Financial management

J. Dahya, R.E.V. Groves
AC3059, 2790059

2011

Undergraduate study in Economics, Management, Finance and the Social Sciences
This subject guide is for a Level 3 course (also known as a ‘300 course’) offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ). For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by: J. Dahya, Bacc., Macc, Lecturer in Accounting and Business Finance, Cardiff Business School, University of Wales, Cardiff. R.E.V. Groves, B.Com., MSc, PhD, FCA, Sir Julian Hodge Professor of Accounting, Cardiff Business School, University of Wales, Cardiff. It was updated in 2008 by Professor Groves. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

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Published by: University of London © University of London 2008 Reprinted with minor revisions 2011 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents

Introduction ............................................................................................................ 1 Aims and objectives ....................................................................................................... 1 Learning outcomes ........................................................................................................ 2 Syllabus ........................................................................................................................ 2 Studying financial management .................................................................................... 2 Reading advice ............................................................................................................. 3 Online study resources ................................................................................................... 4 How to use the subject guide ........................................................................................ 5 Solutions to learning activities ...................................................................................... 6 Examination advice ....................................................................................................... 6 Summary ...................................................................................................................... 7 Abbreviations ............................................................................................................... 7 Chapter 1: Introduction to financial management ................................................ 9 Aims of the chapter ...................................................................................................... 9 Learning outcomes ........................................................................................................ 9 Essential reading ........................................................................................................ 10 Further reading ........................................................................................................... 10 Key tasks of financial management ............................................................................. 10 Financial environment ................................................................................................. 10 Organisational forms of business ................................................................................ 11 Corporate objectives ................................................................................................... 11 Role of managers ....................................................................................................... 12 Conflicts of interest and their resolution ...................................................................... 12 Corporate governance ................................................................................................ 13 Financial management and risk ................................................................................... 13 Financial management and accounting ....................................................................... 13 Financial management and taxation ........................................................................... 14 A reminder of your learning outcomes ......................................................................... 14 Practise questions ....................................................................................................... 14 Problems .................................................................................................................... 15 Chapter 2: Basic investment appraisal methods .................................................. 17 Aims of the chapter .................................................................................................... 17 Learning outcomes ...................................................................................................... 17 Essential reading ........................................................................................................ 17 Further reading ........................................................................................................... 17 Time value of money ................................................................................................... 18 Future value and compounding ................................................................................... 18 Present value and discounting .................................................................................... 18 Interest rates, discount rates and real rates ................................................................. 19 Basic investment appraisal techniques ........................................................................ 19 Application problems – some considerations ............................................................... 21 ‘What-if’ questions ..................................................................................................... 25 The examination ......................................................................................................... 26 A reminder of your learning outcomes ......................................................................... 26
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................................................. 36 Chapter 4: Capital budgeting – risk and return ...............................59 Financial management Sample examination questions ................................................ insider trading and doubts concerning efficiency ............................................................... 39 Risk and return ..... 52 Retained earnings ............................................................................................................................... 29 Learning outcomes ....... 27 Chapter 3: Introduction to risk and return ....................................................................... 41 Capital budgeting and project risk ........ 51 Other sources and types of equity ........................................................... 54 ii ...1 .................... 49 Share capital .............................................................................. 45 Aims of the chapter ........................................... 26 Practise question 2....... 45 Capital markets .............................................................................................................................. 38 Portfolio betas .................................... 35 Problems ......................... 50 Rights issues........................................................................................................................................................................................................................................................................................... 46 Efficient market hypothesis ...................................................................................................................................................................... 43 Problems .......................................................... 29 Further reading ............................................................................ 37 Aims of the chapter ................................................................................................................................................................................................................................................................................................... 38 Measuring beta ........................... 29 Rate of return: a review ........ 40 Project returns and the opportunity cost of capital ................................................... 29 Aims of the chapter .................. 42 A reminder of your learning outcomes ......................... 53 The issue of loan capital ................................ 31 Risk and diversification ............................................................................................................................................................... 37 Learning outcomes .......................................................................................................................................................................................................................................................................................................... 46 Tests of the efficient market hypothesis ......................................................................................................................................... 35 Practise questions .... 30 Calculating expected return...................................................................... 54 Hybrid capital .............................................................................. fads........................................................................................................ 37 Further reading ......................................................................................................................................... 48 London capital market .................................................................................................................................................... 35 A reminder of your learning outcomes ......................................................................................................................................................................... 43 Practise questions ............... 45 Essential reading ................................................................................. variance and standard deviation ............................................................................................................................................ share prices and shareholder wealth ................................................... 39 Capital asset pricing model ...... 37 Essential reading .................................... 29 Introduction .............................................. 37 Introduction ......... 43 Chapter 5: Sources of funds ................ 53 Long-term debt finance ................................................................... 45 Learning outcomes ........................................................... 37 Measuring market risk .................................................................................................... 26 Problems .......... 29 Essential reading .................................................................................................................................................................................................................................. 48 Implications of capital market efficiency ................................................................................................... 47 Anomalies......................................................... 50 Methods of raising share capital ................................................................................................................................... 33 Market risk versus unique risk ....................................................................................................................................................................................................................................................................................

.... 81 Essential reading .............................................................................. 57 Learning outcomes ...............................Contents The attitude of investors and managers to the financing decision ............................................................................................................................ 59 The required return on investment .................................................................................................................... 79 Chapter 8: Financial analysis.......... 71 Chapter 7: Dividend policy ................. methods and uses.................. 73 Essential reading ............................................................ 65 Valuation on the basis of the business’s earnings .................................. 65 Other approaches to share and business valuation ................................................................................... 73 Aims of the chapter ................................................................................................... 76 Determining dividend policy in practice .... 55 Practise questions .................................................................................................................... 62 The reasons for capital gearing ................................ 57 The value of economic assets – debt ......................................................................... 81 iii .................................................................................... 55 Chapter 6: Cost of capital and valuation of a business....................................................................................................................................... 63 The relationship between the level of capital gearing and the cost of capital – the traditional view ............ 55 Problems ........................................................................................................................................................................... 73 Introduction ........................................................................................... 77 Problems .......... 81 Statement analysis ..................................................... 62 Capital gearing and risk ..................................... 64 Weighted average cost of capital (WACC) ..................................................................... 73 Learning outcomes ................. 77 A reminder of your learning outcomes .................................. 61 Valuation of warrants .................................................................................... 74 Dividend irrelevancy argument ......... and financial planning ..................................................... 77 Practise questions ... 61 The cost of retained earnings ............................................................................................................................................................................................................... 73 Further reading ............................................. 54 A reminder of your learning outcomes ............................................................................................... 81 Aims of the chapter .............. 66 A reminder of your learning outcomes ........... 76 Scrip dividends ....................................................................................................................... 73 Dividend policy and shareholder wealth .................................................................................................................................................................................................................................................................................... 70 Problems ...................................... 70 Practise questions ................................................................................................................................................................ 57 Aims of the chapter ...................................................................................................................................................................................................................................................................... 58 The value of economic assets – equity ....................................... 63 The relationship between the level of capital gearing and the cost of capital – the Modigliani and Miller view ................................................................................................................................................................................................................................................................................................................................................................. 74 Information content of dividends ................................................................................................................................ 57 Further reading .............................................................................................................................. 75 Clientele effect .................. 60 The capital asset pricing model (CAPM) ........................................................................................................................ 75 Share repurchase ............................................................................................... 74 Traditional view of dividends .................................................................................................................................................................................................................................................................... 57 Essential reading ...... 81 Further reading ....................................................................................... 81 Learning outcomes .................

59 Financial management

Cash based ratios ....................................................................................................... 82 Practical applications .................................................................................................. 83 Financial planning – introductory comments ............................................................... 88 Financial planning process .......................................................................................... 88 Technical aspects of financial planning ........................................................................ 88 Planning outputs ........................................................................................................ 89 A reminder of your learning outcomes ......................................................................... 90 Practise questions ....................................................................................................... 91 Problems .................................................................................................................... 91 Chapter 9: Short-term finance and asset management ...................................... 93 Aims of the chapter .................................................................................................... 93 Learning outcomes ...................................................................................................... 93 Essential reading ........................................................................................................ 93 Further reading ........................................................................................................... 93 Long- versus short-term finance .................................................................................. 94 Trade credit ................................................................................................................ 94 Debt factoring ............................................................................................................ 94 Bank borrowing .......................................................................................................... 95 Specialist finance ........................................................................................................ 96 Leasing ...................................................................................................................... 96 Evaluation of sources of finance .................................................................................. 96 Management of short-term assets ............................................................................... 99 The management of cash ............................................................................................ 99 The management of trade debtors ............................................................................ 100 The management of stock-in-trade ............................................................................ 101 Working capital and the problem of overtrading ........................................................ 102 A reminder of your learning outcomes ....................................................................... 104 Practise questions ..................................................................................................... 104 Problems .................................................................................................................. 105 Chapter 10: Treasury management and international aspects of financial management ....................................................................................... 107 Aims of the chapter .................................................................................................. 107 Learning outcomes .................................................................................................... 107 Essential reading ...................................................................................................... 107 Further reading ......................................................................................................... 107 Introduction ............................................................................................................. 108 Why should financial managers of firms be concerned with options and other financial instruments? ............................................................................................... 108 Calls and puts .......................................................................................................... 108 What the value of a call option depends upon ........................................................... 109 Option valuation model ............................................................................................ 110 Using options to allow the expansion or abandonment of real assets ......................... 111 Options on financial assets ....................................................................................... 112 Why do companies hedge? ....................................................................................... 112 International financial management .......................................................................... 113 Interrelationships between variable affecting exchange rates ..................................... 114 Exchange risk exposure ............................................................................................. 116 Management of foreign exchange exposure .............................................................. 116 A reminder of your learning outcomes ....................................................................... 119 Practise question ...................................................................................................... 119 Problems .................................................................................................................. 120
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Contents

Chapter 11: Mergers, corporate restructuring and off-balance sheet funding .. 121 Aims of the chapter .................................................................................................. 121 Learning outcomes .................................................................................................... 121 Essential reading ...................................................................................................... 121 Further reading ......................................................................................................... 121 Introduction ............................................................................................................. 122 Merger waves ........................................................................................................... 122 Motives for individual mergers .................................................................................. 123 Economic theories of mergers ................................................................................... 123 Management motives ............................................................................................... 126 Takeover tactics ........................................................................................................ 127 Takeover defences .................................................................................................... 129 Glamorous defence tactics ........................................................................................ 129 Company restructuring ............................................................................................. 130 Divestments ............................................................................................................. 130 Off-balance sheet funding ......................................................................................... 131 Leasing .................................................................................................................... 131 A reminder of your learning outcomes ....................................................................... 132 Practise questions ..................................................................................................... 132 Problems .................................................................................................................. 133 Appendix 1: Review questions ........................................................................... 135 Question 1 ............................................................................................................... 135 Question 2 ............................................................................................................... 135 Question 3 ............................................................................................................... 136 Question 4 ............................................................................................................... 137 Question 5 ............................................................................................................... 137 Question 6 ............................................................................................................... 138 Question 7 ................................................................................................................ 138 Question 8 ............................................................................................................... 139 Appendix 2: Suggested solutions to review questions ..................................... 141 Solution to Question 1 .............................................................................................. 141 Solution to Question 2 .............................................................................................. 142 Solution to Question 3 .............................................................................................. 143 Solution to Question 4 ............................................................................................... 145 Solution to Question 5 .............................................................................................. 146 Solution to Question 6 ............................................................................................... 147 Solution to Question 7 ............................................................................................... 149 Solution to Question 8 .............................................................................................. 150 Appendix 3: Sample examination paper ........................................................... 151

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59 Financial management

Notes

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The aim of the course is to provide an understanding and awareness of both the underlying concepts and practical application of the basics of financial management. selection. It will introduce you to the concepts and theories of corporate finance that underlie the techniques which are offered as aids for the understanding. management and control of new capital investment opportunities • the raising and management of the long term financing of an entity • the need to understand the scope and effects of the capital markets for a company. This subject guide is written to supplement the Essential and Further reading listed for this course. Finance and the Social Sciences (EMFSS) suite of programmes. just as it should be helping to build a critical appreciation of the uses and limitations of the same theories and their possible applications. 1 . The readings and the subject guide should also help to build in your mind the ability to make critical judgements of the strengths and weaknesses of the theories. which includes the management of working capital and the implications arising from exchange rate mechanisms due to international competition • the evaluation. not to replace them. planning and control subsystems of an enterprise • provide an overview of the problems facing a financial merger in the commercial world • introduce the concepts and theories of corporate finance that underlie the techniques • which are offered as aids for the understanding.Introduction Introduction 59 Financial management is a Level 3 course (also known as a ‘300’ course) offered on the Economics. It makes no assumptions about prior knowledge other than that you have passed the course 25 Principles of accounting (or its predecessor. planning and control subsystems of an enterprise. The management of risk in the different aspects of the financial activities undertaken is also addressed. It incorporates: • the treasury function. Aims and objectives This course is designed to: • place financial management as a clear part of the decision making. Studying this course should provide you with an overview of the problems facing a financial merger in the commercial world. and • the need to understand the strategic planning processes necessary to manage the long and short term financial activities of a firm. Management. course 19 Elements of accounting and finance). evaluation and resolution of financial managers’ problems. This course may not be taken with 92 Corporate finance. evaluation and resolution of financial managers’ problems. Financial management is part of the decision-making.

Topics will be set in both national and international contexts. models and methods. Sources and methods of raising finance including venture capital. futures. Analytical tools. and having completed the Essential reading and activities. options and derivatives and their uses in both long and short term situations. you should be able to: • discuss the theoretical models underpinning the practices in financial management • apply the techniques derived from the models and theories in financial management • explain the long and short-term financial needs of a business • describe the techniques used for the selection and management of long and short-term assets • discuss and give examples of the wider aspects of financial management so as to include international considerations and the need to communicate decisions made to other members of a management team. debt and their derivatives and incorporating critical consideration of their costs individually and in combination. A critical review of the different forms of finance such as equity. Studying financial management This subject guide highlights the key theoretical and practical issues relating to financial management. dividend policy and corporate restructuring and refinancing. Evaluation of risk measurement theories and methods and their application to both sources of finance and to investment appraisal. techniques and methods for analysing financial reports incorporating an assessment of their relevance for evaluation and planning purposes. private placements and project finance. for management of corporate liabilities and assets. An introduction to risk management including hedging. public offerings. The topics to be covered in this subject can be divided into six elements: • the theories and techniques of appraisal and management of long-term investments under conditions of both certainty and risk 2 . the role of financial managers and the place of financial markets within the business environment in developed and developing economies. Consideration of theories and techniques for management of short term funds including treasury and currency management.59 Financial management Learning outcomes At the end of this course. Mergers and acquisitions. The above provides a broad checklist for you to refer to as you work through the guide. Strategic considerations of financial planning and control. Theories of capital gearing. with and without constraints. Syllabus A critical perspective of the topic of finance. Investment appraisal techniques in the certain and uncertain world. Valuation methods for costing the different elements of capital such as the Capital Asset Pricing Model and the Arbitrage Pricing Model.

. New editions of one or more of these textbooks may have been published by the time you study this course. why. the methods used to raise them. their individual costs and the effect of gearing in the corporate financial mix • the valuation models used to derive capital costs. 3 . Having decided upon the capital mix on the one hand. Marcus Fundamentals of Corporate Finance. valuation. (McGraw-Hill Inc. Myers and A.Introduction • the various sources of long-term funds. It is therefore necessary to read the appropriate chapters in one of the additional texts listed below to provide this depth. both nationally and internationally • general elements of corporate financial activity such as mergers and acquisitions. To do this. treasury management using the currency and futures markets. noting differences in capital market operations and effects between developed and developing capital markets • the analytical tools necessary for corporate evaluation. The financial manager must be able to identify and quantify the amount of capital required for investment. and the selection of the investments on the other. Where. but on its own is insufficient since it does not provide the depth of discussion and analysis required for an undergraduate degree course. In the text it will be referred to in this subject guide as BMM. incorporating theoretical and empirical aspects of investors’ behaviour both individually and as a capital market. This textbook gives a good introduction to the subject. the manager will use financial planning models to determine the quantity of funds required. risk management. the financial manager has a wide and very important role. whether this is in fixed or current assets. Reading advice Essential reading You need to purchase or have regular access to the following textbook: Brealey. their sources and management. Overall. the financial manager must then fulfil the control function of this role thus ensuring that the planning goals are achieved. and how the funds are obtained is all part of the financial manager’s function just as deciding to what use the funds should be put. S. these elements of financial management can be condensed to the three broad areas of the provision. Also check the virtual learning environment (VLE) regularly for updated guidance on readings. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. From the practical viewpoint. These texts tend to be reflective of the corporate finance perception of the subject matter rather than the more applied view of financial management.J. use the detailed chapter and section headings and the index to identify relevant readings. This has to be born in mind. You can use a more recent edition of any of the books. R.C. allocation and control of a business’s financial resources to enable it to achieve its objectives. 2007) fifth edition (Intl) [ISBN 9780073012384].A. prediction and planning • short-term funds.

(McGraw-Hill. Online study resources In addition to the subject guide and the Essential reading. providing additional support and a sense of community. S. The VLE provides a range of resources for EMFSS courses: • Self-testing activities: Doing these allows you to test your own understanding of subject material. for some courses. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world.ac.uk quoting your student number. If you forget your login details at any point. which complements this subject guide.support@ london. Myers and F. please email: uolia. • Electronic study materials: The printed materials that you receive from the University of London are available to download. • Videos: There are recorded academic introductions to the subject. (FT Prentice Hall . seek support from your peers. The VLE The VLE. which was emailed to the address that you gave on your application form. work collaboratively to solve problems and discuss subject material. audio-visual tutorials and conclusions. it is crucial that you take advantage of the study resources that are available online for this course. It forms an important part of your study experience with the University of London and you should access it regularly. the Online Library and your University of London email account via the Student Portal at: http://my. You have probably already logged in to the Student Portal in order to register! As soon as you registered.londoninternational. Other useful texts for this course include: Brealey. Online Library and your fully functional University of London email account.A.59 Financial management Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text. For those of you who are studying on your own who find difficulty with the recommended basic text of BMM another text is offered. has been designed to enhance your learning experience.uk You should have received your login details for the Student Portal with your official offer. 2008) ninth edition (Intl) [ISBN 9780073368696].C. Allen Principles of Corporate Finance. including updated reading lists and references. 4 . • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered. but note that it does not cover the subjects to the same depth and rigour required. you have free access to the VLE and University of London Online Library (see below). interviews and debates and.. R. • A student discussion forum: This is an open space for you to discuss interests and experiences. paper or online resource. you will automatically have been granted access to the VLE. P Financial Management for Decision makers. including the VLE and the Online Library. This supplementary primer is: Atrill. You can access the VLE. Europe.ac. 2005) fourth edition [ISBN 9780273702498]. To help you read extensively.

Therefore you should pay careful attention to the examples in both the texts and the subject guide to ensure you achieve that basic understanding. The material covered in the examples and in working through the exercises is both complementary to the textbook and important in your preparation for the examination.shl. the sessions from previous years’ Study Weekends have been recorded and made available. with the aim of gaining an initial understanding of the topics.external. question marks and colons. Myers and Marcus. • Carefully read the suggested chapters in Brealey. read the aims and/or introduction and the learning objectives to appreciate the scope of the material to be covered.uk/summon/about. where appropriate. try removing any punctuation from the title. Some of these resources are available for certain courses only.Introduction • Recorded lectures: For some courses. • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. please see the online help pages: www.ac. such as single quotation marks. You may then approach the Further reading suggested in Brealey. • The subject guide material is aimed to identify the scope of your studying of this topic as well as attempting to reinforce the basic messages set out in Brealey. or you will be required to register and use an Athens login: http://tinyurl. • Feedback forms.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine.lon. • Read the remainder of the chapter in the subject guide. others lead into one or more following chapters.php How to use the subject guide This subject guide is divided into 11 chapters. • Ensure you have achieved the listed learning outcomes. Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. If you are having trouble finding an article listed in a reading list. plus appendicies. Myers and Allen. but we are expanding our provision all the time and you should check the VLE regularly for updates. Some chapters in the subject guide are self-contained. application and later revision. Myers and Marcus. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details. By taking notes from Brealey. Myers and Marcus and then from any other books you should have obtained the necessary material for your understanding. For further advice. A suggested order for your studying is as follows: • For each chapter. Complete whichever chapter you are studying and the associated work before moving on. • Pay particular attention to the practise questions and the examples given in the subject guide. 5 .

Please note that subject guides may be used for several years. and the VLE where you should be advised of any forthcoming changes. you do not waste time reading material you are not going to answer. therefore speeding up the analysis and saving time. Solutions to learning activities Solutions to certain learning activities is provided online in the VLE at http://emfss.elearning. by reading the requirements first. or a request for interpretation of your results or something related to the problem or theory used. Each question will also have a small section requiring a written answer which may be a discussion of the theory used in the application.59 Financial management • Attempt the problems at the end of each chapter. One section will include data handling and numerical analysis type questions each requiring analysis. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination. • At the end of your preparations. a luxury you do not usually have time for in an examination. Remember when sitting the examination to maximise the time spent on each question and although. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. • Check you have mastered each topic before moving on to the next. remember that the numerical type questions on this paper take some time to read through and digest. the subject guide will give you advice on tackling your examinations. and if you have the time attempt those at the end of the Brealey. your mind is focused on the sort of information it should be looking for in order to answer the question.london. The examination paper will normally be made up of two sections each containing four questions. by reading only the requirements. This is appropriate whether you are making your selection of questions to answer. since the guide is trying to cover all possible angles in the answer.ac. You will need to answer four questions with a minimum of one question from each section. The other section will contain essay or report-style questions requiring written answers. 6 . Then compare your answers with the suggested solutions.uk/ This is indicated in the subject guide as: See VLE for solution Examination advice Important: the information and advice given here are based on the examination structure used at the time this guide was written. In the question selection process at the start of the examination. or when you are reading the question in preparation for your answer. throughout. but do remember that they may well include more information than the Examiner would expect in an examination paper. composition and presentation. attempt the Sample examination questions at the end of the subject guide. Secondly. Always read the requirement(s) of a question first before reading the body of the question. which are always placed at the end of a question. Therefore try to remember and practise the following approach. you then only read material relevant to your choice. Myers and Marcus chapters.

Introduction Remember. Myers and Allen Brealey. it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available. Myers and Marcus Capital asset pricing model Capital market efficiency Efficient market hypothesis Earnings per share Internal rate of return International Stock Exchange of the UK and the Republic of Ireland Net present value Modigliani and Miller Modem portfolio theory Peter Atrill Price earnings ratio Profitability index Payback period Weighted average cost of capital 7 . Good luck and enjoy the subject! Abbreviations AIM APM ARR BMA BMM CAPM CME EMH EPS IRR ISE NPV MM MPT PA PE PI PP WACC Alternative Investment Market Arbitrage Pricing model Accounting rate of return Brealey. Systematically study the next eleven chapters along with the listed texts for your desired success. Its aim is to give you a clear understanding of what is in the subject guide and how to study successfully. Summary Remember this introduction is only a complementary study tool in your efforts with this subject guide. past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered.

59 Financial management Notes 8 .

The roles of financial managers come next.Chapter 1: Introduction to financial management Chapter 1: Introduction to financial management Aims of the chapter This chapter is clearly one of the most important in the subject guide because it deals with the fundamentals of financial management. One area of major interest is the corporate governance debate on how the relationship between owners and controllers should be systemised to maximise the corporate gain. to be followed by a discussion of some of their conflicts of interest and how they might be resolved. and the control methods used. the environment to which the subject relates. Brief descriptions of how risk is treated in financial management theory. are included and the chapter is concluded with a note of the direction and importance of taxation in today’s financial decisions. you should be able to: • describe the general financial environment in which corporations operate • explain the importance and roles of financial markets • list/outline the roles financial managers can have within an organisation • outline such things as taxation. The chapter starts by looking at the key tasks of financial management. An outline of corporate objectives follows because these form the basis of much of the theory that is covered in this subject. If that is true. the appraisal and selection. then a more detailed and careful review of your prerequisite course may be needed. and how accounting is linked in with financial management. then perhaps only a quick review of this subject matter is necessary. The course 25 Principles of accounting. Learning outcomes By the end of this chapter. and having completed the Essential reading and activities. but if the practise questions and problem(s) here and in the Essential text cause you any problems. the theories presented. the changes suggested. a knowledge of the background. As with any subject area. should have meant you already have all this background knowledge. Without a clear understanding of the fundamentals the remainder of this subject will not be easy to grasp. is important as it helps to put everything learnt later into appropriate perspective. 9 . accounting information and form of business and their implications for financial management • give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation • explain and give examples of how the influence of risk will permeate all aspects of financial management. Since knowledge of the financial environment is vital to managers this comes next before the review of the differing organisational forms of business that are in use. if studied carefully and fully.

J. S. a stock market) in which the shares in a company can be traded. R. not least those funds provided by the equity owners. including Brealey and Myers. P Financial Management for Decision makers. on its structure and on its objectives and operations. 2 and 3. to evaluate the proposed courses of action. Different phases of the trade cycle have different implications for financial operations. Similarly financial control deals with the ways and means by which the plans are achieved. Myers and A. Investment project appraisal is the assessment and evaluation of the relative strengths of a company’s investment propositions. S. as the two most important tasks. (McGrawHill. The quality and amount of that return.C. Potential owners of shares as well as existing 10 . In the capitalist economies of developed countries where there are stockmarkets..e.A. interest rates payable on loans will be higher. Financial environment The economic and social background of a country is a major influence on a firm. Allen Principles of Corporate Finance. (FT Prentice Hall Europe. and thus wealth of the shareholder.C. information disseminated to the capital markets affects the market’s perception of the company and the price of the company’s shares. through plans and projections. Countries that are still developing may not have a public market place (i. the ordinary shareholders.A. will be one of the elements influencing the price at which the share is quoted in the market.59 Financial management Essential reading Brealey. Part of the finance function is dealing with the capital market since a large part of the finance is obtained through the capital market. This function does not just deal with the raising of funds but also with the ongoing relationship between the company and the market place. Key tasks of financial management There are five key tasks undertaken in financial management: • financial planning • investment project appraisal • financial decisions • capital market operations • financial control. investment project appraisal and financing decisions are seen by some. Financial planning provides the means. The next two tasks. the owners of the shares in trading companies will expect returns on those shares. Marcus Fundamentals of Corporate Finance. 2008) Chapter 1. (McGraw-Hill Inc. Firms in socialist or communist countries have different structures and objectives from those that operate in capitalist economies. trading conditions much more risky and so returns to shareholders may be lower or non-existent. Myers and F. Further reading Brealey. The financing decisions involve the identification and choice of the sources of funds which will provide the cash to be invested into the selected projects. Atrill. In depressed times. 2007) Chapters 1. 2005) Chapters 1 and 2.. . R. the dividend.

by way of directors. lenders as well as shareholders. They are managed by the owners and do not have a separate legal entity even though they may have a separate trading name. very sophisticated. creditors. though not the majority in terms of value or employment. Corporate objectives Generally we assume that a company’s objective is to increase the value of the shareholders’ investment in the firm. Each country has its own sets of laws and regulations which provide the parameters for the structure of the entity and how it can operate on a daily basis. We also assume that all managers act to further that objective. The liability being limited to the par or nominal value of the shares or equity held. For that. Shareholder wealth maximisation is the normative objective of a company that underlies financial management theory. vary enormously from the very large. employees. customers want the company to provide the product with the highest quality and lowest price. Organisational forms of business Businesses established for profit-making purposes generally are organised into one of two forms: incorporated and un-incorporated. As groups they have their objectives for the company and as individuals they have their own objectives for their stake in the company. unless of course managers are also major shareholders. Ownership and management risks are intertwined which makes raising very large sums of capital almost impossible. These can 11 . The extent of a country’s capital markets. but this may not result in high profits and share price maximisation. The owners of a company. of which the stockmarket is but a part. ownership and management are likely to be separate. How and why those returns and share prices can be influenced will be covered later. while the unincorporated are either proprietorships or partnerships. These businesses are generally sole proprietorships or partnerships. a company has many stakeholders. have to be appointed to act as the shareholders’ agents. With ownership usually comes some form of control through voting rights. Corporate objectives are determined by a relatively small group of senior management. but much of what is covered is also relevant to the unincorporated business. The unincorporated form of business make up the majority of the numbers of businesses. The incorporated firm are the companies or corporations. The liability of the owners of these entities is unlimited. government. independent of its owners. its shareholders. management. for example. Some of these individual objectives may be at slight variance with the others. very structured markets such as London and New York to some of the very small nascent markets in some developing countries in Africa and the Middle East. in theory. probably the directors. The corporation or company is a legal entity of unlimited life. Therefore. but this does not extend to managerial control of day to day operations. customers.Chapter 1: Introduction to financial management owners of shares are interested in the quoted price of a company’s share and in the return obtainable from that investment. In this subject guide we will be viewing financial management from the perspective of a corporate entity. If the owner/partners want the entity to continue to grow then usually a change in form for the entity will be necessary. In practice. have limited liability for the debts and obligation of the company.

the setting up of an appropriate governance structure which restricts. • Try to list what you believe are the major objectives of each group. This separation can create costs which have been called the costs of agency since management is deemed to be the agent of the owners (the principals). • Next assume you are the Board of Directors and you are required to publish the company’s objective(s). minimises and hopefully enables the removal of management. Activity 1. See VLE for solution Role of managers A company is a complex organisation made up of many employees each with their own objectives. In theory. three or more for each group. who abuse their powers and who are therefore not attempting to ensure the company achieves its goals.59 Financial management be influenced by a number of things with an outcome which may not be shareholder wealth maximisation. and in particular directors. That is. planning and control techniques and systems. Systems should be used to monitor and ensure control of agents. • Then try to rank each group’s objectives in order of importance. Conflicts of interest and their resolution One of the major disadvantages of the corporate form is the separation of management and ownership. using the evaluation. as well as possible ways in which the costs of any such conflict can be minimised. and do not forget the power of the financial market place in steering you towards your final selection. Do not be surprised by the differences and variations. • Which one(s) would you list and why? Do they all directly or indirectly lead to shareholder wealth maximisation? Your lists could be based upon the company(s) you know or work for. It is argued that agents will tend to pursue their own goals and the greater the deviation of those goals from the corporate goals. • Now draft your reasons for your rankings. the greater the agency costs. managers may not be owners. Agency theory attempts to explain this situation and how conflicts between principal and agent can arise. for example use of annual reports. Therefore incentives should be provided to try to ensure convergence of goals between principal and agent (e. the manager. There may be two. share option schemes).1 Consider the stakeholders of a business as described earlier. It is often argued in the UK financial press that though companies may be trying to increase shareholder wealth it is not with a long-term perspective but is only short-term oriented. the manager is expected to act in furtherance of the goals of the owners. The financial manager is expected to act as the intermediary who will undertake the tasks of financial management. However. 12 . will attempt to maximise the return from the optimal selection of investments so as to satisfy the providers of finance from whom (s)he has obtained the cheapest and best combination of funds via the capital markets.g. and which can be allowed to vary with circumstances and over time.

See VLE for solution Financial management and accounting Financial management is not the same as. measuring and communicating economic information to permit informed judgements and decisions by users of the information. both theory and practice show us that risk and return are correlated. (American Accounting Association). At present in the UK there is a voluntary system of governance in place. accounting. projecting next year’s sales budget or evaluating a new investment proposal). Though not legally enforceable. The framework has evolved through. the regulations require compliance and provide for penalties. If there is only one single possible outcome. • Then think of ways to try to measure it and ways to control it. 13 . Activity 1. we are prepared to accept relatively small returns. Where we perceive little risk (e. Different corporate structures. The rules require a company to make a disclosure statement in its annual report about its compliance with the combined code. risk must be a major factor in all aspects of financial management.g. by six key reports starting with the Cadbury report in 1992.Chapter 1: Introduction to financial management Corporate governance The essence of the corporate governance debate is the effects of the particular relationship between directors and shareholders. then there is a lot of risk. or been impacted upon.g. If there are many possible outcomes and many of them are very different from our estimate of the outcome. Financial management and risk Since financial management is concerned with making decisions. (e. Accounting has been defined as: the process of identifying. Risk may be defined as the extent to which what we estimate will happen in the future may or may not happen. and decision making is concerned with the future and the future is uncertain. All this is important because it highlights the differences between the normative theory and the practical application. The various recommendations of these reports have been incorporated into the combined code which is included in the Listing Rules of the London Stock Exchange as an appendix. the greater the potential for abuse and also the greater the possibility of suboptimal behaviour by managers as viewed by shareholders. • Try to identify the causes of that riskiness. Broadly speaking. an investment in government securities).2 • Choose a few practical situations where a business faces the effect of risk. or even a branch of. We seek higher expected returns for investing in riskier projects. legal and social environments require different governance requirements and systems. business. The greater the separation between the two. there is no risk.

for example. In many small businesses one person combines the roles of accountant and financial manager. Despite these facts. which has much in common with the tax systems which prevail in other of the world’s countries.e.3 Think of similarities and differences between the UK tax systems and another country you are familiar with. How might a manager’s objectives differ from those of the company? What are the implications for corporate policies in order to ensure congruence between the sets of objectives? 14 . and having completed the Essential reading and activities. and the control methods used. however. Returns from investments made by the business (i. that you have a broad appreciation of the major aspects of the UK tax system. the theories presented. Consider what objectives might be important to a company other than shareholder wealth maximisation. Those who work as financial managers may very well have a background in accounting. the tax treatment of loan interest is different from that of dividends paid to shareholders. Describe these objectives and show how there may or may not be consistency between the different objectives. Financial management and taxation Virtually all decisions taken by financial managers have tax effects. accounting information and form of business and their implications for financial management • give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation • explain and give examples of how the influence of risk will permeate all aspects of financial management. the appraisal and selection. In the UK. profits) are taxed. It is important. you should be able to: • describe the general financial environment in which corporations operate • explain the importance and roles of financial markets • list/outline the roles financial managers can have within an organisation • outline such things as taxation. Practise questions 1. the role of the accountant and that of financial manager are distinctly different. It is not one of the objectives of this course to turn you into an expert on the UK tax system. Discuss the implications of your findings. The accountant is concerned with the provision of information: financial managers use information supplied by the business’s accounting system and other sources to help them to make financing and investment decisions. Activity 1.59 Financial management Given this definition. Therefore the decision between raising funds from shareholders and from lenders has tax implications. 2. it is clear that financial managers will be major users of accounting information. Are there any major differences in the corporate taxation system? A reminder of your learning outcomes By the end of this chapter. the changes suggested.

7.65. p. 8 and 9 • Chapter 2. numbers 4. pp. attempt the following problems: • Chapter 1. numbers 2.44 and 45. 15 . 10 and 17 • Chapter 3.Chapter 1: Introduction to financial management Problems In BMM. p. 3 and 4. numbers 2. 5.23.

59 Financial management Notes 16 .

2005) Chapters 4 and 5. 6 and 7. This chapter defines and explains the time value of money concept and applies it to problems of investment appraisal in a certain world. 3. the topics in this chapter are integral to the subject as a whole since these basic techniques of time value of money and discounting are used in numerous other aspects of financial management. taxation. Learning outcomes By the end of this chapter and having completed the Essential reading and activities. (FT Prentice Hall Europe. you should he able to: • describe and apply the time value of money in project evaluation.Chapter 2: Basic investment appraisal methods Chapter 2: Basic investment appraisal methods Aims of the chapter Like the topics in the first chapter of this guide. such as internal rate of return and pay-back. Essential reading Brealey. different interest rates. (e.. inflation. We start by describing the time value of money and then explain the concept and approach to the computational methodology used in a practical example of investment appraisal and selection. repeat investments. S. P Financial Management for Decision makers. 2008) Chapters 2. 2007) Chapters 4.J. Allen Principles of Corporate Finance. (McGraw-Hill Inc.C. R. Alternative methods of appraisal are also described. The relaxation of the assumption of certainty occurs in the following two chapters. The major problem of an imperfect world and uncertain outcomes is dealt with later in Chapters three and four. Here we concentrate on the basics since the technique can be and is used in long-term and short-term investment appraisal. Myers and F.A. Atrill.g. 17 . risk management etc. So carefully learn these concepts.. R. whether it be future or present value oriented • defend the use of NPV as the method of appraisal against other suggested methods • prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances. (McGrawHill. S. mutually exclusive investments. The net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world.C. 8 and 9 Further reading Brealey.A. 7. in evaluation of financing methods. . Myers and A. capital rationing). valuing monetary assets. and the process as well as the principles and the pros and cons concerning them. Marcus Fundamentals of Corporate Finance.

The amount of interest is dependent upon the amount of time and the rate of interest. This uses as its basis the sane algebraic relationship but in the opposite way. the recipient would be indifferent between the future receipt and today’s receipt. If the interest earned is reinvested rather than withdrawn then the total amount invested grows at a compound rate. Using a computer. he or she expects to earn a return which can take the form of interest when the investment is in some form of monetary asset. Therefore we need to convert all cash flows into present values. Future value and compounding Whenever someone makes an investment. Apply this knowledge to annuity payments or receipts. the day of the investment). which will be its equivalent. but as these predictions are all in money terms of differing values they must all be converted into a value at a common date (i. By receiving today an amount of cash equal to the present value. cash) has a different value over time. derived thus: P = Note F (1 + r ) 1 (1 + r) t t = F× 1 (1 + r ) t is the discount factor. F = P(1 + r) t Present value and discounting The converse of compounding is discounting. With prospective new investments we can predict the incremental cash flows which will occur because of the investment. 18 . This can be found at the back of all reputable texts. The reward for the delay in spending is the interest received by investing. holders of money can either spend the money on consumption now or delay the consumption by investing the money until it is required for consumption. which we call the present value. So if we predict receiving £F in t years time during which r is rate of interest then £P is the present value of £F. would achieve the future value predicted. if invested at the rate of interest r. today’s values. The further into the future a consumer has to wait.e. The difference between the two receipts is the time value. a table of discount factors for all combinations of r and t has already been prepared. At the end of the life of the investment (at maturity) it will have a value F – the future or maturity value. the greater the interest compensation required.e. So if one knows of a certain future receipt of cash then there must be a certain value today. The present value of a future amount is also known as the discounted value. today. The aim of discounting is to determine the present value of a future amount (i.e.59 Financial management Time value of money Money (i. You should familiarise yourself with the compounding and discounting formulae and procedures and where they are used. the compensation for the passage of time. today’s amount) which. If P is the amount invested today at r% with compound interest for t years then the future value will be F. Remember an annuity is a constant annual amount and so the annuity factor for any year is the sum of the annual discount factors up to and including that year.

(The terms. See BMM sections 7. selection between mutually exclusive projects and so on.3. The real rate is the rate of interest that would persist if there were no inflation or deflation.2. as well as an investment’s internal rate of return (IRR). the degree of inflation may have been different from year to year or between say wages and materials). Similarly. as alternatives to discount rate since the discounting factor is derived using the cost of capital. We can use the expressions cost of capital. The nominal rate is the rate to be found in the market place. money and actual interest rates. Likewise learn how to compute the payback period (PP) and the accounting rate of return (ARR).5. The discount factor used should only incorporate the inflation rate relevant to the capital providers who have to be serviced and repaid from the investment. 4. You must learn the difference between real and nominal interest rates. Activity 2.2 Solve self-tests in BMM.1 and 7.g. Any investments made from that mix of capital must generate flows and in the evaluation of those flows we use the discounting process. Note the short cut sometimes used to derive the nominal rate (r + i) = n. are also used to mean nominal rate). all cash flows prior to discounting should be quoted in actual or money flows for the specific period. a company’s investment or the required return a company has to pay on its loan etc.1 What is the time value of money? How is it different from the real and actual rates of interest of a risky investment? See VLE for solution Basic investment appraisal techniques Using BMM learn how to compute the net present value (NPV) for an investment. The decision rules for each appraisal method should be learnt for the range of different types of decisions a manager might face. 4.14. (1 + real rate)(1+ inflation rate) = (1 + nominal rate) (1+ r)(1+ i) = (1+ n) N. simple go/no go. Activity 2. Do remember this is only an approximation and will usually lead to over-valuing the present value of the future flows.B. that mixture has an average cost which the company has to service. because companies use a mixture of capital types to fund their investments. 19 . when undertaking an investment appraisal. numbers 4. Remember that different items of operating expenditure and revenues may have their own specific inflation rates and. So it could be the return on a bond. 4.4. opportunity cost of funds.1. The expression discount rate is often used synonymously with interest rates because the discount factor is derived using an interest rate.Chapter 2: Basic investment appraisal methods Interest rates. 4.8 and 4. All individual and specific inflation rates will have been separately accounted for (e. discount rates and real rates An interest rate is the proportionate return on an investment appropriate for the risk level of the investment.

500 10. You should learn the process of identifying.251 22 24* 2. while for B they are less so and it even has a net outflow in one period. Using the NPV approach A will have an NPV of £4.500 (1. the time value of the cashflows).000 IRR (%) 2 12. then the four methods will give conflicting results. From the textbooks note the rationales presented for the still considerable use of payback by managers in practice. the present. exceed the estimated outflows. A and B.6 1. it is by chance one gives us the appropriate selection. If one only used ARR. 20 .251. Also payback does not take into account the post payback flows which. which is why it is marked with an asterisk (*). Given below is an example of two mutually exclusive investments.000) 4 12. See BMM p. Each method has its own set of decision rules. The main reason for disregarding the outcomes under these two methods is that neither payback nor ARR take into account the pattern of flows (i.140–43.000 5.166* 1. in the case of A. Since neither method is the correct one.202 and PA pp.166 and B an NPV of £1.5* 35* 26. businesses do not wholeheartedly follow the theoretically correct route of using the net present value approach (NPV) all the time. Using the payback approach would suggest B is preferred as it has the shorter payback period.7 Separately using each evaluation method the pairs of values for projects A and B are shown above. then A is preferred since it has the higher rate.500 £4.59 Financial management You must remember: • that long term projects under consideration should be consistent with the long term corporate plan • that the estimated cash inflows from the project when discounted to a common date. are considerable. also discounted to the present • that the theory in this section assumes certainty of knowledge and forecasting – this is relaxed in the next chapter • that. The decision rule is to select the investment with the higher NPV regardless of the size of the original investment. Assuming an annual cost of capital of 15% and estimated net actual annual cash flows as stated. Profit flows will need adjustment to cash if only profit estimates are given. Project Time periods (years) 0 A B (25. analysing and estimating the investment flows.000 Payback (Years) ARR(%) A B 4. in practice. Under each of the evaluation methods and using the appropriate decision rule the preferred choice can be made. It is marked with an asterisk (*) in each case.000) (10. You should learn the theory behind the four main analytical techniques with emphasis on why NPV is superior to IRR.e. PP and ARR.500 - Total £17. unless ARR is being used.000 3 12. Therefore A will be preferred to B. remembering the projections should be in cash not profit flows.000) NPV(£) 1 5. with an explanation of why only NPV will give the correct signal to management. The amount and timing of the net cash flows of a project are crucial to the viability of an investment.

000. 21 . the specific rates of price increases must be incorporated in the analysis. Application problems – some considerations When considering applications of the NPV analysis to practical situations.197–99). These are all derived from the NPV approach and can be learnt from BMM (see pp.g. the IRR shown is only one of the two IRRs for that project.e. The cost of capital is also called the hurdle rate and the opportunity cost of funds (capital). It is important to identify an optimum replacement period for them. means two roots to the equation (i. Where the capital restriction will only last for one time period (normally one year) the profitability index (PI) should be used to identify the optimal selection of projects. there will be a root to the solution of the equation which produces the IRR. For each change in sign in the sequence of cash flows. The post-audit process should involve the comparison of actual results with the predictions for the project and provoke explanations of whatever differences have occurred. Note it is possible that one or more root could be the square root of a negative number which is of no practical value. Similarly. though B has the higher IRR. Wages. in an inflationary world. the other being a negative value. in particular. Also the IRR does not indicate the difference in the size of the projects. Different groups of vehicles in the fleet will need replacement on a regular basis. Many businesses are faced with decisions regarding projects that may require repetition on a known cyclical basis.Chapter 2: Basic investment appraisal methods In the example. Finally. This is not necessarily true. Thus two sign changes. the benefits from the post audit procedure.000 is not as good as 24% of £25. In compiling the cost of capital or opportunity cost of funds. B has multiple rates of return because the sign of the annual cash flows changes more than once in the sequence. From a practical viewpoint. Therefore. Another problem is that IRR’s reinvestment assumption for the fourth year of B is that the funds have been reinvested at 24% to enable comparison with A. The type and make of vehicle to be used by the group can be identified on cost grounds by use of the net perpetuity value and annual equivalent annuity methods. it is important to ensure that all flows are dealt with on an after tax basis. you should prepare all estimates of flows in actual or money terms and then discount the net flows using the actual or money cost of capital. may be affected by different rates of price changes. as in B. thus enabling improved forecasting in the future and improved operations too. two IRRs). The cost of capital is the average rate payable to the providers of the capital for the company. It is called the hurdle rate because it is the minimum that has to be achieved and the opportunity cost because each element of capital has got its own opportunity cost. we must use the general or average rate of inflation since it is assumed that all providers of funds have the ‘average’ spending pattern used to compute a retail price index. when making estimates of cash flows. For example. businesses have to take investment decisions when their financial resources are limited. you should learn the capital budgeting process and. This is because of one of the technical problems of using IRR that are exemplified in B. take a business with a fleet of vehicles. raw material prices etc. 24% of £10. space or personnel) then linear or integer programming models can be used which maximise the NPV of the portfolio of projects subject to the constraint introduced. If the restrictions are multi-period and/or multi-faceted (e. For example.

a.5 2 50 16 19 13 46 4 0. arising from the sale of the equipment would occur in the fifth year.0) The business estimates that the average annual inflation rate will be 4. Writing down allowance computation (straight line) Tax allowance Outlay Year 1 (20%) Year 2 (20%) Year 3 (20%) Year 4 Sale Year 4 10 2 8 2 6 2 4 3 1 2 2 2 Loss on sale 1 (The same approach can be used for reducing balance based allowances.a. Payback and ARR for the project. Obviously one uses the tax regime requirements appropriate to the country in which one is investing. This may require a transfer of tax depreciation for book depreciation (in this case they are similar). It is estimated the equipment will be sold at the end of the project. The investment will be allowed a 20% writing down allowance (depreciation) on a straight line basis for tax purposes. The corporate tax rate for each of the five years is 30% payable a year in arrears. Required: Compute the NPV.59 Financial management An alternative way of acquiring the services of an asset is to lease it rather than buy it. The incremental revenues and costs and the annual price rises incorporated in the estimates arising from the investment are as follows: £million Years 1 2 3 4 Sales Wages (4% p.5% p. increases) Other costs (5% p. or paid on a gain. The same principles of evaluation should be applied to the incremental cash flows arising as a result of taking out a lease in order to see whether it is a better way of funding the asset as opposed to buying it. during the five years and the business’s real after tax opportunity cost of capital is 10% p.a.a. Solution to Worked example 1 First compute the depreciation for tax purposes. Worked example 1 A business is considering an investment in equipment which requires an initial outlay of £10 million. the end of the fourth year for £3 million. Any tax received on a loss.5 1 4 49 5 (2. increases) Book depreciation Net trading surplus Increases in working capital 10 7 10 2 30 11 13 11 29 1 1 2 40 15 17 12 37 3 0. increases) Materials (20% p.a. 22 .) Then compute the tax payments or receipts based upon the taxable profits. IRR.

6104 2. tax on year 1’s profits of £0.4768 3.0) (28%) (10.480) 3.2 4 5 1 6 1 5 £1.0) 2.0 20.0 (1.e.739 1.3725 (0.9) 9.0) 1 2 3 4 5 Total (10.Chapter 2: Basic investment appraisal methods Tax computation (£million) Years 1 Net trading surplus Add book depreciation Trading surplus (adjusted) Less tax depreciation Taxable profit Tax (30%) 1 2 3 2 1 £0.3) 4.6 0.0) (0.746) 0. The annual discounted flows are computed from the 23 .179 (1.5) 0.6575 5. Cost of capital (discount rate) (i) The actual or money rate is the rate to use.176 0.5) (0. i.604 0.0 0 (10.025 0. Then: (1+i) = = Thus i = (1 + 0. You should use the theoretically correct method given above unless an approximation is called for.0 1.1 0. e.4972 2.7561 3.798 million shown above in the Total column.0 3.2) 9.0 6. The discount factors came from the present value tables and are based on a cost of capital of 15%. 15%) (Some authors and businesses use the quick way and get an approximate value by summing the real and inflation rates.0) (15%) (10.5 Tax is paid in year following the year in which the profits were earned.0) The NPV at 15% cost of capital is therefore the aggregate discounted flows of £2.0 6.15 (i.798 0.3 paid at end of year 2. (The last point depends on the individual country’s tax regime). that the average actual cost of capital had to be calculated and used.5718 (0.0 5.5) (1.2 0.9) 4. All cash flows are assumed to arise at the end of the year concerned except for the initial outlay on equipment. Here: 10% + 4.651 (1.7813 2.) To calculate the NPV £’million Year Outlay Trading surplus (adjusted) Working capital change Sale of equipment Tax payments Net cash flows Discount factors Discounted flows Discount factors Discounted flows – (10. that the tax shield is provided by the writing down allowance (tax depreciation) and that tax is paid a year in arrears.8 0.9 3 4 2 6 2 4 £1.437) – 3.5% = 14.564 (0.1)(1 + 0.563 (0.3 2 3 2 5 2 3 £0.2910 (0.5% = 15%. that in arriving at the annual flows the specific price changes were used in estimating the wages. materials etc.0 1. To obtain the NPV note that the accrued profits have been converted into cash flows by the changes in the working capital.0 (3.1495) 0.5) 2.0 1.8696 3.045) (1 + 0.

1/4 = 10/2 = 4.278 reduction in NPV. then the asterisk indicates the preferred choice under that evaluation method.798 (28 − 15)  + 15 2.6 0. The 13% increase in interest rate produced a £3.8 Flows (£ million) (10. If the four projects were mutually exclusive. Payback Taking the net cash flows: Year 0 1 2 3 Surplus Payback = 2 + 3.1 and £2. so the rate must lie somewhere between 15% and 28%.798 − (−0. By increasing the discount rate from 15% to 8% – an increase of 13%. 24 .278 of the 13% it should move from 15% to the appropriate rate which is the IRR. one positive and one negative. (2 × 0. The IRR is the rate which gives an NPV equal to zero.8/4. Calculation of IRR Using the two discount rates 15% and 28% we have obtained two different NPVs. The row of discounted flows are summed to give the NPV in the final column.180. This approach would have given a much less accurate estimate of 21.2 (3.775/5) ×100 = 95. but more approximate value could have been obtained by using the NPVs of £9.278.798 to zero will require increasing the interest rate from 15%.798 10.5% = 0. So if the interest rate is increased by an amount equal to the proportion of 2.66% using an extrapolation procedure (check your understanding of the method by doing your own calculation and check with the answer given). a total decline of £3.1 + 15 = 26.739).00 = (4.798 to 3.2 6.775 =5 2.59 Financial management product of the actual net cash flow for a year times its discount factor.798 from £2.6 = 2.798 to a negative £0.798 at 0% and 15% respectively.1% Note: A quicker.8696 = 1. The reduction in NPV by £2.8) 4.480)    = 11. Thus the IRR is   2. the NPV declined from £2.83 years Accounting rate of return (ARR) Average inflow Average outlay = Total inflow/Project life = Outlay/2 = 19.0 4.28 Now assume that the business has three other projects it has evaluated.00) ARR = Average inflow/Average outlay Profitability Index (PI) NPV PI = Initial investment = 2. Their characteristics are given below in the table along with those of the project just evaluated.

1% 18.2125 Outlay 10 15 3/5 × 25 40 NPV 2. derived as follows by using the PI ranking: Project A AD 3/5B PI 0.5 million.8m £4. then the combination would have been A. Here it is assumed that each project is discrete and cannot be split up.0% 20. However that is a false comparison because the balance of unused funds of £15 million should be included with its zero NPV.5 Average PI 0.5m* £2.0 yrs ARR 96%* 50% 60% 80% PI 0. in particular those in BMM.145. on the assumption of operating in a world of certainty. so the project with the next best PI is included that does not exceed the outlay limit. then if the business has a maximum of £40 million to invest.8 7.83 yrs 2.00 2.180 0. relax that assumption and consider that in the real world. Understand the conceptual weaknesses and strengths of theoretical methods used and learn how to critique your methods and results.280* 0. though some combinations seem to have higher PIs (e.g. one by one.0m £3.9 yrs* 3.200 Conceptually B is the preferred project from amongst the four evaluated because it has the highest NPV of £4.133 0. There are various ways of doing this. ‘What-if’ questions Now that you’ve learnt the basic techniques for the analysis of investment proposals. This requires an estimate of the effect on the predicted outcome. continuing to combine those projects that satisfy the limit placed on available funds.180 0. Combination (£million) Combination AD AB ADC DB Outlay 25 35 40 40 NPV 5. Third ranked project is B but combining its outlay to A and Ds exceeds the limit.50 Try and understand the applied type problems and examples used in the texts. The combination of ADC provides the highest NPV.195 0. thus giving a lower corrected average PI of 0.4%* Payback 2.0m IRR 26.0% 26. The PI is used to indicate the order of selection. D and 3/5 of B. If it is assumed that all projects could be undertaken fractionally if necessary.3 7. The process is to go through the projects. starting with project A. in descending order of PI. usually NPV . fewer things will actually occur than might have been predicted. 25 . the following combinations of projects are possible.70 8.322 0.200 0.188 The objective is to maximise the NPV of the portfolio of investments. Using the same data and assuming now that all four projects are available for selection and are not mutually exclusive.232 0. The first is by the use of sensitivity analysis.80 3. AD). Here the addition of project D to A used the two highest ranked projects and had a £25 million outlay.209 0.Chapter 2: Basic investment appraisal methods Project evaluation table Project A B C D Outlay £10m £25m £15m £15m NPV £2.5 yrs 1.8 7. Managers need to evaluate the effects of these possibilities in their initial prediction.

This is called scenario analysis. managers may call for three different but consistent combinations of variables. This is sometimes called threepoint estimates. Sample examination questions 1. A. It can be identified from this evaluation those variables whose changes might influence the outcome the most. Make a case to support the reported managerial preference for the use of IRR and payback methods in real world situations.59 Financial management of changes in each variable. is called simulation analysis. the set of the most pessimistic outcomes. It has a number of proposals to consider. for example. calling for a more sophisticated knowledge of probability distributions of outcomes. of appraising investments. A reminder of your learning outcomes By the end of this chapter. and having completed the Essential reading and activities. Effects of changes of combinations of variables can also be evaluated. Practise question 2. The examination Extracts from discount and annuity tables will be supplied in the examination for 59 Financial management if these are relevant for any question. The company has £100. and whether it can be influenced by managerial efforts. is a large proposal requiring an initial investment of £13 million in plant and equipment which at the end of the project’s life of 4 years will have a resale value of £4. 3. another the set of most likely and the third. managers can assess the likelihood of the variable change. The overall impact on the final outcome of the potential changes can be evaluated and aid the decision as to whether or not the proposal can be accepted. You can however use your own calculator to generate the factors if you so wish. An extension of this approach. you should be able to: • describe and apply the time value of money in project evaluation. What is the time value of money? 2. then the different combinations can be reviewed as separate possible scenarios. one is the set of the most optimistic outcomes.0 million. An extension of sensitivity analysis is breakeven analysis which can be used to assess the magnitude of change that will reduce the originally predicted NPV to zero separately for each variable. whether it be future or present value oriented • defend the use of NPV as the method of appraisal against other suggested methods • prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances.1 Snowdon plc has a fund of £15 million to invest in new projects. When a number of variables are interrelated.000 still to pay to the consultants 26 . The first proposal. Arising out of that identification. Discuss the pros and cons of NPV IRR and payback period as methods .

pp.a.25 million p.Chapter 2: Basic investment appraisal methods under the research and development contract for this project of £3 million.a. The life cycle predictions for sales volumes.258. See VLE for solution Problems In BMM attempt the following problems: • Chapter 7. prices and variable costs are as follows: Years Sales volume (‘000) Sales price/unit (£) Variable cost/unit(£) 1 1200 20 4 2 1920 20 4 3 960 18 4 4 600 13 4 The incremental fixed costs were forecast to remain constant over the product’s life which for the annual production fixed overheads were £4. for the annual depreciation write off of the new equipment. REQUIRED a.204–7.20 million p. b. numbers 18 and 25 • Chapter 9..a. p. 27 and 30 • Chapter 8. Calculate the payback period and accounting rate of return for project A. numbers 15. The company has a cost of capital of 15%. p. A working capital fund of £2 million will be needed immediately to finance the build up of stock and debtors.15 million p. 20.234. At the end of the project’s life only £1. and administration and selling were £8. Calculate the net present value to the company of project A. The contractual obligation will be met in 3 months time.8 million will be recovered when stocks of the product are rundown and debtors pay up. numbers 5 and 6. 19. 25. In calculating these fixed overheads the accountant had included £3. 27 .

59 Financial management Notes 28 .

2007) Chapter 10... Before you start reading the recommended textbook. R.Chapter 3: Introduction to risk and return Chapter 3: Introduction to risk and return Aims of the chapter This chapter will start by looking at. here is a word of advice: The cost of capital is the link between a firm’s financing and its investment. P Financial Management for Decision makers. and having completed the Essential reading and activities. 170–208. (FT Prentice Hall Europe.C. (McGrawHill. 29 .A. how this risk associated with a project can be measured.J. R. 2008) Chapter 8. 2005) pp. S. This is followed by an explanation of how to distinguish between market and unique risk. (McGraw-Hill. Allen Principles of Corporate Finance. Learning outcomes By the end of this chapter.A. In this chapter you are required to confront the issue of the relationship between the cost of capital and risk and. or as they are often referred to.C. We will then show how to calculate share returns. you should be able to: • estimate the opportunity cost of capital for a project using shares that have the same risk as the project • calculate the expected return. systematic and unsystematic risk. Further reading Brealey. So the cost of capital provides the discount rate for evaluation of new projects and for valuing the firm as a whole. It measures the return the firm must earn on its assets to meet the requirements of investors. risk and return. Atrill. S. and explaining the concepts and techniques of. The significance of using diversification to achieve risk reduction will then be considered. and it provides a benchmarking for the return from existing business activities. Myers and A. Essential reading Brealey. variance and standard deviation for both a single investment and also for a portfolio of investments • explain why a strategy of diversification reduces risk • distinguish between unique risk and market risk. Marcus Fundamentals of Corporate Finance. Myers and F. Introduction So far in your studies of financial management you have overlooked the issues that are associated with project specific risk and you have assumed that the cost of capital for a project will depend upon the risky nature of the project undertaken. .

the return you will expect from the share will come in two forms: • a dividend (a special form of cash interest payment to shareholders as a return for their investment in the firm) • a capital gain or loss (which will depend upon whether the price of the share has increased or decreased relative to the purchase price). and by 20X6. the value of the share had increased to £100 per share. For instance. during the year. this is also the basis for the Gordon Dividend model used to estimate a company’s cost equity (see Chapter 5). British Airways paid a dividend of £10 per share. far more than either bonds or treasury bills). it is important to concentrate on the concepts and techniques used to measure risk. when they were valued at £80 a share. the London Stock Exchange. one way in which you could estimate the cost of capital is to find shares that have the same risk as the project and then estimate the expected return on those shares. Rate of return: a review When a share is purchased from say. Therefore. if you purchased a British Airways share in 20X5. then process to understand why the diversification of securities reduces unique risk and not market risk. As this chapter is only an introduction to risk and return. 30 . These concepts can at first be difficult to understand but persevere through the chapter and re-read the introductory section again after you have read the whole chapter. Brealey and Myers (2007) adopt a detailed approach to risk and return which may not be suited to students who are new to the subject. Then the return on your investment would be: Total return = (capital gain or loss + dividend) initial price paid for the share Incidentally. In addition.59 Financial management The introductory section to Chapter 10 of BMM. and shares have tended to provide the highest returns in the past. Total return = (20 + 10)/ 80 = 37. shares are riskier than corporate bonds which are in turn riskier than treasury bills.50% (which is the nominal rate of return) nominal rate of return = (capital gain or loss + dividend) initial price paid You already know that the cost of capital will depend upon the risk of the project and you could simply define the cost of capital to be the rate of return shareholders could expect to earn if they invested in equally risky shares. the capital gain would be £100 – £80 = £20 gain. provides a useful but detailed history of capital markets and also points out that certain assets which are associated with a high degree of risk offer high returns relative to assets which offer low returns at a lower level of risk (i.e.

variance and standard deviation To understand the concept of the business of investing in shares. you need to know that risk is related to the spread of the outcomes. You also need to be aware that the higher the uncertainty of the average return. so the more widely spread the returns were and are around the average will imply a greater investment risk. any objective measure of dispersion will provide a reasonable measure of risk and dispersion and that is why variance and standard deviation are able to be used in this context.1 Who ultimately bears the risk of projects undertaken by a company? (Use the diagram below as a guide to your answer.) Dividends as returns Cash returns for investment Ordinary shareholders Company Projects Cash to buy shares Cash to undertake projects See VLE for solution Calculating expected return. the higher will be the risk associated with the share. Thus. 31 . Standard deviation is the square root of the variance and is also a measure of volatility. Variance is the average value of the squared deviations from the mean and is therefore a measure of volatility.Chapter 3: Introduction to risk and return Activity 3. Therefore. you need to appreciate how far returns may differ from their average (which is usually determined by analysing the performance of the share over a long period of time).

35 – 0.5 – 10. that other things being equal.0 – 10.2 – 0.e.076 (i. 7.3)2 + 0. 30%. Its use in this context assumes constant marginal utility. investors will prefer an investment giving the highest expected return for a given level of risk or one that has the lowest risk for a given level of expected return.59 Financial management Equations Expected return = Variance = Standard deviation = variance.50 Total end return 1.2) = 0. under normal market conditions 35% and under unfavourable market conditions −20%.5 – 10. let us consider a simple example: Worked example 2 Suppose you own a single share in company A.92 Thus a rational investor when choosing between two heterogeneous investments will prefer the one with the lower co-efficient of variation – the lower risk per unit of return.6 0. the total return will be 65%. 32 .50 (16. Co-efficient of Variation = standard deviation / R = 0.30 = 0. Market conditions Favourable Normal Unfavourable Probability end share price 0.0) (8.2 × (0.35) + 0.2 × (–0.65 – 0. which may be acceptable over a short range. To best illustrate how the expected return.2 0.276 The Standard Deviation is simply calculated as the square root of the variance. this is the co-efficient of variation. For instance.00 0. The Expected Return R is calculated by multiplying each total period end outcome Ri by the probability Pi associated with its market condition and summing.2 End dividend 15.50 7. 15% and 10%. There is also a measure of risk per unit of return which is helpful when choosing between two independent risky assets. Expected Return = R = P1 R1 + P2 R2+ P3 R3 = 0. which has a current market value of £10 and you expect that the future possible value of the share and the dividends at the end of the period are those set out below. It should be clear at this point.6%) Standard Deviation = σ = √ variance = 0. Variance = = 0.e.30 (i.276 / 0.6 × (0.6 × (0.3)2 + 0.2 × (−0. assuming that the 10% risk rating is associated with the lowest risk.3)2 = 0.00 12. 30%) The Variance.2 × (0. the variance and the standard deviation are calculated.65) + 0. if you were told that the return on a share is expected to be 20% and you have been given three risk ratings.0) (13. which measures how much each individual outcome differs from the average (measures dispersion and volatility) is calculated by multiplying each end period return Ri minus the expected return by R the probability Pi associated with the market condition and summing.50 1. then you will select this level of risk for the given level of return.0) 65% 35% -20% You will notice that under favourable market conditions.

2007. under normal conditions 10% and under unfavourable market conditions −10%. Myers and Marcus. the variance and the standard deviation for a single share.288) Diversification is a strategy designed to reduce risk by spreading the portfolio risk across many investments. you will notice that both the variance and the standard deviation for the portfolio are much lower than the mean return and standard deviation for each individual share. you have decided to purchase a share in company B.Chapter 3: Introduction to risk and return Activity 3. This is mainly due to the reduction in the volatility associated with the greater number of shares you add to than the single share that you started with. Market portfolio is the group of shares that make up the overall market.2 You are now required to re-work the example for company A with the probability of the end share price equally likely for the three market conditions. Compare the expected returns and the standard deviations for both scenarios.50 5. See VLE for solution Risk and diversification In the previous worked example you calculated the expected return. which has a current market value of £5 and you expect that the total end period returns for the share will be as set out below for the three market conditions already identified when analysing company A: Market condition Favourable Normal Unfavourable End period return (Gain + Dividend) £ 6. you are not exposing yourself by having ‘all your eggs in one basket’. Worked example 3 We can now extend our initial analysis of only a single share in worked example (1) to examining more than one share and thus see the effects of diversification. under favourable market conditions the total end period return will be 30%. Suppose. 33 . The risk is spread amongst a large number of shares whose returns do not move in exactly the same direction and magnitude all the time. you would notice that: The standard deviation of individual shares is generally higher than it is for a group of shares. Should you be given the opportunity to calculate the standard deviations for a group of shares (such as that of a market portfolio). (Brealey. By adding additional shares to the one(s) you already have.50 Total end period return % 30 10 –10 Therefore. p.50 4. If you now compare the individual total end period returns for both company A and company B with their combined (portfolio) returns. such as the market portfolio.

0 20 400 20 1. You will also be expected to learn and be able to apply the formulae used to calculate the expected return and the variance of the two share portfolio.R ) / σ σ AB A B A B 34 .R ) = ∑P (R – R )(R – R ) A B R A A B B When you calculate the portfolio variance you also need to consider not only the individual variances of the shares but also the way in which their returns vary as measured by the covariance (usually termed the covariance effect).6 1. but on a constant returns to risk. Two share portfolio Expected return: Variance: Covariance: R = XR + (1 – X)R p 2 2 A 2 p A σ = X σ + (1 – X) σ + 2X(1 – X) r σ σ B B 2 2 AB A B cov(R . It is important at this point to emphasise the effect of a negative covariance which is usually influenced by a negative correlation coefficient.5(–10) = −15.59 Financial management Market condition Probability Return on share % Share A Share B Portfolio return (50% in share A and 50% in share B) 0. Covariances can be negative as well as positive.5(65) 0. in this question assume all other factors remain the same as in the example above. The correlation co-efficient measures the extent to which the returns of pairs of shares vary with one another.2 65 35 −20 30 760 27. Note that the correlation coefficient between the returns of A and B is 1. Calculating the co-efficient of variation for shares A.92 30 10 −10 10 160 12.3 You are now required to re-work the example above for a portfolio of 60% invested in company A and 40% in company B. they are more likely to be concerned with the risk and returns associated with their portfolio.5(10) = 47. The choice of investment between the three alternatives by an individual will depend on the risk and return parameters of the utility curve of the individual.5(30) + 0.6 0. Notice how the addition of a lower return in share B to share A reduces the overall portfolio return and how the standard deviation of the portfolio has been reduced too. See VLE for solution r = cov(R . The lower the risk the lower the return.5 = 22.26 0. share A is better than B or the 50/50 combination.6 0.5 Favourable Normal Unfavourable Expected return Variance Standard deviation Co-efficient of variation 0. Correlation co-efficient: Activity 3.5(−20) + 0.5(35) + 0.0 You must remember that investors with a portfolio of investments will not necessarily be concerned with the returns and standard deviation of the individual shares. B and the portfolio of A and B indicates share A for the higher level of risk gives a disproportionately higher return than the portfolio of A and B.2 0.

Market risk occurs as a direct result of economy-wide perils that threaten all businesses. It is worth reiterating that if you only hold one share. You are now required to extend the analysis performed in Question 1 to examining more than one share and note the effects of diversification. your strategy of diversification is likely to have almost eliminated unique risk and thus leave you to handle only the risk born by every share in the marketplace – market risk.50 0 20 11 0 Suppose. you should be able to: • estimate the opportunity cost of capital for a project using shares that have the same risk as the project • calculate the expected return. 2. the portfolio variance. will generate the following payoffs to shareholders in the following year: Market condition Favourable Normal Unfavourable Dividend Share price 3. Suppose you have now decided to purchase a share in Bards Ltd.00 and you expect that the expected return for this share will be 2. The shares of Carbs Ltd. The shares for Carbs Ltd are currently trading at £10. the portfolio covariance and assuming the portfolio correlation coefficient between the two shares is −0. A reminder of your learning outcomes By the end of this chapter and having completed the Essential reading and activities. 3. which has a current market value of £12. Discuss what would happen to the opportunity cost of capital if investors suddenly became especially prudent and generally less willing to bear investment risk. Practise questions 1. You are required to calculate the expected return and standard deviation of the returns to the shareholders of Carbs Ltd.Chapter 3: Introduction to risk and return Market risk versus unique risk The risk that you will be able to eliminate by the diversification of your investments is known as unique risk or unsystematic risk. The risk that you will not be able to diversify away regardless of the different investments you add to your portfolio is generally referred to as market risk or systematic risk. the portfolio standard deviation.00 1. variance and standard deviation for both a single investment and also for a portfolio of investments • explain why a strategy of diversification reduces risk • distinguish between unique risk and market risk. a chain of bookstores. if the company is faced with unfavourable market conditions it will go out of business. You are required to calculate the combined portfolio returns for Carbs Ltd and Bards Ltd (assuming 50% in each share). Assume that the three possible market conditions are equally likely.00. the variance will be 4. a chain of fashion retail outlets. both unique risk and market risk will be very important.8.00.00 per share. but once you have a portfolio of 20 or more shares. See VLE for solution 35 .00 and the standard deviation 2.

14.1. p.59 Financial management Problems Attempt the following problems in BMM: • Chapter 10. numbers 8.268. numbers 3. selftest 10. 4 and 8. Attempt the following problems in BMA: • Chapter 8. 36 . p.289. 17 and 18.

J. S. 2007) Chapter 11.C. (McGraw-Hill Inc. will be described and calculated and its application in capital budgeting and project risk derivation shown. or opportunity cost of capital. and how risk associated with a particular project could be measured. Learning outcomes By the end of this chapter and having completed the Essential reading and activities. The relationship of market risk and the risk of a share to the rate of return that investors require will be explained. Marcus Fundamentals of Corporate Finance. In the final section of Chapter 3 you were required to understand why the diversification of shares reduces unique risk (firm-specific risk) and not market risk (associated with macroeconomic events faced by all firms). investors will need to earn a higher rate of return to persuade them to take on market risk. Essential reading Brealey..A. Before you start reading Chapter 11 in BMM 37 . Allen Principles of Corporate Finance. Myers and F.. As unique risk can be diversified away by holding a large portfolio of shares. Myers and A. 2008) Chapters 8. R. As this chapter is a logical extension of the previous chapter (Introduction to risk and return). it is important that you concentrate on the concepts and techniques used to measure and interpret the market risk of a security and then proceed to relate the market risk of a share to the rate of return that investors demand and finally. applied to the concept of risk and the measurement of market and investment risk. show how the opportunity cost of capital of a project can be calculated. Introduction In Chapter 3 you were required to confront the basic relationship between the cost of capital and risk.C. R. S. (McGrawHill. This required return.Chapter 4: Capital budgeting – risk and return Chapter 4: Capital budgeting – risk and return Aims of the chapter In this chapter the concepts of market risk and beta will be described and this will include how each can be measured. 9 and 10. through the use of beta. you should be able to: • calculate and interpret the risk associated with macroeconomic factors (market risk) for a share • compare the rate of return that investors demand and the market risk of a share • calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital. Further reading Brealey. The capital asset pricing model (CAPM for short) will be introduced and.A.

As risk depends upon exposure to macroeconomic events. This risk premium relates to the extent to which the particular share is affected by the macroeconomic factors associated with systematic risk. a substitute such as the FT All Share Index is used as a proxy for the market portfolio. • Systematic risk (or market risk) which is risk borne by all companies. Risk premium is the difference between market return and the return from the risk free asset. etc. it is possible to diversify away quite a lot of the risk. it can be measured as the sensitivity of a share’s return to fluctuations in returns on the market portfolio – as a total market portfolio consisting of all types of investments is difficult to establish. changes in oil prices. Investment managers generally refer to these as follows: • where shares are not very sensitive to market fluctuations and therefore have a beta less than one – defensive shares – and • where shares are sensitive to market changes and therefore have a beta value greater than one – aggressive shares.59 Financial management here is a word of advice. part of the risk of share ownership cannot be diversified away. some shares will be less affected than others by market fluctuations. Obviously investors will want to hold a portfolio of aggressive shares should they expect the market to rise in the near future and hold a portfolio of defensive shares should they anticipate the market will fall in the near future. and the second section of this chapter extends your understanding of the basic risk and return relationship by introducing the capital asset pricing model and the security market line. We thoroughly recommend that you also follow-up this chapter in BMM by reading the corresponding chapters in BMA. both these sections may seem to be very technical and the language used by the authors may prove to be difficult to understand at first but we recommend that you persevere through the entire chapter and then revisit the earlier sections for a fuller understanding. it is caused by macroeconomic factors like changes in interest rates. Total risk of investing in a particular share involves: • Unsystematic risk (or project specific risk) which is diversifiable by holding a large portfolio of shares. This part of risk is known as market risk or systematic risk. Measuring beta As you will have already worked out. Beta is a measure of movements of a shares return to the return on the market portfolio. At a glance. The first section to this chapter introduces you to measuring market risk and the beta of shares (which is mainly empirical in nature). The part of total risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. This sensitivity is termed as the share’s beta (ß). 38 . Measuring market risk By holding a portfolio of investments comprising shares in different businesses. This is because this part of the risk relates to factors which affect all businesses and their returns. However. in different industries.

Plot the observations (i.0% then the risk premium is 13.25 × 1.2. as illustrated below.Chapter 4: Capital budgeting – risk and return Procedure for measuring real ’companies’ betas (in the UK): 1. 25% in British Airways shares and 50% in British Petroleum shares.4 0. Amazon.3 + 0.25 × 1.0) + (0. Solution to Worked example 4 The portfolio beta is calculated as follows: (0. 3. if you are told that the return on treasury bills is 4% and the return on the market portfolio is 13%. Fit a line of best fit showing the average returns for the share at different market returns. 4. For example.2) + (0. if the return on the risk-free asset is 4. 39 . usually a proxy is adopted for the market return such as the FTSE 100 all share index (in the UK) or the S & P 500 index (in the US) and the return on the risk free asset is the interest payable on treasury bills issued by the government.0%.0% and the return on the market portfolio is 13. therefore. 1.1 At this point you may find it useful to go through how BMM calculate the betas for Turbot-Charged Seafood.8) = = 0. Portfolio betas The diversification of shares decreases the variability from unique risk but not from market risk. The bold line represents the security market line which shows the relationship between expected return and beta. 2. Worked example 4 Calculate the portfolio beta if you have invested 25% in ICI shares. Follow the rates of return for a particular UK company. weighted by the investment in each share.e.25 + 0. usually monthly/weekly returns over a particular time period and also track the returns for a proxy of the market index such as the FT All Share Index over the same period. the company share returns on the y-axis and the proxy for the market returns over the same period on the x-axis).0 − 4.95 Risk and return The market risk premium can be defined as the difference between the market return and the return on risk-free treasury bills. you should be able to plot the expected return against the beta. The beta of a portfolio of shares is just an average of the betas of the individual shares in the portfolio. and their respective betas are 1.0 and 0.0 = 9. Activity 4. Beta of the share will be the slope of the fitted line (usually calculated in practice using a technique known as regression analysis). You must remember that the risk-free treasury bills will have a zero beta and the fully diversified market portfolio will have a beta of one.5 × 0.8.com and Exxon Mobil.

5 × 4%) = 8. you will be able to calculate the expected return for any asset which has a beta between zero and one.59 Financial management Figure 4. 40 .5 and market risk premium of 9% = β(rm – rf) = 0. you will notice that given the expected return for riskfree treasury bills (zero beta asset) and the expected return for the market portfolio (unitary beta asset).5% Capital asset pricing model ri = rf + β(rm – rf) where: ri is the required rate of return on a particular investment i rf is the risk-free rate β is a measure of the extent to which investment i is affected by macroeconomic factors rm is the expected average return from investing in the market portfolio of shares.5% You can also calculate the expected return for this example more formally by using the following formulae: i.5% iv) Total expected return (r) = risk-free rate + risk premium of investment = rf + β(rm – rf) = 8. Market risk premium = (rm – rf) = 13% − 4% = 9% ii. For example.1 Plot of expected return against beta From this figure.5 × 9% = 4.5 × 13%) + (0. Risk premium of an investment = β(rm – rf) You multiply (i) by beta as beta measures risk relative to the market on any asset. if you have a portfolio split evenly between risk-free assets (which offer an interest rate of 4%) and the market portfolio (which offers an expected return of 13%) the expected return for the portfolio will be: (0. iii) Risk premium of an investment with beta of 0.

almost everyone agrees that investors require some extra return for taking on risk. Remember. say 9% for the increased risk you take on by investing in shares. you require – the risk-free rate. Calculate whether the project is feasible if a.e. The riskier the investment.65 then the expected return on Company Z shares will be: Expected return = risk-free rate + (beta × market risk premium) = 4% + (0.9.87. the beta for company Y is 0. Worked example 5 Company Y has forecasted the cash flows on a project and estimate that the internally required rate of return on this project (internal rate of return) is 10%.5% Activity 4. say 4%. investors are principally concerned with the market risk (the risk which they cannot diversify away). 41 .4 c. However. whereas if you invest in risky shares. if the interest on treasury bills is 4% and the market risk premium is 10% and the beta for Company Z shares is 0. the beta for company Y is 0.2 Calculate the expected return for a share if the risk-free rate of return is 8% and the market premium is 12% and the beta for the company share is 0. the beta is zero) b. the CAPM does capture two simple but fundamental ideas useful to investment managers. First. Then discuss how the beta for a company may be calculated in practice. β = 2) then the risk premium is doubled. CAPM is the theory of the relationship between risk and return which states that the expected risk premium on any share equals the share’s beta multiplied by the market risk premium. if you invest in a risk-free asset. Risk-free treasury bills offer a return of 4% and the expected risk premium is 7%. For example. So if you invest in something twice as risky as the market (i. See VLE for solution Project returns and the opportunity cost of capital The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk. To calculate the returns that investors are expecting from particular shares. the CAPM is only a model of risk and return. Therefore. the expected market risk premium. The basic idea behind the CAPM is that investors expect a reward for waiting and taking on risk.e. the greater the expected return. According to the CAPM. Secondly. you can expect to gain an extra return or risk premium.Chapter 4: Capital budgeting – risk and return This formula is commonly used to calculate expected returns and states the basic risk-return relationship called the Capital Asset Pricing Model or CAPM. you just receive the rate of interest. the project is a sure thing (i.65 × 10%) = 10. and beta. expected rates of return for all securities and all portfolios lie on the security market line as illustrated above.

(ii) 4. In this way the company cost of capital equated to the expected rate of return demanded by investors. The corporate cost of capital is based on a portfolio of assets with individual beta’s β = ∑β ii. If the return on the project lies above the security market line.4 × 7%) = 6. other things being equal. then the return is higher than investors can expect to get by investing in the capital market.5%.3 Should the company accept a project (for the worked example above) if the beta for the project was (i) 7. The project cost of capital may differ from the company cost of capital as it will depend upon the use to which the company’s capital is put. In practice. Since investors will require a higher rate of return from a high-risk company than from a low-risk company.8%.9 then company Y should not take on the project as the project is riskier than the internal rate of return required by the firm (i.9 × 7%) = 10.90 then the hurdle rate is 10.9 then r = 4% + (0.e.30%. but if faced with a new riskier area of business with β of 0. and thus would require a higher rate of return.3% is more than 10%). If the company has a zero beta then r = 4% + (0 × 7%) = 4% If the company has a beta of 0. Thus if a company presently had assets with risk class β of 0.9%? See VLE for solution c i Capital budgeting and project risk Long before the risk-return relationship was established financial managers realised that.4 then r = 4% + (0.7% or (iii) 8. which was determined by the average risk of the company’s assets and operations. the project cost of capital will depend upon the risk of the project and not upon the risk of the company’s existing business.8% If the company has a beta of 0. 0. If the beta is 0. Therefore. high-risk firms will have a higher company or asset cost of capital and they will therefore set a higher discount rate for their new investment opportunities. i. 42 . When we are analysing whether a project is feasible the selection of an individual project beta (or individual area of business beta) will be preferred to the company’s cost of capital as the latter will be a weighted average of all project betas for the company (the average of the betas for all business areas). Activity 4.4. risky projects were not as desirable as those which were considered to be safe projects. the security market line is a good indicator for project acceptance. Since we have already established in an earlier chapter that NPV is the best criterion for project selection we need to note in this question that the selected hurdle rate (cost of capital) is the relevant rate for a particular risk level.3% Company Y would only consider the project if the beta was either zero or 0.40 – the required return – the hurdle rate in the calculation below is 6.59 Financial management Solution to Worked example 5 To answer this question you need to calculate the opportunity cost of capital.

260–61. Share B has a beta of 1. Discuss whether. Which projects should be accepted? See VLE for solutions Problems Attempt the following problems in BMM: • Numbers 1.231. Share A had a beta of 0. and the expected returns calculated by the way of IRR’s are as follows: Project A B C D Beta 0. p. you should be able to: • calculate and interpret the risk associated with macroeconomic factors (market risk) for a share • compare the rate of return that investors demand and the market risk of a share • calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital. A firm is considering the following projects. according to the CAPM. 10 and 13. 3. If the firm has a current single cost of capital as 16%. 8 and 11 (pp.6 1.5 and investors expect it to give a return of 13 per cent. The risk free rate is 4% and the market return is 16%. numbers 5 and 8 • Chapter 10. pp.2 Expected return 13% 12% 19% 18% a. the expected rate of return of a share with a beta less than zero would be more or less than the riskfree rate? Why would investors be willing to invest in such a security? 2. which projects have a higher cost of capital than the firm’s? b.8 0. numbers 9.313–16). Use the CAPM to find the market risk premium and the expected rate of return on the market.5 1. Attempt the following problems in BMA: • Chapter 9. Practise questions 1.5 and investors expect it will provide a return of 5 per cent. 43 .Chapter 4: Capital budgeting – risk and return A reminder of your learning outcomes By the end of this chapter and having completed the Essential reading and activities.

59 Financial management Notes 44 .

Allen Principles of Corporate Finance. Essential reading The chapters in PA and BMA are included as Essential reading here as well as those in BMM. Learning outcomes By the end of this chapter. The efficient market hypothesis has important implications for all market operators and their agents. P Financial Management for Decision makers. 6. investors. It considers the concept of an efficient capital market with its implications for the raising of capital and the assurances for a fair game situation for the transfer of funds between investors. (McGraw-Hill Inc. the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them (e. companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity. its different levels. The second part deals descriptively with the main methods of raising equity and debt funds. Brealey.1. you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis. 45 . Implications. Myers and F.C. R.C. S.8. Marcus Fundamentals of Corporate Finance.g.. The former adds the necessary depth of required background knowledge to that provided in the latter text. R. . 15 and 16. Brealey. 2008) Chapters 14. 2005) Chapters 6 and 7. (McGrawHill.. 2007) Chapters 6. benefits and costs of the alternative methods of funding and raising the funds are considered due to their importance to a company.Chapter 5: Sources of funds Chapter 5: Sources of funds Aims of the chapter The first part of this chapter introduces you to the theory and practice of capital markets. Discrepancies in types and degrees of efficiency between different international markets also have been identified.2. Myers and A. and having completed the Essential reading and activities.J. 13 and 14. 6. S. (FT Prentice Hall Europe.6–6. Atrill. The types and the degrees of efficiency have been tested in many and various ways with more recent research findings highlighting certain anomalies which give support to those who have questioned the concept. as well as including details of the characteristics and costs of using them.A.A.

This description of London is. with the advantage of information which may subsequently come to light. Learn the assumptions underpinning the definition of a perfect capital market and how the economist’s perfect market becomes the financial manager’s efficient capital market and the sufficient conditions for that. through their management. few people or institutions would be prepared to make investment funds available. Note. Note that this latter function is a vitally important one because. use and understand how the notion of being involved in a fair game proves the basis for discussion here. Efficient market hypothesis There are three forms or levels of efficiency: weak. respectively. CME is concerned with the extent to which the knowledge which does exist about a particular security is fully taken account of in its market price. CME requires that the price at which that security is traded today rationally reflects all of the information which is available today. but linked. be above or below the true worth of the security.59 Financial management Capital markets In Chapter 7 of PA and Chapter 16 of BMA these are examinations of the workings of the London Stock Market in the UK and the Securities and Exchange Commission (SEC) in the USA.1 Write out the economists’ assumptions for a perfect market and corporate finance’s assumption for an efficient capital market. It is to this that the Efficient Market Hypothesis (EMH) relates. a description of the typical capital market found in most of the world’s developed countries. without the facility to exit from an investment. It is important to note how capital markets have two separate. that wish to raise funds as well as other investors who may wish to buy or sell existing financial assets. CME does not require that the market is a perfect one in the sense that perfect markets are referred to by economists. Activity 5. thus people who draw charts of past share price movements. and try to detect patterns of share price 46 . functions. Thus this marketplace is providing the needed interface for investors to interact with the companies. Note carefully what is meant by capital market efficiency (CME). Show the links between the two lists. means that one cannot consistently earn better-thanaverage investment returns as a result of studying past patterns of prices for particular securities. See VLE for solution There are three types of efficiency: • allocational • pricing • operational The majority of the research findings in the literature when discussing efficiency are related to pricing efficiency. Neither does CME require that any investors have perfect knowledge of the future. in principle. and a secondary one which provides the opportunity for the providers of funds to liquidate their investments. Thus the price at which a security is traded today may. semi-strong and strong: • weak form. These are a primary one for fund raising.

this has the effect that share prices follow an apparently ‘random walk’ • semi-strong form.2 Take a local paper which quotes daily share prices. would not gain as a result. if a market is efficient in the semi-strong form. So somehow. Activity 5. bearing in mind that CME means that all information is reflected in share prices. it prevents people from consistently earning better-than-average returns. if a market is efficient in the strong form. 47 . on. tends to suggest that the world’s capital markets are efficient in the weak and semi-strong form. Tests of the efficient market hypothesis Researchers have conducted the greatest number of tests on the weak form of the hypothesis. can expect to earn better than average investment returns. Select a company and plot the closing share prices for the 5 days in one week with time on the x axis. Since the emergence of new information will not follow a pattern. This randomness could be seen as a market which is irrational. Is your explanation drawn from the weak. would not be expected to be advantageous • strong form. By reading the paper about Monday’s market activities try to explain why the plot for Monday’s price is where it is. The results have not been uniform in outcome. over different time periods. but not in the strong form. The differences in results can be explained by many features – developed country markets versus developing country markets. only relevant new information will affect them.Chapter 5: Sources of funds movements. Tests have looked for data patterns that might have particular properties similar to different frequency distributions – random-walk. where better than average returns cannot be consistently earned by studying publicly available information about the enterprise. this study of public information. thus. The tests have been performed on numerous different markets. Similarly. simple sequences of increases or declines – all with the aim of being able to derive a trading rule which would enable the investor to out-perform the market using a simple buy and hold strategy. which consists of the results of a large number of research studies. because the market is efficient. for example serial correlation and run tests. would not expect to gain as a result. however. This correctly suggests that share prices move in an apparently random way. those who have relevant information which is not generally known. You should be able to summarise the outcome of these tests which have used a variety of statistical techniques. people who have unpublished information. upward versus downward price trends etc. etc. sub-martingale. These distinctions are useful. Draw a line of best fit through those five points. In other words. Then plot the next Monday’s closing price. monthly versus daily versus weekly prices. above or below the trend line you have drawn. it must also be efficient in the weak form. where better than average returns cannot be earned as a result of having access to information which is not available to the public. This is because evidence. rather than following repeating patterns. it must also be efficient in the semi-strong form and the weak form. perhaps because they work for a particular business. semi-strong or strong form? It is important to understand that. for example the published accounting reports of companies.

then spend money on agents’ fees etc.g. this is provided that the facts concerning the alterations to the accounting bases are made public. insider trading and doubts concerning efficiency There are now many published articles on the anomalies in the evidence investigated for proof of EMH (e. fads. There is a body of evidence which suggests that attempts by corporate managers to make alterations to the accounting bases. There are numerous reasons why management wants financial information presented in a particular way (e. even month of the year. Not surprisingly.59 Financial management The tests on the semi-strong form have also been numerous and again produced results lacking in consistency. to publicly available information).e. Implications of capital market efficiency You should particularly note the implications of CME for financial managers. to sell part of the existing portfolio and replace it with the ‘cheap’ shares.g.g. earn above average profits. these implications are the reason why CME is included in the syllabus. will not affect the market price of the business’s shares. This is in spite of legislation in some countries in the markets outlawing particular operations (e. income smoothing because of the link with a management remuneration scheme). Results from developing market studies have been much fewer and have tended to suggest a lower degree of efficiency. Anomalies. being caught for insider training etc. Even so there is not evidence of consistent above average gains accruing to groups of investors who have based their trading upon those results. Reality is different due in part to human nature. The major implications are: • Accounting misinformation will not fool investors generally. However not everything may be made public and in any case some manipulation may be possible within the guidelines and thus not published. efficiently. insider trading). so if shares look cheap it is illusory – all that will happen is that the investor will waste time and money seeking out the ‘cheap’ shares. size anomalies and small company effect). it is fair to say that there is sufficient anecdotal evidence of investor behaviour of following fads. to indicate that theory and practice are not quite in line. • There is no need for the large body of analysts and others in the securities and investment industry. Again. The strong form tests have been least successful in their proof of the strong form of efficiency in the markets. These anomalies help to explain why the anecdotal evidence quoted by interested parties of abnormal profits can be explained. Clearly there are still circumstances that exist where investors under the strong form could. trading hours of the day effect. • Investors are best advised to buy a portfolio of shares and to hold those shares rather than looking for opportunities to buy ‘cheap’ shares – this is because securities reliably reflect all known information about a business. and do. 48 . to figures published in annual accounts which have the effect of giving a changed view of the profit for a period or the assets on the balance sheet. The tests using data from developed country markets have tended to support the conclusion that the market adjusts quickly (i. day of the week effect.

therefore.’ b. Review question Critically comment on each of the following statements: a. perhaps caused by an effective decline in the number of individual investors active in the market. Possibly it reflects the use of more sophisticated research techniques in recent studies. Possibly the shift in research findings is reflecting a genuine lessening of CME over recent times. For efficiency to exist it is not necessary for all investors to have the relevant information. it means that all investors have complete information about all of the shares quoted in that market. European Association of Security Dealers Automated Quotation (EASDAQ) and so on. This is inconsistent with efficient capital market theory. otherwise you wouldn’t have all those well paid analysts spending most of their working day poring over business reports and other published information. This is a very bad time for our business to make an issue of new shares to the public. It seems that corporate managers are frequently concerned not to issue shares at a point where share prices are historically low. this is irrational if current share prices reflect all that is known about the business. There is no reason to believe that share prices will rise again. Stock market efficiency does not mean what the quote says. ‘The stock market cannot be semi-strong efficient. If the share issue is to be a rights issue. A paradox of capital market efficiency is that it is as a result of people looking for inefficiencies and exploiting them that the market forces drive prices rationally. Only where the businesses managers have economic information about the business. As all relevant information relates to the future.’ Solution to review question a. ‘The stock market is depressed at the moment. it is not possible to know it for certain. the Alternative Investment Market (AIM). since in order for the issue to be successful the new issue would have to be at a low price. Market efficiency means that all known (strong form) or all publicly known (semi-strong form) information is rapidly and rationally reflected in security prices.’ c. the International Stock Exchange of the UK and the Republic of Ireland. which says that the current price rationally reflects all information about the business and. in any case. This implies that the current issue price will make the existing shareholders worse off because the new shares will be sold for less than they are really worth. 49 . b. the issue price will not affect the wealth of the shareholders. Again anecdotal evidence can show in specific instances where during a particular short period businesses did lose out by having to issue at the wrong time. It certainly does not mean that what investors know is ‘correct’. c. London capital market This is a generic title given to a considerable number of specific and specialist markets. It includes such markets as the ISE. simply for investors to have it between them. which are leading to a truer view of things. ‘If stock market prices are efficient. fairly values it. that they have yet to release into the public domain would delay be justified.Chapter 5: Sources of funds • The timing of issues of new shares by businesses is not an important question.

However. shares to be issued are sold to an issuing house which. Methods of raising share capital You must study carefully the various methods of raising share capital. or overpricing. which means the investor will lose potential profits on the issue. A tender issue has distinct advantages for a business where uncertainty surrounds the appropriate price at which to price the shares. It is important to appreciate that a tender issue is not a method of issuing shares but rather a method of determining the price at which shares are issued. Such uncertainty may be due to such factors as stock market volatility or the unique nature of the business. which would use the tender approach to identify the striking price at which the issue would take place.59 Financial management Activity 5. A tender issue will help avoid underpricing the share. When dealing with the main forms of share capital you should note the decline in recent years of the popularity of preference shares and the likely reasons for this.3 Write out and learn the outline of the processes of the main exchange and the rationale and difficulties concerned with the other markets and their requirements. A rights issue offers existing shareholders the opportunity to participate in any new share issue and to maintain control of the business. it is a less popular method of raising equity finance. All the above methods of issue do not place restrictions upon the company as to whom it can offer the shares. in turn. See VLE for solution Share capital Much of the content of the introductory sections concerning the characteristics of limited companies and the main forms of share capital have been dealt with in your earlier studies and so should be familiar to you. A company wishing to extend its share capital may wish to place restrictions and an example of how it can do it is by use of a rights issue. which means the business may experience an unsuccessful share issue. The advantages and disadvantages of this form of issue should be carefully noted. Note the distinction between an offer for sale and a public issue of shares. a public issue entails greater risk as the public may not wish to subscribe for the shares offered. In the former case. Consequently. 50 . many investors find it difficult to decide on an appropriate tender price and so prefer a fixed price share issue. offers the shares to the general public whereas in the latter case a company will make a direct offer of its shares to the public. From a business viewpoint. The method of issue could be an offer for sale or a public issue.

Solution to Worked example 6 a.50/6 = £1.200 @ £1.50 Value of a single share following the rights 10. Worked example 6 Mulberry Chemicals plc has the following capital structure: £000 25p ordinary shares Share premium account Retained profit 15.50) £ Value of investment following rights issue (1. Identify and evaluate the options available to an investor holding 1. The investor can take up the rights issue.50 per share.50) 2.50 £0. At a recent board of directors’ meeting it was decided to undertake an ambitious expansion programme and to finance this with a one-for-five rights issue at £1.000 4.800 Take up rights issue (i.100 300 £1. Study the worked example below.e. the theoretical ex-rights price of a share ii. or let the rights offer lapse (i.000 share investment prior to announcement of rights issue: 1.80 1 rights share 9.800 51 . the price at which the rights are likely to be traded. Calculate: i. The theoretical ex-nights price is: £ 5 ordinary shares @£1. sell the rights.75) Less cost of acquiring rights shares (200 × £1. do nothing). share prices and shareholder wealth It is also important to appreciate the effect of a rights issue on both share prices and shareholder wealth.000 ordinary shares in the company upon receipt of the one-for-five rights offer. b.80 each.560 The ordinary shares are currently being traded on the stock exchange at £1.75 The value of the rights may be calculated as follows £ Value of one share following the rights issue: Less cost of rights share Value of the rights 1.Chapter 5: Sources of funds Rights issues.25 b.80 = £1. acquires 200 more shares @ £1.00 1.000 2.e.75 1. Each of these options may be evaluated as follows: Value of original 1.50 £10.000 @ £1. Required: a.560 21.

so these smaller companies have to turn elsewhere.000 shares are issued @ £1. the smaller the needs and provisions the poorer it gets.75) Add sale of rights (200 × £0. From the viewpoint of a business. but rather to do it in a buoyant share market. you should note the gaps in the capital market for providing equity funds. style etc. the price at which a rights issue is offered is important but not critical. however.4 Write a brief paragraph explaining the advantages and disadvantages of the different forms of equity. for example. The providers of risk capital. of financing in the text. It is possible. However. Clearly the business wishes to issue as few shares as possible when raising its funds. You will find details of their aims. The efficiency and effectiveness of the market place for such funds depends very much on the quality of the network between such providers. With private companies. See VLE for solution 52 . The value of the underlying assets held by the business and the proportion of those assets to which each shareholder has a claim will be the same. 100. given that a business wishes to raise a specific amount of money. can be found various subgroups of fund providers. in practice. that fixed interest borrowing is no longer available because a company may have borrowed to their limit. so it will not tend to make a rights issue when the market is at a low. it is not really important whether. both large and small gaps have been identified since it is much more difficult for them to raise risk capital when required. in theory. Allowing the rights offer to lapse will place the investor in a worse financial position than the other options.000 @ £1. needs.25) Do nothing £ Value of investment following rights issue (1.59 Financial management Sell rights £ Value of investment following rights issue (1. the investor should be in the same financial position whether he sells the rights or takes up the rights issue.750 50 £1. say. Similarly. the business may sell the rights on behalf of the investor and pass on the proceeds thereby putting the investor in the same financial position as if he had sold the rights. are known as venture capitalists.50 per share. The larger and thus more public the company the easier it is to raise funds through the market. important to ensure the offer price is below the market price of the shares for the rights issue to be successful.000 @ £1. venture capitalists.000 shares are issued @ £3 per share or 200.800 Thus. Within the general title. It is. However.75) 1. Activity 5. some funded by financial institutions like pension funds. others made up of local groups of individuals with some money and expertise to offer who are called ‘business angels’.750 1. Other sources and types of equity You should be able to explain the difference between preference shares and ordinary shares along with the variety of each sort and the advantages and disadvantages for each.

as capital gains are only normally taxed when the gain is realised. A policy of retention may also be preferred by investors. The issue of loan capital can bring certain advantages to a business and its shareholders. interest-rate swaps and debt-equity swaps. • There is no risk of failure to obtain the necessary funds or existing shareholders suffering some dilution of control. Examples of these new types are junk bonds. The level of borrowing is also known as the amount of gearing. interest on loan capital is viewed as an allowable business expense which can be offset against profits for taxation purposes – this is not the case for dividend payments. • The degree of sophistication and variety now available in bond or quasi-bond securities has grown enormously over the recent past through the increasing competitiveness within the financial markets. • Loan capital is normally perceived as being less risky by investors than equity shares as loan interest is payable before share dividends and security is normally provided by the business for the loan – this lower level of risk results in lower expected returns by lender than equity shareholders. Some investors may prefer to receive returns from their shares in the fore of capital gains rather than dividends. also brings certain disadvantages: • The higher the level of borrowing the higher the level of financial risk associated with the business. these characteristics are dealt with in rather more detail than before. however. 53 . mezzanine finance. Long-term debt finance The early sections in the readings describing the main characteristics of long-term debt should again be familiar to you as a result of your earlier studies. • It is easier to secure funds in this way as retained profits will already be held by the business in some form or other. The use of loan capital to finance a business. Interest must be paid irrespective of the profit level and capital must be repaid on maturity of the debt. • New shares issues are usually subject to a great deal more scrutiny by investors and their advisers than profit retentions. Moreover. However. • In the UK. This higher level of risk is likely to mean that equity shareholders will seek higher returns in compensation. the returns to equity shareholders will increase providing the returns from the funds invested exceed the cost of servicing the loan.Chapter 5: Sources of funds Retained earnings A business may prefer to use retained earnings rather than a new issue of shares as a source of equity funds. This policy would have the following advantages: • Issue costs and delays in receiving the new injection of funds are avoided. These advantages include: • By employing loan capital to help finance the business. deep discounted bonds. the investor has some control over the timing of their tax liability.

The higher the gearing the greater the gains in earnings for shareholders in times of increasing profits. • There is a risk of a change in the pattern of control from the issue of new equity shares.) Most forms can be evaluated in similar ways to warrants and options.g. conversely in times of declining profits the higher the gearing the faster the decline in earnings per share. simplistically. gearing.) which will restrict management’s freedom of action.) 54 . Existing lenders will be concerned that any new debt issued by the business does not undermine their status or increase the level of risk borne. • The existing level of gearing is fairly low for the particular business sector. However the level of borrowing. will also be influenced by the company’s profitability and the present and future underlying economic conditions. which are covered in a later chapter. • Although interest rates are generally lower than equity returns. (Often their position will be protected by restricting loan covenants and so permission may have to be sought before the business can issue a new class of debtor. there can be occasions when the returns on loan capital are higher than those on equity capital. The attitude of investors and managers to the financing decision When new finance is sought from the issue of either long-term debt or equity shares the views of existing investors and the management of the business are important. • Adequate security for the debt exists. Hybrid capital A clear distinction between share and loan capital is not always possible and so you should cover carefully the sections on the major forms of hybrids in order to understand their characteristics and objectives. maintaining a certain level of liquidity. seeking permission from existing lenders before raising new loan capital etc. Thus. The attitude of existing equity shareholders is likely to be influenced by: • the perceived benefits and costs of gearing (the mix of debt and equity) • the potential problem of dilution of control through a reduction in the proportion of voting equity held • financial implications of additional calls for funds. in growth and high profit periods it is better for the company to be highly geared.(See BMA Chapter 15 or PA Chapter 7. it is better to be low geared in low profit or declining profit periods.59 Financial management • The business may also be required to accept loan covenants as part of the loan agreement (e. including the likely risks and returns arising from the equity option and the effect of the investment on the investors’ consumption pattern. The issue of loan capital Long-term debt is likely to be issued by a business where some of the following conditions prevail: • Earnings are relatively stable over time or on an increasing trend.

companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity. its different levels. Attempt the following problems in BMA • pp. Discuss reasons why. p. you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis.433. number 8. number 9 and 19. p. p. Practise questions 1. p.406. A reminder of your learning outcomes By the end of this chapter. (e. numbers 7 and 8.381–82.171.386 numbers 15 and 17. See VLE for solution Problems Attempt the following problems in BMM • p. the stock markets of the world will never achieve the ‘strong form’ of the efficient market hypothesis. the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them. 55 . They may be more willing to take on higher levels of gearing where their remuneration is linked closely to profits generated.Chapter 5: Sources of funds Managers are employed to act in the best interests of the shareholders although they may feel that a high level of gearing increases their own level of risk.368 number 8. and having completed the Essential reading and activities. in your view. number 10.g. investors.

59 Financial management Notes 56 .

We show the various models suggested to derive these costs. Atrill. Further reading Brealey. 18 and 20. 57 . both in theory and practice. you should be able to: • calculate the value of debt and equity and their respective costs using alternative approaches • describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt. Allen Principles of Corporate Finance. 2007) Chapters 5. debt and equity. So this chapter covers the rationale and derivation of a company’s cost of capital. S.. (FT Prentice Hall Europe.A.J. As the level of gearing varies. 10. (McGrawHill. Gearing is the name given to the degree or level of debt used in the total capital of a firm. 6. R. Myers and F. Approaches to valuing shares and business from a practical viewpoint will be covered since they will be dependent upon the theories which can provide guidance for a company’s financing methods and costs. P Financial Management for Decision makers..A. 12 and 15. Myers and A. The valuation models described and discussed relate to activities of investors and managers in the market place. 2005) Chapter 8. 5. Money raised from these different sources is then invested by the company and its managers to obtain maximum return.C. Learning outcomes By the end of this chapter. 2008) Chapters 4. Marcus Fundamentals of Corporate Finance. Essential reading Brealey. equity and business valuations • explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital • derive and calculate the weighted cost of capital for a company • compute the valuation of a business • provide a reasoned evaluation of the best way a company should raise new capital. the cost of the funds injected. Investments will only be made when it can be shown that they will at least overcome the hurdle of achieving the cost of capital.C. each with their individual cost and quantity. R. This cost of capital comes from the particular combination of funds and their costs. (McGraw-Hill Inc. it will influence a company’s average cost of capital and so this will be discussed for its implications. . S. and having completed the Essential reading and activities.Chapter 6: Cost of capital and valuation of a business Chapter 6: Cost of capital and valuation of a business Aims of the chapter In this chapter we start by investigating the costs of the main capital components. 11. 9. It is a weighted average cost because the total funds have a number of different types of funds.

Required: What is the cost of the perpetual loan stock? Using this cost calculate what the market value of the second type should be Solution to Worked example 7 = 5. The maturity value M is usually the same as the nominal value. for sentimental reasons. ultimately in the form of cash. The second type has the same yield (cost) and interest rate but is quoted at a different market price because it only has a two-year life. a share in a business has value only because it is expected to generate future economic benefits.e. Therefore the market value of a debenture. This contrasts with an asset that has value. Worked example 7 Solo plc has some loan stocks which are quoted at rates per £100 nominal value.31 58 . So using Kd = £ 99. At the end of the maturity period the nominal value of £100 will be repaid. The corporation tax rate is 33%. The first type is a perpetual loan stock and is quoted at £93 per £100 nominal value. Introducing taxation adds minor complications to the formula. will exceed the nominal interest rate it /100 when the present price of the loan L0 is less than the nominal value of the loan. The interest rate for each type (based on the nominal value) is 7. repayment at maturity of M. a term of years n. or debt. Where this is not the case the redemption cash flow must also be taken into account. they are not scheduled to be redeemed). to the typical shareholder.5% per annum.4% This example considers loan stocks which are ‘perpetual’ (i. and cost of debt Kd the present value of the cash flows L0 is given below: This is the discounted cash flow the lender will receive over the outstanding life of the loan. the yield to maturity and cost of debt. Assuming a loan with market value today of L0. Kd. annual interest payment of it. will be the present value of a combination of the interest payments and capital repayment(s). partially or completely. Thus an economic asset is something that has value to the owner only because it is expected to generate economic benefits. There is no capital gains tax. Thus.59 Financial management The value of economic assets – debt The value of an economic asset is determined by the economic benefits which are expected to be generated by that asset.

This is known as the Gordon Dividend model. Thus: (This assumes dividends are payable annually and that the current year’s dividend has already been paid and the company continues forever so t equals infinity).e. Required: Calculate the value of an ordinary share in Apex plc. the value (P0) of a share at any particular point in time is the sum of the discounted values of expected future dividends. 59 . named after the author who derived it many years ago. This in turn will depend upon the levels of return available from investments in the same risk class (i. they do provide helpful starting points in the valuation process. a. Another is to assume a constant growth rate. One solution is to assume that dividends will remain constant at the current level. Next year’s dividend is expected to be £0. year two because the benefit will not occur until two years later. where Dl. and Ke is the required rate of return.25 per share. Learn it and its strengths and weaknesses.Chapter 6: Cost of capital and valuation of a business The value of economic assets – equity Likewise. assuming a constant level of dividends. are the dividends which will be received in respect of the share after one year. it is the opportunity cost of finance to the shareholder). Where a constant level of dividends is envisaged: Where a constant rate of increase in the size of dividend of g is envisaged: By rearrangement of this equation we get which is the equity cost of capital. Though each of these approaches can be criticised as being oversimplifications in real life. say. Worked example 8 Apex plc has just paid a dividend for this year on its ordinary shares. Given the level of interest rates in the economy and the risk associated with the dividends investors require a return of 17% per annum. in real life. Logically. the prospective dividend yield plus the predicted capital growth in share price. the value of a share will be a function of the expected future economic benefits (dividends) from owning it. two years etc. assuming a constant level of growth of dividends of 6% per annum. Obviously. D2 etc. Thus the dividend for year four is more heavily discounted than that of. It will also be a function of the required rate of return from owning the share. estimating the dividend which will be paid on the shares in future years is problematic. and b. It is a simple way deriving a company’s cost of equity.

part of the risk of share ownership which cannot be diversified away. Consequently. This is because this part of the risk relates to factors which affect all businesses and their returns. The basic tenet of MPT is that it is easy and cheap to avoid much of the risk of investing in shares. 60 . By ‘similar’ is meant over the same time scale and with a similar level of risk. which is known as specific (or unsystematic) risk. changes in fuel prices etc. however. So. Thus: The required return equals a risk free rate of interest (perhaps the return from UK government short term securities) plus a risk premium (related to the level of risk associated with the particular investment). By holding a portfolio of investments comprising shares in different businesses in different industries it is possible to diversify away quite a lot of the risk. in real life.17 − 0.25/(0.27 Note how much more valuable a share is when it is expected that the annual dividend will increase each year.25/17% = £1. This explains why.06) = £2.47 b. This is simply achieved by not putting all of your eggs in one basket. investors will not be able to obtain a risk premium for bearing this part of the risk. the investor needs to be compensated for having the money tied up (delaying consumption) and for bearing the risk. Assuming a constant rate of increase in the size of dividend: P0 = D1/(Ke − g) = £0. we find that the shares of businesses which are seen as having good growth prospects are valued more highly compared with those whose future is seen as more static. The required return on investment A question which needs to be addressed is how do we select the required rate of return from a share? As has already been said. In other words it is that which the investor could earn from a similar investment. this should be the opportunity cost of finance. It is caused by macroeconomic factors like changes in interest rates. Thus: Total risk of investing in a particular share equals specific risk (diversifiable) plus systematic risk (undiversifiable).59 Financial management Solution to Worked example 8 a. Assuming a constant level of dividends: P0 = D1/ Ke = £0. There is. This part of the risk is known as systematic or market risk. Both BMM and BMA give good descriptions of the theory and derivation of the debt and equity valuation models which are based on the application of the NPV concept. There is a model for deducing the appropriate risk premium which is based on modern portfolio theory (MPT).

is cost free to the business. Thus some of the increase in the assets to which the profit gave rise typically remains in the business and is reinvested or ‘ploughed back’. and F1. It has a potential successor which is called the Arbitrage Pricing Model (APM). however.are the indices for the various risk factors influencing the return with β1. The cost of retained earnings It is normal practice for businesses to pay dividends of an amount less than their after tax earnings for the year. (In the previous section we used Ke for cost of equity. βi Rm The second term on the right hand side of CAPM is the average risk premium for all shares (Rm – Rf). βs for most businesses which are traded on the International Stock Exchange are published and are readily available. the shareholders would obviously have more cash than if part of the profit is retained. F2 etc. The capital asset pricing model (CAPM) This has been dealt with earlier. It argues that return is linearly related to a number of risk factors for which factor indices can be found and used and thus give a truer relationship. It is tempting to believe that this source of finance costs the shareholder nothing and. There are no solid results yet proving or disproving this theory. therefore. The formal statement of the relationship between the required rate of return from a share and the level of risk is given by CAPM. its equivalent in the CAPM model above is Ri which can be replaced by Ke in that equation when estimating a company’s cost of equity. the cost to the shareholders of their money being reinvested by the business is the same as the original investment. Logically. This risk premium relates to the extent to which the particular share concerned is affected by the macroeconomic factors associated with systematic risk. in Chapter 3. Were all of the profits paid to shareholders by way of dividend. Empirical testing of this model is still ongoing.the sensitivity of the share’s return to those factors. This is not true. which you should learn. The same level of interest rates and risk apply to the reinvested profits as apply to the original investment.Chapter 6: Cost of capital and valuation of a business The part of the risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. 61 . and is only included here as a refresher and introduction to the capital asset pricing model which will be used to derive a company’s cost of equity.) This model like all others has its weaknesses. and e is the random unexplained unrelated element in the return of the (i)th security. this is: Ri = Rf + βi (Rm – Rf) where: Ri Rf is the required rate of return on a particular investment (i) is the risk-free rate of interest is the measure of the extent to which the investment i is affected by macroeconomic factors which cause systematic risk is the expected average return from investing in shares generally. multiplied by the risk factor (βi ) of the particular share (i) concerned. β2 etc. Ri = Rf + β1F1 + ß2F2 + … + e where Rf is the riskless rate.

In theory the value of a warrant in the market is (P0 − E) N. In such cases the business would not need to offer much above the rate of interest currently available on government securities. 10% less tax at 33%). Raising equity can be achieved when the warrant is taken up by its holder at the due date.7% (i. A further reason for the cheapness of most forms of fixed return capital is the fact that interest payments are tax deductible.e. All of this means that fixed return capital is relatively cheap and this is its attraction. Since there may be some considerable time between the present day and the exercise date then a more sophisticated model is necessary to value a warrant. The thrust of the model is: M0 − Pw = VD + Vw where M0 Pw VD Vw price of share(s) today for which the warrant can be exchanged price of the warrant today present value of the-after-tax dividends receivable over remaining life of warrant. incentives to help induce lenders make the loan to the company. present value of the cost of exercising the warrant at the end of its life.1 Describe and evaluate various methods of calculating the costs of debt and equity. What is important is to learn the main conceptual approach to valuing the different types of capital.g. The reasons for capital gearing What distinguishes fixed return capital from equity capital. and therefore to shareholders. preference shares) the risk is much greater.e. Explain with reasons the differences between the types of costs and between the different methods of computation. profit) is fully taxed. but it is still likely to be significantly less than the ordinary shares of the same business. The expectation is that the share price will rise and be well above the exercise price on that future date. In some cases (e. is the amount of interest less the tax rate.g. in the present context. This means that the net cost to the business. Since providers of fixed return capital are not exposed to as much risk as are the equity holders. they are prepared to accept relatively low returns. 62 . whereas the reward of shareholders (i. at a stated price on a given date(s) in the future. where P0 is the market price of the ordinary share today. where the business is well established in a stable industry and the finance is secured on a quality asset) the risk is very small indeed. It is not necessary to learn the various formulae needed in order to derive a warrants price since risk has to be incorporated. assuming a Corporation tax rate of 33%.59 Financial management Activity 6. is cost. Generally warrants are issued as sweeteners. E is the exercise price of the warrant and N the number of shares each warrant allows the holder to buy. So a loan with an interest rate of 10% per annum would cost only 6. See VLE for solution Valuation of warrants A warrant is a right to purchase a given number of shares. In other cases (e.

at lower levels of gearing. Multiplying the EPS’s by the P ratios will give the possible share price . anticipated under each financing alternative. Naturally. WACC falls.e. the higher the proportion of total finance which is raised from fixed return sources). Since increases in the value of the business accrue to the ordinary shareholders.11 on p. Though not shown in the example it is possible that the markets perception of the differences in financial risk may produce different Price Earnings ratios (PE ratio) at different levels. what level of profits will be earned in future.3 on pp. from the shareholder’s point of view.335 of PA or Figure 15. It is not necessarily quite as good as it seems. The obligation to make fixed interest payments exposes the shareholders to increased risk. Essentially. gearing is beneficial to shareholders. The relationship between the level of capital gearing and the cost of capital – the traditional view The view of capital gearing that broadly prevailed until 1958 was that there were clear benefits to the ordinary shareholders because the weighted average cost of capital (WACC) would tend to fall as the capital gearing level was increased. the effect of alterations in the level of (pre-interest) operating profit is multiplied. At high levels of profit the benefits to the shareholders are good.Chapter 6: Cost of capital and valuation of a business Capital gearing and risk On the face of it capital gearing seems. whether the effect of capital gearing will be beneficial or detrimental is not certain. Activity 6. A problem with capital gearing is risk. As the level of gearing increases. The greater the level of capital gearing (i. gearing up to moderate levels would be beneficial. however. The traditional view is illustrated in Figure 8.2 and 15. the greater the risk to which the ordinary shareholders are exposed. at least up to moderate levels of capital gearing. where the business is earning a rate of return on its assets which is greater than the cost of the fixed return finance. as a consequence. to outweigh the advantage of the much cheaper fixed return capital. Thus the expectation would be that the net effect of capital gearing would be beneficial to ordinary shareholders.E. too good to be true. Where the return on assets is below the cost of the fixed return finance ordinary shareholders suffer. At low levels of profit the shareholder’s returns are hit heavily by the need to make interest payments. This increased uncertainty will make the ordinary shareholders place less value on their shares than they otherwise would. If you examine Tables 15. no business will raise fixed return finance at a cost which is above the estimated future rate of return on the business’s assets. This is because of the increasing proportion of the significantly cheaper fixed return finance. At 63 . the ordinary shareholders perceive a higher level of risk and. however. These higher levels of return demanded by ordinary shareholders are not sufficient. Since ordinary shareholders do not know for certain.2 Work through the review question at the end of this chapter. as the level of capital gearing increases.6 of BMM.3 that the level of cover for interest payments becomes less at higher levels of gearing. require higher returns to compensate for this.398–9 of BMM you will see this point clearly illustrated. This shows that. This would have a beneficial effect on the shareholders because the lower the WACC. the more the business would be worth. When there is capital gearing. Note also in Table 15.

One of them. MM argued. Thus the cost of capital is independent of the level of gearing. the providers of the fixed return finance start to perceive an increase in the riskiness of their own returns. If a business has capital gearing. The higher amount of interest and preference share dividend that the business is committed to paying will. at high levels of gearing. who both went on to win Nobel prizes. This means that there is significant effect on the business’s net cash flows and. however. seriously flaws the MM logic. the likelihood of it being unable to meet its contractual financial commitments is increased. Thus the business will only be able to raise more fixed return capital by offering increasingly higher rates of interest and preference dividend.59 Financial management higher levels. At some point the increased requirements of both groups of providers of finance will drive up WACC. with the support of some rigorous analysis. Thus WACC will initially decline as the gearing level is increased. place in jeopardy the business’s ability to meet all of these obligations. however. relates to the effective cost to the ordinary shareholders of the business getting into financial distress (going into liquidation). The MM analysis was based on several assumptions. Thus: 64 . The problem with financial distress is that it costs money.337 of PA. the ordinary shareholders will start to see their returns as being more and more risky and they will require much higher returns. the assumption of no taxes. The relationships are shown graphically in Figure 8. Another of the MM assumptions. MM conceded that fixed return finance is cheaper than equity finance because it is less risky. that it is illogical to argue that the value of a business is related to how that business is financed. This is because legal fees. There is therefore an ‘optimal’ level of gearing at which WACC is at a minimum and the value of the business (and each ordinary share) is at a maximum. the higher the probability of financial collapse. The relationship between the level of capital gearing and the cost of capital – the Modigliani and Miller view Modigliani and Miller (MM). the value of the business as a result of this tax deductibility. Similarly. In 1963 MM dropped their no-taxes assumption and concluded that the higher the level of capital gearing. This is because loan interest is tax deductible. would be incurred. may not fetch this value if they have to be sold piecemeal. the lower the WACC and the higher the value of the business and of each ordinary share. because the demands of the ordinary shareholders will precisely counteract the effect of the cheaper fixed return finance. and other costs of selling off the business’s assets to meet financial obligations.13 on p. as gearing levels increase. At some level of gearing it will reach a minimum value after which it will increase again. these will not alter with the method of financing. two US economists. most of which do not strictly hold in real life. therefore. whose lack of reality could seriously call their conclusion into question. The higher the level of gearing. published a paper in 1958 which fundamentally challenged the traditional view. There is also the cost that assets which may have a particular value to the business. The value of the business is based on the future cash flows which are expected to be generated by that business’s operations. but they argued that introducing fixed return finance into the business’s capital structure will not lower WACC. It is quite reasonable to argue that the lack of reality of most of the assumptions does not seriously undermine the broad conclusions of MM.

Ve and Vd the market values of equity and debt respectively and tc. A review question which utilises the MM theories is given in Chapter 12. thanks to agency costs and a pecking order theory.Chapter 6: Cost of capital and valuation of a business the value of the geared business equals the value of the equivalent ungeared business plus the value of the tax advantage minus the value of the cost of financial distress. Ensure that you are able to discuss why. Activity 6. book values. if a business pays out all of its profits as dividend this should lead to a constant dividend each year. from a valuation point of view. Show how the relaxation of the assumptions affects the propositions. Assuming that the rate of return on the investment is constant. the corporate tax rate. WACC is often used as the yardstick by which the business’s own investments are judged. we must remember to combine the weighted β’s of equity and debt. Similarly. past or present weights. whether we base the valuation on 65 . in theory. It can be written as Ka – the after-tax weighted average cost of capital: where Ke and Kd are the costs of equity and debt respectively. management may not be found to fully follow a target debt/equity approach in spite of the arguments in its favour. If the business retains a fixed proportion of each year’s profit for reinvestment (broadly what seems to happen in real life) then dividends will grow by a steady rate each year. Learn the different approaches to the weights used in the formula. See VLE for solution Weighted average cost of capital (WACC) The overall cost of capital for the business is the average for the various sources.3 Describe the assumptions underpinning MM’s original propositions concerning a company’s cost of capital. market values. to give the asset or project beta risk for the company as a whole. Thus. found from empirical study. Valuation on the basis of the business’s earnings In principle it should not matter whether a business pays out all of its earnings as dividend. It is shown thus: β a = βe Ve + Vd Ve + βd (Ve + Vd) Vd Remember too that the corporate asset beta just so defined is also the weighted average of the individual project betas of the investments being undertaken by the company at the time. weighted according to each one’s importance to the business. average or marginal or target debt/equity levels.

and derive a company’s cost of equity. amounts falling due after more than one year Long term loan 74 53 21 108 32 76 Capital and reserves Called up share capital – 160 million ordinary shares of £0. These approaches include estimating the future cash flow which the business will generate from its commercial activities and discounting these to arrive at their net present value.25 each Profit and loss account balance 40 36 76 Profit and loss account for the year ended 31 August 2007 £ Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit 66 £ million 87 143 24 6 18 9 9 . In practice this is unlikely to occur.e. So from whatever valuation method we use we can work back. By ‘normal’ is meant the level of profits which the average business in the same line of business might be expected to earn. Review question – selection of a source of capital Bycraft plc. One of the assets might be goodwill (i. the asset which arises from the expectation that the business will earn higher than ‘normal’ profits in future). should give the same result. a business whose most recent published accounts are summarised as follows: Balance sheet as at 31 August 2007 £ million Fixed assets Current assets Less: creditors.59 Financial management dividends or on earnings should not. correctly applied. In theory all valuation methods. in theory. Other approaches to share and business valuation There are various other approaches to valuing shares. lead to a different value being placed on the shares. Share valuation is very difficult and is completely surrounded by the need to make assumptions about various aspects of the future. amounts falling due within one year Net current assets Total assets less current liabilities Creditors. or whole businesses and also deriving the resultant cost of equity. Another possibility is to value each of the businesses assets and deduct the amounts owed to creditors to deduce the net value of the business. if necessary. The value of a company’s equity and its cost are intertwined.

by £10 million each year. The increased risk caused by increasing the capital gearing. The expansion programme is expected to generate increased profit.2 £0. State what factors should the directors take into account regarding the choice between the two financing options? Solution to review question a. This would require an immediate cash outlay of £40 million.5 160 80 240 £0. only the tax gain will benefit shareholders. c. at a price of £0.Chapter 6: Cost of capital and valuation of a business The directors are keen to undertake an expansion programme for the business. b.0 10.0 10.5 25. Required: a.2/160) 24. at which the earnings per share figure is the same under each of the two financing options. This is due to the tax relief on the interest and the lower cost of debt relative to equity due to lower risk.0 34.5/240) Debt finance option £ million Existing profit before tax Additional profit Less: Interest Corporation tax @ 25% Profit after tax Earnings per share (22. starting in the year ending 31 August 2008. will exactly cancel the effect of the lower cost of debt. The real world may be different. This could be done by making a rights issue.138 24.4 22. Alternatively.0 4.4 29.6 7. sufficient to raise the £40 million.50) New total (millions) Earnings per share (25. Equity finance option £ million Existing profit before tax Additional profit Corporation tax @ 25% Profit after tax Existing shares (millions) Rights issue (£40 million/£0. According to Modigliani and Miller. before interest and tax. the business could borrow the money at an annual interest rate of 11%. 67 . before interest and tax. Deduce the level of total profit.0 8. Compute the earnings per share figures for 2008 under each of the two financing options and comment on reasons for the difference between the two EPS figures.0 34.50 per share.106 The EPS is higher for the debt financing option. Future levels of profit are expected to remain at the 2007 level and corporation tax is expected to be levied at the rate of 25% of the profit after interest.

The main factors which should be considered in making the choice of financing include: • • • • • • • • • the volatility and growth pattern predicted for the business’s earnings the rate and certainty of corporation tax potential liquidation cost attitudes of the shareholders and directors to risk possible market changes to P.7 Profit and loss account for the year ended 30 September 2007 £ million Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit 31. amounts falling due within one year Net current assets Total assets less current liabilities Creditors. Advance Corporation Tax is 20/80 of the dividends paid.25) 240 million p = = = EPS debt option (p − 4.3 You have found a business.2 million c. 68 .1 2.4 £ 12. similar to Allemby Ltd in terms of type of activity. amounts falling due after more than one year Long term loan Capital and reserves Called up share capital – 10 million ordinary shares of £0.1 17.6 1. This business has a dividend yield of 3.7 11.59 Financial management b.6.7 3.2 5.50 each Revaluation reserve Profit and loss account balance 5.5 5.4)(1 − 0.4 5. Review question – valuation of a share and/or business Allemby Ltd is a small unquoted company. whose most recent published accounts are summarised as follows: Balance sheet as at 30 September 2007 £ million Fixed assets Current assets: Less: creditors.E.25) 160 million £13. Let p be the profit at equal EPS EPS equity option p(1 − 0. rating of the company current and future interest rates returns on equity expected by the shareholders effects on share price restrictions (covenants etc.) caused by debt financing.2 11.3 10. which is quoted on the Stock Exchange.89% and a price earnings ratio of 21.1 1.7 15.0 1.5 1.

Chapter 6: Cost of capital and valuation of a business

Required: Calculate the price of Allemby Ltd’s shares on each of the following bases: • earnings yield • dividend yield • net assets. What reservations would you have about the quality of each of these valuations? Solution to review question Earnings yield approach (Using data from comparable company combined with Allenby’s data.) EPS of Allemby Ltd = £2.5m/10m = £0.25 per share. PE ratio of the other business is 21.6 therefore the price per share of Allemby Ltd is estimated at 21.6 × £0.25 = £5.40. The problems with this basis of valuation include: • How appropriate is the other business for valuation purposes – how similar is it to Allemby Ltd? It might be better to use the average for a range of businesses rather than base the valuation on just one quoted busines Particular differences between the two businesses which may cause problems relate to capital gearing and the tax positions. • How typical of Allemby Ltd are the 2007 profits? It may well be inappropriate to base the valuation on just one year’s profit. Values are based on expected future events, not the past, in any case. • The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Dividend yield approach Dividend (gross) per share of Allemby Ltd = (£1.1m × 100/80)/10m = £0.1375 per share. DY of the other business is 3.89%, therefore the price per share of Allemby Ltd is £0.1375/0.0389 = £3.53. The problems with this basis of valuation include: • As with the earnings yield method, how appropriate is the other business data for valuation purposes? An obvious area of dissimilarity might be the dividend policy of the other business. • How typical of Allemby Ltd is the 2007 dividend? Future dividends should, in any case, be the basis of the valuation. • To what extent are dividends the determinants of value? There is more than one school of thought on this point. • The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Net assets approach According to the balance sheet, the net assets stand at £11.7m or £1.17 (i.e. £11.7m/ 10m) per share. This is completely out of line with the other two valuations. Apart from the weaknesses of those valuation bases, the following points are relevant: • Balance sheet values are not the same, nor are they intended to be the same, as market values. Broadly speaking fixed assets are valued at cost, less an allowance for depreciation where relevant; current assets tend to be valued at the lower of cost and net realisable value. This tends to mean that balance sheet values understate assets relative to their economic value.
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59 Financial management

• The existence of a revaluation reserve implies that the business has not strictly followed the normal rule for valuing fixed assets in the balance sheet. • It appears that the assets are undervalued relative to their economic value or that goodwill exists but does not appear on the balance sheet. This point is based on the fact that the business made a pre tax return on book capital of 31% (i.e. £3.6m/11.7m × 100) in 2007 – this is a very high return.

A reminder of your learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • calculate the value of debt and equity and their respective costs using alternative approaches • describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt, equity and business valuations • explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital • derive and calculate the weighted cost of capital for a company • compute the valuation of a business • provide a reasoned evaluation of the best way a company should raise new capital.

Practise questions
1. Berks plc has been told by its bankers that it has reached its overdraft limit of £100million and that it would be a good time to go to the long term capital market and raise funds. The bank suggested that £210million be raised by one of two methods, either by a 15year debenture which could cost £18million interest (gross) per annum, or by a rights issue @£1.50 per share in proportion of 7 to 15 shares. Berks plc recently published its last Balance Sheet which is: £million Non-Current Assets Current Assets Less Current Liabilities* Represented by Ordinary Share Capital (200 million £/shares) Retained Earnings 200 250 450 * Where Current Liabilities include bank overdraft of £100million. Note this would be repaid out of the £210million raised. Post balance sheet publication, but prior to raising of any long-term capital, the Company announced a 1 for 2 bonus issue of ordinary shares. The founding family of Berks still own 60% of the equity and wish to remain the majority shareholding group. The company’s profit after interest but before tax for the past year amounted to £140million. The corporate tax rate is 50%. 300 250 50 450 400

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Chapter 6: Cost of capital and valuation of a business

If £210million is raised by either of the two methods it is predicted that the net profit, before charging any interest on loans or debentures, for the next three years will be £186million, £130million and £210million respectively. If the rights issue method is used the Price Earnings (PE) ratio will remain as it is at 10x, but if funds are raised by long term debentures, the PE ratio will fall to 9x. If the total debt to total assets ratio rises to above 50% then the P .E. ratio will be reduced by a further unit. REQUIRED a. For each of the two capital raising methods, provide a table that shows what the company’s share price will be for the next three years, assuming the issue of shares or debentures is successful. Show what the balance sheet of the company will be like under each method after the capital raising. (14 marks) b. What is the minimum number of shares the family must subscribe for under a rights issue in order to retain their voting majority? (2 marks) c. Calculate the amount of net profit before interest expense and taxation for the shareholders to be equally well off under either method. (4 marks) d. Write a short report to the family shareholders giving your views and recommendations for the raising of the £210million. (5 marks) 2. Describe and discuss what considerations have to be taken into account when selecting the next installment of finance a company is considering to undertake. See VLE for solution

Problems
Attempt the following problems in BMM: • Chapter 5, numbers 4 and 5; Chapter 6, number 4; Chapter 12, numbers 2 and 11. Attempt the following problems in BMA: • p.80, numbers 2 and 4; p.109 numbers 5 and 6; pp.491–93, numbers 1, 2 and 8; pp.554–55, numbers 1 and 7.

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59 Financial management Notes 72 .

73 . the information content of dividends. Myers and F. In this chapter we consider the nature surrounding that controversy and the factors which influence dividend policy in practice.Chapter 7: Dividend policy Chapter 7: Dividend policy Aims of the chapter Corporate dividend policy or how companies can provide a return to share holders by way of a cash distribution or other means is one of the more important financial decisions management has to make. It also addresses informational aspects concerning dividend payments and potential clientele effects and how dividend payments are set in practice. Some practical aspects concerning the determination of the policy in practice. P Financial Management for Decision makers.. the clientele effect. 2008) Chapter 17. Allen Principles of Corporate Finance. S.C. Myers and A. S. It starts by mentioning the irrelevancy argument before discussing and describing other theories such as the traditionalist approach. We will present opposing views on the effects of dividend policy on the valuation of shares and discuss the significance of the traditional view of dividends. Atrill.C. Learning outcomes By the end of this chapter. Dividend policy has been the source of some controversy over the years. R. you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy • describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision. such as what is and whether to pay non-cash dividends are covered. (McGrawHill. Non-cash dividends would include scrip dividends and share repurchases. The general intention of this chapter is to provide an in-depth discussion on the controversial question of how dividend policy affects firm value. 2005) Chapter 9 Introduction In Chapter 16 of BMM you will be exposed to the theory and practices associated with corporate dividend policy. . and having completed the Essential reading and activities. So this chapter will cover how a firm’s value can or cannot be affected by the chosen dividend policy.A. Marcus Fundamentals of Corporate Finance. (FT Prentice Hall Europe.J. We also consider alternatives to dividend payments which a business might consider.. Essential reading Brealey. 2007) Chapter 16. Further reading Brealey. (McGraw-Hill Inc. R.A.

Therefore.e. the differential treatment of capital gains and dividends is less pronounced today than in the past. Dividend policy and shareholder wealth A share is similar to any other economic asset insofar as its value is related to the future cash flows which it generates. However. Note the restrictive assumptions upon which the MM position is based. This idea therefore suggests that. therefore to deflate future dividends because of this risk is in fact. as the risk of dividend payment in the future is associated with a higher firm risk. Furthermore. dividend policy is irrelevant for identical businesses).00 received as a cash dividend today is worth more than £1. Dividend irrelevancy argument The argument put forward by Modigliani and Miller (MM) concerning the irrelevance of dividends is particularly important and you should study it carefully. As dividends normally represent the cash flows received from holding shares. However. The most important aspect of their argument concerns the notion that share values are not influenced by the particular dividend policy of the firm. Risk arising from an investment will already have been taken into account when determining the appropriate discount rate. double counting. 74 . investors who are registered as holding the firm’s shares before this date are entitled to the dividend. in the UK. it may at first seem that the interests of shareholders would be best served by the business adopting the highest dividend policy it is able to sustain. the notion that MM challenged. MM suggested that firms should only invest in all projects which are likely to yield a positive NPV when discounted at the appropriate cost of capital. However. MM point out that shareholders can create their own dividend policy by selling or cancelling dividends by buying shares in the firm. it would be illogical for share values of identical firms to be different because of differences in their dividend policies (i. we will illustrate that this may not necessarily be the case. If the firm still has surplus liquid funds after undertaking all positive NPV projects then this surplus should be paid to the shareholders as a dividend payment. Much of the controversy concerning dividend policy is based on the extent to which imperfections and inefficiencies in the real world destroy the hypothetically derived MM case. This basic idea is based upon the argument that investors apply a lower discount rate to current dividends than they do to future dividends on the grounds that future dividends have a higher level of risk associated with them. Traditional view of dividends The traditional view of dividends.59 Financial management Ex-dividend date determines whether a shareholder is entitled to receive a dividend payment.00 retained by the firm. managers of the firm can reduce this risk by adopting a strategy of a high dividend payout policy. is that dividends are important in determining share value as £1. this is illogical as risk is associated with the type of business operations undertaken by the firm and not as a result of whether the return from shares occurs now or at a later date. Many proponents of the MM irrelevancy argument believe that the most serious imperfection is the different treatment of dividends and capital gains for taxation purposes.

Often investors will be concerned about their tax position when deciding which business to invest in. the change in share price due to the unexpected size/magnitude/direction of the dividend announced would occur anyway. dividends can be used by them to signal information about the future prospects of the firm to investors. This feeling of uncertainty in firms which have a volatile dividend policy may command a lower share price and a higher cost of capital for the firm. Therefore. Thus. Discuss how it can be said that dividend policy is irrelevant? See VLE for solution Information content of dividends As the board of directors of a firm will know more about the financial position and the prospects of the firm than others. may prefer to invest in a firm which has a low dividend payout policy. the preference for a regular stream of income may be a further important factor which may encourage investors to choose a particular business to invest in. This is because of the different treatment of capital gains and dividend income for tax purposes in the UK. A relatively volatile dividend payout pattern is likely to be unpopular with most investors. They respond to a higher than expected market reaction to dividends as suggesting that. pension funds (which in the UK are exempt from taxation) may prefer their financial managers to invest in firms which offer the highest dividend payment policies particularly as the pension fund will require a stream of relatively liquid funds to meet the payments due to its pensioners. 75 . When firms are likely to dramatically veer away from their target payout.1 It is well documented in academic circles that share prices tend to rise when firms raise their dividend payout and drop when firms cut their target payout ratio. Clientele effect It is often argued that different investors are attracted to the shares of different businesses on the basis of the particular dividend policy being pursued by the firm. which was not expected by the stock market. a higher than expected dividend payment may convey to investors that the board of directors has a level of confidence in the firm’s future. MM view the concept of the information content of dividends as only a temporary phenomenon. The shares are deemed to be riskier and thus a higher return is required. the market should be given as much warning and information as possible concerning the probable change in the dividend policy. A number of academic writers have highlighted the role of dividends in sending signals to the capital market. many academic writers and critics advocate firms to adopt a stable dividend policy based on a target payout ratio. However. Such volatility can create a feeling of uncertainty which is likely to lead investors to invest in firms where the dividend policy is more stable and which may have a dividend policy which may meet their needs more closely. In light of the arguments presented above concerning the information contents of dividend payouts. You will notice when reading the relevant sections that it is the difference between the size of the dividend payment announced and the expectations of the market concerning the size of the dividend which is important. as more information becomes available to the stock market. An individual with a high marginal rate of income tax. for example.Chapter 7: Dividend policy Activity 7. which causes the price to fall.

companies are permitted to re-purchase their own shares under company law. share re-purchase can create greater uncertainty for investors than a stable dividend policy. should investors prefer. investors would be indifferent as between a share re-purchase and a cash dividend. although a greater number of shares will be in issue following the scrip dividend. Share repurchase In the UK. a share re-purchase can have certain tax advantages and also provide investors with the choice of whether to sell or to hold on to their shares. Scrip dividends As another alternative to a cash dividend firms may decide to pay a scrip dividend to its shareholders.2 Outline the main points which should be considered when deciding upon corporate dividend policy. In many instances investors will have a choice of receiving either a scrip dividend or a cash dividend. See VLE for solution Firms usually have a long-run target dividend payout ratios. 76 . In addition. they may create a dividend for themselves by selling shares if cash is required and they may also find that there may be certain tax advantages in receiving a scrip dividend rather than a cash dividend. This ratio is the fraction of earnings paid out as dividends. In essence. a scrip dividend is no different from the firm deciding to retain the profits from the financial year and not to pay shareholders any cash dividends. Those who opt for the scrip dividend will benefit by having an increased share in the value of the firm while those choosing a cash dividend will benefit from receiving an immediate payment. When reading the relevant sections in the books note the possible motives for share re-purchase and also remember that in an MM world. Therefore. Following a scrip dividend. you must remember that transaction costs will be incurred when shares are sold. as the effect on shareholder wealth from both these events would be the same. the total value of shares issued will still remain the same. However. the value of the business will remain unchanged and. This provides an alternative method of cash payment to investors in preference to dividend payments. which is a dividend paid in the form of new shares instead of cash. should the shares of a particular firm not be actively traded (commonly referred to as the phenomenon of thin trading).59 Financial management Activity 7. other practical issues such as the lack of a ready market for the shares. From an investor’s point of view. In addition. Obviously. the problem of indivisibility (whereby shareholders may be unable to dispose of the precise number of shares necessary for their cash needs) and also the inconvenience involved in making changes to investment portfolios may make the issuing of a scrip dividend an unattractive choice. there is a risk that the re-purchase will either overprice the shares (to the detriment of the shareholders who decide to hold on to their shares) or underprice the shares (to the detriment of shareholders who wish to sell their shares).

a. The past year’s profits (year 0) and the dividend paid there from will be the same regardless of the dividend policy chosen. However. 77 . He has been advised he must cover three points of view in his briefing paper. Explain the ‘clientele effect’ and its impact on setting corporate dividend policy.Chapter 7: Dividend policy Activity 7. Describe what is meant by the term ‘the information content of dividends’. secondly a group led by a non-executive director believes that dividends should increase annually at a constant rate of 15% p. The financial director has made the following predictions for profits and dividends for the next five payments under the three alternative views. in your reading you will also come across other factors which may guide the directors of a firm in determining the dividend policy in practice. regardless of the level of profit achieved. there is usually a reluctance for firms to cut dividends because of the (adverse) signals which such an action may elicit. 3. There seems to be a high degree of reluctance in firms to raise dividend levels unless the directors of the firm are confident that the higher payout ratio can be sustained over a long time period. The financial director of Sugary plc is preparing for a forthcoming Board meeting at which the corporate dividend policy for the next four years will be decided. Practise questions 1.. the chairman believes that annual dividends should be a constant proportion of the annual reported profits (ie a constant payout ratio). and it is important that you understand how these factors impact on the dividend decision. The financial director’s own view is that dividends are the residual payment from earnings after retaining all that is needed for the next year’s re-investment. In what circumstances are they likely to be preferred to cash dividends? See VLE for solution Determining dividend policy in practice Both empirical evidence and casual observation seem to suggest that the directors of businesses consider the dividend decision to be very important and that the maintenance of a stable dividend policy is preferred over time. Firstly.3 Explain the importance of share repurchase and scrip dividends. and having completed the Essential reading and activities. There is also evidence to suggest that directors of a firm consider the firm’s level of earnings to be the most important influence on the dividend decision. 2. A reminder of your learning outcomes By the end of this chapter. Similarly. you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy • describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision.

whilst its debt has a zero β value. Bonn plc. It expected future profits to be roughly in line with this year’s amount.) Profit after tax Investment proposed Dividend proposed 100 (50) 50 125 (70) 162 (50) 157 (60) 203 (50) At the end of year four it is predicted that the ‘ex div’ market value of the company is 14 times the after-tax profits.4 times. (10 marks) 4. discussing the theories and rationales of each of the three alternatives proposed and end with your recommendation for the preferred alternative. The total value of the investment in Chicki is £12. c. subsequent to Arras’ share repurchase. Compute the asset β for Arras plc. The company’s cost of equity is 12% net per annum. Corporation tax is 30%. The β value of its equity is given at 1. (15 marks) ii) Write a discussion paper for the Board meeting using the information calculated in i) above. Bonn plc is in the same industry. has just announced its annual results. b. as Arras with a total market value of £25 million. a recently listed company. has decided to extend its business by acquiring Chicki Ltd which is in a very different business risk class and has an asset β of 0. REQUIRED a. Compute the debt and equity β values for Arras plc. (3 marks) (6 marks) (6 marks) 78 . To improve the potential for returns to the shareholders it has decided to borrow £6 million @ 5% (gross) over a long term and use the money to repurchase £6 million of its equity (at market value). It is financed by 70% equity and 30% debt based on market values.5 million and it will be financed in the same proportions of debt and equity as the existing capital structure. Arras plc. stating that its profit before interest and tax was £2. and thus same business risk class. The pre-tax rate of return for the market as a whole is 8% and the risk free rate is 4%. Arras is an all-equity financed company with a market value of £12 million.59 Financial management Alternative views 1 and 2 (Constant dividend payout ratio (50%) and constant dividend growth (15%)) Year Profit after tax Dividend proposed 0 100 50 1 120 2 (£ millions) 150 140 180 3 4 Alternative View 3 (NB Profit shown incorporates the additional profit arising from the extra investment made compared to Alternatives 1 and 2.0 million. Compute the weighted average cost of capital for Arras.7. REQUIRED i) Prepare a schedule for the Board Meeting showing ‘value to the shareholder’ under each of the three alternatives using the information given above and assuming that the presentation is from the viewpoint of a shareholder with 1% of the total equity of Sugary Plc.

447–48. 14 and 15. (4 marks) See VLE for solution Problems Attempt the following problems in BMM: • pp. 79 . numbers 6 and 18. Compute the revised weighted average cost of capital for Bonn and the new asset β for Bonn after it has taken over Chicki. Attempt the following problems in BMA: • pp.Chapter 7: Dividend policy d. (6 marks) e. 467–69. Briefly describe what discount rate Bonn should use in future investment appraisals giving reasons for your suggestion(s). numbers 6. 11.

59 Financial management Notes 80 .

First learn the computational technique then learn how to interpret the messages they are giving or the possible questions they are posing that will require further investigation.. customers and creditors all are interested in a company’s position and performance. methods and uses. A company’s management is also interested because the ratios computed can be used for benchmarks. R.C. Further reading Brealey. P Financial Management for Decision makers.A. . (McGrawHill. Statement analysis A company’s set of accounts. Course 25 Principles of accounting will have given you a solid grounding in each part. but particularly so in the financial analysis. ratio analysis and financial budgeting. its profit and loss account. Myers and F.C. that they can be used in many different contexts. 2005) Chapter 3. Therefore it is important to give meaning to the results portrayed by the accounts via analysis and interpretation. the first half dealing with the technique and application of financial analysis and the second half concerned with financial planning.A. methods and uses. cash flow statement and balance sheet are only of limited value when read in isolation and without analysis and evaluation. as one learns the basic analytical techniques and ratios. and having completed the Essential reading and activities. targets. Remember. and financial planning Chapter 8: Financial analysis..Chapter 8: Financial analysis. Learning outcomes By the end of this chapter. In each case the alternative titles are more restrictive in what they encompass. you should be able to: • compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily • interpret part or all of a set of financial reports • describe and evaluate the means and the limitations of ratio analysis • describe and discuss the requirements for strategic financial planning • construct a simple financial plan or model.J. Marcus Fundamentals of Corporate Finance. Alternative names are often used for each of these parts. (FT Prentice Hall Europe. potential lenders. Myers and A. Potential and existing investors. Atrill. and for review and critical assessment of performance measures. Allen Principles of Corporate Finance. (McGraw-Hill Inc. S. Essential reading Brealey. 2008) Chapter 29. R. S. The analysis of financial information can perhaps be best 81 . 2007) Chapters 17 and 18. and financial planning Aims of the chapter This chapter has two parts.

Because there is less scope for influencing cash based results it is argued that cash flow based ratios will become more important in both the analysis and projection of financial results. competitors’ results or industry means. Look for trends over time. A very detailed review will start by strategically analysing the company and then using the ratios to address strategic elements within each area of enquiry. Profitability also includes the return on the investment made. An understanding of accounting principles learnt in 25 Principles of accounting will enable you to appreciate the effects of any changes a company has made in its reporting practices. These are the process and the context elements and each influences the other. or changes from past trends. Each of these areas can be broken down further. What is important depends on the circumstances. Turn your attention to large and important items first. benchmarks given. depth and detail of work undertaken will be influenced similarly. Remember the process is generally to prepare a set of ratios.59 Financial management broken down into two elements each with their own parts. To those should be added some cash based ratios which are now available internationally thanks to the new requirement that companies must provide an annual set of accounts including balance sheet. for example with profitability it can cover trading profitability. or is it the return on the total assets used to generate the profit or the return to the ordinary shareholders for their investment in the company? Each of the areas has its own family of ratios each providing information for answers to the appropriate strategic questions. Small changes in large items are usually much more critical than large changes in small items. compare the results with targets set. liquidity and solvency. profit and loss account and cash flow statement. the margin on sales. but the calculation of a few well-chosen ratios is generally much more effective than calculating as many as you can think of. and use them for a review of the past performance with the view of helping in the projections for the future. You will find the approach you need to take in numerous specialist books. Is it the return on the long term funds invested – capital employed. Look for answers or interpretations from the questions posed by the results and then you have the basis for your report. The structure. the proportions of sales taken by the different types of costs. analyse them. As to what constitutes investment depends on the reviewers’ perspective. The context of what ratios to compute will depend on the purpose of the analysis. activity and efficiency and financial structure. The subject guide for 25 Principles of accounting (2006) in Chapter 7 has the main ratios that you should know. The process of analysis will be heavily influenced by the mode and needs for its use. Cash based ratios Cash return on net assets (or cash = Net operating cash flow return on capital employed) Total assets less current liabilities Cash interest cover Cash dividend cover = Net operating cash flow Interest payment = Net operating cash flow less tax and interest payments Dividend payment = Net free cash flow Investment Internally generated investment 82 . Most books delineate four areas: profitability.

Consider the reasons why these attempts have not been very successful and this will ensure you understand the weaknesses underlying ratio analysis.660 1. Not all have been successful. and see if it has helped improve the net asset turnover enough to result in an overall improvement in return to the net assets employed.200 1. forecasting profits. and financial planning The Du-Pont system which is based on a pyramid of ratios.768 Net profit before tax Taxation Net profit after tax Dividend paid (during years) Profit retained 2.800 900 900 83 .440 2.020 1.320 1. There have been attempts to use models incorporating ratios to identify potential takeover targets.200 6.760 960 1. This will also help you to understand why the interpretations and predictions are still very subjectively biased.290 270 – 10. credit ratings. is helpful in providing pointers for investigation derived from the inter-relationships.590 900 690 2007 £’000 13.320 300 108 9.Chapter 8: Financial analysis.000 5. say in a price war between competitors. each level interlocking with the next.080 1. Review question The accounts for Chemistrand plc for the two financial years ended 31 December 2008 are given below.232 642 1. and valuing shares. possible bankrupts. None has been wholly successful though the credit rating and corporate failure models have had the best success story.700 1. This causes the analyst to look at the profit margin change. methods and uses. Practical applications There are various areas where ratios have been used in practical applications for commercial ends. CHEMISTRAND PLC Profit and loss account for years ended 31 December 2008 and 2007 2008 £’000 Turnover Variable cost of sales Fixed production costs Administration costs Selling and distribution costs Research and development costs Interest 12. For example return on net assets is the product of operating profit margin (return on sales) and net asset turnover.

880 540 1.200 450 6.59 Financial management Balance Sheets as at 31 December 2008 and 2007 2008 £’000 Fixed assets Leasehold property (note 1) Plant and equipment (note 2) 6.020 1.900 1.880 8.15 per share.200 300 6.190 1.980 2007 £’000 Note 3 No sales of assets took place during the year (NBV – Net Book Value) Note 4 All dividends were paid during the financial year at the rate of £0.750 1.620 6. 370 Current assets Stock Debtors Bank Less Creditors due within one year Tax creditors Taxation Bank Net current assets Net assets Ordinary share capital (£1 shares) – called up Profit and loss account 6.460 1.000 2.140 60 2.140 1.620 8.320 – 2.190 8.470 — 210 8. 84 .900 1.140 60 (120) 1.750 1.080 720 (180) 1.220 6.880 Note 1 Leasehold property (cost) Accumulated depreciation Balance Note 2 Plant and Equipment (NBV) Additions Depreciation for year Closing balance (NBV) 7.000 2.190 7.080 600 630 720 510 8.080 7.

0 1.5 1.2 50 49 15 13.0 2007 M 20.7 35 25 5 11.7 3.0 1. Using a subset of the ratios calculated in (a) above.430 2007 £’000 2. c. comment on the performance of Chemistrand plc in comparison with the statistics provided by the agency.4 2.0 1. Compute a full set of basic financial ratios which will help give a rounded assessment of Chemistrand’s performance in 2008.0 70 67 35 14.0 1.5 M 20. methods and uses.5 2.000 (1.7 LQ – Lower Quartile (25% of group had ratios same as or lower than figure given) M – Median (50% of group had ratios same as or lower than figure given) UQ – Upper Quartile (75% of group had ratios same as or lower than figure given) Required: a.7 2.0 1.1 0. 2008 LQ Return on net assets (%) Net assets turnover (times) Current ratio (times) Acid test (times) Collection period (days) Total owing to total assets (%) Long term debt to capital employed (%) Return on sales 15.0 1.3 UQ 25.0 1.8 2.3 UQ 25.460 The following information from a credit rating agency for the industry is also available for the two years 2008 and 2007.0 0.Chapter 8: Financial analysis.1 65 65 40 14.8 30 20 5 11. 85 .2 45 50 15 13.1 1. b.740) (108) (1482) (720) 120 (900) (780) – (240) (6060) (3840) (900) (4740) 2.7 LQ 15.0 1. and financial planning Cash flow statement for the year ended 31 December 2008 2008 £’000 Cash flow from the operating activities Returns on investments and servicing of finance Interest paid Taxation Capital expenditure Equity dividends paid Management of liquid resources Financing Share issue Increase/(Decrease) in cash in the period – (780) 3. Write a short commentary on what additional information has been obtained from the results of the computations in (a) which were not used in (b) above.9 1.

profit etc.880 2.93× 0% 30.7% n/a 2.460 1.5% Other ratios such as the various costs can be computed as percentages of turnover.77× = £0.140 × 365 7.430 × 100 8.020 0 × 100 8.000 2.5% 2007 33. Solvency and liquidity Current ratio Acid test (quick ratio) Activity ratios Debtors collection period Stock holding period Creditor payment period Financing ratios Long term gearing Total owing to Total Assets Interest cover Dividend cover Earnings per share (EPS) Dividend per share Cash based ratios Cash return on net assets Cash interest cover Cash dividend cover Internally funded investment 86 2.430 108 840 900 = 1.2% = 18.10× 0.000 1.60× = 40.15 0% 19.6× 21.460) (2.0% 40.7% 20.590 900 1.35× =17.0× £0.30 £0.880 2.7% = 22.7× = 1.232 + 108) 108 1.5× = 0.9% = 41.15 = 24.68× 1.61× 22.2 days 31.000 900 6.3 days = 31. Profitability 2008 Return on net assets Return on sales Net asset turnover Return on equity Gross profit margin 2.232 ×100 12. or annual growth rates of turnover.4 days 25. Divisional and regional breakdowns of profit.000 12.880 1.950 1.59 Financial management Solution to review question a.265 = £0.000 = 25.5 days 47.320 × 365 12.370 + 2.26× = 0.2 days = 59.880 1950 × 100 (8.020) × 100 12.950 1. turnover and net assets can be evaluated similarly if itis useful to the task.020 600 × 365 7.232 ×100 8.8% .6% = 1.320 1.880 (12.9% 1.590 × 100 8.000 8.590 6.1 days = 0% = 18% = 21.000 – 7.0% n/a 23.

The decline in the return on capital employed appears to have been caused by falling operating profit margins and the declining level of sales which is also reflected in the falling asset turnover. and financial planning N. (i. its marketing activities perhaps need reviewing).Chapter 8: Financial analysis. the two ratios. methods and uses. Notice how the introduction of the cash based ratios has provided much more meaningful information on interested dividend cover. b. 87 .e. The above ratios incorporate many more ratios and computations than what you would be expected to compute in an exam answer. The increase in collection and inventory periods reinforces this point though the financial effects of this are lessened by the effects of increasing the creditor period. namely that there is no long term debt. N. Since the collection period is below average(i. try to give the actual. could it be that production had become more efficient. Additional operating profitability ratios indicating how different types of costs have changed in proportion to turnover would have been useful. do not just describe a change or an event. Given the asset cover and the fact that the assets are recent acquisitions bankers would. Not knowing what the future holds. To complete the analysis and interpretation this section was added to give the reader further insight into interpreting the accounts. or a possible. then the company’s liquidity and solvency is perhaps to be put under the spotlight. one can probably still recommend that the company takes out a long term loan. total owing to total assets and the long term debt to capital employed reinforce what is obvious from the balance sheet. Chemistrand’s solvency ratios are below average which could be due to efficient management of current assets. The company is distinctly under geared compared with its competitors. as return on equity and earnings per share declined. probably cost less than short term borrowing and reduce the risk of financial distress.e. Note how over the past two years the cash flow statement shows significant outflows of cash. and the overdraft has suddenly emerged and grown. c. Note that gross profit had actually improved so perhaps the company has some internal strengths and some weaknesses. Note when answering these sorts of questions you may have to make some reasonable assumptions in order to make your interpretations. The cash interest cover highlights the security lenders can feel over sufficient cash for the payment of interest. but the administration and selling etc.B. If so. Even so Chemistrand is still in the upper quartile for its profitability both in its operations and on its capital base. Do remember when you are asked to interpret.B. not something you wish to see when a company has just doubled its called up share capital. state the assumptions. since return on sales had declined (i. It could also be due to increasing current liabilities at a rate which could cause future problems. or what the present lending situation is like. in the light of the company’s overall profitability. Turning to the financial structure. This would improve the gearing. be more than willing to make a medium or long term loan to the company. had got less effective?).e. However compared to the rest of the industry it is below average in turning its assets over. The shareholders will not be pleased. the Sales ledger) are doing a better than average job of getting in the money. An appropriate number could be the eight to be analysed in b) below. reason for it. So even though the cash dividend cover hinted at insufficient funds to maintain the dividend level it was probably felt necessary in order to steady the share price.

Therefore it is important to learn why it is necessary to plan and how to do it. Planning for the short term will be dealt with in the next chapter. Financial planning helps avoid the nasty surprises. with serious consequences for those connected with the business. Financial planning is necessary because of the interaction between corporate investment and financing decisions. if done correctly. the strategic and operating implications of the plans are very important. because for corporate managers it is very important. with the amount of detail diminishing over time. when learning and applying these points. contingency plans made to cover the possibility of the government introducing a new sales tax. Learn how to build simple models using equations comprising these ratios. causes managers to think ahead and not just act on a day to day basis or even on a simple reaction basis only (e. Learn how to consider the financing and the investment aspects of the future which are to be combined together in the plan and link those financing or investment requirements in with the short term aspects.g. These decisions should not be undertaken independently and. or rates of return on investment etc. Do not be deceived. Bear in mind. helps to prepare managers and the businesses to deal with those awkward occurrences that can. There should be added to this list the elements that complete the planning and control cycle.59 Financial management Financial planning – introductory comments This is a topic which tends to get a ponderous and generalised treatment in the textbooks. the review of the reasons for the deviations which are then used as bases for appropriate amendments to a revised plan. evaluation and selection of possible strategies and finally the comparison of subsequent performance with the original plan. occur so that the outcome is more favourable for the business. Learn the types of ratios that can be used as either long or short term objectives. It is important to know the detailed requirements and possible approaches for each phase of the planning and control processes. namely the investigation of the deviations from plan. Ratios will and should be used additionally to help prepare the financial plan by acting as the structural links between items in the plan (e. that in a practical scenario. Technical aspects of financial planning The setting of the objectives of a business will include financial objectives such as growth rates in earning per share. or a competitor introducing a new product). the analysis. and do. sales. using an agreed return on sales to arrive at a projected profit given a predicted sales outcome). Financial planning process You should learn the six key elements of financial planning which are the setting of financial goals.g. provide an end result where the sum is greater than the parts. the level of debtors and stock can be predicted by using debtor days or inventory period with the predicted level of sales and purchases. Financial planning helps ensure a more measured response to events and provide motivation for managers through the establishment of agreed goals. forecasting. Businesses which do not undertake financial planning and control more often than not end up in liquidation. or absolute values for profits or sales. Here the emphasis is on long term which means probably looking up to 10 years ahead. 88 .

Planning outputs Learn the three major groups of outputs: the forecast statements of profit flows. combined with the present situation of the business. The different costs of funds and their characteristics will also be of relevance here in the selection. Dividend decisions Whether or not to pay. Review question Plantree plc prepares long term financial plans. methods and uses. similarly what effects will the withdrawal or sell off of a major investment produce. The levels of required return from the investments and their risk levels must be considered. Investment policy decisions This type of decision requires an understanding of the corporate strategy as to how the funds should be apportioned between the strategic groupings – replacement needs. expansion. leasing and sales of assets. and financial planning Learn the ways in which the planning process can be supported by the use of a financial model. retained earning. when and how are all very important and relevant decisions here since they reflect the returns to the shareholders. 89 . new products. The further into the future the more likely the project is to be as yet unsanctioned and just a sum of money earmarked for a particular subgroup of investments. The potentially different cash flow patterns of returns from existing and new investments may need assessment. expansion investments etc. etc. Naturally the detailed short term plans (budgets) will dovetail into the long term ones. if so how much. 3. with the long term ones being updated at least annually. the latter developed in house. b. new product investments. Possible types of finance will include new equity. or one attempts to use an optimisation model based on some form of linear or integer programming. a. Describe briefly some of the main examples of forecast information needed for each type of decision.Chapter 8: Financial analysis. Required: 1. Solution to review question 1. cash flows and balance sheets. Comment on the interrelationship of these three types and how they will be affected by the choice of the long term financial objective(s) of the business. They also provide the market place with information on one of its major decision criteria. the owners of the business. whether one uses a simple approach to review a series of options (much easier these days thanks to the advent of spread sheets). In order to achieve its long-term financial objectives the planning team will be faced with decisions on investment policy. A similar approach should have been used in preparing the financing plan. Financing decisions The amount and type of funds required will be dependent not only upon the selection of investments made. but also the financial market place conditions and availability. 2. In the strategic investment plan the investments to be undertaken will be broken down by category – replacement. Whichever form the model takes it will require exogenous and endogenous inputs. The former can be bought in sometimes from a consultancy. financing policy and dividend policy. c. Comment on the nature of these three types of decisions. the strategic investment and financing plans. loans.

present corporate position vis-à-vis target gearing level. For dividend decisions the business needs predictions on: • the level of profits available for distribution over the planning period • the market’s expectations of the business • the expectations of the payout behaviour of competing businesses • internal sources should provide estimates of the needs for retained profits along with the cashflow predictions of the business. etc. • the trend of costs of funds – increasing costs of loans or equity • market perceptions of gearing. whether it be one or all of those listed. Whatever a business’s objective(s). Interrelations The three types of decisions are interrelated. you should be able to: • compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily • interpret part or all of a set of financial reports • describe and evaluate the means and the limitations of ratio analysis • describe and discuss the requirements for strategic financial planning • construct a simple financial plan or model. reduce availability of funds perhaps restraining or deferring new investment. Likewise. In reality.59 Financial management 2. c. theory would suggest businesses should be aiming to maximise share price. it will influence the plan. b. Main forecast needs of investment decisions will include: • predictions of cash flows. a. 3. sales. People making decisions whether to invest require the opportunity cost of funds for final evaluation. profit growth. and having completed the Essential reading and activities. risk classification for loans • cost of raising different forms of capital. market share. debt. Thus one can see some of the interrelationships amongst the three decision types. A reminder of your learning outcomes By the end of this chapter. For example. 90 . in the shorter term. Increasing dividend payout may. they also need to know the availability of funds. the size of the earnings per share and the annual growth rate of these variables along with the size of profit and its return on investment will influence the availability and cost of funds. The amount of dividend paid per share. share price. while practice might add some other objectives like profit. For financing decisions the main forecast needs are: • predictions of funds available and type of source – equity. their timings and the influence of inflation • the degree of variability in the cashflow estimates • the opportunity cost of capital to be used that is appropriate for the business risk of the project • the impact on the accounting profit profile • the interactions (if any) with existing or new projects. dividend per share etc. earnings per share. profit growth and thus dividend payment may be targeted at the expense of cash flow in order to influence equity market perceptions if the finance plan requires a share issue as the next major source of long term capital. these are not always available precisely when investors want them.

810–14. 2. number 1. and financial planning Practise questions 1. numbers 1. ‘The speed of change increases over time. Describe some of the practical applications where ratio analysis has been used and comment on the effectiveness of such applications. methods and uses. numbers 2 and 12. Chapter 18. Describe and discuss what you understand by the term ‘financial planning’. 3. Answer the following problems in BMA: • pp. 5. Incorporate comments on the quotation into your overall discussion. 12 and 24.Chapter 8: Financial analysis. 14 and 18. Describe the general uses of ratio analysis and discuss the limitations of the results obtainable. making financial planning of little value’. 91 . See VLE for solution Problems Answer the following problems in BMM: • Chapter 17. 6.

59 Financial management Notes 92 .

(McGraw-Hill Inc. 2005) Chapter 10.J. Rather you need to know the main outlines and characteristics of the sources and the processes of managing the current assets. Myers and A.. Atrill.A. 2007) Chapters 19 and 20. S. their characteristics. and having completed the Essential reading and activities.C. Allen Principles of Corporate Finance. however you are not required to learn the detail in the text on cash and inventory models or the management processes described. you should be able to: • explain the rationales supporting the financing mix of short and long term funds for an entity • describe the major short-term sources of funds. R. (McGrawHill. This chapter starts by making the links between long and short-term financing and moves on to reviewing the features of various short-term sources.C. The second part of the chapter considers the management of working capital. 2008) Chapters 30 and 31. R. S. P Financial Management for Decision makers.Chapter 9: Short-term finance and asset management Chapter 9: Short-term finance and asset management Aims of the chapter This is quite a lengthy topic area as can be seen by the number of chapters listed below. Further reading Brealey. Essential reading Brealey.A. costs and the providers’ requirements • evaluate different possible short-term sources to meet the corporate needs • discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels • make a strategic assessment of the effects of the uses of changes in current asset levels. Marcus Fundamentals of Corporate Finance. (FT Prentice Hall Europe. some of which are long and some short. debtors and cash and then some techniques for managing those items. the establishment of optimal levels of inventory. You also need to know the basic evaluation techniques for choice between sources. A problem is then provided to give an example of how and what to do in the choice between different forms of finance. Learning outcomes By the end of this chapter. . 93 . Myers and F..

increases in sales lead. Trade credit This is an extremely important source of finance for small businesses in particular. Debt factoring is often a long-term arrangement because of the administrative arrangements required to deal with the transfer of the sales ledger accounting function. Debt factoring When reading the relevant sections on debt factoring note the services offered by a factor and the fee structure employed. however. they can be repaid more easily and quickly. on the other hand. Invoice discounting. Since a firm’s asset base grows irregularly over time one would expect the mix also to vary. therefore. 94 . in turn. The implicit annual interest cost of a business paying at the end of 28 days rather than at the end of seven days is: We can see that the cost of foregoing discounts can be very high and. the four factors which determine the length of the credit period given to customers.e. other forms of short-term finance may prove to be cheaper. may be a temporary arrangement. No period of notice or penalty would normally be attached to repayment which can be done to best advantage. to increases in purchases on credit from suppliers). Factoring can prove to be expensive and so it is important to identify the relevant costs and benefits before entering into such an arrangement. BMM go through the rationale behind the matching of maturities of assets and liabilities. You should note in particular when reading the relevant sections on trade credit.59 Financial management Long. The level of financial distress will be greater the higher the proportion of short terns funds. However. the payment period for invoices is 28 days (with no discount being allowed). if payment is not made within seven days. It can be described as a spontaneous source of finance as it results from normal business operations (i. since of necessity they will be interest bearing and not equity. though. Trade credit can be a free source of finance to a business providing the goodwill of the trade supplier is maintained and providing discounts for prompt payment are taken. Study the worked example below. can lead to a reduced level of service in the future and failure to take advantage of discounts can have a high implicit annual interest cost. You must be clear about the distinction between debt factoring and invoice discounting. Generally. firms will attempt to choose whether they will be conservative and predominantly financed by long-term sources or more aggressive and have a much higher proportion funded with shortterm sources. Suppose trade suppliers offer a 2% discount for invoices paid within seven days and.versus short-term finance The mix of finance used to acquire the total assets of a firm is a very company specific and time specific selection. Failure to maintain supplier goodwill.

Chapter 9: Short-term finance and asset management Worked example 9 Aztec Electronics Ltd has an annual turnover of £25 million of which £0.000 × 80%)15%} Net annual savings 100 120 411 247 878 23 £ 000 4.5% of sales turnover Interest charge on advance {(£2.5% of sales turnover for this service. Solution to Worked example 9 £ 000 Existing investment in trade debtors {(70/365)£25m} Expected future investment in trade debtors {(30/365)£25m Reduced in investment Factor costs 2.2 million and pays interest at the annual rate of 15%. Bank borrowing You should note the kind of loans that the clearing banks and merchant banks are prepared to make.2m × 0. These include: • the quality and integrity of the management of the business • the quality of the case made in support of the loan application • the period of the loan and the security being offered • the nature of the industry in which the business operates • the financial position and performance of the business. The business has been approached by a debt factoring business which has offered to provide an advance equivalent to 80% of its debtors (based on an average settlement period of 30 days) at an annual interest charge of 14%. When making a decision concerning a business loan application.000 × 15%) Reduction in overdraft interest through advance {(2.000 × 80%)14%} 625 230 855 Factor savings Bad debt savings (£0.055 2. The use of a factoring service is expected to lead to cost savings in credit administration of £120. the employment of a factor will lead to net savings for the business.000 per annum and will reduce bad debts by half. Credit controls within the business have been weak in recent years and the average settlement period for its trade debtors is currently 70 days. a bank will take a number of factors into account.5) Credit admin savings Reduction in trade debtors (£2.055.740.055.740 We can see that.795 2. The settlement period for debtors will be reduced to an average of 30 days which is in line with the industry norm. All sales are on credit and turnover has been stable in recent years.2 million prove to be bad debts. The factor will take responsibility for the collection of credit sales and will charge a fee of 2. Required: Calculate the net annual cost or savings resulting from a decision to employ the services of the factor. in this case. The business currently has an overdraft of £6. 95 .

1 .7 16.3 14.3 4.59 Financial management Specialist finance There are numerous short and medium term sources available which are only provided with a specific end in view. In order to deal with this problem. This is considered the opportunity cost for short-term funds.8 13. During recent months its trade creditors have been pressing for more prompt payment of amounts owing. or finance for specific projects. the directors intend to ask the bank to increase the business’s overdraft by the necessary amount.5 23.2 0. The profit and loss account and balance sheet of the business for the year ended 31 July 2008 is as follows: Profit and loss account for the year ended 31 July 2008. The current annual interest charge on the overdraft is 14%. Evaluation of sources of finance When considering an appropriate form of finance for a particular business. £m Sales Cost of sales Opening stock Purchases Closing stock Gross profit Administration expenses Selling and distribution expenses Finance charges Net profit before taxation Corporation tax Net profit after taxation Dividend payable Retained profit for the year 96 £m 29. General knowledge of their existence is all that is required.5 0.6 0. internal sources of finance as well as external sources of finance should be considered. To finance this policy.2 15. or the more general hire purchase. In addition. Consider the worked example below: Worked example 10 L C Conday Ltd is a family owned business which operates as a wholesaler of garden products. Leasing When reading these sections you should note carefully the distinction between an operating and a finance lease and the reasons put forward to explain the growth of this form of financing in recent years.2 7.4 0. For example there are a number of ways of getting money to support exports.4 6.4 2. Sale and lease back arrangements offer an opportunity for a business with valuable property to raise new finance.2 0. you should study carefully the techniques of lease evaluation. You should compare the advantages and disadvantages of this form of financing with that of a mortgage. the directors of the business have agreed to reduce the level of trade creditors by keeping to an average settlement period for creditors of 30 days.9 6.

2 8.Chapter 9: Short-term finance and asset management Balance sheet as at 31 July 2008 £m Fixed assets Freehold land and buildings Fixtures and fittings Motor vans Current assets Stock Trade debtors Less: creditors – amounts falling due within one year Trade creditors Dividend payable Bank overdraft Creditors – amounts falling due beyond one year 10% debentures (secured on freehold) Capital and reserves £0.2 15.9 7. Calculate the amount of finance required to reduce the level of creditors in line with the proposed policy b. Required: a.6 7.4 12. which you consider to be the most suitable. Evaluate four other methods of financing the proposed policy and state.6 1.8 7.2 £m £m The profit for the year to 31 July 2009 is expected to be similar to that for the year to 31 July 2008. State what you believe the reaction of the bank would be to an approach to finance the proposed policy. c. 2. with reasons and supporting calculations.9 0. 97 .0 4.2 1. 7. No dividends have been announced in the preceding four years.4 9.2 3. Freehold land and buildings are shown at valuation and the other fixed assets are shown at their net book value.4 7.50 ordinary shares Retained profit 3.6 Notes 1. 3. All sales and purchases are on credit.5 15.1 12.6 3.

however.59 Financial management Solution to Worked example 10 a) £m Trade creditors at balance sheet date Trade creditors representing 30 days outstanding (£16. From the information available there does not appear to be any other attractive form of security for prospective lenders – the interest cover ratio is low. To increase the overdraft further will make the bank even more vulnerable to the risk of default.5m × 30/365) Finance required 3. Unless the ability to pay more promptly results in discounts being received from suppliers. the effect will simply be to depress profits (from an already low base) by the amount of the additional interest charge. however. as stated earlier. equity shareholders may see little investment potential in the business as the return to equity for the year is only 5. it is not clear how the overdraft will be repaid.9 1. which will give cause for concern.6 ×100) which is very high. like debt factoring.4/2.5 b) The bank is unlikely to provide the necessary finance for the proposed policy. The finance will not be employed to generate further income for the business but simply used to repay other creditors. it is secured.e.8) and the effect of increasing the overdraft could be to push the interest cover below 1. • Debentures/loans: this form of finance is not a strong possibility.5% (20. The overdraft will not therefore be self-liquidating – indeed. or even if.3% (0. c) Four possible sources are: • Equity shares: lenders are likely to look to equity shareholders for reasons mentioned above – the total owing to total asset ratio is currently 72.4/7. The overdraft is already large in relation to other forms of finance employed by the business (including the equity capital) and it is not clear from the information provided how. it appears that the creditors are bearing a large amount of the risk associated with the business. The bank is likely to feel that the equity shareholders should contribute more to the financing of the business.2 times (i.0/27. • Invoice discounting: this will enable the business to convert trade debts outstanding into cash. 3. At present. the business is already highly geared and there is already a debenture issue which is secured on the freehold land. 98 .6 ×100) and the dividends seem sporadic. it is a costly form of financing a business and is often viewed by outsiders as an indication of financial weakness – a financial institution may expect the debt to be insured before considering an application. however. We are informed that this is a family-owned business and this may raise issues concerning the amount of capital available and the prospect of dilution of control. As the purpose of the finance is not to generate profits the effect of a new share issue will simply be to reduce equity returns further. The effect of increasing the overdraft by the amount required will be to increase interest charges by £350.000 per annum. the survival of the business could be at stake and so investors may respond to additional calls for funds. The interest cover is already low at 1.0.4 2.

4 = 3. however. the requirements of the different stages of the product life cycle. Where a cash deficit is forecast.3 = 6. financial managers can plan for either its short-term or long-term reinvestment.5 × 12/29. the timing of finance. The chapters listed above in general give greater detail of the concepts and techniques employed in managing each element. plans must be made for either the financing of the deficit or for changes in the timing of receipts or payments so as to avoid the forecast deficit. They can reveal to financial managers the effect of planned events on the liquidity of the business. The management of the treasury function is dealt with in the next chapter and should be linked with the critical appraisal of the cash models such as Miller-Orr etc.2) – this seems very high indeed – a reduction in stock levels by one third would release the necessary funds to pay the trade creditors.Chapter 9: Short-term finance and asset management • Reduce stocks/debtors: it may be that an internal source of funds offers the most suitable means of dealing with the financing problem – at the balance sheet date stocks represented more than six months’ cost of sales (7. This is concerned with the establishment of optimum levels of investment in the current asset as well as the decisions concerning their finance. trade debtors and inventory. Hence the need for other approaches to managing the riskiness of the flows. The efficient management of cash is. cash.9 × 12/15. the influence of investment funding. hence. Where stock management is weak and inefficient it may be.1) which again seems to be very high – a reduction in this level by one third would again be sufficient to finance the payment of trade creditors. These models. Cash management models are available which seek to minimise the cost of holding surplus cash balances and to maximise the returns from the re-investment of these funds. than the course requires. Note the general pattern of a cash cycle. 99 . When reading the relevant chapters you should note the importance of controlling the cash collection and payments cycle and the cash transmission techniques available. that there are many items which are obsolete or slow moving. At the balance sheet date trade debtors represented more than three months sales (7. So ensure you understand the principles of the basic approaches along with the strengths and weaknesses of the models described. The management of cash Cash has been described as the ‘lifeblood’ of a business. all these must be reflected in the cash flow projections. When preparing a cash flow statement it is important to consider the timing of cash receipts and payments and to avoid the inclusion of items which do not involve either inflows or outflows of cash. thanks to the variability in the cash flow patterns. it may not be very easy to make the stock reductions required. In order to survive a business must retain an uninterrupted capacity to pay its maturing obligations. have not been overly successful in their applications. Cash flow forecasts are a valuable tool in the management of cash. In the event that a cash surplus is forecast. Management of short-term assets Now we turn to the management of the assets matched with the shortterm finance. therefore. the management of a company’s working capital. of critical importance to a business.

The decision rule to be applied when considering proposed changes is that they should be introduced only where it is expected that the marginal benefits will exceed the marginal costs. These are: • credit terms offered to customers – this includes the credit period and discounts allowed to credit customers • analysis of creditworthiness – credit customers should be investigated to assess the risk of non-payment • collection policy – efficient procedures must be in place for the prompt collection of amounts owing. it might lead to additional credit collection costs and lost sales from customers. this might produce improved cash flows and a reduction in bad debts.1 List the key concepts of the classical static model for cash and inventory. For cash and inventory separately consider the elements in an uncertain world that will affect the static model and its usefulness.59 Financial management Activity 9. A review problem is shown at the end of this book to which you can apply a critique and so use that as a base for criticisms of such models. The business is considering an increase in the average collection period by 15 days. When reading the relevant chapters you should note carefully the ways in which each element can be managed.4m and it is believed that this can be increased in the forthcoming year by increasing the time given for trade debtors to pay. The accountant of Pinewood Supplies Ltd has provided the following information concerning the product: £ Selling price Variable costs Fixed cost apportioned Net profit 42 6 48 22 £ 70 The annual turnover of the business is currently £1. All sales are on credit and the average collection period for the business is 40 days. Worked example 11 Pinewood Supplies Ltd produces a pine bookcase which is sold to retailers throughout Scotland. However. if a business decided to insist on more prompt payment from debtors. State the square root rule. See VLE for solution The management of trade debtors The credit policy of a business has three major elements. Learn the simple approach to a practical derivation of an optimal credit policy. The effect on sales from adopting each option is as follows: Option 1 Increase in average collection period (days) Expected increase in sales (£.000) 15 £120 2 30 £150 3 45 £325 The cost of capital to Pinewood Supplies is 12% per annum. It is important to appreciate that changes in credit policy are likely to result in both benefits and costs for a business. Thus. 30 days or 45 days. 100 .

725 85 70 42 28 The calculations shown above indicate that extending the credit limit by 45 days provides the most profitable option.287 229. unlikely to be very sensitive to any inaccuracies in the underlying assumptions and estimates.074) (17.260 401.740 130. • Financial ratios – the stock turnover ratio.425 £143.425 £248. These include: • Producing sales forecasts – stocks are held in order to meet future requirements. This ratio can be applied to each line of stock for control purposes.55 70 3 1.041 297.616 153. Contribution per unit £ Selling price Less Variable cost Contribution per bookcase Rate of contribution 28/70 = 40% Option 1 Projected sales (£m) Projected debtor period (days) (40 + 15) Projected debtors 1.712 1. it is important to try and establish what the future requirements are likely to be.206 is considerably higher than the other two options.000 £100. which credit policy option should be offered to customers.000 £38. The choice of options based on these figures is.55m × 70/365 1.4m × 40/365 Increase projected Cost of additional investment in debtors (12% × increase) Increase in contribution (40% × sales increase) Increase in profits 48. which has been dealt with in your previous studies.260) (29.835 153.425 £75.52m × 55/365 1. therefore. The expected profit of £100.926 60. can provide an insight into the speed with which stocks are moving through the business. The management of stock-in-trade A number of techniques and procedures may be used when seeking to manage the stock-in-trade of a business.206 (9. 101 . with supporting calculations. hence.52 55 2 1.000 £42.725m × 85/365 Less: Current debtors 1. Solution to Worked example 11 The profitability of each option can be determined by weighing the costs of the additional investment in debtors against the benefits from the expected sales.Chapter 9: Short-term finance and asset management Required: Explain.794) 153. Producing reliable sales forecasts will provide a basis for ordering and drawing up production schedules aid will help in identifying the optimum level of stocks to be held.

which has attracted considerable interest in recent years.59 Financial management • Stock re-order level – the point at which stock is re-ordered will depend on the rate of demand during the period between ordering and receiving the stocks and the lead time. high asset/sales ratios and a poor average creditors payment period. • Stock checks – the business should undertake physical stock checks to ensure the stock levels are consistent with the recorded levels – the existence of slow-moving and obsolete stocks may be detected where stock checks are made on a regular basis. The relevant readings in BMM and PA on this topic provide a good coverage of the stock management models available and should be studied carefully. During the first month of trading the business will make payments for fixtures and fittings of £15. The consequences of overtrading are liquidity problems and difficulties in supplying customers (through an inability to purchase the unnecessary stock).000 for motor vehicles. At the extreme. In addition. can help management ensure the costs of exercising control are commensurate with the expected benefits. Financial ratios may help detect the symptoms of overtrading. and the optimum order quantity – the major models are dealt with in the texts of BMM and PA – the ABC classification system. etc. Working capital and the problem of overtrading Overtrading will arise where the level of working capital and fixed assets employed by a business is insufficient for its level of operations. Overtrading often occurs when a new business expands its trading operations quickly but is unable to find the necessary finance to invest in fixed assets and working capital. • Clear authorisation procedures – authority for the purchase of stocks should be confined to a few key personnel within the businesses and the ordering process should be clearly set out – failure to do so may result in duplication of orders.000. A safety (buffer) stock may be held in order to deal with the risk of stock-outs. Note also the just-in-time (JIT) approach to stock management. The financial statements of a business which is overtrading may reveal low liquidity ratios. failure to control costs or a failure to attract finance at the appropriate times. Revision question Danton Ltd began trading recently on 1 April 2008 with a balance at the bank of £300. the loss of bulk discounts. It may arise through such factors as poor forecasting of profits and cash flows. also mentioned. a business may be forced to cease trading because it lacks the cash to meet maturing obligations. To deal with the problem of overtrading it is necessary to bring the level of operational activity into line with the level of finance available (even if this does lead to the rejection of profitable opportunities in the short-term). • Stock management models – various decision models may be used to help determine the re-order points. Careful monitoring and control of fixed asset utilisation and working capital is essential.000 to cover the first year of trading. 102 .000 and £8. the business will acquire an initial stock on credit costing £24. Overtrading is a reflection of weak financial management.000. The business is both a wholesaler and retailer of carpets and floor coverings. The business has agreed with its bank an overdraft facility of £20.

6) 20.0 4.000 by purchasing an additional £2.8 0.6 5. it intends to increase the initial stock level of £24. From August onwards.3) (26.8 (19.5 0.5 0.4 19.8 0.2 13.8) 15.8 0.000 per month until the end of July.6 52. Administration expenses and selling and distribution expenses are payable in the month incurred.5 0.000 cash. vii) The initial bank balance arose from the issue of 60.50 per share is payable in September 2008. b. Required: a.0 9.4 34.6 (26. during the first six months of the year.Chapter 9: Short-term finance and asset management Danton Ltd has provided the following estimates: i) The gross profit percentage on all goods sold will be 25%.5 (27.000 and to increase at the rate of £4.0 8.4 21.0 24.8 15.0 9.2 10.6 20.4 8.4 21.7 0. vi) The business intends to buy more fixtures and fittings in June for £8.3) 18. ii) Sales during April are expected to be £10.000 ordinary shares payable in instalments.000 per month and selling and distribution expenses will be £700 per month. iv) 60% of sales are expected to be on credit with the remainder being for cash.8 0.000 per month. iii) The business is concerned that supplies will be difficult to obtain later in the year and so. Included in the administration expenses is a charge of £200 per month for depreciation and included in selling and distribution expenses is a charge for £300 per month depreciation. including the initial stock.2 9.8 May £000 June £000 July £000 Aug £000 Sep £000 103 .000 worth of stock each month in addition to the monthly purchases required to satisfy monthly sales.2 (20.6 6.7 0.4 16.8) (27. Credit sales will be paid two months after the sale has been made. All stock purchases.0 7. The second instalment of £0.7 (27.2 8.3) 12.1) 9.0 8.8 17.0 13.5) (19.0 0.5 0.3) (27. v) Administration expenses are likely to be £1. State what problems the business is likely to face in the forthcoming six months and how might these be dealt with? Solution to revision question a) Cash flow forecast for the six months to 30 September 2008 Apr £000 Receipts Share issue Credit sales Cash sales Payments Fixtures Motor vehicles Initial stock Purchases Admin expenses Selling expenses Cash surplus /(deficit) Opening balance Closing balance 0. will be on one month’s credit.8 9.0 4.2 31. Prepare a cash flow forecast for the six months ended 30 September 2008 showing the cash balance at the end of each month.8 0. sales are likely to remain at a stable level of £24.2) 30.7 (29.0 5.4 24.8 0.4 30.7 (8.6) 5.

(It is this purchase which pushes the business over its overdraft limit. However. their characteristics. you should be able to: • explain the rationales supporting the financing mix of short and long term funds for an entity • describe the major short-term sources of funds. Consider the derivation and implementation of an optimal trade credit policy. Purchases represent 75% of the sales for the relevant month plus an extra £2. Though this problem and its solution are relatively straightforward they nevertheless encompass a number of important ideas and concepts. and reducing the level of credit sales. How might a firm go about determining its target cash balance? Evaluate the model(s) you have recommended. reducing the credit period to customers.) However.000 for stockbuilding. Depreciation is a non-cash item and therefore is excluded from the relevant expense figures. Consider the advantages and disadvantages of funding all of a company’s current assets from bank advances or other short-term sources. however. 2. may involve some cost to the business. 3. For example. the proceeds of the second instalment of the share issue will bring the business into cash surplus by the end of the six month period under review. therefore. It may. then the business might consider other options such as the deferring of payments to trade suppliers. Practise questions 1. If this is not possible the business must consider other options. 2. which must be understood both from the practical viewpoint and as a basis for the chapters that follow on treasury management and currency management. Discuss. if this is not possible. costs and the providers’ requirements • evaluate different possible short-term sources to meet the corporate needs • discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels • make a strategic assessment of the effects of the uses of changes in current asset levels. See VLE for solution 104 . These options. it may be possible to defer the purchase of the fixtures and fittings in June until a later date.59 Financial management Notes: 1. A reminder of your learning outcomes By the end of this chapter and having completed the essential reading and activities. b) The cash flow forecast above reveals that the agreed overdraft limit of £20.000 will be exceeded in three consecutive months. be possible to negotiate an increase in the overdraft limit to deal with this short term problem.

numbers 3 and 4.875. numbers 6 and 7. numbers 12 and 15. p. numbers 11 and 19. Chapter 20. 105 .Chapter 9: Short-term finance and asset management Problems Attempt the following problems in BMM: • Chapter 19.846–47. Attempt the following problems in BMA: • pp.

59 Financial management Notes 106 .

Allen Principles of Corporate Finance.Chapter 10: Treasury management and international aspects of financial management Chapter 10: Treasury management and international aspects of financial management Aims of the chapter There is an ongoing expansion of overseas trade by companies which means that they need to keep abreast of the changing international foreign exchange markets. S. Learning outcomes By the end of this chapter. and having completed the Essential reading and activities.A. The three types of currency exposure. 2007) Chapters 22. Myers and F. transaction and economic are explained. Other methods of hedging such as futures and forward contracts are described and then incorporated into examples showing how the currency risk is minimised. Marcus Fundamentals of Corporate Finance..C. R. Further reading Brealey.J. R. (McGrawHill. 2008) Chapters 27 and 28. There is a section on the interrelationships between the variables that affect currency exchange rates in the marketplace. S. The chapter starts with describing types of options and their valuations and then moves on to their use in hedging against foreign currency risk. Thus this chapter describes various forms of financial derivatives such as options which companies can use to help manage their foreign exchange exposure..C. Myers and A.A. (McGraw-Hill Inc. 23 and 24. Essential reading Brealey. 107 . translation. you should be able to: • discuss what derivatives are and how they work • describe the types of options and also the factors which affect them • explain the theory underpinning basic option valuation • explain the application of option pricing theory to corporate finance • explain why financial managers are concerned with international financial management • describe the basic definitions associated with foreign exchange transfers • explain the various theories that underpin the activities in the foreign currency markets • explain how financial managers can manage the three major types of currency exposure.

59 Financial management

Introduction
In this chapter we provide an introduction to both the basic instruments of treasury management and how companies manage foreign exchange risk. At first glance, this chapter may seem very long and daunting, but you are asked, first to attempt the section on options and basic treasury management techniques and, secondly, to proceed to aspects of international financial management. The aim of this chapter is to provide you with a basic appreciation of option valuation; and not to turn you into Wall Street option specialists overnight. Keep in mind that Chapter 23 in BMM only provides an introduction to options whereas Chapter 24 in BMM broadly covers risk management techniques in particular, hedging.

Why should financial managers of firms be concerned with options and other financial instruments?
The opportunity to buy or sell an asset in the future can be expressed using options whereby the opportunity to buy an asset known as a call option and to sell a put option. The price at which the purchase of the option is made is known as the exercise price and as to the date of exercise this can be a specific date such as 25th March, 20X7, as in the case of European options or they may be exercised any time up to and including the exercise date, an American option. First, most capital budgeting projects will have options embedded in them; as these options will allow the company to profit if things go well but also provide downside protection should profits go down. Downside risk is associated with the probability of failure for a business. Second, many of the securities that firms issue will include an option. For example, many companies issue convertible bonds whereby the buyer has the option to exchange the bond for ordinary shares at a certain date in the future. Third, financial managers will invariably use currency, commodity and interest-rate options to protect the firm against a variety of risks and therefore provide the firm with a degree of flexibility (such as unpredictable changes in raw material costs, tax rates, technology, etc.) The purpose of this chapter is to provide an introduction into how companies provide flexibility in managing risk by using options and how they use other financial instruments to offset risk –a process commonly referred to as hedging.

Calls and puts
Call option gives you the right to purchase an asset at a fixed exercise price on or before the exercise date. For instance, you would need to pay £5 for an option to buy British Airways shares (call option) in January 2008 at £40 (exercise price) any time until the exercise date which is December 2008. In all instances the movements in the price of the option (between January and December) will reflect movements in the share price of the company. Therefore, if the share price for British Airways shares was greater than £40 in December, then you would want to exercise your right to purchase the share at the £40; as the market price exceeds the price that you must pay to buy the share. On the other hand, if the share price is below £40 then you would not exercise the right to purchase the option and you would only lose £5 (the value you paid for the option in January).
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Share price as option expires: i. exceeds exercise price ii. less than exercise price

Value of call option on expiration: share price minus exercise price zero as option is NOT exercised

Put option gives you the right to sell an asset (which you may not necessarily own) at a fixed exercise price on or before the exercise date. For instance, you would need to pay £3 for an option to sell British Airways shares at £40 (exercise price) any time until the exercise date which is December 2008. Therefore, if the share price for British Airways shares exceeded £40 in December, then you would not want to exercise your put option as you would need to purchase the share at a price greater then £40 and then have to sell at £40, incurring an overall loss; in passing you would only lose £3 for the original price of the option. However, should the price of British Airways shares be below the exercise price of £40 then you would want to purchase the shares at a price below £40, and then get a guaranteed price of £40 thus making a gain between the current share price and the exercise price. Share price as option expires: i. exceeds exercise price ii. less than exercise price Value of put option on expiration: zero as option is NOT exercised exercise price minus share price

Selling calls and puts
If you decided to sell the December 2008 call on British Airways shares, the buyer would pay you £5. However, in return you must promise to sell British Airways shares at a price of £40 if the call buyer decides to exercise his option. The option seller’s obligation to sell British Airways is just the opposite to the option holder’s right to buy the shares. If the share price is below the exercise price of £40 when the option expires in December 2008, holders of the call will not exercise their option and you the seller will have no further liability. On the other hand, if the price of British Airways shares is greater than £40, the option will be exercised and you will have to give up the shares for £40 each. You will therefore lose the difference between the share price and the £40 that you receive from the buyer. The general rule is that the seller’s loss is the buyer’s gain.

The rights and the obligations of buyers and sellers of calls and puts
These are as follows: Buyer Call option Put option right to buy asset right to sell asset Seller obliged to sell asset obliged to buy asset

What the value of a call option depends upon
• To exercise the option the holder must pay the exercise price. Therefore, with other factors remaining constant, the less you are obliged to pay the more you are likely to gain. Therefore, the value of the option will be lower when the exercise price is high relative to the share price. • Investors who purchase shares by the way of a call option are purchasing on instalment credit. They pay the purchase price of the option today but delay payment of the exercise price until the option is exercised. The higher the rate of interest and longer the period to the expiration date, the higher this ‘free credit’ will be worth.

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• The owner of a call option cannot lose more than the price of the call irrespective of how far the share price falls. On the other hand, if the share price rose above the exercise price, the holder of a call would benefit when the option is exercised. • Thus, the option holder in reality should not lose the total amount as a result of increased variability (share price volatility) if things were to go wrong; on the other hand the option holder would gain if things were to go right. Obviously, the value of the option increases with (a) the variability of share returns and (b) the longer the period to the final exercise date, as this will provide a greater opportunity for the share price to be volatile. In summary, what the price of a call option depends upon: If the following indicators increase The value of the…call option will… Exercise price Share price Time to expiration Share private volatility Interest rate Activity 10.1 Why should financial managers be concerned with using options? What does the value of a call option depend upon? See VLE for solution Drop Rise Rise Rise Rise

Option valuation model
The Basic approach to option valuation relies on finding a balance between a combination of borrowing and investment in a particular share that mimics the option. Worked example 12 Suppose it is January and you are contemplating the purchase of a call option on British Steel shares. The call has a December exercise date and exercise price of £40. The current market value of a British Steel share is £30; thus the option will be valueless unless the share price rises by £10 over the 12-month period. The outlook for British Steel’s share price is uncertain and all you know is that at the end of the year, the price will be either £10 or £70. Finally, the rate of interest on a bank loan is 10 per cent a year. You are required to calculate the value of a British Steel call. Here are the cash flow projections for the alternatives which are currently available: Here are the cash flow projections for the alternatives which are currently available: British Steel shares Jan Outcome 1 Investment Outcome 2 £30 £70 Dec £10 ? £30 Call option Jan Dec £0 £100 £110 Bank loan Jan Dec £110

Note: when the call expires in December, the option will be valueless if the share price falls to £10 and it will be worth 70 − 40 = £30, if the price rises to £70.

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Therefore. The two strategies require a computation of the number of shares per call option to ensure equality between the strategies. the put options exercise price would be the value of the project’s assets if shifted to an alternative use. in this section we extend our current understanding of allowing for flexibility with the aid of options. In contrast. This level is not required here. This would in theory be the complete opposite to the option to expand which utilised a call option and therefore would make use of a put option (to abandon in the future). 2 call options = 30−9. binomial and Black Scholes option valuation models. many capital investment projects on real assets provide flexibility to expand capacity should it be found that demand turns out to be more buoyant than expected.09 buy 2 call options (adopt a strategy to profit from volatility). These projects are in fact. then their value must be the same today.91 +10 −10 0 +70 −10 +60 ? Payoff in Dec if share price is equal to £10 +0 £70 +60 You will notice that. Black and Scholes (1973) came up with a similar formula which showed that you could price calls by replicating the investment in the call by performing a series of investments in shares and partly funded by borrowing. buy 1 British Steel share and then borrow the present value of £10 is Cash flow in Jan Strategy I Buy 2 calls Strategy II 1 British steel share Borrow PV (£10) −30 +9. 111 . For example. If the two investments give the same payoffs in all circumstances.09 = £20.Chapter 10: Treasury management and international aspects of financial management Now consider the two investment strategies that are available: • Strategy I • Strategy II £9. to calculate the value of the call you can replicate a call by combining a bank loan and an investment in the same share. for instance.91 • thus the price of 1 call = (30−9. irrespective of whether the share price falls to £10 or rises to £70. providing the firm with a call option (for the future) on getting additional capacity. Using options to allow the expansion or abandonment of real assets You have seen the need to allow for flexibility in investment projects in Chapter 4 of this guide.09 –20.46.09)/2 = £10. • In other words. the payoffs from Strategy I and Strategy II are identical. firms may also consider the position concerning the alternative uses for their assets. if the firm suddenly realised that demand was not as high as they had anticipated. Therefore. The formula for the number of shares per call option is: Spread of possible share prices Spread of possible options prices = 70 – 10 = 60 = 2 30 – 0 30 Therefore 2 shares need to be bought to replicate one call option. Chapters 22 and 23 in BMA illustrate advanced calculations of option values using put-call parity.

but the final payment for the asset does not occur until the delivery date.59 Financial management Options on financial assets When companies issue securities. By reducing the risk of a project the financial planning of it becomes easier and therefore the likelihood of an embarrassing short-fall is also reduced (in extreme cases the short-fall could even trigger off bankruptcy). forward contracts and swaps which have been regarded as some of the great success stories in finance. The price is usually fixed today. exchange rates and share prices • commodity futures to allow companies to fix the future price that they pay for a wide variety of agricultural commodities. for instance. Here are a few examples of the options that are associated with new financing: • Warrants allow the right to buy shares in a company at a stipulated price on a set date(s) (long-term call option). Other derivatives include futures contracts. they often include an option in the package. They are essentially agreements to buy or sell an asset in the future at an agreed price 112 . Forward contracts These are usually bespoke (specially made) futures contracts. Dramatic changes in interest rates. metals and oil. Hedging is also a technique which may be able to help the directors of a firm assess the performance of their top management. • Callable bonds are bonds that may be repurchased by the firm before the maturity date at a specified call price (gives an option to the firm to buy the bond back at a specified price. • Convertible bonds are bonds that the holder may exchange for a specified number of shares (give the investor the option to buy the firm’s shares in exchange for the underlying bond). Futures contracts These are agreements made today to purchase or sell an asset in the future. Finally. They can adopt the use of a number of specialised financial instruments known as derivative instruments (derivatives) which allow them the opportunity to manage these risks. In essence there are two broad types of futures: • financial futures to help firms to defend themselves from unseen movements in interest rates. should interest rates decline and the value of the bond rise). Futures contracts tend to come in a standardised format and tend to be traded on formal exchanges. options are often used by firms to limit their downside risk. hedging certain likely events such as foreign exchange movements by companies which import or export goods reduces the currency exposure risks these companies are open to. Why do companies hedge? Most companies hedge (using treasury management techniques) to reduce risk rather than make money. if a firm’s profits grew by 30% the directors can decide how much the increase is due to a shift in the exchange rate and how much it is due to good managerial decision-making. As already discussed. exchange rates and commodity prices can make planning difficult for financial managers.

77 or Euros 1. which balances demand and supply for a currency today is called the spot rate. The foreign exchange market enables the transfer of purchasing power denominated in one currency into another currency by providing a market place and acting as an intermediary. In the example HK$ is trading forward at a premium as sterling is expected to weaken.30 12. you will be required to know the basic definitions associated with foreign exchange transfers. Rates per £1 (Sterling) Bid F Francs HK $ 8.80 Spread 0. The difference between the bid and the ask is called the spread. and for a future date is called the forward rate. The market clearing price. Unfortunately. selling you) £1. so if the value of £1 is expected to fall over the month then the HK$ will be trading at a small forward premium to the spot rates since it takes less HK$ to acquire £1.77 Ask 8. The forward rate incorporates the market’s expectation of the future movement in the currency.30 before giving you (i. compared with the environment faced by them solely operating in the domestic market place.e.28 12. exchange risk exposure and management of foreign exchange exposure.03 Thus HK$12. the volume of deals and the type of the market. See VLE for solution International financial management Introduction When a business goes international it adds many new dimensions to the analysis and actions undertaken by its financial managers. However. whilst it would ask $12. Foreign exchange market It is always worthwhile to learn not only the terminology associated with this topic but also the mechanics of the foreign exchange markets before learning the theories and some of the primary management techniques of dealing with currency risk. 113 . Each of the quotes (examples of which are found in the respective chapters of BMM and BMA) are in pairs – bid and ask.28 is the amount the bank will give you for £1. the extent of which is influenced by the level of risk.2 Describe in what circumstances are companies likely to hedge: illustrate your answer with an explanation of two derivative instruments. there is only a brief outline in the BMM textbook on this subject but more can be found in Chapters 27 and 28 in BMA. It is to these new dimensions that you need to address yourself.Chapter 10: Treasury management and international aspects of financial management Activity 10. Trading at a discount means the points would be added to the spot to get the forward rates because the £1 is expected to appreciate.02 0.80 or Euros 1.

on the one hand and the desire for traders to profit through arbitrage which. by the same token.03 (0.80 (0.54 Ask 12. will move closer and closer to the equilibrium positions presented here.60 Spread 0. If this happens the relationships.03) 0.59 Financial management Forward and spot rates per £1 for Hong Kong $ Bid Spot rate ($) Points Forward rate (30 days) ($) 12.06 Remember that the concepts of market efficiency and arbitrage are also applicable here in the international foreign exchange market as they were in the capital market. then the traders will be looking to test the relationships in order to generate trading profits. Interrelationships between variable affecting exchange rates Learn the five basic interrelationships that affect the exchange rate between two currencies.1 attempts to show the theoretical links between differences in interest rates in different countries (A&B). If they are different then the traders should buy or sell appropriately until equilibrium is achieved. shown below. will enhance efficiency.77 (0.1 Interrelationships between variables affecting exchange rates Figure 10. and the market forward rate and the expected spot rate which should be identical. Figure 10. if there are some inefficiencies.20) 12. if the market is operating effectively. But. 114 .23) 12. differences in inflation rates and the resultant expected parity with differences between the present spot rates. Bear in mind the objective of maintaining as efficient a market as possible.

0552 × 4891822 = $10. If the market is in complete equilibrium the dollar proceeds exactly pay off borrowings plus interest.35% 10. convert it into £ sterling at the spot rate of $2. Repay it with interest after 30 days. suggests it might be a worthwhile operation).250 = $ 32. Borrow $10 million at 10.35% p.0552 2. lending and borrowing rates were quoted on 30 March for the US$.40% 10.673 − 10.10% 11. or just $1 or 115 .40% 10. With dollars in hand pay back loan and outstanding interest.25%? Solution to Worked example 13 a. borrow in USA and invest in UK for 90 days and borrow in UK and invest in USA for either 30 or 90 days.0645 2. b. Sterling value at end of 30 days: Buy $ forward contract to convert to £ to $ for the expected proceeds of £4. convert and invest $10 million loan in UK.0511 Ask 2.891. evaluate the above situation in terms of pure interest arbitrage.a.60% Take.Chapter 10: Treasury management and international aspects of financial management Worked example 13 The following exchange. Having borrowed $10 million.90% 11.673 Loss on deal = 10.053. (The difference in annual interest rates of 1. a. This approach can be repeated for the three other alternatives. $ Capital and interest due for repayment in 30 days Borrow Lend 11. Buy a forward contract to convert the sterling investment proceeds back to dollars. – would you comment differently if the transaction costs were 0.a.9% p.60% UK Borrow 12.0587 2. Try this for yourself using easy amounts like $10 million or £10 million.086.55 p.15% 10. discuss whether the interest rate parity equilibrium is holding.577 If the mechanism was operating perfectly there would be zero loss or gain.0615 2.0645 and invest the proceeds in the UK at 11.0551 Interest rates (annualised) USA Lend 30 days 90 days Required: a. take as your example borrowing for 30 days in USA and investing in UK and b. Let us assume we can borrow $10 million for the benefit of our answer (but we could have used $1 just as easily). £ sterling in the USA and UK.822: 2. Bid Spot ($ per £1) 30 day forward 90 day forward 2.053.

59 Financial management

£1. The losses or gains you will derive will tell you in theory whether it is a worthwhile trade. The larger the loss or gain the less the market is in equilibrium and the more likely the arbitrageurs will move in and, by their actions, influence currency and interest rates to make it less rewarding for those that follow. In practice, traders may have to pay some transactions costs which if they amounted to 0.25% would increase the loss shown in (i) above and obviously affect the figures you have calculated for the other possible deals. Any transactions costs influence operating efficiency and the movements towards equilibrium.

Exchange risk exposure
A business is exposed to exchange risk when a movement in a currency would change for better or worse the parent business’s home currency value of any of the business’s assets, liabilities, cashflow or expected profit streams. You will be expected to describe the three main categories of exposure: translation, transaction and economic exposure. Some texts may call economic exposure by another name, operating exposure, as well as treating transaction exposure as a subset of economic exposure. You are only required to learn the basics of translation exposure as an advanced financial accounting course would cover the topic in greater depth. Translation exposure arises from the need to consolidate overseas subsidiary balance sheets and profit and loss accounts into the one set of accounts for the group in one currency. This consolidation requires the translation of foreign currency valued assets etc. into the home-currencyvalued assets etc. on a particular date. The choice of exchange rate can have a material effect on the consolidation figures. For this paper we concentrate on the problems faced by management of actual or potential cashflows. When a debt is payable or receivable, in a foreign currency, this gives rise to transactions exposure, while economic exposure relates to the exposure of potential cashflows For example, if a steel manufacturer tenders a contract to make and supply large steel pipes to an oil drilling company, then the steel business will have a potential (economic) exposure during the tendering process and period which becomes an actual (transaction) exposure once the contract has been accepted with delivery and payment dates agreed.

Management of foreign exchange exposure
You will be expected to discuss the internal techniques a holding company can use to manage and minimise foreign currency exposure such as netting, matching, leading and lagging and asset and liability management. In addition, you will also be required to explain the mechanics of hedging, the use of options and swaps. (you will not be required to do worked examples of these.) Worked example 14 – hedging question Lee Ltd import goods to the UK from Singapore. At the end of December the business has just signed a contract requiring a payment of $ (Singapore) 586,000. The business is considering the cost of three possible ways of hedging the foreign exchange risk arising from the contract: forward contract, money market hedge or the acquisition of foreign currency options. The various rates and prices at the time of signing are given below:

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Chapter 10: Treasury management and international aspects of financial management

Exchange rates (London Market) Singapore $/£ Spot 3 months forward 6 months forward Interest rates (annual) Six months $ Sterling Singapore $ Borrowing 12.5% 9.0% Lending 9.5% 6.0% 3.4212 – 3.4280 1.64 – 1.54 cents premium 2.78 – 2.68 cents premium

Foreign currency option prices (LIFFE Market) (Prices are cent per £ contract size £12,500) Put option Exercise price ($) 3.40 3.60 June 13.80 18.64

(Note: If the forward contract is undertaken then cash will be paid in six months’ time, as it will if the option is taken up.) Required: 1. Calculate the cost of the three possible ways of hedging the foreign exchange exposure open to Lee Ltd; identify the extent of the exposure. 2. Evaluate the three possibilities and make a recommendation to the business. Solution to Worked example 14 1. a. Forward exchange market–forward contract • Use forward rates for six months. • Use the bid rate because you are buying S$ • Remember it is the cost to Lee in £ Sterling that matters (i.e. required as the answer). Forward rates = Spot − premium = (3.4212 − 0.0278) − (3.4280 − 0.0268) = $3.3934 − 3.4012 Cost of forward contract to buy S$586,000 = 586,000 3.3934 = £172,688 b. Money market hedge • S$586,000 to be paid in six months • Borrow £ now, convert immediately to S$ and invest it so it becomes $586,000 in 6 months. • Singapore lending rate 6.0%, sterling borrowing at 12.5% Amount needed for investment: = 586,000 1+[0.06 × (16/12)] = S$568,932

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59 Financial management

Amount if £ required at spot to provide S$568,932 = 586,000 3.4212 = £166,296 Amount required in six months to repay sterling loan and accumulated interest: = 166,296 × [1 + 0.125 × (16/12)] = £176,690 Cost of money market hedge: £176,690 c. Currency option • • • • Choose option rate, note price per £. Calculate required number of option contracts of £12,500. If option to be exercised calculate net S$ flow, convert to £. Sum sterling flows.

Assume buy put option at S$3.60. It gives Lee the right to sell £1 at S$3.60 in June. Price per £=18.64 cents. £ value of debt owed at option rate: = 586,000 360 = £162,778 Number of option contracts (to next whole number): = 162,778 12,500 = 13.02 = 14 contracts Cost of 14 option contracts: = 14 × 12,500 × 0.1864 = S$32,620 Amount required in six months to repay sterling loan and accumulated interest. If exercised, 14 contracts provide: S$(14 × 12,500 × 3.60) = S$630,000 Net S$ cashflow in June: = 630,000 − 32,620 − 586,000 = S$11,380 inflow Net inflow must be converted at forward rate to £ sterling (As an inflow use ask rate, for outflow use bid rate). Total £ sterling outflow in June = (14 × 12,500) − 11,380 3.4012 = £171,654 (Note: If Lee Ltd had chosen to buy options at S$3.40 rate it would have required 14 option contracts, produce a net S$ outflow on conversion, which when translated at the forward bid price plus £ sterling outlay for the contracts of £175,000 would show a total cost of £179,465. You can give yourself some practice by reworking the option section using the information for S$3.40 options, the guidance in this paragraph and then checking your answer.) d. The extent of the exposure is the amount due S$586,000. 2. The cheapest possibility is to buy 14 put options at S$3.60 per £. This method costs £171,654, £1034 cheaper than the simpler, easier method of buying a forward contract at S$3.3934 per £. However, if the spot bid price in June rose above S$3.6039 then Lee Ltd could dispense with using the options and buy S$ in the market to cover the combined cost of the outstanding debt and option purchase cost (586,000 + 32,620) [N.B. The cut off spot price of S$3.6039 comes from dividing the £ sterling cost (£171,654) into the combined S$ cost of S$618,620], the more the future spot price exceeds S$3.6039. The more the future spot price exceeds S$618,620, the cheaper the cost of paying off Lee’s debt becomes. The exposure risks are covered in all three methods but in the money market hedge there is an
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of 75 and 65 rupees.60 – 0. In this situation. the two person department is split equally. Separately set out the financial implications of each of the four options for each of the two exchange rate expectations. Using the figures calculated in (a) review your 119 . of the treasury department members. and having completed the Essential reading and activities. Outline the strengths and weaknesses of the hedging methods used in the four options above. Currently the exchange rates are: £/rupees spot 70. A reminder of your learning outcomes By the end of this chapter. the premium cost would be £0.05 per 100 rupees. To take out a forward exchange contract. Practise question 1. The department is considering four options. REQUIRED: a. Via the bank use a money market hedge. At present.Chapter 10: Treasury management and international aspects of financial management added practical risk that interest rates might change during the six months thus not completely wiping out the exposure risk using this method. Sugarloaf Tea Importers Ltd. annual interest rates are UK 5% India 10%.100 rupees – 70. ii. in that one member believes that shortly the £1 will weaken to 65 rupees per £1. In addition the bank would charge 0. The treasury department of the company is reviewing its general strategies for hedging foreign currency payments as well as trying to decide how to hedge against the foreign exchange risk associated with this payment. Do nothing and pay the bill when it falls due in 6months time. you should be able to: • discuss what derivatives are and how they work • describe the types of options and also the factors which affect them • explain the theory underpinning basic option valuation • explain the application of option pricing theory to corporate finance • explain why financial managers are concerned with international financial management • describe the basic definitions associated with foreign exchange transfers • explain the various theories that underpin the activities in the foreign currency markets • explain how financial managers can manage the three major types of currency exposure. They are: i. (10 marks) b. while the other member believes it will strengthen to 75 rupees. is a British tea-importer importing teas from various foreign countries.5% on the sterling value as administration expenses. To take out an over-the-counter currency option via the bank at an exercise price of £1 = 69 rupees. iv.2657 6 months forward (rupees) 0.150 premium iii. It is required to make a 20 million rupee payment in six months’ time for a shipment of tea just received.

7.781. Briefly discuss whether the treasury department should maintain a general rule as to which hedging method to use. (12 marks) c.59 Financial management results and make a recommendation as to the hedging option to be used for making the payment. Chapter 23. Attempt the following problems in BMA: • p. numbers 1. 4. numbers 19 and 20. and if so. 10 and 18. giving your reasons. 120 . or should they treat each transaction on its merits.750. no. numbers 9. Chapter 24. which one. p. number 16. (3 marks) See VLE for solution Problems Attempt the following problems in BMM: • Chapter 22. 5 and 12. 3.

S. 2007) Chapter 21. corporate restructuring and off-balance sheet funding Chapter 11: Mergers. 2005) Chapter 12. S. There are waves of merger activity and an explanation is put forward for this before describing the motives and theories behind mergers and takeovers. (McGrawHill. These are explained..A. (FT Prentice Hall Europe.C. Myers and F.C. A section then looks at corporate restructuring and divesting. Finally off balance sheet financing and leasing is introduced and explained. corporate restructuring and off-balance sheet funding Aims of the chapter Most companies are involved in either a merger or a takeover sometime during their corporate existence so understanding the motives and tactics behind them is very important. Marcus Fundamentals of Corporate Finance.. 121 . R.A. 2008) Chapters 32 and 33. as does a knowledge of defence tactics should a company not wish to be taken over. Learning outcomes By the end of this chapter and having completed the essential reading and activities. you should be able to: • explain the reasons why companies may decide to merge with another firm • describe the factors that may give rise to merger waves • explain the motives underlying individual mergers (including economic theories) • explain the role that takeovers play in removing inefficient management • describe the rules governing takeovers in the UK • describe takeover defences and any advantages and disadvantages they may have • describe the theory and evaluate the methods of company restructuring and refinancing • explain both the types and reasons underlying leasing. Further reading Brealey.Chapter 11: Mergers. Myers and A. . Atrill. To achieve success in taking over a company requires a knowledge of appropriate tactics. P Financial Management for Decision makers. Essential reading Brealey. (McGraw-Hill Inc. R.J. Allen Principles of Corporate Finance.

there was a takeover boom between 1984 and 1989. say. when a large company makes a bid for a smaller company. from our earlier studies of financial management we will know that the investment should only proceed if there is going to be a net contribution to shareholder wealth. The only problem is that mergers are very difficult to evaluate because the benefits and costs may not be easy to measure and also they are more complicated than. When one firm buys another. This is because in many instances it is not clear whether one or the other is occurring. and the directors of the smaller company do not recommend shareholders to sell their shares to the purchaser and neither the pre-bid shareholders nor the directors of the company have any interest in the combined firm. it is exactly the same as undertaking any ordinary investment. Merger waves In the UK. This supports the idea of the combination while. financial managers spend a great deal of time searching for firms to acquire or they spend time worrying about firms which are likely to take their firm over. In a merger. Therefore. there was increased expenditure on acquisitions which coincided with a general increase in capital expenditures by industrial firms. the accounting rules emphasise the continuity of ownership and in takeovers the emphasis is rather on a purchase and discontinuity of ownership. 122 . During periods of intense merger activity. The terms mergers and takeovers are used interchangeably. in general. Strictly. legal and accounting regulations that need to be followed. value of shares exchanged and pre-acquisition profits. but this boom had been driven largely by a small number of very large acquisitions. Chapter 21 in BMM gives a predominantly US perspective on the topic whereas Chapter 12 in PA though very detailed. buying a machine. gives a UK perspective on merger activity. Several reasons have been advanced for these so called merger waves: • during the 1960s boom conglomerate mergers became fashionable and • during the 1980s boom the UK was preparing itself for the single European market in 1992. France and the US also experienced a similar trend in merger activity. It was also a period when company profits and liquidity in general were relatively high and large funds were available to perform takeovers.59 Financial management Introduction This chapter focuses on trying to explain the motives and tactics involved in merger and acquisition activity. This was not only the case in the UK – Germany. the main differences between the accounting rules are concerned with the treatment of goodwill. Many academics believe that the reasons for merger waves may not be economic but behavioural. this situation is also referred to as the economic disturbance theory of mergers. then this is an acquisition or takeover. due to the tax. The only problem with the notion of the economic disturbance theory of mergers is that we do not understand the economic forces that underlie the pattern of merger activity. One of the most popular reasons advanced for waves of merger activity suggests they are associated with booms and slumps in the economy and stock market prices. a merger is when two companies of equal size come together and continue to have an interest in the combined business.

000 was paid for company B. PVb= 20.000. corporate restructuring and off-balance sheet funding What causes merger waves: • high merger activity when share prices are low (firms are bought at a bargain) • high merger activity when share prices are high (the stock market allows a firm’s management to finance takeovers through equity issues) • high merger activity in certain economic situations (especially prevalent in technology driven industries).000 then PVab = PVa + PVb + Gain 100.000.000/30.000 + Gain Here the relative gain would be 30.000 = 10. Motives for individual mergers Before the motives are discussed.000 = 50. in which situation the shareholders of company B would gain.000 + 20. For example: PVab = PVa+ PVb + Gain If company A decided to bid for company B (the target).000. and 20. PVa = 50. this is commonly referred to as a synergistic effect (the simplest explanation is that the combined firm’s resources increase the potential for future growth and make it possible to utilise each firm’s relative advantage). or • if they can buy company B at a price below the present value of its future cash flow.000 Gain. it is important to point out that. The management of the firm should be acting in the interests of their shareholders (we discuss managerial motives for takeovers in a later part of this chapter). as the shareholders of company B would then receive two-thirds of the gain (30. but the gain would be much smaller if 40. it is the management of the firm who make the decision.000 = 2/3 gain to shareholders of company B). If company A decides to take over company B then their reasons for the attempt would be either: • if they believed the value of the two firms together exceeds the value had they remained separate entities. when a firm decides to merge with another.000 − 20. If we assume: PVab = 100. it could end up paying a price above the PVab.Chapter 11: Mergers. Economic theories of mergers • Economies of scale • Internationalisation of transactions • Market power • Entry into new markets/industries • Elimination of misguided management • Free cash flow (trapped equity) • Undervalued shares 123 . Note: if PVab is the value placed on the consideration by company A’s management then (PVab − PVa) equals the maximum value they will pay for company B.

It is an important form of merger as it eliminates transaction costs when firms have to deal with each other. and the merger leads to a greater share of a particular market). Shareholders do not appoint or supervise the firm’s management. Entry into new markets/industries Entry into areas where an expanding firm lacks the know-how.59 Financial management • Tax advantages • High prices/earnings rations (bootstrapping) • Risk diversification Economies of scale The topic economies of large scale production should have been adequately covered in your earlier economic studies. it can provide almost instantly the necessary size for a firm to be an effective and formidable competitor. In some instances. Elimination of misguided management There is a substantial separation between the ownership and management of large firms. 124 . it was estimated that 3% of assets in the UK changed hands as a result of vertical integration while 57% were a result of horizontal integration (horizontal integration occurs where firms acquired are at the same stage of the production process. but if markets are efficient then over the longer period. extra costs may result. suppliers may be less inclined to compete with one another leading to higher prices paid by the merged entity. Internalisation of transactions This usually occurs when firms vertically integrate (vertical integration backwards occurs by the acquisition of firms that supply raw materials and vertical integration forwards occurs when firms are acquired nearer the selling of the product). this is commonly termed the agency problem. One drawback is that by merging two large firms. For example. they will be identified and the market mechanism should ensure that they are replaced. What then happens if managers are inefficient? Inefficient managers can exist for a limited time period. This is an attractive feature for firms as it has been shown that a concentration in an industry leads to a greater level of profit. this general process is referred to in the academic literature as the market for corporate control. it may only be that the interests of managers differ from those of the shareholders. but to revise the concept we provide a brief explanation of economies of scale in finance – which arise where administrative costs per unit raised are less with large issues of finance than with small issues. As the growth through a takeover is quick. they only elect directors who are agents responsible for the choosing and monitoring of top management of the firm. Market power During the boom of 1979–85.

C. American Economic Review 26 (May 1986) pp. if a firm is not too familiar with its stock market valuation and its share price is low in relation to its actual potential. The same would apply if profitable growth opportunities were limited. then the former company is able to purchase the latter firm on advantageous terms. The point here is that the victims of takeovers are not necessarily the firms failing to make the most efficient use of their resources. 323–29. promising the shareholders of company A that they will be able to manage the assets of the firm better than the present managers. then this may make it an ideal takeover target. then the stock market value of the shareholders’ investments would increase more than if the money was distributed to shareholders. 1 Undervalued shares An acquisition can also occur when the stock market is underestimating the real value of a firm. Tax advantages The crucial point is whether or not the losses of one company can be used to offset the profits of another in the group. 1 Jensen. 125 . Free cash flow (trapped equity) Michael Jensen (1986) suggested that managers with cash flows in excess of those required to finance all positive NPV projects within a firm would use the excess resources to finance takeovers. if company A has inefficient management or they are neglecting the interests of shareholders then the managers of another firm. which would ultimately raise shareholders wealth in the future.Chapter 11: Mergers. The victims could actually be firms using assets to their best advantage but their share price may not fully reflect the true value of the firm and its assets. there would be tax benefits and second. Corporate Finance and Takeovers’. and rather than distribute the excess cash to the shareholders. company B will make a takeover bid for company A. High price/earnings ratios (bootstrapping) This was particularly important during the conglomerate merger booms of the 1960s. so as to reduce the overall groups taxation liability. ‘Agency Costs of Free Cash Flow. M. First. as banks and financial institutions are more likely to support a takeover bid from a company with a better stock market rating. Two benefits to shareholders were identified by Jensen concerning the free cash flow theory. they would use the funds to acquire other firms. In the UK. if the excess cash was used to finance a takeover in preference to a dividend. corporate restructuring and off-balance sheet funding How then do takeovers perform the disciplining function on inefficient management? For example. the law is more restrictive with regard to these considerations than in the US. If company A possesses a high stock market rating relative to another company B. For instance.

Briefly describe the benefits and limitations of four different economic theories of mergers. As firms in different industries experience booms and slumps in their profits and cash flows at different times. If company A purchases company B. The shareholders of company B will also have benefited as prior to the merger they held 1. the lower the share price of the acquirer. the share price will be £2.333.000 shares priced at £l. If the same P/E ratio is maintained for company A. If company A’s share price fell to £0.000 shares at £1) and 500 shares of company A (500 shares at £2) will need to be offered. Companies A and B each have 1. From this point of view takeovers reduce risk for companies.5 then 2000 shares would be needed.10 1. Activity 11.67.1 Discuss how merger waves may occur. the rationale for the mergers was said to be diversification. showing a gain for shareholders of company A of £0. as a firm can raise its EPS by merely acquiring other firms and not by normal trading. This is because they hold shares in company A which now has higher growth prospects.500 0.59 Financial management Worked example 15 If an acquisition is valued at £1.000 shares would need to be exchanged for the takeover.000 and the present market price of company A (purchaser) shares is £1. Risk diversification During the conglomerate merger boom of 1979–85.67 each giving a total value of £1.000 (1. then 1. The key to this type of problem lies in the earnings per share (EPS). valuing the company at £1. The position of company A after the purchase is as follows. which would not be in their interest. Total earnings Number of shares EPS £200 1.10 2. it was felt safer for firms to conglomerate to reduce this volatility.000 but after the takeover they hold 500 shares at £2.13 The EPS has increased due to purchasing company B.00 10:1 Company A has a higher P/E ratio because it is assumed to have a higher prospect of future growth.00 20:1 Company B 100 0. which would eventuate in the stability of future cash flows.000 shares outstanding Company A Total earnings EPS Share price P/E ratio 100 0. See VLE for solution Management motives In the traditional theory of takeovers it is assumed that one company (bidder/purchaser) seeks to acquire another company (target). the greater the number of shares (proportion of the acquirer) need to be exchanged. then the market value of company B is £1.67. therefore. It is in reality the management who initiate the bidding for the target on behalf 126 .

127 . 2 Jensen and Ruback (1983) referred to the takeover market as creating the ‘market for corporate control’. The rules will vary between countries. As already mentioned. managers are unable to diversify their risk. Takeover tactics • Rules governing takeovers in the UK • Bidding tactics • Market raids • Concert parties • The offer Rules governing takeovers in the UK Rules are self-regulatory and statutory: • the self-regulatory rules are known as the City Code on Takeovers and Mergers • the City Code is designed to protect shareholders • the City Code does not have the force of the law but all stock exchange listed firms must follow it • the major problem with the Code is that it cannot reverse events (impose sanctions after the event) • the statutory rules are governed by the Companies Acts.C. Activity 11. in which alternative managerial teams compete for the rights to manage corporate resources.S Ruback ‘ The Market for Corporate Control. The bidding management will make an offer to the target company’s shareholders. corporate restructuring and off-balance sheet funding of the shareholders of the bidding firm. Fair Trading Act and the Monopolies and Mergers Act • the objective of the Monopolies and Mergers Commission is to promote competition and prevent takeovers that reduce competition and are against the interest of the public • an EU takeover code and a statutory harmonisation code still needs to be developed. who are regarded as the activists in the takeover.2 Explain the role that takeovers play in disciplining inefficient management. See VLE for solution 2 Jensen. M. with or without agreement from the target company’s management. 5-50. The Scientific Evidence’ Journal of Financial Economics 11 (April 1983) pp. as they are tied to one firm usually. higher status and remuneration). Can you think of real examples that you have read about in the newspaper. Another motive for management might concern their own survival. The bidding company’s managers cannot diverge too much from shareholder wealth maximisation but they can and do take their own interests into account (i. the reduced risk of losing their job. This theory moves the emphasis from shareholders to the management of the company. It will obviously be the target company’s shareholders who will ultimately decide whether to sell their shares to an acquirer. and R.Chapter 11: Mergers.e. Thus by pursuing an active takeover strategy they are less likely to offer themselves as targets for takeover predators. Unlike shareholders.

However. so that no one individual owns or has an interest exceeding 5%. The offer only becomes unconditional (win/accepted) when the bidder has acquired over 50% of the voting equity. The offer The acquiring company first announces its intention to make an offer disclosing its terms to the board of the target firm. The raider achieves their acquisition objectives before they have to notify the target company of the acquisition. the consent of the targets board and the takeover panel may be required. the offer is posted disclosing the terms to the shareholders of the target. If the purchaser fails to acquire all the shares from the target firm’s shareholders then the remaining shareholders will become minority interests who will be entitled to receive dividends on their shares until they are sold. thus they do not need to notify the company of their holding. When only between 30–50% of the shares can be acquired. 128 . Almost always. only informed brokers acting on behalf of large institutional shareholders are quick enough to benefit from any market raids. In the meantime. Concert parties Concert parties occur where several persons act together to buy shares in a particular company. the value of the target’s assets. The factors which have been most commonly found to influence the size of the premium are: a. Market raids Market raids occur when a person or a company acts with speed of action in buying shares of a target company. In the UK.59 Financial management Bidding tactics Having decided to purchase a company. the problems that arise are: • what is the value of the company and • how to finance the purchase. whether there are any other firms keen to bid for the target b. recently in the UK the city code has been revised to strengthen the restrictions prior to the announcement of an offer in an effort to achieve equity between shareholders. this is the difference between the value of cash and securities being offered and the pre-bid market price of the target company. usually. debentures. The offer can be financed by the purchasing company’s equity. Dawn raids are ones which take place at the early minutes/hour after the stock exchange has opened. cash or other security. the levels of cash flow for the target and c. The disadvantage with raids is that the initial high price offered at the outset of the raid is not usually offered to all the shareholders and. The bidding company may have to obtain approval from its shareholders before the bid for the target can be made. the bidding firm has to offer a premium to the target’s shareholders. the board of the target must circulate its own view of the offer and suggest whether shareholders should accept the offer. Within a few days. both the stock exchange and the city code require concert parties to disclose any holding greater than 5% in total within 36 hours of an action. The idea is to make the offer as attractive as possible to the target company’s shareholders.

3 Under what circumstances are the rules and regulations which govern takeovers in the UK likely to prevent a takeover from occurring? Explain the following terms: • market raids • the offer. Crown jewels This defence involves a tactic of selling off certain highly-valued assets of the company subject to a bid: the intention being to put off any acquirer. they need to convince their shareholders of the benefits associated with the defence. In most takeover cases. shareholders are given the right to convert loan stock/preference shares into ordinary equity on the announcement of a takeover bid.Chapter 11: Mergers. the board of the target company may also offer future incentives to their shareholders such as higher future dividends/profits or even changing the management team. The city code makes it clear that shareholder approval is usually required before any approach to an outside party can be made. Poison pills Another defence occurs where a company takes steps before a takeover bid has been made to make it less attractive to a potential bidder. in this case the friendly acquirer is termed the white knight. corporate restructuring and off-balance sheet funding Activity 11. as the value of the firm will be substantially reduced with the ‘crown jewels’ sold off. Glamorous defence tactics • White knights • Poison pills • Crown jewels. Usually. Takeover defences The directors of a company that is the subject of a takeover bid should act in the best interests of the shareholders. White knights One defence the directors of the target company may employ is to offer the ownership of their firm to a more friendly outside interest (defensive merger). professional advisors are recruited in the preparation of any documents relating to bids and defences. In addition to these suggestions. the purchaser’s shares are overvalued or • the current market price offered by the purchasers is undervalued. It is a very successful strategy but should only be used as a last resort. If directors find a bid financially unattractive to their shareholders then in defence they may try to convince their shareholders that: • at the current market price. The city code on takeovers and mergers requires certain principles that must be met. If directors decide to fight the bid. there are many defences open to them. Before they decide to defend a bid. 129 .

we briefly outline other forms of corporate restructuring in addition to mergers and acquisitions. there are many problems involved in attempting to evaluate the results of divestment as the mechanics of divestment involve a number of important behavioural issues. means the sale of either a subsidiary. Typical mergers seem to realise positive net benefits for the shareholders of the acquiring firm. In concluding. several aspects of mergers have been discussed.59 Financial management Other tactics which you may be asked to discuss can be found in BMA chapter 32 are: • golden parachutes • pac-man • greenmail • producing a revised profit forecast • ESOP’s • shark repellents. namely divestments. on the other hand. 130 . premium buybacks. mergers are only one form of company restructuring. Company restructuring In the previous section of this chapter. although this term is usually reserved for describing the practice of selling unwanted or unprofitable parts of a business following an acquisition. mergers seem to generate economic gains. occur whether or not a company has been involved in takeover activity. This increased competitive pressure encouraged firms to reorganise their group structure into more specialised and smaller manageable units and sell off aspects of the business which were not likely to be profitable in the future. You should be aware that this section only briefly outlines corporate divestments. division or product line by one business to another. However. This came about partly due to the increased tendency of company management to concentrate on the strategic processes of the firm. These include: demergers (spin-offs). Divestments During the 1980s and 1990s a new trend in corporate restructuring was evidenced. going private. Practically. refinancing and reverse takeovers. and you should read about and understand the motives and methods behind the other forms of change in Chapter 33 of BMA. in additional to the financial issues. Selling the parts of a business can be seen as similar to ‘asset stripping’. or divestiture. The term divestment. probably the form which attracts the greatest media attention. namely a move towards company management adopting strategies of demerger or divestment. especially to focus on the core-business activities. In this section. during the 1970s many conglomerates (such as Hanson plc and ICI in the UK) sold off assets that they thought were unprofitable to them. A situation soon developed in the UK whereby conglomerates were seen as being risky and highly inefficient both from a managerial and an investor’s point of view. buy-outs/buy-ins. Therefore. Divestitures. but competition between bidders and active defence strategies by the target firm’s management may push most of the benefits to the selling shareholders.

Leasing has increasingly become a popular form of medium. In the case of an operating lease (which is usually for a shorter period than a finance lease) it is the lessor who is usually responsible for the maintenance of the asset and it is the lessor who loses should the asset become obsolete before the end of its useful economic life. given that a firm has a mix of business activities.or shortterm finance. a firm may be able to achieve a better value position for itself when it is more tax efficient to lease rather than own an asset. whilst. The difference between hire purchase and leasing is that the former agreement the ownership of the asset at the end of the hire purchase period transfers to the party which had made the hire purchase payments. But. a finance lease essentially passes the risks (maintenance) and rewards of ownership to the lessee over the useful economic life of the asset and who in turn agrees to pay fixed annual amounts. The major advantage of adopting a lease in preference to buying an asset is that it allows one party (the lessee) the use of an asset for a specified period of time. while the supplier of the asset (the lessor) still retains legal ownership. off-balance sheet financing is undertaken so that its effects will not influence the market’s view since it is not information that is publicly available and visible to investors and potential investors. Reasons for leasing The main reasons for leasing are as follows: • A company may not have the funds available to purchase the asset. The distinction between the is concerned with the risks and rewards associated with the ownership of the asset.Chapter 11: Mergers. at the end of the period of the lease the ownership of the assets remains with the lessor. There is a brief introduction in PA (pages 226–8). There are two broad types of lease: namely. Leasing The topic of leasing is not covered in BMM but BMA (Chapter 26) provides too much material on the topic as you are only required to possess a general understanding of what leasing entails. • There can be considerable tax advantage. For instance. 131 . The lessor is usually a finance company. finance leases and operating leases. yet it obviously contains information content. In reality. But at other times the effect is merely cosmetic. to make the balance sheet look different. Therefore in this section we analyse the ways in which off-balance sheet financing may add value to a firm. corporate restructuring and off-balance sheet funding Off-balance sheet funding This subject guide is. it can choose alternative ways of structuring its assets and liabilities to achieve the same business outcome. The lessee is usually the company making use of the equipment and in return paying a rental to the lessor. which purchases the asset and then leases it out for a period of time. in large part. about how to make investment and financing choices which add value. In contrast. The most common example of off-balance sheet financing involves the decision to lease assets rather than purchase them outright.

Suppose you are the financial manager in a large firm and have been asked by the board of directors who have been threatened by a takeover bid to describe some policies that the firm may adopt in defending the takeover bid. £ million Fixed assets net Current assets Less Current liabilities Less Long-term liabilities Ordinary share capital Share Premium Profit and Loss Account (50p shares) 800 (300) 500 860 (200) 660 50 250 360 660 (£1 shares) 360 200 (300) (100) 40 – 40 100 – (60) 40 Wilco plc £ million 140 132 . you should be able to: • explain the reasons why companies may decide to merge with another firm • describe the factors that may give rise to merger waves • explain the motives underlying individual mergers (including economic theories) • explain the role that takeovers play in removing inefficient management • describe the rules governing takeovers in the UK • describe takeover defences and any advantages and disadvantages they may have • describe the theory and evaluate the methods of company restructuring and refinancing • explain both the types and reasons underlying leasing. Jono plc is considering making an offer for Wilco plc. The abbreviated st financial accounts for the year ended 31 December 2008 for both companies are as follows: Balance Sheets as at 31 December 2008 Jono plc. Prepare a report describing the takeover defence policies you are likely to suggest.59 Financial management • A company may not wish to own a certain type of asset (such as a computer which may become out of date relatively quickly) • It is often suggested that leasing does not interfere with other borrowing or credit facilities. and having completed the Essential reading and activities. 2. Practise questions 1. A reminder of your learning outcomes By the end of this chapter.

8 and 11. whilst the average net dividend yield for the industry is 3% p.910–12. The after-tax profits of Wilco would increase to 10% of its turnover with no change in the after-tax profits of Jono. by the original owner and members of her family. REQUIRED a.Chapter 11: Mergers. 7. corporate restructuring and off-balance sheet funding Profit and Loss Accounts for year ended 31 December 2008 Rhy plc £ million Turnover Net Profit after tax Dividends proposed Profit Retained 2.000 100 50 50 Wilco plc £ million 500 1 1 0 Jono plc is a quoted public company with a price earnings (PE) ratio of 16x.a.. with the second expected to be successful if the first is not. earnings yield approach iii dividend approach. Calculate the maximum. Using the underlying rationale of the valuation methods to support your argument. its ordinary share capital is 40% owned by a group of business angels and the majority. 60%. The merchant bank report that the average net dividend yield for the market as a whole is 4% p. nos 6. in their view. that Jono could pay for a share in Wilco without loss of value to Jono shareholders. Provide valuations per share of both companies using three separate approaches: i. (9 marks) Problems Attempt the following problems in BMM: • Chapter 21. the PE ratio for the company would be 5x. numbers 1. Jono and its advisors have just completed their due diligence investigation of Wilco and believe that if the two companies were combined then. even with no change in the annual turnover of Wilco or Jono. Attempt the following problems in BMA: • pp. Jono and Wilco are in the same industry. there would be considerable savings in administration and other fixed overheads. in your view. net asset value ii. the combined company would have a PE ratio of 14x.a. 133 . (10 marks) b. and that if the two companies were to merge. provide a reasoned strategy for Jono to follow in bidding for the share capital of Wilco assuming they will only make a maximum of two offers. Wilco plc. The merchant bank advising Jono have indicated that if Wilco were a quoted company. 3 and 12. Give your reasons. is not a quoted company. (6 marks) c.

59 Financial management Notes 134 .

Associated Industrial Producers plc (AIP) is another Stock Exchange listed company which is identical to MIM in every respect except that it is financed 50% (based on market values of debt and equity) from a debenture loan. which has a yield of 10% per annum. Both the chairman and chief executive have recently expressed concern at the rising level of inflation within the economy and its implications for the financial management of the business. On the basis of your assessment of Jane’s position. Apart from the assumption of no taxes in part (a). with identical risk.000 to invest and wishes to make an investment either in MIM or AIR She is able to borrow as much money as she wishes. what is the theoretical price per share of the shares of MIM? b. Assess the position of Jane in respect of each of the two investment strategies. It is the business’s policy to pay all of its annual profit as a dividend to the shareholders.Appendix 1: Review questions Appendix 1: Review questions Read Chapter 26 in BMM. assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business and that there are no taxes. Jane is an individual who has £1. at an interest rate of 10% per annum. again assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business. and the remainder from equity. Question 2 Modern Industrial Manufacturers plc (MIM) is a Stock Exchange listed company. What will be the value of a share in MIM. within reason. Required: Prepare a report for the board of directors which sets out the ways in which inflation may effect the financial management of the business. Question 1 Simat plc produces electrical and electronic components for the defence industry. It will help you review and critique the subjects covered in this guide. This level of profit is expected to continue indefinitely.000 on shares in AIP. A board meeting has been arranged to discuss the issue. The current market price is £4 per share. AIP has 5 million shares in issue. MIM is all equity financed and generates a steady profit of £5 million a year. but that there is Corporation tax at 25%. or • make an investment in MIM which will provide her with an identical income. c. Required: a. above. MIM has 10 million shares in issue. Jane is contemplating two investment strategies: • spend all of her £1. what other assumptions have you made and how valid are they in real life? 135 .

Estimates have been made of the cash flows which will arise from the investment and the management is fairly confident of these estimates. A problem has arisen in selecting an appropriate cost of capital to apply to the cash flow estimates.5 28.5 19. 136 .0 James plc cum-div share price is £3. Average annual returns from short term UK government stocks over the past 10 years have been 10%. Capital asset pricing model Published sources reveal the following: James plc equity beta is 0. The two approaches and the relevant data for use are as follows: 1. Dividends per share for James plc over the past six years have been as follows: Year 1988 1989 1990 1991 1992 1993 Dividend per share (£) 15.5 17.90 Average annual returns from Stock Exchange listed companies over the past 10 years have been 18%. which will be issued at par with a coupon investment rate of 12% per annum. medium sized business. Use the information provided to deduce James plc’s cost of capital on both of the suggested approaches. nor has there been a recent sale of shares in the company.0 24. One of the staff of the business has recently complete an Economics degree. He has been asked to look into the problem of finding an appropriate cost of capital figure. The chosen figure will then be used in the assessment of Aspiration plc’s investment proposal. Because of the size of the outlay the business’s management is keen to assess the investment as carefully as possible. should it go ahead. The cash for the investment. particularly since the business’s shares are not traded on a Stock Exchange. Dividend valuation model The Gordon growth model will be used.47. b. 2. To what extent would the management of Aspiration plc be justified in using the figures calculated for James plc’s cost of capital (part (a)) to apply to the estimated cash flows of Aspirations plc’s investment proposal? Explain any reservations which you may have about using these figures. He has decided to select a business of similar size and activity to those of Aspiration plc and apply two approaches to deducing that business’s cost of capital. will come from debentures.5 22. Required: a. The management is contemplating making an investment which will expand its existing business. The business selected is James plc. which included a course in Financial Management.59 Financial management Question 3 Aspirations plc is an unquoted.

The level of sales for the next 12 month is expected to be £4m if there is no change in credit policy. b. All expenses are paid one month in arrears. and ii. c. cash discounts are introduced. to encourage customers to pay earlier. The variable costs of the business (excluding cash discounts) are expected to represent 15% of sales and fixed costs are £20. Required: a. This pattern is expected to continue in the forthcoming year if the current trade credit policy continues. Address critically the assumptions underlying your proposed method and. there is no change in credit policy. which sells all of its goods on credit. Having obtained the (β value for a business’s equity from a research source. cash discounts are introduced. whether or not the business should implement the proposed policy. Separately prepare a forecast profit and loss account for the business for the forthcoming year assuming: i. Briefly describe how the equity (β of a publicly quoted company could be estimated. there is no change in credit policy. Question 5 a. is currently reviewing its policy concerning trade credit. interpret the possible empirical results you could have obtained.000 at the year end. At present. The rate of corporation tax is 30%. c. However. The introduction of a cash discount scheme is likely to attract new customers and so a 10% increase in sales is predicted. Separately calculate the investment in working capital at the end of the forthcoming year assuming: i. discuss how and why it may have to be adapted if it is to be used by the business in evaluating a major investment. No cash discounts are currently offered to customers for prompt payment. and ii. in the light of those comments. b. It is expected that this incentive will lead to 50% of customers paying one month after the invoice date and the remainder paying two months after the invoice date. State. Describe and critically evaluate at least three methods of evaluating risk that might be used when a business is appraising a group of investments. The business also intends to achieve a cash balance of £50. 25% of trade debtors pay one month after the invoice date and the remainder pay two months after the invoice date. Trade creditors will represent two months’ cost of sales and the dividend payout ratio of the business is 60% of after tax profits.Appendix 1: Review questions Question 4 Cameron plc. the business is considering offering a 2% discount for those paying amounts outstanding in one month or less. the business will maintain a gross profit margin of 25% on all goods sold and will hold two months stock throughout the year. Whatever trade credit policy is adopted. 137 .000 per month. with reasons.

4875 .59 Financial management Question 6 a.5 4. Discuss briefly four techniques available to a company to use in hedging against foreign exchange risk arising from overseas trading.0 i. The directors of Atlane Ltd are currently considering the offer and have collected the following information: • New equipment costing £85.0 7.000 At the end of the three year contract the workers will no longer be required and redundancy payments of £2. You have been given a challenge as part of a competition to see who can make the most money through trading on the foreign exchange market. You are not allowed to borrow in the UK and invest the proceeds in Singapore. The wage costs for the additional workforce is expected to be £200.000 per worker will be paid. ii. The bank which is sponsoring the competition will lend up to 100. there are no transactions costs).0 Borrowing 11.000 per annum One third of this figure is arrived at by the reallocation of existing overheads to the contract. At the end of the three-year period the equipment will be sold for an estimated £6.1378 2. Take up the competition’s challenge and indicate your predicted maximum gain through your money market operations. 138 .0 7. The equipment required is highly specialised and can only be used by the company for production of the new fibre. Recruitment and selection costs.000 tonnes of the new fibre each year for a three-year period at a price of £44 per tonne. Question 7 Atlane Ltd has recently received an offer to produce a new type of synthetic fibre for a large international company. to be paid at the outset.e.5105 Fixed money market rates Lending Euro sterling (£) Euro dollar (US$) Singapore (S$) 6. Foreign exchange rates Singapore $/US$ Spot 3 months forward 2. • Eleven new workers will be required to help produce the fibre. Assume you can buy and sell the currencies at the same mid rate for the time period (i. iii. Indicate with evidence whether the S$ and US$ are in equilibrium together.000 units of the local currency at the going market rate.0039 US$/£ 1. • Overheads relating to the contract are estimated at £60.000 in the first year and will rise at a compound rate of 10% per annum. are expected to be £15. All other combinations are possible.000.0 11. borrow in Singapore and invest proceeds in UK. nor the reciprocal. b.000 will be required immediately in order to commence production. Indicate with evidence whether the £ sterling and US$ are in equilibrium together. The offer is to produce 14.

Prepare a statement showing those incremental cash flows which are relevant to a decision concerning whether or not to accept the offer. State whether or not you believe the offer should be accepted. The company already has 3.00 0. The company has 4. Present value of £1 receivable in ‘n’ years at 12%: n 0 1 2 3 12% 1.89 0. Required: a. The directors have agreed that. Ignore taxation. The original cost of this stock was £16 per tonne. The directors of Atlane believe that successful execution of the contract may result in further contracts being offered by the same company.000 tonnes of chemical ZF6 each year to produce the required amount of fibre. This chemical is widely used in other production processes of the company. c. Outline the basic principles to be applied when identifying relevant costs and benefits relating to the offer. b. The original cost of this stock is £22 per tonne and the replacement cost is £25 per tonne. • The production process also requires the use of 8.71 Question 8 Dewstone Ltd has received the following credit rating report on the customers in its industry. the existing stock of XT3 will be disposed of immediately at a cost to the company of £2 per tonne. Points rating classes Cumulative percentage of market sales 11 40 82 95 100 Cumulative percentages of sales which turn out good 2 15 54 66 71 of sales that turn out bad debts 9 25 28 29 29 0 – 19 0 – 39 0 – 59 0 – 79 0 – 100 139 . The replacement cost of the chemical is £20 per tonne.80 0.000 tonnes of chemical XT3 each year in order to produce the required amount of fibre.000 tonnes of this chemical in stock. The report gives the points rating for customers and the cumulative percentage of sales in the market that fall in that category or worse. however if the contract is not undertaken the chemical could not be used in any other of the company’s production processes or resold in the market. Calculate the net present value of the offer.000 tonnes of this chemical already in stock. The total market is estimated at sales of one million units of which Dewstone has 25%. if the new fibre is not produced. Atlane has an estimated annual cost of capital of 12%.Appendix 1: Review questions • The production process requires the use of 6. d.

000 405. Of the year’s sales of 1 million units 29% turn out to be bad debts.000 225.000. Assuming selling price and variable cost per unit are £20 and £11 respectively and fixed administration etc.000 £180. Using the credit rating agency estimates and the above company costs show what is the optimal credit policy for the company to follow (show your workings). etc Bad debt cost (25% × 1.000 175.000. Dewstone is considering restricting its sales personnel to making sales to customers with a credit rating of 60 or better. At present they estimate they will still only achieve success with 25% of the total market sales to customers with those ratings.000 140 .000 × 11 Contribtion Fixed – administration. Any customer with a 0–59 rating is rejected. Sales (25% × 1.000 for the year.000 50. Selling price/unit £20.000) × 18% × 20 Variable costs 45. b. check whether the predicted profit from the sales under the suggested credit policy are correct.01 × 20 Net profit Required: a.costs are £175. The following profit estimate is based on that assumption. 15% of the total markets sales turn out good and the balancing 25% turn out to be bad debts. = = 900.000 495.59 Financial management In other words 40% of the market’s sales are taken by customers with a rating of between 0 and 39.000) × .

• Financial reports. Where prices have to be established some time in advance. However. • Pricing policy. These may be important in the assessment of performance. 141 . lenders will normally expect to receive compensation for this in the form of a higher rate of interest. Financial reports based on the historic cost convention produce distorted results during a period of inflation. Rising prices may make it more difficult to forecast future receipts and payments during the period of an investment project. there may well be some customer resistance to attempts to pass on price increases and so any policy on this matter should be considered carefully. Underestimating the rate of inflation may result in a lower than expected profit or even a loss. This means that increased investment in working capital may well be required. The effect will be to overstate the return on capital employed. there will be a transfer of wealth from lenders to equity shareholders. Conversely. Some adjustment for inflation is required in order to ascertain the profitability of an investment proposal. which will reduce the amount available for retention or dividends and which may also result in the depletion of the capital base. • Working capital. The effect of overstating profit may be to encourage the payment of higher dividends. gains and losses from holding monetary items during a period of inflation are not recorded. Profits are understated and assets understated because of the time lag between acquiring and utilising resources. • Taxation and dividends. inflation can complicate matters. • Investment projects. the overstatement of profit may lead to higher tax payments. A fixed loan will mean that inflation will erode the value of the amount owing in real terms. The value of stocks and debtors held will increase during a period of inflation. In addition interest rates are likely to increase making it difficult to estimate the correct discount rate. In addition. Similarly. Escalation clauses may have to be built into long-term contracts in order to pass on the risk of price rises to the customer. overestimation may result in producing uncompetitive prices for goods and services which will again result in lower than expected profits. In effect.Appendix 2: Suggested solutions to review questions Appendix 2: Suggested solutions to review questions Solution to Question 1 The major ways in which inflation can have an effect on the financial management of a business are as follows: • Loan capital. However. Gains and losses in holding the monetary elements of working capital must be taken into account when considering the appropriate level of investment. If the dividends paid exceed the profit as measured in real terms the capital of the business will be eroded. although this is likely to be offset by an increase in trade creditors to some extent.

a share in MIM must be worth £3.00 87. b) Assuming a 25% rate of corporation tax. If MIM shares cost less than £4. Jane (and others) could achieve a better return on her investment than by an investment in AIR If the price were above £4.00 100. Jane could buy sufficient shares in MIM to gain an annual dividend of £250 and pay interest out of this of £100. This amount of interest (at 10%) would imply a loan of £1.50 Were Jane to buy shares in MIM Jane’s portion of the profit would be as follows: £ Profit per annum of AIP Corporation tax @ 25% Profit and dividend Less: interest on personal loan 250.0005 of the business. 0.000 2.50 per share.59 Financial management Solution to Question 2 a) If Jane has £1.000 to invest in AIP at a market price of £4 per share she can buy 250 shares. the value of a share is independent of the level of capital gearing. Thus must be the theoretical price of MIM shares. both risk and return. Market forces should ensure that this cannot happen.50 100. Were this not the case it would be possible to earn higher returns for the same risk by buying one share rather than the other.50/112.00 150.50 If a share in AIP is worth £4.50). on the basis of the assumptions stated below.00 37. 142 . investors could get better returns by an investment in AIR Market forces would drive the price of both shares to the same value. as had she bought shares in AIR.00 62.000.e. £4 × 87. Jane’s portion of the profit of AIP would be as follows: £ Profit per annum of AIP Less: Debenture interest Corporation tax @ 25% Profit and dividend 250.000 3. Thus if Jane paid £4 per share. This means.11 (i. she would be exactly as well off in terms of income. In order to generate a dividend of £250 Jane would need to buy 500 shares in MIM.000.50 112. because the business pays a dividend of £0.50 187. This would mean a total maximum expenditure on MIM shares of £2. Thus: Total £ million Profit per annum of AIP Less: debenture interest (10% x £20m) Profit and dividend 5.000 Jane’s portion £ 250 100 150 In order to have the same income with the same level of risk.

• Borrowing and lending rates are the same. thus the shareholders will not lose wealth as a result of the business being forced into liquidation because of the financial distress arising from capital gearing. Using the assumption of a compound annual growth rate. This seems unlikely to be true in real life. where the interest is allowable for tax. as compared with personal borrowing. corporate and ‘home-made’ gearing are not perfect substitutes for one another. then: DKNY = Dl(1+g)n–1 According to the Gordon dividend growth model 143 . Solution to Question 3 a. Generally. as in Gordon’s model. If individuals have to pay more to borrow than does the business. Gordon Dividend growth model basis The annual rate of dividend growth (for the current year) is calculated as: (Dividend of current year – dividend of previous year)/dividend of previous year. c) The main assumptions on which the above analysis is based are as follows: • There are no ‘bankruptcy’ (liquidation) costs. may not fully operate. it is probably the case that businesses can borrow more cheaply than can the average individual.Appendix 2: Suggested solutions to review questions The difference between the theoretical values of the two shares stems entirely from the greater tax efficiency of a business borrowing. This does not hold in real life. where there are identical returns. Unless this is valid the market forces necessary to drive share prices together. where the interest is not allowable for tax. • Interest rates are equal between individuals and businesses. • Shares can be bought and sold without dealing costs.

2244 or 22. set out below.19) + 0. This and other reasons. are based on historic data.9(0.47 – 028 = £3. next year’s dividend) P0=£3.e. • Is the quoted company (James plc) really comparable with Aspirations plc? They may operate in the same industry and be of similar size.10) = 0.1256) − £0. nevertheless be profoundly different in other significant ways. • The annual figures for past dividend growth are a little erratic. which makes the assumption that it will continue at the same rate as it has done historically. should cause management to view the results with some scepticism. the current ex-dividend price per share) i = (0. • The rates used in CAPM look to be incompatible as regards the treatment of taxation.1256 = 0. Inflation is incorporated into the analysis.172 or 17. the risk free rate.59 Financial management D1 = £0. Other relevant points include the following: • The inputs. for example the level of capital gearing. The past may provide a useful guide as to that which is likely to happen in the future.2% b. Both approaches are theoretically valid and should. but they could.e. The fact that the figures obtained using these two bases are different should be a cause for concern.3152 (i. The business is seeking a future cost of capital and should use estimates of the future in the analysis. but it is illogical to presume that the past will be precisely replicated in the future. rf. which raises doubts about using them as a guide for the future.18 – 0. the risk free rate looks as if it is a gross figure. βi(Erm – rf) are respectively the expected return from a particular security i.10 + 0.19 (i.44% Capital asset pricing model basis Eri = rf + βi (Erm – rf) where Eri.3152/3. 144 . therefore.28 × (1 + 0. produce the same result. whereas the expected return from the market is almost certainly an after-tax figure. which have been used for both models. the beta of a particular security i and the expected return from the market portfolio Eri = 0.

The benefits of increased sales to the business are more than offset by the cost of the cash discounts. Forecast profit and loss accounts Current policy £000 Sales Cost of sales (75% sales) Gross profit (25% sales) Less Variable costs (15% sales) Fixed costs Discounts allowed [2%(50% × £4.400 3.000 Cash discounts £000 £000 4.000 3.4m × 2/12) Cash Trade creditors (£3m × 2/12) (£3.300 1. The proposed policy leads to a slight reduction in working capital. Investment in working capital Current policy £000 Stock (£3m × 2/12) (£3.3m × 2/12) Accrued expenses fixed variable (600 × 1/12) (660 × 1/12) Taxation due Dividends due Working capital 48 67 685 448 50 55 47 65 737 413 20 20 500 550 50 1.4m)] Net profit before taxation Corporation tax (30%) Net profit after taxation Dividend (60%) Retained profit b. This is largely because the increase in stocks are more than offset by the decrease 145 .3m × 2/12) Trade debtors [25% × £4m × 1/12) + (75% × £4 × 2/12) [(50% × 4.100 The calculations reveal that the proposed policy to introduce cash discounts will lead to a marginal decline in profitability in the forthcoming year.000 1.4m × 1/12) + (50% × 4.150 500 550 £000 Cash discounts £000 £000 600 240 840 160 48 112 67 45 660 240 44 944 156 47 109 65 44 £000 4.133 583 550 50 1.Appendix 2: Suggested solutions to review questions Solution to Question 4 a.

low r2) and the estimates 146 . 1. the equity and debt betas and the market values for the equity and debt the company’s WACC can now be calculated. and thus the company will need to calculate its equity and debt betas and then weight them as above. Starting with the equity beta of a company. 5. The equity beta and debt beta can be calculated separately using regression analysis on time series data of the price relatives of the company’s equity and debt with the market index movements. it does not seem sensible to adopt the cash discount scheme. Yes. If the company is investing in a new commercial area then it will have to go to the market and find a company with the appropriate beta and return for that risk class. the quality of their estimates may be poor. To obtain the asset beta necessary for the calculation of the required rate of return to be used in the evaluation of a major physical investment requires a number of steps. Using the values for the market rate of return and the riskless rate. Is the company a geared company? No.59 Financial management in debtors and the increase in trade creditors. On the basis of the calculations above. Derive weighted average beta for the company using market values of debt and equity as weights for the debt and equity. ri is the return of the risk class i of which the company has no divisions MVi is the market value of the ith division MVd is the market value of the division d which wants to make the investment TMV is the Firms total market value. Where: rd id the desired rate of return. So if the company is a single industry company then the WACC will be the asset beta. Solution to Question 5 a. There are weaknesses in the model used to derive the ßs and thus the cost of capital. (See text) 3. 2. then equity beta is average asset beta for the company. If the company is a ‘single industry’ company then its asset beta is the same as weighted average beta. If the company has a portfolio of investments in a different risk class then use the following formula to solve to find the required rate. but in general the rates obtained are accurate enough for practical use. (i. However. Remember that the ßs are actually single period estimates. In practice they are available from brokers. b. thus WACC is the required rate of return. Thus knowing its own equity values will be of no use. 4.e. The rate needed is that one appropriate for the risk class of the investment under investigation. To do that requires estimates of equity and debt betas. this change does not compensate for the decline in profitability.

• The simplest technique is for a company to trade solely in its own currency. Then one selects. standard deviations and coefficient of variations. What this means is that there is a range of rates that one can choose from. Solution to Question 6 a. so transferring the risks to its customers or suppliers. This depends on its competitive situation as to whether it can use that approach. where the NPV for each project is calculated under three environments. thus locking the company into a given future payment for the future contracted date. The profit or loss on sale will correspond approximately to the loss or profit on the currency transaction they were hedging. since the projects’ results will not necessarily be straightforward to assess. If assessing the investments individually then one can compute their expected NPVs. The optimal combination is the one that provides the highest return R at the company’s risk level. A third way is to use the three point estimate approach. Moving away from the world of certainty means that there are no hard and fast decision rules which will ensure you select the optimal mix of investments. sales. They are usually sold before maturity since their prices move in response to forex price movements. c. Then there is the decision of selecting the appropriate riskless rate and market index bearing in mind they vary daily and there is more than one market index. either buying or selling the currency forward at the contracted rate. They are a form of insurance in that if the rates move favourably then the option can lapse and they can take advantage of the new favourable rate. The range is probably not too wide and is no more error prone than the figures estimated for the investments’ cash flows. • The company can use the financial future exchange and buy foreign currency futures. This allows for risk but not the benefits arising from diversification. The conceptually sound method of evaluating a group of investments is to use the portfolio approach where one combines the expected returns and standard deviations of the group of projects with those of the existing portfolio of assets. most likely and best possible. Futures are effectively forward contracts in standard sizes with fixed maturity dates. • The company can use the forward market contracts. otherwise the company avails itself of its option. 147 . etc. with the buyer acquiring the right to sell (put option) or buy (call option) a certain amount of a currency at a fixed rate on some future date. • Buying foreign currency options is a fourth way. are the most sensitive and thus the ones that need most careful management. costs. • The matching technique whereby assets and liabilities in a particular currency are netted off and any difference between the two kept as small as possible. worst possible. using rule of thumb. Finally one can use sensitivity analysis which will give the company an indicator as to which of the variables.Appendix 2: Suggested solutions to review questions could vary from one time period to the next. The following are techniques a company can use to protect itself from adverse foreign exchange movements.

Borrow $1 in USA and invest in UK then repatriate. The early conversion is undertaken to provide the protection against adverse exchange rate movements.0629 (loss) 2.0275 = $0.0775 – 1. = 1.0032 (Gain) 4. Proceeds of Investment – Cost of Borrowing = 0. 148 =1. Borrow S$1 in Singapore and invest proceeds in USA. convert it. Borrow £1 in UK and invest in USA then repatriate. i.) The size of the debt. = 1.0178 = −S$0. One is to compute the values in accordance with the basic equations: whether or not The second method. the frequency of the foreign trades.9549 – 1. as well as the level of market efficiency will influence the size and sophistication of the organisation used by a company. since this is a subject guide. (Note: More than the requested four answers were given in order to provide an indication of the majority of options. There are two ways to present the evidence on whether or not the market appears to be in equilibrium.59 Financial management • A further way is to use the money market hedge.0032 (Gain) . the degree of hardness in the currency of the trades. Borrow $1 in USA and invest proceeds in Singapore then repatriate. The reconverted amount should just equal the amount to be repaid if equilibrium holds. then repatriate.05 (Gain) 3. thus influencing the choice of techniques used.0307−1.0307 – 1. invest the conversion then reconvert the accumulated principal and interest. the variety and range of currencies used.0275 = $0. b. This is where one currency is borrowed. 1. which will be used here since it helps with the answer to the second part of the question is to see if it pays to borrow a unit of currency in one country.0275 =$0. rather than to provide an answer that precisely fits the requirements. converted into another which is invested to earn sufficient by the end of the original period to pay off the due debt in that currency. with the cost of protection being the difference between the cost of borrowing in one and the returns of investing in the other currency.

Acceptance of the offer would.00) £36.a.000.00 (94. Thus.80 28. However. the additional overheads (£40. therefore Gain 100. Incremental cash flows 0 £000 Sales Equipment Wages Recruitment & selection costs Overheads Disposal cost savings Cost of chemical XT3 Cost of chemical ZF6 (94) b.1378. If the bank will lend up to $100. therefore.000) resulting from the decision to accept the contract will be included in the analysis whereas those overheads reallocated (£20. 149 . ii. Net present value 0 Incremental cash flows Discount factor (12%) Present value Net present value (94) 1.000 gain. d.e. the ‘margin of safety’ relating to the offer is relatively low and further analysis to deal with the problems of risk and uncertainty would be prudent before a final decision is made. for example.000 Proof: = $5. increase the wealth of shareholders in Atlanta Ltd. The calculations in (b) above reveal that the offer has a positive net present value. a gain of 5%.89 103.6 1 116 0. for three months and selling forward the proceeds at the forward rate of S$2. From answer 2 above.42) 6 (60) (200) 116 (120) (200) 36 (120) (200) (2) (15) (40) (40) (40) (85) (200) (200) 1 £000 616 2 £000 616 3 £000 616 6 (242) c.000 Gain Solution to Question 7 a. those costs and benefits which vary as a result of the decision) should be taken into account whereas costs which are independent of the decision should be ignored. gain for $1 = $0.000 × $0. When identifying relevant costs and benefits the following principles should be applied: • Differential costs and benefits (i.0039 should give a $5.000) will be ignored as they will have to be paid whether or not the offer is accepted.000 then the gain to be made by borrowing $100..Appendix 2: Suggested solutions to review questions The computations suggests that the market is close to equilibrium except when one borrows in the USA and invests in Singapore.20 2 26 0.05. converting it at S$2. investing at 4% p. since traders cannot make material gains through arbitrage except through that one combination.71 (1.80 3 (2) 0.05 = $5.

000 units). £9.5 250 Good Sales Bad Sales (‘000) (‘000) 5 37.e.5 100 205 237. the Dewstone sales can only be .5 70 72. Since only (100 – 82) (i.5 72.500 units). Sales Less Less 150K units @ £20 variable costs @ £11 contribution overheads Administration. This means that the cost of stock already acquired by the company is irrelevant whereas the (future) replacement cost of the stock is relevant.350.5 22 62. 80–100 make incremental profits therefore the optimum credit policy is to restrict sales to customers with rating of 40 or better and a net profit of £975. No decision can be taken to alter the past and. 2.650.25 × 1 million(i.000 150 . Points rating 0–19 0–39 0–59 0–79 0–1000 Cum. 2.5 800 Incremental profit/class (£’000) (202. 45. Thus £180. (£’000) (202. • Only costs and benefits which can be expressed in cash terms should be taken into account.000 will be achieved.5 Contribution (‘000) 247. 60–79. 18% of the market sales are purchased by customers with ratings of 60 and above) then.5 2250 Bad debt Expense (‘000) (450) (1. therefore.000 1.e.000 375.000 200. the fact that successful execution of the contract may result in further benefits accruing to the company may be taken into account only if it is possible to quantify the expected benefits in cash terms. By computing the profit before fixed costs we can assess the optimum credit policy.18 × .400) (1.000 is the correct net profit. and sales to customers in each of the three rating classes 40–59.5 Note that sales to customers of rating 39 and below make losses.e.000 1.5) 795 242.5) (147.5) (350) 445 687. only future costs are relevant. (29 – 28)% × 25% of 1 million) will cost the company £20 per unit of lost revenue (i.000 £ 975.450) (1.5 900 1845 2137.5 112. Thus.250) (1. Solution to Question 8 1. etc Bad debts (10K@20) 175.e. Contribution per unit is £20 – £11.59 Financial management • Past costs are irrelevant to the decision to accept the offer.000 3. % sales 11 40 82 95 100 Dewstone Sales (‘000) 27. All bad sales (i. since Dewstone can only achieve 25% of that slice of the market.450) Net profit cum.000.5 135 165 177.

it must be detached and fastened securely inside the answer book. The format and structure of the examination may have changed since the publication of this subject guide. 151 . The make and type of machine must be clearly stated on the front cover of the answer book. 8-column accounting paper is provided at the end of this question paper. Workings should be submitted for all questions requiring calculations. Time allowed: three hours Candidates should answer FOUR of the following NINE questions: TWO from Section A. If used. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given in the Regulations. Any necessary assumptions introduced in answering a question are to be stated. All questions carry equal marks. You can find the most recent examination papers on the VLE where all changes to the format of the examination are posted. ONE from Section B and ONE further question from either section. Extracts from compound interest tables are given at the end of Section A of the paper.Appendix 3: Sample examination paper Appendix 3: Sample examination paper Important note: This Sample examination paper reflects the examination and assessment arrangements for this course in the academic year 2010−2011.

Required: a.000.000 per annum and $60. Briefly describe one way how the above analysis could be extended to incorporate a treatment of risk. Calculate the project’s net present value. (5 marks) 2. (You are reminded that four questions in total are to be attempted with at least one from Section B.) 1. Old line (per unit) c Materials Labour Variable overheads Fixed overheads Selling price Profit per unit 40 22 14 44 120 150 30 New line (per unit) c 36 10 14 20 80 150 70 Fixed overheads include depreciation on the old machine of $20. At present the line has a capacity of 650. The introduction of the new machine will enable stocks to be reduced by $80.000 units per annum. It will replace equipment with a scrap value of $25.000 and a book written-down value of $90. 152 . fixed overheads are unlikely to change. Splott Engineers Limited manufacturers components for the car industry. The new line has a capacity of 750. He is near retirement and he would like to sell some of his shares in the company and then also to raise further equity to reduce its gearing. The automated equipment will cost $350. You should ignore taxation.000.000 for the new machine. He understands that one way to do this. Calculate the project’s approximate internal rate of return. (8 marks) b. Its life is expected to be 5 years and its scrap value at that time $50.000 units per annum. Discuss which method you consider to be preferable and under what sets of circumstances.000 units per annum but typically it has only been run at 80% of capacity because of the lack of demand for its output. The accountant has prepared the following cost estimates based on output of 500. Explain the terms net present value and internal rate of return.000. Prepare a statement of the incremental cash flows arising from the project. Your client is the owner of a small group of hotels. It is considered that for the company overall.59 Financial management SECTION A Answer two questions from this section and not more than one further question. It is considering automating its line for producing crankshaft casings. (3 marks) d. is to seek a quotation on the unlisted securities market. The company uses 10% as its cost of capital.000. An extract of some recent accounts of the company appear below. (2 marks) c. Give a brief critique of the method you have selected. (7 marks) e.

1 0.4 13.12.Appendix 3: Sample examination paper Profit and loss data 31.9 4.0 16.9 3.4 13.4 2012 7.6 3.2 16.5 36.9 4.1 million and after tax at £3.5 1.08 £ million Sales Profit before interest and tax Interest Profit before tax Taxation Profit after taxation Retained Balance sheet data Fixed assets Less: Depreciation Current assets Stock Debtors Cash Less creditors (Amount due in under 1 year) Trade creditors Taxation Dividends Net current assets Total assets less current liabilities Less: Loans (due in over 1 year) Net assets Capital and reserves Share capital* Reserves * 5p shares Profit before tax for 2009 is forecast at £6. 153 .8 36. it would anticipate paying out 2/3rds its income as dividends. If the group went public.2 1.9 2.9 2011 7.5 43.6 31.8 1.5 1.5 1.2 47.7 31.5 12.0 6.3 1.3 3.4 54.0 34.8 0.5 3.7 2015–30 9.9 0.5 15.0 10.07 £ million 33.12.5 1.3 million.5 43.7 2.0 5.5 9.3 1.3 3.0 8.1 7. An analyst forecasts the free cash flow of the company to be: 2010 £ millions 6.9 1.1 1.3 22.5 1. Similar hotel groups have price earnings ratios of approximately 17 times and dividend yields of approximately 4%.5 The company’s cost of capital is 12% net of tax.8 1.9 0.3 2.8 0. A surveyor has recently valued the fixed assets of the group at £93 million.8 8.8 0.1 3.8 2013 8.4 2014 8.

Prepare a forecast balance sheet at 30 June 2008. (5 marks) c. i. Prospective price earnings ration iii. These fittings are to be depreciated over 3 years on the straight-line basis (their scrap value is assumed to be zero at the end of their lives). Other costs shown above do not include rent and rates of £20.000 per quarter.0 61. The sales and purchases forecast for the company are as follows: Jan £000 Sales Purchases Other costs* 20. All other costs will be paid in cash.0 108. Osmond Limited is a small company to be formed by Conny and Winnie Bond to sell an exclusive range of furnishings from a boutique in a fashionable suburb of London.0 Feb Mar Apr May June Total * These include wages but exclude depreciation.6 50. One month’s credit is allowed by suppliers. Calculate how many shares need to be issued to reduce the company’s gearings so that it has the same amount of long-term debt as equity. Closing stock at the end of June is expected to be £116. (5 marks) d. Free cash flow (4 marks) (4 marks) (4 marks) (4 marks) b. For your convenience you are advised to work to the nearest £’000.2 60.0 81. (6 marks) c. commenting on the practical and theoretical merit of each basis used. You should refer both to its profitability and liquidity. You should ignore taxation.2 50.0 320.4 40. payable on 1 January and 1 April. (7 marks) 154 .0 18.59 Financial management Required: a. Comment briefly on the financial prospects of Osmond. Select the share price from the above calculations at which the company’s shares should be issued.0 102.0 61. Prepare a forecast profit and loss account for the same period.0 18. In January 2008 they plan to invest £100.000 £1 shares each in the company.0 81. Net assets ii.0 18. A half-year’s depreciation is to be charged in the first six months. Required: a.0 18.000. Calculate the value of one 5p share in the company on each of the following bases.0 18.000 cash to purchase 50. Prepare a cash forecast for each of the six months to 30 June 2008. with your reasons for selection. Of this £60. The credit card company will take one month to pay and will deduct its fee of 2% of gross sales before paying amounts due to Osmond Limited. The sales will all be made by credit card.0 60.000 is to be invested in new fittings in January. (3 marks) 3. Dividend yield iv. (8 marks) b.6 60.0 408.0 18.

Proposal B The company is also considering whether it should factor its trade debts. The company is currently reviewing its credit policies to see whether more efficient and profitable methods could be employed.000 per annum. which is equivalent to that of its major competitors. The bank has written recently to the company stating that it would like to see a reduction in the overdraft of the company.2 million at an interest rate of 14% per annum. Two major proposals have so far been put forward concerning the management of trade credit. (10 marks) b. Explain which of the two proposals (if either) you would support and why? (5 marks) 155 . The accounts department has recently approached a factoring company which has agreed to provide an advance equivalent to 80% of trade debtors (based on an average settlement period of 40 days) at an interest rate of 12%.000. at present. Trilley Building Supplies Ltd has an annual turnover of £25 million before taking into account bad debts of £150. The factoring company will undertake collection of the trade debts and will charge a fee of 2% of sales turnover for this service. The credit department are confident that these new policies will not result in any reduction in sales. adopting the proposals of the credit control department (10 marks) or ii. The settlement period for trade debtors will be reduced to an average of 40 days. All sales made by the company are on credit and. a maximum of 50 days credit should be given. On average. The factoring service is also expected to eliminate bad debts and will lead to credit administration savings of £130. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. As less time will be spent chasing debtors. Required: a. The company currently has an overdraft of £5.000 in the credit control administration can be made if the new policies are adopted. the settlement period for trade debtors is 60 days. The credit department believes that all bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures costing an additional £50. savings of £60. credit terms are negotiable by the customer. factoring the debts of the company. These are as follows: Proposal A The credit control department has proposed that customers should be given a 2.5% discount if they pay within 30 days.Appendix 3: Sample examination paper 4.000. For those who do not pay within this period. Calculate for each proposal the net annual cost (savings) to the company of changing its existing credit policies and either i.

Some authorities maintain that the dividend payout ratio is unimportant. Describe and discuss the relevance of the Fisher Effect and the Purchasing Power Parity theories to a foreign currency dealer in a merchant back in London (25 marks) 9. However for assessing the viability of capital projects cash flow forecasts are used.) 5. Describe two methods whereby a company may estimate its costs of equity capital. Assume a quoted British company wants to use the CAPM approach in deriving the hurdle rate (cost of capital) it will use in evaluating its major investments. a. Explain and evaluate this apparent anomaly. (13 marks) 7.59 Financial management SECTION B Answer one question from this section and not more than one further question. the stockmarkets of the world will never achieve th ‘‘strong fom’’ of the efficient market hypothesis. What are the advantages and limitations of each method? (13 marks) 6. (12 marks) b. a. Rights issue iii. Describe and discuss the problems the company faces in trying to achieve the use of a single period empirically determined and market based hurdle rate. (You are reminded that four questions in total are to be attempted with at least two from Section A. (25 marks) END OF PAPER 156 . However press comments suggest otherwise. Offer for sale ii. (12 marks) b. in your view. Discuss why these authorities believe the dividend payout ratio to be irrelevant and give your own views on this matter. (25 marks) 8. Accountants place considerable emphasis on profit when reporting results to shareholders. Securities can be issued using the following methods: i. Discuss why. Tender issue Describe briefly each method and state where its use might be appropriate.

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