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SOURCES OF FINANCE
Since every organisation needs finance to conduct its operations, the financial
manger must consider the broad categories of finance to be raised, the mix of
debt and equity and the cost of the finance. In addition, the financial
instruments to be issued to raise funds must appeal to investors for funds to
be forthcoming.
This part of Corporate Finance will look at the markets and institutions through
which finance can be raised as well as types of finance available.
A broker, on the other hand, acts as an agent for somebody. He buys and
sells shares on behalf of the investor and is paid a commission. He uses the
investor’s funds and not his own and therefore is not a principal in the
transaction, and thus he has to follow instructions from the investor on whose
behalf he is acting.
Merchant Banking
It offers a range of facilities and services which, inter-alias, include:
Corporate finance – e.g. provision of advice and assistance during
mergers, and debt and equity issues;
Lending – the actual provision of funds;
Money market – trading in money markets and foreign markets for
clients or on their behalf.
Investment Institutions
These include mutual funds, pension funds, and unit trust institutions. They
are significant participants in the financial markets because of the vast
amount of money under their control.
Chapter 7 VALUATION OF LONG TERM SECURITIES 5
Special Institutions
These are institutions created either formally or informally for specific
purposes, e.g. ZDB (now Infrastructure Development Bank, IDB) and SEDCO.
They usually offer short- to medium-term loans for fixed assets and working
capital, either through direct financing or indirect financing (guarantee a
percentage of loan offered from banking institution).
7.3.1 Return
Fixed Interest: Debt has a fixed interest charge whereas equity has no
such commitment. This is an advantage when the company is doing
well and earning more than interest charges.
Tax Deductibility: Interest charge on debt is usually tax-deductible. Its
effective cost to the company is therefore only about half of the nominal
rate. Dividends, on the other hand, are not tax deductible and so there
is no relief from the company’s point of view.
Cost of funds: the cost of debt is usually less than the cost of equity.
This allows the company to lever the return to shareholders higher than
the return on investment.
7.3.2 Risk
Commitment: Interest payment on debt must be met whether there
are profits or not, whilst with dividends this is not the case.
Capital Repayment: Debt requires capital repayment. This may put
strain on the company since it has to raise enough capital and interest
repayment and remain with more funds to run the company.
Chapter 7 VALUATION OF LONG TERM SECURITIES 6
7.3.3 Control
Dilution of Control: Raising finance through the use of equity dilutes
the control of the existing shareholders, especially if the new equity is
being issued to new shareholders.
Levels of Control: Control over the affairs of a company is the ability
to arrange matters according to the preference of the body that can
exercise such control, and some of the more important points of control
are:
o 75% of issued share capital – enables the passing of special
resolutions;
o 50% of issued share capital – enable the passing of ordinary
resolutions;
o 30% of issued share capital – control in terms of the Securities
Regulation Code on takeovers and Mergers;
o 20% to 30% of issued share capital – it is generally believed that
this is enough to effectively control a listed company depending on
how the other shares are held.
o Control of the board – it may be exercised not only through the
holding of shares, but also the ability to control or to have influence
over the board of directors.
o Default – control may be lost through the company’s failure to
meet certain commitments, which transfer certain rights to other
parties.
TBs are the most marketable and least risky of all the money market
instruments. They are issued at a discount from face value and have no
explicit interest payment. The benefit to the investor is the difference between
the face value and the purchase price. They can also be traded on the
secondary market.
Repurchase Agreements/Repos
They are agreements between the borrower and the lender to sell and
repurchase the government securities. The borrower (issuer) will contract to
sell securities to the lender (buyer) at a given price and at the same time
contract to buy them back at a future date at a given price. The return to the
lender is the difference between the two prices.
Repos usually range from overnight to two weeks with long term repos being
called term repos.
Commercial Paper
It represents unsecured promissory note of large financially sound
corporations. Because of their financial soundness such corporation paper
Chapter 7 VALUATION OF LONG TERM SECURITIES 8
earnings of the business, i.e. the shareholder will only get a dividend after all
claim holders have been paid, and only so if the BOD thinks it appropriate.
Due to this, equity is much riskier that all types of fixed income securities.
However, as residual claimants, in good times they tend to benefit.
Definition of Terms
The following terms are used in conjunction with ordinary shares:
Nominal/Face Value: The value written on the share certificate that all
shareholders will be given by the company in which they own
shares.
Market Value: The amount at which a share is being sold in the stock market.
It may be radically different from the nominal value.
Par Value: Shares sold at their par value are sold by the issuing company in
the primary market at the value equal to their nominal value.
Premium value: These are shares issued at par value plus an additional
premium.
Discount value: these are shares issued at a price less than the nominal
value.
Preference shares
Preference shares are of a hybrid nature, with characteristics of both
fixed/debt and equity nature.
Typically preference shares promise a fixed dividend hence they are likened
to debt. Unlike the interest paid on debt, the preference dividend is not
deductible for tax purposes. If dividend is not paid at one point it may be
cumulated (unless if it is non-cumulative) and will have to be paid at a future
date with other dividends. In this way it is likened to equity. Because
Chapter 7 VALUATION OF LONG TERM SECURITIES 10
The three major differences between ordinary and preference shares are that:
1. Preference shares offer their owners preferences over ordinary shares
(i.e. they are paid dividends before ordinary shareholders);
2. Preference shareholders are often entitled to a fixed dividend even
when ordinary shareholders are not;
3. Preference shareholders cannot normally vote at general meetings.
Treasury notes are medium term treasury bonds with maturity of between 1 to
10 years.
Both instruments pay interest twice a year with principal paid at maturity.
Treasury bonds can also be called before maturity. Normally the government
exercises this option if conditions are favourable to it (i.e. if the call price is
less than the market price). Due to this embedded risk in callable treasury
bonds they pay a higher return as inducement to investors to buy them.
Corporate bonds/debentures
These are issued by business entities. They have similar payment a pattern to
treasury bonds, only that they have an element of risk should the company go
under. Debentures are usually issued for a fixed interest rate and secured
over certain assets.
If the debenture is secured then, just like a mortgage for a private house, the
debenture holder has a legal interest in the asset and the company cannot
dispose of it unless debenture holder agrees.
NB: Debentures can also be callable (if interest rate is low). Debenture
holders have the right to receive their interest payments before any dividend
is payable to shareholders, and even if the company makes a loss; it still has
to pay interest charges. Debenture usually have restrictive covenant clauses
that restrict the way management runs the business so as to protect investors.
Mortgage bonds
They are long term loans secured over the fixed property of the company, e.g.
land and buildings.
Leases
These are common sources of finance for movable assets. A leasing contract
is between the leasing company (the lessor) and the customer (the lessee).
The lessor buys the asset and retains ownership whilst the lessee uses the
asset.
There are two types of leases:
Finance lease: Rental covers virtually all costs of the asset.
Operating lease: The lease does not run for a full life of the asset and
the lessee will not be liable for the full value. The lessor assumes
residual risk.
Hire purchase
It is a method of acquiring assets without having to invest full amount in
buying them. A hire purchase agreement typically allows the hire purchaser
sole use of an asset for a period after which they have the right to buy them at
normally a small or nominal amount. The benefit is that the company gains
immediate use of the asset without having to pay a large amount for it or
without having to borrow a large amount.
Chapter 7 VALUATION OF LONG TERM SECURITIES 13
Factoring may impose constrains on the way to do your
business.
Ending a factoring arrangement can be difficult especially where
it involves repurchase of the sales ledger.
Lines of credit from creditors: This is a type of short-term credit. In
this case the supplier of, for example raw materials, will allow the
company to buy goods now and pay later.
Personal savings: These are amounts of money that a
businessperson, partner or shareholder has at their disposal to do as
they wish. If such money is used to invest in their own or other
business then it becomes a source of finance.
Working capital: Working capital is the money used to pay for the
everyday trading activities carried out by the business. It is defined as:
Working Capital = Current Assets – Current Liabilities.
Where:
Current Assets = Short-term sources of finance, e.g. stocks,
debtors and cash and cash equivalents.
Current Liabilities = Short-term requirements for cash, e.g. trade
creditors, expense creditors, tax owing and dividends owing (Those
payable in a month or less)
Sale of Assets: This involves selling of surplus fixed or movable
assets.
Retained profit: Since this profit is not distributed it is then at the
company’s own disposal to do as it sees fit. They can be retained for
suspected future rainy days.
Chapter 7 VALUATION OF LONG TERM SECURITIES 15
I
V
k
n
I MV
V
1 k 1 k
t n
t 1
Example
A bond has a par value of $1,000 with 10% coupon paid over nine years. The
required rate of return is 12%. Calculate its value.
Assuming the required rate of return was 8% the value becomes $1,124.70.
The present value is greater than the par value because the required rate of
return is less than the coupon rate. In this case investors will be willing to pay
a premium to buy the bond. In the previous case, with the required rate of
Chapter 7 VALUATION OF LONG TERM SECURITIES 17
return at 12%, investors would be willing to buy the bond only if it is sold at a
discount from par value.
Thus: If k > coupon rate the bond will sell at a discount.
If k < coupon rate the bond will sell at a premium.
If k = coupon rate the bond will sell at par value.
i. Zero-coupon bonds
It pays no interest but sells at a deep discount from its face value. Thus the
investor buys the bond at below face value and redeems it at face value on
maturity. The present value is:
MV
V
1 k
n
Example
Assuming the bond with a face value of $1,000, with a 10-year maturity and
required rate of return of 12%, calculate its value.
1000
V $322.00
1.12
10
D
V
k
Chapter 7 VALUATION OF LONG TERM SECURITIES 18
D1 D2 D
V ..........
1 k 1 k 1 k
1 2
Dt
t 1 1 k
t
Where: D = Cash dividend at the end of time t, and
k = Discount rate.
For finite common stock or those we intend to sell in the future the formula
becomes:
D1 D2 Dn Pn
V ..........
1 k 1 k 1 k 1 k
1 2 n n
D 1 g D0 1 g D 1 g
2
V 0 .......... 0
1 k 1 k
2
1 k
D1
V
k g
Where: D1 D0 1 g , which is dividend in period 1.
V 1 b
Earnings Multiplier
E1 k g
Example
A company’s dividend per share at t1 is $4, the dividend is expected to grow
at 6% forever and the discount rate is 14%. Calculate the value of the stock.
4
V $50
0.14 0.06
Assuming the same company has retention rate of 40% and earnings per
share at t1 of $6.67.
V
1 0.4 7.5 times
E1 0.14 0.06
V 7.5*6.67 $50
Chapter 7 VALUATION OF LONG TERM SECURITIES 20
D1
V
k
Example
Assuming the dividend is expected to grow at 10% for the first five years and
thereafter at 6%. Value can be calculated as:
D0 1.10 D5 1.06
t t 5
5
V
1 k t 6 1 k
t t
t 1
0
5 D 1.10
t
1 D6
V
5
t 1 1 k 1 k k 0.06
t
n
I MV
P0
1 k 1 k
t n
t 1
Given the value of MV, P0, and I one can calculate the value of k using
interpolation.
Chapter 7 VALUATION OF LONG TERM SECURITIES 21
Example
Assuming a bond with a par value of $1,000; current market value of $761; 12
years to maturity; and 8% coupon rate. Gives a k of 12% (YTM).
D D
P0 k
k P0
Example
Assuming the current market price of a company’s 10%, $100 par value
preferred stock is $91.25. Calculate the yield.
$10
k 10.96%
91.25
D1 D1
P0 k g
k g P0
D
Thus common stock yield comes from expected dividend yield 1 and
P0
capital gains yield g .
Example
What market yield is implied by a share of common stock currently selling for
$50 whose dividends are expected to grow at a rate of 10% per year and
whose dividend is currently at $2.20.
1* PV C1 2* PV C2 n * PV Cn
Duration ..........
V V V
Where: V = Total value of the bond,
n = Period, and
PV(Cn) = Present value of cash flow n.
Volatility, on the other hand, is the percentage or degree by which the price of
a bond changes due to a change in the bond yield.
Thus:
Duration
Volatility ( percentage)
1 Yield
NB: A bond’s volatility is directly related to its duration. It shows the likely
effect of a change in interest rates on the value of a bond.
Example
a. Calculate the duration and volatility of a 6-year, $1,000 par value bond
paying 13.125% coupon rate annually and a YTM of 6.5%.
b. Calculate the duration and volatility of a 6-year, $1,000 par value bond
paying 8% coupon rate annually and YTM of 6.5%.
c. Which bond is riskier?
Chapter 7 VALUATION OF LONG TERM SECURITIES 24
Answer
a. Bond A
b. Bond B
COST OF CAPITAL
Cost of capital is the required rate of return on the various types of financing.
The overall cost of capital is the weighted average of the individual required
rates of return (costs).
A company is a collection of projects; hence the use of an overall cost of
capital as the acceptance criterion (hurdle rate) for investment decisions is
appropriate only in situations where the current proposed projects are of
similar risk and characteristics. If they differ then the cost of capital on its own
is not adequate for decision-making.
The advantage of using the company’s overall cost of capital is for simplicity.
The overall cost of capital is a proportionate average of the cost of the various
components of the firm’s financing. These are cost of equity capital; cost of
debt and cost of preferred stock.
= K x Wx
n
Cost of capital
x 1
The three securities have different required rates of return due to differences
in risk. The required rate of return of each capital component is called the
component cost.
The explicit cost of debt can be derived by solving for the discount rate (K d)
that equates the market price of the debt issue with the present value of
interest plus principal payments. The discount rate (Kd) known as the yield to
maturity (YTM) is solved for using the following formula:
n
I Pt
P0 t t
t 1 1 K d
Since the after tax cost of debt is the one that is required, the following
formula is used:
Ki Kd 1 T
Where: Ki = After-tax cost of debt;
T = Company’s marginal tax rate.
Since interest charges are tax deductible to the issuer, the after-tax cost of
debt is substantially less than the before-tax cost.
Example
Suppose the company borrow at an interest rate of 11%, and if it has a
marginal government tax rate of 40%, then its after-tax cost of debt is
calculated as:
Ki Kd 1 T = 11%(1 – 0.4)
= 11%(0.6)
= 6.6%
this calculation assumes that the firm has taxable income. Without the taxable
income Ki = Kd.
Example
If the company where to sell 10% preferred stock issue ($100 par value). The
company has incurred flotation cost of 2.5% per share. Calculate K p.
$10
KP 10.3%
$97.5
NB: This cost is not adjusted for taxes because the preferred stock dividend
used is already an after-tax figure. Thus explicit cost of preferred stock is
greater than that of debt.
If the firm used either method it should earn more than K e to provide this rate
of return to investors.
Where as debt and preferred stock are contractual obligations, which have
easily determined costs, it is more difficult to estimate K e . The three principles
Step 1: Estimate the risk-free rate (Rf) generally taken to be the yield of a long
or intermediate-term government bond.
Step 2: Estimate the stock’s beta coefficient i , and use it as an index of
stock’s risk.
Step 3: Estimate the current expected rate of return of the market, or on an
average stock Rm . Rm estimates can be from stock exchange
the future.
Example
Assume: Rf = 8%; Rm = 14% and ßi = 1.1.
Ke 0.08 (0.14 0.08)
= 14.6%
Thus 14.6% is the rate of return investors expect the company to earn on its
equity.
Weaknesses
i. If the firm’s stockholders are not well diversified, they may be concerned
with stand-alone risk in addition to market risk. Thus in such a case the
firm’s risk should be measured by i alone as the CAPM procedure
ii. Even if the CAPM method is valid it is hard to obtain correct estimates of
the inputs required since:
A) There is controversy as to whether one should use long-term or
short-term treasury yields (CAPM is a one period model);
B) It is hard to estimate the beta that investors expect the company
to have in the future; and
Chapter 8 COST OF CAPITAL 31
Rf
d e
Systematic Risk (Beta)
As illustrated, in addition to the risk premium on debt, the common stock of a
company must provide a higher expected return than the debt of the same
company. The reason being that there is more systematic risk involved.
The historic risk premium in expected returns of stocks over bonds has been
around 3% to 5% points. The greater the risk of the firm, as shown by the
slope of the SML, the greater the premium.
Using this approach the company’s approximate cost of equity K e would be:
Ke Before-tax Cost of Debt + Risk Premium in Expected Return for Stock Over Debt
(Bond Yield)
E.g. The Company’s bonds yield 10% in the market.
Ke 10% 4% 14%
Thus the company’s before-tax cost of debt will form the basis for estimating
the firm’s cost of equity.
Chapter 8 COST OF CAPITAL 32
Weaknesses
i. Since the premium over debt is simply added, the method does not
give a precise cost of equity;
ii. It does not allow for changing risk premiums over time.
equates the present value of all expected future dividends per share, as
perceived by investors at the margin, with the current market price per share.
Thus:
D1 D1 D
P0 .....
1 Ke 1 Ke 2
1 K e
Dt
1 Ke
t
t 1
Constant Growth
If dividends are expected to grow at a constant rate then the constant growth
model can be used, i.e.:
D1
P0
Ke g
D1
Thus : K e g
P0
Chapter 8 COST OF CAPITAL 33
D
Thus investors expect to receive a dividend yield, 1 plus a capital gain ( g )
P0
for a total expected return K e and in equilibrium this expected return is also
Example
Dividends are expected to grow at 8% per annum into the foreseeable future.
The dividend in the 1st year is expected to be $2 and the present market price
is $27. Calculate the cost of equity.
$2
Ke 8% 15.4%
$27
Whilst it is easy to determine the dividend yield, it is difficult to establish the
proper growth rate.
Growth Phases
If the growth rate changes from time to time then constant growth rate will not
apply in calculating cost of equity K e using the Discounted Cash Flow (DCF)
approach.
Example
If dividends were expected to grow at a 20% for 5years, at 15% for the next
5years, and then grow at 10% into the foreseeable future, then:
By solving for K e the cost of equity is obtained. The last phase i.e.
D10 1.10
t 10
Compilation
According to the calculations of K e using CAPM, Risk Premium and DCF
Thus:
WACC Wd K d 1 T Wp K p We K e
n
Wx K x
x 1
NB: i. WACC is the weighted average cost of each new, or marginal, dollar of
capital – it is not the average cost of funds raised in the past. On
average each of the new dollar will consist partly of debt, preferred
stock, and common stock.
ii. Weights can be based either on:
a) Accounting values as shown in the balance sheet (i.e. Book values)
b) Current market values of the components, or
c) Management’s target capital structure. The current weights are
those based on the firm’s target capital structure, since this is the
best estimate of how the firm will, on average, raise money in the
future.
A) Economic Factors
a. Level of Interest Rates
If interest rate increases the cost of debt increases. Also the higher the
interest rates the higher the cost of common and preferred equity capital.
b. Tax Rates
Tax rates are used in calculating the cost of debt; hence it affects the cost of
debt. Lowering the capital gains tax relative to the rate on ordinary income
would make stocks more attractive which reduces the cost of equity relative to
that of debt.
Chapter 8 COST OF CAPITAL 36
b) Dividend Policy
The percentage of earnings paid out in dividends may affect a stock’s
required rate of return K e . Also, if a firm’s payout ratio is so high that it must
issue new stock to fund its capital budget, it will be forced to incur floatation
costs, which will affect the cost of capital.
c) Investment Policy
It is assumed that if the firm acquires a new capital it will invest it in the
existing line of business or assets. This is why estimation of the cost of capital
as a starting point is by use of the outstanding stock and bonds. However, it
will be incorrect if the firm dramatically changed its investment policy. This will
drastically change the firm’s marginal cost of capital, so as to reflect the
riskness of the new line of business.
return, the firm is able to increase the market price of its stock. This
increase occurs because investment projects are expected to return
more on their equity-financed portion than the required return on
equity K e . Once these expectations are apparent to the market place,
the market price of firm’s stock should increase because expected future
earnings per share and dividends per share are higher than those
expected before the projects were accepted.
2. Another rational is that the use of WACC is based on the assumption
that investment proposals being considered do not differ in systematic
risk from that of the firm and that the unsystematic risk of the proposals
does not provide any diversification benefits to the firm. It is only under
these circumstances that the cost of capital figure obtained appropriate
as an acceptance criterion. Thus these assumptions imply that the
projects of the firm are completely alike with respect to risk and that only
project only projects of the same risk will be considered.
3. For a multi-product firm with investment proposals of varying risk, the
use of an overall required rate of return is inappropriate. A required rate
of return based on the risk characteristics of the specific proposal should
be used. Thus the key to using the overall cost of capital as a project’s
required rate of return is the similarity of the project with respect to risk of
existing projects and investment proposals under consideration.
Fig. 7.2: Trade Off Between Risk and The Cost of Capital
Rate of Accept
Return WACC
12.0
10.5 A Reject
10.0
9.5 D
7.0
KF
Using the same criterion of accept of reject stated above, one can apply it to a
company with different divisions or subsidiaries. Assuming company Y with
two subsidiaries, one a clothing shop and another a grocery shop. Assuming
the clothing shop is low risk and has 10% cost of capital and grocery shop is
Chapter 8 COST OF CAPITAL 39
highly risky with 14% cost of capital. If these shops have equal weights then
the overall company’s cost of capital will be 12%.
Example
Assume in 2006 the clothing manager has a project with an 11% expected
return whilst the grocery manager has a project with a 13% expected return.
Which project should be accepted or rejected?
The clothing manager’s project should be accepted and the grocery
manager’s project should be rejected basing on each subsidiary’s specific
hurdle rate. However, had one considered the overall company Y’s hurdle rate
of 12% then the grocery manager’s project should have been accepted yet it
infact decreases the shareholders’ wealth.
i. Stand-Alone Risk
It is project’s risk disregarding the fact that it is but one asset within the firm’s
portfolio of assets and that the firm is but one stock in a typical investor’s
portfolio of stocks. It is measured by the variability of the project’s expected
reruns.
A project with a high degree of stand-alone or corporate risk will not necessarily
affect the firm’s beta. However, projects with high uncertain returns that are
highly correlated with returns on the firm’s other assets and with most other
assets in the economy will have a high degree of all types of risk.
Market risk is theoretically the most relevant risk because of its direct effect on
stock prices. Unfortunately, it is also the most difficult to measure. Most
decision makers consider all three risk measures they classify projects into low,
average, or high risk projects. Risk-adjusted costs of capital are developed for
each category using composite WACC.
Risk-adjusted cost of capital is the required return (discount rate) that is
increased relative to the firm’s overall cost of capital for projects or group
showing greater than average risk and decreased for projects or groups
showing less than average risk.
While this approach is better than not risk adjusting at all, these risk
adjustments are subjective and somewhat arbitrary.
between excess returns for project e and those of the market portfolio.
Example
Assuming e = 1.1; R f 8% and Rm 12%
Re 8% 4%*1.1 12.4%
Chapter 8 COST OF CAPITAL 41
If the firm intends to finance a project entirely with equity the acceptance
criterion would then be invest in a project if the expected rate of return met or
exceed the required rate of return Re , which in this case is 12.4%.
If the company uses only equity capital its cost of capital is also its corporate
cost of capital or WACC.
Example
The firm currently has Ke 12.4%; R f 8%; Rm 12% and e 1.1 . It intends to
take on a particular project which would cause its beta coefficient to change and
hence its cost of equity. The new weights and beta coefficients will be as
follows:
Calculate:
i. Portfolio beta
ii. Overall corporate cost of capital
iii. The cost of capital the new project should earn for the corporate to earn
the cost of capital calculated in ii above. Fist use weights and then use
beta coefficient.
Solution
i. 0.8(1.1) + 0.2(1.5) = 1.18
ii. Kp = 8% + 4%*1.18 = 12.72%
iii. Using weights: 0.8*12.4% + 0.2*X = 12.72%
X = 14%
Using beta: K N 8% 4%*1.5 14%
Excess Return on
Market Portfolio
Accounting betas are used for large projects or divisions, and divisional betas
are then used for division projects.
Handling Depreciation
A good approximation to the firm’s internally generated cash flow is found as:
2. Measurement Problems
Difficulties are encountered in estimating the cost of equity. It is difficult to
D1
obtain good input data for CAPM, for growth (g) in K e g , and for risk
P0
5. Small Businesses
Small businesses are generally privately owned making it difficult to estimate
the cost of equity. Again the three equity cost-estimating approaches
discussed have serious limitations when applied to small firms.
For example:
Growth (g) in constant growth model is difficult to measure since the firm
might not pay dividends in the foreseeable future;
In the second method of adding the risk premium, this might be difficult if
the firm does not have publicly traded bond outstanding;
The third approach of CAPM is difficult to use because, if the firm’s stock
is not publicly traded, then one cannot calculate beta. For privately owned
small firms the pure play CAPM can be used.
Small firms’ capital budgeting is also greatly affected by floatation costs
which tend to be very high. The higher the floatation cost the higher the
coat of external equity.
DIVIDEND POLICY
Dividend policy can be defined as a trade-off between retaining earnings on
one hand and paying out cash and issuing new shares on the other hand. It
forms the integral part of the firm’s financing decision.
The dividend payout-ratio determines the amount of earnings that can be
retained in the firm as a source of finance. The firm should therefore
determine the proper allocation of profits between dividend payments and the
retained earnings. The dividend policy is generally determined by legal
framework, liquidity, control issues, stability of dividend, stock dividend and
stock splits, stock repurchase and administration considerations.
For situations between zero dividend and a 100% dividend payout the
dividend-payout ratio will be a fraction between zero and one respectively.
Thus M&M suggest that the sum of the discounted value per share of
common stock after financing plus current dividends paid is exactly equal to
the market value per share of the common stock before the payment of the
Chapter 10 DIVIDEND POLICY 48
current dividend. In other words, the common stock’s decline in market price
is because of dilution caused by external equity financing and is exactly offset
by the payment of the dividend.
The shareholder is therefore, said to be indifferent between receiving
dividends and having earnings retained by the firm.
If corporate dividends are the only source of income for old stockholders then
receiving extra dividend payment plus an offsetting capital loss will make a
difference to them. However, in a perfect capital market, they can make
homemade dividends through the selling of shares to new shareholders.
In either case there is a transfer of old to new shareholders, only that in the
former case it was through dilution and in the later it was through a reduction
in the number of shares held.
Because investors can manufacture homemade dividends they will not pay a
higher price for the shares of the firms with high payouts. Thus firms should
not worry about dividend policy, as in the eyes of the shareholder, they are all
the same. Thus firms should let dividends fluctuate as a by-product of their
investment and financing decisions.
Firm Cash
Cash Shares
Cash
Even under dilution the total value of the firm remains unchanged, what
changes is simply the value of each share (gets smaller).
Put in other words, a firm that reports good earnings and pays a
generous dividend is putting its money where its mouth is.
Firms, however, can cheat in the short run by overstating earnings and
scraping up cash to pay a generous dividend. This cannot be sustained
in the long run, and hence the firm will be revealed.
M&M on the other hand arguer that the jump in stock price that
accompanies an unexpected dividend increase would have happened
anyway as information about future earnings came out through other
channels.
subtracted from the book net worth. Thus dividends can be paid from surplus
and not legal capital.
Another legal rule is the undue retention of earnings rule. This rule prohibits
the company from retention of earnings significantly in excess of the present
and future investment needs of the company. This is meant to prevent
companies from retaining earnings for the sake of avoiding tax.
9.4.3 Liquidity
The greater the cash position and overall liquidity of the company, the grater
is its ability to pay a dividend.
9.4.7 Control
Shareholders may prefer that the company pay a low dividend payout and
retain some earnings to finance future investment shares instead of issuing
shares to new stakeholders. Should old shareholders fail to take-up new stock
leading to new shareholders coming in, their control will be diluted.
From another angle companies in danger of being acquired may establish a
high dividend payout in order to please shareholders and hence avoid a
takeover.
Company A
Amount
Per 4
Share
3 Earnings per
Share
2
Dividends per
Share
1
Chapter 10 DIVIDEND POLICY 54
Time
Company B
Amount
Per 4
Share
3 Earnings per
Share
2 Dividends per
Share
Time
If a firm sticks to its payout ratio then dividend should change each year,
however, managers are reluctant to do this hence they pay a constant
dividend.
Thus:
D1 – D0 = Adjustment rate x Target change
= Adjustment rate x (Target ratio x EPS1 – D0).
The more conservative the company, the more reluctant it is to move towards
its target and, therefore, the lower would be its adjustment rate.
vii. Stock Dividend – It is when the company gives out extra stock to
investors instead of cash dividend.
viii. Dividend Reinvestment Plan (DRIP) - Some companies offer
automated DRIPs. New shares are issued at, say % discount from the
market price.
BEFORE AFTER
Current Market Price $40 $40
Par Value $5 $5
Common Stock $2,000,000 $2,100,000
Additional Paid in Capital $1,000,000 $1,700,000
Retained Earnings $7,000,000 $6,200,000
Total Shareholders’ Equity $10,000,000 $10,000,000
Number of Shares 400,000 420,000
Overally, shareholders have more shares of stock but lower earnings per
share. However, proportionate claim against total earnings remains constant.
Chapter 10 DIVIDEND POLICY 57
Conservative Way
Par Value $5
Common Stock $4,000,000
Additional Paid in Capital $1,000,000
Retained Earnings $5,000,000
Total Shareholders’ Equity $10,000,000
Number of Shares 800,000
BEFORE AFTER
Par Value $5 $2.50
Common Stock $2,000,000 $2,000,000
Additional Paid in Capital $1,000,000 $1,000,000
Retained Earnings $7,000,000 $7,000,000
Total Shareholders’ Equity $10,000,000 $10,000,000
Number of Shares 400,000 800,000
Except in accounting treatment, then, the stock dividend and split are very
similar. A stock split, like a large percentage stock dividend, is usually
reserved for occasions where the company wishes to achieve a substantial
reduction in the market price per share of common stock, thereby at times
Chapter 10 DIVIDEND POLICY 58
attracting more buyers. Whilst the dividend per share falls the effective
dividend usually increases, e.g. if the dividend was $2 per share it will be
reduced to $1.20 per share.
Reverse stock splits are employed to increase the market price per share
when the stock is considered to be selling at too low a price. The informative
effect in this case is negative, as it might appear as if the company is in
financial difficulties. On the other hand, it might be driven by the need to move
the stock price into a higher trading range where total trading costs and
servicing expenses are low.
Example
The company is considering distributing $1.5 million either in cash dividend or
through share repurchase. The following are key company figures just prior to
the $1.5 million distribution:
Earnings After Tax $2,000,000
Number of Common Stock Outstanding 500,000
Earnings per Share $4
Current Market Price per Share $63
Expected Dividend $3
Chapter 10 DIVIDEND POLICY 60
Option 1: Cash dividend – Investors expect $3 per share cash dividend (i.e.
$1,500,000/500,000). The $63 thus consists of $3 dividend and $60 market
price of stock expected to be earned after the cash dividend distribution.
Should the firm decide to pay a cash dividend, its price-earnings ratio after the
dividend would be 15 (i.e. $60/$4). If this ratio stays at 15 after a stock
repurchase, total market price per share will be $63 (i.e. $4.20 x 15). Thus the
two options bring the same benefits.
If personal tax rate on capital gains is less than that on dividend income, the
repurchase of stock offers a tax advantage over the payment of dividend to
the taxable investor. Again capital gains tax is postponed until the stock is
sold, whereas with dividends the tax must be paid on a current basis.
Whilst cash dividends provide regular information on the ability of the firm to
generate cash, stock repurchase provides a once off extra bulletin on the
degree to which management feels the stock is undervalued.
A stock that has gone ex-dividend is market with an “X” in newspaper price
listing.
In case of old stock all funds to be reinvested are transferred to a bank that
acts as a trustee. The bank then purchases shares of the company’s common
stock in the open market with either the company or investor bearing
brokerage costs.
The other method is when the firm issues new stock and this is when the firm
actually raises new capital. This method effectively reduces cash dividends.
The company does not pay brokerage costs as the stock is coming from itself.
Normally investors buy the stock at a discount of the market price. Even
though reinvested, the dividend is taxable to the shareholder as ordinary
income, and this posse as a major disadvantage to taxable investors.
Chapter 11 LEASE FINANCING 63
LEASE FINANCING
A lease is a contract under which one party, the lessor (owner) of an asset,
agrees to grant the use of an asset to another, the lessee (user), in exchange
for periodic rental payments.
TYPES OF LEASES
i. Operating Lease
This is a short-term lease that is cancellable during the contract period at
the option of the lessee with proper notice. The term of operating lease is
shorter then the asset’s economic life. The lessor does not recover the full
investment during the first lease but through leasing the asset over and
over, either to the same lessee or different lessees. Examples include
office space, copying machines, computers software or hardware and
automobile leases.
NB: At expiration of the lease the lessee has the option, according to
contract’s specification, either to return the leased asset to the lessor, to
Chapter 11 LEASE FINANCING 64
renew the lease at the agreed rate or, to buy the asst at its fair market value.
If the lessee fails to exercise the option, the lessor takes possession of the
asset and is entitled to any residual value associated with it.
x. Direct Leasing
This usually involves a lease arrangement for brand new assets. The lessee
identifies the equipment, arranges for the leasing company to buy it from the
manufacturer, and signs a lease contract with the leasing company. Major
types of lessor in this case are manufacturers, finance companies, banks,
independent leasing companies and partnerships.
Short-term leases are convenient, e.g. if one needs the use of a car for a
week or if the company needs the use of an asset for 1 year or 2. However,
short-term leases tend to be very expensive for equipment that can easily be
damaged.
d) Tax Shields
The lessor deducts the asset’s depreciation from taxable income. If such
depreciation tax shields are put into a better use than an asst’s user can, the
benefit can be passed on to the lessee in the form of low lease payments.
Using AMT, part of the benefits of accelerated depreciation and other tax
reducing items are added back hence increasing total tax to be paid.
However, lease payments are not on the list of items added back in
calculating AMT. Thus, if you lease rather than buy, tax depreciation is less
and the AMT is less.
The lessee can purchase the asset for a bargain (fair market value)
price when the lease expires.
The lease lasts for at least 75% of the asset’s estimated economic life.
The present value of the lease payments is at least 90% of the asset’s
value.
Thus all other leases are operating leases as far as the above is concerned.
Example
The company has decided to acquire a piece of equipment valued at
$148,000 to be used in the fabrication of microprocessors. If financed with
lease the manufacture will provide such financing over seven years. The
terms of the lease call for an annual payment of $27,500. The annual
payments are made in advance, i.e. annuity due. The lease is a net lease.
Required:
a. Calculate the before-tax return to the lessor.
b. Calculate the annual lease payment if required rate of return is 11%.
Answer:
a. Use the formula:
n
C0 = [LCFt/(1+k)t]
t=0
= LCF0 + LCFt(PVIFAk,n)
Where:
C0 is cost of the equipment
LCFt is lease cash flow at time t.
Yr LCFt PV @ 5% PV @ 10%
0 27,500.00 27,500.00 27,500.00
1 27,500.00 26,190.48 25,000.00
2 27,500.00 24,943.31 22,727.27
3 27,500.00 23,755.53 20,661.16
4 27,500.00 22,624.32 18,782.87
5 27,500.00 21,546.97 17,075.34
6 27,500.00 20,520.92 15,523.03
Total 167,081.53 147,269.67
NPV at 5% = $19,081.53
NPV at 10% = -$730.33
k = r1 + [NPV1/(NPV1-NPV2)]*[r2-r1]
= 0.05 +(19,081.53/19,811.86)*(0.05)
= 9.82%
b. 6
$148,000 =[(LCFt/1.11)t]
t=0
= LCF0 + LCFt(PVIFA11%,6)
Yr LCFt PV @ 11%
0 X 1.0000
1 X 0.9009
2 X 0.8116
3 X 0.7312
4 X 0.6587
5 X 0.5935
6 X 0.5346
Total 5.2305
X = $148,000
5.231
= $28,293.00
Chapter 11 LEASE FINANCING 69
In the example above the company makes annual lease payments of $27,500
for leased asset. These are tax deductible in the year in which they apply, i.e.
$27,500 paid in year 0 is only deductible for tax in year 1.
Leasing is analogous to borrowing, thus an appropriate discount rate for
discounting the after-tax cash flows is the after-tax cost of borrowing.
Assume the cost of borrowing is 12% and the tax rate is 40%. Thus, the after-
tax cost of borrowing is 12%x(1-40%) = 7.2%.
Calculate the Present value of cash flows of the lease.
Answer:
Year End
0 1 2 3 4 5 6 7 Total
A= Loan
Payment 28,955 28,955 28,955 28,955 28,955 28,955 28,955 (15,000)
B = Bt-1 - A+C
Principal Owing 119,045 104,375 87,945 69,544 48,934 25,851 -
C = Bt-1 x 0.12
Annual Interest - 14,285 12,525 10,553 8,345 5,872 3,102 -
D = Annual
Depreciation - 24,667 24,667 24,667 24,667 24,667 24,667 - 148,000
E = (C+D)*0.40
Tax-Shield
Benefit - 15,581 14,877 14,088 13,205 12,216 11,108 (6,000)
F = A - E Cash
Outflow After
Tax 28,955 13,374 14,078 14,867 15,750 16,739 17,847 (9,000)
G = F/(1.072)t
P.V. Cash
Outflow 28,955 12,476 12,251 12,068 11,926 11,824 11,760 (5,532) 95,728
Chapter 12 WORKING CAPITAL MANAGEMENT 72
Working capital can be viewed from two concepts, i.e. net working capital and
gross working capital.
Accountants use the term working capital to mean net working capital, which
can be defined as current assets less current liabilities. Financial analysts, on
the other hand, mean current assets when they speak of working capital.
Thus their focus is on gross working capital, which is the firm’s investment in
current assets, e.g. cash, marketable securities, receivables, and inventory.
Working capital is therefore all about the administration of the firm’s current
assets namely cash and marketable securities, receivables and inventory and
the financing (especially current liabilities) needed to support current assets.
To come up with the optimum level management must consider the trade off
between profitability and risk. For each level of output, the firm can have a
number of different levels of current assets. The greater the output level the
greater the need for investment in current assets to support that output. The
relationship is not linear; current assets increase at a decreasing rate with
output as illustrated below:
Policy A
CURRENT
ASSETS Policy B
LEVEL ($)
Policy C
OUTPUT (UNITS)
Chapter 12 WORKING CAPITAL MANAGEMENT 73
Policy A is associated with high liquidity low profit and low risk, policy B is on
the medium side whilst policy C is associated with high liquidity and high
profitability and risk. This is due to the fact that looking at the relationship
between current assets and profitability one can use the return on investment
(ROI) equation, i.e.:
Thus, from the above equation, decreasing the amounts of current assets
held will increase the firm’s potential profitability, provided output and sales
remain constant or increase.
However, a decrease in current assets means a reduction in the firm’s ability
to meet obligations as they fall due, adopting stricter credit terms in order to
reduce accounts receivables, leading in loss of customers and lose of sales
as products run out of stock. Thus, adopting an aggressive working capital
policy leads to increased risk.
Varying working capital levels leads to two most basic principles in finance,
i.e.:
Profitability varies inversely with liquidity, and
Profitability moves together with risk (i.e. there is a trade off between
risk and return)
The optimal level of current assets in the firm will be determined
management’s attitude to the trade-off between profitability and risk.
Chapter 12 WORKING CAPITAL MANAGEMENT 74
Amount
Time
For a growing firm the level of permanent working capital needed will increase
over time in the same manner as does fixed assets. However, unlike fixed
assets, permanent current assets are constantly changing.
Amount Short-term
Financing
Current Assets
Long-term
Financing
Fixed Assets
Time
If total funds requirements behave in the manner shown above only the short-
term fluctuations shown at the top of the figure would be financed with short-
term debt. If such fluctuations are financed using long-term debt then the firm
will be paying interest for the use of funds during times when these funds are
not needed.
Thus, loans to support a seasonal need would be following a self –liquidating
principle, e.g. loan taken to finance purchase of Easter eggs will be paid from
receivables from sale of eggs.
Short-Vs-Long-Term Financing
Due to uncertainty the exact matching of the firm’s schedule of future net cash
flows and debt payment schedule is usually not appropriate. The question is,
what margin of safety should be built into the maturity schedule to allow for
adverse fluctuations in cash flows? This depends on management’s attitude
to the trade-off between risk and profitability.
Chapter 12 WORKING CAPITAL MANAGEMENT 76
Generally, the expected cost of long-term financing is usually more than the
short-term financing. However, in periods of high interest rates, the rate on
short-term borrowings may exceed that of long-term borrowing. In addition to
being generally more expensive, firms borrowing on long-term basis might
end up paying interest on debt over periods of time when funds are not
needed.
Thus generally, short-term debt has greater risk then long-term debt but also
less costly.
The firm should therefore come up with the margin of safety, which can be
thought of as the lag between the firm’s expected net cashflow and the
contractual payments on its debt. The margin of safety will depend on the risk
preferences of management, as shown below:
Chapter 12 WORKING CAPITAL MANAGEMENT 77
Amount Short-term
Financing
Current Assets
Long-term
Financing
Fixed Assets
Time
Amount Short-term
Financing
Current Assets
Long-term
Financing
Fixed Assets
Time
Under conservative policy, the higher the long-term financing line, the more
conservative the financing policy of the firm, and the higher the cost. Under
the aggressive policy there is a negative margin of safety. The greater the
portion of the permanent asset needs financed with short-term debt, the more
aggressive the financing is said to be.
Chapter 12 WORKING CAPITAL MANAGEMENT 78
A firm can employ four different ways of managing cash and marketable
securities and these are:
Speeding up cash receipts,
Slowing down cash payouts,
Maintaining cash balances, and
Investing in marketable securities.
Chapter 12 WORKING CAPITAL MANAGEMENT 79
a) Collections
This involves the acceleration of collections, it includes the steps taken by the
firm from the time a product or service is sold until the customers’ cheques
are collected and become usable funds for the firm. Collections can be
accelerated thorough:
The second and third aspects above collectively represent collection float. It
represents the time it takes from the point when the cheque is mailed, (mail
float), to the point when funds are available for use by the company (available
float). The finance manager should therefore reduce collection float as much
as possible.
The main advantage with this method is that cheques are deposited before
any processing or accounting work is done (thus eliminating processing float).
The main disadvantage is cost in the form of bank charges for additional
service.
b. Concentration Banking
Firm that use lock –box system and over-the-counter payment system find
themselves with numerous regional banks. Such firms find it more reasonable
to move part or all of these remote deposits to one central location
(concentration banking) usually at the head office.
If cash discounts are taken on accounts payable, the firm should send
payment at the end of the cash discount period, but if discount is not taken,
the firm should not pay until the final due date in order to have maximum use
of cash.
Companies can also draw cheques from remote bank (e.g. a Harare supplier
and a Kwekwe bank) to try and increase the time within which the cheque will
be outstanding.
Using this model, the carrying cost of holding cash – interest foregone on
marketable securities – is balanced against the fixed cost of transferring
marketable securities to cash or vice versa. It can be illustrated as follows:
Cash
C
Average
Cash
Balance
(C/2)
Time
Key: C = Total cash
C/2 = Average cash
The model assumes that the cash flows are constant. One limitation to this
however is the fact that cash payments are seldom completely predictable.
The minimum average level of cash balances required is the point at which
the account is just profitable.
b) Marketability (Liquidity)
The ability to sell a significant volume of securities in a short period of time in
the secondary market without significant price concession. That is the ability
of the owner to convert it into cash at short notice without suffering a great
lose. This requires a large active secondary market.
c) Yield (Return)
This relates to interest and/or appreciation of principal provided by the
security. Treasury bills do not pay any interest but they are sold at a discount
and redeemed at face value. The portfolio manager needs to be aware of the
interest rate (yield) risk, i.e. variability in the market price of a security caused
by changes in interest rates.
d) Maturity
It simply refers to the life of the security. Usually, the longer the maturity the
greater the yield, but the more is the exposure to yield risk.
Economic conditions, product pricing, product quality and the firm’s credit
policies are the key influences on the level of a firm’s accounts receivable. Of
these, financial manager only influences credit policies.
Lowering credit standards may stimulate demand, leading to higher sales and
profits, but at the same time increases cost of carrying the additional
receivables, as well as a greater risk of bad debt loses. Thus the trade-off
between profitability and risk should be managed. Policy variables include the
quality of the trade accounts accepted, the length of the credit period, cash
discounts and the collection program of the firm. All these determine the
average collection period and the level of bad debts.
a) Credit Standards
In theory the firm should lower its quality standard for accounts accepted for
as long as profitability of sales generated exceeds the added cost of the
receivables.
Added costs are in the form of additional work due to increased receivables
and increased probability of bad debt loses. There is also the opportunity cost
of committing funds to the investment in additional receivables instead of
other investments.
Relaxing credit standards means customers who initially were not credit
worthy now qualify and collection from these clients is usually slower. Those
who qualified initially will also tend to relax.
Chapter 12 WORKING CAPITAL MANAGEMENT 85
Example
Assume the firm’s product is selling at $100. Variable cost per unit is $80.
Contribution per unit is $20 (i.e. $100 - $80).
The firm plans to increase sales and this increase can be accommodated
without any increase in fixed costs since the company is currently operating
below capacity.
Current clients pay in 1 (one) month and are expected to continue doing so.
Annual credit sales stand at $24 million.
Credit liberalisation will result in new credit clients paying in 2 (two) months’
time. The same relaxation will result in a 25% increase in credit sales (i.e. $24
million x 1.25 = $30 million thus additional sales units is $6 million/$100 = 60
000 units)
The firm’s opportunity cost of carrying the additional receivables is 20%
before tax.
Answer
Additional Sales Profitability = Unit Contribution x Additional Units Sold
= $20 x 60 000 units
= $1 200 000
Since additional sales profitability ($1.2 million) far exceeds the required
before tax return on additional investment ($160 000), the firm should relax its
credit standards up to a point where the two are equal assuming all other
things remain constant.
b) Credit Terms
1. Credit period
This specifies the total length of time over which credit is extended to a
customer to pay a bill.
A firm’s credit term might be expressed as “2/10 net 30”.
Where: “2/10” means 2% discount is given if the bill is paid within 10 days of
invoice date, and
“net 30” means if discount is not taken full payment is due by the 30 th
day from invoice date.
Thus credit period still remains 30 days.
Example
Assume, using the above example, credit period has changed from net 30 to
net 60. This change also affects the old clients.
The credit policy has resulted in additional sales of $3,600,000 and these new
clients also pay on average in two months.
Answer
Additional Sales Profitability = Unit Contribution x Additional Units Sold
= $20 x 36 000 units
= $720 000
Example
Assume a firm with annual credit sales of $30 million and an average
collection period of two months. Sales terms are “net 45” with no discounts.
Assume by initiating terms of “2/10, net 45” the average collection period can
be reduced to one month as 60% of the customers (in money terms) take
advantage of the 2% discount.
Thus Opportunity Cost of the Discount = 0.2 x 0.6 x $30 million = $360 000,
annually.
The firm therefore realises $2.5 million (i.e. $5 million - $2.5 million) from
accelerated collection.
The value of the funds received is the opportunity cost and assuming a 20%
before-tax rate of return, the Opportunity Savings = $2.5 million x 0.2 = $500
000.
3. Seasonal datings
In this case, during periods of slack sales, firms will at times sale to customers
without requiring payment for sometime to come (usually until after the peak
sales period), e.g. in the sell of jerseys. Again the firm should compare the
profitability of additional sales (due to this incentive) with the required return
on the additional investment in receivables to determine whether datings are
appropriate terms by which to stimulate demand.
Datings also help in reducing storage costs. If warehousing costs plus the
required return on investment in inventory exceeds the required return on the
additional receivables, datings are worthwhile.
c) Default Risk
It is important to note that the optimum credit standard policy will not
necessarily be the one that minimises bad debt loses. The optimal policy to
adopt should be the one that provides the greatest incremental benefit to the
firm.
The bad debt loses tend to decline as collection expenditure in the form of
letters, phone calls, personal visits and legal action increases. The same
applies to the average collection period.
The main disadvantage of investing in inventory is the total cost of holding the
inventory including storage and handling costs and the opportunity cost.
There is also the danger of obsolescence.
Assume a known, stead usage of 2,600 items for six months period, 100
items are used each week. Ordering costs (O) are constant regardless of the
order size. Thus total ordering cost is the cost per order times the number of
orders for that period.
Chapter 12 WORKING CAPITAL MANAGEMENT 91
Carrying costs per unit (C) represent the cost of inventory storage, handling,
insurance and the required return on the investment in inventory, per period of
time. Again they are assumed to be constant per period per unit. Total
carrying cost for that period is therefore equal to the carrying cost per unit
times the average number of units of inventory for that period. Its assumed
that inventory units are filled without delay when needed.
With a steady use of inventory over time and with no safety stock, average
inventory can be expressed as:
Q
2
Where Q = Quantity ordered.
This can be illustrated as follows:
Inventory
Q
Average
Inventory
(Q/2)
Time
As shown, when a zero level of inventory is reached, a new order of Q items
arrives.
Thus, total inventory cost = Total carrying cost x Total ordering cost, i.e.
T = C(Q/2) + O(S/Q).
It implies that the higher the order quantity (Q) the higher the total carrying
costs, but the lower the total ordering costs. The firm therefore becomes
worried about the trade-off between the economies of increased order size
and the added cost of carrying additional inventory.
Q0 = 2(O)(S)
C
Example
Assume inventory usage of 2,000 during a 100 day planning period costs are
$100 per order, and carrying costs are $10 per unit per 100 days. Calculate
the optimal order quantity.
Answer
Thus with an order quantity of 200 the firm can order 10 times (i.e. 2,000/200)
during the 100 days, i.e. every 10 days.
Q0 varies directly with usage (S) and order costs (O) and inversely with
carrying cost (C). However, the relationship is not linear due to the square
root effect. Thus Q0 changes at a lower proportionate rate in relation to others.
Chapter 12 WORKING CAPITAL MANAGEMENT 93
Source: http://en.wikipedia.org/wiki/Economic_order_quantity
In the previous example it was assumed that there is no lead-time, i.e. the
order is replenished as soon as request is made.
Assuming a lead-time of 5 days it follows that the firm needs to order every 5
days before it run out of stock or at 100 units of stock on hand.
Chapter 12 WORKING CAPITAL MANAGEMENT 94
As illustrated below, when the new order is received 5 days later, the firm will
just have exhausted its existing stock.
Inventory
200 units
Order
Point
(100 units) Q0
5 10 15 20 25 30 Days
Lead-Time
5. Safety Stock
This is inventory stock held in reserves as a cushion against uncertain
demand (or usage) and replenishment lead-time.
Thus, in this case, owing to fluctuations, it is not feasible to allow expected
inventory to fall to zero before a new order is anticipated as illustrated below.
Inventory
300 units
Order
Point
(200 units)
100 units
Safety Stock
5 10 15 20 25 30 Days
Lead-Time
In real life where demand and lead-time are not certain the diagram can be
shown as:
Inventory
300 units
Order
Point A B C
(200 units)
100 units
5 10 15 20 25 30 Days
Chapter 12 WORKING CAPITAL MANAGEMENT 96
As shown in the diagram, the real life experience shows that at the first
segment the usage was less than expected hence the slope of the demand is
less than expected. The order point was only reached three days (shown by
A) before the next order is received hence it was received before the safety
stock level was reached. In the next segment usage was as expected but it
took six days (represented by B) instead of five for the order to be received
hence the company was already utilising its safety stock. In the third segment
the order is placed soon after receiving the other one due to low stock levels
and delivery is also done immediately hence stocks are replenished.
All these issues point to the fact that the amount of safety stock depends on
things like demand uncertainty, lead-time uncertainty, work stoppage costs
and the cost of carrying additional inventory.
Management will not wish to add safety stock beyond the point at which
incremental carrying costs exceed the incremental benefits to be derived from
avoiding a stock out.
By reducing the ordering related costs, the firm is able to flatten the total
ordering cost curve thereby shifting Q0 to the left thereby approaching the JIT
ideal of one unit.
Chapter 13 MERGERS AND ACQUISITIONS 97
FORMS OF MERGER
i. Horizontal Merger
Involves the coming together of two firms in the same line of business.
Such mergers result in economies through the elimination of duplicate
facilities and offering a broader product line.
If company A has acquired company B then the Net Present Value (NPV) to A
of acquiring B will be given by:
b) Economies of Scale
These occur when average cost declines with increase in quantity. Cost
declines come from things like sharing central services like office
management, accounting and marketing, financial control, executive
development and top-level management.
The surviving firm also gains the market share and can even dominate the
market.
Companies tend to gain through the combined use of facilities and gain
through synergy.
d) Eliminating Inefficiencies
Some firms are inefficiently managed, with the result that profitability is lower
than it might otherwise be.
e) Signalling Effect
Value could occur if new information is conveyed as a result of the corporate
restructuring. This usually works when there is information asymmetry
between management and common stockholders.
Chapter 13 MERGERS AND ACQUISITIONS 99
f) Surplus Funds
Firms with surplus cash and a shortage of good investment opportunities
often turn to mergers financed by cash as a way of redeploying their capital.
Firms with excess funds and not willing to redeploy it can also be targeted for
acquisition.
g) Tax Reasons
A company coming out of bankruptcy can have lots of money in unused tax-
loss carry-forwards. Such a company can buy of merge with another profit
marking company and hence be able to utilise the carry-forwards.
j) Diversification
By merging with another firm and attaining more diversification, either through
product or market diversification, help in reducing risk of loses to the
company. Diversification can be shown using the Ansoff (Product/Market)
Grid below.
i. Earnings Impact
In this case the acquiring firm considers the effect that the merger will have on
the earnings per share of the surviving corporation.
Example
You are given the following financial data in the case where company A is
considering the acquisition, by common stock, of company B.
Company A Company B
Present Earnings (000) $20,000 $5,000
Shares outstanding (000) 5,000 2,000
Earnings per share (EPS) $4.00 $2.50
Price per share $64.00 $30.00
Price Earnings (P/E) ratio 16 12
Chapter 13 MERGERS AND ACQUISITIONS 101
Company A has agreed to offer $36 (i.e. 20% premium above company B’s
stock) a share to company B, to be paid in company A’s stock.
E.R. = 36 = 0.5625
64
Thus company A will pay 0.5625 share for each of company B’s share.
Thus the merger has lead to an immediate jump in the earnings per share for
company A from $4.00 to $4.08.
Suppose company A had offered a 50% premium its EPS would have
declined to $3.90 indicating an initial dilution due to the acquisition. On the
Chapter 13 MERGERS AND ACQUISITIONS 102
P/E ratio in the first instance was 14.4 (i.e. $36/$2.50) and in the second
instance it was 18 compared to 16 for company A.
In general, the higher the pre-merger P/E ratio and earnings of the acquiring
company in relation to the acquired company, the greater the increase in EPS
of the surviving company. Thus, avoid acquiring companies with high P/E
ratios and high earnings.
Expected
EPS ($)
Growth with merger
12
1 2 3 4 5 Years
The greater the duration of the dilution, the less desirable the acquisition is
said to be from the standpoint of the acquiring company.
Chapter 13 MERGERS AND ACQUISITIONS 103
If the market exchange ratio is 1 (one) it follows that the shares will be
exchanged on a 1:1 basis and the company being acquired finds little
enticement to accept such an exchange. The acquiring company should offer
a price in excess of the current market price per share of the company it
wishes to acquire. Ceteris-paribus, shareholders of both companies will
benefit from such a merger, as shown below.
Example
You are given the following financial information of the acquiring and the
acquired company:
The P/E ratio of the surviving company is expected to remain at its high level
of 18 after the acquisition.
The acquiring company has offered $40 for each of the shares in the acquired
company.
Chapter 13 MERGERS AND ACQUISITIONS 104
The shareholders of the acquired company benefit in the sense that their
share, which is going for $30.00 in the market, has been bought for $40.00.
Surviving Co.
Total Earnings (000) $26,000
Shares outstanding (000) 7,334
Earnings per share (EPS) $3.55
Price Earnings (P/E) ratio 18
Market Price Per Share $63.90
It follows that companies with high P/E ratios would be able to acquire
companies with low P/E ratios and obtain an immediate increase in EPS,
despite the fact that they have offered a premium, with respect to the market
price exchange ratio, provided the P/E ratio after the merger remains
sufficiently high.
Empirical evidence has shown that share prices of the target company start
increasing in days before the announcement date whilst those of the acquiring
company remain constant or fall. Returns to shareholders of the acquiring
Chapter 13 MERGERS AND ACQUISITIONS 105
company tend to fall immediately after the merger whilst shareholders of the
acquired firm experience high and positive return.
The relative abnormal stock returns around the announcement date of a
successful merger can be illustrated as follows:
Cumulative
Average
Abnormal
Return
Selling company
+
0 Buying company
Announcement Days
Date
losses. Such is the case when an acquisition is made with cash or with a debt
instrument.
ACCOUNTING TREATMENT
Accounting for mergers can be treated either as a purchase method or a
pooling of interests method.
TAKEOVER DEFENCES
These are antitakeover amendments that a firm can employ to frustrate the
company intending to acquire it in a hostile takeover bid. Such a bid is when
the acquiring company makes a tender offer (an offer to buy current
shareholders’ stock at a specified price) directly to the shareholders of the
company it wishes to acquire.
Chapter 13 MERGERS AND ACQUISITIONS 107
There are two hypothesises usually used as the motive to employ “shark
repellent” devices, and these are:
i. Management entrancement hypothesis, which suggests that the
devices are employed to protect management jobs and that, such
actions work to the detriment of shareholders.
ii. Shareholders’ interest hypothesis, which argues that contest for
corporate control are dysfunctional and take management’s time
away from profit making activities.
DIVESTITURE
This is the opposite of merger. It is the divestment of a portion of the
enterprise or the firm as a whole.
The following are the various methods of divestment.
The subsidiary will have its value realised since it will have a separate stock
price and trading publicly. This will encourage managers for that subsidiary to
perform well.
If the subsidiary is in leading-edge technology which cannot be realised whilst
it is financed from the parent, equity curve-out will the subsidiary’s market to
be more complete hence accessing finance. Also investors will be able to
obtain a pure play investment in technology.
NB: Pure play is an investment concentrated in one line of business. It is the
opposite of investment in a conglomerate.
i. Going Private
This is process of making a public company private though the repurchase of
stock buy current management and/or outside private investors.
The motive to go private could be to do away with the high costs of running a
public company, to do away with legislations governing public companies or
the need to realign and improve management incentives, hence increasing
efficiency.
However, going private involves high transaction costs, little liquidity to its
owners, large portion of owner’s wealth is tied up in the company, and the
company’s true value might not be realised unless it goes public.
LBOs are done using cash and not common stock and the division bought
becomes a private company. LBOs are motivated by the following reasons:
The division might no longer fit in the company’s strategic objectives.
The division enjoys a window of opportunity extending for several
years.
The company has gone through a program of heavy capital
expenditure and hence the plant is modern.
The company has assets that can be sold to finance its debts without
affecting its company business.
The division has proven historic performance and has an established
market position.
Also the availability of experienced and good quality senior
management is critical.
Due to the leverage management will be forced to work hard so that nothing
goes wrong.