text
5. Delcars plc
(a) The working capital (or operating) cycle is the length of time between when a business
makes payments to its suppliers for raw materials and goods entering into stock, and when
the business receives payment for those resources from its customers. The number of days
in the cycle is equal to:
Debtor days or debtor collection period + Stock days or stockholding period(s) (i.e. Finished
goods + Work in progress + Raw materials) – Creditor days or supplier payment period.
For example, if analysis of the company’s financial statements revealed the following
statistics:
Days
Debtors 45
Finished goods 15
Work in progress 25
Raw material stocks 20
Creditors 50
Working capital cycle = 45 + (15 + 25 + 20) – 50 = 55 days
The number of days in the cycle represents the length of time for which the business
requires funding for working capital if it is to continue trading. As the length of the cycle
increases, the amount of working capital required by the business also increases. Working
capital may be funded from either long-term or short-term sources of finance, but as a
69
general rule it is argued that ‘permanent’ working capital should be paid for by long-term
sources and ‘temporary’ working capital by short-term sources. Debentures are an example
of a long-term source of funds, and an overdraft facility is an example of a short-term
source.
The significance of the cycle for working capital management lies in the fact that if a
company can reduce the length of the cycle, it can lower its funding needs, and this can in
turn increase the potential return on capital employed (ROCE). The length of the operating
cycle can be reduced in a number of ways, which vary from the very simple to the
sophisticated. The use of tight credit controls, just-in-time stock management and debt
factoring are various examples of ways in which the cycle can be reduced.
(b) Annual sales £25m, split as follows:
New vehicles (60%): £15m
Second-hand vehicles (25%): £6.25m
Servicing (15%): £3.75m
Second-hand vehicle sales:
Weekly value: £6.25m/52 = £120,192
Daily value: £120,192/6 = £20,032
Daily overdraft cost = 8.5%/365
The cost of not banking receipts can be calculated daily, with the maximum delay equalling
four days (e.g. for sales made on Tuesday but not banked until the following Monday.) The
total delay (in days) in any one week is thus equal to:
Sales Delay
Monday Nil
Tuesday 4 days
Wednesday 3 days
Thursday 2 days
Friday 1 day
Saturday Nil
Total: 10 days
Weekly cost of delay = 10 × £20,032 × 8.5%/365 = £46.65

Annual cost of delay = £46.65 × 52 = £2,426
Using the same approach, to calculate the cost of delayed banking of receipts from vehicle
servicing:
Weekly sales value: £3.75m/52 = £72,115
Daily sales value: £72,115/6 = £12,019
Total banking delay (in days):
Sales Delay
Monday 2
Tuesday 1
Wednesday Nil
Thursday 1
Friday Nil
Saturday 2
Total: 6 days
70
Weekly cost of delay = 6 × £12,019 × 8.5%/365 = £16.80

Annual cost of delay = 52 × £16.80 = £874
Total cost of delays in banking both sets of receipts = £2,426 + £874 = £3,300
Note
The calculation assumes that Delcars plc are operating on an overdraft on every working
day of the year, and hence the sooner the money is banked, the greater will be the associated
interest saving. In practice, it is likely that the level of overdraft will vary throughout the
year, and when the account is in credit, the company will gain no interest-saving benefit
from faster banking of the receipts.
(c) Management of the banking side of a business’s operation is just one of the functions of the
treasury department. Treasury is also responsible for the raising of short- and long-term
finance for a business, the control of cash and investment of cash surpluses, foreign
currency risk management, management of capital investment procedures and organising
insurance for company assets. When treasury activities are centralised, these activities
become the sole responsibility of the central unit, and local divisions of a business simply
hold cash for day-to-day transactions and do not get involved in raising finance, hedging
foreign exchange risk, and so on. The primary need is to maximise overall corporate profit.
This means, for example, that if one dealership is currently running a cash surplus, and all
surpluses come back to the central treasury, the treasury can then use that money to fund
any of the dealerships which may be running a cash deficit. In this way, the need to look for
external funding is reduced or eliminated. Consequently, it is argued, centralised
treasurership can save a company’s money via reduced borrowing requirements and lower
bank charges. Lower bank costs may also be available via the use of the central department
to negotiate finance when required. If, for example, a dealer wishes to acquire and develop a
new retail site and if the organisation were decentralised, the funding terms would be
negotiated between the individual dealership and the local bank. If all funding requirements
are dealt with via the central treasury, it is likely that the terms available will be preferable
because the overall account will be larger, and the company regarded as a more ‘important’
bank customer.
A secondary benefit of centralisation is the elimination of the need for each element within
a group company to employ staff with treasury skills. This reduces duplication, and should
work to raise the overall standard of treasury provision as the skills and experience of the
centre’s staff are likely to be greater than those of the staff working in smaller individual
divisions.
For some businesses which buy/sell in foreign markets, the role of central treasury in
managing the process of hedging foreign exchange risk can be very important. Delcars are
unlikely to require such hedging, but if they were, then a central department could offer the
advantage of expertise that is often scarce at a local level.
The main disadvantage of centralisation of treasury activities is that it can lead to slower
decision-making, and as a result, the potential loss of local market advantage. If a local
manager wishes to obtain funds to buy assets, for example, second-hand car stock, he may
have to put a business case to head office to obtain the funds. In the time taken to process
the application, the buying opportunity may disappear, and with it the opportunity to
increase profit. At the same time, many writers would argue that the independence of local
management is important for good performance, because responsibility serves to motivate
staff. Giving responsibility to the centre can simply demotivate staff, while at the same time
eradicating the detailed understanding of local conditions.
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There is no clear-cut answer as to whether centralised or decentralised treasury functions are

preferable. The choice is ultimately dependent on the specific needs of the individual
company.
7. Micrex Computers Ltd
(a) Overtrading and its consequences
Overtrading arises where the capital base is inadequate for the level of operational activity.
Where a business expands rapidly, as in the case of Micrex Computers Ltd, there is a need
to increase the level of working capital and fixed assets in line with the increase in sales.
This in turn means that the business must be adequately funded by appropriate long-term
and short-term sources of finance. Failure to do this can result in difficulties in supplying
customers (as stock levels will be insufficient to meet demand) and in liquidity problems.
Liquidity problems may take various forms such as exceeding overdraft limits, failing to
pay interest on borrowings or making capital repayments on due dates, slow payment of
trade creditors and so on. Management of the business during a period of overtrading is
often reduced to reacting to particular crises as they occur which can be time consuming and
can detract managers from more profitable use of their time. At the extreme, overtrading can
result in the business having to cease trading because it does not have the cash available to
meet obligations as they arise. For a fuller discussion on overtrading problems, see Section
13.11 in the text.
(b) Causes of overtrading and remedies
Overtrading is a symptom of weak financial management of the business. It can arise in a
relatively young business, such as Micrex Computers Ltd, from a failure to foresee the
growth potential of the business and, as a result, failing to invest sufficient start-up capital to
deal with the level of demand for the products. Undercapitalisation may also occur because
the owners simply do not have sufficient resources to invest in the business and are also
unable to convince others to do so. Errors and miscalculations may also result in
overtrading. These might include: a) the failure to forecast levels of profits and cash flows
to materialise, thereby placing a strain on working capital and fixed asset requirements, b)
failure to control costs leading to a drain on liquidity and c) investment in fixed assets
without sufficient finance being in place.
To deal with the problem of overtrading, it is necessary for a business to ensure that the
permanent capital base matches the level of activity. This may mean an increase in the
equity and/or the borrowings of the business. However, when the business is unable to find
new finance it will be necessary to reduce the level of activity in line with the available
capital of the business. This is likely to mean turning away profitable opportunities to
ensure there is a long-term future for the business. It is also important to ensure that the
capital available is used as effectively and efficiently as possible. This means monitoring
fixed asset utilisation and tight control over working capital requirements.
72
(c) Ratios for detecting overtrading

Six ratios which could be used to detect symptoms of overtrading are as follows:
Sales
1. Sales/fixed assets =
Fixed assets
660,000
=
84,000
= 7.9 times
This ratio reveals that for every £1 invested in fixed assets there is £7.9 generated in sales
during the year. A very high ratio may suggest that the company has under-invested in fixed
assets for the given level of sales.
Current assets (less stock)

2. Acid-test ratio =
Current liabilities
59,000
=
105,000
= 0.6 :1
This ratio compares the liquid assets of the business with the maturing obligations. In this
particular case, it shows that the company has insufficient liquid assets to meet short-term
obligations. The company is, therefore, in a weak liquidity position.
Current assets
3. Current ratio =
Current liabilities
85,000
=
105,000
= 0.8 :1
This ratio compares the current assets with the maturing obligations. It is a further measure
of liquidity. The ratio reveals that the current assets do not cover the maturing obligations of
the company. Although this is a less stringent test of liquidity than the acid-test ratio, the
ratio helps to confirm the liquidity problems of the company.
Trade debtors
4. Average debtors payment period = × 12
Credit sales
59,000
= × 12
660,000
= 1.1 months
This ratio reveals that debtors are taking an average of 1.1 months to pay the amounts they
owe. When a company is overtrading, it may decide to reduce the debtors payment period to
a minimum to improve its cash flows.
73
Trade creditors
5. Average creditors payment period = × 12
Credit purchases
88, 000
= × 12
426, 000
= 2.5 months
This ratio reveals that the company is taking 2½ months, on an average, to pay trade
creditors. This seems to be a rather long period and may indicate liquidity problems.
Average stock
6. Average stockholding period = × 12
Cost of sales
(22, 000 + 26, 000) / 2
= × 12
422, 000
= 0.7 months
The average stockholding period is less than one month. This seems rather low and may
suggest that the company is unable to invest sufficiently in stocks so as to meet the
requirements of its customers. Too low a stockholding period can, therefore, lead to lost
customer goodwill and lost sales.
Other ratios which could be used include sales/total assets, sales/working capital and total
debt/total assets.
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CHAPTER 14
Short-term asset management
Learning objectives
Having read the chapter, the reader should have a general appreciation of short-term asset
management in corporate finance and of the basic control methods involved. Specific attention
is paid to the following:
• Managing trade credit.
• Inventory management.
• Cash management.
Question summary
5. Torrance Ltd examines the financial implications of granting additional days credit to
customers and claiming cash discounts from suppliers.
6. Keswick plc considers trade credit as a source of finance.
7. International Golf Ltd requires the preparation and analysis of a cash flow forecast.
8. Ripley plc/Bramham plc addresses financing policy and cash management policy.
5. Torrance Ltd
(a) Assessment of credit policies
Option
1 2 3
£ £ £
New debtors’ level
£630,000 × 40/365 69,041
£645,000 × 50/365 88,356
£650,000 × 60/365 106,849
Current debtors
£600,000 × 30/365 49,315 49,315 49,315
Increase in debtors 19,726 39,041 57,534
Cost of capital 15% (2,959) (5,856) (8,630)
75
Additional contribution
50% × £30,000 15,000

50% × £45,000 22,500
50% × £50,000 25,000
Increased profit 12,041 16,644 16,370
NB Contribution percentage is the percentage of selling price less variable cost to the selling
price, i.e.
(£36 − £18)
× 100 = 50%
£36
(b) Advantages of trade credit as source of finance
• Arises as part of the normal business process, that is, as customer orders increase so
does the finance received from trade creditors for purchases to fulfil such orders.
• A free source of finance provided the goodwill of suppliers is maintained.
Disadvantages of trade credit
• Excessive time to repay may result in lost goodwill with suppliers and a reluctance by
creditors to continue to supply.
• Generous cash discounts may be forgone.
(c) Annual cost of cash discounts
2.5 365
30 days: × = 46.8%
97.5 (30 − 10)
2.5 365
45 days: × = 26.7%
97.5 (45 − 10)
The cost to the firm for not taking the discount by paying within 10 days is costly – 46.8%
if paid within the terms of the invoice, or 26.7% if the company squeezes a further 15 days
beyond the agreed credit terms. This compares with a cost of capital of only 15%.
Unless the company can extend payment to above 70 days, the generous cash discount
terms should be taken:
2.5 365
× = 15.6%
97.5 (70 − 10)
Extending the credit period to over 70 days is likely to result in deterioration in customer–
supplier relationship.
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6. Keswick plc
(a)
(i) For many firms, trade creditors – suppliers of goods and services – represent the major
component of current liabilities, the amounts owed by the company which have to be repaid
within the next accounting period. Together with current assets – cash, stock and debtors –
current liabilities determine the firm’s net working capital position, that is, the net sum it
invests in working capital.
Different suppliers will operate different credit periods, but the average trade credit period
in days can be calculated as follows:
Trade creditors/Credit purchases × 365
Sometimes it is expressed in terms of total purchases and sometimes in terms of overall cost
of sales. The length of the trade credit period depends partly on competitive relationships
among suppliers and partly on the firm’s own working capital policy.
The trade credit period is an important element in a company’s cash conversion cycle – the
length of time between a firm making payment for its purchases of materials and labour and
receiving payment for its sales. The time period over which net current assets have to be
financed depends not only on the policy towards suppliers but also on the debtor
management and stock control policy:
Cash conversion cycle = [Debtor days + stock period] – [trade credit period]
(ii) In effect, because trade credit represents temporary borrowing from suppliers until invoices
are paid, it becomes an important method of financing the firm’s investment in current
assets. Firms may be tempted to view trade creditors as a cheap source of finance, especially
as, in the United Kingdom at least, it is currently interest-free. Having a debtors collection
period shorter than the trade collection period, may be taken as a sign of efficient working
capital management. However, trade credit is not free.
First, by delaying payment of accounts due, the company may be passing up valuable
discounts, thus effectively increasing the cost of goods sold.
Second, excessive delay in the settlement of invoices can undermine the existence of the
business in a number of ways. Existing suppliers may be unwilling to extend more credit
until existing accounts are settled, they begin to attach a lower priority to future orders
placed, they may raise prices in the future or simply not supply at all. In addition, if the firm
acquires a reputation as a bad payer among the business community, its relationship with
other suppliers may be soured.
(b)
Working capital cycle
At present, the working capital cycle is:
Debtor days: £0.4m/£10m × 365 = 15 days
Stock days: £0.7m/£8m × 365 = 32 days
Creditor days: £1.5m/£8m × 365 = (68 days)
Total = (21 days)
Clearly, Keswick is exceptionally efficient in its use of working capital.
77
The proposed arrangement would shorten creditor days in relation to half of cost of sales to 15
days. The effect is to lower the average to:
(1/2 × 68 days) + (1/2 × 15 days) = 41.5 days.
Overall, this will increase cycle time to:
[15 + 32 – 41.5 days] = 5.5 days.
Interest cover
At present, interest cover (Earnings before interest and Tax/Interest) is:
£2m/£0.5m = 4.0 times, that is not unduly low.
The advanced payment will raise interest costs but will generate savings via the discount. The
discount applies to half of cost of sales, that is, 1/2 × £8m × 5% = £0.2m.
The net advanced payment of (£4m – £0.2m) = £3.8m will have to be financed for an extra (68
– 15) days, generating interest costs of:
[£3.8m × 12% × 53/365] = £66,214.
The interest cover slightly declines to:
[£2.0m + £0.2m]/[£0.50m + £0.066m] = 3.89 times.
Profit after tax, ROE and EPS

The ‘before’ and ‘after’ profit and loss accounts appear thus:
£m £m
No discount With discount
Discount
Sales 10.000 10.000
Cost of sales (8.000) (7.800)
Earnings before interest
and tax 2.000 2.200
Interest (0.500) (0.566)
Taxable profit 1.500 1.634
Tax @ 33% (0.495) (0.539)
Profit after tax 1.005 1.095
£1.005m £1.095m
ROE = = 50.3% = 54.8%
£2m £2m
£1.005m £1.095m
EPS = = 25.1p = 27.4p
£1m × 4 £4m
The proposal appears beneficial to Keswick in terms of the effect on profitability measures, that
is, EBIT, PAT, EPS and ROE. Conversely, it does have a marginally harmful effect on its
interest cover and lengthens its working capital cycle and turns it into a net demander of capital.
This suggests an increase in its capital gearing.
78
Before the adjustment, gearing at book values (overdraft/shareholders’ funds) was:

£3m/£2m = 150%.
Ignoring the beneficial effect on equity, the overdraft will increase by:
[£3.8m × 53/365] = £0.55m.
Gearing after the adjustment becomes
£3.55m/£2m = 178%.
This looks rather perilous, considering the short-term nature of much of this debt and
Keswick’s low liquidity. Perhaps Keswick should reconsider its policy regarding long-term
borrowing, and whether prospective lenders would oblige is doubtful.
7. International Golf Ltd
(a) A cash flow forecast can be a useful tool for planning and decision-making, providing
managers with an insight into the implications of possible decisions on the cash position of
the business. Cash has been described as the ‘life-blood’ of a business and it is important
that this asset is properly managed.
Cash flow forecasts help managers identify whether and, if so, when cash surpluses or
deficits are likely to occur in the future. When a surplus is forecast, consideration must be
given to possible ways in which the surplus can be re-invested. When cash deficits are
forecast it may be necessary to re-plan the timing of certain items in order to overcome the
deficit. Alternatively, the business may seek ways of financing the deficit. By giving prior
warning of a likely deficit, the financial manager will have time to consider the problems
and to seek appropriate remedies. In addition, prospective lenders will often expect to be
provided with a cash forecast before considering a loan to a business.
(b) The costs associated with holding too much or too little cash are as follows:
Borrowing costs. Insufficient cash may lead a business to borrow to continue operations.
Interest payments on loans will be an explicit cost of having too little cash.
Monetary losses. During a period of inflation, the holding of cash will result in a monetary
loss being incurred. Cash held on deposit will be protected to the extent that inflation is
taken into account in the rate of interest given.
Loss of goodwill. A business may have to delay payments to suppliers if there is insufficient
cash. This may result in a loss of goodwill and this, in turn, may affect future supplies.
Opportunities forgone. Too little cash may mean that a business is unable to take advantage
of profitable opportunities when they arise. Similarly, a shortage of cash may prevent a
business from taking cash discounts for prompt payment to suppliers.
Loss of income. Cash in hand, or cash held in a current account in the bank, will not yield
the business any income. Other forms of asset held by the business, however, are likely to
yield income. Therefore, there is often an opportunity cost associated with the decision to
hold cash rather than some other form of asset. Although cash held on deposit will generate
interest, this form of investment is likely to yield a lower return than other investment
opportunities available to a business.
Cessation of trade. A business must retain an uninterrupted ability to pay debts as and when
they fall due. Failure to do so can, in the extreme, lead creditors to take legal action
resulting in the winding up of the business.
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Cash flow forecast for the six months ending 31 May 1994
Dec Jan Feb Mar Apr May

£000 £000 £000 £000 £000 £000
Receipts
Cash sales 48 60 68 88 100 112
Credit sales 33 77 72 90 102 132
81 137 140 178 202 244

Payments
Purchases 140 156 180 195 160 150
Advertising 15 18 20 25 30 30
Rent 40 40
Rates 30
Wages 16 16 18 18 20 20
Sundry expenses 12 16 16 18 18 18
Motor vans 24
Taxation 30
223 236 258 326 228 218
Cash flow (142) (99) (118) (148) (26) 26

Balance b/f (56) (198) (297) (415) (563) (589)
Balance c/f (198) (297) (415) (563) (589) (563)
(d) The cash flow forecast reveals that the overdraft is going to get progressively worse
over the first five months of the period. At the end of April the overdraft required will
reach a maximum of £589,000 for the period. Given the concern of the bank over the
existing overdraft level, this position will almost certainly be unacceptable. In the
following month, the cash flows become positive and the overdraft will begin to reduce.
However, the overdraft at the end of the six-month period will still be at an
unacceptably high level of £563,000.
The business does not appear to have a great deal of room to manoeuvre. We are told
that purchases in the first three months are necessary to meet the demand from April
onwards; however, it may be possible to delay purchase of some of these stocks until a
little later to ease cash flows. Similarly, the purchase of the motor vans may be delayed
until a later date. However, it may prove more difficult to delay payments relating to the
other expenses.
It may be possible to get credit customers to pay more promptly. However, this will
depend on various factors such as the normal terms of trade operating within the
industry and the market strength of the company.
Although delaying payments and chasing credit customers may bring some success in
reducing the forecast overdraft, such steps are unlikely to be sufficient. The size of the
deficit suggests that the business is undercapitalised and should therefore consider some
form of long-term finance to alleviate its problems. The business should also examine
its level of profitability. If we assume that there will be no significant changes in stock
levels over the period, the income for the period will be significantly lower than
expenses. This will result in a net cash outflow from operations.
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8. Ripley plc/Bramham plc

(a) Memo to: Ripley plc Main Board Members
From: An(n) Accountant
Subject: Alternative Financial Strategies
The present policy is termed a ‘matching’ financial policy. This policy, attempts to match
the maturity of financial liabilities to the lifetime of the assets acquired with such finance. It
involves financing long-term assets with long-term finance such as equity or loan stock and
financing short-term assets with short-term finance such as trade credit or bank overdrafts.
This avoids the potential waste of overcapitalisation where short-term assets are purchased
with long-term finance, that is, the company having to service finance not continuously
invested in income-earning assets. It also avoids the dangers of undercapitalisation which
entails exposure to finance being withdrawn when the company is not easily able to
liquidate its assets. In practice, some short-term assets may be regarded as permanent and it
may be thought sensible to finance these by long-term finance and the fluctuating remainder
by short-term finance.
The proposed policy is an ‘aggressive policy’, which involves far more reliance on short-
term finance, thus attempting to minimise long-term financing costs. This requires very
careful manipulation of the relationship between creditors and debtors (maximising trade
creditors and minimising debtors), and highly efficient stock control and cash management.
While it may offer financial savings, it exposes the company to the risks of illiquidity and
hence possible failure to meet financial obligations. In addition, it involves greater exposure
to interest-rate risk. The company should be mindful of the inverse relationship between the
interest-rate changes and the value of its assets and liabilities.
Before embarking on such an aggressive policy, the Board should consider the following
factors:
• How good are we at forecasting cash inflows and outflows? How volatile is our net cash
flow? Is there any seasonal pattern evident?
• How efficiently do we manage our cash balances? Do we ever have excessive cash
holdings which can be reduced by careful and active management?
• Do we have suitable information systems to provide early warnings of illiquidity?
• Do we have any holdings of marketable securities that can be liquidated if we run into
unexpected liquidity problems?
• How liquid are our fixed assets? Can any of these be converted into cash without unduly
disrupting productive operations?
• Do we have any unused long- or short-term credit lines? These may have to be utilised
if we meet liquidity problems.
• How will the stock market perceive our switch towards a more aggressive and less
liquid financial policy?
81
(b) To determine the net benefits of each policy, both cash costs and opportunity costs have to
be considered.
First, consider the management costs over the course of the forthcoming year expected from
each policy:
Policy 1: Selling securities
This policy involves an opportunity cost in terms of the forgone returns from holding
securities as well as cash transaction costs. This opportunity cost is partly offset by small
interest earnings on the average cash balance held.
Transaction costs:
2 × £1.5m × £25
Optimal proceeds per sale: Q = = £25,000
0.12
No. of sales = £1.5m/£25,000 = 60
Transaction costs = 60 × £25 = £1,500
Average cash balance = £25,000/2 = £12,500
Holding cost = £12,500 × 12% = £1,500
Interest on short-term deposits:
Average cash balance × 5% = £12,500 × 5% = (£625)
Total management costs £2,375
Policy 2: Secured loan facility
Assuming an even run-down in cash balances:
Interest charges = £1.5m × 14% = £210,000
Offsetting interest receipts:
(= average balance × 9%)
= £1.5m/2 × 9% = (£67,500)
Arrangement fee = £5,000
Total management costs £147,500
Hence, the policy of periodic security sales appears greatly superior in cost terms by [£147,500
– £2,375] = £145,125. However, this simple comparison ignores the income likely to be
received from the portfolio of securities under each policy. By taking the secured loan, the
company preserves intact its expected returns of [12% × £1.5m = £180,000] from the portfolio.
Conversely, making periodic sales from the portfolio during the year lowers the returns to:
[average holding × 12%] = £1.5m/2 × 12% = £90,000.
The net benefits from the two policies can be shown as:
Security sales
Income from portfolio £90,000
Net management costs (£2,375)
Net income £87,625
82
Loan alternative
Income from portfolio £180,000
Net management costs (£147,500)
Net income £32,500
Difference £55,125
The policy of periodic security sales thus offers greater benefits. However, it is also necessary
to consider the company’s net worth position at the end of the year ahead. By relying on
security sales, the company would avoid the need to repay a loan at the end of the year, but,
against this, will have no holdings of securities to fall back on. Moreover, the capital value
of this portfolio is uncertain due to exposure to variation in the return from the portfolio. For
example, if money market rates rose over the year, the capital value of the portfolio would
probably fall, although the extent of the decrease in value would depend on the nearness to
maturity of the securities.
(c) Some limitations of the simple inventory model are as follows:
• It assumes a steady run-down in cash holdings between successive security sales. In
reality, the pattern of cash holdings is likely to be far more erratic, with exceptional
demands for cash punctuated by periods of excessive liquidity. However, the period
between sales is short enough and the transaction cost low enough to allow flexibility in
cash management.
• It allows for no buffer stock of cash. In reality, security sales are unlikely to be made
when cash balances drop to zero, but rather when they fall to a level deemed to be the
safe minimum.
• It uses a ‘highly uncertain’ estimate of the return from the portfolio. Bramham should
investigate the implications of assuming alternative (higher and lower) rates, and
perhaps determine a ‘break-even rate’, at which the two policies are equally attractive.
In this example, the actual rate would have to be well above 12% to achieve this result.
• There may be economies in bulk-selling of securities, although exploiting these would
increase the holding cost.
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CHAPTER 15
Short- and medium-term finance
Learning objectives
The aim of this chapter, which is largely descriptive in nature, is to evaluate the advantages and
disadvantages of the following means of short- and medium-term finance:
• Trade credit.
• Bank finance.
• Factoring and invoice discounting.
• Bills of exchange and acceptance credits.
• Hire purchase.
• Leasing.
• Financing foreign trade.
Particular attention will be given to leasing in view of its importance as a method of financing
the acquisition of a wide range of assets.
Question summary
5. Haverah plc. This is an exercise to demonstrate the impact on financial ratios of new
working capital management policies.
6. Raphael Ltd examines the cost and benefits of factoring.
5. Haverah plc
Working capital cycle
First, note that cost of sales =
Sales – EBIT = (£45m – £5m) = £40m
At present, the working capital cycle is:
Debtor days: £2.50m/£45m × 365 = 20 days

Stock days: £1.00m/£40m × 365 = 9 days
Creditor days: £6.0m/£20m × 365 = (109) days
Total (80) days
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Clearly, Haverah is exceptionally efficient in its use of working capital especially on stocks
implying perhaps a J.I.T approach to purchases.
The proposed arrangement would shorten creditor days in relation to 40% of its cost of sales
to 25 days. The effect is to lower the average to:
(0.4 × 25 days) + (0.6 × 109 days) = (10 + 65.40) = 75 days
Overall, this will increase the cycle time to:
[20 + 9 – 75 days] i.e. to (46) days, which still leaves Haverah as a net recipient of working
capital.
Interest cover
At present, interest cover [Earnings before interest and tax/Interest] is:
= (£5m/£2.0m) = 2.5 times, which may appear on the low side.
The advanced payment will raise interest costs but will generate savings via the discount.
The discount applies to 40% of cost of sales, i.e. (0.4 × £40m × 4%) =£0.64m. The net
advanced payment of (0.4 × £20m × 96%) = £15.36m will have to be financed for an extra
(109 – 25) = 84 days, generating interest costs of:
(£15.36m × 10%) × (84/365) = £0.35m
The interest cover slightly declines to:
[£5.0m + £0.64m]/[£2.0m + £0.35m] = (£5.64m/£2.35m) = 2.4 times

Profit after tax, ROE and EPS
The ‘before’ and ‘after’ profit and loss accounts appear thus:
£m £m
No discount With discount
Sales 45.00 45.00

Cost of sales (40.00) (39.36)
Earnings before interest and tax 5.00 5.64
Interest (2.00) (2.35)
Taxable profit 3.00 3.29
Tax @ 33% (1.00) (1.09)
Profit after tax 2.00 2.20
£2.00m £2.20m
ROE = = 50% = 55%
£4m £4m
£2.00m £2.20m
EPS = = 100.0p = 110.0p
£1m × 2 £2m
The proposal appears, beneficial to Haverah in terms of the effect on profitability measures,
i.e. EBIT, PAT, EPS and ROE. But it does have a marginally harmful effect on its interest
cover and it lengthens its working capital cycle. This suggests an increase in its capital
gearing.
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Gearing
Before the adjustment, gearing at book values (overdraft/shareholders’ funds) was:
£5m/£4m = 125%
Ignoring the beneficial effect on equity, the overdraft will increase by:
[£15.36m × 84/365] = £3.53m
Gearing after the adjustment becomes
£8.53m/£4m = 213%
This looks pretty perilous, especially considering the short-term nature of much of this debt,
and Haverah’s low liquidity. Perhaps Haverah should reconsider its policy regarding long-
term borrowing, although whether prospective lenders would oblige is probably doubtful.
6. Raphael Ltd
(a) Cost of existing credit policies

£
Cost of debtors (50/365 × £2.4m × 12%) 39,452
Bad debts (1.5% × £2.4m) 36,000
75,452
Factor costs
Factor charges (2% × £2.4m) 48,000
Factor finance charges
[30/365 × (80% × £2.4m) × 11%] 17,359
Overdraft charges
[30/365 × (20% × £2.4m) × 12%] 4,734
70,093
Less: Cost savings 18,000
Net cost of factor agreement 52,093
This shows that the net cost of the factoring agreement is much lower than the cost of the
existing policies.
(b) Factoring involves the administration of the credit sales of a business including the
accounting, invoicing and debt collection procedures. A factor may be prepared to
underwrite the outstanding debts of the business for an additional fee. In order to help
finance the business, a factor will usually be prepared to advance up to 80% of the value of
the trade debts outstanding at a reasonable rate of interest. Factoring arrangements can help
to free-up management time which may otherwise be spent chasing debtors and can help
align the financing of the business with the level of sales generated.
Invoice discounting involves the purchase of selected invoices from a business by a
financial institution. The invoice discounter will normally be prepared to advance up to 75%
of the face value of the invoices purchased and this advance will be recouped from the cash
received from debtors. A business which uses the services of an invoice discounter may
only sell a proportion of the total debtors outstanding and the arrangement is purely to help
finance the business. Thus, the invoice discounter will not offer to administer the credit sales
of the business as a factor is prepared to do.
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Factoring agreements are usually for a long period because of the time and cost involved in
setting up the factoring arrangements. Invoice discounting, on the other hand, may be an
one-off arrangement.
(c) The cost of forgoing discounts in order to obtain an extra 35 day’s credit (i.e. 50 – 15 days) is:
365/35 × 2.5/(100 – 2.5) = 26.7%
In order to assess whether or not it is worthwhile for the company to take advantage of the
discount offer it would be necessary to compare the cost of forgoing the discounts with the
opportunity cost of using the funds available for other purposes. Unless, the funds available
generate a return of at least 26.7%, it would be worthwhile to take advantage of the
discounts offered.
(d) The company must bear in mind the need to maintain the goodwill of its suppliers. At
present, the company pays the owing amounts10 days after the final due date for payment.
This might be unacceptable to suppliers who may respond by giving lower priority to future
orders, refusing back-up or technical services, charging interest on owing amounts or even
refusing to supply goods in the future. A reputation for persistent late payment can also lead
to problems when negotiating terms with new suppliers and is likely to have an adverse
effect on the credit rating of the company.
The above will represent real costs to the company and must be taken into account when
deciding on any change of policy directed towards suppliers.
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CHAPTER 16
Long-term finance
Learning objectives
Reading this chapter should give the reader a grasp of the following:
• The key characteristics of the main forms of long-term finance.
• The benefits and drawbacks of each capital form.
• The factors that influence the choice between the various forms.
Question summary
3. Shaw Holdings plc. A question designed to highlight the decision options facing investors
in a company making a rights issue.
5. Lavipilon plc. This question examines the balance sheet impact of various forms of
distribution to shareholders ranging from cash dividends to the issue of shares.
6. Netherby plc. Another case study set in the context of a make-or-buy decision but
involving consideration of alternative financing options in order to raise the funds required
for restructuring.
3. Shaw Holdings plc

(a) Theoretical ex-rights price
Number of Value per share Total value

shares (m) (£) (£m)
Value of company before
rights issue 20 1.60 32.0
Value of rights issue
(20/4) 5 1.30 6.5
25 38.5
Theoretical ex-rights price = £38.5m/25 = £1.54
(b) Theoretical value of the rights = (£1.54 – £1.30) = £0.24
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(c) Evaluation of the options by owner of 2,000 shares

(i) Selling the rights
Value of the ex-rights holding = 2,000 × £1.54 £3,080
Add: sales proceeds of the rights = 500 × £ 0.24 £120
Value of existing holding £3,200
(ii) Taking up the rights
Value of the ex-rights holding = 2,500 (i.e. 2,000 + 500)
× £1.54 £3,850
Less: cost of acquiring the rights

= 500 × £1.30 £650
Value of existing holding £3,200
(iii) Allowing the rights to lapse

Value of the ex-rights holding
= 2,000 × £1.54 £3,080
There is, in theory, no financial difference between selling or taking up the rights, but
allowing the rights to lapse will reduce wealth for investors.
(d) Rights issues are normally made at a discount because:
• To encourage investors to take up the rights or to sell them to someone who will do so.
The discount increases the likelihood that the company will raise the required funds
from the issue. Some small investors often think (incorrectly) that they are getting a
special inducement.
• In a volatile stock market, it is always possible that share prices will fall below current
prices during the rights offer period. No one is going to pay more than the current price,
to take up shares in a rights issue. Companies must set a level below which they are
confident the share price will not fall.
(e) We have already seen that the shareholder is not affected by rights issues unless the rights
are allowed to lapse. The only concern for the company, therefore is that the price set does
not exceed the market share price.
5. Lavipilon plc
(a) The three proposals would produce the following balance sheets (all figures are in £m):
Bonus Scrip Share

issue dividend split
Net assets (a) 135(b) 165(f) 135
Ordinary shares 35(c) 30(g) 25(j)

Share premium
account 40(d) 45(h) 50(k)
Revenue reserves 60(e) 90(i) 60(e)
135 165 135
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The letters in brackets refer to points listed below:

(a) Net assets = fixed plus current assets less current liabilities less long-term debt.
(b) Existing net assets of £115m plus profit of £50m less dividends £30m, yielding a net
increase in assets of £20m, presumably in cash form.
(c) 50m ordinary shares plus 20m bonus shares = 70m, valued at par 50p, book value =
£35m.
(d) The extra £10m ordinary shares at par, comes out of share premium in this answer.
(Alternatively, it could come from revenue reserves.)
(e) £20m retention added to existing £40m revenue reserve.
(f) Existing net assets of £115m plus retained profit of £50m (no cash dividend paid).
(g) 10m new shares added to the existing 50m. Valued at par of 50p, book value = £30m.
(h) The extra £5m ordinary shares, comes out of share premium; alternatively, it could
come from revenue reserve.
(i) £50m retained profit added.
(j) 50m ordinary shares at par 50p become 100m ordinary shares at 25p to generate the
same total book value.
(k) No reason why this should change.
Lavipilon’s equity is worth (50m shares × £3) = £150m. In an efficient capital market,
none of these adjustments in themselves should affect company value. In each case,
additional shares are issued but no additional funds are raised. In effect, the same basic
company is now split into smaller pieces, but more of them! However, each device will
result in a different number of new shares. In each case, the resulting share price will be
the equity value divided by the new number of shares. This can be seen most clearly if
we assume that the new shares are not excluded from the dividend.
Bonus issue £150m/70m = £2.14 cum div
Scrip issue £150m/60m = £2.50 cum div
Share split £150m/100m = £1.50 cum div
However, in reality, it is usually the case that new shares do not qualify for dividends until
the next declaration. In this case, the arithmetic (but not the principle) is different. For the
bonus issue, the ex-div share price is £3 less 60p = £2.40. With the new shares in issue,
share price falls to £2.40 × 25/35 = £1.71p.
With the share split, the ex-dividend price of £2.40 is reduced as follows: £2.40 × 25/50 =
£1.20.
(b) In theory, none of these proposals will provide an extra return. However, if these devices
provide new information to the market about the future earnings potential of the company,
the predicted prices may not prevail. Often, the capital market will receive all three types of
proposal favourably, especially if the company declares its intention of maintaining the
same dividend per share. In the share split case, this is tantamount to doubling the dividend
and is rather unlikely. In practice, empirical evidence shows that financial adjustments of
this nature do portend a future dividend increase, although to a more modest degree. It
should be noted that because companies do not like having to rescind a dividend increase,
and try to smooth dividend payments over time, dividends are usually regarded by the
market as a better guide to the director’s assessment of future profits than current earnings.
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(c) (i) From the company’s point of view, a scrip dividend preserves liquidity, which may be
important at a time of cash shortage and/or high borrowing costs, although it may become
committed to a higher level of cash outflows in the future if shareholders revert to a
preference for cash. However, having issued more shares, the company’s reported financial
gearing may be lowered, possibly enhancing borrowing capacity. In this respect, the scrip
dividend resembles a rights issue.
For shareholders wishing to increase their holdings, the scrip is a cheap way into the
company as it avoids dealing fees. The conversion price used to calculate the number of
shares receivable is based on the average share price for several trading days after the ‘ex-
dividend day’. Should the market price rise above the conversion price before the date at
which shareholders have to declare their choice, there is the prospect of capital gain,
although if the share price appreciation exceeds 15%, any such gain is taxable.
A scrip dividend has no tax advantages for shareholders as it is treated as income for tax
purposes.
If the capital market is efficient, there is no depressing effect on share price of the scrip
dividend through earnings dilution. This is because the scrip simply replaces a cash
dividend that would have caused the share price to fall anyway due to the ‘ex-dividend’
effect. In other words, the shareholder wealth is unchanged.
However, if the additional capital retained is invested wisely, then the share price may either
be maintained or even rise, although this would depend on the proportion of shareholders
who opt for the scrip.
(ii) A share split will not generate additional funds, or even preserve liquidity. So why do
companies do this?
A stock split will reduce unit share price and perhaps make the shares more marketable.
This contradicts the EMH which asserts that all shares are always fairly priced, but it is
often agreed that a ‘heavyweight’ share value is a deterrent to active trading, i.e. it makes
the shares less liquid and hence less valued.
6. Netherby plc
(a) The costs of restructuring are set against profits in year zero, thus generating a tax saving
after a one-year delay. The estimated cash flow profile is thus:
Cash flow profile (£m)
Year
Item 0 1 2 3 4 5 6
Closure costs (5)
Tax saving 1.65
Cash flow increase 2 2 2 2 2
Tax (0.66) (0.66) (0.66) (0.66)
NPV (£m) = –5 + 1.65(PVIF15,1) + 2(PVIFA15,5) – 0.66(PVIFA15,5 PVIFA15,1)
= –5 + 1.65(0.870) + 2(3.352) – 0.66(3.784 – 0.870)
= –5 + 1.44 + 6.70 – 1.92 = +1.22, i.e. + £1.22m
Hence, the restructuring appears worthwhile.
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(b) A semi-strong efficient capital market is one where security prices reflect all publicly
available information, including both the record of the past pattern of share price
movements and all information released to the market about company earnings prospects. In
such a market, security prices will rapidly adjust to the advent of new information relevant
to the future income-earning capacity of the enterprise concerned, such as a change in its
chief executive, or the signing of a new export order. As a result of the speed of the
market’s reaction to this type of news, it is not possible to make excess gains by trading in
the wake of its release. Only market participants lucky enough already to be holding the
share in question will achieve super-normal returns.
In the case of Netherby, when it releases information about its change in market-servicing
policy, the value of the company should rise by the value of the project, assuming that the
market as a whole agrees with the assessment of its net benefits.
Net present value of the project = £1.22m
Number of 50p nominal shares in issue = £5m × 2 = 10m
Increase in market price = £1.22m/10m = 12.2p per share
(c) Arguments for and against making a rights issue include the following:
For
(i) A rights issue enables the company to maintain (or possibly, increase) its dividends,
thus avoiding both upsetting the clientele of shareholders, and also giving negative
signals to the market.
(ii) It may be easy to accomplish on a bull market.
(iii) A rights issue automatically lowers the company’s gearing ratio.
(iv) The finance is guaranteed if the issue is fully underwritten.
(v) It has a neutral impact on voting control, unless the underwriters are obliged to purchase
significant blocks of shares.
Against
(i) Rights issues have to be made at a discount, which usually involves diluting the historic
earnings per share of existing shareholders. However, when the possible uses of the
proceeds of the issue are considered, the prospective EPS could rise by virtue of
investment in a worthwhile project, or in the case of a company earning low or no
profits, the interest earnings on uninvested capital alone might serve to raise the EPS.
(ii) Underwriter’s fees and other administrative expenses of the issue may be costly,
although these may be avoided by applying a sufficiently deep discount.
(iii) The market is often sceptical about the reason for a rights issue, tending to assume that
the company is desperate for cash. The deeper the discount involved, the greater the
degree of scepticism.
(iv) It is difficult to make a rights issue on a bear market, without leaving some of the shares
with the underwriters.
(v) A rights issue usually forces shareholders to act, either by subscribing directly or by
selling the rights, although the company may undertake to reimburse shareholders not
subscribing to the issue for the loss in value of their shares. (This is done by selling the
rights on behalf of shareholders and paying over the sum realised, net of dealing costs.)
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(d) A rights issue normally has to be issued at a discount firstly, to make the shares appear
attractive, but more importantly, to safeguard against a fall in the market price prior to
closure of the offer below the issue price. If this should happen, the issue would fail as
investors wishing to increase their stakes in the company could do so more cheaply by
buying on the open market. Because of the discount, a rights issue has the effect of diluting
the existing earnings per share across a larger number of shares, although the depressing
effect on share price is partly countered by the increased cash holdings of the company.
The two possible rights prices are now evaluated:
(i) A price of £1
It is assumed that to raise £5m, the company must issue 5m new shares at the issue price
of £1.
In practice, it is possible that the number of new shares required might be lower than
this, as the post-tax cost of the project is less than £5m due to the (delayed) tax savings
generated. The company might elect to use short-term borrowing to bridge the delay in
receiving these tax savings, thus obviating the need for the full £5m.
Notwithstanding this argument, the terms of the issue must be ‘1-for-2’, i.e. for every
two shares currently held, owners are offered the right to purchase one new share at the
deeply discounted price of £1.
The ex-rights price will be:
[Market value of 2 shares before the issue + cash consideration]/3 = [(2 × £3) + £1]/3 =
£7/3 = £2.33
(ii) Similarly, if the rights price is £2, the required number of new shares = £5m/£2 = 2.5m,
and the terms will have to be ‘1-for-4’.
The ex-rights price will be [(4 × £3) + £2]/5 = £14/5 = £2.80.
Clearly, the smaller the discount to the market price, the higher the ex-rights price.
(e) The cash flow benefit of the proposal, after tax at 33%
= (£2m × 0.67) = £1.34m
This will coincide with the increase in profit as the existing plant is fully depreciated.
The rights issue at £2 involves 2.5m new shares.
The EPS was £15m/10m = £1.50 per share.
After the rights issue, the prospective EPS will become
[£15m + £1.34m]/12.5m = £1.31 per share
With debt finance, there will be a financing cost, net of tax relief, of (12% × £5m)
(1 to 33%) = £0.40m p.a. This reduces the net return from the project to (£1.34m –
£0.40m) = £0.94m p.a.
(In the first year, the cash flow cost will be the full pre-tax interest payment – thereafter,
Netherby will receive annual cash flow benefits from the series of tax savings.)
The EPS will be: £15.94m/10m = £1.59 per share.
Therefore, in terms of the effect on EPS, the debt-financing alternative is preferable,
although it may increase financial risk.
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(f) A range of factors could be listed here. Among the major sources of risk are the following:
(i) Reliability of supply. This can be secured by inclusion of penalty clauses in the
contract, although these will have to be enforceable. The intermediation of the European
Bank for Reconstruction and Development may enhance this.
(ii) The quality of the product. Again, a penalty clause may assist, although a more
constructive approach might be to assign a UK-trained Total Quality Management
expert to the Hungarian operation to oversee quality control.
(iii) Market resistance to an imported product. This seems less of a risk, if retailers are
genuinely impressed with the product, and especially as there are doubts over the
quality of the existing product.
(iv) Exchange rate variations. Netherby is exposed to the risk of sterling depreciating
against the Hungarian currency, thus increasing the sterling cost of the product. There
are various ways of hedging against foreign exchange risk, of which use of the forward
market is probably the simplest. Alternatively, Netherby could try to match the risk by
finding a Hungarian customer for its other goods.
(v) Renewal of the contract. What is likely to happen after five years? To obtain a two-
way protection, Netherby might write in the contract an option to renew after five years.
If the product requires redesign, Netherby could offer to finance part of the costs in
exchange for this option.
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CHAPTER 17
Returning value to shareholders: the dividend

decision
Learning objectives
There is some dispute whether companies should pay dividends at all. Some observers even say
it makes no difference whether a company pays dividends or not! After reading the chapter, the
reader should be able to:
• Understand the competing views about the role of dividend policy.
• Understand what factors a financial manager should consider when deciding to recommend
a change in dividend payouts.
• Understand what is meant by the ‘information content’ of dividends.
• Know what alternatives to cash dividends may be used to deliver value to owners.
• Appreciate the impact of taxation on dividend decisions.
• Understand why changes in dividend payments usually lag behind changes in company
earnings.
Question summary
6. Laceby centres on the use of the DVM and the impact of variations in dividend and
investment policy. It also requires consideration of the conditions under which a dividend
cut could increase company value.
7. Pavlon plc requires a clear understanding of the relationship between dividend per share
(DPS) and payout ratios, and the respective merits of attempting to stabilise DPS and the
payout. Again, issues involving the company’s clientele are raised and again, it requires
operation and criticism of the DVM.
8. Mondrian plc. This question requires, evaluation of the respective views of three directors
who make conflicting recommendations about the dividend policy of their firm
6. Laceby
(a) The return required by shareholders is
ERj = Rf + βj [ERm – Rf]
= 11% + 0.83 [6%] = 11% + 5% = 16%
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Expected value of cash flow
= (0.2 × £0.5m) + (0.6 × £1.5m) + (0.2 × £4m)

= (£0.1m + £0.9m + £0.8m) = £1.8m
 £1.8m(1 − 33%) 
NPV of project = −£2m + £1m +  
 0.16 
= −£1m + £7.54m = £6.54m
(b) (i) Existing value of Laceby (cum dividend)
 £8m(1 − 33%) 
=  + cash dividend of 50% × £8m(1 − 33%)
 0.16 
= £33.5m + £2.68m = £36.18m
The ex-dividend price will fall by £2.68m to £33.5m. (The solution assumes that retentions
are normally invested at the cost of capital, i.e. 16%.)
(ii) In principle, the value of Laceby should increase by the NPV of the project, i.e. by
£6.54m.
The cum dividend value = (£36.18m + £6.54m) = £42.72m
If the project is undertaken, the dividend will be only:
[‘normal’ dividend – £2m] = [£8m(1 – 33%) × 50%] – £2m = £0.68m
Hence, the ex-dividend value = (£42.72m – £0.68m) = £42.04m

(c) In practice, the expectation and receipt of the grant will tend to affect this calculation. The
solution assumes that the grant is paid immediately. Any delay in approval and payment of
the grant will lower the NPV of the project and thus lower the value of Laceby.
More fundamentally, the solution assumes that the market agrees with the company’s
assessment of the value of the project and is not perturbed by any information content in the
decision to lower the dividend. In reality, the market is likely to apply a ‘precautionary
discount’ when managers announce details of a new project to counter what is often
perceived as an optimistic bias among project sponsors. In addition, there may be a negative
information content in the decision to retain. If the market considers that the real reason for
the reduced dividend is concern about future earnings prospects, the price reaction could be
negative, despite the apparent attractions of the project. Finally, if existing shareholders, due
to their time preferences and tax positions, rely heavily on a stable flow of dividends, such
interference in their income stream, causing them to borrow or sell shares, will have an
adverse impact on the company value.
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7. Pavlon plc
(a)
Years prior to No. of shares Total dividend Payout ratio
listing
21.33m £768,000 42.7%
4 21.33m £1,024,000 42.7%
3 26.67m £1,642,860 42.7%
2 26.67m £1,750,000 42.7%
1 26.67m £1,898,000 42.7%
Current 40m
The number of shares is found by working backwards from the present figure of 40m and
adjusting by the two specified new issues (50% at listing and 25% three years previously).
The total dividend paid is found by multiplying the dividend per share by the number of
shares and the payout ratio then follows.
The company’s declared objective is to maximise shareholder wealth. In principle, a variety
of dividend policies is consistent with this aim depending on factors such as the tax position
of the clientele and whether dividend policy has been used to convey information to the
market. Pavlon has followed a remarkably consistent dividend policy, adhering to a constant
payout ratio. At the time of listing, it would presumably have stated its dividend policy in its
prospectus and unless specified otherwise, shareholders would have been justified in
expecting continuation of this policy. A switch in dividend policy so soon after listing is
certain to offend at least some portion of its clientele.
However, whether the pursuit of a constant payout ratio is rational is debatable. As long as
earnings are increasing, the company is able to continue to increase dividends, but should
earnings fall, adherence to a constant payout implies lower dividend per share and possibly
lower share price. It is more usual to follow a dividend policy incorporating a stable
dividend per share, with ample dividend cover, to allow earnings fluctuations to be
smoothed out.
(b) The interim of 3.16p per share plus the proposed final of 2.34p makes a total payment of
5.50p per share, which represents a cut in dividend per share of 23% and involves a payout
ratio of 40%. A large cut in DPS is associated with only a small cut in the payout ratio
because, while issued share capital has risen by 50%, the profit after tax has increased
relatively slowly (24%). The new shares were issued presumably to finance some new
projects and perhaps some acquisitions. In either case, these investments do not yet appear
to have had a substantial pay-off. Against this background, the proposed dividend cut could
be construed as a signalling concern over faltering new ventures.
If the majority of shares are owned by wealthy private individuals, the proposed dividend
cut may be beneficial if it enables them to convert dividend income into capital gain.
However, retention will only generate capital gain if the market expects the company to
utilise the finance involved in a profitable fashion.
If the majority of shares are owned by institutions, the proposed dividend cut may be
undesirable. Many institutions rely on a steady stream of dividend income to meet their
largely known liabilities, while some are exempt from income tax and therefore prefer
dividend income to capital gains.
There are, therefore, two issues here – whether the company’s recent financial performance is
viewed as disappointing or not, and whether the shareholders actively prefer dividend income.
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(c) The Dividend Valuation Model states

D1
share price =
ke − g
This ‘works’ so long as ke is greater than g. However, for the next three years, dividend
growth of 15% is expected. Therefore, the valuation calculation must be a multi-stage
exercise, valuing the dividend stream over periods of fast and slow growth respectively, i.e.
P0 = (PV of dividends over years 1–3) + (PV of subsequent dividends)
D1 D2 D3 P3
= + 2
+ +
(1.12) (1.12) (1.12) (1.12)3
3
where P3 = end of Year 3 share price and hence the PV of dividends from Year 4 and
thereafter.
7.12p(1.15) 7.12p(1.15) 2
P0 = +
(1.12) (1.12) 2
7.12p(1.15)3 P3
+ 3
+
(1.12) (1.12)3
[10.83p(1.08)](PVIF12,3 )
= 7.31p + 7.51p + 7.71p +
[0.12 − 0.08]
= 22.53p + 292.5p(0.7118)
= 22.53p + 208.20p = 230.73p, i.e. £2.31
The present share price is:
market value £78m
= = £1.95
number of shares 40m
On this basis, Pavlon appears to be undervalued.
(d) In addition to some mathematical weaknesses, such as inability to cope with zero dividend
payers and cases where ke is less than g, the DVM suffers from several key weaknesses. It
assumes infinite company life, and a constant rate of growth over specified periods.
Constant growth, in turn, implies a constant retention rate and a constant rate of return on
re-invested earnings. Moreover, dividend-paying capacity is not the only guide to a
company’s value. Some companies may experience significant increases in asset value that
exerts a more important influence on share price. However, this is really a signal that the
assets concerned are more valuable in an alternative use.
8. Mondrian plc
(a) The position taken by Director A reflects the traditional view of dividend policy which
assumes that investors would prefer dividends today rather than either dividends or capital
gains at some future date. This is because investors prefer a certain sum of cash today to an
uncertain return in the future. The implications of this view for dividend policy are that
companies should attempt to pay out as much in the form of current dividends as is
consistent with the long-term objectives of the company. It is argued that, because investors
dislike uncertainty, they will apply a rising discount rate to future returns. Thus, if current
dividends are lowered in order to ensure high investment for the future, the value of the
company will fall as future dividends will be discounted at an increasing rate over time.
However, many believe that such views are based on a misconception of the nature of risk.
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It can be argued that there is no reason why risk needs to necessarily increase over time.
Risk arises from the nature of the activities undertaken by the company and investors will
normally demand a higher return from companies that engage in high-risk ventures than
companies that engage in low-risk ventures. The level of risk associated with the activities
of a company will already be reflected in the discount rates applied to investment projects
when assessing future returns.
The view of Director B is supported by the work of Miller and Modigliani (MM). MM
demonstrated that, given certain restrictive assumptions, dividend policy is irrelevant. They
show that dividends do not change shareholder wealth but only its location. MM argue that
the value of a company will be determined by the level of future earnings, and the degree of
risk associated with the company. The way in which earnings are divided as between
dividends and retentions is not important. The level of dividend will not influence share
values providing the amounts retained are invested in similarly profitable projects. Any
reduction in dividends will be compensated by an increase in capital gains. In the event that
a shareholder requires cash, ‘home-made dividends’ may be created through selling a
portion of the shares held. Thus, any differences in the consumption patterns of shareholders
will be irrelevant.
The arguments of MM concerning dividend irrelevance rest on a number of important
assumptions which include the absence of taxes and share transaction costs, and
shareholders and managers having identical information concerning future investment
opportunities. These assumptions do not hold in the real world and, as a result, the
arguments put forward by MM are weakened. Differences in tax treatment between
dividends and capital gains have led many investors to prefer capital gains as we discuss in
some detail below. In addition, share transaction costs can be relatively high when small
amounts are being dealt with.
The view of Director C can be supported because of the different treatment, for taxation
purposes, afforded to dividends and capital gains. In the United Kingdom, dividends are
taxed at the taxpayer’s marginal rate of income tax, whereas, in the past, capital gains have
been taxed at a single rate of tax that, for many shareholders, has been lower than their
marginal rate of income tax. This difference in tax treatment has led many investors to
prefer capital gains to dividends. Although capital gains are now taxed at the marginal rate
of income tax of investors, some benefits of capital gains over dividends still remain. Tax
on capital gains only arises when the gain is realised which means that investors can defer
payment of the tax, or perhaps even offset the capital gains in a year when a capital loss
arises. In addition, a certain amount of capital gain arising in a particular year is exempt
from taxation.
However, there are practical problems associated with the view that dividends should not be
paid. The creation of ‘home-made dividends’ as a substitute for a company dividend policy,
as suggested above, may be difficult due to problems which include the share transaction
costs referred to earlier, the indivisibility of shares leading to investors being unable to sell
precisely the amount of shares required, and the lack of marketability of shares in unlisted
companies.
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(b) A number of factors will influence the level of dividends that may be paid by a company.
These include:
(i) Availability of profits
Dividends are payable only out of profits which the law defines as being available for
distribution.
(ii) Shareholder requirements
The requirements of shareholders concerning the balance between dividends and
capital gains should be considered.
(iii) Market expectations
The market may have expectations concerning the level of dividends payable that the
company may wish to meet in order to retain the confidence of investors.
(iv) Liquidity
The cash available for dividend payments must be determined. Other commitments of
the business (e.g. purchase of fixed assets) will have an influence on the amount
considered prudent to distribute to shareholders.
(v) Market signals
Dividends can be used by companies to signal to the market the director’s views
concerning the future. For example, a higher than expected dividend may be used to
signal confidence in future earnings levels.
(vi) Financing policy
Some companies may decide to reinvest a high proportion of earnings, thereby
leaving a relatively small amount available for dividends. This policy may be adopted
for various reasons including the avoidance of dilution of control and share issue
costs.
(vii) Loan restrictions
A company may be prevented from announcing a high dividend because of loan
covenants. To protect lenders, a loan agreement may contain a clause restricting the
level of dividend that can be paid to shareholders.
(viii) Earnings pattern
A company that has a volatile earnings pattern may decide to smooth the flow of
dividends over time. This will involve retaining a proportion of profits during years
when profits are high in order to be able to distribute dividends when profits are low
or losses are being made. Thus, the future pattern of earning volatility may influence
current dividend policy.
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CHAPTER 18
Capital structure and the required

return
Learning objectives
This chapter has the following aims:
• To explain some of the ways of measuring gearing.
• To enable the reader to understand more fully the advantages of debt capital.
• To explain the meaning of, and how to calculate, the WACC (weighted average cost of
capital).
• To enable the reader to understand the likely limits on the use of debt, and the nature of
‘financial distress’ costs.
• To help the reader to understand the issues involved in financing foreign operations.
• To enable the reader to understand the factors that a finance manager should consider when
framing capital structure policy.
Question summary
6. Zeus plc. This question involves calculation of the WACC from the data provided in the
balance sheet .
7. RH plc. This question examines the impact of different ways of financing a new activity on
both the gearing measures and the WACC.
8. Celtor plc. This question involves explanation of the cost of capital concept, and discusses
the main factors that determine a company’s cost of capital. The question also requires the
calculation of the WACC.
9. Redley plc requires calculation of dividend cover and dividend yield for a company with
sharply rising profits and requests advice about alternative ways of reducing an increasing
cash surplus.
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6. Zeus plc
Capital structure:
Market value of equity = no. of shares × share price
= 2m × £1.36 = £2.72m
Market value of the debenture = £0.7m × 60% = £0.42m
Plus long-term loan = £0.80m
£3.94m
Percentage cost
Equity 69.0 19.1%
Debenture 10.7 13.3%
Long-term loan 20.3 17.0%
100.0
Cost of equity: dividend growth found from
10.0 (1 + g)4 = 13.7
whence g = 8.2% (approx.)
ke = D1 + g = 13.7 (1.082) + 0.082

Po £ 1.36
= 0.109 + 0.082 = 19.1%

Coupon rate 8% × 100
Cost of debenture = = = 13.3%*
Market value 60
Cost of long-term loan = 16% + 1% = 17%*
WACC = (19.1% × 69%) + (13.3% × 10.7%) + (17% × 20.3%)
= (13.2% + 1.4% + 3.5%)
= 18.1%
∗Note that the incorporation of tax relief on interest payments would reduce this figure
appreciably (so long as Zeus was able to utilise the tax relief available on debt interest).
7. RH plc.
(a) (i) The current market capitalisation = (2m shares × £1.68) = £3.36m.
The present value of the cash flows from the investment project is (£0.3m[1 – 33%]/18%)
= £1.12m (i.e. the NPV is (£1.12m – £1m) = £0.12m). Under all-equity financing,
market capitalisation should rise by the full value of the project as it involves additional
financing, i.e. to (£3.36m + £1.12m) = £4.48m.
If the finance is raised via borrowing at 12% p.a., the net cash flow will be:
(£0.3m – interest on £1m at 12%) [1 – 33%] = £0.12m p.a.
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At 18%, this has a PV of (£0.12m/0.18) = £0.67m. On the assumptions given, this

would be the increase in the market capitalisation (i.e. the project is debt financed). The
new capitalisation is (£3.36m + £0.67m) = £4.03m.
(ii) Assuming equity financing, gearing becomes (£1m/£4.48 + £1m) = 18.25%.
Assuming borrowed finance, gearing is £2m/(£4.03m + £2m) = 33.2%.
(iii) Assuming equity finance, the WACC is:
(10% [1 – 33%] × £1m/5.48m) + (18% × £4.48m/£5.48m)
= (6.7% × 0.18) + (18% × 0.82) = 16.0%
Assuming borrowing, the WACC is:

(10% [1 – 33%] × £1m/[£4.03m + £2m]) + (12% [1 – 33%] × £1m/6.03m) +
(18% × £4.03m/£6.03m)
= (6.7% × 0.165) + (8.0% × 0.165) + (18% × 0.67) = 14.5%
(b) Report to: The Board of RH plc

From: Financial Manager
Subject: Financing Alternatives
Date: 24th November 1998
Introduction
At our recent meeting, you had instructed me to examine alternative ways, and
consequences, of raising an extra £1 million for working capital investment. Using the
assumptions we discussed, and assuming that the aim of the exercise is to maximise
Market Value-Added, i.e. the excess of market capitalisation over funds provided by
shareholders, the borrowing alternative is superior. This offers an increase in the net
value of equity of £0.67 million, compared with only using equity of £0.12 million. (see
attached computations).
Reservation
However, the equity enhancement may be moderated by the stock market’s possible
adverse reaction to the increased level of capital gearing. As you know, increased
gearing pre-empts a greater proportion of earnings before interest and tax for interest
payments, thus increasing the volatility of the net after-tax earnings available to the
shareholders. In an efficient financial market, rational investors will demand higher
rewards for bearing greater risk, i.e. the cost of equity will increase, possibly negating
or reversing the decrease in the WACC implied in my calculations. However, the
increase in the discount rate applied to shareholder earnings, required to eliminate the
potential increase in the market value of equity, would be implausibly substantial.
Other issues
Debt may carry restrictions in the form of covenants. Long-term finance may be
unnecessary to fund working capital. The ‘Golden Rule’ of finance argues that short-
term assets should be financed by short-term means, for example, a bank overdraft
facility that has greater flexibility so far as interest is only paid on any balance
overdrawn. A revolving credit facility may be more suitable, as this is, in effect, a
medium-term overdraft, and our requirement is for medium-term finance.
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Non-financial factors
Given that our need is for working capital, we should consider ways of shortening the
operating cycle and thus reducing our investment in working capital. This involves
close scrutiny of stock management and consideration of the extent to which, and how,
we can speed up collections and slow down payments to suppliers.
We would need to canvass the views of our major shareholders, especially concerning
the acceptability of a rights issue, given that it could dilute control (although we might
consider making a non-assignable rights issue). The future prospects for the economy
have an important bearing on our prospective level of sales, and hence ability to meet
the interest payments out of the operating cash flows. Volatility in cash flows will also
depend on our level of operating gearing. We might consider ways of eliminating some
fixed operating costs, for example, out-sourcing some activities.
If you require further details on any of these points, please contact me on my mobile.
Signed: F. Manager, ACMA
8. Celtor plc
(a) A company’s cost of capital is the discount rate which, when used to discount the future
cash flows of the particular company, will not result in any change in the value of the
business. The cost of capital is crucial in appraising investment opportunities, because it
represents the minimum return required for investors. The net present value (NPV) of an
investment project is calculated by discounting its future cash flows by the cost of capital of
the company.
For a company wishing to maximise the wealth of its shareholders, only investment projects
yielding a positive NPV should be accepted. If the cost of capital is calculated incorrectly
this may, in turn, lead to incorrect investment decisions. If the cost of capital is overstated,
the resulting NPV of a project may be shown to be negative, whereas, if the correct cost of
capital were applied to the cash flows, the NPV would be positive. Conversely, if the cost of
capital is understated, the resulting NPV of a project may be positive, whereas, if the correct
cost of capital were applied, the NPV may be negative. In this case, the investment should
not be undertaken.
(b) The main factors that determine the cost of capital of a company are as follows:
Business (or Activity) risk. These are risks associated with the nature of the business in which
the company is engaged. The higher the level of these risks, the higher the level of return
investors will require as compensation.
Financial risk. Where a company takes on gearing, it risks inability of making interest
payments and capital repayments when they fall due. Other things being equal, the higher
the level of gearing the greater the level of risk for shareholders. As a result, shareholders in
highly geared companies are likely to demand higher returns than shareholders in low-
geared ones.
Taxation. In the United Kingdom, interest payments in respect of loans attract relief from
corporation tax. In calculating the weighted average cost of capital of a company, the after-
tax cost rather than the pre-tax cost of interest payments is relevant. Thus, the cost of loan
capital to the company will be determined, in part, by the relevant rate of corporation tax for
the period.
Inflation. During a period of inflation, the money rate of return required by investors is
likely to increase in order for investors to protect their real rates of return from investment.
104
Other investment opportunities. The required returns by investors in a particular company

will be influenced by the returns offered in similar types of investment opportunities.
Marketability of investment. Where shares are purchased in a public limited company listed
on a recognised stock exchange, it is relatively easy for investors to dispose of their
shareholdings when they so wish. However, shares of a private limited company are likely
to be more difficult to sell. As a result, investors in private limited companies are likely to
require a higher rate of return in compensation.
All of the above factors help determine the cost of the individual elements of capital. These
individual elements are then combined, using market values, to obtain the weighted average
cost of capital.
(c) Weighted average cost of capital (WACC)
Cost of equity:
D1
ke = +g
Po
(20p × 1.04)
= + 4%
390p
= 9.3%
Cost of loan capital (after tax)
Interest(tax-adjusted)
kd =
Value of debt
9(1 − 0.25)
= × 100
80
= 8.4%
Weighted average cost of capital (WACC)
Cost Target capital

% Structures %
(Weights)
Cost of equity 9.3% 100 58.8
Cost of debentures 8.4% 70 41.2
WACC = (9.3% × 58.8%) + (8.4% × 41.2%)
= 5.5% + 3.5%
= 9%
9. Redley plc
(a) Payout ratios/dividend cover
Redley’s last dividend was 1.45p per share, making a total payout of £90m × 2 × 1.45p =
£2.61 m. The profit after tax (£m) was:
Profit before interest and tax 27.00

Interest (2.70)
Taxable profit 24.30
Tax @ 33% (8.02)
Profit after tax 16.28
Payout ratio £2.61m/£16.28 = 16%
Dividend cover = 6.3 times
105
Share price = EPS × P:E ratio

= [£16.28/180m] × 17 = 9p × 17 = £1.54
Dividend yield = DPS/Share price = 1.45p/£1.54 = 0.9%
(This represents [0.9%/1 – 20%] = 1.2% before 20% income tax.)
If the present cash balances are used to increase the dividend by £10m, making a total dividend
of (£2.61m + £10m) = £12.61m, the figures (in £ m) will appear thus:
Profit before interest and tax 42.00

Interest (2.70)
Taxable profit 39.30
Tax @ 33% (12.97)
Profit after tax 26.33
% Payout £12.61/£26.33 = 48%

Dividend cover = 2.1 times
DPS = £12.61m/180m = 7p
Dividend yield = 7p/[(£26.33m/180m) × 17]
= 7p/£2.48 = 2.8%
(or [2.8%/1 – 20%] = 3.5% before 20% income tax)
This represents a substantial fall in dividend cover, from significantly above the sector average
to well below it. Such an apparent shift in dividend policy is bound to provoke comment, both
from shareholders and also from the market, in general.
(b) Report to: Redley plc Finance Director
Subject: Utilisation of excess cash balances
From: Financial Strategist
Date: Everyday
1. Introduction
We have built up significant cash balances over the past year because of exceptional growth
in sales and profits, as the economy has recovered from recession, sparking demand for the
high-quality building products in which we specialise. There are several possible uses for
surplus cash balances, such as investment in the short-term money market and acquisition of
other companies. However, my remit is to consider only two such uses: first, an increase in
dividends; and second, early repayment of the long-term loan stock, which is repayable in
2004. This report will consider each of these in turn.
2. Dividend increase
The factors that need to be considered and investigated are as follows:
(i) The preferences of our shareholders. Many shareholders would have purchased
Redley shares rather than those of competing companies with higher payouts hoping for
long-term capital growth rather than dividend payments. In the past, we have served
their interests by restricting dividends and ploughing back profits into the business. We
will need to consider how they are likely to respond to such a sharp shift in our
distribution policy, albeit because of lack of investment opportunities.
(ii) Shareholders’ tax position. A major determinant of shareholders’ preferences is their
liability to tax. Some institutional shareholders enjoy tax advantages from distribution,
while some private shareholders, perhaps the majority, prefer capital gains to dividends
106
because of the tax advantages attached to the former. This factor underlines the need to
inspect our shareholder register and to consult with major shareholders.
(iii) Actual and expected liquidity. We are highly liquid at present and have no plans to
engage in significant capital expenditures. However, it is prudent to examine our
medium- to long-term capital requirements to ascertain whether the cash balances
concerned are best left on deposit so as to avoid having to mount a major capital-raising
exercise in the future. By the same token, group cash flow forecasts will need to be
examined to identify any major demands for cash of a non-capital nature, for example,
closure costs, in the foreseeable future.
(iv) Loan covenants. It is proposed to lower dividend cover significantly. Our lawyers will
have to inspect the terms of our long-term loan outstanding to discover whether there
are any restrictions on dividend payouts.
(v) Stock-market reaction. The proposal is to more than triple dividend payments.
Clearly, this represents a major departure from the past policy and raises several issues.
Presumably, we will present this payment as a special dividend of the kind paid by
certain UK utility companies in recent years to dampen any expectations of similar
increases in the future. This would best be done by paying it at a time different to the
regular dividend. However, this requires the tactical question of the extent to which the
‘normal’ final dividend should be raised. If the normal dividend is also raised
significantly, this will signal directors’ confidence in our ability to sustain future
payments and thus exert pressure on the company to meet these expectations. Given that
our earnings are cyclical and have recently been depressed, it is important that we settle
on a dividend payout policy, which we feel confident of maintaining through the
various phases of the business cycle. The stock market tends to be unforgiving of
companies which cut dividends.
3. Repayment of the loan stock
(i) Conditions of the loan. We must scrutinise the terms of the loan to ascertain whether
early payment is permitted and whether it triggers any penalties.
(ii) The tax shield. If we repay the loan, we will lose the benefit of the tax relief accorded
to debt interest payments. Admittedly, the tax saving is not substantial, i.e. [33% × 9%
× £30m] = £0.9m, but it is nevertheless, worthwhile. Given our recent increase in
profitability, and assuming this can be sustained, there is a strong case for increasing
gearing rather than reducing it, although this would be contrary to our traditional policy.
Our capital gearing is well below, and our interest cover is well above, current industry
averages:
Redley Industry
Capital gearing £30m/£200m = 15% 48%
(ignoring retentions for the current year)
Interest cover £42m/£2.7m = 15.6 times 5.9 times
(iii) Interest rate expectations. If we need to borrow sometime in the future, we will lose,
if future interest rates exceed 9%, since we will have effectively replaced 9% debt by
higher-cost debt. The reverse argument also applies.
(iv) Reaction of the market. When companies with high gearing levels and thus high levels
of financial risk repay debt, there is usually a favourable effect on share price. Given
our low level of gearing, it is doubtful that there would be any such benefit. Indeed, the
107
effect could be adverse, if the market perceives the debt retirement as a signal of harder
times ahead.
4. Recommendation
Subject to the conditions of the existing loan, if we believe that our profitability will
remain buoyant, there is a strong case for raising the level of dividends and for
increasing our level of financial gearing. The risks seem low, although we will need to
consult our major shareholders to sound out their potential reactions.
108
CHAPTER 19
Does capital structure really matter?
Learning objectives
This chapter offers a more theoretically oriented analysis of capital structure decisions.
After reading it, the reader should:
• Understand the theoretical underpinnings of ‘modern’ capital structure theory.
• Appreciate the differences between the ‘traditional’ view of gearing and the Modigliani–
Miller versions.
• Appreciate how the CAPM is integrated into capital structure analysis.
• Be able to identify to what extent a Beta coefficient incorporates financial risk.
Question summary
4. Kipling plc. This question requires discussion of the arguments whether it is possible to
lower the WACC by gearing, and of the relative merits of financing by debt and by
preference shares.
5. Berlan plc/Canalot plc. This is a two-part question. Berlan involves a straightforward
calculation of the WACC, using the DVM to derive the cost of equity, and the IRR method
to find the cost of debt. Canalot is more complex, requiring application of the MM theory
with tax to find the value of a geared company and its component securities, and then to
deduce the WACC.
6. Stanley plc. This question requires calculation of share price, value of equity and value of
firm in an MM with-tax world under alternative financing options.
7. Electronics plc. This question uses the CAPM in a mixed capital structure context to find a
company’s existing cost of equity, and the effect on this of retiring some of its debt. The
impact of diversification into activities of different business areas is also examined.
8. Claxby requires consideration of the impact of corporate restructuring on
Betas and required returns, and also the relative systematic and unsystematic risk
components of the overall company. As in Chapter 10, the issue of whether corporate
diversification is necessarily beneficial for shareholders is raised.
109
4. Kipling plc
At present, Kipling has the following capital structure:
%
Equity (£2.5m + £1m + £1.4m) £4.9m 56.3
Preference shares £1.2m 13.8
10% Debentures £2.6m 29.9
£8.7m 100.0
Counting the preference shares as debt (i.e. fixed charge capital), the fixed charge capital is
43.7%. Alternatively, counting the preference shares as part of shareholders’ funds, the
gearing ratio (long-term debt to total capital) is 29.9%. These are not especially high
figures, but whether they would give cause for concern or not would depend on the nature
of the industry, its operating gearing and the prospects for trading conditions, bearing in
mind that capital structure per se is less significant than interest cover in signalling the
changes of gearing. For example, if Kipling’s products are income-elastic and the economy
is moving into recession, a reduction in profitability and cash flow out of which interest
payments are made may be imminent.
(a) The traditional view of capital gearing suggests that, at modest levels of gearing, equity
investors will not increase their required rates of return following the increase in risk from
the introduction of additional gearing. As debt is less costly than equity capital, this means
that increased gearing may reduce the Weighted Average Cost of Capital of the company.
However, beyond a certain point, the level of risks involved will be more significant and the
expected returns required by shareholders will rise. The point at which the WACC is at its
lowest is considered to be the optimum level of gearing for the company. Here, the value of
equity shares is maximised.
This view of gearing has been challenged by Modigliani and Miller (MM). They argue that
the WACC will be constant at all levels of gearing. They assert that the value of business
will not be affected by the way in which it is financed. Hence, it is not possible to increase
the value of a business by assuming additional gearing. MM argue that shareholders’
required rates of return will change immediately if there is a change in the level of gearing
and, furthermore, will rise in proportion to increases in the level of gearing. Thus, any
benefit from the introduction of low-cost loans will be immediately cancelled out by a
corresponding increase in shareholders’ requirements. The MM position, although on the
basis of rigorous logic, does rest on certain simplifying assumptions, such as the absence of
bankruptcy costs and a constant cost of debt.
(b) The main factors to consider when deciding between preference shares and debentures are
as follows:
Payment of interest and dividends. It is of vital importance that a company honours its
commitment to pay interest on debentures and makes capital repayments when due. Failure
to do so can have grave consequences for the company. At the extreme, a company may
have its assets seized by lenders or be forced to cease trading if it is unable to pay the
amounts due. However, failure to pay a preference dividend will have less serious
consequences. Preference shareholders have no right to receive a dividend if there are
insufficient profits available for distribution.
110
Rates of return. Preference shareholders will normally expect higher rates of return than
debenture holders. This is because, from the investors’ viewpoint, there are higher risks
associated with preference shares than debentures regarding both income received and
capital repayments.
Taxation. In the United Kingdom, debenture interest is an allowable expense, which can be
offset against profits, whereas preference dividends are regarded as an appropriation of
after-tax profits. This difference in tax treatment has meant that debentures are normally
viewed as more attractive when raising non-equity finance.
Redemption. Preference shares and debentures may be issued in a redeemable form.
However, the conditions attached to redemption are significantly different. Redemption of
preference shares requires either an issue of new shares or a transfer from distributable
reserves (or some combination of these) to offset the reduction in share capital. However,
redemption of debentures does not require replacement in the same way.
Security. To make a debt issue attractive to investors, it is usual to offer some form of
security to prospective lenders. However, preference shareholders are members of the
company and cannot be offered such security. In the event of the company being wound up,
lenders rank higher than preference shareholders in order of payment.
Management restrictions. The issue of a debenture loan may carry with it various restrictive
covenants, which inhibits management’s freedom of action. For example, there may be
restrictions concerning issue of further loans and payment of dividends to shareholders.
There may also be requirements concerning levels of liquidity to be maintained. These
restrictions and requirements are designed to protect the interests of the lenders. For a
debenture secured on assets of the company, management may also have to seek permission
from debenture holders before disposing of the assets. Preference shareholders, however,
cannot impose such restrictions on the actions of management.
(c) Factors which may influence the level of debt financing by the company include:
Sales and profits. Companies that have stable or growing sales and profits are better placed
to finance the fixed interest charges and capital repayments than companies that have
volatile or declining sales and profits. Hence, higher profits make it feasible to sustain
higher levels of gearing. Companies may, in practice, change their gearing according to
changing economic conditions.
Security. Companies wishing to raise debt finance usually have to offer some form of
security. Lenders will normally require good-quality assets as security for any loan offered.
If such assets are not available, or are already secured, it may not be possible for the
company to raise debt finance. Kipling plc has already issued debentures and may have
problems in finding security for additional debt.
Borrowing restrictions. The company may have restrictions placed on it concerning the
additional amount of debt finance it can raise. These restrictions may be contained in the
company’s Articles of Association or in earlier loan agreements, or in policy decisions made
by the owners. Kipling plc may, therefore, be restricted because of the previous issues of
debentures.
Cash availability. A company must ensure that it has the cash resources to make interest
payments and capital repayments when due. Failure to do so can have serious consequences.
Risk/returns. The higher the level of debt finance, the higher is the level of financial risk
associated with the company. This higher level of risk is likely to lead to higher expected
returns from prospective lenders. Beyond a certain level of debt finance, however, the costs
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may become too high. Kipling plc already has a significant level of gearing and this must be
taken into account when assessing the feasibility of further borrowing.
5. Berlan plc/Canalot plc
(a) Because Berlan has constant expected earnings and no retentions, the cost of equity can be
estimated using the basic Dividend Valuation Model, that is,
Annual dividend D
ke = =
Market value (ex-div) v
Earnings available for dividend payments are as follows:

£000
EBIT 15,000
Interest = £23.697 m × 16% = (3,792)
11,208
Taxation at 35% (3,923)
7,285
As the ex-dividend share price is 80p and the number of shares issued is 50 million, the
market value of the equity
= 80p × 50m = £40m.
7, 285
Hence, k e = = 18.2%
40, 000
The cost of debt, kd, can be found by discounting the stream of after-tax interest payments
and the redemption payment, and equating the resulting sum to the market value. Thus (in
£m):
16(1 − 35%) 16(1 − 35%) 16(1 − 35%) + 100
105.5 = + +
1 + kd (1 + k d ) 2 (1 + k d )3
Discounting at 8%, NPV = 0.70
Discounting at 10%, NPV = (4.54)
0.70
By interpolation, k d = 8% + × 2%
0.70 + 4.54
= 8.3%
The market value of Berlan’s debt is:
£23.697m × (£105.5 per £100) = £25m
Hence, the WACC is:
 40   25 
= 18.2% ×  +  8.3% × 
 40 + 25   40 + 25 
= 11.2% + 3.2% = 14.4%
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(b)
(i) Under MM’s revised proposition with tax, the market will value a geared company at the
equivalent all-equity financed company value plus the tax shield, i.e.
Vg = Vu + TB
For Canalot, this is
Vg = £32.5m + (£5m × 35%) = £34.25m
This is a premium of £1.75m over the corresponding all-equity value.

(ii) For a geared company, the market value of equity, Vs, is found simply by subtracting the
market value of debt from the total market value, that is,
Vs = Vg – VB
= £34.25m – £5m = £29.25m
Assuming that Canalot is meeting its cost of capital, the gross EBIT is:
 100 
 £32.5m × 18% ×  = £9m
 65 
The earnings available for dividend are as follows:
EBIT – Interest – Tax
= [£9m – (£5m × 13%)] × (1 – 35%) = £5.428m
The cost of equity is thus,
Earnings £5.428m
ke = =
Market value of equity £29.25m
= 18.6%
This result suggests that the introduction of financial risk has induced shareholders to raise
their rate of return requirement by 0.6%.
NB Alternatively, the cost of equity can be found from the equation:
VB
k eg = k eu + (k eu − k d )
(1 − T)
Vs
(iii) The WACC is given by:
 29.25   5 
 18.6% ×  +  13%[1 − 35%] × 
 29.25 + 5   29.25 + 5 
= 15.9% + 1.2% = 17.1%
(c) Many managers and financial analysts appear to believe that there exists an optimum level
of financial gearing at which the market value of the company is maximised and its overall
cost of capital is minimised. The actual optimum is likely to vary according to differences in
reliability of cash flow, business risk and marketability of fixed assets. These factors
probably differ between industries because of differences in technology and inherent
business risk, but there may exist, a definable optimum capital structure for particular
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industries. This suggests a U-shaped cost of capital profile in relation to the gearing ratio.
Initially, as gearing increases, the stock market will acknowledge the beneficial effects on
EPS but as gearing increases beyond a critical ratio, the required return by shareholders
begins to rise, outweighing any further beneficial effects of using debt.
If this optimum is definable, it follows that managers should move to this gearing ratio and
adhere to it in any subsequent project financing. In practice, this presents difficulties so far
as market values continuously fluctuate, thus pulling the actual ratio, at any point in time,
out of alignment with the optimum. Also, it is often not possible to finance specific projects
in the optimum proportion. It is likely that managers have in mind an optimum longer-term
gearing ratio as a target around which the actual ratio will oscillate. It follows that there is
probably a range of capital structures that are considered equally acceptable by the market.
However, if the company strays outside this range, it is likely to be punished by a down-
grading of the share price in the market.
Modigliani and Miller (MM) showed that under certain highly restrictive assumptions,
including the absence of corporate profits tax, there was no optimum capital structure. With
the introduction of corporate tax, it appeared that the cost of capital would continuously
decline until 100% debt in the capital structure. However, the implication that the optimum
capital structure should be comprised almost entirely of debt has been rejected for two broad
reasons:
(a) Lack of realism of assumptions. However logically the conclusions follow from the
assumptions of the model, if the underpinnings of the theory are blatantly unrealistic, it
is unlikely to win broad support from practising business people.
For example, MM assumed that individuals could borrow at the same interest rate as
companies, that borrowing costs did not vary with level of borrowing, that information
was freely available and that there were no transaction costs and no bankruptcy costs.
(b) It ignores the costs associated with high levels of gearing, including those of financial
distress. When the impact of these factors begins to outweigh the tax benefits of debt
finance, there may appear an optimum level of gearing beyond which the cost of capital
will increase. These factors are:
(1) Bankruptcy costs. The direct costs associated with corporate failure that would not
occur if the company thrives. As gearing (and interest payments) increases, the
probability of bankruptcy also increases along with the associated costs.
(2) Agency costs. Agency costs arise because of the constraints (e.g. restrictive covenants)
that suppliers of finance (the principals) impose on managers (the agents) to protect the
principals’ interests. At high levels of gearing, more onerous constraints are likely to be
imposed.
(3) Tax exhaustion. Debt finance is attractive because of the tax relief on interest payments.
This tax relief is only available if a company has enough tax liability on its earnings to
utilise the tax relief. The higher the gearing level, the more tax relief is available and the
greater the chance of tax exhaustion where there is insufficient liability to utilise
available relief. Use of non-debt corporate tax shields, especially capital allowances on
investment, will also affect the likelihood of tax exhaustion.
(4) Debt capacity. Since adequate security must be provided on many types of debt, a
company’s financial gearing may be limited by its ability to offer acceptable security to
lenders.
When these factors are included, the resulting cost of capital profile appears remarkably
like that of the traditional theory, which tends to support the view commonly held that
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there does exist an optimum gearing ratio. However, this is likely to vary across
industries and also alter over time along with changes in expectations about the future
earnings of companies, which in turn influence notions of ‘safe’ levels of gearing.
6. Stanley plc
(a)
With new investment With new
Current and equity investment and
(£m) (£m) debt (£m)
EBIT 79.500 85.2001 85.200
Interest 0 0 (4.560)3
EBT 79.500 85.200 80.640
Tax @ 33% (26.235) (28.116) (26.611)
Ord. shares of £1 each 50.000 54.6572 50.000
EPS 107p 104p 108p
P:E ratio 9.0 9.5 8.5
Share price (pence) 963 988 918
Market value equity 481.500 540.011 459.000
Market value debt 0 0 38.000
Market value firm 481.500 540.011 497.000
Notes
(1) £79.500 + (£38.000 × 15%)
(2) £50.000 + [£38.000/(960p × 85%)]
(3) £38.000 @ 12%
Apparently, using equity is preferable because of the expected adverse impact of gearing on
the P:E ratio.
(b) (i) MV of equity = MV of ungeared firm (Vug)
= (£85.2m × 1 – T)/0.14 = £407.7m

(ii) MV of geared firm =
Value of ungeared (Vug) firm + tax shield (TS) – financial distress cost (FD)
Vug = (85.2 × 1 – T)/0.14 = £407.743
TS = (£38m × 0.12 × 0.33)/0.12 = £12.540
FD = £5 million = (£5.000)
= 415.283
Note that, in the geared case, the value of the equity
= [Value of firm – Value of debt]
= [£415.3m – £38m]
= £377.3m
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7. Electronics plc
Notice there is no mention of taxation in this question, so we are dealing with a pure MM –
no tax world.
(a) Using the CAPM,
ke = 6% + 1.33 [13.5% – 6%]
= 6% + 10% = 16%
To find market value of the shares:
D1
Po =
ke − g
g = retention ratio × return on reinvested earnings (ROE)
= (b.R) = (1 − 60%) × 20%
= 8%
£2.0
Hence, Po = = £25
16% − 8%
Market value of equity = £ 25 × 1m = £ 25m
To find market value of debt:
PV = (10% × £100) (PVIFA8.5) + £100 (PVIF8.5)
= (£10 × 3.9927) + (£100 × 0.6806)
= £39.93 + £68.06 = £108 per £100 of stock
Value of debt = 1.08 × £20m = £21.6m
Asset Beta (or Beta ungeared)?
βG 1.33 1.33
= = =
V £21.6m 1.864
1+ B 1+
VS £25m
= 0.71
Overall cost of capital
= 6% + 0.71 [7.5%] = 11.3%
(NB. Using the standard formula for the WACC will only yield the same answer if the
risk-free rate is used as the cost of debt.)
(b) 50% of debt at current market value
= 0.5 × £21.6m = £10.8m
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As the activity Beta is unchanged, the new equity Beta is:
 VB   £10.8m 
β = 0.71 1 +  = 0.71 1 + 
 VS   £25.0m 
= 0.71 × [1.432] = 1.02
ke = 6% + 1.02[7.5%] = 13.65%
In an MM world, the overall cost of capital is unchanged.

(c) To find the asset Betas (βu):
1.5
A βu = = 1.00
1 + 12
1.8
B βu = = 0.90
1 + 11
1.2
C βu = = 1.20
1+ 0
Using market capitalisation weights, the weighted average Beta
= (0.2 × βA) + (0.3 × βB) + (0.5 × βC)
= (0.2 × 1.00) + (0.3 × 0.9) + (0.5 × 1.20)
= 1.07
When the required return on new business is
ER = 6% + 1.07 (7.5%) = 14.03%

The diversification thus involves moving to a higher level of systematic risk.
8. Claxby
(a) To find the asset Beta for Sloothby, the geared Beta for the industry sector must be
ungeared, that is:
ßg
ßu =
VB
1+ (1 − T)
VS
1.12 1.12
= = = 0.92
1 + [0.33(1 − 33%)] 1.22
This assumes that Sloothby’s risk is ‘typical’ of the industry as a whole.
(b) Systematic risk = ßj δm = δj rjm

δ jrjm
ß=
δm
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For Claxby (c = Claxby, m = market):

δ c rcm
ßc =
δm
40rcm
0.6 =
10
This yields a very low correlation coefficient of
rcm = 0.15
This, in turn, implies that the proportion of variation in the overall return explained by co-
movement with the market is also low. This is measured by the Coefficient of
Determination, R2, i.e.
R2 = (0.15)2 = 0.0225, i.e. 2.25%
For Claxby, total variation, i.e. the variance, is
402 = 1,600
Hence of this variation only 2.25% [i.e. 36] is because of general market movements, the
remainder [i.e. (1,600 – 36)] = 1,564 is because of specific risk factors.
A variance of 36 corresponds to a standard deviation of √36 = 6
The same result is obtained by using the expression
Systematic risk = ßc δm = (0.6)(10) = 6, i.e. 6%

Similarly for Sloothby,
Systematic risk = ßs δm = (0.92)(10) = 9.2, i.e. 9.2%

This implies a variance of (9.2)2 = 84.64
Total variation is (25)2 = 625
Hence, for Sloothby, the proportion of total variation explained by market movements, i.e.
the R2, is:
84.64
= 13.5%
625
As with Claxby, this implies a substantial unsystematic risk component, i.e. (625 – 84.64) =
540.36
(c) The Beta for the expanded company is found by weighting the component asset Betas
accordingly:
0.4 1.0
ß = (0.92 × ) + (0.6 × ) = 0.69
1.4 1.4
(d) The required return for the firm as a whole is now
ERj = Rf + ßj[ERm Rf] = 11% + 0.69 [18% – 11%]
= 11% + 4.8% = 15.8%
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(e) Claxby has diversified by acquiring a firm with lower total risk (25). As a result, the total
risk of the new enterprise is likely to fall. Whether this is desirable for shareholders depends
on the impact on systematic risk. As it happens, Claxby has very a low systematic risk while
the proportion of Sloothby’s risk that is systematic is rather higher. As a result, the Beta
for the whole company increases from 0.6 to 0.69, forcing a higher required return standard
on the parent. If shareholders really wanted to alter the risk/return profile of their
investment, they could have purchased shares of companies in the sector where Sloothby
operates. Consequently, the diversification, especially if it involves transaction costs greater
than Claxby’s shareholders, would incur in altering their personal portfolios, may well not
be in the interests of investors.
The main reason for the managers of a company to carry out this sort of diversification is
because it may enhance earnings stability for the company as well as job security for the
managers. Hence, managers will aim to reduce total risk and will not distinguish between
systematic and unsystematic risks. In practice, however, it is easier to sell shares than to
liquidate whole companies. Usually, there are substantial liquidation costs when a company
fails. Diversification would therefore reduce such risk and the costs of portfolio disruption
and readjustment.
Further practical consideration might be given to other benefits of profit stability, such as a
greater access to debt finance. On the other hand, if the diversification can bring about more
efficient use of resources, then these should also be taken into account in the investment
appraisal.
119
CHAPTER 20
Acquisitions and restructuring
Learning objectives
A major aim of the chapter is to emphasise the strategic aspects of takeovers. Having read it, the
reader should understand the following:
• Why firms select acquisitions rather than other strategic options.
• How acquisitions can be financed.
• How acquisitions should be integrated.
• How the degree of success of a takeover can be evaluated.
• How corporate restructuring can enhance the shareholder value.
Question summary
2. Gross plc and Klinsmann plc. This question focuses on the potential economies, which an
acquiror may exploit by more efficient operation of the acquired company.
3. Dangara plc. A relatively simple valuation exercise, which emphasises the strategic and
contextual issues that impact, takeover bidding and integration of the target.
4. Larkin Conglomerates plc. This question involves simple application of three takeover
valuation methods and a discussion of the problems with each. It also requires discussion of
the reasons for business divestment and considers the relevant strategic internal information
concerning the target company.
5. Fama Industries plc. This question looks at valuation of a takeover target but also focuses
on the impact of the takeover on the EPS, the share price of the bidder and on the sharing of
the gains from the takeover among the two sets of shareholders.
6. Europium plc. This question requires evaluation of the terms to complete a takeover via
share exchange, and focuses on issues of due diligence.
2. Gross plc and Klinsmann plc

(a) Examination of the respective ratios suggests considerable scope for economies, if Gross
can improve Klinsmann’s efficiency by bringing its ratios on par with its own, resulting in
savings and profits. Notice that most of the savings can be made from an efficient use of the
working capital.
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Ratios Gross Klinsmann

Operating profit margin 105 41
×100 = 49% ×100 = 37%
216 110
Average age of stock (on the 20 25
basis of purchases) (days) × 365 = 73 × 365 = 130
100 70
Debtor payment period 40 24
(days) × 365 = 68 × 365 = 80
216 110
Creditor payment period 28 12
(days) × 365 = (120) × 365 = (63)
100 70
Operating cycle (Cash 73 + 68 −102 = 39 130 + 80 − 63 = 147
Conversion Period) (days)
Current ratio (times) 68 50
= 2.4 = 2.5
28 20
Fixed asset turnover (times) 216 110
= 2.8 = 2.2
76 50
Total asset turnover (times) 216 110
= 1.5 = 1.1
76 + 68 50 + 50
ROI (Op profit ÷ LT capital) 105 41
×100 = 91% ×100 = 51%
116 80
To illustrate the savings potential, consider investment in debtors. If the Klinsmann ratio
can be lowered to the Gross ratio (from 80 down to 68, i.e. 12 days), the reduction in
average stock investment will be:
12
× £ 25m = £ 3.75m
80
With an interest cost of 12%, this would generate higher pre-tax profits of [12% × £3.75m]
= £0.45m. While, this is only a small fraction of the bid premium [(£8.50 –£7.00) ×20m =
£30m], the saving would persist into the future, and would be combined with similar
economies elsewhere.
(b) Some other important issues to consider are as follows:
• Gross gearing (long-term debt ÷ equity) at market values is:
£60m
= 10%, compared to Klinsmann’s :
£6 ×100 m
£56m
= 40%
£7 × 20m
Assuming these are both regarded as safe values, there may be scope for Gross to gear up its
existing business, to reduce its overall cost of capital and exploit the tax shield.
• Although Klinsmann has a higher EPS than Gross:
£21 £72m
= 105p compared to = 72p
£20 m 100m
121
its P:E ratio is lower:

£7 £6
= 6.7 compared to = 8.3
105p 72 p
Although Klinsmann is making a fair level of profits for its shareholders, the market
assessment of its future earnings potential is inferior to that for Gross.
• Gross is taking over a competitor, which should enable a degree of rationalisation of the
two businesses and a variety of synergies. Possibly most crucially, this is a horizontal
merger, resulting in a reduced level of competition. At least for a time, Gross may be
able to improve its margins.
3. Dangara plc
(i) Net asset value (NAV)
Using a net asset value approach, the accounts suggest a NAV of £650m. However, there is
a likely gain on disposal relating to the potential sale to Lucky Break. Including this would
yield an adjusted NAV of (£650m + £100m) = £750m.
However, the remaining assets could well be revalued upwards (see note c).
Earnings-based
Tefor’s PAT is £200m. With its own P:E ratio of 10, this suggests a market value of (10 ×
£200m) = £ 2,000m. However, if a rationale for acquisition is to sweat Tefor’s assets more
vigorously, it might be appropriate to allow for this growth by applying Dangara’s P:E ratio,
yielding a value of (14 × £200m) = £2,800m.
DCF
Ignoring working capital complications and tax delays, cash flow is broadly PAT plus
depreciation.
No data is given for depreciation, but since Tefor’s assets are mainly property-based, the
depreciation provision is unlikely to be large, say 5% of fixed assets i.e. £40m. Thus,
estimated cash flow = (£200m + £40m) = £240m. However, there appears to be a need for
refurbishment investment of £50m p.a. (assumed to be tax-allowable). Allowing for growth
at Dangara’s rate (although this may take time to ‘kick in’), the PV of future cash flows is as
follows:
£240m(1 + 7%)
PV = − £50m(1 − 33%)(PVIFA14% / 5 )
14% − 7%
= (£257m / 7%) − £50m(1 − 33%) × 3.4331
= £3,671m − £115m
= £3, 556m
Note that Tefor’s market value of equity is currently P:E × PAT = 10 × £200m = £2bn. A
premium of 20% would suggest that a bid of £2.4bn might succeed. Clearly, a variety of
answers are possible, depending on the assumptions made.
(ii) Other issues
Takeover premiums. The figure of 20% (note f) is only an average. A greater premium
may be required if the present board and their supporters have a major stake, or if the
institutional shareholders are sceptical about Dangara’s ability to utilise Tefor’s assets more
efficiently.
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Ability to raise Tefor’s efficiency. A key motive for the acquisition seems to be to realise
cost savings from Tefor. A programme of post-merger integration needs to be carefully
planned well before the acquisition so that restructuring can begin immediately and
efficiency gains exploited as soon as possible to raise the growth rate of earnings generated
by Tefor’s assets.
Attitude of the competition authorities. Prior to the bid, Dangara would be advised to
consult the relevant authority for guidance as to whether, and which, assets might have to be
divested so as to avoid creating a monopoly position in one or more of the market segments
served by the expanded company. Although it seems that Dangara has already considered
this aspect (note b), it should require utmost clarity on this issue. Equally, the sell-on value
to Lucky Break needs to be subject to a firm undertaking.
Political changes. A new government may soon be in power. Dangara will have to assess
the likelihood of it introducing a more rigorous competition policy. Against this, it is
possible that the stock market is dampened by political uncertainties, suggesting that Tefor
may be temporarily undervalued at this time.
Property values. Dangara would need expert advice as to the market value of Tefor’s assets,
last revalued in 1992 towards the end of a recession period. It is possible that major
revaluation gains might be revealed.
Role of Tefor’s present Chairman. Dangara would have to assess the likelihood of the
present Chairman being able to raise sufficient funding to take Tefor off the market. He and
any team that he assembled would have to raise funding of at least the market value of £2bn
(offset by the extent of his present holdings). This looks like a tall order. Also, should
Dangara’s bid succeed the likelihood of being able to sell some assets back to him needs to
be assessed. If at the moment he is a major shareholder, then he is likely to be highly liquid
post acquisition.
4. Larkin Conglomerates plc
(a) (i) Net assets (liquidation) basis
Net assets at realizable values
Value per ordinary share (Vo ) =
No of ordinary shares
£160,000
=
60,000
= £2.67
The net asset figure is calculated as follows:
£000 £000
Freehold premises 235
Motor vans 8
Fixtures and fittings 5
Stock 36
Debtors 22
Cash at bank 20
326
Less:
Creditors due within one year (66)
Creditors due beyond one year (100) (166)
160
123
(ii) To apply the dividend yield method, the net dividend needs to be grossed up.
(Net dividend per share* × 100 / 75)

V0 = ×100
Gross dividend yield
(6.67p × 100 / 75)
= × 100
5
= £1.78
*
Net dividend per share is calculated as follows:
= 4.0k/60k
= 6.67p
(iii) Price earnings ratio
P : E ratio × profit after tax

V=
No. of ordinary shares
£16, 400 ×12
=
60, 000
= £3.28
(b) Net assets (liquidation) basis – values a share in a company using the realisable value of
the net assets held. If a company plans to cease trading and dispose of its assets
piecemeal, this method can provide a suitable form of share valuation. However, if a
company intends to remain in business and continue trading, this method is likely to
provide a valuation figure which is too conservative. The value of the business as a
going concern is likely to be greater than the sum of the realisable values of individual
items shown on the balance sheet. This may be because of such factors as unrecorded
goodwill (arising from customer loyalty, brand names and so on.) and the fact that the
value of individual assets to the company when used in the business may exceed their
realisable values.
Dividend yield – arrives at a share valuation using the dividend payments made.
However, dividends normally represent only part of the earnings generated by a
business. For valuation purposes, the total returns of the business should be taken into
account. The method fails to take account of any growth in dividends that may occur
over time.
Application of this method requires the use of dividend yield data from a comparable
company in the same industry, which is listed on the Stock Exchange. However, it may
be very difficult to find a company, which closely matches the risk and growth
characteristics of the one being valued. Moreover, the dividend policies pursued by the
companies concerned may be quite different, especially since Hughes is a wholly owned
subsidiary of Larkin.
Price earnings ratio – uses a multiple of existing earnings to value company shares. P:E
ratios reflect market sentiment concerning the value of a share. However, like the
dividend yield method mentioned above, valuation requires the use of data from a
similar listed business. Problems similar to those above can therefore arise. In addition,
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differences in accounting policies between companies may affect the way earnings are
measured that can further complicate matters.
(c) A company may decide to divest part of its business for a number of reasons. These
include:
Core business. The company may review its business operations and decide to
concentrate on what it regards as its core business. Any business operations that are not
regarded as core may be sold off following such a review.
Poor performance. Some parts of the company’s business may not meet the required
standards of performance. The company may not wish to invest time and resources
trying to improve the level of performance or may feel that the standards originally set
can no longer be achieved. As a result, the company may decide to dispose of low-
performance operations. This may increase the overall profitability of the business.
Takeover defence. A company may become the target of an unwelcome takeover bid
because of interest by another company in particular aspects of the company’s activities.
The target company may decide to sell off the business activities of interest to the
bidder to protect the rest of its operations from takeover.
Raising finance. A company may decide to sell off part of its business in order to raise
funds to use for purposes such as investing in other business operations or dealing with
cash flow problems within the company.
(d) Other useful information may include:
Future obligations. Details of any onerous contracts to, which the company is
committed, and any contingent liabilities, will need to be carefully considered.
Quality of assets. The condition of the assets held by the company should be evaluated.
For example, a prospective buyer will need to know if any fixed assets are nearing the
end of their useful lives or need major improvements.
Key personnel. A prospective buyer will need to know whether any change in
ownership will affect the decision of key personnel to stay with the company and
whether any re-negotiation of their contracts has to be undertaken.
Sales information. The market share of the company’s products, the range of its
customer base and the state of its order book would be of great interest to a prospective
buyer.
Employees. The morale and motivation of employees, management/employee relations
and the quality (e.g. training and experience) of employees is likely to be of vital
importance.
Forecast information. Financial forecasts prepared by the company and its advisers
concerning the future performance may be extremely useful.
Detailed costings. Information on the costs of operations may be useful to predict future
savings arising from management decisions following the takeover.
125
5. Fama Industries plc

(a) (i) The total value of the bid can be calculated as follows:
No. of shares of Beaver plc in issue = 30m
Rate of exchange: 4 Fama for 5 Beaver
No. of shares issued by Fama = 30m × 4/5
= 24m
EPS of Fama = £83m/100m
= £0.83
Value of share in Fama = 16 × £0.83
= £13.28
Total value of bid = £13.28 × 24m
= £318.72m
(ii) EPS of Fama following a successful takeover is
Earnings of Fama before takeover = £83m
Earnings of Beaver before takeover = £25m
Cost savings because of takeover = £4m
Total £112m
Shares in issue by Fama before takeover = 100m
Shares issued for takeover consideration = 24m
Total 124
EPS after takeover = £112/124m
= £0.90p
(iii) Share price of Fama after takeover = EPS × P:E ratio:
= £0.90 × 16
= £14.40
(b) EPS of Beaver before takeover:
= £25m/30m
= £0.83
Value per Beaver share = EPS × P:E ratio
= £0.83 × 12
= £9.96
After the takeover agreement, five shares in
Beaver are exchanged for four shares in Fama
The value of five shares in Beaver = £9.96 × 5
= £49.80
126
Assuming the P:E ratio of Fama is maintained and the economies achieved, the value of
four shares in the newly combined company is: = £14.40 × 4
= £57.60
These calculations suggest that a shareholder in Beaver would be better off by accepting
the offer. However, there may be some doubt as to whether the existing P:E ratio of
Fama can be maintained following the takeover. The market would need to be
convinced that the takeover would result in a significant improvement in future
earnings. The companies are in different industries and so the investors are likely to
scrutinise the rationale for the takeover.
The dividend per share of Beaver is currently 40p compared with 8p for Fama.
Assuming no change in payouts, a shareholder with five shares in Beaver will receive
32p dividend (i.e. 4 × 8p) after the takeover instead of the current £2.00 (i.e. 5 × 40p) –
a loss of £1.68. The prospect of a reduction in future dividends after the takeover may
concern shareholders in Beaver who rely on receiving cash returns from the company.
This may create problems in getting the share-for-share offer accepted.
As the expected EPS post takeover exceeds the current returns, shareholders of Fama
may be pleased to obtain Beaver shares for the offer price. However, if the current P:E
ratio is not maintained, the share offer may seem too generous towards Beaver
shareholders. For example, a reduction in the P:E ratio to 14 following the takeover
would reduce the value of a share in Fama to £12.60 (i.e. 14 × £0.90), below the current
share price.
(c) A company may wish to acquire another company for several reasons apart from the
pursuit of shareholder wealth maximisation. Two such reasons are as follows:
Diversification. A company may acquire another company operating in another industry
to reduce risks. However, if investors can reduce investment risk by holding a
diversified portfolio of shares they do not need the company to diversify in order to
achieve this. Moreover, it is usually cheaper for an investor to diversify than for a
company to do so. Diversification to reduce risk offers no benefit for the shareholder if
it provides nothing beyond what the investor can do for him/herself.
Management objectives. The management of a company may decide to take over
another to satisfy personal objectives. For example, it may feel that the increased size of
the company following the takeover will lead to an increase in power, status and
remuneration. Diversification may lead to managers feeling more secure, and may be
used as a means of reducing risks for managers rather than for owners.
6. Europium plc
£60m
(a) Europium plc’s EPS = = £0.75
80m
£24m
Promithium plc’s EPS = = £0.80
30m
Market value per share = EPS × P:E ratio
Europium plc = £0.75 × 16 = £12.00
Promithium plc = £0.80 × 10 = £8.00
127
Rate of exchange:
Market capitalisation of
Promithium plc = 30m × £10.00 [£8.00 + (25% × £8.00)]
= £300m
No. of shares to be issued by Europium plc
£300m
to acquire shares = = 25m shares
£12.00
Thus, 25m Europium plc shares will be issued for 30m Promithium plc shares. The
required rate of exchange is therefore 5 Europium plc shares for 6 Promithium plc
shares.
(b) Reasons for offering above the current market value include the following:
Incentive to sell. Shareholders who continue to hold shares in the company at current
market values are unlikely to accept an offer for the shares set at the current market
value. Thus, a premium on the market value will normally be required simply to tempt
shareholders to part with their shares.
Inside knowledge. The managers of Europium plc may have access to information not
generally available to the market and hence not taken into account in the current market
value of the shares.
Synergy. The managers may believe that, by combining the two businesses, substantial
gains can be made. The potential gains from the merger may make it feasible to increase
the bid price above the current market value of the shares.
The ‘Knock-out Blow’. Where the bid is likely to be resisted or where Europium plc is
in competition with other companies to acquire the business, the managers of Europium
plc may increase the price offered to a figure so high that it can be neither matched nor
refused.
(c) Market value per share of combined group:
Total market capitalization

=
No. of shares issued
Total market capitalisation = Combined profit after tax × P:E ratio
= £84m × 16 = £1,344m
No. of shares issued = 80m + 25m = 105m
£1, 344m
Market value per share = = £12.80
105m
The P:E ratio would stay the same if the market failed to recognise the difference in
growth potential between the two businesses. The P:E ratio may also stay the same if
synergy between the two businesses and/or improvements in performance resulting
128
from better management is expected. If these factors are not present, the P:E ratio will
change and should reflect a weighted average of the P:E ratios of the separate
businesses.
(d) Europium plc might investigate the following:
Financial record. Past financial performance including comparison with industry
performance. Information regarding forecast future performance.
Operations. Nature of business operations including production, selling and distribution
methods. Details of major suppliers and customers. Information regarding onerous
contracts with suppliers or customers.
Personnel. Information concerning directors and other senior managers including
details of employment contracts. Number of employees, skills profile and history of
employee relations over time. Details of pension schemes, profit-sharing arrangements
and redundancy agreements.
Marketing and sales. Details of the market including size of market, major competitors
and market share. Market penetration of products over time and potential for future
growth. Details of product range, new products being developed and R&D activities.
Assets. Age, condition, location and market value of the assets. Efficiency and
utilisation of assets. Details of legal title to assets and any financial claims against
assets.
Liabilities. Details of loans, debentures and leases. Details of future expenditure
commitments and contingent liabilities, especially off-balance sheet.
Owners. Details of shareholders and their rights. Likely reaction of major shareholders
to takeover bid.
Due diligence. Europium plc will send in its own team of independent accountants to
carry out checks on the adequacy of accounting systems and controls and the reliability
of the accounting information produced by Promithium plc to depict the financial
performance and position of the business.
129
CHAPTER 21
Managing currency risk
Learning objectives
This chapter explains the nature of the special risks incurred by companies that engage in
international operations:
• It explains the economic theory underlying the operation of international financial markets.
• It offers an understanding of the triple forms of currency risk: translation risk, transaction
risk and economic risk.
• It explains how firms can manage these risks by adopting hedging techniques internal to the
firm’s operations.
• It explains how firms can use the financial markets to hedge these risks externally.
Question summary
4. This question requires application of PPP.

7. This question examines the extent to which an investor can profit from covered interest
arbitrage.
8. Europa plc. This question requires construction of hedges on the forward market and the
money.
9. The Slade plc question is a simple comparison of money market hedging versus using the
forward market over two separate time horizons.
10. Philadelphia. This question involves analysis of the appropriate option hedge that the
corporate treasurer should purchase.
4.
(a) The exchange rate consistent with the two prices is £100 versus DKR 1,200, i.e. £1 versus
12 DKR.
(b) The two bundles will rise in price as follows:
UK: £100(1 + 5%) = £105
Denmark: DKR 1,200(1 + 3%) = DKR 1,236
Assuming PPP holds, the future spot rate is expected to be as follows: (1,236/105) = DKR
11.77 versus £1, i.e. appreciation of the DKR by about 2%.
130
(b) The UK price level is expected to rise by (5%/4) = 1.25% over three months’ and in
Denmark by (3%/4) = 0.75%. The exchange rate in the forward market consistent with
these rates is 12 × (1.0075/1.0125) = DKR 11.94 versus £1. Hence, the DKR would be
quoted at a premium of DKR 0.06, indicating that it was expected to strengthen against
the GBP.
7. In calculating the agios, mid-points are used here for both interest rates and exchange rates:
£:$ Spot : $1.6575

Forward : $1.6375
New York interest rate : 5 3/8% = 5.375%
London interest rate : 5 11/16% = 5.6875%
(a) The interest agio
 i$ − i £   5.375% − 5.6875% 
 =  = −0.3%
 1 + i£   1.056875 
The exchange agio
 F0 − S0  1.6375 − 1.6575% 
 =  = −1.2%
 S0   1.6575 
The discrepancy between the two agios does suggest the possibility of gains from arbitrage.
(b) Covered interest arbitrage (using the rates available to the investor)
Now
Convert £ into $ : £100,000 × 1.6550 = $165,500
Invest at 5 1 4 % p.a. : $174,189 in one year
$174,189
Sell forward : = £105,890
1.6450
Net gain = (£105,890 – £100,000) = £5,890
OR
Invest in London at 5.625%: £105,625 in one year
Net gain = (£105,625 – £100,000) = £5,625

In principle, covered interest arbitrage would generate a guaranteed relative gain of
(£5,890 – £5,625) £265 on paper, but this might well be eaten up by transaction costs.
131
8. Europa plc
(a) Forward market hedge: this simply involves arranging to sell the receivable $1.25m at the
3-month forward rate, which is as follows:
1.6480 – 1.6490 Spot

130 124 Deduct forward premium
1.6350 – 1.6366 Forward outright
Europa could only access the rate at the high end of the spread. Hence, amount payable to
Europa by its bank in three months’ time is:
$1.25m
= £763, 779
1.6366
(b) Money market hedge:
Amount of USD to borrow at 8% p.a.
$1.25m
(i.e. 2.67% over 3 months) = = $1,217,493
1.0267
$1, 217, 493
Convert to £ at spot: = £738,322
1.6490
Invest in UK at 8%: £738,322 (1.0267)

(i.e. 2.67% over 3 months) = £758,035
(c) The forward hedge appears superior as it generates
higher net proceeds of
(£763,779 –£758,035) = £5,744
9. Slade plc
Outright exchange rates are: £/$
Spot 1.4106–1.4140
3 months forward 1.4024–1.4063
6 months forward 1.3967–1.4006
(i) Hedging the 3-month transactions
Forward market
$197,000
Sell $197,000 3 months forward = = £140,084
1.4063
Net sterling payments in 3 months are £140,084 – £116,000
= £24,084
Money market
Borrow $194,808 at 4.5% p.a. to repay $197,000 from receipts in 3 months’ time.
Convert $194,808 Spot to £ at 1.4140 = £137,771
132
Invest £137,771 for 3 months at 6% p.a. to receive

£137,771 (1.015) = £139,838
Net sterling payments

= £139,838 –£116,000 = £23,838
Hence, using the forward market is the better alternative.
(ii) Looking ahead 6 months
Any hedge should apply to the net payment of $447,000 – $154,000 = $293,000 (inflow)
Forward market
Buy $293,000 at 6 months forward at 1.3967 = £209,780
Money market
Borrow £204,643 for 6 months at 7.5% p.a. (i.e. 3.75% over 6 months)
Convert to $ at spot of 1.4106 = $288,670
Invest $288,670 for 6 months at 3.0% p.a. (i.e. 1.5% over 6 months) to yield the required
total of $293,000 to make the payment.
Total cost = (£204,643 + interest at 7.5%/2) = £212,317
The lowest net sterling payment is by using the forward market.

10. Philadelphia
Beliefs about future spot exchange rates are personal evaluations. If the treasurer decides to
act upon his own hunch, this could dangerously expose the company to risk. Most
companies have a system of controls in place that should prevent individuals from pursuing
personal intuition. If the company is worried about exposure to currency risk, a portion of
the risk that is not self-hedging should be hedged by using financial market techniques such
as forward contracts, options or swaps.
Acting on the treasurer’s forecast the company will need to sell sterling for dollars, i.e. buy
put options on sterling. £1,625,000 will require 130 contracts.
(a) $1.8950–$1.8970/£. The relevant future spot rate for selling £ for $ is $1.8950/£. If the
future spot rate is $1.8950, the company would receive $3,079,375 using the spot market.
The £ is expected to weaken relative to the dollar. September options are available at
exercise prices of $1.90, $1.95, $2.00. At all of these prices, the option will be exercised.
At $1.90
Receipts are 1.625m × $1.9 = $3,087,500
Less option cost of 1.625m × 0.42 cents = 6,825
Net receipts $3,080,675
133
At $1.95
Receipts 1.625m × $1.95 $3,168,750
Option cost 1.625m × 4.15 cents 67,438

At $2.00
Receipts 1.625m × $2.00 $3,250,000
Option cost 1.625m × 9.40 cents 152,750

All three options result in higher expected dollar receipts than using the spot market in three
months (excluding any further transaction costs). Selection of the $1.95 exercise price
would give the highest expected receipts.
(b) $2.0240–$2.0260/£. If the spot rate for buying dollars in three months’ time is $2.0240/£
then, if purchased, the options would not be exercised because using the spot rate in three
months would give higher dollar receipts than any of the available option exercise prices.
Therefore, the company would not purchase currency options.
This would leave the company exposed to foreign exchange risk, because the spot rate in
three months’ time could be very different from the rate forecast by the treasurer.
134
CHAPTER 22
Foreign investment decisions
Learning objectives
This chapter focuses on foreign investment decisions by Multinational Corporations (MNCs).
• Study the advantages of MNCs.
• Discuss different ways of entering foreign markets.
• Consider the complexities of foreign direct investment (FDI).
• Analyse the appraisal of foreign FDI.
• Consider the impact of foreign exchange variations on foreign projects.
• Analyse ways of insulating projects against foreign exchange risk.
• Study political and country risk, and how to cope with it.
Question summary
4. Kay plc. This is a capital investment appraisal of an overseas-located project that

incorporates staged project receipts and UK taxation.
5. Brighteyes plc. This is another investment appraisal problem that looks at project value
from three different perspectives – that of the foreign government, that of the firm’s
overseas subsidiary and that of the parent company’s shareholders.
7. This question requires appraisal of the project both in sterling terms and in terms of the
currency of the host country.
4. Kay plc
Assumptions
Project inflation is assumed to occur at the national rate. PPP applies so that the project
costs can be converted to sterling at the present rate of exchange, i.e. the increase in local
construction costs is offset by appreciation of sterling.
Construction costs are (10 million ponchos/4) = £2.5m half-yearly. At 20% (i.e. 10% for
four half-yearly payments), the PV is as follows:
(£2.5m × four-period discount factor @ 10%) = £2.5m × 3.169
= £7.92m
135
Output of plant = 20,000 tonnes p.a., of which Kay will receive 40%, i.e. 8,000 tonnes p.a.
At today’s prices, this is worth (8,000 × 500 Euros) Euros 4m.
The value of output depends on the Euro versus sterling exchange rate, given that sterling
will depreciate by 5% p.a. At the expected exchange rate (Euros versus £1), this is worth the
following:
Year 2 1.45 (no output)

Year 3 1.38 Value: £2.90m
Year 4 1.32 £3.04m
Year 5 1.25 £3.20m
Year 6 1.19 £3.36m
Year 7 1.13 £3.52m
Calculation of NPV (£m)
Year 20% Sterling cash flow Tax Post-tax cash flow PV @ 20%
3 2.90 – 2.90 1.68
4 3.04 – 3.04 1.47
5 3.20 – 3.20 1.29
6 3.36 (0.76) 2.60 0.87
7 3.52 (1.06) 2.46 0.69
Total 6.00
NPV = (£7.92m) + £6.00m = (£1.92m), therefore it is not acceptable.
Kay should not proceed on these terms. It needs a higher share of the output, or local incentives
such as grants or concessionary finance.
5. Brighteyes plc
The table given below summarises the cash flows for the three decision-making levels. Net
present values for each are shown in the second table. The project meets the Ministry’s
requirement to achieve a 10% return, since the NPV at 10% is positive (L37.3m). It also
achieves a satisfactory NPV at the project level after local financing costs. However, the
project fails to offer an acceptable net present value for the parent company. The contrasting
results stem from three factors:
• Deteriorating exchange rates
• UK taxation and Lastonia withholding taxes
• Spillover effects in terms of lost exports.
136
Brighteyes plc: cash flow profiles

Year 0 1 2 3 4 5
Basic project (Lm) (40)
Plant working capital (20)
Operating cash flows 10 22 22 22 22
Sale of plant 24
Sale of working capital 16
Country cash flow (60) 10 22 22 22 62
Loan and interest 20 (2) (2) (2) (2) (22)
Project cash flow (40) 8 20 20 20 40
Withholding tax (1.6) (4) (4) (4) (8)
Remitted to UK (40) 6.4 16 16 16 32
Exchange rate 4 4 5 5 5 5
Sterling receipts (10) 1.6 3.2 3.2 3.2 6.4
UK tax (net)
(30% – 20%) (0.2) (0.3) (0.3) (0.3) (0.3)
Post-tax cash flows (10) 1.4 2.9 2.9 2.9 6.1
Lost exports (0.5) (0.5) (0.5) (0.5)
Parent cash flow (10) 1.4 2.4 2.4 2.4 5.6
The value of the project: discounted cash flows
Year (i) Country PV (ii) Project PV (iii) Parent PV

(£m) @ 10% (£m) @ 15% (£m) @ 15%
0 (60) (60) (40) (40) (10) (10)
1 10 9.1 8 7.0 1.4 1.2
2 22 18.2 20 15.1 2.4 1.8
3 22 16.5 20 13.2 2.4 1.6
4 22 15.0 20 11.4 2.4 1.4
5 62 38.5 40 19.9 5.6 2.8
NPV 37.3 NPV 26.6 NPV (1.2)
7. If interest rates are expected to remain 2% higher per annum in the United Kingdom than in
Eastasia (presumably due to higher UK inflation) then the £ sterling will be at a discount of
that order in the forward markets, which is as follows:
Year 1 Year 2 Year 3 Year 4
EA$ per £1 sterling 1.9633 1.9273 1.8919 1.8572
(NB For Year 1, the calculation is 2 × 1.07/1.09, etc.)
137
If the institute requires a 16% per annum rate of return in £ sterling, then it would require
1.07
16% ×
1.09
per annum return in dollars, implying discount factors of
£ sterling 0.8620 0.7432 0.6407 0.5523

EA$ 0.8782 0.7712 0.6772 0.5948
The forecast cash flows can then be summarised as follows:
Undiscounted: $000 750 950 1,250 1,350
£000 382 493 661 727
Discounted: $000 658 732 846 802
£000 329 366 423 401
Hence,
(a) The discounted cash flows in £ sterling total £1.519m, against an investment of
 2.5m 
£1.250m  EA$  or an NPV of £269,000.
 2 
(b) The discounted cash flows in EA$ sum to $3.038m, against an investment of $2.500m for
an NPV of $538,000. At the spot rate of EA$2:£1, this equals
EA$538, 000
= £269, 000 .
2
138

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Instructor’s Manual

Corporate Finance and

For further instructor material

 Pearson Education Limited 2009

Associated Companies around the world.

Visit us on the World Wide Web at:

First published 1999

© Pearson Education Limited 2009

1. An overview of financial management 5

• A note of the key learning objectives.

An overview of financial management

• What corporate finance and investment decisions involve.

• How financial management has evolved.

• The central role of cash in business.

• The underlying principles of finance.

6. This question examines shareholder goals and social objectives.

8. In the Cleevemoor Water Authority, stakeholder goals and performance measures of a

Examples of possible conflicts include:

(ii) A bonus based on turnover growth.

7. (a) Quoted high-growth company.

(e) Non-profit-making organisation, for example, a charity.

8. Cleevemoor Water Authority

The financial environment

• The function of financial markets.

• The operation of the stock exchange.

• The extent to which capital markets are efficient.

• How taxation affects corporate finance.

4. Beta plc examines the merits of a stock exchange listing.

5. Collingham plc considers the issues involved in gaining a listing.

1. (a) See Section 2.3 in Chapter 2 – wholesale banks.

2. (a) See Section 2.2 in Chapter 2

Present values, and bond and share valuation

• Why the value of money changes with time.

• The financial arithmetic underlying compound interest and discounting.

Discount rate A B Advice

(i) Assuming full distribution, and hence no growth:

(ii) With 50% retentions, dividends = £2.5m

(iii) With 50% retentions, dividends again = £2.5m

(iv) Assuming again 50% retentions:

(b) This year’s earnings after tax

Investment appraisal methods

• The underlying strengths and limitations of the above methods.

• Analysing investments when capital availability is an important constraint.

1. Yorkshire Autopoints is a basic NPV problem.

4. Mylo plc employs various appraisal methods to compare alternatives.

6. XYZ plc is a capital rationing problem involving the profitability index.

Year Cash flow Discount rate 30% Present value

1 30,000 0.769 23,070

Less initial cost and setting-up expenses 140,000

Net present value (23,640)

Project 2 – Incremental cash flows

Project 2 – Incremental cash flows

(iii) Profitability index

Project 2 = 36,000 (Year 1) + 16,000

Project A DISCOUNTED CASH FLOWS NPV

Discount rate Year 0 Year 1 Year 2 Year 3 £

–100 56.58 35.60 25.20 17.38

–100 53.58 31.88 21.36 6.82

–100 50.82 28.72 18.27 –2.19

Project B DISCOUNTED CASH FLOWS NPV

Discount rate Year 0 Year 1 Year 2 Year 3 £

–100 9.43 17.80 92.4 19.63

12% –100 × 10 × 20 × 110 ×

–100 8.93 15.94 78.32 3.19