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Business Management

Study Manuals
Advanced Diploma in
Business Management
The Association of Business Executives
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Advanced Diploma in Business Management
Unit Title Page
1 The Context of Corporate Finance 1
Introduction 2
Basic Principles of Companies 3
Financial Objectives 6
Corporate Governance 10
Corporate Financial Management 24
2 Company Performance, Valuation and Failure 35
Introduction 37
Ratio Analysis 37
Using Ratio Analysis 44
Introduction to Share Valuation 51
Methods of Share and Company Valuation 52
Non-financial Factors Affecting Share Valuation 61
Predicting Company Failure 61
Capital Reconstruction Schemes 64
3 Acquisitions and Mergers 67
Introduction 69
Company Growth 69
The Regulation of Takeovers 73
The Acquisition/Merger Process 78
Measuring the Success and Failure of Mergers and Takeovers 82
Disinvestment 86
4 Financial Markets 91
Introduction 92
Stock Markets 92
Other Sources of Finance 99
Other Financial Markets 102
Recent Changes in Capital Markets 103
Impact of the Markets on Market Decisions 103
5 Sources of Company Finance 105
Introduction 107
Share Capital 107
Methods of Issuing Shares 110
Share Repurchases 116
Debt and Other Forms of Loan Capital 118
Short-Term Finance 129
International Capital Markets 134
Finance and the Smaller Business 136
Unit Title Page
6 Cost of Finance 143
Introduction 145
Investors and the Cost of Capital 145
Cost of Equity 146
Cost of Debt Capital 149
Cost of Internally Generated Funds 153
Weighted Average Cost of Capital 154
Assessment of Risk in the Debt Versus Equity Decision 157
Cost of Capital for Other Organisations 159
7 Portfolio Theory and Market Efficiency 161
Introduction 162
Risk and Return 162
The Impact of Diversification 164
Portfolio Composition 168
The Application of Portfolio Theory 175
Market Efficiency 177
8 The Capital Asset Pricing Model 189
Introduction 190
Risk, Return and CAPM 190
Calculation of Betas 196
Validity of the CAPM 197
Practical Applications of CAPM 199
The Arbitrage Pricing Model 200
9 Capital Structure 203
Introduction 204
Capital Gearing 204
Factors Determining Capital Structure 208
Theory of Capital Structure 211
Capital Gearing and the Effects on Equity Betas 217
Operational Gearing 218
10 Corporate Dividend Policy 221
Introduction 222
Key Influences on Dividend Policy 222
Theories of Dividend Policy 228
Practical Aspects of Dividend Policy 229
11 Working Capital and Short-Term Asset Management 233
Introduction 235
Working Capital 235
Overtrading 243
Cash Management 245
Management of Stocks 251
Management of Debtors 256
Creditor Management 263
Short-Term Finance and Investment 263
Unit Title Page
12 Capital Investment Decision Making 1: Basic Appraisal Techniques 275
Introduction 277
Future Cash Flows and the Time Value of Money 277
Return on Investment (Accounting Rate Of Return) 278
Payback 279
Discounted Cash Flow 280
Net Present Value (NPV) 281
Internal Rate of Return 288
Cost/Benefit Ratio 291
Comparison of Methods 291
Impact of Taxation on Capital Investment Appraisal 292
Appendix: Discounting Tables 296
13 Capital Investment Decision Making 2: Further Considerations 307
Introduction 308
Allowance for Risk and Uncertainty 308
Impact of Inflation and Taxation on Investment Appraisal 311
Capital Rationing 312
Lease Versus Buy Decisions 313
Adjusted Present Value (APV) 316
Use of the Capital Asset Pricing Model 319
Worked Examples 319
14 Managing Risk 339
The Nature of Risk 341
Principles of Hedging 343
Interest Rates, Risk and Exposure 346
Internal Techniques of Managing Interest Rate Exposure 350
Futures Contracts 350
Forward Rate Agreements (FRAs) 354
Interest Rate Swaps 355
Options 357
15 International Trade and Finance 371
Introduction 373
Theory and Practice of International Trade 373
International Investment 380
Finance and International Trade 383
Exchange Rates 394
Risk and International Trade/Finance 400
Internal Methods of Managing Exchange Rate Risk and Exposure 402
External Methods of Managing Exchange Rate Risk and Exposure 404
© ABE and RRC
Study Unit 1
The Context of Corporate Finance
Contents Page
Introduction 2
A. Basic Principles of Companies 3
Types of Company 3
Regulatory Framework for Companies 4
B. Financial Objectives 6
The Prime Objective 6
Valuation of Companies 7
Shareholder Value Analysis (SVA) 8
Long-term Versus Short-term Objectives 8
Objectives of Multi-National Companies 8
Objectives of Public Sector Organisations 8
C. Corporate Governance 10
Company Stakeholders 10
Management/Shareholder Relationship and Agency Theory 15
The Cadbury Report 16
The Greenbury Report 18
Hampel Committee Report 19
The Combined Code 19
The Turnbull Report 21
Financial Services and Markets Act, 2000 and the FSA 22
The Higgs and Smith Reports 22
Other Disclosure and Behaviour Compliance Provisions 24
D. Corporate Financial Management 24
Financial Decision Making 24
Financial Functions in Organisations 25
The Role of the Finance Manager 26
Planning 28
Forecasting 29
Budgeting 29
Cash Management 30
Economic and Government Influences 32
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Corporate finance covers a wide range of topics and functions within an organisation. The
three main areas we will look at in this course relate to answers to the following questions:
 Which investments should the firm undertake?
 How, where, when and how much finance should be raised?
 How should the firm's profits be used or distributed?
These questions are more commonly referred to as:
(a) The investment decision
(b) The financing decision
(c) The dividend decision.
In making such decisions, the firm must ensure that it achieves its objectives. Central to this
first unit, then, is the issue of what the objectives of companies are. This is our first main
area of study.
The prime objective is often stated as the maximisation of shareholder wealth. This would
imply that companies must be run in the interests of shareholders. However, there are a
range of interests involved in the way in which companies are managed. We shall examine
these in the second main section of the unit and consider, in particular, the importance of the
stakeholder concept and the tensions that arise from the different interests involved.
Finally, we turn to the scope of corporate financial management. We shall develop the
issues of financial decision-making referred to above and consider their implications for the
range of financial functions carried out in modern organisations and the roles required of the
finance manager.
The modern financial manager also needs to consider two different issues:
 Risk. Some of the financial decisions made will incur little risk, for example, investing
in Government backed bonds, but other areas of investment, such as investing in
derivatives, will incur a lot of risk. There is a balance to be struck between the return
that can be expected and the risk involved with the particular investment concerned.
 The strategic role of the modern financial manager. There is an ever increasing need
in the modern business world for key staff, including the financial manager, to play a
key role in the strategic vision and environment within which the business is operating.
There needs to be input at all three levels of strategic involvement – ie at a strategic
level for broad issues, at a business or competitor level in respect of how strategic
vision can be turned into reality, and at an operational level for how the broader plans
can be turned into operational success.
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We shall start by reviewing two fundamental concepts relating to companies which underpin
much of our studies.
Types of Company
When a company is formed, the person or people forming it decide whether its members'
liability will be limited by shares. The memorandum of association (one of the documents by
which the company is formed) will state:
 the amount of share capital the company will have; and
 the division of the share capital into shares of a fixed amount.
The members must agree to take some, or all, of the shares when the company is registered.
The memorandum of association must show the names of the people who have agreed to
take shares and the number of shares each will take. These people are called the
A company is a separate legal entity, which means that it may take legal action against its
shareholders or vice versa. Limited liability companies have capital divided into shares. If a
shareholder has paid in full for his or her shares, then liability is limited to those shares. This
is the concept of limited liability.
The two main classes of limited company are public and private companies:
(a) Public companies
Company legislation defines a public company as one which:
 Has an authorised share capital of at least £50,000;
 Is trading a minimum of £50,000 issued share capital
 Has a minimum membership of two (there is no maximum);
 Has a name ending with "public limited company" or plc.
Not all public companies have shares which are traded on the Stock Exchange. Those
traded on the Stock Exchange are known as quoted or listed companies.
(a) Private companies
A private company can be formed by two or more persons. They are often smaller or
family owned businesses. A private company:
 Can have an authorised share capital of less than £50,000, although there is no
maximum to any company's authorised share capital and no minimum share
capital for private limited companies.
 Cannot offer its shares for sale to the general public.
You may know of private companies which have become public companies and have
started to trade on the Stock Exchange. An example was the clothing retailer Laura
Ashley which started life as a family owned private company.
The amount of share capital stated in the memorandum of association is the company's
"authorised" capital
 A company can increase its authorised share capital by passing an ordinary resolution
(unless its articles of association require a special or extraordinary resolution). A copy
of the resolution – and notice of the increase on Form 123 – must reach Companies
House within 15 days of being passed.
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 A company can decrease its authorised share capital by passing an ordinary resolution
to cancel shares which have not been taken or agreed to be taken by any person.
Notice of the cancellation, on Form 122, must reach Companies House within one
Issued capital is the value of the shares issued to shareholders. This means the nominal
value of the shares rather than their actual worth. The amount of issued capital cannot
exceed the amount of the authorised capital.
A company need not issue all its capital at once, but a public limited company must have at
least £50,000 of allotted share capital. Of this, 25% of the nominal value of each share and
any premium must be paid up before it can can get a trading certificate allowing it to
commence business and borrow.
A company may increase its issued capital by allotting more shares, but only up to the
maximum allowed by its authorised capital. Allotments must only be done under proper
 A public company may offer shares to the general public. Share offers to the public are
made in a prospectus or are accompanied by listing particulars.
 A private company is normally restricted to issuing shares to its members, to staff and
their families, and to debenture holders. However, by private arrangement, the
company may issue shares to anyone it chooses.
"Allotment" is the process by which people become members of a company. Subscribers to
a company's memorandum agree to take shares on incorporation and the shares are
regarded as "allotted" on incorporation.
Later, more people may be admitted as members of the company and be allotted shares.
However, the directors must not allot shares without the authority of the existing
shareholders. The authority will either be stated in the company's articles of association or
given to the directors by resolution passed at a general meeting of the company.
Regulatory Framework for Companies
The main legislation regulating companies is the Companies Act 1985 and the Companies
Act 1989. The 1989 Act added to and amended the 1985 Act, but this is now being
superceded by the Companies Act 2006.
The 1985 and 1989 Acts have been changed in order to meet four key objectives:
 To enhance shareholder engagement and a long term investment culture;
 To ensure better regulation and a 'Think Small First' approach; lst
 To make it easier to set up and run a company; and
 To provide flexibility for the future.
Following the establishment of a Company Law Review Group in 1998 to consider in detail
the modernisation of company law, The subsequent report of this group formed the basis of a
White Paper for consultation in March 2005 and eventually the new Companies Act was
passed in November 2006.
Some of the key effects resulting from the Act include the following.
(a) Applying to all companies:
 A clear statement of directors' general duties clarifies the existing case law based
 Companies will be able to make greater use of electronic communications for
communications with shareholders.
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 Directors will automatically have the option of filing a service address on the
public record (rather than their private home address).
 Directors must be at least 16 years old, and all companies must have one natural
person as a director – i.e. they cannot have all corporate directors.
 There will be improved rules for company names.
 Companies will no longer be required to specify their objects on incorporation.
 The articles will form the basis of the company's constitution.
(a) Applying to private companies:
 There will be separate and simpler model Articles of Association for private
 As part of the "think small first" agenda, there will be a separate, comprehensive
code of accounting and reporting requirements for small companies.
 Private companies will not be required to have a company secretary.
 Private companies will not need to hold an annual general meeting unless they
positively opt to do so.
 It will be easier for companies to take decisions by written resolutions.
 There will be simpler rules on share capital, removing provisions that are largely
irrelevant to the vast majority of private companies and their creditors.
(c) Benefits to shareholders:
 There will be greater rights for nominee shareholders, including the right to
receive information electronically or in hard copy if they so wish
 There will be more timely accountability to shareholders by requiring public
companies to hold their AGM within 6 months of the financial year-end.
This 2006 Act is a piece of primary legislation under which number of provisions are currently
being set out in secondary legislation, mainly through regulations or orders made by statutory
instrument. It will not be fully implemented until October 2009, although parts of it were
implementated in April 2007, October 2007 and April 2008. (Full details can be found on the
Department for Business, Enterprise and Regulatory Reform (BERR) and the Companies
House websites.)
The following changes came into force in April 2007:
 Removal of the maximum age limit (which was 70) for directors of PLCs
 Directors no longer need to provide details of their interests in shares or debentures of
the company or its group – the result being that Companies House no longer accepts
Form 325 (Location of Register of director's interests in shares) or Form 325a (Notice
for inspection of a register of directors interests in shares kept in a non-legible format)
 There will no longer be a statutory annual report by the Secretary of State to Parliament
(the "Companies In" report), but BERR will continue to produce the information.
 Directors are not required to disclose their interests in shares in the Directors report of
the Annual Accounts for reports signed on or after 6 April 2007.
 Takeover forms have been replaced with forms that align with the clauses of the new
Act – 429(4) Notice of non-assenting shareholders will become Form 980(1); 429dec
Statutory Declaration relating to a Notice to non-assenting shares will become Form
980(dec); and 430A Notice to non-assenting shareholders will become Form 984.
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In addition, UK company law must also incorporate European company law directives. For
example, the European Eighth Directive on company law required more direct control of
auditors and therefore the Companies Act 1989 introduced the concept of supervision of
auditors. There is an ever increasing amount of legislation being enacted by the EU and the
following examples illustrate the many different items currently being added to existing UK
legislation in place for limited companies :
 Company Disclosures – 4
and 7
Company Law (Accounting) Directives
 The Companies (Cross-Border Mergers) Regulations 2007
 Implementation of Directive 2006/43/EC on Statutory Audits of Annual and
Consolidated Accounts (8th Company Law Directive)
 Shareholders' Rights Directive
 Simplification of Capital Maintenance Rules – 2
Company Law Directive.
Companies are also regulated in other ways:
 The production of company financial statements must be prepared in accordance with
UK accounting standards. These are issued by the Accounting Standards Board
(ASB). Recent legal opinion has now established accounting standards as a source of
 Another key area of regulation for the privatised utility companies are the consumer
watchdogs – for example, Oftel which regulates British Telecom.
 Case law is also a very important aspect of company regulation. Try to think of
examples from your legal studies.
The Prime Objective
The underlying assumption of the theory of finance states that:
"the main objective of the firm is the maximisation of shareholder wealth in
the long term".
In order to maximise shareholder wealth the management must maximise the value of the
firm, because the legal owners of the company are the shareholders, and all surplus value
after creditors and other liabilities have been met belongs to them. Thus the greater the
value of the firm after liabilities, the greater the wealth of the shareholders. The value of the
firm and shareholder wealth are represented by the market price of the company's shares,
which is the amount a shareholder could obtain for selling his part of the business as a going
It may seem to be a strange choice of major objective, but perhaps by thinking about some
other likely objectives you will appreciate why the maximisation of shareholder wealth is the
major objective of firms.
(a) The maximisation of company profits is often considered to be a major objective of
firms. Clearly it is important, but even when there are rising profits the value of shares
(and thus shareholder wealth) can fall. Can you think of how this might happen?
There are several ways in which it may occur; one is when a company raises additional
share capital in order to fund an investment to increase profits, but may cause earnings
per share to fall (there being more shareholders to share in the profits), thus resulting in
a fall in share price. Consider the following example.
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A company currently has 200,000 shares in issue and has expected profits of £50,000,
thus EPS (earnings per share) are 25p. If the company issues a further 100,000 £1
shares to invest in a project which will give a 10% return on investment, then expected
profits will increase by £10,000. However, there are now 300,000 shares in issue, and
the EPS has fallen to 20p (£10,000 + £50,000/300,000 shares). The falling EPS
causes the share price to drop, and shareholder wealth is therefore also reduced.
(b) Another objective you might feel to be important is the maximisation of balance sheet
or asset values. Whilst a company's balance sheet is important to investors, you will
discover from this course and your accountancy studies that balance sheets do not
reflect a true and up-to-date valuation of the company and its assets, and thus cannot
be relied upon to determine the worth of the company.
All of the objectives we have considered so far are financial objectives. In addition, a
company will have important non-financial objectives which might include:
 Raising the skills of the workforce – perhaps through training and appraisal
 Adhering to environmental legislation – for example, by reducing pollution emissions
 The provision of a quality service to customers.
Increasing importance is now being placed on business survival. The modern market place
for most businesses is becoming truly world-wide and this when, added to government and
political influence and interference, presents much greater challenges than existed a few
decades ago. The modern business will need to adapt and change continually to ensure that
it survives, and continued growth is one of the keys to survival and one that all today's
businesses strive for.
Another area that is increasing in importance in the modern business world is social
responsibility. Some businesses have adopted social responsibility as a key objective to
work alongside their other main goals and objectives, and this is increasingly being seen in
explicit policies in both such traditional areas as good working conditions for staff, providing a
good all round product for customers and helping provide adequate and competent training
for staff and the local labour force, and also in more modern areas such as reducing
environmental pollution or stopping corrupt promotional practices.
Financial and non-financial objectives are both important to a company. They may
sometimes be in conflict, but often they are complementary. For example, training the
workforce will increase costs initially, but should result in increased production which will
generate additional profit for the company. There is also the recent example of many food
manufacturers spending time and resources on the issues of obesity in respect of their
products and, whilst it is very much in line with not having their profits adversely affected, it is
also an serious attempt to address their social responsibilities.
Valuation of Companies
In order to achieve the main objective of maximising shareholder wealth we have to
determine exactly how we value companies and their shares. Shareholder wealth obtained
from a company is measured by increases in the price of shares above the price the
shareholder paid for them (capital gains) and dividends received. You will see later that the
price of a share is strongly affected by expectations of future dividends (the higher the
expected dividends the higher the share price), and thus we can conclude that shareholder
wealth can be maximised by maximising a company's share price.
Management should therefore set itself financial targets directly related to maximising
shareholder wealth, but how can this be done?
 The price of a company's shares reflects the future earnings of the company so, in
order to maximise shareholder wealth, the company must invest in those projects
which give the highest value over time.
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 Increasing earnings per share and dividends per share also increases the share price,
and firms should take decisions which allow a potential for maximisation of future
dividends and earnings.
 By maximising profits – whilst we noted that maximising profits does not always
increase shareholder wealth, in general it does and firms should aim to achieve this
whilst considering the points raised above. Firms, however, should take care not to
take undue risks when attempting to maximise their profits.
Shareholder Value Analysis (SVA)
SVA utilises the concept of NPV (net present value, which we shall discuss later) and argues
that the value of an organisation is the net present value of its net future cash flows
discounted at its appropriate cost of capital.
SVA states that managers should concentrate on the value drivers, which are the factors
which maximise shareholder value. They include:
 Growth in sales
 Profit margins
 Investment in fixed assets
 Investment in working capital
 The cost of capital
 The tax rate.
Management must identify the value drivers, cash flows and risks that result from investment
options and aim to maximise value in the long term. Whilst this approach is popular in
several companies (well-known examples being Disney and Pepsi) it relies on subjective
judgments of cash flows in the future, and so does not have universal appeal.
Long-term Versus Short-term Objectives
Unfortunately, the Stock Market is often more concerned with short-term increases in share
prices rather than the maximisation of long-term profits (short-termism) e.g. choosing the
project with the higher profits in the first year rather than over the life of projects. Often
companies have to trade off short-term gains (e.g. achieving an earnings figure for a financial
year) against acting in the best interests of the company in the long term (e.g. investing in
future training and development expenditure).
Objectives of Multi-National Companies
The objectives of multinational companies (MNC) are similar to those of other organisations
but may be more complicated due to the number of differing views and requirements of the
different countries they are based in.
Objectives of Public Sector Organisations
Characteristics of organisations generally considered to be within the public sector include
being non-profit making, with the Government accepting full, or a degree of, responsibility for
their performance and exercising some measure of control over their activities. Broadly the
public sector encompasses central government departments, local authorities, the Health
Service, the police, and public bodies which receive their principal financing from central and
local government (e.g. the Arts Council, the Fire Service, The Sports Council), plus
nationalised industries (see below).
These bodies are statutory organisations created by Acts of Parliament. The appointment of
some of the members of the organisation is a matter for the Executive. It may be that a
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minister has statutory powers to make appointments, such as in nationalised industries, or
administrative power, e.g. making appointments to advisory committees.
Public sector organisations will be funded either wholly or in part by money provided by
Parliament. Care must be taken, however, to distinguish between those organisations
financed by Parliament and those which simply receive grant-aid to assist them with an
investment programme.
There are several differences which may exist between public bodies and commercial
 Many public organisations may have monopolies in either a service or geographical
 Although prices may be charged for some public services, they are rarely related to
profit-making objectives and sometimes fail to cover the full economic cost. In general,
the public sector does not use the price mechanism to test whether the public want the
services provided. Instead, the criteria applied tend to be based on the political
judgment of elected representatives under the constraints of the political mechanism of
elections, pressure groups and consultative processes.
 The public sector exists to serve the community and, in the field of accounting, the
stewardship of funds is often the key objective (rather than the profit motive). However,
the responsibilities of the financial manager and the need to exercise good financial
public relations are as important as in commercial organisations. In order to replace
the profit motive as a yardstick performance measures have been developed in order
to ensure that the three "Es" of efficiency, economy and effectiveness are achieved,
and to protect public money. Thus, for example, in an attempt to improve the
performance of central and local government departments, the Government has
introduced a wide range of key performance indicators (K.P.I.'s).
Within these overall points about the public sector in general, we should also recognise a
number of particular aspects and developments relating to specific types of organisation.
(a) Nationalised Industries
In recent years the number of nationalised industries has been reduced due to the
privatisation programme of the Conservative Governments of 1979-1997. However,
there are still some large organisations remaining in this category, including the Post
Office (although this may soon be privatised). The objectives of such organisations are
generally social or service-led.
They are funded by borrowing from the capital markets and the Government. Whilst
the maximisation of profits is not their main objective they generally have to obtain set
financial targets, perhaps to maintain required subsidies at a set level or below. In
general nationalised industries in the UK have been expected to aim to achieve a set
rate of return (before interest and tax) on new investment programmes. The rate of
return is measured by current cost operating profit as a proportion of the net
replacement cost of assets employed. Nationalised industries also have other
performance measures, including cost reductions and efficiency gains which they have
to achieve.
(b) Government Departments
One major change in this area within the UK recently has been the formation of
executive agencies to carry out specific functions, such as the Contributions Agency.
They are expected to achieve a set level of service and are answerable to the
Government for their service levels but are managed independently on business-led
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(c) Private Finance Initiative (PFI)
The Private Finance Initiative (PFI) is a small, but important part of the Government's
strategy for delivering high quality public services.
The Private Finance Initiative (PFI) was introduced in 1992 as a means of obtaining
private finance for public sector long-term capital projects, e.g. the building of prisons,
schools and hospitals. The current government is committed to developing this
approach across a wide range of public services. A new Commission on Public Private
Partnerships was set up in Autumn 1999 (the Institute of Public Policy Research
Commission, IPPR) to examine questions about specific forms of partnership between
private sector firms and public sector organisations – for example, how can private
firms involved in partnerships be made accountable to the public, and how does this
accountability fit in with achieving the best value for money?
In assessing where PFI is appropriate, the Government's approach is based on its
commitment to efficiency, equity and accountability and on the objectives of public
sector reform. PFI is only used where it can meet these requirements and deliver clear
value for money without sacrificing the terms and conditions of staff.
Where these conditions are met, PFI delivers a number of important benefits. By
requiring the private sector to put its own capital at risk and to deliver clear levels of
service to the public over the long term, PFI helps to deliver high quality public services
and ensure that public assets are delivered on time and to budget.
(d) Not for Profit Organisations
The prime objectives of organisation such as charities are not concerned with profit-
making, but with the provision of services, e.g. to offer a service such as training guide
dogs for the blind, or to fund research into cancer treatments. They do, however,
operate within financial constraints and must work within the funds they obtain.
All not-for-profit organisations also strive, as do many commercial ones, to obtain the
three Es of economy, efficiency and effectiveness.
Shareholders are the owners of a company and it is important to remember that the
maximisation of their wealth is the prime objective of companies in the private sector. This is
the underlying concept in the theoretical parts of this course. However, they are not the only
groups with an interest in the company and the interplay of factors in the governance of a
company is a key concept.
Company Stakeholders
Stakeholders are usually divided into two distinct categories:
 Internal stakeholders such as managers and employees, and
 External stakeholders such as shareholders, creditors and lenders.
In practice companies often have multiple objectives (both financial and non-financial)
involving various stakeholder groups, which prevent the maximisation of shareholder wealth.
The different stakeholder groups in an organisation were identified in 1975 by the Corporate
Report (ASC) which dealt with their objectives and specific requirements from accounting
information. Clearly, different users will look at the company in different ways, and the
objectives of organisations have to be designed to satisfy their varying needs, with the
objectives of one group often also applying to another group. The objectives of different
groups may conflict, and compromises will have to be made.
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We consider the interests of some of the stakeholder groups below, but you should try to
think of other points yourself.
(a) Banks and other lenders
This group includes anyone who makes a loan or other financial accommodation
available to an organisation, examples being debenture-holders, finance companies,
building societies and venture capitalists.
The main concern of this group is the safety of the investment; lenders expect to get
their money back within an agreed period and to make a profit. In order to maintain the
safety of the investment they want to ensure that the level of debt to equity does not
become too high, because increases in the level of debt increase the risk of insolvency
of the firm, with the firm being unable to pay the required interest payments. Short-
term lenders are especially concerned with the ability and willingness (known as
"corporate integrity") to repay the liability from cash generated by the business. Long-
term lenders may place a restrictive trust deed or set financial guidelines, e.g. a set
proportion of working capital, in order to ensure their investment remains safe.
(b) Business-contact group (includes debtors and creditors)
This group includes suppliers, competitors and all other business affected by an
organisation's activities. Their objectives include ensuring that the firm deals honestly,
does not misuse any monopoly powers and pays its bills promptly within the terms of
the trading agreement.
The group will be interested in developing long-term strategic relationships and the
continuity of trading opportunity with an organisation which is financially stable with
minimal administration. Customers of the organisation will be concerned with having a
supplier who is reliable, and who provides a constant supply of the product (when
required) of consistent quality with good, efficient service at a fair price. Customers
will also be concerned with the level of service they are receiving, the value for money,
and the safety of the goods they receive.
Competitors are also included in this group, and include those who may be interested
in acquiring the business as well as those who are rivals in trade. The group will
require as much information about the company and its finances as possible, although
the company will not wish them to have such information, and secrecy may conflict with
the needs of other groups.
(c) Public
The needs of the general public can take many forms, e.g. sections of the general
public may wish to see a restriction on contributions to political parties, charities or
social groups, or a restriction on the business activities carried out with, or in, a
particular country. Another example is where local residents are interested in the
amount of investment and degree of control that an entity has in their own community
and its ultimate effect on their local environment. When public money assists the
enterprise the public may wish to see the return in profitability, jobs and services.
(d) Government
The Government (and, indeed, the public) wish to ensure that the organisation adheres
to the law, pays the correct amount of taxes and other financial charges levied upon it
by government bodies, and provides the statistical and other information required in
order to ensure control over its (the Government's) own economic policy. The
Government will also be interested in ensuring that the organisation respects its social
and environmental commitments.
Moreover, the Government has a desire to regulate some of the privatised utilities to
prevent them abusing their monopoly powers. For this reason it has set up consumer
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"watchdogs", e.g. Oftel, which regulates British Telecom, to oversee such companies.
The watchdogs may, amongst other things, limit price levels which can conflict with a
company's desire to maximise profits.
(e) Financial analysts and advisors
This group will comment upon the progress, or otherwise, of the entity. In order to do
so they will need the fullest possible information in whichever field their interest lies.
Their requirements may mirror those of any of the other user groups. They will,
however, have the key objective of ensuring compliance with accounting standards to
provide for uniformity to the presentation of information and the easier comparison with
other organisations.
(f) Employees and management
Employees will be concerned with the remuneration they receive from the company,
their working conditions and security of employment. They may also be concerned
with other factors such as training and career development prospects within the firm;
benefits in kind such as company cars; company pension and redundancy provisions;
and the potential for future expansion of jobs for themselves and their friends and
(g) Shareholders and investors
Shareholders and investors are obviously an important stakeholder group, being the
owners of the business. In order to meet the needs of shareholders management
 Maximise their wealth (shown by the growth in share price and the payment of
 Achieve a specific level of earnings, earnings per share and dividends per share.
Note that some shareholders prefer high dividends and some prefer capital gains
(see later study unit) but the needs of the majority should be met as far as
 Stick to a preset target for operating profitability represented by either a set return
on capital employed or a profit/sales ratio (also discussed later).
 Expand the business when feasible – to be a worthwhile investment, growth,
level of risk, return on investment and profitability in relation to competitor
businesses and other investment opportunities will be expected to be at an
appropriate level.
 Maintain the security (as far as is consistent with profit-making) of the
shareholder's investment. (The risk-return trade off is discussed in more detail in
a later study unit.) This includes considering the fact that shareholders have
different risk preferences and thus prefer different levels of gearing.
 Satisfy the investor that the company has sufficient cash flow to accommodate its
plans and avoid future potentially fatal liquidity problems.
 Give details of political, charitable or social donations in order to allow
shareholders to decide whether the convictions of the management are in line
with their own views.
This is not an exhaustive list of management objectives in respect of shareholder
interests and you may be able to think of several others. A company therefore has to
know who its major shareholders are and what their objectives for the company are,
and concentrate on achieving those objectives. Such knowledge would also help to
explain recent price movements when shareholdings change hands, and might help in
fighting off a takeover bid.
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Companies may have only a few shareholders (e.g. a private family company) or they
may have many small shareholders (e.g. some of the privatised utilities). Advantages
of having a large number of shareholders include a reduced risk of one shareholder
obtaining a controlling interest; greater market activity in the firm's shares and thus the
likelihood of vast price movements caused by one shareholder selling his shares is
also reduced; and takeover bids are easier to frustrate. Against this, however, will be
increased administration costs covering statutory requirements of information to
shareholders, and it may be more difficult to meet all shareholders' conflicting
Many decisions in financial management are taken in a framework of conflicting stakeholder
viewpoints. For example, consider the stakeholders and the related financial management
issues involved in the following situations.
 A private company converting into a public company
The stakeholders will include:
(a) Shareholders of existing private company;
(b) Shareholders of new public company;
(c) Employees and management.
Some of the key financial management issues will be:
(i) Who will gain a controlling interest in the new company?
(ii) Will the company be administered differently, perhaps as family owner
shareholders no longer have day to day involvement in running the company?
How will it affect terms and conditions of employees?
(iii) How will the conversion affect maximisation of shareholder wealth?
 A highly geared company, such as Eurotunnel, attempting to restructure its
capital finance
The stakeholders will include:
(a) Debenture holders;
(b) Banks and other lenders;
(c) The government;
(d) Shareholders.
Some of the key financial management issues will be:
(i) Shareholders will be concerned about the effects of additional gearing on the
company's ability to pay dividends, which may conflict with the government's
objective of ensuring financial stability.
(ii) As this is a large public interest project (Eurotunnel) the government will want to
see financial stability to ensure that the company can complete the project
without financial collapse.
(iii) Debenture holders are concerned to ensure that the company will have sufficient
cash flow to meet interest payments as they fall due.
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 A large conglomerate "spinning off" its numerous divisions by selling them, or
setting them up as separate companies, e.g. Hanson
The stakeholders will include:
(a) Employees and management;
(b) Debtors and creditors;
(c) Shareholders.
Some of the key financial management issues will be:
(i) The security of jobs for employees and management in the new companies,
which may conflict with the aim of shareholders to maximise wealth.
(ii) Customers (debtors) will be concerned about the quality of the product and
whether the new structure will affect this.
(iii) Suppliers (creditors) will want to know the liquidity of separate companies and
their ability to pay outstanding debts. Also how will outstanding debts be settled if
divisions are sold?
 Japanese car-makers, such as Nissan and Honda, building new car plants in
other countries
The stakeholders will include:
(a) Shareholders;
(b) Employees and management;
(c) Government;
(d) Public.
Some of the key financial management issues will be:
(i) The public may be concerned that they have no control over foreign companies
setting up in their local areas, which may conflict with the aims of government in
encouraging investment by overseas companies.
(ii) The government may grant development finance and incentives to incoming
(iii) The shareholders of the Japanese companies will be concerned about the
security of their investment overseas.
(iv) Japanese management may be concerned about different pay and conditions if
they are sent to manage the overseas plants.
 A public company offering to run the UK national lottery for free rather than for
The stakeholders will include:
(a) The government;
(b) The public;
(c) Shareholders;
(d) Financial analysts.
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Some of the key financial management issues will be:
(i) The government will be concerned about the company's objectives if profit is not
the obvious one.
(ii) Shareholders will want to know how this non-profit making venture will affect
dividends and the value of shares. After all, their main objective is maximisation
of shareholder wealth.
(iii) Financial analysts will study the possible effects on the company's value if it gains
the contract to run the lottery.
(iv) The public will want to know what percentage of takings will be donated to good
causes and how much will be retained by the company for administration and
investment in equipment.
Management/Shareholder Relationship and Agency Theory
The skill and experience of the senior management board (and to a lesser extent its
subordinate management) are important to shareholders as they are employed to manage
the shareholders' investment on their behalf. There must be trust in the integrity and ability
of the managers; a dynamic board of management can make a significant difference to the
performance of a business and the way the market views it.
An agency relationship exists where one person (an agent) acts on the behalf of another
(the principal). The management/shareholder relationship is an example of an agency
relationship. Goal congruence occurs when the objectives of the agents match those of the
principals. The agency problem is the conflict that arises from the separation of
management and ownership in many companies, leading to a lack of goal congruence. The
financial and other rewards of managers (agents) may not be linked to the shareholders'
(principals) financial return. In theory management should not be able to act contrary to the
wishes of shareholders because shareholders can dismiss the managers or sell their shares.
Unfortunately it is often not the case. Small shareholders frequently have little knowledge
about the running of the business and little power to alter its execution; and the large
institutional shareholders have often been passive and uninvolved.
However, a series of "corporate raids" in the late 1980s, when firms acquired and then asset
stripped managerially-focused companies believing them to be undervalued, has led to the
large institutional shareholders considering the actions of management more carefully.
A number of incentive schemes have been introduced in an attempt to encourage goal
congruence between management and shareholders. The most popular is the stock option
scheme. This allows senior management up to a certain number of the company's shares at
a fixed price at a specified time in the future. The management therefore have a financial
incentive to act in ways to maximise the share price, which benefits all shareholders.
However, such schemes are of doubtful benefit – management do not have to buy shares if
the price has fallen; and the schemes can lead to volatility in the share price which is counter
to the principle of a stable share price which many shareholders desire.
Another popular scheme involves profit-related incentives in which bonuses are based on
the annual growth in earnings per share, measured against a pre-set target such as
companies in the sector. However, you will appreciate that accounting figures can easily be
manipulated and can also be affected by external factors such as a change in tax rates.
Such measures therefore only give a partial (and perhaps misleading) picture of
managements' activities.
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The Cadbury Report
The Committee on the Financial Aspects of Corporate Governance (known as the
Cadbury Committee, after its Chairman) was set up in May 1991 by the Financial Reporting
Council (FRC), the London Stock Exchange and the accounting profession, in response to
increasing public concern over the management of large companies and professional
investors' low levels of confidence in financial reporting and auditing. Concerns included lack
of direction and control of organisations by the boards, a lack of true auditor independence,
and an increase in litigation and damages awarded against companies. The aim of the
Cadbury Committee was "to bring forward proposals to promote good financial corporate
governance, without stifling entrepreneurial drive or impairing companies' competitiveness".
"Corporate governance" was defined by the committee as "the system by which companies
are directed and controlled" and is the responsibility of the directors of the company. The
Committee intends to consider the responsibilities of each group involved in the financial
reporting process including:
 The links between board, auditors and shareholders;
 The role and responsibilities of audit and the auditors;
 The need for audit committees, their functions and membership;
 The type and frequency of information required by shareholders and other parties with
a financial interest;
 The role and responsibilities of executive and non-executive directors as regards the
reporting of financial performance.
The heart of the Committee's recommendations was a Code of Best Practice, to be
adopted by the directors of all UK public companies, with all company directors to be guided
by it. Some allowances are made for the way in which it might be implemented in different
You will see later that the Cadbury Code of Best Practice has been incorporated into the
Combined Code. However, the recommendations of the Cadbury Committee are so
important in the development of corporate governance in the UK that we will look at them in
The Code of Best Practice
The major points are as follows:
(a) The Board
There should be a clearly accepted division of responsibility at the head of a company
ensuring a balance of power and authority. In cases where the Chief Executive is also
the Chairman there should be strong independent executives on the board with their
own appointed leader.
The calibre and number of non-executive directors should be such that their views
carry significant weight on the board.
Boards should meet regularly and have a formal schedule of matters reserved for their
decision to ensure that the direction and control of the company remain firmly in their
hands, including the monitoring of the executive management.
All directors should have access to the advice and services of the company secretary,
who is responsible to the board for ensuring that board procedures are followed and
that applicable rules and regulations are complied with. Any question of the removal of
the company secretary should be a matter for the board as a whole.
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(b) Executive Directors
Directors' total emoluments and those of the Chairman and the highest-paid UK
director should be fully disclosed and split into their salary and performance-related
elements, with an explanation of the basis on which performance is measured.
Executive directors' pay should be subject to the recommendations of a remuneration
committee made up wholly or mainly (and preferably chaired) by non-executive
directors. Directors' service contracts should not, unless approved otherwise by
shareholders, exceed three years.
(c) Controls and Reporting
Boards must establish effective audit committees. The chairmen of audit and
remuneration committees should be responsible for answering questions at the AGM.
The board should ensure that an objective and professional relationship is maintained
with the auditors. The board must explain their responsibility for preparing the
accounts next to a statement by the auditors regarding their reporting responsibilities.
The Code requires that directors report on the effectiveness of the company's system
of internal control, and state that the business is a going concern, with supporting
assumptions or financial qualifications if necessary.
The board's duty is to present a balanced and understandable assessment of their
company's position. Balance sheet information should be included with the interim
report, which should be reviewed by the external auditors but need not be subject to a
full audit.
(d) Shareholders
Both boards and shareholders were encouraged by the Committee to consider how to
improve the effectiveness of general meetings.
(e) Auditing
The annual audit is described as "one of the cornerstones of corporate governance".
Several minor recommendations were made to ensure its effectiveness and objectivity:
 Audit Effectiveness
Audit effectiveness should be increased by clarifying the respective
responsibilities of directors and auditors for preparing and commenting on
financial statements, and by developing audit practice in areas such as internal
control, going concern, fraud and other illegal acts.
 Audit Objectivity
Both the board and auditors have a responsibility to ensure that the relationship
between them is professional and objective. Audit Committees
The Committee stated that the board should establish an audit committee of at
least three non-executive directors with written terms of reference which deal
clearly with their authority and duties.
(f) Non-executive or Outside Directors
Non-executive directors should bring an independent judgment to bear on issues of
strategy, performance and resources including key appointments and standards of
The Committee recommended that a majority of non-executive directors should be
independent and free of any business or financial connection with the company (apart
from their fees and shareholdings). Fees should reflect the time which they commit to
the company, but they should receive no pension or share options as part of their
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service. The Code also suggested that an agreed procedure should be in place for
non-executives to take independent professional advice at the company's expense.
The selection of non-executive directors should be by a formal process, for a specified
term, and their nomination should be a matter for the board as a whole. However, the
report does not discuss the action that should be taken in the event of a non-executive
director resigning or being released.
The independence of non-executives must be transparent. Fees should be such that
part-time rather than full-time involvement is encouraged and, since resignation is the
ultimate sanction of the non-executive director, the fees should not be so large that the
non-executive is dependent upon them.
In summary, the recommendations of the Cadbury Report, as encompassed by the Code of
Best Practice, were that listed companies should include in their accounts full and clear
disclosure of directors' total emoluments and those of the Chairman and the highest-paid
director. The disclosures should include pension contributions and stock options.
Performance-related elements, and the basis upon which performance is measured, should
be shown separately.
With effect from April 1993, the Stock Exchange stated that UK-incorporated listed
companies must state in their accounts for accounting periods ending after 30 June 1993,
whether they have complied with the Code throughout the accounting period in addition to
the other continuing obligations. Any failure to comply must be stated, along with reasons for
the non-compliance. The compliance statement must be reviewed by the auditors. Other UK
companies should adopt the Code at the earliest practicable date.
In addition, from 1 January 1995 directors' statements should include the following:
(a) An acknowledgment that directors are responsible for the system of internal financial
control including the main procedures established and their effectiveness.
(b) An explanation that the system can only provide a reasonable level of control.
(c) Confirmation that the directors have reviewed the effectiveness of their present internal
financial control.
The Greenbury Report
The Greenbury Report, published by the Greenbury Committee in July 1995, goes beyond
the Cadbury Code of Best Practice in establishing principles for determining directors' pay
and disclosures on pay to be given in the annual accounts and company reports.
The Greenbury Code recommends that a remuneration committee should be established
comprising solely non-executive directors – though the Chief Executive or Chairman may be
asked for advice – and that this committee should determine executive directors'
remuneration. The Code also recommends that directors should have service contracts
limited to one year.
Other important recommendations are:
 Public companies should publish an audited statement detailing compliance with the
Greenbury Code under Stock Exchange rules.
 The remuneration committee should report to shareholders via the annual report and
accounts. Full details should be included of directors' remuneration:
(i) Basic salary
(ii) Benefits in kind
(iii) Annual bonuses
(iv) Long-term incentive schemes.
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The majority of the Greenbury Code principles have been included in the Listing Rules of the
Stock Exchange.
Hampel Committee Report
Sir Ronald Hampel was given the task of continuing the work of Sir Adrian Cadbury on
corporate governance. The final report of the Hampel Committee was issued in February
1998. Sir Ronald summed up the essence of his committee's report by saying that "Good
governance requires judgment, not prescription and for that reason I believe it is in business'
own interest to conform, and that it will". The main features of this report relating to
corporate governance are:
 Most non-executive directors should be independent and their independence should be
identified in the annual report.
 Directors should receive appropriate training.
 The roles of chairman and chief executive should be separate.
 A senior non-executive director should be appointed to deal with shareholders'
concerns. The name of the director should be identified in the annual report.
 The practice of paying non-executive directors using company shares is not
recommended, although there is nothing against it in principle.
 Directors should be on contracts of one year or less.
 A remuneration committee of the board should be established, made up of independent
non-executive directors. The committee should make decisions on the pay packages
of executive directors and the framework of executive pay.
 Companies should include in the annual report a narrative account of how they apply
broad principles and should explain their policies. Any departure from best practice
should be justified in the report.
 The creation of an internal audit department is recommended.
 Directors should review the effectiveness of the company's internal controls (not just
financial controls) but need only report publicly on the system rather than its
The Stock Exchange has a code of practice which incorporates the recommendations of the
Cadbury, Greenbury and Hampel reports (see later). The Stock Exchange will be
responsible for overseeing adherence to the code. The government has indicated that if
companies do not adopt best practice, it may take action to introduce legislation on corporate
governance. In particular, continuing large pay awards to directors and extensive share
option schemes may prompt the government to take action.
The Combined Code
In June 1998 the London Stock Exchange published the Hampel Committee Principles of
Good Governance and the Code of Practice (the Combined Code). It replaces the Cadbury
and Greenbury Codes but incorporates aspects of both of them.
(a) The Principles of Good Governance
 Directors and the Board
(i) There should be an effective board to lead and control the company.
(ii) Running the board and running the business are separate tasks. There
must be a clear division of responsibilities at the head of the company. No
one individual should have unfettered powers.
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(iii) There should be a balance of executive and non-executive directors
(NEDs) including independent NEDs. No individual or group should
dominate the board.
(iv) Timely and quality information should be provided to the board.
(v) There should be a formal and transparent procedure for board
appointments (usually a nomination committee of mainly NEDs).
(vi) Directors should be re-elected at least every three years.
 Directors' Remuneration
(i) Remuneration should be sufficient to attract and retain the directors needed
but no more than necessary. Executive directors' remuneration should be
partly linked to corporate and individual performance.
(ii) There should be a formal and transparent procedure for developing
remuneration policy and individual packages, i.e. a remuneration committee
of NEDs. Directors should not be involved in deciding their own
 Relations with Shareholders
(i) The board should encourage dialogue on objectives with institutional
(ii) The annual general meeting (agm) should be used to communicate with
private investors and encourage their participation.
 Accountability and Audit
(i) There should be a balanced, understandable assessment of the company's
position and prospects.
(ii) There should be a sound system of internal control to safeguard the
shareholders' investment and the company's assets.
(iii) There should be formal and transparent arrangements to apply the above
two principles and maintain relationships with the auditors.
The Combined Code requires an explanation in a listed company's annual report of
how these principles have been applied. A major impact of the Combined Code is that
a company must review the effectiveness of all controls, not just financial controls.
(b) Examples of Contents of Combined Code
 Directors
(i) The Board must comprise at least one third non-executive directors.
(ii) There must be a senior independent director (not the Chairman) to whom
shareholders can raise their concerns.
(iii) A nomination committee is strongly recommended.
(iv) All directors should receive training when first appointed.
 Directors' Remuneration
(i) A significant proportion of executive remuneration should be linked to
corporate and individual performance.
(ii) The remuneration report should be issued in the name of the board and not
just the remuneration committee.
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 Accountability and Audit
(i) Financial reporting provisions apply to all price-sensitive public reports and
reports to regulators.
(ii) The definition of "internal control" covers all controls, not just financial
(iii) The majority of the audit committee should be independent non-executive
(iv) The audit committee should review the scope, results, cost-effectiveness,
independence and objective of external audit.
(v) The company should review the need for internal audit.
(c) Matters to be Reported Publicly by Companies
 How the company applies the principles
 Whether or not the company complies with detailed provisions; any exceptions
must be explained
 Justify combined posts of chairman and chief executive
 Give the names of:
(i) The chairman, chief executive, senior independent director and other
independent directors
(ii) The chairman and members of the nomination committee
(iii) Members of the remuneration committee
(iv) Members of the audit committee
(v) Biographies of directors submitted for election or re-election
 Remuneration policy and details of the remuneration of each director
 Explain the directors' responsibility for preparing the accounts
 Whether the business is a going concern, together with the supporting
assumptions or qualifications
 State that directors have reviewed the effectiveness of internal controls
The Turnbull Report
Guidance for directors on the scope, extent and nature of the review of internal controls was
issued by the Institute of Chartered Accountants in England and Wales in late September
1999 in the form of the Turnbull Report – "Internal Control: Guidance for Directors of Listed
Companies in the UK". This guidance has the support and endorsement of the Stock
The Turnbull Report states that:
"A company's system of internal control has a key role in the management of
risks that are significant to the fulfilment of its business objectives".
The company's system of internal control should:
 Be embedded within its operations and not be treated as a separate exercise;
 Be able to respond to changing risks within and outside the company; and
 Enable each company to apply it in an appropriate manner related to its key risks.
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The Report makes it clear that the board of a company is ultimately responsible for its system
of internal control. It will normally delegate to management the task of establishing,
operating and monitoring the system.
Financial Services and Markets Act, 2000 and the FSA
The Financial Services and Markets Act 2000 set out four statutory objectives, supported by
a set of principles of good regulation which companies must have regard to when
discharging their functions. The objectives are:
 market confidence – maintaining confidence in the financial system
 public awareness – promoting public understanding of the financial system
 consumer protection – securing the appropriate degree of protection for consumers,
 the reduction of financial crime – reducing the extent to which it is possible for a
business to be used for a purpose connected with financial crime.
The Act also set up the Financial Services Authority (FSA), one of now a number of financial
service regulators. The FSA has set out its aims under three broad headings:
 promoting efficient orderly and fair markets
 helping retail consumers achieve a fair deal
 improving companies' business capability and effectiveness.
These objectives condition the way in which the FSA acts:
 providing political and public accountability – so its annual report contains an
assessment of the extent to which it has met these objectives, and scrutiny of the FSA
by Parliamentary Committees may focus on the extent to which this is being achieved
 governing the way it carries out its general functions in respect of rule-making, giving
advice and guidance, and determining general policy and principles – so, for example,
it is under a duty to show how the draft rules it publishes relate to these statutory
objectives; and
 assisting in providing legal accountability – so where it interprets the objectives
wrongly, or fails to consider them, it can be challenged in the courts by judicial review.
The Higgs and Smith Reports
At the turn of the century the world markets were affected by major collapses such as
ENRON and these had an adverse impact on the profile of corporate governence. In the UK,
the Government established enquiries into two areas in which failures were were seen as
key to these collapses:
 the effectiveness on non-executive directors, reported on by the Higgs Report, and
 the independence of audit committees, reported on by the Smith Report.
(a) The Higgs Report
The main recommendations were as follows:
(i) The chairman:
 runs the board
 sets its agenda
 ensures effective communication with the shareholders
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 ensures that the members of the board develop an understanding of the
views of the major investors
 ensures that sufficient time is allowed to discuss complex or contentious
 takes the lead in ensuring induction training for new directors
 takes the lead in identifying development needs for directors
 ensures the performance of individuals and the board as a whole
 encourages active involvement by all members of the board
 should maintain a good working relationship with the chief executive.
(ii) As members of a unitary board, all members are required to:
 Provide entrepreneurial leadership of the company within a framework of
prudent and effective controls
 set the company's strategic aims
 ensure that the necessary financial and human resources are in place to
meet its objectives
 review the performance of management.
(iii) Non-executive directors should:
 constructively challenge and help develop strategy
 scrutinise the performance of management
 satisfy themselves on the integrity of financial information
 satisfy themselves that financial controls and the system of risk
management are robust and defensible
 set the remuneration of the executive directors
 have a prime role in appointing and removing executive directors
 be independent of judgement and have an enquiring mind
 be well informed about the company and the environment in which it
 by visiting sites and meeting middle and senior management ensure that
his/her knowledge of the company is kept up to date
 uphold the highest standards of integrity and probity
 question intelligently, debate constructively, challenge rigorously and decide
 promote the highest standards of corporate governance
 declare any potential conflicts of interest and refrain from discussion on
matters where conflict of interest may arise
 understand the views of major investors through the chairman and the
senior non-executive director.
(b) The Smith Report
This examined the role of audit committees and gave authoritative guidance on how
audit committes should be operated and run. The main recommendations were that
the audit committee should:
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 be a committee of the board
 consist of at least two, and preferably at least three, members
 consist of independent non-executive directors, of whom at least one member
should have recent and relevant financial experience (although this does not
comprise a departure from the principle of the unitary board)
 have written terms of reference including:
– to monitor the integrity of the financial statements
– to review company's internal financial controls
– to monitor the effectiveness of internal audit
– to recommend appointment of external auditors
– to approve remuneration of external auditors
– to approve terms of engagement of external auditors
 develop policy regarding use of external auditors for non-audit services
 review whistle blowing policy and procedures
 meet at least three times per year
 meet at least annually with the internal and external auditors without the
presence of management
 be provided with adequate resources
 be able to take independent legal, accounting or other advice
 be provided with appropriate training and additional remuneration as necessary.
Other Disclosure and Behaviour Compliance Provisions
There are requirements for disclosure of directors' remuneration in the annual financial
statements. These are the Company Accounts (Disclosure of Directors' Emoluments)
Regulations 1997 and they apply to all listed and unlisted companies.
The various Companies Acts and European Union legislation require certain minimum
standards of behaviour from organisations, as does the Stock Exchange.
There is also an avenue for action to be taken against companies that do not adhere to the
recognised standards, through being investigated and potentially prosecuted by the Serious
Fraud Office (SFO).
In this final section, we shall consider the scope of financial management within the modern
Financial Decision Making
We noted earlier that corporate finance deals with three decisions which a firm must
 Which investments should the firm undertake? – the investment decision
 How, where, when and how much finance should be raised? – the financing decision
 How should the firm's profits be used or distributed? – the dividend decision.
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(a) The Investment Decision
The investment decision involves a firm in choosing which projects to invest or
disinvest in. It can include internal decisions concerned with current areas of the firm's
involvement, and external decisions concerned with expansion or contraction of the
firm by takeover, merger or disinvestment.
(b) The Financing Decision
An organisation is funded by a combination of debt (both long and short term) and
equity (share capital). The financing decision involves deciding on the level of funds
required, which type or types of funds to raise, and the raising of funds. In deciding the
level and type of funds to raise the firm has to know the cost and risk involved in each
particular type of funds. The cost involved is the opportunity cost to the provider of the
funds; the risk involved in raising finance is the possibility of negative returns on the
investment (risk is dealt with in more detail in a later study unit). In making the
financing decision a trade-off is often made between keeping as low a level of funds as
possible to aid profitability (by limiting the costs of servicing those funds, i.e. interest
payments and administration of share registers) and ensuring the firm has sufficient
funds to remain solvent.
(c) The Dividend Decision
This is the trade-off between retaining profits in the business and distributing them to
Whilst initially you will study the three decisions separately, always remember that in practice
they are interconnected and their interrelationship must not be ignored. Before reading
further try to think of some likely interrelationships.
One common interrelationship is between investment decisions and the financing
decision. If a firm decides to invest in a major new project it may have to raise additional
finance, having to make a choice with regard to the type and level of finance to acquire.
Moreover, the cost of the funds will affect the viability of the project. Another common
interrelationship is between the financing decision and the dividend decision – if a firm
pays out a high percentage of its profits as dividends it may need to raise additional finance
and – as we discussed earlier – it may not be in the shareholders' best interest. Clearly
these are only two examples and whenever a decision is made in one of the areas it will
have an impact on the other areas. We shall cover the interrelationships of the decisions in
greater detail later in the course.
Financial Functions in Organisations
The role of the finance function within an organisation is considerable and includes the
following aspects:
 The determination of the volume of financial resources required.
 The acquisition of the required financial resources, either internally through profit
retention and dividend policy, or externally through share issues, debenture issues or
 The maintenance of an optimum mix of funding, bearing in mind the potential impact of
the capital structure on the market value of the business.
 The needs of the providers of finance have to be considered, including their required
return on investment and the maximisation of the value of their shares. If the company
is floated on the Stock Market its rules and regulations must be adhered to. A financial
manager has a duty to value a business in a manner which shows its true worth, and
he should take into account the effect of price changes over time on the valuation of
the business. The financial manager must take account of factors which determine
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share prices, particularly those over which he has control. The business should not
only be maximising the wealth of its shareholders, but it should also be seen to be
doing so, which requires some degree of financial public relations by the financial
managers, in order to maintain a good financial image of the firm to outside sources of
 Assessment and valuation of investment opportunities to ensure that the generated
resources are employed efficiently. This includes the investment of surplus cash in
short-term investments. In order to do the latter the financial manager must have a
thorough understanding of the workings of the "City" and investment markets generally.
 The assessment of the optimum amount of assets provided, including the calculation of
fixed assets, current assets and liquid resources wanted by the business. Plans should
cater for seasonal fluctuations as well as medium- to long-term strategic requirements
and plans of the organisation.
 The finance manager should ensure that suitable control systems are employed for the
authorisation of expenditure on fixed assets, to ensure that stocks of raw materials,
finished goods and work in progress are kept to a level which is the lowest possible to
be consistent with efficiency, and to ascertain that the cash available in the business is
used as fully as possible throughout the year. The control function also covers
investments, and the maintenance of a reasonable balance between credit taken and
credit given.
 The control of liquidity, by ensuring sufficient working capital within the company taking
account of the timing of future plans for growth and fixed asset purchases.
 In all but the smallest of organisations there should be provision for internal audit to
ensure that control systems are working and to help prevent and detect errors and
 The financial manager should ensure that all risks capable of being calculated are
covered by insurance, including cover in respect of accident, fire and consequential
loss and, if appropriate, credit insurance.
 The business must comply with statutory requirements including those of central and
local government and the European Union, and for a listed company with those of the
Stock Exchange. Accounts must show a true and fair view of the position of the
business at the time they are drawn up. Moreover, they should be capable of being
interpreted in a way that gives the reader the correct impression. Problems arising
from reconstructions and amalgamations of companies also form a major part of the
role of the financial manager.
The Role of the Finance Manager
The tendency to internalise corporate finance means that the financial manager of the major
or multinational company must become an expert in a wide variety of areas including the
responsibilities we described above. He must also remain up-to-date in a world-wide market
which is rapidly changing. It is a massive task and, to combat the resulting problems, larger
companies have typically created specialist functions, each reporting to the Financial
Director. They are senior roles and their functional responsibilities are discussed below. In
the biggest organisations, responsibilities would be further broken down and delegated.
Smaller organisations may not require all the functions, and one person may take
responsibility for more than one area of work. The job titles in any one organisation may
differ from those listed below, but the functions remain the same.
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The different functions are:
 The Controller
This role encompasses capital budgeting and investment appraisal, stock and credit
control, short-term investments and the internal and external audit functions.
 The Accountant
The accountant will be responsible for the records of financial data and for producing
management reports and company accounts. The role is split into the disciplines of
management and financial accounting covered elsewhere in your studies.
 The Treasurer/Cashier
This involves budgeting for cash flows, procuring adequate liquid funds and the
physical security of cash resources. In a business which deals internationally this
function will also include foreign currency management.
 Financial Strategist
This involves procuring and managing the correct volume and optimum mix of funds,
whilst organising a suitable channel of communication with external bodies such as
government and investors and, as a member of general management, in meeting the
demands of fellow functional managers.
 Corporate Planner and Strategist
The modern financial manager has a wider corporate role, involving sharing
responsibility for corporate goals and objectives, including the development of strategic
and business plans.
In the past it was often the case that many managers would immerse themselves within
their own particular discipline and financial managers were no exception. In the
modern business world it is very important that all managers are able to develop a
corporate role whereby they are willing and able to look at the entire business rather
than just their own particular functional area. One aspect of this is in respect of social
responsibility. This is increasingly important to the modern business and the finance
manager needs to incorporate its implications into all aspects of his/her role.
 Communicator
Finance is a difficult subject for many people and one of the skills that is required by
the modern financial manager is to communicate these often complex issues to staff
within, and stakeholders outside, the business in an easy to understand manner.
Often smaller firms do not have a full-time financial manager, relying simply on regular visits
by a member of the firm's external audit staff. At least some businesses lack an awareness
of the degree of financial expertise required for their business to operate effectively. Even in
firms that do employ a financial manager, many limit his key responsibilities to the production
of accounting information and recording of financial data.
The finance director may also be responsible for general administration and/or information
technology, depending on the size of the organisation.
When considering financial functions in organisations remember that the financial manager
must, to some extent, be concerned with the way in which finance interacts with the other
activities in an organisation such as production and personnel. The financial manager must
ensure that the individual objectives of each function do not conflict with the overall corporate
objective of the business. For example, the marketing manager who seeks to increase sales
or market share must do so within budgetary constraints and profitably in the long term.
Budgeting is a useful way of coordinating all functional activities, and we discuss this in more
detail later in this study unit.
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There are a number of different types of planning.
(a) Strategic Planning
Strategic planning is the process by which the objectives of an organisation are made
or changed. Examples of decisions involving strategic planning include deciding what
to produce and sell and where; whether to merge with another company; and what
overall profitability targets to set for the organisation.
Strategies are likely to exist at a number of levels in an organisation and strategic
planning must take this into account. Many management theorists have identified three
different levels of corporate strategy:
 The corporate level, which is concerned with what type of business the
company should be in. The company may specialise in one product or operate in
diverse markets. Decisions would include considering whether to widen the
range of products or move into different geographical areas.
 Competitive or business strategy, which focuses on how to compete in a
particular market; for example, a company may consider a strategy of
modernisation and rationalisation of its factories to help it compete in a fabric
manufacturing market.
 Operational strategies, which look at how the different functions of the company
contribute to other levels of strategy; for example, in seeking to be competitive a
company will consider price and marketing of its products.
Strategic planning involves generation of options which are then evaluated and choices
made. Management will select the options they intend to pursue and use them to form
the basis of strategic plans.
(b) Tactical Planning
Management or tactical planning deals with the achievement of strategic plans utilising
the organisation's resources in the most effective and efficient manner. It involves
setting budgets and performance targets for departments, determining the
organisation's structure and developing and launching products and their marketing
(c) Operational Planning
Operational planning deals with the achievement of tactical plans by carrying out
specific tasks in the most effective and efficient manner.
The dividing lines between strategic and tactical planning, and tactical and operational
planning are often unclear, and some decisions involve more than one type of planning. The
level at which the decision is taken is generally a guideline as to the type of planning being
undertaken, as is the frequency of the decisions. Operational decisions are often taken
several times a day by lower-level management and supervisory staff; tactical decisions are
generally taken at regular weekly, monthly or yearly intervals by middle and senior
management; whereas strategic planning is generally undertaken by senior management
and board members, and at infrequent and irregular intervals.
Knowing what is to be accomplished within a specific time-scale is a basic requirement of the
planning process, which is necessary to establish how the required results are to be
achieved. The financial manager should provide a focal point for functional managers
throughout the process, emphasising the importance of financial matters in developing and
implementing plans. Especially important in the planning process are the source and timing
of cash requirements. The shape of the balance sheet may also be an important issue for
the private company whose shareholders wish to realise a part of their investment by floating
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the company on the Stock Market at a later date. Similarly, a firm wishing to sell the entire
business may be very concerned about the size and value of its asset base.
In order to develop plans with any degree of accuracy a company must forecast the variables
included in plans. Can you think what they might be?
The variables to be forecasted include:
 Demand for, and sales revenue from, the company's products (analysing each product
 Costs of raw materials
 Wage and salary costs
 Other expense costs
 Competition in the product and supplier markets
 Potential for new product or production methods development, including the results of
research and development
 Interest rates and the cost of capital
 Product and safety legislation
 Availability of skilled workers
 Rate of inflation
 Economic growth rates
 Changes in the political environment, including industry regulation
 Exchange rates
 Taxation
 Dividend policy
 Assets and liabilities
 Potential for new sales and marketing methods.
Plans should include contingencies for external factors which may occur (also known as
sensitivity analysis). Lenders will usually act with extra caution when the economy
emerges from recession, because of their potential exposure to the risks of second-round
failure (see later in this study unit). Modern computer modelling techniques can help with
forecasting. The computer model can be built to assess the effect of changes in all variables
and produce scenarios which match the change in the variables.
The actual outcomes of the above must be compared to the forecasts and the variations from
the predictions fed back into the planning process to help improve the accuracy of future
We have already seen how a business implements its long-term plans via tactical and
operational plans; often, they are expressed as budgets.
Budgets are quantitative and/or financial statements of the plans of an organisation which are
prepared and approved before the period to which they relate.
Budgets can be set for long periods of time covering several years, or for short periods
covering days or hours. Often the very short-term plans are expressed in quantitative rather
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than financial terms and may deal with the production or service process. Similar to the
different levels of planning, the longer the period of time covered by a budget the less precise
the plans. The common length of time for most budgets, and the budgets you will probably
meet at work, are those of one year.
Budgets will be set for a wide variety of areas including all parts of sales and production. A
company, a group of companies, or other organisation will have a master budget. A master
budget includes an approved summary of production, sales and costs for the period, showing
the budgeted trading and profit and loss account, cash flow statement and the balance sheet.
In the area of financial planning an organisation will have some, or all, of the following
 Financial returns on investments
 Cash flow planning
 Profitability
 Sources of finance
 Capital structure
 Working capital control
 Arrangements for banking
 Tax planning
 Foreign currency management
 Changes in asset structures
 Funding planned takeovers
Part of the budgeting and control process is the monitoring of actual results against those
forecast in the budgets and other plans. It is unlikely that the plans will be met precisely, and
management has to set a tolerance limit for deviations (or variances as they are known in
accountancy and finance). The tolerance limit will vary between organisations and between
different items of income and expenditure. Variances falling outside the limits must be
investigated to see whether there is a problem that needs correcting, an opportunity which
can be capitalised, the forecasts need revising in view of unforeseen circumstances, or
whether the variance happened purely by chance.
A major part of the process of analysing variances is that the results of the analysis will be
used with other new information to update plans and budgets for the future. Indeed, part of
strategic planning involves the continual updating of plans as new information becomes
Cash Management
(a) Cash Flow Planning
In order to understand cash management you should be aware of the difference
between profits and cash flow. From your accountancy studies you will be aware that
profit is the amount by which income exceeds expenditure when both are matched on a
time basis. However, cash flow is the actual flow of cash in and out of the organisation
with no adjustments made for prepayments or accruals.
An organisation must ensure that it has sufficient liquid funds to pay its bills as they
become due. A business which has insufficient cash may be forced into liquidation by
its unpaid creditors, even if it is profitable. Management must therefore plan and
control cash flow to prevent liquidation. In the short term this is done by cash flow
budgeting, which can be daily, weekly, monthly or yearly, ensuring that the organisation
has sufficient cash inflows to meet its outflows as they become due. If a shortage is
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expected, then the firm can arrange finance, perhaps by increasing its overdraft, to
overcome the problem. If there is a short-term surplus of funds then they should be
invested in short-term marketable securities. Fluctuations in cash can arise for a
variety of reasons, a major one being seasonal fluctuations in trade.
A significant part of strategic planning is the setting of long-term financial plans, setting
out the medium and long-term financial objectives. The plans can allow the business
to judge whether or not it will achieve its financial objectives, e.g. the repayment of
loans, what finance needs it may have in the long term and short term, and whether
there is any surplus cash which should be invested.
Strategic cash flow planning is basically long-term cash flow budgeting, except that
there are greater uncertainties about cash flows due mainly to the longer planning
horizon. The cash flows which result from planning must be consistent with the firm's
financing, investment and dividend policies. The firm will be able to respond to cash
flow shortages or surpluses in a planned way – raising or investing the required amount
of finance in the way most optimal for the company. This includes taking advantage of
changing interest rates and economic climates to the benefit of the company. Some
businesses will be at risk of failure due to insufficient financial resources to
accommodate their necessarily increased investment when the upturn in the economy
does arrive. Such failure is known as the "second-round" failure.
However, there may be unexpected changes in the business cash flow patterns, such
as a slump in trade, which can not be forecasted for, so an organisation must have
sufficient cash to cover such eventualities. Cash flow planning which considers the
ability of an organisation to overcome such cash flow deficits is called strategic fund
Strategic fund management may deal with such unexpected changes by cutting
dividend payments; improving working capital management by increasing creditors or
the overdraft level or by cutting debtors and stocks; or by selling assets which are not
required by the core activities of the organisation. (Those assets which are most
marketable, such as short-term marketable securities, would be sold before those
which would take longer to realise, such as land and unused machinery.)
Whilst a company should ensure that it has sufficient cash to cover unforeseen
circumstances, holding too much cash is inefficient because of the opportunity cost of
income foregone (either from placing short-term surpluses in marketable securities, or
from the investment in projects earning a rate of return higher than the return required
by the supplier of finance for longer-term surpluses). If the company cannot invest
long-term surplus money in projects which receive higher returns than placing the
money in a bank account, then they should return the money to the shareholders to
allow them to utilise the money in the way they consider optimal. This can be done
either by paying out higher dividends or by repurchasing the company's shares.
(b) Capital Structure and Cash Flow
The capital structure of an organisation is the way in which its assets are financed, i.e.
the levels, types and proportions of equity, debt capital, long- and short-term liabilities.
Obviously, when the business is growing it will require additional capital to fund its
increased assets.
The working capital of the business is made up of the more permanent current assets
plus the fluctuating current assets less current liabilities. Different levels, and types, of
long- and short-term sources of finance can be used to fund the fixed assets and the
working capital of the business. The method chosen will have an impact on the cash
flow of the organisation.
An aggressive approach to the financing of working capital is to finance all fluctuating
current assets and some more permanent ones from short-term sources. This may be
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beneficial to the company if the short-term funds are cheaper than the equivalent long-
term ones, but increases the likelihood of liquidity and cash flow problems.
A conservative approach uses long-term financing to fund all permanent assets and
some fluctuating current assets. In fact it is only when current assets are large that
short-term financing is necessary – at other times there may be surplus cash to invest.
The company would probably invest this in marketable short-term securities, especially
if the amount is significant.
A balanced approach is to fund permanent assets from long-term sources and
fluctuating assets from short-term sources.
The method chosen will be a choice for senior management and will reflect their overall
policy and plans for the organisation. However, a business may be forced to adopt a
sub-optimal approach (from their viewpoint) due to restrictions in their ability to raise
the "correct" type of funds. As in all areas, the policy adopted by the firm should match
the expectations of the shareholders (see Study Unit 1 if you wish to remind yourself of
this topic).
Moreover, the market's view of the company's prospects and abilities will determine the
level of debt investors will be willing to lend the company. The nature of the industry
that the company operates in will also affect the level of debt that the market will
consider prudent – the more volatile the sector, the lower the level of gearing which
would be advisable.
Economic and Government Influences
The operations of an organisation are subject to a whole series of constraints imposed by
competitors, customers, trade unions, the general public and statutory bodies. As the social
environment has evolved, government has become more involved in the operation of
business – issuing laws, regulations, directives, voluntary policies and codes of practice
covering most areas of commercial life.
The area is rapidly changing, and we cannot possibly hope to cover every aspect affecting
companies, e.g. in areas such as health and safety; instead we will highlight some of the
more important pieces of legislation and government policy which directly impact in the area
of finance.
(a) The Companies Acts
The Acts of 1985, 1989 and 2006 contain various legal requirements for a company
operating its affairs in the UK including, in the field of accounting and finance:
requirements for depositing accounts; annual returns; registration of changes with the
Registrar of Companies; requirements for disclosure of information in the published
accounts; and procedures for the winding-up of a company. The legislation lays down
the minimum standards with which the company must comply.
There are also a number of further requirements established under the Acts and set
down by various different organisations such as:
 Serious Fraud Office (S.F.O.)
 Financial Services Authority (F.S.A.)
 London Stock Exchange
(b) The European Union (EU)
The EU provides a huge area of government involvement in corporate laws. The
Council of Ministers can publish requirements that impose obligations upon all
companies in member countries, even overriding the laws in those member states.
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However, the Community does provide the opportunity for additional markets and
greater availability of financial resources, including grant aid.
(c) Government Monetary Policy
Monetary policy is the manipulation by the Government of interest rates and/or the
supply of money in an attempt to influence the economy, and such economic variables
as growth, inflation and the balance of trade. However, in May 1997 the UK Labour
Government surrendered its setting of interest rates to the Bank of England, in line with
many other European countries. Nevertheless, the Bank of England will still
manipulate interest rates to achieve the desired levels of major economic variables,
including inflation, and this clearly, along with changes in the money supply, will have
an impact on the cost and availability of capital to an organisation. Moreover, as with
fiscal policy discussed below, monetary policy will also impact on other areas of a firm's
operation including the ability to export the firm's goods and the cost of imported raw
materials and components.
(d) Fiscal Policy
Fiscal policy is the alteration by the Government of the levels of taxation or the level of
government spending in order to affect economic variables such as unemployment and
inflation. It will obviously have an impact on the organisation – not just in the levels of
taxation which it pays and in the availability and level of grants, but also in the overall
level of demand in the economy and for the firm's products or services.
The current Government has taken significant steps to strengthen the framework for
fiscal policy since taking office. Fiscal policy is now directed firmly towards maintaining
sound public finances over the medium term, based on strict rules. Where possible,
fiscal policy supports monetary policy over the economic cycle and this approach,
together with the new monetary policy framework, provides the platform of stability
necessary for achieving the Government's central economic goal of high and
sustainable levels of growth and employment.
Central to the fiscal framework are five principles of fiscal management:
 transparency in the setting of fiscal policy objectives, the implementation of fiscal
policy and the publication of the public accounts
 stability in the fiscal policy-making process and in the way fiscal policy impacts on
the economy
 responsibility in the management of the public finances
 fairness, including between generations
 efficiency in the design and implementation of fiscal policy and in managing both sides of the
public sector balance sheet.
These principles were enshrined in the Finance Act 1998 and in the Code for Fiscal
Stability, approved in December 1998. The Code explains how these principles are to
be reflected in the formulation and implementation of fiscal policy. In addition, it
requires the Government to set out its fiscal policy objectives and the rules by which it
intends to operate fiscal policy over the life of the Parliament.
As set out in the 2007 Budget, the Government's fiscal policy objectives are:
 over the medium term, to ensure sound public finances and that spending and
taxation impact fairly both within and between generations. In practice this
requires that:
(i) the Government meets its key taxation and spending priorities while
avoiding an unsustainable and damaging rise in the burden of public debt;
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(ii) those generations who benefit from public spending also meet, as far as
possible, the costs of the services they consume; and
 over the short term, supporting monetary policy, by:
(i) allowing the automatic stabilisers to play their role in dampening variations
in economic activity – for example, other things being equal, when the
economy is growing rapidly, there will be higher tax receipts and lower
social security payments – thus helping to moderate economic upturns and
stabilise the economy, and
(ii) where prudent and sensible, providing further support to monetary policy
through changes in the fiscal stance.
The Government has also specified two key fiscal rules that accord with the principles.
These are:
 the golden rule – whereby, over the economic cycle, the Government will borrow
only to invest and not to fund current spending, and
 the sustainable investment rule – whereby public sector net debt as a proportion
of GDP will be held over the economic cycle at a stable and prudent level.
These fiscal rules provide benchmarks against which the performance of fiscal policy
can be judged. The Government will meet the golden rule if, on average over a
complete economic cycle, the current budget is in balance or surplus. The Chancellor
has stated that, other things being equal, net debt will be maintained below 40% of
GDP over the current economic cycle, in accordance with the sustainable investment
In setting fiscal policy, the Government takes a deliberately cautious approach. This
prudent approach is implemented, among other things, by basing public finance
projections on cautious assumptions for a number of key variables including the
economy's trend growth rate, levels of unemployment and oil and equity prices.
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Study Unit 2
Company Performance, Valuation and Failure
Contents Page
Introduction 37
A. Ratio Analysis 37
Liquidity 37
Profitability 38
Debt and Gearing 40
Investor Ratios 41
Miscellaneous Items 43
B. Using Ratio Analysis 44
Analysing Company Performance 44
Problems with the Use of Ratios 48
The Centre for Inter-firm Comparison 49
C. Introduction to Share Valuation 51
D. Methods of Share and Company Valuation 52
P/E Method 52
Net Asset Method 53
Dividend (Valuation) Models 54
Discounted Future Profits 56
The Berliner Method or Free Cash Flow Method 57
Note re CAPM 57
Worked Example 57
E. Non-financial Factors Affecting Share Valuation 61
(Continued over)
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F. Predicting Company Failure 61
Company Information Services 62
The Z Score 62
Other Models 63
Other Indicators 63
Problems with Prediction Models 64
G. Capital Reconstruction Schemes 64
Reasons for Capital Reconstruction 65
Principles of Capital Reconstruction 65
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A company’s financial position will affect its plans, and its ability to carry out those plans, in
the key areas of financing, investment and dividend policy. Shareholders and other
interested parties will thus be interested in the profitability of the company, its ratio of debt to
equity, its liquidity and other measures of a company’s financial performance. Company
reports and financial statements can be used to assess the performance of companies by the
use of ratio analysis.
When considering ratios it is important that a number of years are looked at to obtain as
meaningful a picture as possible, and also to compare the organisation with others which are
similar in size and industry. The ratios chosen should be relevant to the organisation in
question, e.g. stock turnover would not be relevant to a service organisation with little or no
stock. The wider economic and environmental context the firm is operating in must also be
This should be a revision section for you, ratio analysis having been covered in your earlier
studies. The ratios we shall consider can be grouped into four main types:
 Liquidity
 Profitability
 Debt and gearing
 Investor.
We will now consider the main ratios under each heading.
A company may be profitable but not necessarily liquid and able to pay its obligations when
required – failure to do so may lead to the company being wound-up. The ratios and figures
under this heading indicate the extent to which a company can meet its current liabilities as
they become due. The common liquidity ratios are:
 The current ratio, which is calculated as:
s liabilitie Current
assets Current
 The acid test ratio, which is calculated as:
s liabilitie Current
stock less assets Current
These two ratios show the liquid resources available to pay the short-term liabilities, low
ratios indicating potential cash flow problems. The quick (acid test) ratio is often calculated
because of the length of time it may take to convert stock into cash, this ratio giving the truer
picture of the liquid assets of the organisation. The yardsticks which an organisation’s ratios
are traditionally compared to are 2:1 for the current ratio and 1:1 for the acid ratio. However,
the yardsticks should be viewed in relation to the organisation in question, and in relation to
other ratios – a company with high stock turnover can have a healthy liquidity position with an
acid ratio of less than 1.
When considering current and acid ratios remember that high results may indicate
overstocking, poor collection of debtors or that the company has excessive cash; in such
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cases action should be taken to determine why there is a high ratio and steps taken (if
appropriate) to correct the situation.
 The debtors’ payment period, which is calculated as:
sales Credit
debtors Trade

This shows the length of time taken by a company’s debtors to pay their bills. In
general companies give 30 days’ credit on invoices and this can be used as a
yardstick. The resultant ratio, however, must be viewed in the light of any seasonal
variations which may be present in the figures used to calculate the ratio. Industry
norms and the type of customers the firm has also need to be considered in
determining a yardstick to use (e.g. a high level of overseas customers may mean that
terms longer than 30 days may be given).
 The stock turnover ratio, which is calculated as:
sales of Cost
stock Average

It shows the number of days that stocks are held; as with the debtors’ payment period
care must be taken to note any seasonal fluctuations contained in the figures used, for
which reason it is better to look at the trend in this figure. An increase may indicate a
slow down in sales or that the firm is overstocking.
Stock turnover  debtor payment period give a good indication of the cash
conversion period.
The ratio can also be calculated to show the number of times average stock is turned
over in a year:
stock Average
sales of Cost
 In addition, calculations by Beaver, Lev and others in the USA have shown that the
most significant single index of solvency is provided by establishing a trend line over a
period, from the ratio:
debt Total
flow Cash
The primary (or most frequently used) ratio is return on capital employed (ROCE). This is
usually calculated as:
employed Capital
taxation and interest before activities ordinary on Profit
employed Assets
taxation and interest before activities ordinary on Profit
This provides a measure as to how the investment of capital in the company is being
rewarded. The result can be compared to the cost of capital and the returns available
elsewhere reflected in interest rates and other companies’ ROCE figures. You can see a
breakdown of this ratio in Figure 2.1.
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Profit/Assets employed
Assets/Sales Profit/Sales
Selling &
Stock Land & buildings Labour
Debtors Plant & equipment Material
Cash Fixtures & fittings Expenses
Figure 2.1: Breakdown of ROCE
However, as with many other ratios, there is no one agreed method of calculating it.
Problems in its calculation include the following:
(a) Should profit be pre-tax or post-tax? Shareholders will prefer post-tax because this is
the money available to pay dividends with; management will prefer pre-tax unless
they are responsible for minimising the company’s tax liability.
(b) Should non-recurring items, e.g. profit on the sale of an asset or arising from an
insurance claim, be included?
(c) Should non-trading profits, such as rents and investment income, be included?
(d) Should total assets or net assets (net assets = total assets minus current liabilities) be
used as the capital employed figure? Often a company has a permanent bank
overdraft (which is included in the current liabilities) and therefore should be considered
to be part of capital employed.
(e) Should intangible assets such as goodwill be included in the capital employed figure?
(f) How should assets be valued:
 At cost?
 At written-down book values?
 At replacement values?
 At current market values?
(Remember – the understatement of a company’s assets can produce an artificially
high ROCE.)
(g) Which balance sheet date and profit figures are relevant? Should the capital employed
be that at the start or end of the year, or some average figure?
The method chosen to calculate ROCE depends on the individual company. There is some
evidence that companies often choose the set of values which gives them the highest ROCE
but, whichever method is chosen, you must be consistent between years and companies to
allow comparability. Industry norms are also important, e.g. service industries tend to have
higher profit margins than manufacturing industries.
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Other common profitability ratios are:
 Gross trading profit : Sales
 Net trading profit : Sales
(It is useful to compare trends in these two measures against each other to provide an
indication as to how well expenses are being controlled.)
 Net profit : Equity capital
 Net profit : Working capital
 Sales : Capital employed (expressed as a number of times)
 Fixed asset turnover rate, measured by Sales : Fixed assets (expressed as a number
of times) with a possible breakdown to asset class.
 Current asset turnover rate, which is subdivided into the following:
(i) Sales : Total current assets
(ii) Sales : Debtors
(iii) Sales : Stocks held
In this calculation the figure of sales may be replaced by the cost of sales (if
known) since stocks at cost value remove the potentially distorting effects of
selling price changes in response to market conditions.
Note: The Du Pont Index is a variation on the primary ratio:
employed Capital

made up of the secondary ratios – the profit margin and asset turnover. Profit may be
calculated before interest and taxation or just as pre-tax profit. The first shows the level of
profit achieved on sales and the second shows how well assets are being used to generate
sales. Often there is a trade-off between profit margin and turnover – high profit levels may
lead to low sales and vice versa. Used in a series of ratios over a period of time this
provides more information than the basic ROCE ratio.
An obvious check on profitability is to look at the level of profit or loss shown in the accounts
and the change from previous years.
Debt and Gearing
 The gearing ratio is expressed as Debt capital : Equity capital. Again there is no one
accepted method of calculating this ratio – some analysts prefer to use long-term debt
only, whilst others prefer to use all debt (excluding provisions) in a company’s structure.
(The latter is often called the debt ratio.) Similarly, there is no agreement as to
whether balance sheet or market values should be used.
There is no absolute “correct” level of gearing, although an often quoted benchmark for
the debt ratio is 50%; the resultant figure again should be considered in line with
previous years and industry norms.
The significance of the gearing ratio is the extent to which profit fluctuations are borne
by the equity holders. The higher the level of gearing the greater the impact on
shareholder wealth of changes in profit levels (see later in course). Moreover, a high
level of debt makes future borrowing more difficult.
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Gearing ratio is frequently calculated using the formula:
Gearing ratio 
Reserves + capital share Ordinary
capital dividend Fixed + interest Fixed
The following is an extract from the balance sheet of Denton Ltd as at 31 December
Creditors: Amounts falling due after more than one year
8% debentures 10,000
Capital and Reserves:
Ordinary share capital (£1 ord shares) 30,000
10% Preference shares 15,000
Reserves 23,000
The gearing ratio is:
000 23 000 30
000 15 000 10
, ,
, ,

 0.47 : 1
Remember, however, that this is only one method of calculating the gearing ratio, and
you should always make this clear in using it.
Other ratios in this group include:
 Equity interests : Net assets
 Debentures : Net assets
These two ratios provide an indication of the cover of fixed assets to the particular type of
capital investment. Moreover, by establishing a ratio of Fixed assets : Equity capital you can
see to what extent the shareholders “own” the fixed assets.
 Debenture interest cover measures the “safety” of the interest payment – the higher
the cover the more dependable the payment is. It is calculated by dividing the Net
profit before tax and debenture interest by the Debenture interest payable. For
example, if the profit before tax and interest was £15,000 and the debenture interest
was £3,000 then it would be 15/3 = 5 times covered.
 The cash flow ratio, measured as:
) provisions (including debt Total
statement) flow cash company the from (taken flow in cash annual Net
This shows the ability of an organisation to meet its commitments, with changes in the
ratio showing changes in the cash position of the firm.
Investor Ratios
 A major ratio in this class is that of earning per share (EPS) calculated as:
Net profit after tax, debenture interest, extraordinary items, minority interests and
preference dividends/No. of ordinary shares in issue and ranking for dividends. It is
measured in pence.
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Investors wish to see growth in the EPS in order to fund investment and increases in
dividend payments. An inability to sustain a level of EPS could have a negative impact
on the level of a company’s dividend.
When looking at the trend of the EPS over time changes in capital structure, such as
the issuing of new shares or the conversion of convertible loan stock, need to be
considered. Similarly, when comparing different companies differences in their number
of issued shares should be considered. In the former case it would be useful to
calculate the fully diluted earnings per share which takes into account all capital
instruments ranking as equity shares now or in the future; for example, convertible loan
stock or share options. This also gives investors an indication of the effects of the
future exercise of share options, warrants and such like (including in the numerator the
savings in financing such instruments and the additional profits to be earned from
utilising the funds raised in the business).
 Dividend cover shows how many times the declared dividend could be paid out of
distributable profits. For example, if a company’s profit after tax and debenture interest
was £40,000 and a dividend of £32,000 was declared, the dividend cover would be:
dividend Declared
interest debenture and tax after Profit

 times covered.
If preference share dividends are payable these, too, form a prior deduction when
considering dividend cover on ordinary shares. The ratio shows the proportion of
distributable profits being paid out and indicates the risk that if earnings fall this level of
payout could not be maintained. A high cover may indicate that the firm is investing in
future growth.
Dividend cover can also be calculated using the EPS:
Dividend cover =
share ordinary per Dividend
 The dividend yield of a company’s shares is important because it shows the return the
investor receives on the market value of shares (declared dividend is based on the
nominal (or par) value of shares). The shareholder can compare the yields between
different investments to help determine the value for money of his shares in the
company. Dividend yield is calculated as:
share per value Market
share per dividend Gross

Dividends paid to shareholders in the UK are net dividends (after tax); to determine the
gross dividend figure to use in the above calculation we have to adjust for taxation,
using the following formula:
dividend Gross
(%) tax income of rate Lower 100
100 share per dividend Net

Thomas plc has just declared a net dividend of 10p per share. If the current share
price of Thomas is 135p, what is the dividend yield?
Gross dividend 
(%) tax income of rate Lower 100
100 share per dividend Net

20(%) 100
100 10

= 12.5p
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Dividend yield  100
share per value Market
share per dividend Gross

 100
 = 9.259
 Interest yield is the equivalent of dividend yield for the return on the market price of
loan stock.
yield Interest 100
stock loan of value Market
tax) (before interest Gross
 
Be careful not to confuse interest yield with the coupon rate, which is the return on the
face value of the debt.
The interest yield is generally higher than the dividend yield. This is because
shareholders expect to receive capital gains on their shares. When capital gains and
dividend yield are added together they should produce a higher return than interest
yield, reflecting the greater risk of holding shares (risk is considered in detail in a later
study unit).
 Earnings yield is the equivalent of dividend yield for the return on the market price of
earnings per share.
yield Earnings 100
share of value Market
tax) (before earnings Gross
 
The gross value of the EPS is used in order to allow comparability with dividend yield.
 The price earnings (P/E) ratio compares the market price of a share to the earning
per share and is expressed as:
tax) (after share per Earnings
price Market
Note that the net basis is used rather than the gross basis we encountered in earlier
ratios. For example, if ABC plc has 200,000 ordinary shares of £1 which are currently
quoted in the market at £1.70, and its net earnings for the year were £45,000, the P/E
ratio would be:

0,000) (45,000/20
An investor purchasing the shares at £1.70 would, in other words, be paying 7.56 times
the annual earnings on those shares. The level of a company’s P/E ratio is seen as a
reflection of the market’s views on the prospects of a company. A company with a
higher P/E ratio than another may have better growth prospects or more secure
earnings. This is because the P/E ratio should remain constant over time, and an
increased EPS will result in an increased market price and thus an increased P/E ratio.
However, the only real value of the P/E ratio is that it shows the relationship between
earnings and market price for a company, which may be difficult to interpret when
market prices are fluctuating widely due to circumstances outside the control of the
company, such as changes in interest and exchange rates.
Miscellaneous Items
The following ratios may also be of use to stakeholders when analysing reports:
 Value added per employee
 Sales per employee
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 Asset structure – this involves calculating the varying proportions in which the assets
are structured, for example:
Fixed assets 35%
Investments 5%
Net current assets 60%
 Sources of asset structure, for example:
Ordinary capital and reserves 50%
Debt capital 45%
Net current liabilities 5%
Alternatively the asset structure could show gross current assets, while gross current
liabilities are shown in the source of asset structure. The two could then be compared
to see to what extent outside interests “own” the company assets.
 Proportions of shareholders’ interests, for example:
Preferential capital 10%
Ordinary capital 50%
Capital reserves 8%
General reserves 20%
Specific reserves 12%
It would not be possible to list every single ratio capable of calculation. The important point
to note is that different groups will be interested in using different ratios to reflect their
particular interest in the company. You must also remember that ratios should always be
considered as part of a trend, and once calculated they require careful interpretation.
Companies often give information on ratios in their five and ten year summaries, but the full
set of accounts is essential to allow a full comparison – they are generally only available for
the year of the accounts and the previous years.
There are two fundamental reasons why ratio trends are important:
 To identify the trends within the business itself over the last few years – for example, to
assess whether the business is doing better or worse, or what remedies or corrective
action can be taken
 To identify how the business is doing compared to similar businesses in the same
operating and market environment.
It is also important to recognise that whilst much can be made of ratios and their
interpretation, they are after all calculated at a particular point in time. In the past,
organisations have been accused of manipulating their year end accounts to perhaps
produce a “healthier” looking picture.
Analysing Company Performance
We will now study the use of ratio analysis by considering a detailed example. It is important
to remember that you will generally be asked for an interpretation of the ratios identified,
Company Performance, Valuation and Failure 45
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which means you must comment not only on individual ratios, but also on the composite
position disclosed by your analysis, including changes in profit before and after tax and
turnover. You must also remember, where possible, to look at a selection of ratios with at
least one from each of the four main groups we have discussed.
The summarised accounts of New Ideas plc are as follows:
Balance Sheets as at 30 April
Year 2 Year 1
£000 £000
Fixed assets (net) 6,401 2,519
Current assets
Stock 25,426 20,231
Debtors 21,856 20,264
Balance at bank 2,917 6,094
56,600 49,108
Ordinary shares of 50p 5,000 5,000
Revenue reserves 14,763 12,263
Deferred taxation 5,433 3,267
10% Debenture loans 10,000 10,000
Creditors: Amounts falling due within one year
Trade creditors 18,762 16,431
Taxation 1,642 1,247
Dividends 1,000 900
56,600 49,108
Results for the year ended 30 April
Year 2 Year 1
£000 £000
Sales 264,626 220,393
Trading profit 9,380 8,362
Interest payable 1,000 1,000
Taxation 4,380 3,642
Dividend 1,500 1,400
The following additional information is provided.
(a) The ordinary shares are quoted at £1.20.
(b) New Ideas plc requires £16 million for an investment project and is considering one of
the following:
(i) The issue to shareholders of £16 million 10% convertible (£1 for 1 share)
debentures at par.
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(ii) A rights issue at 80p.
(iii) The sale in the market of £16 million 13% debentures at par.
You are required to:
(a) Calculate from the balance sheet and results:
(i) Two ratios particularly significant to creditors.
(ii) Two ratios particularly significant to management.
(iii) Two ratios particularly significant to shareholders.
(b) Comment briefly on the change between Year 1 and Year 2 in the ratios you have
(c) Calculate the immediate effect of the three schemes on the gearing of the company.
(d) Calculate the effect of the three schemes on the earnings per share, on the assumption
that the Year 2 profits from the existing assets will be maintained and that the £16m net
investment will produce profits of £3.5m before tax and interest. The rate of tax can be
assumed at 50% (this is not the current rate but is used for ease of calculation).
Year 2 Year 1
(a) (i) Ratios significant to creditors
 Current ratio 
s liabilitie Current
assets Current
Year 2 50,199 : 21,404 2.35 : 1
Year 1 46,589 : 18,578 2.51 : 1
 Liquidity ratio 
s liabilitie Current
Stock assets Current 
Year 2 24,773 : 21,404 1.16 : 1
Year 1 26,358 : 18,578 1.42 : 1
(ii) Ratios significant to management
 Activity ratio 
profit tax - Pre
Year 2 8,380 : 264,626 3.17%
Year 1 7,362 : 220,393 3.34%
 Profitability ratio 
assets Net
profit tax - Pre
Year 2 8,380 : 35,196 23.8%
Year 1 7,362 : 30,530 24.1%
(iii) Ratios significant to shareholders
 Return on capital employed 
funds rs' Shareholde
profit tax - After
Year 2 4,000 : 19,763 20.2%
Year 1 3,720 : 17,263 21.6%
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 Dividend cover ratio 
interest debenture and tax after Profit
Year 2 4,000 : 1,500 2.7 : 1
Year 1 3,720 : 1,400 2.7 : 1
Note that after-tax profit is used as this is preferred by shareholders.
(b) Comments on ratios
In spite of an increase in sales of 20% and an increase in pre-tax profits of 13.8%, the
ratios mentioned show a marginally unfavourable trend between Year 1 and Year 2.
Among the unfavourable trends, the change in the liquidity ratio may cause concern to
(c) Effect of fund-raising schemes on gearing
Gearing is:
reserves) + capital (share Equity
shares Preference + capital Loan
This is currently:

(i) Issue of £16m 10% convertible debentures changes the gearing to:

(ii) By implementing a rights issue of ordinary shares, the gearing is reduced to:

(iii) By issuing £16m 13% debentures, the gearing is the same as under (i) above.
It is considered that schemes (i) and (iii) represent a dangerously high level of gearing.
(d) Effect of fund-raising schemes on Earnings per Share
The current EPS is calculated as follows:
£000 £000
Trading profit 9,380
less: Interest payable 1,000
Taxation 4,380 5,380
Net profit 4,000
Earnings per share  40p

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(i) On issue of £16m 10% convertible debentures:
£000 £000
Net profit as before 4,000
add: Additional profit 3,500
less: Tax @ 50% 1,750 1,750
less: Debenture interest (10% on £16m) 1,600
Tax @ 50% 800 800
Earnings per share  49.5p

(ii) On issue of 20 million ordinary shares (at 80p each = £16m):
£000 £000
Net profit as before 4,000
add: Additional profit 3,500
less: Tax @ 50% 1,750 1,750
Net profit 5,750
Earnings per share  19.2p

(iii) On issue of £16m 13% debentures:
£000 £000
Net profit as before 4,000
Additional profit (net) 1,750
less: Debenture interest (13% on £16m) 2,080
Tax @ 50% 1,040 1,040
Earnings per share  47.1p

Note that potential problems can also be detected from the company’s accounts by carefully
reading the reports that accompany the figures and the use of significant financial ratios. We
shall look at this in more detail in later in the course.
Ratios can also be used in inter-firm comparisons. Inter-firm comparisons involve the
contrasting of the results of a company with one or more other companies in order to help
assess their relative performances.
Problems with the Use of Ratios
The main difficulty with the use of ratios is the question: “Are we really comparing like with
Even where the comparison is between two companies of roughly equal size and ambition,
there will always be an element of doubt that the comparison has true validity because of
alternative accounting policies which can be adopted in areas such as depreciation and the
use of off-balance sheet items. One of the biggest problems in all forms of comparison is the
differences which occur in the structure and culture of businesses, the economic and general
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environment making strict comparison extremely difficult. Similarly, when making
comparisons over time the impact of inflation must be considered because of its impact on
turnover, earnings, profit and asset values. However, the comparisons are useful in helping
to judge stewardship and the return on the investment relative to others available.
If the accounts are different to those of the industry or segment to which they belong, further
investigation may be required by the financial manager or analyst.
The Centre for Inter-firm Comparison
Established by the Institute of Management and the British Productivity Council in 1959, the
Centre has evolved the pyramid method of selecting ratios. Under this method the principal
ratios are listed at the top of the pyramid, starting with return on capital employed which is
referred to as the primary ratio. This is taken to be the key indicator of company
performance and profitability. The ratio is then broken down into a number of subordinate
ratios as shown in Figures 2.2 and 2.3. (All ratios shown in the pyramid are compiled for the
industry as a whole.)
The overall profitability of the operations of the business, and the
overall success of its management, depend on the ratio:
employed assets Total
tax before Profit
Differences between constituent parts of this ratio could arise from:
Differences in the ratio or Differences in the ratio
tax before Profit
employed assets Total
Inter-firm variations could arise from Inter-firm variations could arise from
the ratio of: or the ratio of: or the ratio of:
profit Gross
various ratios
costs to sales
assets Fixed
assets Current
Sales v Current assets
may be affected by
stock turnover or
debtor turnover
Figure 2.2: Pyramid Diagram of Ratios – Certain Distributive Trades
(as devised by the Centre for Inter-firm Comparison)
Firms can raise their gross profits either by achieving a higher volume of sales of items
earning high gross profits, or by adjusting prices within market constraints. The extent to
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which either of them affects total gross profit will be indicated by the inter-firm comparison of
ratios showing:
(a) The composition of sales made;
(b) The gross profit achieved on different products.
employed Assets
profit Operating
profit Operating
employed Assets
sold goods of costs Factory
costs tion Administra
assets Fixed
assets Current
costs on distributi and Marketing
production of value Sales
costs Production
stocks Material
cost at Sales
progress in Work
cost at Sales
cost at stocks goods Finished
cost at Sales
production of value Sales
costs material Direct
production of value Sales
costs labour Direct
production of value Sales
overheads Production
Figure 2.3: Pyramid Diagram of Ratios – Manufacturing Industries
(as devised by the Centre for Inter-firm Comparison)
Once the ratios are compiled for the industry as a whole, they will be prepared for the
participating firm. The resultant ratios are then compared and any material deviations
For example, if the primary ratio shows that the rate of return for the company is less than for
the industry as a whole, one or more of the subordinate ratios that make it up must be
affected. This type of comparison will indicate those work areas which are “up to standard”
as well as those which are either under, or over, performing. Senior management can then
focus its attention on the specific areas which have been identified.
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Advantages and Disadvantages of Inter-firm Comparisons
Advantages Disadvantages
Participating firms can see their
efficiency in comparison with others.
It is often difficult to obtain uniformity
of procedure, methods and definitions.
Correcting action to address
weaknesses can be made in good
Some companies hide or refuse to
release key data required in the
By using a specialist, confidential
agency, the fear that personal
company data will pass to a competitor
is removed.
The nature of a company’s operations
may be too diverse for true
Major customers’ and suppliers’
accounts can be compared to
measure their future stability and plans
made where serious weaknesses are
The process can be time-consuming
and requires specialist skills.
Whilst for quoted companies share values can always be found from market prices on the
Stock Exchange, it may be necessary to calculate another valuation for a quoted company’s
shares in the process of a takeover bid. (We shall consider this in more detail in the next
study unit.)
Unquoted companies do not have a market price for their shares, and may have to estimate
the value for them in the following situations:
 The shares are to be sold.
 The shares may have to be valued for taxation purposes.
 Shares may be used as collateral for a loan.
 The company may wish to be quoted on the Stock Market and wants to fix an issue
 The relative values of shares involved in a merger may need to be assessed in order to
determine the relative prices.
With mergers and takeover bids in the case of a quoted company, the minimum price which
can be suggested will be the current market price of the shares. Often the final, negotiated
price will be around 20% higher than this minimum in order to encourage the shareholders to
part with their shares.
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In this section we will look at company valuation in addition to share valuation. You will see
that a number of different methods can be used to value a company. Valuations using these
methods can often differ significantly from the total of shareholders’ funds on a company
balance sheet.
The main methods that are required to be understood more comprehensively for this study
module (and the ones that will be concentrated on) are as follows:
 Price Earnings Ratio (P/E Ratio)
 Net Asset Value (NAV)
 Free Cash Flow and
 Dividend Valuation Model (DVM)
P/E Method
This is probably the most common and popular method to adopt when trying to value a
company share, as the historic price earnings ratio compares a businesses share price with
its latest profit figures and that is what is most likely to attract, or otherwise, new
shareholders and hence new capital investment.
This method calculates the value of a company’s shares by using the following formula:
Market value per share  EPS  P/E ratio
This method makes use of a company’s level of earnings to calculate its value; the EPS used
can either be an historical one, an average of past figures, or a prediction of a future figure.
The latter is the best but care must be taken when using forecasts, especially with the figures
used for growth in earnings. Similarly an appropriate P/E ratio should be used. The P/E
figure used depends upon:
(a) How secure the earnings of the company are – the more secure the earnings, the
higher the P/E ratio. Companies with high gearing levels tend to have lower P/E ratios
reflecting greater financial risk.
(b) Expectations of future profits – the higher the expected earnings, the higher the P/E
ratio. Adjustments may be made for past profit trends and the reliability of the
estimates. (Expectations of future profits can be calculated using the discounted cash
flow techniques which we shall discuss later in the course.)
(c) Companies which are unquoted generally have a P/E of between 50% and 60% of a
company which is quoted on the Stock Exchange and around approximately 70% of
shares quoted on the AIM, reflecting their reduced marketability and smaller size.
However, an unquoted company with earnings of £300,000 or more and growing at a
regular rate may have a higher P/E ratio because it may be able to be quoted on the
(d) General financial and economic conditions.
(e) The industry or industries which the firm is in and the prospects of those sectors.
(f) Liquidity and asset backing, including the nature of assets – specialised assets with a
restricted resale market may reduce the P/E ratio.
(g) The make-up of the shareholders and the financial status of any major shareholders.
(h) Companies dependent on one or two key individuals and their skills may have their P/E
ratio lowered.
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Sometimes the P/E ratio of a company being acquired may be increased to reflect the
improvements the predator thinks they can introduce into the “victim” company, although
often such improvements are not realised.
Sinbad plc is considering acquiring Flower Ltd. Sinbad plc’s shares have been quoted
recently at an average of £6.40 and the recently published EPS of the company is 40p.
Flower Ltd has 100,000 shares and a current EPS of 50p. Suggest an offer price for Flower
First we have to decide a reasonable P/E ratio. The P/E ratio for Sinbad plc is 640/40  16.
Assuming Flower Ltd is in the same industry its P/E ratio can be based on Sinbad plc’s P/E
ratio, adjusted for the fact that it is not quoted, its growth prospects, and riskiness of its
earnings. (If Flower Ltd is in a different industry then a typical P/E ratio for that industry could
be used as a basis for the calculations.)
Using Sinbad plc a P/E ratio for Flower Ltd can be estimated as, for example, 16  50%  8.
A value for the shares can then be calculated as 8  50p  £4. This price would be the basis
for negotiations on the value of the company.
Net Asset Method
With this method the company is viewed as being worth the total of its net assets and this
makes the balance sheet the critical part of the business that is needed for share valuation
purposes. If the share value is undertaken using this method, it is often necessary to update
the balance sheet values, to ensure that the basis on which the valuation is done is as
accurate as possible.
The premise that the value of a class of a company’s shares is equal to the net tangible
assets of the company attributable to those shares is the basis of this method of calculating
share values. Intangible assets are only included in the calculation if they have a
recognisable market value, e.g. a copyright. To calculate the value of a share we simply
divide the value of the assets attributable to a class of shares by the number of shares in the
Whilst this may seem to be an easy method in principle, in practice it can be quite difficult,
the problems arising from arriving at a value for net assets. The problems include the
 Are the assets to be valued on a going concern or break-up basis?
 Are any assets covered by prior charges?
 How can the assets be valued – is a professional valuation required?
 What are the costs of sale – redundancy, taxation charges on disposal?
 Have all the liabilities been identified and correctly valued, including contingent
If you are given the information to do so in an exam question on valuation, always calculate
the net assets per share. There are two reasons for this:
(a) The value shows the amount a shareholder could expect to receive if the company
went into liquidation. A potential shareholder could compare the asking price for the
shares with the net assets per share value to calculate the maximum possible loss if
the company fails to provide the promised dividends and earnings figures.
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(b) An adjustment may be required in a scheme of merger to the value of the companies’
shares to reflect differences in asset-backing – shares with higher net assets per share
figures could be expected to gain a higher price.
Unless otherwise told in an exam situation you should use the balance sheet figures
provided, adjusted for intangible assets, to calculate the share values. However, you should
list any concerns that you have along the above lines regarding the figures given.
Dividend (Valuation) Models
These models are based on the assumption that the market value of ordinary shares
represents “the sum of the expected future dividend flows, to infinity, discounted to present
The model used under this method varies with the assumptions used. The simplest model
assumes that dividends will remain at a constant level in the future. The value of a
company’s shares can be calculated using the formula:
Market value 
% shares the on yield) (or return Expected
pence in Dividend
Tinkeywinkey Ltd’s shareholders expect a dividend yield of 12% and have been told that
dividends per share for the foreseeable future will be 20p. Calculate the value of
Tinkeywinkey’s shares if they have 100,000 in circulation.
Using the above formula to calculate the value of one share:
Value  166.67p.
return Expected
pence in Dividend
 
The value of all 100,000 shares  value of one share  number of shares in issue so the
value of the company  166.67p  100,000  £166,670.
In other words, a shareholder in Tinkeywinkey who accepted a yield of 12% on an investment
of £1.67, would be prepared to pay £1.67 for a share which paid him a dividend of 20p, or
12% on a nominal value of £1.
However, as we will see in a later study unit, shareholders prefer a constant growth in their
dividends. In order to reflect this in valuing the company using a dividend method we have to
predict future growth in dividends – which generally reflects predicted changes in a
company’s earnings. When the expected growth figure has been determined we can
calculate the value of the company’s shares using the Dividend Growth Model or Gordon’s
Model of Dividend Growth.
This model states:

g) r (
g) + (1 d

where: P
 the current ex dividend market price
 the current dividend
g  the expected annual growth in dividends
r  the shareholder’s expected return on the shares
The expression d
(1  g) represents the expected dividend in the next year.
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Poh Ltd is expecting to pay a dividend of 20p this year, increasing at a rate of 5% per annum.
If its shareholders have a required return of 15%, calculate the current market price.
Using the formula:

g) r (
g) + (1 d

0.05) (0.15
0.05) 20(1

 210p
The dividend yield method is often used when valuing small shareholdings in unquoted
companies. The reasoning behind the model is that such shareholders, being unable to
influence a company’s earnings to any extent, will only be really interested in the dividends
they receive from holding their shares. This method assumes that a share price is equal to
the value of all the dividends it will attract during the time it is held, plus the amount received
when it is sold (the sale price will reflect future dividends expected at the point of sale).
Amounts of cash received in the future are worth less than cash received today, so we must
discount the future values to compensate and express them in terms of their equivalent value
today. The discount rate used is the cost of the capital provided (which is the yield the
investor expects to receive from his investment in the company). (We will cover this topic in
much greater detail later in the course.)
This discounting can be expressed as:

2 1
1 1 1 1 ) ( ) ( ) ( ) ( r

where D  dividend (i.e. D
is dividend in next year)
To calculate D
, D
, D
, etc.:
 d
(1  g)
 d
(1  g)
 d
(1  g)
This model can be expanded to allow for potential growth in the dividend rate, and can be
simplified to the dividend growth model shown above:

g) r (
g) + (1 d

Dipsey Ltd, whose shareholders require a return of 20%, expects to pay no dividends for the
following three years, but then expects to be able to pay a dividend of 10p per share for the
foreseeable future. What is the value of its shares?
There is no return in the first three years so the price is:
0  0  0 

 .......
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Because the cash flows continue into the foreseeable future this will be the same as:
p 10
at time t
The present value of £1 a year forever at r% growth is
Therefore the price today 
p 10


 28.94p (say 29p)
Note that growth will usually be expressed as a percentage.
Discounted Future Profits
This method is sometimes used when a company intends to purchase another’s assets and
invest in improvements in order to increase future profits. It is best illustrated using an
Bear plc is proposing to acquire Lion plc who is currently just breaking even. Bear feels that
the investments it plans to make should lead to the following after-tax figures (ignoring any
price paid) for Lion:
Year Earnings
1 85
2 88
3 92
4 96
5 96
Bear wishes to recover its investment within five years. If the after-tax cost of capital is
12.5%, what is the maximum price Bear should be prepared to pay?
The maximum price is the one where the discounted future earnings exactly equal the
purchase price paid.
Year Earnings Discount Factor Present Value
(Earnings × Discount
£000 £
1 85 0.893 75,905
2 88 0.797 70,136
3 92 0.712 65,504
4 96 0.636 61,056
5 96 0.567 54,432
 Present Value 327,033
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Therefore the maximum purchase price would be £327,033. (Don’t worry if you do not
understand the discount factors at this stage; they will be fully explained later in the course.)
The Berliner Method or Free Cash Flow Method
This method is calculated by using the average of share prices obtained using the net assets
method and the earnings methods (see above).
This method is also known as the free cash flow approach. The method may be difficult to
adopt in practice as it needs forecasts of working capital (see later in the course) and
taxation to ensure that estimates of future cash flows and their timings are accurate.
Note re CAPM
The Capital Asset Pricing Model is a further method of valuing shares. It is used especially
to determine the required yield on equity when the shares are being priced before a Stock
Market listing. We shall cover this topic in a later study unit, but we mention it here to remind
you to include it in your revision of this stage.
Worked Example
The following question is taken from the June 2006 examination paper.
The directors of Steel Ltd are considering putting in a bid to purchase a rival company Bronze
The most recent accounts of Bronze Ltd shows the following:
Profit and Loss Account for the year ended 31-12-05
£’000 £’000
Sales 3,064,100
less: Cost of sales (924,100)
Gross Profit 2,140,000
less: Distribution expenses 225,000
Advertising expenses 308,000
Marketing expenses 568,000 (1,101,000)
Net Profit before tax 1,039,000
Corporation tax (311,700)
Net profit after tax 727,300
Dividend (127,300)
Retained profit 600,000
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Balance Sheet as at 31-12-05
£’000 £’000 £’000
Fixed Assets Cost Depreciation NBV
Land 500,000 500,000
Buildings 1,200,000 (300,000) 900,000
Fixtures 280,000 (40,000) 240,000
Motor vehicles 370,000 (50,000) 320,000
2,350,000 (390,000) 1,960,000
Current Assets
Stock 640,000
Debtors (trade) 110,000
Prepayments 40,000 790,000
Current liabilities
Creditors (trade) (346,800)
Taxation (311,700)
Dividends (127,300)
Bank overdraft (38,500) (34,300)
Long term liabilities
8% Debentures (secured) (114,000)
Net Assets 1,811,700
Financed by
Ordinary shares (£1par) 1,500,000
Profit and loss 285,000
Revaluation 26,700
Additional Information
1. A professional surveyor has recently established the following current realisable values
of the assets of Bronze Ltd
Land 650,000
Buildings 780,000
Fixtures 80,000
Motor Vehicles 260,000
Stocks 610,000
Trade debtors 100,000
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2. The estimated cash flows of Bronze Ltd (ie after tax, interest and replacement
investment) over the next ten years are estimated as follows:
2006 225,000
2007 275,000
2008 290,000
2009 360,000
2010 – 2015 380,000 p.a.
3. The directors would be seeking a return of 14% if they went ahead with the purchase.
4. A similar business to Bronze Ltd listed on the stock exchange has a Price Earnings
(P:E) ratio of 8:1
5. No strategic investment is envisaged over this period.
(a) Calculate the value of a share in Bronze Ltd using the following valuation methods:
(i) Net asset ratio
(ii) P:E ratio
(iii) Discounted (free) cash flow
(b) What are the main disadvantages of each method?
(a) (i) Net asset ratio:
Net asset value – per accounts 1,811,700
Land 150,000
Buildings (120,000)
Fixtures (160,000)
Motor vehicles (60,000)
Stocks (30,000)
Trade debtors (10,000)
Adjusted net asset value £1,581,700
Valuation per share is
= £1.05 per share
(ii) P:E ratio:
Profit after tax = £727,300
P:E ratio = £727,300 x 8 = £5,818,400
Valuation per share is
= £3.88 per share
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(iii) Free cash flow:
Cash flow Present value
Year £ £
2006 225,000 197,325
2007 275,000 211,475
2008 290,000 195,750
2009 360,000 213,120
2010 – 2015 380,000 ^ 874,760
Assume Current assets = Current liabilities
Long term loan (debentures) (114,000)
^ combined aggregate annuity value, based on annuity table
Valuation per share is
= £1.05 per share
(b) Main Problems
(i) Net asset ratio
Fixed asset values are usually based on current historic cost less depreciation.
Different depreciation methods result in different values of fixed assets and,
whatever method of depreciation is used, the book values are unlikely to
correspond to market values. Although companies do revalue their assets
periodically, this is a subjective exercise, often undertaken by the directors
Values of stock may not be reliable, especially if the accounts were prepared
some time ago. Companies often “window dress” their accounts at year- end and
stock values in some industries are often outdated.
Some accounts may be uncollectable. Provision should have been made for bad
and doubtful debts, but the bidder should be wary of the extent of this allowance.
(ii) Price Earnings
The earnings figure can be distorted by accounting policies.
The current earnings may be untypically high or low and it may be more
appropriate to take the average earnings over the last few years.
It is difficult in reality to find close substitutes – i.e. companies which produce the
same product lines, serve the same markets and have similar management
Companies have different potential for growth.
(ii) DCF
Can the future investment be accurately predicted?
How can we measure the discount rate?
Over what time period should we assess value?
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Despite all the influences of financial figures and projections on the value of a company
share, there are a number of key non-financial factors that can have an effect on a company
share price. The key ones are as follows:
 Business reputation – Sometimes a business might have a key individual or individuals
who have a flair for business and who tend to succeed in whatever business venture
they are invloved.
 Knowledge – Some businesses are known as being market leaders and key innovators
in research and development.
 Capabilities of the management team might be well advanced and seen as a good
working management team.
 Company attitude might be such that the business is prepared to do whatever is
reasonable to improve their products and services for their customers.
 Market penetration – Some companies may have such a good product or such a good
marketing capability that they are able to penetrate their markets aggressively to
increase their market share. For example, Tesco currently accounts for an ever
increasing share of the supermarket trade in the UK and they are rapidly expanding
their range of business ventures both in the UK and abroad and aggessively buying up
surplus land for future use or to stop rival expansion.
 Dynamism – Some businesses might have an individual or individuals who are seen as
dynamic and encourage customers.
 Leadership qualities in some companies could be seen as excellent and this
encourages good customer confidence in the business.
We have seen that ratio analysis is used to assess several factors of the firm’s performance
including the financial stability, the return received from investment and the efficiency and
effectiveness of management. We have also seen that inter-firm comparison can be a useful
way of identifying the strengths and weaknesses of different companies, and as a tool to
increase efficiency. It is also useful in predicting and identifying corporate failure.
A business that is highly dependent on one major customer or one major supplier, must
monitor that company’s activities in order to detect any early warning signs of potential
collapse which leave those who deal with it with potentially serious problems. A further
reason for monitoring the progress of companies is when the managers of the firm are
seeking a takeover opportunity, at which time they may be reviewing certain businesses to
see which could be the most suitable targets for acquisition.
The problem of corporate collapse is a serious one; empirical evidence shows that for every
company which is in receivership there are three or four others with serious cash constraints.
Many such businesses are at risk of second-round failure, which we discussed in the
previous unit.
Avoiding the pitfalls which the managers of such firms are likely to face will require, among
other things, careful control of debtor and creditor relationships. The quality of credit control
in the firm may, in these circumstances, mean the difference between survival and disaster,
by ensuring that the firm always has sufficient funds to pay its obligations thus avoiding
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liquidation. Time spent in credit control should be regarded as equally important as time
spent developing new business.
Company Information Services
Besides specialists in the field of inter-company comparison, there are several organisations
that provide company information services. They include:
(a) Performance Analysis Services
Performance Analysis Services was formed to collect and collate results of some 800
of Britain’s largest, listed, industrial companies. From data collected, the company has
developed ways of predicting firms that appear to be most at risk of receivership.
(b) Dun and Bradstreet
Dun and Bradstreet are suppliers of financial information and related services and they,
too, have developed an early warning system on possible company failures. The
service is based on Stubbs Gazette, which is used as a key source of information,
providing up-to-date information on compulsory winding-up orders, voluntary
liquidations, court judgments, mortgages and charges.
(c) Institute of Chartered Accountants in England and Wales (ICAEW)
ICAEW has produced an operational guideline on the continuity of business, which
identified a number of factors which put continuity into question:
 Loss of key management and staff
 Significantly higher stock levels, without the apparent source of finance to pay for
 Regular work stoppages and labour disputes
 Dependence on a single product or project
 Dependence on a single supplier, or a large customer
 Outstanding legal proceedings
 Political risks
 Technical obsolescence
 Loss of a major franchise or patent
 History of poor performance within the industry.
Clearly it is the trend towards the regular occurrence of several factors which is
important, not a single “one off” event in isolation. If there should be a build up, then it
could lead to a situation of “crisis management”, i.e. where managers are dealing with
one serious problem after another rather than focusing on planning for the future needs
of the business.
In extreme circumstances, managers may have no option but to slim down the entity
resulting in lower, but more manageable, operating capacity. However, not every
manager will be willing to sacrifice the prestige of running a business of a certain size.
Many problems stem from the failure of managers to react in time (if at all).
The Z Score
The analysis of financial ratios is generally concerned with the assessment of the
effectiveness and efficiency with which a company deploys its resources. This is in itself an
attempt to measure the overall financial stability of the organisation – you will remember that
this is a principal duty of the financial manager.
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An American, E.I. Altman, researched the use of ratio analysis in order to examine ratio
correlation and business failure. In his research he looked simultaneously at several ratios to
attempt to predict business failure. He used some 22 accounting and non-accounting ratios
which he applied to a selection of failed and continuing US companies. From this initial
analysis, he determined that there were five key indicators of impending failure, and he used
them to formulate the Z Score.
Using the Z score, Altman predicted that firms with a score below a certain level were much
more likely to fail than those with higher scores, and he identified “middle ground” in which
the outcome of the company’s future was uncertain.
Other Models
(a) Argenti
This model, also known as Argenti’s failure model, is based on the calculation of a
company’s scores in the areas of defects of the company, management mistakes and
symptoms of failure.
Company defects include a passive board, an autocratic Chief Executive and weak
budgetary control. Managerial mistakes include high levels of gearing and the failure of
a large (in relation to the company) project. Overtrading (the business expanding too
quickly for its level of cash funding and thus having insufficient liquid funds to pay
creditors) is also noted as a major managerial mistake. Symptoms of decline include
deteriorating ratios, quality and staff morale and the use of window dressing. Each of
these three areas has a danger mark.
Argenti based his model on past company data and, as with the other models, it is
difficult to assess its predictive ability.
(b) Taffler
Taffler has developed a model to predict business failure which is based on a series of
 Sales/total assets
 The current ratio
 The reciprocal of the current ratio
 Earnings before tax/current liabilities.
(c) Beaver
Empirical research conducted by Beaver found that the best prediction of corporate
failure is a low cash flow/borrowings ratio, and the poorest measure for forecasting
failure is the current ratio (current assets/current liabilities).
Other Indicators
One quick method of predicting company failure is the use of the liquidity ratios – proponents
of this method state that a current ratio of below 2 : 1 and an acid (quick) ratio of less than
1 : 1 means that the firm is illiquid and liable to fail. However, as we discussed earlier, these
ratios need to be viewed in the light of the nature of the business and the overall position of
the firm. Moreover, empirical evidence (see Beaver above) has found that these ratios, and
trends in them, give little or no indication of eventual business failure. A worsening liquidity
position could, however, indicate that the firm is having problems and its financial and
operational performance should be carefully scrutinised.
Other accounting information which may provide indications of financial difficulties include
important post balance sheet events, large contingent liabilities and large increases in
intangible assets.
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Non-accounting information contained in the annual report may also provide indications of
company problems, as may changes in the composition of the board if the more able
directors have left. In addition, the Chairman’s Report, although generally optimistic (and not
audited), may discuss current and future unsolved problems.
External events such as legislation, political changes at home and abroad, competitors’
actions, and changes in economic variations (e.g. interest and exchange rates) may also
give forewarning of potential problems for a firm. In addition, newspapers and journals may
report on the financial and other difficulties a firm is or may be experiencing.
Problems with Prediction Models
There are several problems with the use of the above models:
 Many assumptions have to be made in interpreting information, including the methods
of accounting which have been used. Indeed, any limitations in the accounting data
used will also affect the models.
 It is difficult to value the equity in a private company, which may make the use of the
models for private company analysis difficult and extremely subjective.
 The information they use reflects the past and thus is out of date. The problem is
exacerbated by the delay in the publication of company accounts.
 Prediction models take little or no account of economic conditions occurring when they
are used, and the effect that economic variables may have on the figures used in their
 It is very difficult to define corporate failure because companies which would otherwise
have been liquidated can be “rescued” or taken over. Similarly, businesses may close
for reasons other than failure, e.g. a private company may cease to operate because
the owner-manager wishes to retire.
 Companies may manipulate the measures used in the models in order to prevent
predictions of failure.
It is not unusual for companies to be liquidated, the principal reasons for this being that:
 The company does not have enough cash to pay its liabilities and its creditors apply to
the court for it to be wound up – this may happen even if the company is profitable.
 A company may not be profitable enough to continue in business (or it may be acquired
by another company).
However, a company may be able to prevent liquidation if it can devise a capital
reconstruction scheme attracting new capital and/or persuade its creditors to “change” their
loan to the business into company securities, thus allowing the business to continue trading.
The business must be able to show that its problems are only temporary and that the scheme
will allow it to become profitable and/or improve its cash flow situation. Negotiating such
schemes is often difficult, but a failure to do so may lead to the business being liquidated.
We should distinguish between the term reconstruction, which is used to refer to major
changes to capital as a prelude to a merger, and capital restructuring. Capital
restructuring (or reorganisation) is the term usually used when there is only one company
concerned and the rights of its members, and sometimes of its creditors, are varied by an
alteration of its capital structure but with the existing company continuing in business.
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Reasons for Capital Reconstruction
There are a number of reasons why a restructuring may be necessary:
 The company may have become too highly geared and a solution may be to issue
equity in place of debt capital.
 The existing capital structure may have become over-complicated with perhaps too
many classes of shareholder with different rights to each class. They can be
consolidated into one or two classes, but care must be taken to ensure that the relative
voting strength remains in the same proportion.
 Capital with prior rights may carry a high fixed dividend which then gives a misleading
impression of the company, or preference shareholders may have control of the
company. In such cases the structure should be reorganised into a more convenient
 The company may decide to replace preference shares with debentures in order to
reduce the corporation tax on the company’s shares.
Principles of Capital Reconstruction
There are a number of points of principle in the design of a scheme of reconstruction.
(a) Firstly, if the company is having problems it is likely to require more finance which may
come from either existing shareholders or a bank, generally in the form of equity
finance, although some may be in the form of loan stock. This new equity may replace
existing share capital, or may have a different nominal value to it. Those providing
such finance will require profit and cash flow forecasts to show how the business can
be turned round and provide a good return for their additional money. In such cases it
is wise to maintain the income position of a particular class under the scheme as far as
it is possible. Often more income will be offered as an incentive to the holders of a
particular security to agree to the capital restructuring.
(b) In addition, a reconstruction scheme must treat all parties fairly, and not favour one
group over others. The outcome of the scheme should be more beneficial to creditors
than if the company went into liquidation, or they may press for the winding-up of the
company. Often this is avoided by including in the scheme provision for paying off the
company’s debts in full. The increased benefits to creditors (and investors) from the
reconstruction scheme can be shown by comparing the liquidation value of the firm
with the estimated future results arising from the reconstruction scheme.
(c) The company must also take account of fixed charges (e.g. a mortgage on a factory)
on assets of the business used as security for loans. These charges mean that the
creditor is “secured” and thus entitled to first claim in the process of liquidation (if there
are insufficient funds the creditor becomes unsecured for the balance of the loan
unpaid). The charges mean that such creditors may have less incentive to keep the
business afloat. Second charges are when the lender has the prior claim on the
surplus from the sale of a secured asset after the prior claim has been met.
(d) In addition, the company may have to consider the existence of floating charges over
the assets (generally the current assets of the business which are continually turned
over during trading) that crystallise on liquidation thus providing the charge owner with
prior call on the funds realised from these assets. Similarly to above, such creditors
may have less incentive to keep a business afloat, unless it can be shown that it would
be financially beneficial to them to do so.
You may also find in practice that certain creditors can have a fixed charge on an asset,
with a floating charge over a group of assets for the balance of their loan – this is
known as a fixed and floater.
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Study Unit 3
Acquisitions and Mergers
Contents Page
Introduction 69
A. Company Growth 69
Strategies for Growth 69
Economic Justification for Growth via Acquisition 71
The Development of "Mega-Mergers" 72
B. The Regulation of Takeovers 73
Extent of Coverage of the Code 73
General Principles 74
Rules of the Code 74
Companies Act 1985 77
Competition Commission 77
European Union 78
C. The Acquisition/Merger Process 78
Tactics for Acquisitions and Mergers 78
Defences Against an Unwelcome Takeover Bid 79
Consideration 80
D. Measuring the Success and Failure of Mergers and Takeovers 82
Company Performance 82
Shareholder Wealth and Power 82
Employment 83
Example 84
E. Disinvestment 86
Management Buy-Outs 86
Buy-Ins 88
Spin-Offs 88
Sell-Offs 88
(Continued over)
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Demergers 88
Going Private 88
Answer to Practice Question 90
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In this study unit we will start to consider corporate structure and corporate growth. The first
part of the unit investigates what happens when a company goes beyond being an individual,
single entity and, by means of acquisition or merger, becomes a multiple concern or a group
of companies.
When a firm is considering expanding whether internally (by expansion, integration or
diversification) or externally (via a merger or acquisition) it must ensure that growth is
economically justified, carefully planned and structured. Management must consider the
impact on the company, its (and if appropriate the target's) shareholders and employees, the
environment it operates in, and the Stock Market's views. In addition, the current regulatory
framework should be borne in mind and it is very important that the firm allows for a period of
transition for success to be achieved.
The converse of mergers and acquisitions is where a firm may decide to disinvest part of
itself, and this is the subject of the second part of the unit.
Reasons for disinvestment include removing a part of the business which does not fit
correctly into a group's portfolio or its core business, selling an unprofitable subsidiary, or
selling a profitable subsidiary to finance expansion elsewhere. There may also be a desire
by the owners of a private concern to arrange their affairs to the best advantage to their heirs
in the light of favourable political or tax regimes. Disinvestment includes demergers,
management buy-outs, management buy-ins, spin-offs and sell-offs.
In common with the expansionary policies discussed in the first part of the unit, it is essential
that such activity is carefully planned and monitored, and that the needs of the various
parties involved, including internal and external stakeholders (and especially the
shareholders), are considered.
We saw earlier in the course that there are several internal and external stakeholders in an
organisation, and the majority of them will be concerned with its stability and long-term
viability. In order to help them assess this several models of corporate failure have been
developed using financial and other ratios, often based on past empirical evidence. Although
these models can provide some useful guidance, as yet there is no one method that is
capable of predicting corporate failure in advance.
Acquisitions and mergers are a fairly frequent occurrence, and you should read the financial
press for details of any currently taking place – providing up-to-date examples is always
useful to your arguments.
Strategies for Growth
The three main strategies a firm may adopt for growth are expansion, integration and
(a) Expansion
This is the growth of existing, or development of new, markets or products, which can
be in response to changes in technology, customer taste or simply to exploit an
opportunity in the market.
(b) Integration
Integration, of which there are two forms – horizontal and vertical – is a form of
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 Horizontal integration is when a firm adds either new markets for its existing
products, or introduces new products to its current markets. It may be done so
the firm can benefit from economies of scale, although this may cause difficulties
for the firm if there are problems with the markets or the products.
 Vertical integration is expansion of the firm along the supply chain and can be
either backward (supply of components or raw materials) or forward (being one
step closer to the end customer). It allows a firm to have greater control over the
industry including quality, quantity, price and share of the profits, although it
becomes more prone to falls in demand within the industry as a whole.
(c) Diversification
This policy is also a form of expansion – indeed, integration is sometimes referred to as
related diversification.
The diversification we are now going to consider is referred to as unrelated
diversification and comprises concentric and conglomerate diversification.
 Concentric diversification is the development of products which are synergetic
with current products.
 Conglomerate diversification is the development of products with no marketing,
technology or product synergy with the business's current products. The firm,
however, expects to obtain management synergies from the conglomeration.
There are several other potential advantages of conglomerate diversification. Can you
think what they might be?
Advantages include the following points:
 The firm can move quickly into high profit areas by acquiring a firm in that market.
 The resultant larger firm may have better access to funds.
 A larger firm may have greater influence in the market and in the political
 A spreading of risk may occur from operating in different markets.
 Profitability may improve as a result of the diversification.
 The new firm may be more flexible, and the acquisition of new firms may allow
withdrawal from existing markets.
 There may be synergies to be obtained from the merger utilising a surplus in one
firm to satisfy a deficit in another (e.g. cash).
 Unlike the takeover of a similar firm which may lead to a referral to the
Competition Commission, conglomerate (and concentric) diversification are
unlikely to be regulated by the state.
However, there are several problems associated with conglomerate diversification.
 Profits in one part of the business may be used to help others making losses,
which may lead to the failure of the whole organisation.
 Empirical evidence has shown that EPS (Earnings per share) are diluted when
companies with high P/E (Price Earnings) ratios are acquired and that risk may
be increased rather than reduced.
 Empirical evidence has also shown that management synergies are often not
obtained in practice.
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Economic Justification for Growth via Acquisition
Internal growth is one method of growth and here there is a balance to be struck between
distributing available profits to shareholders as dividends and retaining profits to fund internal
An alternative method of growth is by acquiring or merging with another company (known as
external growth):
 The purchase of a controlling interest by one company in another is known as an
acquisition or takeover – this is the acquisition by one company of the share capital of
another company in exchange for cash, ordinary shares, loan stock or some
combination of these.
 A merger or amalgamation is the combination of two separate companies into one
single entity. It is a pooling of interests of two companies into a new business requiring
an agreement by both sets of shareholders.
It is often difficult to determine in practice whether a takeover or merger has occurred,
especially when there is a difference in size between the organisations. Whilst many such
joinings are called mergers, and the two terms are often used interchangeably, in reality there
are very few true mergers, and those which are tend to occur in industries with histories of
poor growth and returns.
Note that you should take care not to confuse acquisitions and mergers with joint ventures.
In a joint venture the managers of two or more businesses decide to establish a new
company under their common ownership and management for the purposes of exploiting an
opportunity which neither of them has the resources to exploit individually. There were a few
joint ventures occurring to celebrate the millennium!
There are several potential reasons for an acquisition or merger but it is important there
should be a resulting synergy with, and that it helps in achieving the overall strategic
objectives of, the firm.
A firm must also consider the cost and value of the merger or acquisition and the relationship
between the two.
Common reasons for acquisitions and mergers are:
 To reduce competition, although this may be prevented in the UK by the Competition
 To purchase a new product range or move into a new market.
 To obtain tax advantages..
 To spread risk by diversification into new markets and/or products, which should lead to
more secure earnings.
 To obtain assets that are undervalued or can be sold off ("asset stripping"), cash (if the
victim company is very liquid) and/or access to finance, expert staff, management
expertise, technology, suppliers or production facilities. Whilst they might all be
acquired internally they can be acquired a lot quicker by a takeover.
 To achieve economies of scale in production, purchasing or marketing and other areas
of the business.
 To act as a defence against being acquired itself, either by purchasing the predator
company or by making itself bigger and thus harder to be taken over.
 Growth can be achieved via a share exchange rather than having to acquire the cash
that an internal policy of growth would require. The policy may also be less expensive
than internal growth if a premium has to be paid to attract assets and staff.
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There are also major problems with acquisitions and mergers:
 Economies of scale, especially in head office functions, often do not materialise, or
indeed become diseconomies of scale. There can also be transportation problems
when the acquired sites are geographically separate from existing sites.
 There can be problems integrating the different work forces and there may be large-
scale redundancies. Similarly problems in integrating new products, markets,
customers, suppliers, management and systems can lead to management overload. It
is sometimes known as "indigestion".
 There may be public relations problems with customers and the general public
boycotting the firm because they disagree with the takeover. Directors of the victim
company may also do their best to impede the takeover.
 There may be regulatory intervention.
 The cost of the acquisition may be too high.
 Shareholders of the target company may adopt defensive tactics to oppose the bid, and
there may be problems in unifying dividend, reporting and other policies affecting the
shareholders of both companies.
In addition to the reasons for, and potential problems with, a mooted acquisition or merger
the firm has to consider the views of its shareholders, the shareholders of the target company
and of the market. The company must also determine how it will pay for the company – will it
be with cash, share exchange, via loan stock or some combination? Unless it is purely
financed by cash the target company's shareholders will have an interest in the new merged
Reasons why a company's shareholders and the market may not approve of a takeover or
merger include the following:
(a) There may be social or moral disapproval of the target company, e.g. it may produce
arms or deal with a country with an unpopular regime.
(b) The merger may result in a fall in the EPS or net asset backing per share.
(c) The merger may result in an increase in risk due to the nature of the target's industry or
financial profile.
A company may not need shareholder approval, but a lack of shareholder and market
backing can lead to a fall in the market price of the company's shares, which is not achieving
the company's primary objective of maximising shareholder wealth. Moreover, when a
takeover is to be paid for by the issuing of a large number of new shares in the predator
company, shareholder approval at an AGM or EGM will be required by Stock Market
The views of the target company's shareholders are considered below.
The Development of "Mega-Mergers"
You may be aware from your reading of the financial press that in recent years there have
been several very large or "mega" mergers. The reasons for these mega mergers include
the following:
 Globalisation and deregulation of financial markets makes it easier to arrange finance
for such deals.
 Buoyant equity markets allow share exchange schemes to be successful and cash to
be raised via rights issues.
 Investors are demanding growth in earnings and a merger is often the cheapest and
most expedient way of doing this.
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 The globalisation of operations and opportunities to achieve operating economies in
some fields (e.g. oil).
 Market trends (e.g. in the car industry) may mean that the small company can no
longer compete successfully – a merger may be a defence against being taken over.
 Mergers may lead to economies of scale in overhead costs. For example, the merger
of Glaxo and Wellcome was undertaken with the aim (amongst others) of achieving
economies of scale in research, development, testing and marketing of drugs.
The City Code, administered by the Takeover Panel, specifies the behaviour which
companies are expected to adopt during a takeover or merger. The Code is issued by the
Panel on Takeovers and Mergers (the Panel), and whilst it does not deal with the price to
be offered in a merger or acquisition, both the Code and the Panel operate to see that
shareholders receive fair and equal treatment during this process.
The fundamental objectives of the Takeover Panel are to ensure fair and equal treatment for
all shareholders and their main areas of concern are as follows:
 Shareholders who may be treated differently – for example, because they belong to a
very large business or they hold a large number of shares
 Insider dealing
 Actions that is not in the best interests of the shareholders
 Lack of adequate and timely information released to shareholders
 Artificial manipulation of the share price
 Slowing down of the bid process.
The Panel on Takeovers and Mergers (POTAM) is the City watchdog whose job is to oversee
the conduct of takeovers involving companies listed on the London Stock Exchange. The
Panel writes and enforces the City Code on Takeovers and Mergers which sets out in
meticulous detail the management and timing of takeover bids. The objective of the City
Code is to ensure that high standards of integrity and fairness are maintained, and that
shareholders in both the bidding and target company are treated equitably. The Panel is not
concerned with the financial or commercial advantages or disadvantages of a takeover, nor is
it concerned with competition issues. The City Code does not have the force of law, but, as
the Code says "those who seek to take advantage of the facilities of the securities markets in
the United Kingdom should conduct themselves in matters relating to takeovers in
accordance with best business standards and, so, in accordance with the Code". It goes on
to say that "those who do not so conduct themselves may find that, by way of sanction, the
facilities of those markets are withheld".
Extent of Coverage of the Code
The Code applies to offers for all listed and unlisted public companies as well as, when
appropriate, statutory and chartered companies considered by the Panel to be resident in the
UK, the Channel Islands or the Isle of Man and it provides the main governing rules for
companies engaged in merger activity. It also applies to an offer in respect of a private
company of the same residency, where at some time during the 10-year period prior to the
announcement of the offer:
(a) Its equity capital has been listed on the Stock Exchange;
(b) Dealings in its shares have been advertised in a newspaper on a regular basis for a
continuous period of at least six months; or
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(c) It has filed a prospectus for the issue of equity share capital at Companies House.
The Code is concerned with takeovers and mergers for all companies defined above and
includes partial offers and offers by a parent company wishing to acquire shares in its
subsidiary. Generally, the Code excludes offers for non-voting, non-equity capital.
You should note that, unlike legislation, the Code is not enforceable in law. However, those
who fail to conduct themselves in accordance with its rules may, by way of sanction, have the
facilities of the securities markets withdrawn from them.
The Code is made up of a number of general principles, which are essentially statements of
good commercial conduct, together with a set of Rules supported by substantial notes. The
Rules are not laid down in technical language, and they should therefore be interpreted by
their underlying spirit and purpose rather than appertaining to some specific legal framework.
General Principles
The six general principles are listed below:
1. All holders of the securities of an offeree company of the same class must be afforded
equivalent treatment; moreover, if a person acquires control of a company, the other
holders of securities must be protected.
2. The holders of the securities of an offeree company must have sufficient time and
information to enable them to reach a properly informed decision on the bid; where it
advises the holders of securities, the board of the offeree company must give its views
on the effects of implementation of the bid on employment, conditions of employment
and the locations of the company's places of business.
3. The board of an offeree company must act in the interests of the company as a whole
and must not deny the holders of securities the opportunity to decide on the merits of
the bid.
4. False markets must not be created in the securities of the offeree company, of the
offeror company or of any other company concerned by the bid in such a way that the
rise or fall of the prices of the securities becomes artificial and the normal functioning of
the markets is distorted.
5. An offeror must announce a bid only after ensuring that he/she can fulfil in full any cash
consideration, if such is offered, and after taking all reasonable measures to secure the
implementation of any other type of consideration.
6. An offeree company must not be hindered in the conduct of its affairs for longer than is
reasonable by a bid for its securities.
From time to time conflicts of interest may arise for the financial advisors involved. This may
apply where material confidential information is available to them or where the advisor is a
part of a multi-service organisation. Where the first situation arises, conflict may be removed
by the advisor declining to act; in the second circumstances, a careful segregation of the
business will be necessary to prevent conflict occurring within the rules – the latter is
sometimes referred to as "building a Chinese wall".
Rules of the Code
Numerous rules are contained in the Code that stretches to over 250 very detailed pages and
they are supported by detailed notes. Whilst you do not have to memorise individual Rules,
you should have an understanding of their nature and the way they impact on the parties to a
takeover. We will consider the Rules of the Code under the following headings:
 The approach, announcements and independent advice
 Dealings and restrictions on the acquisition of shares and rights over shares
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 The mandatory offer and its terms
 Conduct during an offer
 Substantial acquisition of shares
(a) The Approach, Announcements and Independent Advice
The buying firm usually employs advisers to help make a takeover bid. (Indeed,
identification of suitable takeover targets might be one of the first jobs of the various
An offer should be proposed to the board in the first instance. The identity of the
offeror or, in an approach with a view to an offer being made, the potential offeror must
be disclosed at the outset. The board must be satisfied that the offeror has the
resources to implement the offer.
An announcement should be made as soon as sufficient details have been decided.
Any announcement of a firm intention to make an offer must contain:
(i) The terms of the offer;
(ii) The identity of the offeror and details of any existing shareholding;
(iii) The conditions to which the offer is subject;
(iv) Details of any arrangements which may be an inducement either to deal, or not to
deal, in the shares.
Promptly after the start of the offer period, the board of the offeree company must send
a copy of the announcement to its shareholders and to the Panel.
Any person stating that he does not intend to formulate an offer for a company will
normally be bound by the terms of that statement. All statements should be as clear
and unambiguous as possible.
Another rule requires that the board of the offeree company must obtain competent
independent advice on any offer and the substance of that advice must be
communicated to the shareholders. This is especially important in cases such as
management buy-outs which we shall look at later in the unit. The Panel consider that
it is inappropriate for independent financial advice to be given by a person who is either
in the same group as the financial advisor to the offeror or who has a substantial
interest in either the offeror or the offeree.
(b) Dealings and Restrictions on the Acquisition of Shares and Rights over Shares
Whilst some rules deal specifically with the criminal offence of insider dealing (the EC
Directive on Insider Dealing was implemented through the Criminal Justice Act 1993),
another rule restricts dealing in the securities of the offeree company by any person
other than the offeror, where such a person has access to confidential, price-sensitive
information, from the time when there is reason to believe an offer is imminent to the
time of its determination (or lapse). Additionally, dealing will not be permitted in the
securities of the offeror company where the offer is price-sensitive in respect of the
offeror's securities.
A rule restricts the sale of securities in the offeree company by the offeror during the
period of the offer, unless the Panel has given its approval and at least 24 hours' public
notice has been given. After such consent and notice, the offeror may make no further
A rule limits the opportunity for persons to contact private or small corporate
shareholders with a view to seeking irrevocable commitments to accept (or to refrain
from accepting) an offer, or a contemplated offer, without the prior approval of the
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Generally, unless a person (including those acting in concert with him) holds less than
30%, or rights over less than 30%, of the voting shares in a company, he may not
acquire a holding that would carry voting rights of more than 30%. Where a person
similarly holds between 30% and 50% of shares, or rights to shares, of the voting kind
within a company, he may not acquire more than a further 1% (2% before 3rd March
1993) of the voting rights in any 12-month period. Exempt from those described in this
paragraph are those who make an offer for the company.
When an offer is contemplated and the offeror (or person acting in concert) acquires
shares in the offeree in the three months prior to the offer, subsequent general offers
must not be on less favourable terms without the consent of the Panel. If, while the
offer is open, the offeror purchases shares at a higher price than the offer price, then
the offer price must be increased to be not less than the highest price paid for the
shares so acquired.
Immediate announcements may be required should the terms of the offer have to be
amended under various rules. Another rule requires immediate disclosure relating to
the number of shares acquired and the price paid, if practical, as soon as an acquisition
at a price higher than the offer price has been agreed.
Any dealings by the parties to a takeover or their associates must be disclosed daily by
12 noon on the business day following the transaction to the Stock Exchange, and it
will then be made available to the Panel and to the press. Additionally, disclosure
(excluding the financial press) will be required where purchases or sales of relevant
securities in the offeree or the offeror companies are made by associates for the
account of non-discretionary clients, themselves not being associated. Intermediaries
may be required to disclose the name(s) of their client(s).
(c) The Mandatory Offer and its Terms
Various Rules lay down the requirements and mechanics of a formal offer, providing
time limits in respect of acceptances, counter-offers, etc. The various options available
to both the offeror and the offeree are also laid down and reflect the percentage of
shareholders accepting or rejecting the offer. Whilst you do not have to remember
detailed prescriptions, you should remember that they exist and must be adhered to by
all parties concerned.
(d) Conduct During an Offer
The Rules lay down the requirements of a code relating to the conduct of the parties to
an offer while it is progressing. They are summarised below:
(i) All shareholders must have an equality of information.
(ii) Advertisements must be cleared by the Panel before their publication.
(iii) Details of all documents and announcements must be lodged with the Panel.
(iv) Generally, no actions are to be taken that would mislead shareholders or the
markets, including taking any action by the offeree that may frustrate the offer
prior to a bid being under way.
(v) Transfers by the offeree must be promptly registered.
(vi) Special care must be exercised with all documents, and the terms of the bid must
be covered carefully, including conflicting views, and so forth. Offer documents
should always be available and on display.
(vii) Specific rules govern the way profit forecasts are stated and assets valued.
(viii) The offer document should normally be posted within 28 days of the
announcement of a firm intention to make an offer. An offer must be open for at
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least 21 days after it is posted, and this period of time may be extended by further
(e) Substantial Acquisition of Shares
The Rules regulate the speed at which a person, or persons acting in concert (a
concert party), may increase shareholdings between 15% and 30% of the voting rights
of the company. They also invoke the accelerated disclosure of acquisitions of shares
or rights over shares relating to such holdings.
Companies Act 1985
Section 151 prevents financial assistance being given by a company for the purchase of its
own shares. This is done in order to prevent the manipulation of share prices and ownership
in several scenarios including takeover and merger discussions.
Under Sections 428-430 a company holding more than 90% of the shares in another
company may compulsorily purchase the remainder on the same terms. The minority
shareholders can also insist that their shares are purchased on these terms.
You should also note that the legislation dealing with insider dealing may also be invoked
when considering a merger or takeover bid – it being illegal to act on unpublished information
regarding such a bid (especially if with a view to financial gain).
Competition Commission
The Competition Commission (CC) is one of the independent public bodies which help
ensure healthy competition between companies in the UK for the benefit of companies,
customers and the economy.
The CC replaced the Monopolies and Mergers Commission in 1999, following the
Competition Act 1998. The Enterprise Act 2002 introduced a new regime for the assessment
of mergers and markets in the UK and under this, the CC's role is now clearly focused on
competition issues, replacing a wider public interest test under the previous regime. The
Enterprise Act also gave the CC remedial powers to direct companies to take certain actions
to improve competition, whereas under the previous regime, its role was simply to make
recommendations to Government.
Role and Work
It deals with issues in three broad areas:
 In mergers – when larger companies will gain more than 25% market share and might
prove anti-competitive.
 In markets – when it appears that competition might be distorted or restricted in a
particular market
 In regulatory affairs – when the major regulated industries in the UK may not be
operating fairly.
Its investigations are thorough and open. If an investigation concludes that the situation
significantly damages or restricts competition in the UK, then it will work to determine and
implement appropriate remedies. For example, the CC can stop a merger from going ahead,
require a firm to sell off part of its business, or require it to behave in a way that safeguards
Its inquiries are always initiated following a concern referred to it by another authority, usually
the Office of Fair Trading. It also investigates issues referred by the sector regulators for
communications, gas and electricity, water, rail, airports, postal services, or by the Secretary
of State for Business, Enterprise and Regulatory Reform.
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Membership and staff
The decision making body for each inquiry is a group of at least three independent experts,
drawn from a wider panel of around 50 appointed members. Members are supported by a
specialist staff team on each inquiry. Inquiry groups are usually led by the CC's Chairman or
one of the Deputy Chairmen.
Members are appointed to the CC for eight years, following open competition. They are
selected and appointed by the Government for their experience, ability and diversity of skills
in competition economics, law, finance and industry. All except the Chairman work part-time
for the CC.
The CC's staff includes economists, business advisers, lawyers, administrators, accountants
and support staff (information services, finance, human resources). Two-thirds are direct
employees, with the remainder on temporary contract to help meet the CC's workload at any
particular time, or on loan from government departments.
European Union
A regulation introduced in 1990 gives the European Commission the power to block or
authorise mergers with a world-wide turnover of over 5 billion ecu (approximately £3.5
billion). Mergers with EU-wide turnover of 250 million ecu (approximately £175 million) need
to be agreed by the Commission. Reasons used to block mergers include incompatibility
with the European Common Market.
The European Union's 13th Company Law Directive dealing with takeover bids and
procedures will have statutory power in EU member states when it is adopted. This will be a
major change from the current UK approach of self-regulation.
You may find it interesting to note here that Britain has several more large industrial units
resulting from past mergers than the rest of Europe.
This area is well known for its tactics both for acquisition and defence.
Tactics for Acquisitions and Mergers
A common acquisition tactic is for the predator company to purchase shares in the target
company in the market place quickly, to prevent the market interpreting its motives and
increasing the share price – known as a dawn raid. It is illegal for a "concert party"
acquisition of shares to take place (i.e. a number of connected or unconnected parties
purchasing shares together).
When the predator has obtained 3% of the shares it must inform its target of its holding. The
London Stock Exchange publishes market-makers' holdings of 3% or more in UK-listed
companies quoted either on the main Stock Market or the Alternative Investment Market
When a company has acquired 30% it must make an offer to the remaining shareholders in
the target company (we will discuss this in the section on the City Code later in this study
unit). The company should then make an offer to the target's board (either directly or through
its merchant bank) in order to determine the board's view of the bid. The price discussed
should be below what the predator feels the company is worth but above its current share
price. If the predator continues with the bid a formal offer document is then sent to
shareholders with details of its offer price.
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Defences Against an Unwelcome Takeover Bid
The City Code requires directors to act in the best interests of the shareholders, employees
and creditors and there may be circumstances when they consider that it is in the best
interests of the above to contest the bid. The directors can contest an offer because they
feel that the terms offered are too low, that there is no advantage to the merger, or because
employees or founder members may be opposed to the bid. If the former is the case the
predator may offer a higher price. The relative prices of the companies' shares is a very
important issue during a takeover or merger bid which uses shares as part of the
consideration. A significant rise in the target's shares or a fall in those of the predator can
jeopardise the takeover by reducing the value of the consideration offered to the
shareholders of the firm being taken over.
In order to defend against an unwelcome takeover bid, the directors have to plan and take
action as early as possible. They should keep a careful watch on dealings in the company's
shares to spot whether an individual (or group of individuals) is building up a significant
holding. They must also review the market price of their shares constantly in relation to their
earnings and asset values, in order to determine whether the company is undervalued by the
market and therefore prone to a takeover. In addition, directors should assess the
company's position within its industry as regards technology, size, etc., to see whether it is
uncompetitive and likely to attract a takeover bid by a major player in the industry. A further
tactic is to maintain contact with a range of stockbrokers, analysts and merchant bankers
who are the most likely to hear of hints and rumours of any takeover strategies at an early
The majority of mergers and bids are masterminded and engineered by the merchant
banking firms, and a defending company will almost invariably have to appoint its own
merchant bank to act in its defence.
The appointment of a merchant bank is just one of the substantial costs which may be
incurred in contesting a takeover bid – others include advertising, public relations and
underwriting costs. Similarly, the predator company will incur such costs. There is also the
possibility of capital gains or losses on the sale and repurchase of shares in the victim.
For a takeover bid to succeed enough shareholders must be willing to sell; this will happen
when they are attracted by the potential capital gain due to the high offer price, or when they
are unhappy with the current performance and its shares.
There are a number of different tactics used by companies to try and stop a bid, particularly a
hostile one. These include the following:
 Developing their own management team to be creative and proactive, and ensuring its
potential is understood and appreciated by the shareholders
 Keeping a very close eye on the businesses share register to spot individual
organisations building up a major shareholding in the company
 Close co-operation of share buying between friendly companies
 Attacking the logic and rationale of the bid
 Improving the image and reputation of the business
 Encouraging internal and external stakeholders to lobby on their behalf.
 Considering share repurchase schemes as this reduces the number of shares available
for a rival to buy
 Buying another business, thereby possibly making the business too large and
unattractive to predators!
 Attacking the record of the bidder.
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 Convincing the shareholders that the shares are valued too low and they should
therefore not sell them, usually by circulating profit and dividend forecasts. They can
also suggest that forecasts may be at risk on a change of management, by the issue of
"defence documents" and press releases.
 Revaluing the company's assets (using independent expert valuers) to increase the
asset-backing and encourage upward movement in the share price.
 Launching a strong publicity campaign, aimed at highlighting present strengths and
potential, including promised improvements, e.g. in efficiency.
 Using additional shares either by issuing a block of shares to a friendly party, who will
act in the directors' interests making it almost impossible for the bidder to acquire 100%
control; or by issuing "A" shares, normally non-voting, so as to maintain shareholder
control but increasing the funds required by the predator to purchase the company.
 Inviting a bid from another company (a white knight) which the directors believe would
be friendlier than the initial offeror. This is called a defensive merger.
 Arranging a management buy-out.
 If the companies are of a similar size, then the target company could make a counter-
bid for the predator.
 Launching an advertising campaign against the predator, its accounts and methods of
 Trying to have the bid referred to the Competition Commission.
 The target company could introduce a "poison pill" preventing a build up of shares by
causing a change in structure and rights to be triggered by "abusive" takeover tactics.
It is important to remember that just as bids must follow the City Code on Takeovers and
Mergers, so must the actions taken by directors defending a company against a takeover
If a takeover of an unquoted company is resisted then the bid may simply fail. However, with
a quoted company some or all shareholders may wish to sell and there is more chance that
the takeover may succeed.
Acquisitions will be financed by cash, shares, debentures or a mixture of the three. The
choice of payment will be determined by individual circumstances. When a merger takes
place, a share-for-share exchange occurs.
The factors to be considered when deciding the form that the consideration for acquiring a
firm will take are:
 A potential capital gains tax liability may arise when shareholders dispose of their
shares for cash.
 An increase in the number of shares may lead to a fall in the EPS and, perhaps, a
significant change in shareholder control.
 Increases in borrowing limits or authorised share capital may have to be formally
approved by shareholders. Such increases will also have an effect on the gearing level
of the firm.
 It may be cheaper to fund the takeover with debt rather than equity because interest is
allowable against tax.
 The views of the shareholders in the target company should be considered; they may
wish to maintain an investment in the firm and thus prefer shares, and they will want to
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ensure that they maintain their income levels – a fall in dividends will need to be
matched by a capital gain. Each shareholder will want to ensure that he receives at
least an equivalent return from his holding in the new company, assuming that there
are no other pressing external factors which make aspects other than return on
investment significant criteria for the shareholders.
As we discussed in the previous study unit there are several accepted methods of valuing a
company. Prices will generally reflect market forces and will tend to be higher when there
are several interested parties in competition. The package can be negotiated in such a way
as may benefit both parties, perhaps by staggering the purchase over a period of time to aid
the purchasers' cash flow and to minimise capital gains tax liability.
The cost of the acquisition or merger will be the purchase price, plus any extra amounts to be
invested in, less the sale proceeds of any surplus assets in, the target company. When
considering the cost of the investment the projected returns and profits must be considered
alongside existing figures to ensure that the merger or acquisition is in the company's best
(a) Shares
A share (or paper) purchase involves the exchange of shares in the predator company
for the shares in the target company. The shareholders of both companies are now
shareholders in the predator company.
(b) Cash
A cash purchase simply involves the exchange of cash for the shares in the target
company. The predator should offset the expected earnings on the cash (if no takeover
were to take place) against the expected earnings from the acquired firm when
considering the purchase. The cash for the purchase can be raised from a Stock
Market issue of the predator company's shares or loan stock.
In assessing the sources of funding available, the financial manager should take into
account existing cash resources, and that a proportion of the capital can be generated
 Increasing working capital, e.g. by improving credit control. However, care
should be taken not to fund long-term assets with short-term finance.
 Sale and leaseback of equipment or premises.
 Staff share purchase schemes, or a rights issue to existing shareholders.
 Disposal of surplus assets.
 Borrowing, e.g. from the bank or by issuing debentures.
(c) Vendor Placing
This is a mixture of the above two approaches. Shares are exchanged in the target
company with those of the predator company – the predator shares are then "placed"
by the predator's stockbrokers with other buyers in order to raise the cash for the
target's shareholders.
You should remember that when shares are issued in the process of a takeover bid the
predator company's share capital will increase, and the effects on, for example,
earnings per share should be allowed for when considering the impact of the merger on
the company's performance.
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Company Performance
Following a merger or takeover there has sometimes been a fragmentation process, with the
decentralisation of individual companies and often the promotion of competition between
them. There have also been times when the advantages planned for the merger have failed
to materialise, with economies arising from increased buying power being lost completely by
increased administration and duplication of effort.
There will always be a certain level of risk in such an investment, but adequate research and
preparation should help to minimise such risk. Key features of the target company which will
improve the chances of success include:
 A well-defined market niche
 A balanced customer portfolio
 A growth industry
 Seasonal, fashion and economic cycle stability
 A stable and motivated work force
 High added value
 Good technical know-how
 A short production cycle
 Located near the acquisitor's business
 Matches the corporate strategic plan
 Provides something the firm does not have for itself.
The early months will be critical in settling down the enlarged business and gradually
bringing about new working practices to improve the efficiency of the operation. It requires
commitment from all levels of the organisation. Mergers and acquisitions have often been
found to fail because senior management are more concerned with future expansion,
especially via further acquisitions, rather than with integrating the organisation's current units.
There is a particular problem if the cultures of the merging organisations are very different.
A further point for you to note is that mergers have often been criticised as being
implemented to reduce competition and thus to create a more comfortable environment for
further business development, rather than due to a desire for increased operating efficiency.
Shareholder Wealth and Power
We saw above that a major concern of the predator's shareholders is changes in their
earnings per share. The change in EPS depends on the relative price earnings ratios of the
two companies – in general, if the target has the higher P/E ratio then the EPS will fall, but
may rise if sufficient levels of synergy and profit growth are achieved. Often, in practice,
companies who purchase shares with high P/E ratios do not achieve sufficient growth and
experience falls in their EPS. A fall may be acceptable if the shareholders wish to, and do,
obtain an increase in net assets per share or a reduction in the risk of its earnings.
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In a takeover environment, it will be possible for companies to increase their earnings per
share simply as a result of the acquisition, for example:
Company A Company B
Total earnings £300 £300
No. of shares 1,000 1,000
EPS 30p 30p
Share market price £4.50 £3.00
P/E ratio 15 10
Company A is seen by the market to be better managed, with better growth prospects, when
compared with Company B, and therefore its P/E ratio is higher. In the event of a takeover,
the position would be:
New Aplc
Total earnings £600
No. of shares* 1,666
EPS 36p
* Company B's value on the market was (1,000  3)  £3,000.
Company A would need to issue 3,000  4.50  666 (say) shares to acquire B.
The EPS of NewA plc has increased because it was able to "save" 334 of its shares (1,000 
666), because the market has set a higher value on its shares when compared to company
We are left with the question: "What P/E ratio should we set for the new company?"
Generally the market will tend to place a higher P/E ratio on the amalgamated companies
than would be expected from the result of an averaging. In the scenario above, we might
expect a P/E ratio of around 12½.
If the P/E ratio were 14, representing a partial fall, the market price of the shares in NewA plc
would be £5.04. A's original shareholders would have seen their shares increase in value
from £4.50 to £5.04, whilst B's (who owned 1,000 shares at £3.00) now own 666 shares at
£5.04  £3,356.64. The somewhat illogical situation arises because of the expectations of
the market that the assets of B will be managed similarly to those of A. This, of course, may
not always be the case.
The make up of shareholder control will change after a merger, and often changes after an
acquisition, especially in the case of a reverse takeover (when a smaller company acquires a
much larger one and may require a more than doubling of its equity capital in order to fund
the purchase).
Staff will want to talk to the new owner and to be recognised for what they are able to
contribute. Talk will be important in order to maintain staff morale which may fall when the
sale is confirmed, especially if there is no more information forthcoming. The best staff will
be the first to go, because they will readily find jobs even in a depressed market.
Competitors may even tempt them away, with a resulting loss of goodwill. One method of
keeping key personnel is to require, as part of the purchase offer, that they sign service
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contracts forbidding them to resign (and perhaps preventing them from selling their shares)
for a period of time (often three years). This will be in exchange for an attractive employment
In some cases new contracts of employment may be required for all staff to unify procedures
between the two firms.
Strachan plc, a successful engineering company has made a bid for Atkinson plc, a large but
declining competitor. The following information is available for both companies which are
quoted on the Stock Exchange:
Atkinson Strachan
Share price £5 £3.10
No. of shares 10 m 25 m
Both a cash and a share bid have been made. Strachan has offered Atkinson two shares in
Strachan plc for every share in Atkinson plc. Alternatively a cash offer of £6 per share has
been made. Strachan plc expects the takeover to generate savings of £5 m in present value
(a) Advise the shareholders of Atkinson plc on which offer to accept. Include financial and
other factors in your advice.
(b) How might Strachan plc expect to achieve the extra value of £5m? What uncertainties
might face Strachan plc in achieving this figure?
Framework Answer
We will consider briefly some points you could make in answering.
(a) Cash Offer:
Cash received  10 m  £6
 £60 m.
Share offer:
Shares in Strachan received  10 m  2
 20 m shares.
At the current valuation of Strachan shares this would be worth 20 m  £3.10  £62 m.
However, Strachan would now have 45 m shares in issue, which would be likely to
have an impact on earnings per share. In addition, the share price of the expanded
company will change as a result of the acquisition.
Advice to shareholders of Atkinson plc
The cash offer of £60 m is £10 m greater than the current value of the company's
shares, i.e. 10 m  £5. We are not given any information about earnings per share of
each company or about future growth in earnings, other than the projected savings of
£5 m. The acquisition may result in a fall in earnings per share in Strachan plc. This in
turn may reduce the value of shares from £3.10 per share.
Cash proceeds are certain, the return on shares in Strachan plc is less certain.
However, receipt of cash means that shareholders of Atkinson plc face an immediate
tax liability on the capital gain. Strachan plc is already a successful company and it is
likely to have considered the acquisition of Atkinson plc very carefully. Strachan plc
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must consider that it will be able to increase future earnings because of the acquisition.
With a competitor removed from the market, there is a real possibility of increased
turnover for Strachan plc.
On balance the acceptance of the cash offer would seem to pose less risk to
shareholders of Atkinson plc.
(b) Savings on acquisition may be achieved by:
 Economies of scale, e.g. one head office with less staff than exists in the two
companies currently;
 Additional expertise from staff of Atkinson plc, reducing training and development
 Lack of competition should result in operating economies, e.g. the advertising
budget may be reduced;
 Tax advantages may occur on acquisition.
Problems likely to be faced by Strachan plc include:
 Economies of scale are often difficult to achieve in practice. Additional
expenditure may be required, for example, to integrate the computer systems of
the two companies.
 Staff redundancies may be necessary, incurring redundancy costs.
 Strachan plc may be keen to retain the skills of senior management of Atkinson
plc. Additional costs may be incurred in drawing up new management service
 If the operational units of the two companies are geographically separate,
additional transport costs will arise.
Practice Question
Blue plc and Yellow plc have entered into negotiations to merge and form Green plc. Details
of the companies are as follows:
Blue plc Yellow plc
£1 ordinary share capital £500,000 £300,000
Estimated maintainable future earnings £200,000 £92,280
Agreed P/E ratio for amalgamation 15 13
Suggest a suitable scheme for a merger between the two companies.
Now check your answer with the one given at the end of the unit.
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Some groups specialise in buying companies, either stripping their assets or "turning" the
business around, and then selling the companies, generally at a profit. Other groups may be
forced to sell off parts of themselves due to financial problems, changes in the markets or
alterations in their strategic plans.
It is not always easy to move out of a market – one reason may be a reluctance to admit to
failure. Management may feel they are safer continuing in the market and may want
(wrongly) to attempt to recover sunk costs. There may also be economic costs – it may be
easier to sell a going concern; there may be large redundancy costs; and the withdrawal of a
product may have a detrimental impact on the sales of the company's other products. In
certain countries government action may prevent withdrawal from a market.
Management Buy-Outs
A management buy-out (MBO) is the acquisition by the management of all or part of a
business from the owners. The owners can be the shareholders, an owner-proprietor or the
parent company, although it is generally the directors who make the disinvestment decision.
In general, MBOs have been of profitable subsidiaries which do not match the group's
strategic plans.
Management buy-outs have become more common since the late 1980s, the number
increasing five fold in 10 years and the value increasing from less than £50 million to more
than £2,800 million. It has been due partly to incentives provided by the UK Government and
partly due to a belief that management functions better as part of an autonomous profit-
seeking unit.
(a) Advantages of MBOs
The potential benefits of an MBO include:
 For the vendor an MBO provides an alternative to the closure of the business or
part of it, and prevents the sale to a third party who could be a competitor. The
management and employees are more likely to be cooperative to an MBO rather
than in a sale to a third party. Moreover, the sale of the going concern may well
achieve more money for the vendors.
 For the management team the buy-out allows them to purchase an operation of
which they already have full operational knowledge. They must be certain,
however, that they can turn the business around to obtain a better return once
they are released from the constraints of the current ownership. An MBO will
also allow the management team to be owners rather than employees and, if the
business is threatened with closure, will prevent them losing their jobs.
 For the financiers who may be invited to participate there is a reduced risk
compared to a new venture which has no track record to be evaluated.
(b) Disadvantages of MBOs
There are also potential problems with management buy-outs which include:
 Technical managers, who are good at managing processes, may not have the
financial or legal knowledge required to conduct a management buy-out. They
will have to use expert advisors, who can be costly, for the tax and legal
complications that can arise from an MBO.
 There are often redundancies following an MBO, used as a means of reducing
costs. In addition there may be problems convincing employees of the need to
adjust working practices and the company may lose key employees. There may
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also be previous employment and pension rights to be maintained which may be
a drain on resources.
 Individual managers will be required to be financially committed to the venture.
This may include borrowing from the bank, which may create problems in the
manager's personal financial affairs.
 Problems may arise with regard to the continuity of relationships with suppliers
and customers.
 It may be difficult to decide on a fair price to be paid for the business.
 Management may resent the board representation required by suppliers of
 Cash flow problems can arise, especially if fixed assets need replacing.
(c) Financing MBOs
The management's own financial resources which they are willing to invest will
generally be insufficient for the purchase of the business, and they will have to find
financial backers. In order to convince the backers of the viability of their idea the
management team should prepare a business plan. The business plan should
contain cash flow, sales and profit forecasts and planned efficiency savings. This will
probably be relatively straightforward – management should have access to a lot of this
information, especially if the vendor is happy with the sale.
Financial backers will include banks, accepting houses and venture capitalists, and in
general they view their investment as a long-term one. There will often be several
financiers providing venture capital for an MBO, and they may require an equity stake
in the business because of the risk they are taking – indeed, often the management
have only a minority of the shares in the business. Some backers may insist that some
of their capital be in the form of redeemable convertible preference shares with voting
rights should dividends become in arrears. This form of security allows them to
capitalise on the business if it is successful and to cover themselves if the business
fails. The purchasing company will usually be financed by bank and subordinated debt,
together with the management's and financiers' equity. The resultant business will
often have a financial gearing level which is far higher than that accepted in general
trading circumstances.
We noted above that the financiers' money is at risk in such an investment, and should
be assessed in relation to:
 The expertise, motivation and ability of the management team (including the mix
and range of management skills) and the amount the management are willing to
invest from their own funds.
 The relationships with its suppliers and customers.
 The projections contained in the business plan.
 Is the projected return from their investment sufficient to offset the risk they are
 Why is the business being sold, and what is being bought? Is additional capital
required to replace or improve the assets of the business?
 What is the price and has it been set at the correct level?
The risks will be considered against projected returns before the financiers agree to
back the buy-out.
More capital will often be wanted to finance growth. Raising it may be difficult because
of the high existing debt/equity ratio. Financiers may commit to the provision of further
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capital at the start, but will apply stringent performance conditions before allowing a
further release of funding.
An alternative form of funding for expansion would be for the management to float the
company, perhaps on the Alternative Investment Market. However, this, too, will
require careful thought as such action will involve relinquishing at least some control
over the business, but it does allow financiers a means to realise their investment.
The long-term viability of a typical MBO in its initial form is a question of very careful risk
assessment. It is the ability of the management to plan and develop the business which
determines its success. There have been a number of great successes in the past, e.g.
National Freight. Empirical evidence has found a number of possible reasons, including
reduced overheads; higher levels of managerial motivation; quicker and more flexible
decision-making; more austere action on pricing and debt collection; and the MBO having
acquired the business for a good price.
A management buy-in is similar to an MBO except that it is a team of outside managers who
mount a takeover bid to run the company.
A spin-off is the creation of one or more new companies with shares being held by the
shareholders of the "old" company in the same proportion as before. The assets of the
business, having been separated, will be transferred to the new company which will usually
be under different management from the "old" company.
A sell-off is the sale of part of the company, generally for cash, to a third party. An extreme
form of sell-off is the liquidation of the entire company.
A demerger is simply the opposite of a merger. A demerger can either be the selling of part
or parts of the business to a third party, or offering shareholders shares in the demerged
parts of the business in place of their current shares in the "merged" company. A famous
example of a demerger is the split of ICI plc.
There are both advantages and disadvantages of demergers, mainly arising from their
smaller size, e.g. if there were diseconomies of scale before the demerger these should be
reduced. Similarly any economies of scale would also be reduced. There may also be an
increased risk of takeover or, if the attractive parts of the company have been disinvested,
there may be a reduced takeover risk. Other advantages include an ability to concentrate on
fewer areas, thus hopefully improving efficiency and removing control problems, and an
increase in cash and earnings. Disadvantages include the reduction in the ability to raise
finance, lower turnover, status and profits.
The Stock Market's reaction to the demerger will depend on the reasons for it and the view
on the future profitability of the demerged components, but generally demergers are viewed
favourably. This may be because visibility of individual parts of the business is improved, and
there is a greater choice of shares for investors.
Going Private
A listed company may decide to go private. This occurs when a small group purchases all a
company's shares and the company is no longer quoted on the Stock Exchange – a well-
known example being the repurchase of shares in Virgin by Richard Branson.
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The reasons for such a move may be to prevent takeover bids, reduce the costs of meeting
listing requirements and limit the agency problem. In addition, because the firm is not subject
to volatility in share prices, it can concentrate less on the short-term needs of the Stock
Market and more on its own medium- and long-term requirements.
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Value of shares for merger:
Blue plc Yellow plc
EPS  40p
 30.76p

EPS × P/E ratio  40p  15 30.76p  13
 Market value  £6.00 £4.00
If Green plc is to have ordinary share capital of £500,000  £300,000 (£800,000), the
holdings of ordinary shares in the new company could be divided between the former
companies' shareholders in the following proportions:
Blue: 500,000  £6  £3,000,000
Yellow: 300,000  £4  £1,200,000 (i.e. in the proportion of 3 : 1.2)
Blue: 571,429 shares in Green (approx. 114 for 100)
Yellow: 228,571 shares in Green (approx. 76 for 100)
Total 800,000
This would mean that Green would have an EPS of:
share per 36.535p

and that the proportions attributable to Blue and Yellow are:
Blue: 571,429  36.535p  £208,772
Yellow: 228,571  36.535p  £83,508
Total £292,280
In this scheme Blue gains some earnings contributed by Yellow, and Yellow loses earnings to
Blue. The critical point to both sets of shareholders will be the rating placed on the shares of
Green by the market. Gains and losses in EPS will be mitigated by movements in the new
share prices.
As an alternative to the above, the shares in Green could be apportioned on the basis of
input of earnings without heeding the market price situation. This would penalise Blue in the
sense that the market appears to favour its development and growth potential more highly
than it does Yellow's. A straight proportional split would not acknowledge the apparent
difference in market rating.
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Study Unit 4
Financial Markets
Contents Page
Introduction 92
A. Stock Markets 92
Why do we have Stock Markets? 92
The London Stock Exchange 93
Over-The-Counter 97
"Big Bang" 97
Market Participants 98
Some Other Common Market Terms 98
B. Other Sources of Finance 99
Banks 99
Merchant Banks 99
Institutional Investors 99
Government and European Union Assistance 101
C. Other Financial Markets 102
The London Money Market 102
Parallel Markets 102
Option Markets 102
D. Recent Changes in Capital Markets 103
E. Impact of the Markets on Market Decisions 103
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Financial managers have the responsibility of ensuring that sufficient short- and long-term
capital is available to organisations, at the time it is needed, and that surplus funds are
placed at suitably high rates of return. He/she will need to ensure that a suitable balance is
struck between obtaining a good rate of interest on funds held (the longer the term then
usually the higher the interest rate received) and when those funds are needed for internal
investment and business growth. It is not uncommon for the financial manager even to
invest "overnight" to get a small amount of investment before the funds are needed the
following day – maybe, for example, to pay staff salaries and wages!
To achieve this, the financial manager must therefore have a good all round working
knowledge of the financial markets that are available to the firm.
This study unit considers the financial markets, the institutions which operate upon them and
some of the terminology used. We shall pay particular attention to the markets for share
capital – highlighting the importance of the Stock Market and its players in company and
market decisions. (However, share capital itself, and alternatives to equity, are dealt with in
more detail later in the course, as are options and other financial instruments.)
There are several different stock markets in the world, of differing levels of sophistication.
Indeed, most major industrial countries have stock markets of some form. However, the
three major ones (or the "golden triangle") are those in London, New York and Tokyo. Here
we are mainly concerned with the London Stock Exchange.
Why do we have Stock Markets?
The main reasons for having stock markets are:
(a) To provide an efficient mechanism for the bringing together of organisations wishing to
raise capital to invest in new projects and investors wishing to place capital in such
companies and institutions. A common way of doing so is for a company to issue
There are a number of reasons why a company may want to issue more shares.
Before reading further, think of as many different reasons as you can.
The reasons include:
 The company may need to raise more cash to fund investment in profitable
 The company may wish to be "floated" on a stock market. In the UK, when a
company is floated on the Stock Exchange there is a minimum proportion of
shares which must be made available to the general (investing) public unless the
shares are already widely held. This also allows the owners of the company to
realise some of their investment in the company by offering their shares for sale.
 Shares may be issued to shareholders in another company in the process of a
takeover bid. This is really only feasible when shares that are offered have an
identifiable market value and can be easily traded on a recognised stock
(b) To allow a ready "second-hand" market in stocks and shares allowing investors to
realise their investment if they wish to, either for investing in other securities or for
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What reasons might a business have for seeking a stock market listing?
 Access to a wider pool of resources. The number of potential investors in a business
grows much larger when it is opened up to a public arena, and this makes it much
easier to obtain funding for expansion, investment and growth and so on.
 Improved marketability of shares as they are traded on the stock market and they can
be bought and sold relatively easily and in any quantities.
 Capital can be transferred to other uses – raising capital through the stock market can
release internal funds for other purposes.
 There is a perception in business that a quoted company is more secure and their
image is improved, allowing often easier relationships with customers and suppliers
and so on.
 A listed company is in a better position to merge and acquire additional business
through the capital growth potential of a stock market listing.
Equity capital
The largest proportion of long term finance for a modern large business is usually provided
by shareholders and is called equity capital.
Ordinary share capital is usually the main source of new money provided from shareholders.
Shareholders are allowed to participate in the running of the business (usually through voting
in general meetings) and to receive dividends from profits. They carry the greatest risk in
terms of financial return and because of this the directors of a company will usually strive to
ensure that the shareholders (in recognition of this risk and support) get a good return on
their investment.
When a business is formed the original shareholders decide on the number of shares to be
issued – this is the authorised capital of the firm. This is the maximum amount of share
capital that the business can issue (unless shareholders vote to amend the limit).
At any one point in time, the business will have a certain amount of shares issued to the
market. This can never exceed the amount that is authorised in the legal documentation.
So, for example, a business might have an authorised ordinary share capital limit of, say,
£5,000,000, but only have say £3,000,000 issued on the stock market – allowing them at
some future stage to offer, for sale, up to another £2,000,000.
Shares have a stated par value, usually 25p, or 50p or more commonly £1. This nominal
amount has no bearing at all on the actual market price of the share or how much they can
be bought and sold for on the stock market. Whilst the par value has no real significance,
note needs to be taken of the fact that when looking at a balance sheet the share capital
figure often appears out of place and insignificant.
The London Stock Exchange
The London Stock Exchange functions both as a primary and a secondary market:
 A primary market is one in which organisations can raise "new" funds by issuing
shares or loan stock.
 A secondary market is one for dealing in existing securities.
The primary market is known as the New Issue Market. The more important function,
especially in terms of volume, of the Stock Exchange is the latter. In addition to acting as
primary and secondary markets for corporate shares and loan stock, the London Stock
Exchange also functions as the market for dealing in gilts (government securities).
The London Stock Exchange administers and regulates the main market which deals with
companies which are "fully listed" (see below) and the second-tier market for smaller
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companies. Until a few years ago the second-tier was the Unlisted Securities Market
(USM), but this was phased out and replaced by the Alternative Investment Market (AIM).
(a) The Main Market
Any company wishing to be floated on the main market must comply with Stock
Exchange rules and regulations in addition to the legislation in this area.
Joining the Main Market involves two processes.
 A company applies for its securities to be admitted to the Official List (a "listing")
through the UK Listing Authority (UKLA), a division of the Financial Services
Authority (FSA); and
 the listing is dependent on those securities gaining admission to trading on the
Main Market through satisfying the Exchange's Admission and Disclosure
The UKLA is responsible for drawing up and monitoring the FSA's Listing,
Transparency and Disclosure, and Prospectus Rules for Main Market companies.
The Exchange is a recognised investment exchange under UK law and has a duty to
ensure that dealings in securities admitted to its markets are conducted in a proper and
orderly manner. To ensure this, it requires listed companies to meet specific standards.
The listing rules are contained in the Stock Exchange's Admission of Securities to
Listing. The requirements seek to secure the confidence of investors in the conduct of
the market. This is done by:
 Ensuring that applications for listing are of at least a minimum size. The size
rules relate to the market capitalisation and annual profit figures.
 Requiring companies to have a successful track record of at least three years.
 Ensuring that companies requesting listing at least appear to be financially stable.
 Insisting that a sufficient number of shares of a tradable value (i.e. several shares
of a smaller value rather than fewer shares of a higher value are preferred), are
made available to the general investing public to allow a free market to exist in
the company's shares.
 Requiring the directors of a company to make a company resolution to adopt the
terms and conditions of the Stock Exchange Listing Agreement. This includes the
provision of sufficient information (e.g. interim results) to form a reliable basis for
market evaluation.
Note that you may also see flotation on the Stock Exchange referred to as "going
public", or "getting a listing on the Stock Exchange".
From a company's viewpoint there are both advantages and disadvantages in obtaining
a full listing. Table 4.1 summarises the principal advantages and disadvantages of a
full listing to a company.
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Table 4.1: Advantages and disadvantages of full listing
Advantages Disadvantages
Once a listing is obtained, a company
will generally find borrowing funds
easier because its credit rating will be
Additional long term funding can be
raised by a new issue of securities.
Shares can be easily traded,
facilitating expansion of the capital
Future acquisitions will generally be
easier because the company will
have the ability to issue equity as a
consideration for the transaction.
Share option schemes can be
arranged potentially attracting the
highest calibre employees.
The profile of the business and its
management team will be raised
Publicity will not always be of
advantage. An unquoted company
will be able to conceal its activity
because of its lower profile in the
community at large.
The costs of entry to the Stock
Exchange are high.
At least some control will be lost
when shares are available to the
general public.
The requirements of the Stock
Exchange are onerous and
compliance is enforceable.
The company can (potentially) be
more exposed to a hostile takeover
Going public and becoming a listed company is a major step for a business. It could
lead them to a greater amount of funds being available through the public capital
markets to help with development and business growth. However, there is a price for
this – for example:
 There is a great deal of administrative and legal requirements that come with a
stock exchange listing and a very demanding (and ever increasing) list of rules,
regulations and constraints that all need to be met. The directors of a listed
company have a very large degree of responsibility to ensure that all these
various rules and regulations are met in full or they could be personally liable.
 All companies that obtain a full listing must ensure that at least 25% of their share
capital is in public hands. This is to make sure that shares are available to be
traded on the "public market" and in this respect public means individuals that are
not associated with the company (for example, current directors or shareholders).
 There will be great pressure to pay dividends to the shareholders as their reward
for providing equity funds for the company. In particular, institutional investors
(and particularly the ones who have a great deal of influence with companies) will
be looking for regular and good returns on their investments. Regular and
consistent dividend payments are often seen as a measure of how well the
business (and the senior management team) is performing.
 The directors also need to be aware that in a listed company they lose some of
their privacy, particularly as details of their pay and "perks" will be reported as an
integral part of the annual accounts process.
There are a number of critical points that affect the timetable for an official listing and
these can take days, weeks or months depending on the work that needs to be done
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between expression of interest and actual listing day. The critical points could be
summarised as follows:
 Issue of prospectus
 Offer closure for share bids
 Allocation and allotment of shares
 Dealing begins.
The listing process itself involves a number of key specialist advisers as follows:
 The sponsor, who may be a merchant bank, a stockbroker or other professional
adviser, is the key adviser to a business trying to gain a place on the official list.
The sponsor examines the company and its aims and objectives by taking into
account its structure, strategy, long term plans, aims and objectives and capital
 Accountants, who are responsible for providing a detailed financial "health
check" on the company.
 Legal advisers who are there to ensure that all the detailed legal requirements of
listing are met.
 Brokers advise the business on share market conditions and the anticipated
demand, from the public, for shares in the business if full listing is obtained.
 Registrars maintain the records of ownership of shares when they are bought
and sold.
 Underwriters, who are usually issuing houses or merchant banks, generally act
in a syndicate by agreeing to purchase any securities not taken up at the issue
price (underwriting). The underwriters will charge a fee which will be payable
whether or not they are called upon to take up surplus securities. Whilst not used
in placings, they are often used in rights issues.
 Merchant banks, who are sometimes employed to give financial advice, but may
also act in the role of issuing house or sponsor.
There are a number of different methods of issue which can be summarised as follows:
 Offer for sale. When companies go public for the first time a large issue will
probably be by offer for sale and the offer price is advertised a short time in
advance so it is fixed without certain knowledge of the condition of the market at
the time applications are made.
 Offers for sale by tender. A minimum price will be fixed and subscribers will be
invited to tender for shares at prices equal to or higher than this minimum price.
The shares will be allotted at the highest price at which they will all be taken up.
 Offer for subscription is only partially underwritten. This method is
sometimes used by small companies who stop the offer if a stated minimum price
is not achieved.
 A placing. This is an arrangement whereby the shares are not all offered to the
public and instead the sponsor arranges for most of the shares to be bought by a
small number of investors (usually institutional investors) such as pension funds
and insurance companies.
 Reverse takeover. Sometimes a larger unquoted company makes a deal with a
smaller quoted company, which then takes over the larger company.
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(b) Alternative Investment Market
The Unlisted Securities Market (USM) of the London Stock Exchange was a second-
tier market for shares in companies not floated on the main market. For some
companies the USM was seen as being a stepping stone to full listing – a major
purpose in its development. The USM closed to new members at the end of 1994 and
completely at the end of 1996.
To replace the USM, which was being gradually phased out, a new market – the
Alternative Investment Market (AIM) – was launched by the London Stock Exchange in
June 1995. Like the USM it is a market for smaller growth companies that either do not
wish to join, or fail to qualify for, the official list. It has, however, less stringent entry
requirements and regulations than the USM and as such should not be seen as a direct
replacement for it.
The main difference between the process of obtaining full listing on The London Stock
Exchange and the AIM is that the rules for AIM listings seek to keep cost of
membership and of raising capital to a minimum. However, in common with all quoted
companies, AIM companies are subject to the Exchange's Market Supervision and
Surveillance Department and can be fined for breaches of AIM rules.
Unlike the Official List, however, there are no requirements as to size, profitability, track
record, number of shareholders or ratio of shares in public hands for companies
wishing to join the AIM. The only restriction on the type of security which can be traded
is that it must be fully transferable.
The Inland Revenue treats AIM shares as unquoted, thus providing a number of reliefs
for investors, which helps to ease the process of raising finance at critical stages for
firms (e.g. start-ups). We shall deal with these reliefs in more detail later in the course.
The AIM has established itself as a leading stock market for smaller growing
companies, with listings from companies in 26 countries and ranged across 30 market
sectors and 90 sub-sectors. Fast-growing businesses with turnovers between £4
million and £20 million are particularly keen to list on the market, with smaller computer
and hi-tech companies feeling that an AIM listing gives them a higher City profile and
access to a wider source of funds. There are two fully investable indices − the FTSE
AIM UK50 and the FTSE AIM100 – and from 2006 the FTSE AIMAll-Share
Supersector Indices provides sector indices.
Every AIM company is supported, advised and monitored by its own Nominated Adviser
(Nomad). Firms that wish to act as Nomads must undergo stringent checks before
they can be authorised to become a London Stock Exchange-approved Nomad for the
AIM. These checks ensure the suitability both of Nomads and of the companies they
assist to operate as part of AIM, bringing investors increased certainty and security.
It is also possible to buy shares and other financial instruments in the "over-the-counter"
(OTC) markets. These are not regulated or supervised by the Stock Market so there is less
protection for the investor, although the costs of dealing on the OTC are less than those of
dealing on the main or secondary markets.
"Big Bang"
"Big Bang" occurred on 27 October 1986 and was considered necessary because of
restrictive practices on the London Stock Exchange, including fixed commission scales and
the limited number of firms permitted to participate in dealing.
The effects of "Big Bang" included the abolition of the fixed commission scales and the
opening of the Stock Exchange to a wider range of participants. The changes resulted in an
increase in competition due to large institutional investors being able to negotiate
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commission levels. There has also been a change in the constitution of the membership,
with foreign companies moving into the Stock Exchange (a well-known case being Merrill
Lynch) and some other overseas organisations acquiring hitherto private dealers, e.g.
Citicorp purchased Scrimgeours. In addition, there is now 24 hour trading in leading
international shares – starting in the Far East, moving to London and then to New York and
back to the Far East for the following day.
Market Participants
Prior to "Big Bang", there was a rigid distinction in the membership of the Stock Exchange
with brokers buying and selling financial instruments on behalf of clients for which they
charged fixed commissions, and jobbers acting on their own behalf in buying and selling
securities. Jobbers would trade with the brokers, but never actually came into contact with
the original investors. This was known as single capacity trading.
Single capacity trading has now been replaced by dual capacity trading as both activities
can now be conducted by a single firm. Firms can act as agents of the investor (previously
the responsibility of the broker) whilst also acting as principal in their own right in buying and
selling shares (previously the role of the jobber). Some firms only act as agency brokers,
working solely as agents on the behalf of clients in return for commission, and do not deal as
principals for themselves.
The new traders acting in a dual capacity are called market-makers. Market-makers must
be members of the Stock Exchange. They must register to deal in certain types of security,
and must agree to quote two-way prices (for buying and selling) in the shares they trade in.
"Chinese walls" are required to be set up in firms which deal as market-makers in order to
separate the broker and dealer functions. This is to prevent the investor (and the firm) from
unscrupulous market-makers making profits at their expense, and will also help provide some
protection for market-makers and firms against allegations of this type.
Only market-makers are permitted to use the Stock Exchange Automated Quotations
System (SEAQ) which is a computerised price display regularly updated by the market-
makers themselves. Dealers and investors may view the system on computer terminals via
dedicated networks.
Two other terms you may come across in this area are GEMMs and SEMBs. GEMMs are
Gilt-Edged Market-Makers and SEMBs are Stock Exchange Money Brokers. SEMBs
help to ensure liquidity in the share markets by dealing with the lending and borrowing of
money and stocks to those who are experiencing difficulty in fulfilling share-trading deals.
For larger institutional investors there is a growing alternative to this system of market-
makers known as crossing networks. Crossing networks, of which examples are Instinet
and Global Posit, electronically link buyers and sellers of shares and other financial
instruments. Another example of a crossing network is Tradepoint, which operates a screen-
based matching of orders for certain UK equities. Whilst the use of crossing networks is still
rare in the UK it is common practice in the US.
Some Other Common Market Terms
The Stock Market, and its related activities, is full of unusual terms, e.g. the "Chinese walls"
noted above. Below we mention a few of the more common terms, which you may have
heard of but be unsure as to their meanings. A useful exercise for you to undertake is to see
if you can relate the terms to your wider reading of the financial press.
Bull markets are those with rising prices, and bear markets are ones whose prices fall.
Similarly, optimistic people are bullish, expecting increases in share prices, whereas
bearish people are more pessimistic about market prospects.
If an investor goes long in a sector it means he is building up a holding of shares in the
bullish hope of them increasing in value, whereas someone who goes short (generally a
bear) sells shares he does not own, again with the hope of making a profit. A short bear is
someone who takes a gamble that he may be able to purchase the shares cheaper (a bear
covering) before he has to deliver them (at a pre-arranged price) and thus make a profit. An
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uncovered bear (one who sells shares he does not have) can face unlimited losses if the
price rises quickly and he has to purchase shares to sell at a loss.
A bear-raid is when a number of dealers sell ostentatiously in an attempt to drive down the
market. In order to prevent this market-makers can mark up the prices near the end of the
account period – a so-called bear squeeze.
A bull may buy shares and intend to sell them at a profit before he receives them (he may
need the sale proceeds to pay for the shares); if this goes wrong and a loss is made he is
referred to as a stale bull.
A stag is someone who applies for shares at the start of a new issue of shares intending to
sell them straightaway. This is because new issues are usually priced low in order to ensure
that they are sold, and hence start trading at a substantially higher price. The difference
between the issue price and the initial trading price (the premium) is the stag's profit.
The markets discussed earlier are not the only sources of finance, and other sources include:
Banks are a major source of short-term (and recently medium-term) corporate financing.
Long-term loans from banks are in the form of mortgages. The banks will expect the
customer to provide a reasonable proportion of the required funding from its own resources
(e.g. from equity). Clearing banks like to lend against security (i.e. assets).
The rate of interest charged to larger companies on medium-term bank loans will be set at
LIBOR (London Inter-Bank Offer Rate) plus a margin which depends on the credit rating and
riskiness of the borrowing. For smaller companies the interest rate will be the bank's base
rate plus a margin, again depending on the riskiness and credit rating of the firm. The rate of
interest in both cases can be either fixed or variable. Often in the former cases it is adjusted
every quarter, half-yearly, three-quarterly, or yearly in line with changes in LIBOR.
Merchant Banks
These are banks dealing as investment banks, generally for corporate clients. They have a
range of activities, including:
 Involvement in the business of the Stock Exchange for their clients, helping in the
issuing and underwriting of share issues and share registration.
 The provision of venture capital and large scale medium-term loans to companies.
 The taking of wholesale deposits in all currencies.
 Dealing in foreign exchange and the bullion markets, and through subsidiaries in stocks
and shares.
 The provision of advice during takeovers and mergers.
 Granting acceptance credits.
 The management of client investments and acting as trustees.
 The provision of general investment and deposit advice to corporate clients.
Institutional Investors
These are institutions with large funds to invest in assets which provide sufficient returns and
security, including investments in company stocks and shares. The UK's main institutional
investors are:
(a) Unit Trusts
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Unit trusts were developed in order to allow small investors to hold a diversified
portfolio of investments. The portfolio is managed on behalf of investors by a unit trust
company which deducts management expenses from the income of the portfolio before
paying the investors their share of the income. Each investor holds a sub-unit or stake
in the portfolio. The sub-units are sellable, their price being determined by the
underlying value of the securities included within them.
(We shall examine portfolios in detail later in the course.)
(b) Investment Trusts
Investment trusts invest in a wide range of securities though they are generally
concerned with quoted and larger unquoted companies. They are interested in both
returns and securities, wishing to maintain a steady growth in income in order to pay
their shareholders' dividends.
(c) Venture Capital Organisations
Venture capital is the investment of money in a new or expanding business, or in a
management buy-out. It is generally done in exchange for an equity stake in the
business and a seat on the board.
There are several organisations offering venture capital, including venture capital funds
acting as agents for the venture capital industry, the clearing banks. Those which have
joined are regulated by the British Venture Capital Association. The biggest and oldest
venture capital provider is the 3i group (Investors in Industry plc).
Venture capital is a high risk, high return investment, which is generally short term,
being between five and seven years in duration. Often the venture capitalist will be
able to realise his investment (and hopefully profits) when the business is floated on
the AIM and the venture capitalist can sell his shares.
In order to qualify for venture capital a company must be able to show the venture
capitalist that it has the ability to succeed; that the product or service is viable and
meets a need in the market; that sufficient levels of the correct form of finance are
available; and there is, or will be, a good management team.
Venture Capital Trusts (VCTs) are investment trusts investing a significant proportion
of assets in unquoted companies to a maximum in a company of £1m, and per investor
of £100,000. There are general tax reliefs available to individuals aged 18 years or
over (but not to trustees, companies or others) who invest in VCTs as follows:
 exemption from income tax on dividends from ordinary shares in VCTs ("dividend
relief"); and
 "income tax relief" at the rate of 30% of the amount subscribed for shares issued
in the tax year 2006/07 and onwards (for subscriptions for shares issued in
previous tax years the rate is 40%). The shares must be new ordinary shares
and must not carry any preferential rights or rights of redemption at any time in
the period of five years (three years if the shares were issued before 6 April 2006)
beginning with their date of issue. This income tax relief at 30% is available to be
set against any income tax liability that is due, whether at the lower, basic or
higher rate.
The maximum amount of deferral relief is the amount subscribed for eligible shares in
VCTs that are issued in the year (up to a maximum of £100,000).
(d) Pension Funds
Pension funds hold large amounts of money which will provide retirement benefits for
their members. In most pension funds there is a surplus of incoming funds from
contributions over outgoings as pension payments. The surplus must be invested to
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achieve the best possible return whilst maintaining the security of funds. The pension
fund manager often spreads the investment between high yield securities, e.g. gilts,
and equity or property.
Pension funds may provide substantial finance for major investment schemes. For
example, funds from the Coal Industry Pension Scheme helped fund the new
"Galleries" in Wigan town centre. A new multi-million pound expansion of Milton
Keynes shopping centre is being funded by the Universities Superannuation Fund.
(e) Insurance Companies
These, along with pension funds, provide the most funds for investment in the UK.
They have similar investment policies, seeking secure returns and steady growth in
order to meet their commitments.
Government and European Union Assistance
In common with the majority of governments, the UK Government provides financial
assistance to companies, especially those operating in high technology industries or in areas
of high unemployment.
 Enterprise Initiative Scheme
This is a series of measures including local business advice centres, "Business Links",
and grants provided by the Department of Trade and Industry (DTI).
 Regional Enterprise Grants
These are available for companies in Development Areas employing fewer than 25
staff, and are used to help finance investment in fixed assets or to aid innovative
 Regional Selective Assistance
This is considered by the local office of the DTI and is only available in areas defined
geographically for the purpose of the availability of financial assistance. The amount of
grant will be the minimum required to commence the project. To be eligible the project
must need assistance, be commercially viable, safeguard or create jobs and offer a
distinct advantage to the region or country as a whole.
The EU funds the European Regional Development Fund (ERDF) which gives money to
member governments – the majority going to the poorest member nations. The UK received
over £3.5 billion during the first 15 years of the ERDF's life.
Note that the sources of finance available to the company, especially from governmental
bodies, are an ever-changing area, and you should follow developments in the financial
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The London Money Market
The London money market covers a wide range of UK institutions.
 The Bank of England
 Merchant banks
 Discount houses
 Finance houses
 Pension funds
 Unit trusts
 Parallel markets
 Clearing banks
 Other banks
 Insurance companies
 Investment companies
 Building societies
 The Stock Exchange.
Parallel Markets
These consist of the Foreign Exchange Market and the Eurocurrency Market, both of which
we shall consider later in the course. They also include:
 The Local Authority Market
 The Interbank Market
 The Finance House Market
 The Intercompany Market
 The Certificate of Deposit (CD) Market.
Option Markets
Options are a form of dealing which can be used as an insurance against, or for speculation
on, a rise or fall in a particular share, and act as a way to limit the cost of taking a view on the
future performance of the share.
An option is the right to buy (a call option) or sell (a put option) shares at a future date
(generally three months forward) at a fixed price agreed now. There is also a double option
which gives the right to buy or sell and this is called a put and call option or a straddle.
Bargains are agreed at a striking price (the figure at which shares can be called or put at
the end of the option period), which is the current share price, plus interest to meet the carry-
over facilities during the option period. It is not necessary to wait until the end of the option
period before taking action, and it is possible to deal in those shares during the period. A fee
per share will be charged by the broker whether or not the option is exercised.
Options have a maximum life of nine months with expiry dates arranged on a three-month
cycle, so that a maximum of three extensions can be arranged on shares of any one
company. They are popular because they provide investors with price and time variety not
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possible with traditional call and put options and the opportunity to profit from price changes
which involve a smaller outlay than direct involvement in the securities themselves.
An extension of the options market is the Traded Options Market. This gives the holder of
the option the right to buy or sell the option itself before its expiry date.
(We shall examine options in detail later in the course.)
There have been vast changes in the capital markets over recent years including:
 Increased competition with the impact of Big Bang, building societies becoming banks,
and banks operating in non-domestic markets have, amongst other things, increased
the levels of competition in the financial services industry.
 Securitisation of debt, i.e. firms are increasingly issuing securities rather than borrowing
from the banks.
 The deregulation of the financial and other service markets.
 The abolition of exchange controls allowing companies to use overseas markets to
obtain funds.
 Disintermediation – firms using securitisation to avoid using banks.
 Globalisation – shares issued in one country are traded around the world.
 The development of, and greater use of, risk management tools such as the use of
swaps and options which help in the borrowing of money and also reduce the financial
risk apparent in the balance sheet.
We shall consider these points in greater detail elsewhere in this course.
The Stock Market and its players have a major impact on a company's, and on the market's,
decisions. We will refer to them throughout this course, and you should take time to consider
the point when you have completed each study unit.
One example we can see from the last study unit is in the field of MBOs. Many firms are
adopting the policy of focusing management and financial resources on core activities, and to
a large extent it has been supported by the stock markets and institutional investors. With
diversification often less attractive, opportunities for managers to buy-out their operations
have become more common.
Other examples from earlier study units include the existence of short-termism (see Study
Unit 1); the market's views on the relative strengths of two companies will affect the valuation
placed on them and the resulting terms of any acquisition or merger (Study Unit 2); and the
three financial management decisions discussed in Study Unit 1 will be affected by the
market and its workings.
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Study Unit 5
Sources of Company Finance
Contents Page
Introduction 107
A. Share Capital 107
Value 107
Authorised and Issued Capital 107
Types of Share Capital 108
Retained Profits 109
Dividend Payable 109
Newspaper Information on Shares 109
Share Categories 109
Penny Shares 110
B. Methods of Issuing Shares 110
Placing or Selective Marketings 110
Offers for Sale 110
Sale by Tender 111
Rights Issue 112
Other Methods 114
Pricing Shares for a Stock Market Quotation 115
Costs of Share Issues 115
Issuing New Shares Without Raising Capital 116
C. Share Repurchases 116
D. Debt and Other Forms of Loan Capital 118
Debt Capital 118
Debentures and Loan Stocks 119
Mortgages 122
Convertible Loan Stock 122
Warrants 124
Leasing 125
Hire Purchase 127
Licensing and Franchising 127
(Continued over)
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Bonds 127
Syndicated Loans 128
Mezzanine Finance 128
Medium Term Notes (MTNs) 129
Project Finance 129
E. Short-Term Finance 129
Securitisation 129
Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs) 129
Commercial Paper (CP) 130
Syndicated Credits 130
Banks 130
Trade Credit 132
Factoring 132
Invoice Discounting 133
Bills of Exchange 134
F. International Capital Markets 134
Eurocurrency 134
Eurobonds 134
Euroequity 135
Choice of Currency for Borrowing 136
Advantages of Raising Funds in International Markets 136
G. Finance and the Smaller Business 136
Government Measures 136
Business Angels 137
Grants 138
Banks 138
Venture Capital Providers 138
Finance Companies and Lessors 139
Private Investors 139
Answers to Practice Questions 140
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In this study unit we will look at the main sources of finance available to companies.
We start by considering the primary source of funding for limited companies – equity finance
– including how it is raised. Whilst under UK company law all limited companies must have
equity, many also utilise additional types of finance. We go on, then, to examine the different
forms available, including those from international capital markets. This is an area in which
there are always new arrangements developing, and you will almost certainly learn of more
from your reading of the financial press as new ideas come to market.
Shares are described as permanent capital because the funds supplied for their acquisition
are non-returnable (to the investor who provided them) in most circumstances other than in
the event of a liquidation. The ordinary shareholders collectively own the company, but stand
last in line for rewards on investment and in the event of liquidation, although they do have
ownership of the remaining funds either in a trading period or in the event of liquidation.
Ownership means that the ordinary shareholders bear the greatest risk. In return for their
acceptance of the risk they are equity shareholders, each share carrying a vote in the
management of the business, although as we saw in Study Unit 1, managerial control may
be limited.
In the case of a limited company, the Articles of Association will include details of each class
of shares which comprise the capital structure of the company.
We have already determined that the owners of the company are the shareholders – and to
show their ownership they have shares issued to them. Shares are issued in the UK at a
nominal, authorised or face value generally of £1, 50p, 25p, 10p or 5p.
Be careful not to confuse nominal value with market price, to which it bears no relationship.
The market price is the price that shares are sold for. (If the market value and the nominal
value are the same, the shares are said to be at par value.)
The only exception to this rule of no relationship is when the shares are first issued, and the
nominal value is the minimum at which the price would be set. Established companies
issuing new shares to the market, with existing shares that have a market value in excess of
the nominal value, may issue the new shares at a premium (i.e. at a value greater than their
nominal value).
(Not all countries have company shares with nominal value. It would be a useful exercise for
you to find out if countries which you deal with at work have shares with nominal values.)
Authorised and Issued Capital
The maximum amount of capital (detailed in the Memorandum of Association) that a
company may issue is known as the authorised capital. Do not confuse this with a
company's issued capital.
The issued capital is the nominal value of share capital allotted (also referred to as issued)
to shareholders. The maximum amount of capital that can be issued is an amount equal to
the authorised share capital.
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Types of Share Capital
The rights and voting powers of shares, and the differentials between the different classes of
shares, are listed in the Articles of Association. The issue of different classes of ordinary
(equity) shares is strongly discouraged by the Stock Market and only allowed in exceptional
cases. We will now look at some of the different types of share capital, but unless stated
otherwise we will generally be considering ordinary share capital.
(a) Redeemable Shares
A limited company may, if authorised by its Articles, issue shares which are to be
redeemed at the option of the shareholder, provided it has issued other shares before
the redeemable ones. There are various rules relating to the redemption of
redeemable shares, varying between public and private companies, developed in order
to protect shareholders and the general investing public.
(b) Preference Shares
Unlike ordinary share capital, preference shares are entitled to a fixed percentage
dividend, which is paid before any profits are distributed to ordinary shareholders.
However, like ordinary share dividend it can only be paid if there are sufficient
distributable profits available. However, unpaid dividends on cumulative preference
shares are carried forward and must be paid before any dividends can be paid to
ordinary shareholders.
Preference shareholders may be entitled to receive the nominal value of their shares in
the event of a company winding-up, before any distribution is made to ordinary
shareholders – in which case the rules underlying it will be stated in the company's
Articles of Association.
There are three further types of preference shares.
 Participating preference shares may be entitled to some extra dividend, over
and above their fixed dividend entitlement, but it may only be paid after the
ordinary shareholders have received an agreed amount in dividend.
 Convertible preference shares are preference shares that can be converted
into equity shares. A company may issue them to finance major acquisitions
without increasing the company's gearing or diluting the EPS of the ordinary
shares. The shares potentially offer the investor a reasonable degree of safety
with the chance to make profits as a result of conversion to ordinary shares if the
company prospers.
 Redeemable preference shares may be issued provided the Articles permit the
company to do so. The shares will be redeemable, either at some future date or
within a range of dates, and at that time the shareholder will have his investment
returned to him.
Preference shares constitute a small proportion of companies' finance, especially in
recent times – investors prefer loan stock where the returns and security are greater
and, from the companies' point of view, the dividend on preference shares, unlike
interest on loan stock, is not allowable against corporation tax.
(c) Deferred Shares
These are the last in line for dividends and the proceeds of liquidation. In rare
circumstances, a founder's ordinary share may be authorised and held by the
founders of the company. Where it exists, it will rank behind all other shares for
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(d) Non-voting Shares
A company may issue non-voting shares which still carry the risk of equity shares but
do not allow the shareholder any say in the running of the company – for this reason
they are not very popular except in takeover bids.
Retained Profits
You will recall from your earlier accounting studies that part of shareholder funds is retained
profit. Indeed the major source of new funding for companies in the UK is retained earnings.
Dividend Payable
Dividends are paid on ordinary shares as a percentage return on their nominal value. For
example, the holders of a £1 nominal ordinary share in a company which declares a dividend
of 20% will receive 20p per share regardless of the price paid for the share.
You will recall from an earlier unit that the dividend yield relates the market price of a share
and the dividend received. If the dividend yield falls, then the share becomes less attractive
compared to other investments, demand for it will fall, and supply will increase as investors
wish to sell. Its market price will then reduce until the yield on its new market price is in
equilibrium with returns received elsewhere for similar levels of risk. Although this is a highly
simplified explanation, it does underpin the basic rationale behind the workings of the stock
We shall discuss the level of dividends paid by the company in greater detail later in the
course, but dividends are generally dependent on the results of the company. This benefits
the company, since ordinary shares have a fluctuating service cost which only increases (in
theory at least) during periods in which the company is successful.
Newspaper Information on Shares
Many of the broadsheet papers include a section showing security prices and related
information including: the highest and lowest prices during the year; the closing price the
previous day; the change in price over the previous trading day; dividends net of tax;
dividend cover; gross yield; and the P/E ratio. You should try to "read" such information on a
regular basis and ensure that you understand the information contained in the different
Share Categories
Shares are categorised according to the company type and trading frequency:
(a) Alphas
These are the shares of the most prestigious companies which are generally heavily
traded and dealt in by a large number of market-makers. Prices are posted
immediately on SEAQ.
(b) Betas
These are also large company securities, but they are not as heavily traded as alphas.
They must have at least four market-makers dealing in them and prices quoted on
SEAQ are those at which firm deals can be made.
(c) Gamma
These securities are traded less frequently than betas and the prices quoted for them
are merely indicative.
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(d) Deltas
These are the least traded of all and no prices are actually shown, simply indications of
a dealer's interest.
Penny Shares
Penny shares are shares which have a very low value (often because the company is
experiencing difficulties) with the bid or offer spread of such shares exceeding 10% of their
market value. Investors buy such shares in the hope that the market has undervalued their
prospects and that they will make a substantial profit when the price recovers. In practice,
however, the market is rarely wrong and the price often falls further or the company goes into
liquidation. The low valuation of such shares reflects the high risk attached to them and the
efficiency with which the market operates.
One way in which a firm can expand is to issue additional equity – usually on the main Stock
Exchange or second-tier market, either by a quoted company issuing additional shares or by
an unquoted company obtaining a quotation. An unquoted company may also wish to issue
shares without being floated.
We discuss below various methods of issuing shares. The factors which help to determine
the best approach to adopt are the amount to be raised, the cost of raising it, and the state of
the market and economic conditions generally.
Placing or Selective Marketings
This method is often used for a company wishing to be floated for the first time and to issue a
small issue, or by a quoted company wishing to raise additional finance. It involves
securities' acquisition by a market-maker so that they can be purchased by a small number
of investors.
The method is widespread because it is relatively cheap, with the sponsoring firm
approaching selected institutional investors privately. However, it does limit the number of
shares available for trading on the market.
Offers for Sale
This method is popular with companies being floated for the first time and undertaking a large
issue, e.g. an unquoted company may sell some of its existing shares on the market. An
unquoted company can also issue new shares and market all (new and existing) shares.
The selling of existing shares provides a wider market for finance (and shares) in a company
and allows shareholders a chance to sell their shares. A company will only receive additional
funds if new shares are issued.
An unquoted company applying for quotation has to be sponsored by a Stock Exchange
member firm and an issuing firm. The responsibility of the former is to ensure that the
company fulfils the requirements for listing; the issuing house has to ensure that the issue is
successful both in price set and take up of shares.
In an offer for sale the issue price (which must be advertised a short time in advance) is
usually given as based on a P/E ratio allowing for easy comparison by investors. The price
of shares is generally set at a discount to what could be obtained because of uncertainties
regarding the market, and to prevent an undersubscription (when shares have to be bought
by the underwriters). Whilst the issuing house attempts to set the price so that share prices
rise briskly once trading commences, they should prevent the price being too low and
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causing the company to issue more shares than necessary. A rise in share prices of
approximately 20% is usually aimed for.
Sale by Tender
This method is occasionally used for large first time issues but it is less common than offers
for sale because of uncertainties as to the amount of finance which will be raised and it may
give the impression that the issuing house is unable to set a price for the shares. An issue
by tender has become a more common method of share issue in recent years.
The issuing house (or the company) invites members of the public to subscribe by tender, i.e.
to state at what price they will take the security offered; sometimes there is a minimum price
below which tenders will not be accepted. Applications may be dealt with in a number of
ways and the most common methods are explained in paragraphs (1) to (4) in the following
ABC plc is to make an issue of £2m ordinary shares by tender. The minimum tender price
has been fixed at 50p. Applications were received as shown in the table below:
Tender Price Number of Shares
Applied For
Value of
£ £ £
2.00 100,000 100,000 200,000 200,000
1.75 200,000 300,000 350,000 550,000
1.50 300,000 600,000 450,000 1,000,000
1.25 400,000 1,000,000 500,000 1,500,000
1.00 450,000 1,450,000 450,000 1,950,000
0.75 550,000 2,000,000 412,500 2,362,500
0.50 1,000,000 3,000,000 500,000 2,862,500
Different methods are:
 Applications are accepted in full at the prices tendered, starting with those offering the
highest prices and working downwards until the new issue has been allotted in full.
Therefore in the example above, the full issue is fully subscribed at a price of £0.75,
which yields an overall value of £2,362,500 for the 2m shares. This method is
unsuitable for most public issues as it tends to frighten away the private investor and
the issue is not spread amongst many applications.
 Shares are allotted in full, starting with the applications offering the highest prices and
working downwards until all the issue has been fully allotted. However, here, the price
fixed is that of the lowest tender to be accepted and all applications pay at this price.
In our example, the issue price is the point where the full 2m shares are allotted,
namely at 0.75p. As everyone will pay this price, the issue will raise £0.75 × 2m =
£1,500,000. Whilst the approach is fair for the small shareholder, the issue is not
usually spread amongst many applicants.
 The applications accepted are scaled down so that each applicant only receives a
proportion of the shares for which he asked. The issue price is again the lowest
successfully tendered. In our example and assuming that 2.5m shares are to be
issued, five would be issued for every six applied for by each applicant – the issue
price being 50p. If therefore an investor had requested 600 shares and tendered at £1
per share, he would have sent in a cheque with his application for £600. Under the
rules, he would be allowed 500 shares at 50p per share (£250) and receive a refund of
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£350. This method is the fairest so far for the small investor and generally means that
more applications are successful.
 A further improvement results from a method whereby two prices are fixed.
Applications at prices between them are scaled down. Applications at lower prices are
rejected, and those above the higher price are accepted in full, up to a certain
maximum number, or scaled down slightly.
There are, of course, a number of variations to the above and issuing houses are continually
researching to make improvements. Although small investors tend to avoid tenders as they
have difficulty in deciding on a fair price, recent experiences suggest that the fixing price is
usually not much different from the ensuing market price, reflecting the influence of the
institutional investors.
The two main advantages for the company issuing shares are that:
(a) Paperwork is reduced as the number of applications is reduced.
(b) The fixing price in recent years has usually been higher than would be necessary in an
offer for sale. In an offer for sale, the price is kept low in order to ensure that the offer
is accepted, but in a tender the forces of supply and demand have improved the price.
Rights Issue
The term rights issue is applied to the system of issuing shares to existing shareholders,
usually at a discount from the market price, in order to raise further capital from existing
shareholders. (A discount makes rights issues impractical when current market price is at or
below nominal value.)
When offering shares in a rights issue, the company sends an explanatory letter to each
shareholder detailing the price, accompanied by a provisional allotment letter indicating the
number of shares to which the member is entitled to subscribe, e.g. a rights issue on a 1 to 5
basis at 120p per share means that for every 5 shares a shareholder holds he can purchase
an additional 1 at 120p. The offer must be on a "rights basis" in proportion to the member's
existing holding as a fraction of the holdings of all members eligible to receive the offer.
Forms of acceptance or renunciation accompany the offer, and should a member choose not
to accept he may renounce his "rights" in favour of someone else. In due course, if the
member accepts the offer, or exercises his rights, he will lodge his acceptance and cheque
with the company.
Should the member choose to renounce the offer he can sell the rights to his shares, a sale
being attractive because the price of the shares is below their current market value. The
rights of shareholders to buy the rights are known as pre-emptive rights.
If shareholders do not take up the rights or sell them, the company must, under Stock
Exchange rules, sell them for the shareholders who get the rights value. If small amounts
are involved the benefits can go to the company. In order to maintain his share of control the
shareholder must take up all his rights. The shares may be issued to outsiders or in different
proportions between members. Members may, if permitted under the company's Articles of
Association, be offered the shares which their peer group have rejected.
The key to a successful rights issue is to achieve a balance between the ratio of the
proposed new issue to those already in issue, and the price at which rights may be taken up,
considering that the rights issue will generally be at a discount.
Rights issues offer advantages to both the company and existing shareholders – for the
company there is less administration and no prospectus is required, both factors reducing
costs. The cost of underwriters, if used, will also be lower.
Shareholders obtain shares at a discount or can sell their rights allowing the purchaser a
chance to buy shares at a discount. The share price before dealing in the newly-issued
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shares will be "cum" rights, and thus the shares will trade at a higher price. Shareholder
control can be maintained provided the shareholder exercises his full rights.
Calculation of Issue Price
This is the amount that the company wishes to raise from the issue divided by the number of
new shares. It is important to issue a sufficient number of shares so that the issue price is
below current market price.
Alternatively, if the number of shares as well as the price is to be determined, the factors to
be considered include:
 the ease of issue
 the current market price – too large a discount is to be avoided, and a discount of
approximately 25% is usual; and
 the number of shares currently in issue – too many new shares might dilute the EPS
too much.
Calculation of Price after Issue
(a) Ex-rights price
This is the theoretical price and is essentially a weighted average. If, for example, a
company is making a 1 for 3 rights issue, with each new share costing £2 and the
current market price being £3, then the ex-rights price will be:
Cum rights value of 3 shares (× £3) £9
New share £2
Therefore the theoretical ex-rights price is 11/4 = £2.75.
This could also be shown in terms of total value of the issue divided by the total
number of shares.
(b) Actual Price After Issue
The actual price after issue often differs from the theoretical price, which is due to
differences in expected earnings between the existing and the new shares.
Here the shares can be valued on a P/E basis. Using the figures in (a) above, we will
first consider the situation where the earnings from the new shares are expected to
yield the same return as the existing shares. We will then look at what happens if
expected earnings are relatively higher or lower.
 At current earnings:
Assume a P/E ratio of 10, which means that the earnings are currently 10% of the
market value (i.e. £3/10 = 30p) or if, for example, 3m shares are currently in
issue, £900,000 in total.
If expected earnings from the new shares are at the same level, they will yield
1m × £2 × 10% = £200,000. Total earnings will, therefore, be £1,100,000.
Monetary value of the shares (× P/E of 10) = £11,000,000.
The share value is therefore 11,000,000/4,000,000 or £2.75, i.e. the same as the
theoretical ex-rights price.
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 At lower earnings: if, say, the new shares are expected to yield 5% earnings:
Total earnings will be (£900,000 + (1m × £2 × 5%)) = £1,000,000.
Monetary value of shares = £10,000,000.
Value per share £10,000,000/4,000,000 = £2.50 per share.
 At higher earnings: if, say, the new shares are expected to yield 15% earnings:
Total earnings (£900,000 + (1m × £2 × 15%)) = £1,200,000.
Monetary value of shares = £12,000,000.
Value per share = £12,000,000/4,000,000 = £3.00 per share.
The break-even point (i.e. no dilution of earnings per share) is when the rights price
equals the current capital employed per share, assuming that current trends continue.
The actual impact on shareholder wealth will depend on the earnings generated
compared to the existing earning rates – if lower the market value will fall, if higher it
will rise and so forth.
Empirical evidence has found that the market price of shares tends to fall after a rights
issue due mainly to uncertainty as to the company and its prospects – the level
depends on the company and the rights issue.
Value of Rights
We noted earlier that shareholders can sell their rights. How do we determine what price
they would receive.
The value is the difference between the price of the rights shares and the ex-rights shares.
In the above example, the price of the rights shares was £2; if the value of ex-rights shares
was £2.75, then the value of the rights is £2.75 ÷ £2 or 75p. The new shareholder in effect
pays the ex-rights price purchasing the rights for 75p and the share for £2. The value of
rights attached to each existing share is the value of rights divided by the number of shares
required to issue. In the above example this would be 75p/3 shares or 25p per share.
Shareholders can take up part of their rights and sell the others.
Other Methods
(a) Subscription offers
An offer for subscription is an invitation to the public by, or on the behalf of, an issuer to
subscribe for securities not yet in issue or allotted.
(b) Prospectus issue
If reasonably substantial, the company might make an issue direct to the public with the
absolute minimum of assistance from the outside sources we discussed earlier. It is
rather unusual because of the complexity of the nature of the capital issue.
(c) Stock Exchange introduction
This is the introduction of the shares on the Stock Exchange so that a quotation (i.e. a
price) can be fixed, rather than the issue of shares. An introduction cannot be made
unless sufficient shares are available to establish a market and thus a price, and this
method tends to be restricted to larger firms.
(d) Role of underwriters
As we saw earlier, underwriters agree to purchase any securities not taken up at the
issue price and will charge a fixed fee for their service. Use of underwriters removes
the risk of a share issue being under-subscribed.
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However, the costs of underwriting are high and companies with marketable securities
may choose to use another method known as the bought deal. Here a major
investment bank will buy all the shares in the new issue at a slightly discounted price.
(e) Open offers
This is an offer to existing shareholders to subscribe for securities, whether or not pro
rata to their existing shareholdings. They are not allotted through the use of
renounceable documents.
An open offer is a concessionary method of listing, approval being sought in principle
early on. Once approval has been granted, the sponsor firm has to inform the market
ten business days prior to the "on-register" date. The announcement will state that the
proposals are subject to shareholder approval at general meeting.
(f) Vendor share scheme or placing
Where a vendor prefers cash to shares issued to finance an acquisition by a purchaser,
an issuing house can place the securities with clients for cash.
(g) Exchanges and conversions
This is the process used to replace one security with another, e.g. a vendor
consideration issue or paper issue used in a merger or takeover bid.
(h) Employee share schemes
Such schemes are often used as incentives, e.g. share option schemes which give
certain employees (usually directors) the chance to purchase shares in the company at
a price determined in advance, hopefully, for a financial benefit.
Pricing Shares for a Stock Market Quotation
We have seen that the setting of a price is the job for the sponsor, and we dealt with the
valuation of companies in Study Unit 3. However, factors a firm should take into
consideration include:
 The current and future market conditions and the firm's results.
 P/Es of similar quoted companies.
 Whether the quotation is to be on the main market or the AIM.
 An initial premium on launch, followed by steady growth in the share price is desirable.
 The amount of finance required.
 Future dividends and earnings forecasts (the more shares the more dividends need to
be paid out).
 Underwriting costs or deep discount required to avoid undersubscription of shares.
New issues are generally made when share price and expectations are high – investors are
more likely to buy shares, dilution of the EPS will be limited and the increases in the
dividends required to be paid will occur.
Costs of Share Issues
Share issues (and debenture issues) can be expensive and depend on the method used.
Costs involved in share issues include:
 The Stock Exchange listing fee for the new securities.
 Fees of advisors, including those of the issuing house.
 Underwriting costs.
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 The compulsory advertising in national newspapers.
 Printing and distribution costs of details and prospectus.
Whilst some costs are variable, such as the commission payable to issuing houses, most are
fixed and thus it is more economical to issue large amounts of shares, which discourages
small firms.
Compliance with Stock Exchange rules (which vary according to the size of the issue) is also
a cost to be borne by the company (the rules include the number of market-makers to use
and how to issue the shares).
Issuing New Shares Without Raising Capital
There are also three methods by which new shares may be issued without bringing
additional funds into the company.
(a) Scrip issues
A scrip issue, also referred to as a capitalisation, or a bonus issue, involves the
conversion of reserves into capital, causing a fall in the reserves. Shareholders receive
additional shares in proportion to their holding. Unlike a rights issue no additional
funds are brought into the company – the shareholders do not "pay" for the shares.
This results in more equity in circulation with the result that the market value will
generally fall in the short term, thus making it more attractive to potential investors.
The reserves used are either from a credit balance in the profit and loss account or
from reserves specifically marked for the payment of shares, and requires authority
from the Articles of Association and the AGM.
(b) Scrip dividends
Scrip dividends are a conversion of profit reserves into issued share capital offered to
shareholders in lieu of a cash dividend. Enhanced scrip dividends are those where
the value of shares is greater than the cash dividend offered as an alternative. Such
dividends are of benefit to the company as they maintain cash within the business and
are not liable to advance corporation tax. There may, however, be tax complications
arising for individual investors.
(c) Stock split
A stock split is the splitting of existing shares into smaller shares, e.g. each ordinary
share of 50p is split into two of 25p, in order to improve the marketability of the
company's shares. It can also be used to send signals that the company is expecting
significant growth in EPS and dividends per share, and for this reason the resulting
market price of the split shares is higher than the simple split price would be. For
example, if a share with a market value of £10 was split into two shares their price
would be higher than £5. Reserves are not affected.
Repurchases, or buy-ins, of shares may be made by companies out of their "distributable
profits", or out of the proceeds of a new issue of shares made especially for the purpose,
provided they are authorised to do so in the company's Articles of Association.
A company may not, however, purchase its own shares:
 Where, as a result of the transaction, there would no longer be any member of the
company holding other than redeemable shares.
 Unless they are fully paid up, and the terms of the purchase provide for payment on
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Purchases may be in the market or off-market. An off-market purchase is said to occur
when the shares are purchased not subject to the marketing arrangements of the Stock
Exchange, or other than on a recognised stock exchange. A buy-in of shares by a public
company will be subject to the rules of the Stock Exchange and to the provisions of company
The change in the capital base will cause management to rethink its investment decisions,
gearing, interest cover, earnings, etc. This is particularly important as the financial
institutions focus their attention more towards income and gearing as an indicator of financial
It is important to be aware of the various advantages and disadvantages of share
repurchases. The advantages of share repurchases include the following:
 It may allow a company to prevent a takeover bid. The control by the existing
shareholder group will be increased.
 A quoted company may purchase its shares in order to withdraw from the Stock Market
(see below).
 It can be a useful way of using surplus cash.
 Repurchasing shares will reduce the number in circulation which should allow an
increase in earnings and dividends per share, and should lead to a higher share price.
It will increase future EPS as future profits will be earned by fewer shares.
 Reducing the level of equity will increase the gearing level for a company with debt
which may be considered beneficial by the company.
 If the business is in decline a share repurchase may give the firm's equity a more
appropriate level.
The disadvantages of share repurchases are that:
 Repurchasing of shares may be viewed as a failure by the company to manage the
funds profitably for shareholders.
 The company requires cash for the repurchase.
 It may be difficult to fix a price which is beneficial to all involved.
 It requires existing shareholder approval.
 Capital gains tax may be payable by those shareholders from whom the shares are
 It increases gearing.
We mentioned above that a firm may decide to go private, which happens when a small
group purchases all a company's shares and the company is no longer quoted on the Stock
Exchange – a well-known example was the repurchase of shares in Virgin by Richard
The reasons for such a move may be to prevent takeover bids, reduce the costs of meeting
listing requirements and to limit the agency problem. In addition, because the firm is not
subject to volatility in share prices it can concentrate less on the short-term demands of the
Stock Market and more on its own medium- and long-term requirements. Another key reason
for a company wanting to buy its own shares stems from the desire of management to
improve earnings per share, a financial ratio in which investors are becoming increasingly
interested. Such opportunities will be considered against financial performance, share price
and capital structure.
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Practice Question 1
TT is a public limited company with a paid up share capital of 1.2m £1 shares and no long-
term debt. The dividend has been paid at a rate of 45 pence per share in each of the last two
years and the market price per share has not varied significantly from its current market price
of £3.60.
The company now wishes to finance the expansion of its existing premises and the board
has announced a rights issue of 1 new ordinary share at a price of £3.00 for every 4 shares
currently held. The company forecasts that future dividends will be at a rate of 43.5 pence
per share on the enlarged share capital and that its existing ratio of dividend cover can be
You are required to comment on the theoretical and the practical validity of the following
three reactions to the announcement from various shareholders.
(a) I hold 5% of the equity. Whether I take up or surrender my rights, I should be getting a
bargain at the offer price of £3.00.
(b) As I understand the position, I should not have been out of pocket in the long run if the
company had priced the rights issue at £5.00 instead of £3.00. I think they should have
done that to raise a bit more money.
(c) The company could have fixed a lower price for the issue if the underwriters hadn't
been looking for a high amount of commission, 1¼% being the amount charged.
Now check your answer with the one given at the end of the unit.
Debt Capital
At many different stages of their development (including at the business start up stage)
companies will need to borrow funds to expand and grow. These borrowed funds (from
whatever source) will need to be paid back and the cost of debt is simply the amount that has
to be paid back (to the lender) for those funds that have been borrowed. This cost would
typically include interest and capital repayments at a rate determined by the particular
contract concerned, although in some cases there may be other elements involved in the re-
payment – for example, shares in the company. Interest payments and capital repayments
will be spread over an agreed timescale until the debt has been repaid or be liable at the end
of an agreed period.
The cost of debt is generally cheaper than the cost of equity (ordinary shares). This is largely
because there are high costs associated with raising equity finance, such as:
 Arrangement fees
 Bank, accountants' and solicitors' fees
 Issuing house fees
 Advertising and marketing fees
 Stock Exchange fees
 Underwriting fees.
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It is also highly likely that the returns that investors will require from their equity investment
will exceed that required by the suppliers of debt capital. This is because there is less of a
risk involved for the suppliers of debt capital than there is for the suppliers of equity capital.
Further, in the event of a shortage of profits or the business going into liquidation, then the
debt capital would be paid before the remainder of profit (if there was any) would be paid as
dividends to shareholders.
Another major advantage to the business is that debt interest can be used to reduce taxable
profits (and hence tax liabilities) whereas dividends paid to shareholders cannot be used to
reduce a tax burden.
Legal implications
Whenever a business secures a loan there is usually a legal agreement between the lender
and the borrower that deals with the non-repayment by the borrower to the lender. Often the
debts and loans granted to a business will be secured loans – i.e. secured on named assets
of the company that stand to be lost if the business fails to repay the agreed debt to the
agreed schedule. In the event of a problem, most companies and lenders will do their best to
arrange a different repayment schedule that will meet the requirements of both parties – after
all, it is not in the interests of either party to be paying expensive legal fees to recover debts.
The important thing to bear in mind is that, with any debt, there will inevitably be a legal
obligation on both parties to keep to the agreed terms of the particular debt involved.
Debentures and Loan Stocks
Companies often raise long-term interest-paying debt, which is known as loan stock, and its
holders are long-term creditors of the company. Debt capital is attractive to companies
because the interest charges on it are allowable against corporation tax, and the status quo
of shareholder control is also maintained. In addition, we will see later in the course that an
increase in the gearing ratio may be beneficial to shareholders by improving their EPS.
There are, however, limits to the amount a firm will borrow, including restrictions in the
Articles of Association, debenture trust deeds (see below) and market attitudes. In addition,
high interest rates may make high levels of borrowing impractical and there may be
insufficient security to cover new loans. We shall discuss the optimal amount of gearing a
company should have in detail in a later study unit.
Loan stock is often issued at its nominal value or face value (i.e. at par). The nominal value
represents the amount the company owes and the "coupon" (or interest rate) is based on the
nominal value. The coupon rate set depends upon the company, its credit rating and the
market conditions when the debt is issued. The market value of the stock will, however,
fluctuate with changes in interest rates and in the company's results and prospects.
(a) Features of debentures
A debenture is a multiple loan to the company in the sense that it is contributed by
several people as opposed to just one individual. Debentures attract a fixed rate of
interest, and debenture-holders are creditors, not members, of the company. Therefore
their interest ranks for payment prior to shareholders' dividends, and must be paid even
if the company has made a loss.
Debentures may be either redeemable or permanent; a holder of permanent
debentures can obtain a return of his original investment by disposing of his holding to
a third party, and companies may repurchase permanent debt.
Most debentures are redeemable. Typical issue periods are from 10 to 30 years, often
with two redemption dates – for example, 2008 or 2009 – with the choice of redemption
date being the company's. This choice will depend on:
 Whether the company has sufficient liquid funds to redeem the debentures, and
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 The current levels of interest rates compared to the rate being paid on the
Companies frequently find that interest rates are higher as the redemption date
approaches and will delay their redemption to the later date.
Debentures tend to be issued in times of low inflation and low interest rates. The
redemption will be financed either by cash reserves or by the raising of fresh debt or
equity capital. A company, and potential investors, will compare the finance a company
has available with the planned repayment of its debt shown by the repayment dates of
its loan stock and debentures.
Debentures may be issued at par, at a premium or at a discount. Debentures issued
at large discounts and redeemable at par or above are known as deep discount
bonds. They are generally issued at low rates of interest which can be attractive to
companies with cash flow problems. However, there is a high cost of redemption. The
investor may be attracted by the capital gain at maturity, but you should note that it is
taxed as income (less notional interest not paid).
(b) Security and debentures
Debentures are generally secured by a trust deed setting out the terms of the contract
between the company and the debenture-holders. The deed may include security
given in the form of:
(i) A specific or fixed charge over particular asset(s) in the form of a mortgage
debenture, restricting the alteration and disposal of the asset by the company.
(ii) A general or floating charge on assets, giving a general lien to the debenture-
holders, but not restricting the company in its utilisation of assets.
The trust deed may also contain provisions for a trustee (e.g. a bank) acting on the
behalf of debenture-holders to intercede if the terms of the trust deed or Articles of
Association in relation to the debentures were breached, e.g. failing to pay the correct
amount of interest, or exceeding prearranged borrowing limits. A receiver may be
appointed if the company is unable to honour its debts. However, as we saw in Study
Unit 5 a reconstruction scheme may be used to avert liquidation.
A well-established company may occasionally issue an unsecured or naked
debenture. Naked debentures generally have interest rates at least 1% higher than
secured debt in order to compensate investors for the additional risk they are bearing.
(c) Registration
Mortgages and debentures must be registered in the company's own register of
charges and with the Registrar of Companies to record their existence.
(d) Issue price and conditions for purchase
Debentures can be issued at a discount and a company may also enter the market and
buy up its own debentures without formality.
(e) Types of interest
The great majority of debentures are issued at fixed rates of interest. There are two
possible variations and these are:
(i) Floating rates
The issuer will be able to vary the interest paid. For the issuing company, floating
rates afford protection in periods of volatile interest rates since it will benefit when
rates fall. Investors benefit, since they should obtain a fair return whatever
happens to interest rates generally.
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The market value of the debentures depends on the coupon rate of interest
compared to general market rates. The value should remain stable since the
interest payable on the debentures will follow that of the market.
(ii) Zero coupon
These are debentures which are issued with no rate of interest attached.
Instead, they are issued at a discount. Thus there is an implied rate of interest in
the level of the discount. The advantage to the borrower is that there is no cash
outlay until redemption. For the lender, there may be tax advantages in not
receiving income in the short term.
(f) Return for investors
To determine whether a potential investor will receive a certain rate of return by
investing in a particular debenture, we need to calculate the NPV (net present value) of
all the cash flows involved. Whilst we will cover this topic in more depth later in your
course, it is worth spending a few minutes considering an example.
An investor requires a return of 15% on his investments and is considering investing
£200 in 12% debentures redeemable in exactly three years' time. Their current price is
First calculate the amount of stock he can purchase:
£(200 × 100/80) = £250.
The yield will be (£250 × 12%) = £30 per year.
The calculate the return (assume interest is paid at the end of the year and personal
taxation is ignored).
Year Cash Flow Discount Factor 15% Present Value
0 Purchase 200 1.00 (200.00)
1 Interest 30 0.87 26.10
2 Interest 30 0.76 22.80
3 Interest 30 0.66 19.80
3 Redemption 250 0.66 165.00
NPV +33.70
As the NPV is positive, the investor will achieve more than his required return of 15%.
To find the market price given the cash flows and the anticipated market rates of
interest is simply a matter of excluding the purchase price from the calculation. In other
words, the NPV would be 233.70. This is, of course, the value of £250 worth of stock.
For £100 worth of stock, the calculation is: 233.70/2.50 = £93.48.
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If market interest rates were 20%, the value would be as follows:
Year Cash Flow Discount Factor 15% Present Value
1 30 0.83 24.90
2 30 0.69 20.70
3 Capital & interest 280 0.58 162.40
NPV 208.00
£100 worth of stock would be valued at 208/2.50 = £83.20
Because market rates have increased, the price of debt capital has fallen, so there will
be a greater capital gain on redemption to make up for the interest shortfall when
compared with what is available in the market.
(g) Reverse yield gap
Generally, the investor will expect to be compensated for increased risk of loss by an
enhanced return and vice versa. Consequently, ordinary shareholders expect a higher
return than debenture-holders.
However, in times of inflation this may be an oversimplification. Investors may be
prepared to bear the risk and, at the same time, accept modest returns in the
anticipation of future capital growth which will maintain the value of their investment in
monetary terms.
When the return from equities exceeds that available from fixed interest stocks, there is
said to be a yield gap. When fixed interest returns are higher than those from equities,
there is said to be a reverse yield gap.
A mortgage is a form of secured loan placing the title deeds of freehold or long leasehold
property with a lender as security for a cash loan, usually up to two-thirds the value of the
property. The cash is generally repayable over a prearranged period, and interest (at either a
fixed or floating rate) is payable on the amount borrowed.
Convertible Loan Stock
Convertible loan stocks have proved to be a particularly attractive form of capital instrument
during recent years. Usually this class of stock is sold as fixed interest loan stock initially, but
there will be an option to convert the loan into equity shares at a given price and during a
specified period. The terms of conversion often increase over time with increased
expectations as to the share price and returns from the shares. The conversion value (the
current market value of a unit of stock converted into shares) will be below the loan stock
value on issue but is expected to rise as conversion approaches.
From the investor's point of view, he will stand to gain a stake in the company, whilst
maintaining the status of a creditor and the security of fixed interest during the potentially
risky period when his funds are being used. At a later date and without extra outlay, he may
expect the right to equity by which time it will be his hope that his money will have begun
successfully to contribute to the company's profits.
The company benefits by securing funds at fixed interest rates, supplemented by tax relief on
its interest payments, at a time when it may not be able to support the burden of dividend
payments. As the intention is to convert into equities funds do not have to be repaid, and
there should be a realistic chance that the future increased dividend payments can be met
from profits generated by successful utilisation of the invested moneys.
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There is no specific requirement for loans to be converted into shares on every occasion.
There may even be an option not to convert but simply to redeem the original investment.
You should understand and be able to calculate the following:
(a) Conversion Ratio
This is the number of ordinary shares that will be obtained from each unit of loan stock.
For example, if a company has 8% convertible loan stock standing at par and £10 of
loan stock can be converted into three £1 ordinary shares, then the conversion ratio is:
£10 3 ÷
= 0.30
0.3 shares will be obtained for every £1 of loan stock converted.
(b) Conversion Price
This is the amount of stock necessary to obtain each ordinary share. In the example
above this would be:
= £3.33
£3.33 of stock is required for each share.
(c) Conversion Premium
This is the difference between the value of the stock and the conversion value of that
stock on the date of issue. Therefore, again using the figures above, £100 of stock
was worth £120 on issue and we know that £100 of stock can be converted into 30
shares. (We ascertained 0.30 shares can be obtained for every £1 of loan stock in (a)
above.) Supposing that on the day of issue, the market value of each share was £3,
then the conversion premium would be:
3) (30
3) (30 120
× ÷
× 100 = 33.33%
The premium per share is calculated as:

date conversion at shares of No.
stock loan e convertibl of value Market
÷ Current price
In our example we have:
(120 ÷ 30) ÷ 3 = 4 ÷ 3 = £1 per share.
Looking at it another way, 30 shares, currently worth £90 (£3 per share) will be worth
£120 on their conversion (i.e. £4 per share).
From the point of view of the issuing company, the greater the amount of conversion
premium the better, because they will have to issue fewer shares for the amount of
original loan stock. For the investor, the level of conversion premium which is
acceptable will be weighed up against expectations for the company. If the investor
considers the premium reasonable, he will invest.
He may, for instance, expect that the value of each share will rise between the date of
purchase and the date of conversion. In our example, if the price has risen to £5, the
value of the conversion will then be (30 × £5) = £150 for an original investment of £120.
The conversion premium is often stated as a percentage of the conversion value.
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The attractiveness of convertible loan stock will depend on a combination of factors such
 The cost of the stock at the time of purchase.
 The period of time to conversion.
 Stockholders' future expectations for the company.
As a rule of thumb, convertible loan stock issued at par has a lower coupon rate than normal
stock, the lower returns effectively being the price the investor is prepared to pay for his
conversion rights.
The market value of the convertible stock cannot go lower than the market value of normal
stock of the same coupon rate. Should this occur, it will signify that the market does not
attach any value to the conversion rights.
The advantages of convertible loan stock to the respective parties are set out in Table 5.2.
Table 5.2: Advantages of convertible loan stock
The Issuing Company The Investor
Stock can be issued at a lower
coupon rate – useful in times of high
interest rates.
Interest on loan stock should be tax-
deductible unlike dividends on equity.
As it is a form of deferred equity,
there will be no cash outlay on
Convertible loan stock may be
counted as equity for gearing
calculations, unlike ordinary loan
If share prices are depressed, it may
be easier to issue loan stock instead
of equity.
The market value of the stock cannot
fall below that for similar ordinary
stock of the same coupon rate.
Increases in share prices will cause
the value of the conversion to rise
because this is the amount the
investor will eventually receive.
Stockholders will be paid before
shareholders in the event of a
Warrants are rights given to investors allowing them to buy new shares in a company at a
future date at a fixed, given price. This price is known as the exercise price, and the time at
which they can be used to obtain shares in is known as the exercise period.
Whilst warrants are generally issued alongside unsecured debt as a "bribe" to potential
investors, they are detachable from the debt and can be traded in any time up to the end of
the exercise period.
The value of the warrant is dependent on the market's view of the likely price of the shares it
can be traded for in the future. Its "theoretical value" is the difference between the current
share price of the company and the exercise price multiplied by the number of shares which
each warrant can be used to obtain. During the exercise period the value of the warrant will
not fall below this price; if this theoretical price is zero, then the value of the warrant will also
be zero (the holder would be better not exercising his rights and obtaining £0, than obtaining
something worth less than he paid for it).
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The price of warrants and their attached premiums depend on the length of time until the end
of the exercise period, the exercise price, the current share price and the future prospects of
the company.
Generally, if the company has good prospects then the warrants will be quoted at the warrant
conversion premium which is calculated by comparing the cost of purchasing a share using
the warrant, and the current share price. The premium will reduce the closer it is to the
exercise price because if there was a premium during the exercise period then it would be
cheaper to purchase the shares directly rather than via a warrant.
Ella plc issued 50p warrants which entitle the holder to purchase one share at £1.75 at a
specified time in the future. If the current share price of Ella is £1.50 calculate the conversion
The conversion premium is:
Cost of the warrant 0.50
Exercise price 1.75
Current share price 1.50
Premium 0.75
The premium would be quoted as a percentage of the current share price – in Ella plc's case
There are several advantages to investors of purchasing warrants. Initially they have to
spend a smaller amount than if they were purchasing shares and, because of this lower
outlay, the potential loss is much less (the value of the warrant compared to the value of the
share). Conversely, because the initial outlay is less than for shares any increase in the
share price (and thus in the warrant's price) will result in a greater percentage increase in the
wealth of the warrant-holder than of the shareholder. For example, a 25p increase in the
value of Ella plc's shares (see above) would give shareholders an increase in their wealth of
25/150 or 16.67%, but warrant-holders would have an increase in wealth of 25/50 or 50%, –
this is known as the gearing effect of warrants. A final advantage for taxpayers is that
profits from warrants are classed as capital gains rather than income.
Companies often issue warrants to make debt issues more attractive, and even sometimes to
make them viable. In addition, they may be able to offer a lower rate of interest on the debt if
warrants are attached to the issue. Warrants are a potential future source of equity, which do
not require dividends immediately or cause a dilution of earnings per share or current
shareholder control.
Leasing is a common method of financing the use of an asset – commonly equipment such
as office equipment and cars.
A leasing agreement is between two parties – a lessor and a lessee. A financier (the
lessor), generally finance house subsidiaries of banks, purchases the asset and provides it
for use by the company (the lessee). The lessor is considered to be the legal owner and can
claim capital allowances for the asset. The lessee makes payments to the lessor for the use
of the asset.
There are two forms of leases – finance leases and operating leases. In addition, you
need to be aware of the use of sale and leaseback methods.
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(a) Finance leases
Finance leases are leases in which the lessor (the owner) will expect to recoup the
whole (or most) of his cost of performing the contract during the initial period of rental,
referred to as the basic lease period (or primary term). At the end of the period the
asset is generally either leased for a further period for a peppercorn rent, sold by the
lessor, or sold by the lessee for the lessor for a large amount of the proceeds. The
servicing and maintenance of the asset is the lessee's responsibility. Finance leases
are reported on the face of the balance sheet.
(b) Operating leases
Operating leases are leases other than finance leases, and do not have to be reported
on the face of the balance sheet. Common examples of operating leases include
short-term rental contracts for office equipment, and contract hire agreements for the
provision of vehicles. Operating leases do not cover the economic life of the asset, and
at the end of one contract the equipment is leased to someone else. This is especially
useful for the lessee in the case of high-technology products which are quickly
obsolete, the risk being borne by the lessor. The servicing and maintenance of the
asset is the lessor's responsibility.
As operating leases are not reported as balance sheet items, they will not be included
in gearing calculations. However, liability for payment of future rentals under the terms
of contract will be reported as a note to the accounts, and will thus be considered when
the company's accounts are analysed, e.g. by potential lenders.
Leases are popular with lessors, lessees and the suppliers of equipment. The latter
like them because they are paid fully for the asset at the start of the contract. Lessors
are able to make profits from leasing equipment, and obtain capital allowances on the
purchase. A lessee may find this option cheaper and easier than taking a bank loan
out to purchase the asset. A lessee may also have insufficient cash to purchase the
asset outright.
(c) Sale and leaseback
A financing arrangement, whereby a company will sell its building to an investment
company or other specialist in the field. The purchasing company (lessor) takes an
interest in the freehold land on which the property stands, and the selling company
becomes the lessee who then rents the building which it previously owned, generally
for a minimum of 50 years. The rent is reviewed every few years.
The lessor will wish to obtain a good investment which could be rented to another
company if for some reason the original lessee no longer wishes, or is unable, to rent
the property. Thus they would prefer the building to be in good repair, non-specialised
and in an area which is, or is likely to be experiencing, rises in commercial property
The main advantage from this method of financing is that the company can raise more
money than would be the case if the property was used as security for a mortgage.
The main disadvantage is that fewer assets remain to support future borrowing, and
the effect of the removal of a significant asset from the balance sheet may cause an
adverse reaction by financial commentators and the market in general.
Other disadvantages are that the company loses the flexibility to move and sell the
property, the real cost can often be very high especially if rents are increasing rapidly,
and the company loses future capital gains on the property.
Although this method is complex, you do not a detailed working knowledge – merely be
aware of it as a financing arrangement, whereby the company is able to obtain
additional capital without recourse to further borrowing.
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Hire Purchase
Hire purchase is in many respects a hybrid between lending and renting. The facility may be
simply defined as "hiring with the option to purchase". The HP payments consist partly of
capital and partly of interest payments. On payment of the final instalment ownership of the
asset passes to the customer. By concession the Inland Revenue will generally permit the
customer to claim and retain capital allowances provided that the option to purchase fee is
less than the market value at the end of the contract term.
The common procedure is for the finance house to buy the good from the supplier who
delivers it to the customer. The finance house and the customer set up a hire-purchase
agreement, which includes the payment of an initial deposit by the customer, the size of
which depends upon the finance company's policy and the credit worthiness of the customer.
The advantage for the customer is that the interest part of the payments are allowable
against tax, and capital allowances can be claimed on the asset.
Licensing and Franchising
These allow for the acquisition of a product, service or business concept of another
organisation, without the purchase of the other entity as a whole. Examples of the former are
most forms of computer software, where the user pays a licensing fee for the right to use the
software, and examples of the latter are McDonalds and Kentucky Fried Chicken. Generally
for a franchise an initial payment is required by the provider, and royalties will be due on
subsequent sales, in return for marketing the provider's goods and services in an exclusive
territory. It is usual for the franchisee to have to acquire all goods and consumables from the
franchisor under the terms of the agreement.
A bond is a loan to a company, government or a local authority. Generally, interest is paid to
the lender and the full amount of the loan is repaid at the end of the term, which is usually for
ten years or less. There are many other names for this type of investment – for example:
 loan stock
 fixed interest
 debt securities
 gilts (loans to the government), and
 corporate bonds (loans to companies).
The main benefit of these investments is that the investor normally gets a regular stable
income. They are not generally designed to provide capital growth.
Bonds have a nominal value. This is the sum that will be returned to investors when the
bond matures at the end of its term. Most bonds have a nominal value of £100. However,
because bonds are traded on the bond market, the price paid for a bond may be more or less
than £100. There are several reasons why the price might vary from the nominal value,
 If a bond is issued with a fixed interest rate of, say, 8% and general interest rates then
fall well below 8%, then 8% will look like a good yield and the market price of the bond
will tend to rise – perhaps from £100 to £110 or £120.
 The reverse is also true – if interest rates rise, the fixed rate of a particular bond might
become less attractive and its price could fall below its nominal value.
 Ratings agencies might take the view that a particular company's bond no longer
qualifies for a high rating – perhaps because the company is not doing as well as it was
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when the bond was issued. If this happens, then the market price of the bond might
fall. On the other hand, the company's rating may be improved leading to a price rise.
 The inflation rate might start to creep up and the interest rate on some bonds might
start to look less attractive compared with other investments.
Bonds are generally less risky than having a share in a company. One of the main risks is
that the company to which the money has been lent can no longer afford to pay the interest
due or may be unable to pay the money back at the end of the term (for example, if it is
It is generally considered that these risks do not apply to gilts – a government is always
expected to pay in full, although there have been instances of certain countries being unable
to repay. Bonds issued by governments will usually pay a lower rate of interest as a result of
the perception that they are less risky.
Companies have different credit ratings and a company with a high credit rating is regarded
as a safer bet than a company with a lower credit rating. Thus, companies with a lower credit
rating will have to offer a higher rate of interest on their bonds than companies with the top
credit rating, simply to attract investors and to compensate for the higher risk.
Buying and selling
Bonds can be bought and sold in the market (like shares) and their price can vary from day
to day. A rise or fall in the market price of a bond does not affect what the investor would get
back if the bond is held until it matures. He/she will only get back the nominal value of the
bond, in addition, of course, to any coupon payment to which the owner is entitled during
ownership of the bond, irrespective of what was paid for it. If the holder paid less than the
nominal value then he/she will have made a capital gain when the bond matures; and a
capital loss if more was paid than the nominal value.
Bonds may be bought directly through a stockbroking firm, which incurs charges similar to
buying shares. Alternatively, bonds may be bought through a pooled investment.
Syndicated Loans
It is quite often the case that, where a business requires a very large loan, one single bank is
not willing to lend the whole amount – particularly if this is seen as exposing the bank to an
unacceptable level of risk with one client and one loan. In such cases, in order to spread the
risk involved, a number a banks may each contribute a proportion of the loan to the borrower,
with the bank that orginiates the loan being the lead manager and the one that is responsible
for the overall management of the syndicate and the loan. The managing bank will often
underwrite much of the loan whilst inviting other banks to underwrite the rest, so
guaranteeing to provide the funds if other banks do not participate.
Such syndicated loans generally offer lower returns than bonds, but on the grounds that they
are usually paid out (in the event of liquidation problems) before bond holders, then they are
less of a risk to the lender.
Mezzanine Finance
Mezzanine finance is a form of hybrid finance that offers a high return with a high risk. It is
somewhere between normal debt finance and normal equity finance and, because of its low
priority, it attracts a reasonably high rate of interest payment.
Mezzanine finance is often used in the funding of a management buyout (MBO) and is often
used when the limits of bank borrowing has been reached and the busines cannot or is not
willing to issue any more equity capital. It is a form of finance that allows the business to
move beyond what would normally be considered as a safe level of debt to equity ratio.
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Medium Term Notes (MTNs)
A medium term note is a promise to pay a certain amount on a named date. It is unsecured
debt and the maturity period can be anywhere from nine months to twenty years. Medium
term notes are sold on the financial markets usually as part of a series under an MTN
programme. The interest rates can be either fixed, floating or zero rate.
Project Finance
Sometimes it is preferable to finance a major project through a stand alone investment with
its own source of funding. In a typical project-financed venture, a finance deal would be
created by a buiness that provides some equity capital for a separate legal identity to be
formed to build and operate the project – for example, the building of the Channel Tunnel or
a major sporting stadium (such as for the Olympics).
The amounts involved in this form of finance are usually large and complex in nature. It
usually takes the form of a loan provided through bonds or bank loans directly to the
separate entity, with the finance being secured through the assets of the particular project
rather than the parent company's assets.
For major new ventures, project finance offers a number of advantages, including:
 Off balance sheet financing which is not recorded as debt in the parent company
 Where the project involves another country in which there might be a greater level of
political risk, this method of finance provides more "arms length" control
 There is a transfer of risk to a separate legal identity
 Management involved in the project may well be given an equity stake in the new
venture, which can provide incentives to the relevant management team to ensure that
the project succeeds.
The company will not always wish to raise long-term finance. In recent years, the capital
markets have recognised this need in the growing company, and there has been an
increased concentration on the short- or medium-term floating rate sector.
This is the practice whereby instead of lending money to customers, banks raise finance for
them by arranging and selling to customers their securities (e.g. commercial paper) often
allowing lower interest rates. Similarly companies can invest short-term securities in
commercial paper for better rates.
Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs)
A major development in capital provision is the arrival of the Note Issuance Facilities (NIFs)
and Revolving Underwriting Facilities (RUFs). They are examples of Multiple Option
Facilities (MOFs) which are arranged by a company's bank, and involve a package of
medium-term back-up facilities provided by a group of banks. The banks will underwrite the
facility to ensure that the borrower obtains the required funds, usually over a period of three
to ten years. The bank will also arrange a panel of banks tendering loans in a variety of
forms and currencies to the company, and a panel to provide "standby" loans. The firm can
then, at competitive interest rates, have a series of short-term loans and in effect obtain
medium-term financing, or have standby loans for use as and when required.
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Commercial Paper (CP)
The company will usually be afforded a number of other mechanisms so that it can raise
short-term funds, not just from underwriting banks. One example is where the company
issues six month dollar notes in the European Commercial Paper Market (ECP). Other
examples of commercial paper include ECP in other currencies and SCP (Sterling
Commercial Paper). These short-term securities issued in bearer form are a written promise
to pay (promissory note), within a fixed period of less than one year, the amount on the note.
The rate of interest is the difference between its face price and the issue price which is at a
Medium-term notes (MTNs) are similar to commercial paper but have a stated rate of interest
and are issued for between one and five years. The use of CPs and MTNs is limited in that a
minimum size of company and issue restricts it to large companies, multinationals and
certain public sector bodies, and they are driven by the demand of investors (investor-
driven). However, where they can be used they are very flexible, allowing the company to
schedule borrowing to match its requirements and make the best use of interest rate
fluctuations. The company does not have to be finely rated.
The company may also be able to call for advances of a multi-currency nature, perhaps in
dollars or sterling.
Syndicated Credits
This is a facility whereby a borrower can borrow money when necessary up to the limit of the
facility – thus the company only has to borrow as and when required. The interest rates are
high compared to those offered elsewhere and are generally used by highly-geared
companies (who may find it difficult to find other sources of finance), and government-related
bodies (e.g. Eurotunnel). Another common use is in takeover bids. Syndicated credits are
most common in the US and are generally denominated in US dollars.
Bank lending to companies is predominantly short term, although it is also now a valuable
source of medium term finance.
(a) Bank loans
This is straightforward lending by a bank to a business whereby a fixed amount is lent
– for example, £40,000 – for a fixed period of time, say for four years. The bank will
charge interest on this, and the interest plus part of the capital (the amount borrowed)
will have to be paid back each month. As with all forms of loan, the bank will only lend
if the business is credit worthy, and it may require security. If security is required, this
means the loan is secured against an asset of the borrower – forexample, an asset of
the business or, in the case of a sole trader, the borrower's house. If the loan is not
repaid, then the bank can take possession of the asset and sell the asset to get its
money back!
Loans are normally made for capital investment, so they are unlikely to be used to
solve short-term cash flow problems. However, if a loan is obtained, then this frees up
other capital held by the business which can then be used for other purposes.
The interest rate for small companies on medium-term loans may either be at a fixed
rate or at a margin above the bank's base rate. For larger companies, the interest rate
on medium-term loans may again be fixed for up to five years, but is usually at a
margin above the London Inter-Bank Offered Rate (LIBOR) adjusted every three, six,
nine or twelve months in line with LIBOR movements (the size of the margin being
determined by risk and the credit standing of the company).
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Not all term loans are drawn, in cash, at the commencement of the loan. Typically,
where a loan is to fund a longer term project such as a construction undertaking, it
would be common to draw the cash at different stages of the project. This has the
advantage for the borrower of not committing large sums of money against an asset
that has not yet been created.
The administrative procedures and the paperwork involved with term loans are often far
more than with a simple overdraft particularly as the lender (the bank) is entering into a
much longer agreement timescale. Typically, the bank will require a set of obligations
to be met by the borrower such as information flows to the bank and required levels of
gearing and liquidity ratios, and failure to deliver on these conditions would give the
bank the right, if needed, to terminate the contract.
(b) Overdrafts
These are, effectively, also a form of loan from a bank. A business becomes overdrawn
when it withdraws more money out of its account than there is in it and this leaves a
negative balance on the account. This is often a cheap way of borrowing money as
once an overdraft has been agreed with the bank the business can use as much as it
needs at any time, up to the agreed overdraft limit. However, the bank will of course
charge interest (on a daily basis) on the amount overdrawn, and will only allow an
overdraft if they believe the business is credit worthy – i.e. is very likely to pay the
money back. Interest rates on overdrafts are usually higher than with other forms of
finance, but it is a very flexible method of finance, particularly when a company has to
provide for seasonal variations in cash flow which will require facilities for short periods
of time only.
There is no penalty for repayment of an overdraft, unlike (usually) the early repayment
of a medium-term loan. The bank, though, can demand the repayment of an overdraft
at any time, and many businesses have been forced to cease trading because of the
withdrawal of overdraft facilities by their bank.
Even so, overdrafts are often the ideal solution for short term borrowing and are
extensively used to overcome short term cash flow problems, such as for funding
purchase of raw materials whilst waiting payment on goods produced. Many
businesses have a rolling (on going) overdraft agreement with their bank.
The advantages of an overdraft facility with the bank are that:
 It provides flexibility – the borrower can't predict with any significant accuracy
what funds will be needed in the short term and the overdraft facility allows the
business to borrow up to stipulated limits an amount without unnecessary added
paperwork and bureaucracy.
 It is a relatively cheap form of finance. The usual procedure from the lender
would be to add between two and five percentage points above the bank base
rate (or LIBOR). There may also be an arrangement fee in addition to the
overdraft rate (typically one or two percentage points).
 Because interest is charged on the daily balance, a large cash surplus one day
can be used to reduce overdraft charges on further days.
The major drawback of an overdraft (as stated above) is that the bank can withdraw the
overdraft facility at short notice.
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Trade Credit
This source of finance really belongs under the heading of working capital management
since it refers to short term credit. By trade credit we mean that a creditor, such as a supplier
of raw materials, will allow a purchaser to buy goods now and pay for them later. Why have
we included lines of credit here as a source of finance? Well, if a business manages its
creditors carefully, it can use the credit they provide to finance other parts of the business.
Take a look at any company's balance sheet and see how much they have under the heading
of "Creditors falling due within one year". Let's imagine it is £50,000 for a particular
company. If that company is allowed an average of 30 days to pay its creditors, then we can
see that effectively it has a short term loan of £50,000 for 30 days and it can do whatever it
likes with that money, as long as it pays the creditor on time.
The advantages of trade credit is that it is a relatively convenient, cheap and informal way of
securing short term finance and is available to companies of all sizes.
Trade credit is often different for different firms in different types of business environment.
There are often quite big differences in the approach to this within different industries and
some industries have traditionally relied on a large amount of trade credit. Consider the
trade credit terms offered to, say, a retailer and a heavy goods manufacturer – little is usually
offered in the first case, but typically around three months in the latter case. The bargaining
strength of both parties will also have an impact on the case for trade credit and it has often
been the case that major retailers (with an ever increasing share of the market) have been
able to negotiate "one sided" and often unfair trade credit terms on much smaller suppliers.
The product type will also often have an impact – for example, where the product has a high
level of turnover compared to the level of stocks held, then it is likely to have a much smaller
level of trade credit than a product that has a longer shelf life between supply and sale.
Factoring allows a company to raise finance based on the value of its outstanding invoices.
It also gives the business the opportunity to outsource its sales ledger operations and to use
more sophisticated credit rating systems.
The way it works is as follows:
 Once a sale is made, the company invoices its customer and sends a copy of the
invoice to the factor (with most factoring arrangements requiring a company to factor all
its sales).
 The factor then pays the company a set proportion of the invoice value within a pre-
arranged time – typically, most factors offer 80-85% of an invoice's value within 24
hours. (Thus, a major advantage of factoring is that the company receives the majority
of the cash from debtors within 24 hours rather than a week, three weeks or even
 The factor issues statements on the company's behalf and collects the payments.
However, the company remains responsible for reimbursing the factor for bad debts,
unless a "non-recourse" facility has been arranged. (Non-recourse means that if a
debtor doesn't pay, the factoring company will either suffer the loss or will have insured
themselves against the loss.)
 The company will receive the balance of the invoice (less charges) once the factor
receives payment.
 The factor provides regular reports on the status of the company's sales ledger.
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Factoring Charges/Fees
Finance charges should be comparable to an overdraft. Typical charges on the amount
financed range from 1% to 4% over base rate, with interest calculated on a daily basis.
Credit management and administration charges, including the maintenance of the sales
ledger, depend on turnover, the volume and number of invoices. Typical fees range from
0.50% to 3.0% of annual turnover – a company with 50 live customers, 1,000 invoices per
year and £1 million turnover might pay 1%.
Credit protection charges (for non-recourse factoring) largely depend on the degree of risk
the factor associates with the business. Typical charges range from 0.5% to 3% of annual
There are several advantages to factoring, including:
 Cash flow is maximised as factoring enables a company to raise up to 80% or more on
outstanding invoices
 Using a factor can reduce the time and money spent on debt collection since the factor
will usually run the sales ledger for the company
 The factor's own credit control system can be used to help assess the creditworthiness
of new and existing customers
 Factoring can be an efficient way to minimise the cost and risk of doing business
There are, however, disadvantages to factoring and, unless carefully implemented, factoring
can have a negative impact on the way a business operates. The most significant problems
are as follows:
 The factor usually takes over the maintenance of the sales ledger, and customers may
prefer to deal with the company it is trading with rather than a factor
 Factoring may impose constraints on the way business is conducted – for example, the
factor will apply credit limits to individual customers (though these should be no lower
than prudent credit control would suggest), and for non-recourse factoring, most factors
will want to pre-approve customers, which may cause delays
 The client company might only want the finance arrangements and yet it might feel it is
paying for collection services they do not really need
 Ending a factoring arrangement can be difficult where the only exit route is to
repurchase the sales ledger or to switch factors and that could cause a sudden shortfall
in working capital.
Invoice Discounting
Invoice discounting is similar to factoring in that the invoice discounter makes a proportion of
the invoice available to a company once it receives a copy of an invoice sent. However, the
client company collects its own debts, and this enables it to retain the control and
confidentiality of its own sales ledger operations. Once the client receives payment, it must
deposit the funds in a bank account controlled by the invoice discounter. The invoice
discounter will then pay the remainder of the invoice, less any charges.
The requirements are more stringent than for factoring and different invoice discounters will
impose different requirements.
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"'Confidential invoice discounting" ensures that customers do not know a company is using
invoice discounting as the client company sends out invoices and statements as usual.
However, the costs of this are greater since the discounter is carrying a greater degree of
risk. The requirements for "disclosed" (i.e. non-confidential) invoice discounting are generally
less demanding.
Bills of Exchange
These are a form of commercial credit instrument, or IOU, used in international trade. In
Britain, a bill of exchange is defined by the Bills of Exchange Act 1882 as an unconditional
order in writing addressed by one person to another, signed by the person giving it, requiring
the person to whom it is addressed to pay on demand or at a fixed or determinable future
time a certain sum in money to or to the order of a specified person, or to the bearer.
There is an increasing internationalisation of capital markets, especially for the larger
companies, e.g. when BT was floated it was on both the domestic and international markets.
Note that many of the terms discussed below have the prefix "euro" but it does not limit them
to European currencies, the term being an historical one. The transactions are any
undertaken in a currency outside the country of origin of the particular currency concerned.
The Eurocurrency market is the borrowing and lending of Eurocurrency loans via banks
based outside the currency's country, e.g. a UK company could borrow Yen for trade with
Japan from a British bank (Euroyen). The loans are generally short term (three months),
often between banks.
The market generally offers high rates of interest, flexibility of maturities and a wide range of
investment qualities in comparison with other capital markets. The dealings for substantial
funds (generally in excess of $1m) are highly competitive. The unique feature is that the
transactions in each currency take place outside the country from which that currency
originates. The main function of the market is the financing of international trade, e.g. to fund
down payments of goods sold on export credit terms.
On the short-term, inter-bank Eurocurrency market, transactions may take place between
banks on an unsecured basis from overnight to five years' duration. Most transactions are
for six months or less and transactions of over £1m are common.
The Eurobond market is an international capital market which has developed alongside the
Eurodollar market since the 1960s. Eurobonds are bonds sold outside the jurisdiction of the
country in which the currency is based – so, for example, the UK financial regulators have
little influence over the Eurobonds denominated in sterling even though the transactions are
in pounds. It deals in the lending of currencies for longer terms under bonds which are often
denominated in dollars.
The following advantages are claimed for the Euromarkets in various currencies:
 Extremely large sums can be raised or deposited.
 Money will often be cheaper than the domestic markets.
 Controls tend to be less restrictive.
 Some protection against exchange rate movements is offered, but here the user will
require a high level of skill in selecting his or her alternatives.
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 Any period of surplus or shortage from one day to five years can be accommodated.
 The markets offer a useful alternative to other sources of capital which the company
may not wish to use at the time.
 US involvement in world trade makes a pool of dollars outside the home country most
useful when:
(i) It is impossible or undesirable to transfer funds from the home country.
(ii) Projected currency movements suggest that it is advantageous to rearrange
dollar commitments to parent companies, etc.
Eurobonds Available
There are three broad types of Eurobond which can be classified as follows:
 Straight fixed rate bonds
The majority of Eurobonds with a fixed coupon can be described thus. Interest is
generally paid out once each year and is calculated using a 360-day year. Some older
issues do pay half-annually.
Whilst a 15-year term is typically the norm, maturity may range from three to 25 years.
Shorter maturity bonds (up to five years) are usually referred to as notes and issues
from the Netherlands are often within this period.
 Equity related bonds
These may take two forms:
(a) Convertibles – whereby the bond holder has the right (but not the obligation) to
convert the bond into ordinary shares at a pre-determined price.
(b) Eurobonds with warrants – which are similar to convertible bonds in that
warrants are attached to the Eurobond enabling the holder to purchase ordinary
shares represented by the warrants at, or between, specified dates. The
exercise price will be set in a similar fashion to that of convertible Eurobonds.
 Floating rate notes (FRNs)
These have a variable coupon reset on a regular basis, usually every three to six
months, in relation to a reference rate, such as LIBOR. The size of the reference rate
will reflect the perceived risk to the issuer.
Borrowing in the Euromarket
Borrowers in the Euromarket include:
 Companies needing dollars for investment in the USA.
 Unit trusts and investment trusts investing in foreign securities.
 The United States banks, which find that it is expedient to take up loans through the
European market rather than to borrow in the USA.
 Multinational companies wishing to invest in a particular country without wishing, or
being able, to transfer capital from their base country.
 National governments and bodies associated with national and international agencies.
This is the issue of equity in a stock market outside the company's domestic stock market. A
lack of sufficiently active secondary markets limits Euroequity markets (as you can see by the
poor showing of the attempted issues by US and Japanese companies in European
markets). Hence they are not as popular as Eurobonds. This has led to the use of
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sweeteners in an attempt to sell Euroequity, including the issuing of bonds with warrants
Choice of Currency for Borrowing
The factors affecting the choice of currency used for company borrowing include:
 The ease and speed of raising finance, which is often easier outside the domestic
 The size of the debt – larger loans tend to be borrowed in the Euromarkets.
 The cost of issues – small changes in interest rates can have a significant impact if the
loan is large.
 Whether the currency is required immediately (including coverage in preventing
exchange exposure) and in the long run.
 The security the company has available – Euroborrowings are generally unsecured.
Advantages of Raising Funds in International Markets
You will realise from the above that there are several advantages to the company in raising
funds in international markets, including:
 It is useful if the company's own capital market is too small, or too complex and/or
regulated to raise the required finance quickly and easily.
 It improves the liquidity and reputation of the company.
 It may improve trade if the company trades in the country of the currency/capital
 It can help in preventing takeover bids.
Small businesses generally rely on retained earnings, bank borrowings and (limited) issuing
of shares to private shareholders. They are often criticised as being too dependent on short-
term finance, but only because they often experience difficulty in raising finance due to a
perceived higher risk of failure.
Several initiatives have been taken to try and solve the funding gap, a sample of which are
discussed below.
(Note that, whilst your examiner will not expect you to be able to demonstrate intimate
knowledge of every source of assistance, those described below are given to give you some
insight into the variety of assistance available. This topic is continually changing and you
should supplement your studies by reading the financial press to ensure you are up-to-date
with the latest developments.)
Government Measures
There are two main government schems providing funding support to small businesses.
(a) Enterprise Investment Scheme (EIS)
The Enterprise Investment Scheme is a government scheme that provides a range of
tax reliefs for investors who subscribe for qualifying shares in qualifying companies.
There are five current separate EIS tax reliefs:
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 Income tax relief
Provided an EIS qualifying investment is held for no less than three years from
the date of issue, or three years from commencement of trade, if later, an
individual with no more than a 30% interest in the company can reduce their
income tax liability by an amount equal to 20% of the amount invested. The
minimum subscription is £500 per company and the maximum per investor is
£400,000 per annum. Where an individual subscribes for qualifying shares
before 6 October in a tax year, a claim may be made to carry back one half of the
amount subscribed to the previous tax year, subject to a maximum of £50,000.
 CGT deferral relief
Tax on gains realised on a different asset can be deferred indefinitely where
disposal of that asset was less than 36 months before the EIS investment or less
than 12 months after it. Deferral relief is unlimited – in other words, this relief is
not limited to investments of £400,000 per annum and can also be claimed by
investors (individuals or trustees) whose interest in the company exceeds 30%.
 CGT freedom
No capital gains tax is payable on disposal of shares after three years, or three
years after commencement of trade, if later, provided the EIS initial income tax
relief was given and not withdrawn on those shares.
 Loss relief
If EIS shares are disposed of at any time at a loss (after taking into account
income tax relief), such loss can be set against the investor's capital gains or
his/her income in the year of disposal or the previous year. The net effect of this
is to limit the investment exposure to 48p in the £1 for a 40% tax payer if the
shares become totally worthless.
 Inheritance tax exemption
EIS Investments are generally exempt from inheritance tax after two years of
holding such investment.
EIS is appropriate for those investors who wish to include in their portfolio some high
risk companies.
(b) Small Firms Loans Guarantee Scheme (SMLGS)
The Small Firms Loan Guarantee Scheme provides a government guarantee for loans
by approved lenders. Qualifying loans are those made to firms or individuals unable to
obtain conventional finance because of a lack of track record or security. The
guarantee generally covers 70% of the outstanding loan, rising to 85% for established
businesses trading for two years or more. Loans can be for amounts between £5,000
and £100,000 (£250,000 for established businesses) and over a period of between two
to ten years.
Business Angels
The Business Angels movement is an important, but still under-utilised source of money for
new and growing businesses.
Business Angels are high net worth individuals who invest on their own, or as part of a
syndicate, in high growth businesses. In addition to money, they often make their own skills,
experience and contacts available to the company, and their commitment is often very strong.
Business Angels invest across most industry sectors and stages of business development,
but especially in early and expansion stage businesses. Most prefer to invest in companies
within 100 miles of where they live or work. Investors in technology companies tend to be
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more prepared to travel longer distances. They rarely have a connection with the company
before they invest, but often have experience of its industry or sector.
The majority of Business Angels make investments for financial reasons. However, there may
also be other motives for investment – for example, taking an active part in the
entrepreneurial process, the enjoyment from being part of the success of a good investment,
or the sense of putting something back in.
A typical Business Angel makes one or two investments in a three-year period, although
some invest more frequently. The level of investment is usually between £10,000 and
£750,000. Where larger amounts are invested, this is often as part of a syndicate organised
through personal contacts or a Business Angel Network.
The methods used by Business Angels to decide which businesses to invest in vary greatly.
However, the following issues are all taken into consideration:
 The expertise and track record of the founders and management
 The businesses competitive edge or unique selling point
 The characteristics and growth potential of the market
 Compatibility between the management, business proposal and the business angel's
skills and investment preferences
 The financial commitment of the entrepreneur
The company must also ensure that the Business Angel willing to invest in them is right for
their company. Before signing an agreement the business must ensure that:
 The management team and the business angel are compatible and will be able to work
together; and
 The Business Angel's skills match the company's needs.
Grants are available to all businesses, most of which carry a test relating to the number of
new jobs created from the project or development requiring assistance. The second test for
grant assistance will usually be that the project cannot proceed without financial assistance.
Grants are available from a range of institutions including governmental bodies and the
Prince's Youth Business Trust.
Whilst banks will usually be willing to lend a degree of support, without the ability to offer
some tangible security the business may have to seek finance from elsewhere.
Venture Capital Providers
Venture Capital Trusts (VCTs) were devised in the 1993 budget as a way for new and
unquoted companies to obtain money from investors. VCTs are essentially investment trusts
and, like other investment trusts, their shares are often traded in the stock market.
Since these small and growing companies are a higher risk than investing in bigger, more
mature businesses, VCT's offer more attractive tax breaks – everyone is permitted to invest
up to £100,000 in a VCT each year, and investors receive tax relief at 20% on the money
they put in, and any dividends or capital gains are free of tax:
 Relief on distributions – VCT dividends are free of income tax on investments of up to
£100,000 each year
 Relief on disposals – individuals are exempt from Capital Gains Tax on disposals of
ordinary VCT shares on investments of up to £100,000 each year.
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 Capital Gains Rollover Relief will be given to people reinvesting up to £100,000 and, if
the shares are held for five years, no CGT will be payable on disposal.
 Deferred Capital Gains Taxation on investment – subscribers for new ordinary VCT
shares who invest gains arising from the disposal of any asset will be able to defer the
tax chargeable, subject to certain timing restriction.
 Exempt from Corporation Tax – on capital gains (such as an investment trust).
The 2000 Budget reduced from 5 years to 3 years (for shares issued on or after 6 April 2000)
the minimum period for which investments in VCT companies carrying on a qualifying trade
at the time of issue must be held if they are to qualify for income tax relief.
The 1999 budget tightened up the rules on VCTs to exclude schemes which are low risk,
often offering guarantees or being property backed.
Finance Companies and Lessors
Finance companies typically specialise in providing financial accommodation in respect of
fixed assets. Since they generally retain title to the assets throughout the term of the
contract they do not usually seek additional security. They may, however, seek directors'
personal guarantees when the directors of a small business are also the principal
Private Investors
In some cases, particularly with a very small business that is in the early stages of its
development, a number of private investors may be prepared to get involved with its
financing. These may be family members or friends who have a genuine interest in making
sure that the business succeeds.
Practice Question 2
Redbrick plc's 10% convertible loan stock is quoted at £138 per £100 nominal. The earliest
date for conversion is in three years time at the rate of 25 ordinary shares per £100 nominal
loan stock. The current share price is £5.20.
(a) Calculate the conversion price;
(b) Calculate the conversion premium.
Now check your answer with the one given at the end of the unit.
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Practice Question 1
(a) Investor who holds 60,000 ordinary shares (5% equity)
Present position If shareholder takes up
If shareholder sells rights
£ £ £
Value of investment:
60,000 O/S × £3.60 216,000 60,000 O/S × £3.60 216,000 60,000 O/S × £3.60 216,000
15,000 O/S × £3.00 45,000 less 60,000 × 12p* (7,200)
216,000 261,000 208,800
Dividend received:
60,000 × 45p 27,000 75,000 × 43.5p 32,625 60,000 × 43.5p 26,100
% ROI (net): 12½% 12½% 12½%
* Theoretical ex-rights price would be
000 500 1
000 220 5
, ,
, , £
shares = £3.48.
Thus, the value of one right =
= 12p
The total value of £5,220,000 derives from:
Value of shares on issue 4,320,000 (1,200,000 × £3.60)
Value of rights issue 900,000 (300,000 × £3)
The present net dividend yield is
000 320 4
000 200 1
, ,
, ,
£ × 45p = 12.5p
The future net dividend yield is
000 220 5
000 500 1
, ,
, ,
£ × 43.5p = 12.5p
From these calculations, the shareholder will be no better or worse off after the rights
issue and his or her action, therefore, can be determined on whether he or she wishes
to continue to be involved in the company to the same extent or to increase or
decrease his or her overall holding.
(b) The idea of a rights issue is to encourage existing shareholders to invest more funds in
a company so as not to dilute further the membership interest. To do so, a discount on
the market price is built into the price ruling on the market. To price the rights issue
above market price would mean it would be cheaper to go to the market to purchase
the shares, and the rights issue would fail.
(c) The total sum to be raised = £900,000, made up as follows:
× £3 = £900,000 (300,000 new shares)
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Therefore, the underwriting commission will be £900,000 × 1¼% = £11,250.
It would have been possible to price the rights issue below that, at say £2.50, to raise
the same sum on a 3 for 10 issue at £2.50 as follows:
× 3 × £2.50 = £900,000 (360,000 new shares).
The underwriting commission will still be:
£900,000 × 1¼% = £11,250
This will be payable whether the issue is fully subscribed or not.
An underwriter agrees to take up the remnants of an issue if it is not altogether
successful, which ensures that the company raises the sum required, i.e. the, albeit
small, element of risk associated with the failure of the issue is insured against.
It would be argued that a slightly lower price could be offered if underwriting
commission were less or if the issue were not underwritten, but whether such a
minimally lower price would influence the success of the issue enough to ignore the
risk is unlikely. Underwriting commission is usually between 1¼% and 2%.
Practice Question 2
(a) The conversion price is the amount of stock required to obtain each ordinary share.
For Redbrick plc this is:
100 £
= £4
£4 of stock is necessary for each share.
(b) The conversion premium is:
÷ 5.20 = 5.52 ÷ 5.20
= £0.32 per share.
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Study Unit 6
Cost of Finance
Contents Page
Introduction 145
A. Investors and the Cost of Capital 145
The Required Rate of Return 145
The Effect of Risk 145
B. Cost of Equity 146
Dividend Yield (or Dividend Valuation) Method 146
Cost of Preference Shares 148
Retained Earnings 149
Capital Asset Pricing Model 149
C. Cost of Debt Capital 149
Irredeemable Debt 150
Redeemable Capital 150
Cost of Floating Rate Debt 152
Cost of Convertibles 152
Cost of Fixed Rate Bank Loans 153
Cost of Short-term Funds and Overdrafts 153
D. Cost of Internally Generated Funds 153
E. Weighted Average Cost of Capital 154
Methodologies 155
Assumptions When Using WACC 156
Arguments Against Using the WACC 156
F. Assessment of Risk in the Debt Versus Equity Decision 157
Effect on Market Value 157
Break-even Profit Before Interest and Tax 158
Other Considerations 158
(Continued over)
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G. Cost of Capital for Other Organisations 159
Unquoted Companies 159
Not-For-Profit Organisations 159
Answers to Practice Questions 160
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It is essential for a company to know the cost of the various types of funds included in its
capital structure in order to satisfy the terms of the providers of that capital – the investors. If
the investors are not satisfied with their returns they may remove their money from the firm.
The required rate of return to investors is how much the company has to pay to obtain its
finance – i.e. the cost of capital to the firm.
In addition, it is important for companies to know their cost of capital in order to ensure that
projects they invest in achieve the level of return required to satisfy those who provide funds
which finance the project.
We will consider initially the costs of the different types of capital individually, before looking
at the cost of the capital structure of the company as a whole.
It is important when you are revising this area to also consider the capital asset pricing model
(CAPM) that we will discuss later in the course.
It is important to remember that the cost of finance to the firm is the return required by
investors in the firm.
The Required Rate of Return
The required return of investors will be determined by the opportunity cost foregone of the
investors, and the risk they are required to bear. For example, if the return on a company's
ordinary shares is 8% with no real prospect of capital growth in the short term, and a building
society deposit will yield 10%, it is unlikely that the shares will be attractive to investors – the
opportunity cost (the building society rate) is greater than the projected return, and the risk of
investing in a company is generally considered to be higher than that of depositing the
money in a building society account.
The Effect of Risk
Investing in companies involves risk – investors may lose some or all of their funds placed in
the company. The risk comprises two elements:
 Business risk – due to a lack of certainty about the firm's prospects and projects, and
 Financial risk – the higher the level of gearing the higher the risk of bankruptcy.
The return investors require depends on the level of risk – the higher the risk the higher the
expected return, because people expect to be compensated for bearing additional risk. This
"risk premium" (made up of premiums for business and financial risks) will be required in
addition to the risk-free rate of return which is the basic return which would be required if
there was no risk. (The risk-free rate is typically taken to be the return on government
Thus the return required from investing in different companies will vary with the differing
levels of risk involved in the firms.
It is possible to assess the different risks involved by calculating both the operational gearing
(as a measure of business risk) and the financial gearing (as a measure of financial risk).
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The requirements and expectations of shareholders must be considered when looking at the
cost of equity. The effect that changes in earnings and dividends may have on the share
price must also be considered.
Dividend Yield (or Dividend Valuation) Method
The main method of calculating the cost of equity is the dividend valuation or dividend yield
model. The precise form of model used varies with the assumptions used. The simplest
model to use assumes that dividends will remain at a constant level in the future.
The value of a company's shares can be calculated using the formula we discussed earlier:
Market value =
shares the on yield) (or return Expected
pence in payable dividend Current
The formula can be rearranged for use in calculating the cost of equity as follows:
Expected return (or yield) on the shares =
value Market
pence in payable dividend Current
The expected return (or yield) on the shares is the cost of equity, and the market value of the
shares is the current ex div share price (i.e. the share price after the dividend has been paid).
This is often written as:
Ke =
where: Ke = cost of equity
De = current dividend payable
Se = current share price (ex div).
Example 1
Tigger plc's current dividend is 25p and the market value of each share is £2. What is the
cost of Tigger's equity?
Using the above formula Ke =
Ke =
= 0.125 = 12.5%
However, shareholders prefer a constant growth in their dividends. In order to reflect this in
the dividend valuation method, we have to predict future growth in dividends. Growth
generally reflects predicted changes in a company's earnings, although it is difficult to decide
the level of growth that will be sustained in future years. The most usual approach is to take
several years' historical data and then attempt to extrapolate forward.
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Example 2
Assume Pooh's past dividends have been:
Dividend per
Year 1 0.26
Year 2 0.27
Year 3 0.28
Year 4 0.32
We can now find the average rate of growth by using the following formula:
Growth rate (g) =
dividend Earliest
dividend Latest
÷ 1
where: n = number of years growth.
Applying this to the above figures, we get:
g =
26 0
32 0
÷ 1 = 0.0717 or approximately 7%.
Note that here we are using the cube root because there are three years of growth. If we
had been given five years' data (from which we could project four years' growth) the fourth
root would have been used.
When the expected growth figure has been determined we can calculate the value of the
company's shares using the Dividend Growth Model or Gordon's Model of Dividend
This model states:
= d
g) r (
g) (1
which is also written as Se =
g) (Ke
g) + (1 De
where: P
or Se = the current ex dividend market price
or De = the current dividend
g = the expected annual growth in dividends
r or Ke = the shareholder's expected return on the shares
and can be rewritten as:
Ke =
g) + (1 De
+ g
Note that growth, if given, is usually be expressed as a percentage.
Example 3
Using the example of Pooh above, and assuming its share price is £2.50, then:
Ke =
) 0.32(1.072
+ 0.072 = 0.137 + 0.072 = 20.9%.
The dividend valuation and dividend growth model are based on the following assumptions:
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 Taxation rates are assumed to be constant across all investors, and as such the
existence of higher rates of tax are ignored. The dividends used are the gross
dividends paid out from the company's point of view.
 The costs of any share issue are ignored.
 All investors receive the same, perfect level of information.
 The cost of capital to the company remains unaltered by any new issue of shares.
 All projects undertaken as a result of new share issues are of equal risk to that existing
in the company.
 The dividends paid must be from after-tax profits – there must be sufficient funds to
pay the shareholders from profits after tax.
Share Issue Costs
Share issue costs can be incorporated in the formula, especially if they are considered to be
high. The formula then becomes:
Ke =
I) (Se
where: Ke = cost of equity
De = current dividend payable
Se = current share price (ex div)
I = cost of issue per share.
Thus, for the example of Tigger above, if issue costs divided by the number of shares is 5p,
then the cost of equity becomes:
Ke =
5 200
= 0.128 = 12.8%
If you are given issue costs you should, unless told otherwise, incorporate them in the
formula as shown above.
Cost of Preference Shares
The formula for calculating the cost of preference shares is:
Kp =
where: Kp = cost of preference shares
Dp = fixed dividend based on the nominal value of the shares
Sp = market price of preference shares
Anorak plc has 8% preference shares which have a nominal value of £1 and a market price
of 80p. What is the cost of preference shares?
Using the above formula, dividends are 8% of the nominal value of £1 and as such are 8p.
Kp =
= 10%.
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Retained Earnings
Retained earnings will also have an effect because, when left in the business rather than
being distributed, they should achieve higher returns in the future to offset the lack of current
dividends. The shareholders' expectations of increasing future dividends rather than constant
payments may, however, persuade them to accept initial lower dividends.
Capital Asset Pricing Model
The Capital Asset Pricing Model, which we shall discuss later in the course, can also be used
to value the cost of equity. You should revise this topic when you have worked through the
relevant unit.
Estimating the cost of fixed interest or fixed dividend capital (such as debenture interest) is
relatively easy because the interest rate is prescribed in the contract. The cost of debt
capital already issued is the rate of interest (the Internal Rate of Return) which equates the
current market price with the discounted future cash receipts from that particular investment.
Whilst it is possible to calculate the cost of any individual sources of capital, this is not the
same as the cost of capital as a whole, or the necessary discount rate to apply when
considering different investment proposals. It is more common in this scenario to consider
the financing of a business as a pool of resources rather than any particular way of funding a
specified investment opportunity and, under these circumstances, it is usual for the business,
when considering the opportunity cost of the capital needed for an investment, to consider an
average cost of capital to be used as the discount rate to be applied.
The weighted average costs of capital (WACC) is the average cost of the company's finance,
weighted according to the relative size of each element compared with the total capital.
There are a number of other factors that might affect the costs of debt capital for a business
 The bargaining power of the business
 The availability of government assistance – for example, the special government
assistance (grants or reliefs) available in deprived areas
 The conditions at any particular moment of the financial markets
 The tax regime
 Interest rates in the markets
 The availability of internal sources of finance available
 The record of debt repayment for the business concerned
 The type of industry involved.
We saw earlier that debentures can be either redeemable or irredeemable. It is important
that you know the type of debenture a firm has in issue when calculating its cost of capital
because, as we shall see, the approach used varies with the form of debentures being
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Irredeemable Debt
The formula for calculating the cost of irredeemable debt is:
Kd =
t) I(1÷
where: Kd = cost of debt capital
I = annual interest payment
Sd = current market price of debt capital
t = the rate of corporation tax applicable.
Taxation is considered because the interest can be offset against taxation, which will lower its
nominal rate, and thus its cost. The higher the rate of corporation tax payable by the
company, the lower will be the after-tax cost of debt capital. Thus the cost of debt capital is
much lower than the cost of preference shares with the same coupon rate and market value
as the debentures because of the availability of tax relief on the debt. Naturally this only
applies if the business has taxable profits from which to deduct its interest payments. When
the business has generated a taxable loss, the interest will increase that loss for carry
forward (to be offset against future taxable profits in later years), and the immediate benefit of
tax relief will be lost.
Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current market
price of £92 per £100 of nominal value. If the corporation tax rate is 33% what is the cost of
the debt capital?
The annual interest payment will be based on the nominal value, i.e. 8% of £10,000 or £800,
so using the above formula:
Kd =
10,000 92/100
0.33) 800(1
= 0.0583 = 5.83%.
Redeemable Capital
In order to determine the cost of such capital to the date of redemption we must find the
internal rate of return (IRR). IRR is discussed in greater detail later, but basically involves
calculating all the necessary cash flows (generally the assumption will be made that all
payments and receipts are made at the end of the year) and determining at what cost of
capital the value of future cash flows are equal to zero. The IRR is calculated using discount
factors for the appropriate cost of capital and the following formula. Wherever possible the
ex-interest values should be used, so if the cum-interest value is quoted (i.e. if the interest is
due to be paid soon and thus is reflected in the market price of the debt) we should deduct
the interest payment from the market price. The longer the period to maturity, the lower will
be the overall cost of capital. This is to be expected because the real cost of redemption will
be lower in the future because of the effects of the time value of money. (Do not worry if this
appears complicated at this stage since we shall explain the IRR fully later in the course.)
In this example, Clown's rate of corporation tax is assumed to be 33% throughout and
redemption is in 20x5. The following table sets out the workings on which the calculation is
Note: df = discount factor
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Year Amount df 6% df 12%
a b c b × c d b × d
Current market price 20x1 (94.0) 1.00 (94.00) 1.00 (94.00)
Interest 20x2 10.0 0.94 9.40 0.89 8.90
Tax saved 20x3 (3.3) 0.89 (2.94) 0.80 (2.64)
Interest 20x3 10.0 0.89 8.90 0.80 8.00
Tax saved 20x4 (3.3) 0.84 (2.77) 0.71 (2.34)
Interest 20x4 10.0 0.84 8.40 0.71 7.10
Redemption (1.1.x5) 20x4 100.0 0.84 84.00 0.71 71.00
Tax saved 20x5 (3.3) 0.79 (2.61) 0.64 (2.11)
8.38 (6.09)
The cost of capital is therefore:
6 +


÷ ×
) ( 6 12
6.09) (8.38
by interpolation
= 9.47% (that is the IRR)
If redemption occurs three years later in 20x7, the cost of capital changes as follows:
Year Amount df 6% df 12%
a b c b × c d b × d
Current market price 20x1 (94.0) 1.00 (94.00) 1.00 (94.00)
Interest 20x2 10.0 0.94 9.40 0.89 8.90
Tax saved 20x3 (3.3) 0.89 (2.94) 0.80 (2.64)
Interest 20x3 10.0 0.89 8.90 0.80 8.00
Tax saved 20x4 (3.3) 0.84 (2.77) 0.71 (2.34)
Interest 20x4 10.0 0.84 8.40 0.71 7.10
Tax saved 20x5 (3.3) 0.79 (2.61) 0.64 (2.11)
Interest 20x5 10.0 0.79 7.90 0.64 6.4
Tax saved 20x6 (3.3) 0.75 (2.47) 0.57 (1.88)
Interest 20x6 10.0 0.75 7.50 0.57 5.7
Redemption (1.1.x7) 20x6 100 0.75 75.00 0.57 57.0
Tax saved 20x7 (3.3) 0.70 (2.31) 0.51 (1.68)
10.00 (11.55)
The cost of capital is:
6 +


÷ ×
) ( 6 12
11.55) (10.00
= 8.78% (i.e. the IRR).
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Cost of Floating Rate Debt
If a company has floating rate debt in its capital structure, then an estimated fixed rate of
interest should be used to calculate its cost of debt in a way similar to the above. The
"equivalent" rate will be that of a similar company for a similar maturity.
Cost of Convertibles
To determine the cost of convertibles we have to find the internal rate of return (IRR) of the
following equation:
r) (1
t) K(1
r) (1
t) K(1
r) (1
t) K(1
+ . . . .
r) (1
t) K(1
r) (1
where: P
= current market price of the convertible ex interest (i.e. after paying the current
year's interest)
K = annual interest payment
t = rate of corporation tax
r = cost of capital
= market value of the shares at year n
CR = conversion ratio.
It is also a useful exercise to calculate the cost of convertibles as though they were not
converted – if the cost is higher the holders will choose not to convert, because not
converting produces a higher return to the investor. The higher cost of capital should
therefore be the one used in the calculation of the company's cost of capital.
Quality plc has 10% convertible debentures due for conversion in two years' time. They have
a current market value of £108 per cent. The conversion terms are 5 shares per £10 of
debentures. All the debenture-holders are expected to convert, and the shares are expected
to have a price of £4 at this time. What is the cost of capital?
For ease of calculation, we shall assume the rate of corporation tax is 50% and is payable in
the same year.
The market value of £108 per cent means that it is £108. Interest on convertibles is
offsettable against tax, and thus is shown as a saving in the following calculation:
Year 0 1 2
£ £ £
Current market value of convertibles (108)
Interest 10 10
Tax relief (5) (5)
Value of shares on conversion:
((5 × 100/10) × £4) 200
Total yearly cash flow (108) 5 205
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Now apply an estimate of the cost of capital – say 40%:
Year 0 1 2
£ £ £
Total yearly cash flow (108) 5.000 205.000
Discount factor at 40% 1 0.714 0.510
Present value (108) 3.570 104.550
Net present value = (108) + 3.57 + 104.55 = 0.12
Thus the cost of capital is just over 40% – the precise level could be found using the
interpolation formula given above.
Again do not worry if the mechanics seem a little complicated since they will be covered in
greater detail later in the course.
Cost of Fixed Rate Bank Loans
The cost of this major source of finance is given by:
Cost = Interest rate = (1 ÷ t)
Cost of Short-term Funds and Overdrafts
The cost of short-term bank loans and overdrafts is the current interest rate being charged on
the capital lent.
Internally generated funds typically represent around 60% of all sources of capital available
to a business. The principal benefit of using internal funds is derived from the fact that there
are no formalities to their acquisition, but it will often be difficult to generate the optimum
amount at exactly the time the business needs additional funding.
Whilst internally generated funds avoid the formal costs of issue, e.g. issuing house fees,
they are not free of cost to the company.
Retained earnings (e.g. provisions, retentions) belong to the shareholders and, in order to
justify their retention, the company must be able to earn a return in excess of that which the
shareholders could earn before tax had they been distributed to them. Thus there is an
opportunity cost related to the cost of retentions. When the company is unable to meet that
rate, it has an obligation to distribute its retentions to its shareholders, allowing them to obtain
better returns on their investments.
We can show an example, using a comparison between two companies:
Company X pays out most of its earnings, whereas Company Y retains a high percentage.
Company X £ Company Y £
Year 1 Profits 200,000 Profits 200,000
less Dividend 160,000 less Dividend 20,000
Balance c/f 40,000 Balance c/f 180,000
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In Year 2, the capital needs of both companies are an additional £200,000. X obtains equity
of £160,000 and Y equity of £20,000. Assume dividends of 10% on new capital.
Company X £ Company Y £
Year 2 Profits (year 2) 200,000 Profits (year 2) 200,000
less Dividends: £ less Dividends: £
On existing capital 160,000 On existing capital 20,000
On new capital 16,000 176,000 On new capital 2,000 22,000
Balance c/f 24,000 Balance c/f 178,000
Suppose in Year 3 profits fell sharply to £100,000 for each company. The following would be
the result.
Company X £ Company Y £
Year 3 Profits 100,000 Profits 100,000
less Dividend (halved) 88,000 less Dividend (doubled) 44,000
Balance c/f 12,000 Balance c/f 56,000
What do these figures mean? That Y is more efficient than X? No, because profits each
year have been the same, the only difference being that Y obtains large amounts of "cost-
free" capital, whereas X is paying out most of its profits as it has to pay for its capital in the
form of a dividend.
Is Y able to weather the storm better than X? Yes, because it has a large balance, made
possible by its low pay-out ratio. It has been able to double dividends to shareholders
despite reduced profits in
Year 3.
Sooner or later the shareholders of Company Y will realise they are losing out, to the benefit
of the company itself.
From this two important principles emerge:
 All capital has a cost.
 Even retained profits should carry a cost (an implied or imputed cost).
Here the opportunity cost is concept related to the cost of retentions that we noted earlier.
Companies tend to have a mixture of the different types of capital in their structure, and when
considering the cost of capital used to finance a project it is common to use the cost of the
mix of capital held by the company – the weighted average cost of capital (WACC).
The cost of capital that should be used in evaluating projects is the marginal cost of the funds
raised in order to finance the project, and WACC is considered to be the best estimate of
marginal cost (the capital structure of a company changes slowly over time). Note, however,
that it is only the most reliable if the company is assumed to continue investment in projects
of a normal level of business risk and funds are raised in similar proportions to its existing
capital structure.
The weighted average cost of capital is the average of costs of the different types of finance
in a company's structure weighted by the proportion of the different forms of capital employed
within the business. The financial manager will therefore need to ensure that any project
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which is under consideration will produce a return that is positive in terms of the business as
a whole and not just in terms of an issue of capital made to finance it. Investments which
offer a return in excess of the WACC will increase the market value of the company's equity,
reflecting the increase in expected future earnings and dividends arising as a result of the
There is no one accepted method of calculating a company's WACC – some use book values
in the proportions that they appear in the company's accounts and some use market values.
For unquoted companies book values may have to be used because of the problems we
discussed in earlier study units of estimating market values for their securities. Book values
are generally easier to obtain than market values. However, many would argue that for
quoted companies market values are more realistic and, indeed, may be easier because only
one cost of equity is required – it being impossible to split the value of equity between the
shares and the retained earnings.
(a) Using book values in the proportions that they appear in the company's accounts:
Weighting Cost Weighted Cost
Ordinary shares 60% 12% 7.2%
Debentures 40% 8% 3.2%
WACC 10.4%
(b) Using market values:
Number Price Market Value Cost Weighted
Market Value
Ordinary shares 6,000 2.50 15,000 12% 1,800
Debentures 4,000 1.50 6,000 8% 480
21,000 2,280
The WACC is then calculated as:
= 10.86%
Both methods produce the historic WACC and you should remember that raising fresh capital
could well alter the weighting and therefore the cost of capital, the model assuming that new
investments are financed by new funds. A change in the risk level of the company will also
affect the cost of a company's capital.
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You may also come across the following formula for use in calculating a company's WACC:


+ D) (E
+ K
(1 ÷ t)


+ D) (E
where: K
= is the cost of equity
= the cost of debt
E = the market value of the company's equity
D = the market value of the company's debt
t = the rate of corporation tax applicable to the company.
The model assumes that debt is irredeemable.
The model is simply another approach to calculating a company's cost of capital. It is often
considered easier by students, but you should use whichever method you feel the most
comfortable with. If you wish to calculate WACC using the above formula when the debt in
the company's structure is redeemable then you should calculate the cost of debt using the
methods above and replace Kd(1 ÷ t) in the formula with the answer.
Assumptions When Using WACC
To use WACC in capital investment appraisal the following assumptions have to be made:
 The cost of capital used in project evaluation is the marginal cost of funds raised in
order to finance the project.
 New investments must be financed from new sources of funds, including new share
issues, new debentures or loans.
 The weighted average cost of capital must reflect the long term future capital structure
of the company.
Arguments Against Using the WACC
There are arguments against using WACC for investment appraisal based mainly on the
assumptions underlying WACC.
 Businesses may have floating rate debt whose cost changes frequently, and as we
have seen only an estimate is used to calculate the cost of this type of finance. Thus
the company's cost of capital will not be accurate and will need frequent updating.
 The business risk of individual projects may be different to that of the company and will
thus require a different premium included in the cost of capital.
 The finance used for the project may alter the company's gearing and thus its financial
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Effect on Market Value
The direct cost of borrowing is represented by the interest charges and fees which are
applied by the lender. In common with debenture interest, such charges will generally be
deductible for tax purposes, and therefore the after-tax cost of borrowing will usually be less
than the gross cost. Although the cost of borrowing will by and large appear cheaper than
equity, there is a risk to the company and the financial manager should take this into account
when comparing the costs of borrowing.
A company has a current profit before interest and tax (PBIT) of £5m pa and current interest
payable of £1.7m. The company's issued share capital comprises £10m in ordinary shares
and the earnings per share (EPS) are 5p.
The firm wishes to invest £7.5m of new capital and it expects to increase its PBIT by £1.25m
pa as a result. The alternatives under consideration by the directors are as follows:
(a) To issue 3.75 million shares at 200p, representing a discount on the current market
price of 240p.
(b) To borrow £7.7 million on 10-year debentures at 12% annual interest.
Assume a corporation tax rate of 33% although note that current rates will vary from this rate.
One approach to decide on the better route would be to attempt to predict the effect on the
market value of the ordinary shares. The company would then elect for the opportunity which
gives the best return to shareholders (remember the dominant objective of financial
The following table shows the effect on the earnings per share:
Current Projected
(£m) (£m) (£m)
PBIT 5.00 6.25 6.25
Interest payable (1.70) (1.70) (2.62)
Profit before tax 3.30 4.55 3.63
Tax at 33% (1.09) (1.50) (1.20)
Profit after tax 2.21 3.05 2.43
Issued ordinary shares 10m 13.75m 10m
Earnings per share 22.10p 22.18p 24.30p
From this we can see that the market value of the shares will be improved by choosing to
raise the debt capital, on the assumption that the PBIT really does increase by £1.25m.
However, the financial manager should always remember that debt is a riskier route than
equity, because:
 Debt payments cannot be deferred whereas dividends to shareholders can, should
trading estimates fail to materialise.
 Use of debt capital could result in a lower price/earnings ratio than an equity issue.
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In our example the financial gearing ratio would increase and the interest cover will fall from
the present 2.94 to 2.4. (We shall consider gearing in detail later in the course.)
Interest cover should be calculated as the number of times the interest payable can be
divided into the PBIT figure. Unequivocally, the higher the number of times, the better the
result and the less risk will be attached to the decision.
A low figure, generally less than three times cover (when interest rates themselves are low),
indicates that the company should be cautious regarding further borrowings if these are likely
to be sensitive to adverse (upward) movements in interest rates, because the company's
ability to service the necessary payments may be in doubt.
Break-even Profit Before Interest and Tax
The financial manager may choose to compute the break-even PBIT at which the earnings
per share will be the same for the use of either equity or debt.
Using the same information as in the above example, this is done as follows:
EPS under debt =
2.62) 67%(y ÷
= EPS under equity =
1.70) 67%(y ÷
(67% is used to represent the position net of tax at 33%, and y represents the break-even
13.75 (y ÷ 2.62)= 10(y ÷ 1.70)
13.75y ÷ 36.02 = 10y ÷ 17
3.75 y = 19.02
y = 5
This shows us that the break-even PBIT in our example is £5m. Earnings per share will be
greater using debt above this level, but below it equity should be favoured. In practice,
more than one source of financing may be used, and it will be important for the financial
manager to consider the risks and rewards of the alternatives.
Other Considerations
It is quite common for a company to lease a large part of its expenditure on capital items and
to use equity for its increased working capital needs although, due to the costs involved, a
quoted company will be unlikely to consider issuing less than £250,000 in new shares to be
worthwhile. Whilst the calculations demonstrated in this study unit will be simpler to apply to
quoted companies (because of the ease with which share prices can be determined) the
underlying principles will be appropriate to all businesses seeking to increase the capital
available for investment.
It is important when a business considers any particular source of finance to understand the
costs and relationships of that particular method of finance. Any method of debt finance will
require repayment and the business will need to ensure that profit and liquidity forecasts will
be high enough to meet any capital and interest payments as they become due. This will
require sound income and cash budgets to be compiled by the business on a regular and
moving basis.
Any payments of interest and capital will, therefore, result in less finance being available for
the shareholders and the business will need to ensure that there are readily available funds
for shareholders if they do not want the market to lose confidence in their business.
There are also tax reasons to be considered – for example, interest on debt capital can
currently be offset against Corporation Tax, but dividends to shareholders can not.
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For any business (particularly a large one), there is always a balance to be struck between
ensuring that there is a blend of different sources of finance within the firm, that it does its
best to ensure that it is not either too highly geared or too lowly geared and that there is
adequate available internal funds predicted to make interest and capital repayments to
lenders and dividend payments to their owners (i.e. the shareholders).
Unquoted Companies
Unquoted companies do not have market values for their shares and thus calculating the
cost of equity can be difficult. To estimate an approximate cost of capital the firm can either
use the cost of equity of a similar quoted company and adjust it for difference in gearing and
business risk, or it could add estimated premiums for its financial and business risk to the
risk-free rate given by government bonds.
Not-For-Profit Organisations
Government departments do not have a market value, nor do they have business or financial
risk, and thus cannot calculate the cost of capital. To evaluate projects they use a targeted
"real rate of return" set by the Treasury as a cost of capital.
Non-profit making firms do not generally have market values, and will thus have to determine
a cost of capital to use to assess projects – many use the cost of any borrowing they have in
their balance sheets, but you will appreciate from this study unit that it is not ideal.
Practice Questions
1. A company has a share value of £1.27 (ex-div) and has recently paid a dividend of 8p
per share. If dividend growth is expected to be approximately 3% per annum into the
foreseeable future, calculate the cost of equity.
2. Calculate the WACC from the following information:
Balance Sheet Extract from CD plc
Capital Balance Sheet Value Market Value
Ordinary shares
(20,000 – 50p ordinary) £10,000 £1.72 per share
8% Preference shares
(£1 nominal value) £5,000 £0.98 per £1
Long-term liabilities
10% debentures £7,500 £1.04 per £1
The cost of equity has been calculated at 9.5%.
Now check your answers with those given at the end of the unit.
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1. Ke =
g De ) ( + 1
+ g
27 1
03 0 1 08 0
) . ( . +
+ 0.03
= 0.065 + 0.03
= 0.095 or 9.5%
2. (a) WACC at Balance Sheet Values
Value Weighting Return Weighted Average
Equity 10,000 0.45 0.095 0.0428
Preference Shares 5,000 0.22 0.08 0.0176
Debentures 7,500 0.33 0.10 0.0330
22,500 0.0934
WACC = 9.34%
(b) WACC at Market Values
Value Weighting Return Weighted Average
Equity 34,400 0.73 0.095 0.069
Preference Shares 4,900 0.10 0.08 0.008
Debentures 7,800 0.17 0.10 0.017
47,100 0.094
WACC = 9.40%
Note that strictly speaking the return should be recalculated in line with the
market values if the information is available.
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Study Unit 7
Portfolio Theory and Market Efficiency
Contents Page
Introduction 162
A. Risk and Return 162
Expected Return 162
Measuring Risk in a Portfolio 163
B. The Impact of Diversification 164
Correlation 164
Assessing Risk under Different Forms of Correlation 165
The Importance of Correlation 168
C. Portfolio Composition 168
Investment Indifference Curves 168
Efficiency Frontier 170
The Capital Market Line 171
Efficient and Inefficient Portfolios 173
Securities Market Line 175
D. The Application of Portfolio Theory 175
Planning Diversification 175
Selected versus Random Portfolios 176
Practical Difficulties 176
Limitations of Portfolio Theory 177
E. Market Efficiency 177
Fundamental Analysis Theory of Share Values 178
Technical Analysis 179
Random Walk Theory 182
Efficient Markets Hypothesis 182
Alternatives to the EMH 184
Answers to Practice Questions 186
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Portfolio theory is a model which provides investors with an insight into the required rates of
return for a given level of risk.
A portfolio is the collection of investments or projects which an individual holds. A company
will generally also have a series of projects in its portfolio, and may make external
investments (in the financial sense) in some other investment market, when it has surplus
funds available. In order to do so effectively, and to understand investor behaviour in the
management of his firm's own share price, the financial manager requires a good working
knowledge of the "City", its efficiency and of portfolio theory.
In order to simplify the model, finance theorists have assumed perfect capital markets and, in
particular, that there are no transaction costs, and that borrowing and lending rates are equal.
Whilst they clearly do not exist in reality, the model still provides us with a basic
understanding of the effect that levels of risk have on expected returns from investment.
In determining the composition of the portfolio the investor or company will consider the
following points:
 The return received from the investment – obviously higher returns are more desirable
than low or negative returns; in general the better the growth prospects of the firm the
better the expected returns.
 Risk and security – investors will wish to minimise their risk of the level of returns
obtained and maintain at least their initial investment; often by diversifying (or
spreading the risk).
 The liquidity of the investments may be important if they are only to be held for a short
Different investors have different attitudes to risk – some are risk-seekers and others are risk-
averse. Obviously an individual's attitude to risk will affect his/her choice of portfolio.
However, risk aversion is extremely difficult to quantify in tangible terms with many factors
affecting it including age, personal wealth, family circumstances, taxation, time restrictions on
the availability of investment capital and the requirements of trust deeds.
Traditional economic theory, upon which much of this course, and portfolio theory in
particular, is based assumes that individuals are "rational risk-avoiders" – i.e. they are risk
Expected Return
An investor will expect his individual investments and portfolio as a whole to yield a certain
return. The expected return of a portfolio is the weighted average of the expected returns of
its constituent investments weighted by their proportion in the portfolio. This is best
explained by an example.
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Mr Trollope holds the following shares in his portfolio which have these expected returns:
Share Proportion Expected Return
% %
A 25 20
B 15 10
C 30 15
D 30 25
What is the expected return on his portfolio? It is the weighted average of returns:
Share Proportion Expected Return Prop. × Expected Return
% %
A 25 20 0.25 × 20 = 5
B 15 10 0.15 × 10 = 1.5
C 30 15 0.30 × 15 = 4.5
D 30 25 0.30 × 25 = 7.5
Total expected return from portfolio = 5 + 1.5 + 4.5 + 7.5 = 18.5%
Measuring Risk in a Portfolio
The return the investor will expect to receive from his portfolio is dependent principally on the
risk of the portfolio. In the portfolio the greatest risk is that the investments will fail to achieve
the required return. The risk can be measured as the standard deviation of expected returns.
These expected returns are calculated using probabilities.
Let's consider an example of an investment with the following expected returns.
Probability Factor (P) Return (r) Expected Value
0.3 10% 3%
0.4 15% 6%
0.3 20% 6%
Here the expected (the most likely) return ( r ) is 15% – it is the most likely estimate from the
information available to us. However, it is only an average figure and there will be variations
around this point. To calculate the likely variation we need to work out the variance and, from
this, the standard deviation:
P Return (r) (r ÷r ) P(r ÷ r )
0.3 10% (5%) 7.5
0.4 15% 0% 0
0.3 20% 5% 7.5
Variance: 15
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The standard deviation is the square root of the variance ( 15 ), which is 3.87%. In other
words, we have found that our likely return could fluctuate by up to 3.87% in either direction.
(You need to be familiar with the concept of standard deviation from your earlier studies in
Quantitative Methods.)
The higher the standard deviation the higher the risk. Since the standard deviation shows
the range of expected returns (in the above example these are 15% ± 3.87%), we can see
that the higher the risk, the higher the expected returns or expected losses.
In general, the higher the risk of the investment, the higher the expected return. Investors
will aim to avoid as much risk as possible whilst aiming for the highest return, and look to
strike a balance between the risk that they are prepared to take with the expected return for
that risk.
Investors and companies generally have more than one investment in order to minimise their
exposure to risk. A good example is the unit trust, which comprises a large number of
investments thereby spreading the risk incurred by the investor and generally reducing it.
Portfolio theory states that it is the relationship between the returns from the individual
investments which is important, rather than the return on individual investments. The
relationship between the returns is known as correlation.
This can take three forms.
(a) Positive Correlation
This concerns the situation which may arise when two or more investments in the
portfolio are in connected industries. It is assumed that, if one investment is successful
and rises in value, then the other in a related industry will also do well. Similarly, if the
first does badly, then the second will follow. For example, if there is a slump in the
property market, the shares in a house-building concern will fall and be followed by a
decline in the share price of related firms, such as those supplying building materials.
(b) Negative Correlation
This concerns the theory that, if one investment performs poorly, the other will do well.
In the real world negative correlation is almost impossible to achieve. One example
could be a steep rise in the price of oil. Initially this will usually benefit oil companies,
whilst the rest of the market will be depressed. You may like to try to think of similar
(c) Nil Correlation
Here, the performance of an investment is unrelated to that of another. This situation
would typically arise when investments include an engineering firm and a clothing
manufacturer. Barring a total market collapse, both investments will be expected to
perform entirely independently of each other.
From the above, we can see that, to reduce the risk, the finance manager in his or her role of
investor should choose investments which are perfectly negatively correlated, and where this
cannot be achieved, he or she should seek nil correlation as the next best alternative.
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Assessing Risk under Different Forms of Correlation
We shall consider this through an example.
Two investment opportunities have the following potential outcomes.
Investment 1:
Probability (P) Return (r)
Worst outcome 0.3 10%
Most likely outcome 0.4 15%
Best outcome 0.3 20%
Investment 2:
Probability (P) Return (r)
Worst outcome 0.3 9%
Most likely outcome 0.4 16%
Best outcome 0.3 21%
Where the investments are perfectly correlated, we can assume that if investment 1 yields
20%, then investment 2 will yield 21%, and so on. If they are negatively correlated, then
investment 1 will yield 20% whilst investment 2 will yield 9%, etc.
Having accepted the theory, we can move forward and calculate the return of a portfolio
which is composed of exactly half of each type of the above securities under conditions of
positive, negative and nil correlation.
(a) Positive Correlation
Where the two investments are positively correlated, the worst outcome will occur at
the same time for both.
Firstly, we work out the expected return of the portfolio by combining the expected
returns of each investment. The expected return for investment 1 is 15% (from the
example considered previously). For investment 2 it is:
Probability Factor (P) Return (r) Expected Value
0.3 9% 2.7%
0.4 16% 6.4%
0.3 21% 6.3%
Expected return ( r ): 15.4%
The expected return on the portfolio is therefore:
(50% × 15%) + (50% × 15.4%) = 15.2%.
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Having determined the expected return from the investment, we can now go on to
calculate the likely variation in it. From the example above, we know that the standard
deviation for investment 1 is 3.87%. The standard deviation for investment 2 is
calculated as follows:
P Return (r) (r ÷r ) P(r ÷r )
0.3 9% (6.4%) 12.29
0.4 16% 0.6% 0.14
0.3 21% 5.6% 9.41
Variance: 21.84
The standard deviation of investment 2 = 84 21. = 4.67%.
We can now consider the standard deviation of the portfolio under perfect correlation:
on 1
on 2
Probability Expected
(r ÷r ) P(r ÷r )
outcome 5% 4.5% 9.5% 0.3 2.85 (5.7) 9.75
Most likely
outcome 7.5% 8% 15.5% 0.4 6.20 0.3 0.04
outcome 10% 10.5% 20.5% 0.3 6.15 5.3 8.43
r = 15.20 Variance: 18.22
Standard deviation = 22 18. = 4.27%.
(b) Negative Correlation
If the two investments in our portfolio are negatively correlated, then the worst outcome
for investment 1 should coincide with the best outcome for investment 2 and vice
versa. Our calculations will look like the following:
on 1
on 2
Probability Expected
(r ÷r ) P(r ÷r )
outcome 5% 10.5% 15.5% 0.3 4.65 0.3 0.027
Most likely
outcome 7.5% 8% 15.5% 0.4 6.20 0.3 0.036
outcome 10% 4.5% 14.5% 0.3 4.35 (0.7) 0.147
r = 15.20 Variance: 0.210
Standard deviation = 21 0. = 0.46%.
The figures demonstrate the difference which occurs between perfect positive and perfect
negative correlation. With positive correlation, the standard deviation (the risk) is 4.27% on
our return of 15.2%, whereas with negative correlation it is only 0.46%.
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There is also a formula which you may encounter that can also be used to calculate the
standard deviation of a portfolio which contains two investments:
S = ) )(σ )(c)(σ )( 2( + σ ) ( + σ ) (
2 1 2 1
× × × ×
where: S = the standard deviation of the portfolio
= the weighting applying to the first investment
= the weighting applying to the second investment
= the standard deviation of the first investment
= the standard deviation of the second investment
c = the correlation coefficient between the investments
Using the two investments considered in the above example, we can use the formula to
calculate the standard deviation, and hence the risk, of the portfolio.
In a situation of perfect positive correlation, the correlation is expressed as + 1 and the
formula becomes:
S = (4.67) )(1)(3.87) 2(0.5)(0.5 + 21.84 (0.5) + 15 (0.5)
2 2
= 04 9 46 5 75 3 . . . + +
= 25 18.
S = 4.27%.
Under conditions of perfect negative correlation, the correlation coefficient is ÷1 and the
formula becomes:
S = .67) 1)(3.87)(4 )( 2(0.5)(0.5 + 21.84 (0.5) + 15 (0.5)
2 2
= 04 9 46 5 75 3 . . . ÷ +
= 17 0.
S = 0.41%.
The answers, as you can see, approximate very closely to the answers we calculated
previously. The negative calculation shows a slightly higher variation because of its relative
size, i.e. a standard deviation of less than half a percent.
Note that if no correlation existed at all, the correlation coefficient would be 0 and the second
half of the formula would, therefore, equal zero.
S = 0 46 5 75 3 + + . .
= 21 9.
= 3.03%
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The Importance of Correlation
You may be wondering why the relationship between the returns from the individual
investments is more important than the returns on individual investments.
When considering the risk from holding securities, we saw above that we look at the
variations in returns from individual securities and the correlation between the returns. If we
call the variance of an individual security v, and the correlation between returns from
securities c, we can see the factors affecting risk as the number of securities in the portfolio
is increased:
Figure 10.1: Variance and correlation in a portfolio
Number of
1 2 3 4 5 6 7 8 9 10
1 v c c c c c c c c c
2 c v c c c c c c c c
3 c c v c c c c c c c
4 c c c v c c c c c c
5 c c c c v c c c c c
6 c c c c c v c c c c
7 c c c c c c v c c c
8 c c c c c c c v c c
9 c c c c c c c c v c
10 c c c c c c c c c v
Thus, as the number of securities in the portfolio increases, the significance of individual
variances becomes less important, and it is the correlation between returns that is important.
When choosing his portfolio the investor will wish to maximise expected returns and minimise
risk. We can illustrate the relationship between the two using graphs and this can help us
determine portfolio composition.
Investment Indifference Curves
The basis for this is the indifference curve. The indifference curve for an investor represents
the mixtures of risk and return which will be acceptable in terms of an investment. Consider
Figure 7.2. At any point along the curve, the risk-return relationship is the same for the
investor and he will be indifferent to whether the investment is at point A or point B.
(Indifference curves are curved because of the diminishing returns provided as the quantities
of risk or return become disproportionate in the mixture towards the extremes of the curves.)
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Figure 7.2: An Investor's Indifference Curve
A will be preferable to D because it offers the same expected return for a lower risk and to C
because it offers a higher expected return for the same level of risk. A is said to dominate C
and D. Whether an investor will choose A or B depends on their attitude to risk – and
remember that an investor may be risk averse or risk-seeking.
Traditional economic theory states that individuals will seek to maximise their utility. The
Markowitz model of investment analysis seeks to measure the investor's utility function U
U = U( Ro)
where: R = the investor's expected return from the shares; and
o = the standard deviation or risk of the investment.
We can be plot this as series of indifference curves for investors as shown in Figure 7.3.
Figure 7.3: An Investor's Indifference Curves
Thus shows the portfolios between which the investor will be indifferent. They all give equal
utility – for example, A gives a lower return but has a lower risk than B.
The further the indifference curves go to the left the greater will be the value of utility to the
investor, because these portfolios provide higher returns for the same level of risk, or lower
risk for the same level of returns. Portfolios to the left of the curves are preferable because
those below are mean variance inefficient and those on or above the utility curve are mean
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variance efficient. Mean variance efficient portfolios are those which give the maximum
return for a given level of risk, or have the minimum risk for a given level of return. Mean
variance inefficient portfolios are those which are not efficient in the sense explained above.
Efficiency Frontier
We can develop the above analysis into a model of expected risk and return for all possible
If we plot the risk-return relationship for a number of investments, we get a scattergram as
shown in Figure 7.4. The resultant plot does not follow a linear course, but is regarded as
having an "umbrella" shape.
Figure 7.4: The Efficient Frontier
Those investments which maximise the expected return for a level of risk or minimise risk for
a level of expected return can be seen to fall on the line AB – this is known as the efficient
frontier. A combination of investments falling on the line AB represent the most efficient
portfolios. Before reading any further think why they give the most efficient portfolios.
The reason is that it is impossible to create a portfolio which gives a higher rate of return for a
given level of risk, or a lower level of risk for a given level of return. Remember – the
traditional economic theory on which it is based assumes that investors are risk averse.
We can now combine the indifference curve for a particular investor with this concept of the
efficiency frontier. Consider Figure 7.5.
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Figure 7.5: The Optimum Portfolio
The optimum portfolio is the one where the efficiency frontier touches the individual's
indifference curve at a tangent, shown as portfolio M. Indifference curves above the efficient
frontier are not attainable there being no portfolios of securities offering both levels of
expected return and risk.
The Capital Market Line
The return on government stocks is deemed to be risk-free (governments can always print
money to meet their obligations). This is a point on the y axis (return) of the risk-return graph
where risk is zero and is shown in Figure 7.6 as point R
– the risk-free rate of return. If we
draw a line tangential from R
to the efficient frontier we obtain the capital market line(CML).
Figure 7.6: The Capital Market Line
Any portfolio not on this line can be seen to be either mean variance inefficient (producing
lower expected return or higher risk than those on the capital market line), or to be not
obtainable (those above the line). Investors will be able to invest in a mixture of the market
portfolio and the risk-free investment. They can either invest in the risk-free investment with
or without investing in the market, or borrow at the risk-free rate and invest in the market
portfolio, or invest solely in the market.
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You may be wondering what portfolio M consists of since it is the only portfolio investors wish
to hold. All shares quoted must be held and therefore M must consist of all shares on the
Stock Market. In practice, no one shareholder will be able to hold every one, but a well
diversified portfolio of 15 to 20 shares has been found to mirror M.
An efficient portfolio would be one that offers a better combination of risk and return than that
offered by the CML (although as we saw above it is unobtainable) and an inefficient one is
one which offers a worse combination than that available on the CML.
Let's examine this in more detail. Consider the CML shown in Figure 7.7.
Figure 7.7: The Capital Market Line
We see the higher the risk the higher the expected return (this is in line with all the theory we
have discussed thus far). Using the equation for the gradient of a straight line (y = mx + c)
we can give the gradient at any point on the CML.
Consider y =
f m
R R ÷
This shows the level of expected return required to compensate investors for the risk they
are bearing (including both business and financial risk).
The expected return over and above the risk-free rate is known as the risk premium. If you
look at the CML you can see that the statement "the greater the risk the greater the expected
return" does, indeed, hold, with riskier securities offering a higher level of risk premium.
We saw earlier that the expected rate of return comprises an element for the risk premium
and return required on the risk-free securities. The return required on portfolio P (and the
equation of the CML) is:
= R

| ÷
f m
The risk premium

| ÷
f m
can be rewritten as o

| ÷
f m
Capital Market Line
Risk (o)
Return R
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The expression
is commonly known as the beta factor and, thus, the equation can be
written as:
= R
+ |(R
÷ R
where: R
= the return required on a portfolio by an investor
| = the beta factor
= the return required for holding the market portfolio
= risk-free rate
The beta factor equation can also be used to determine the required return on an individual
investment or security. Thus, the required return on a portfolio is determined by the
relationship of its risk in relation to that of the market. This is because the greater the
difference in risk of the portfolio to that of the market (measured by their respective
variances), the greater the difference in required returns.
The beta factor can be used to measure the extent to which the return on a portfolio or
security should exceed the risk free rate of return.
This point and the equation above is the basis of the capital asset pricing model which we
shall discuss in the next study unit.
The capital asset pricing model can be used to calculate the market value of equity (see
Study Unit 2) and the cost of equity (and thus the weighted average cost of capital) taking
financial and business risk into consideration.
Efficient and Inefficient Portfolios
Consider the following information:
Expected return on market portfolio = 16%
Risk-free rate of return = 8%
Measure of risk on market portfolio = 4%
If we plot these figures on a graph it would give us the CML as shown in Figure 7.8. Plotting
the CML simply involves locating the position on the graph which corresponds to the market
portfolio (M) – here, where the expected return is 16% and the risk is 4% – and joining it to
the point on the return axis corresponding to the risk-free rate (8%).
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Figure 7.8
Now consider a number of portfolios with different risk-return relationships. If we plot these
on the graph, we can establish whether they are efficient or inefficient.
Portfolio Expected Rate of Return Standard Deviation (Risk)
P 15% 5%
Q 15% 8%
R 17% 4%
S 23% 7.5%
These figures are shown plotted on Figure 7.9.
Figure 7.9
The efficiency of each of the portfolios is given by their relationship to the CML:
Capital Market Line (CML)
Risk %
2 4
Risk %
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 Portfolios P and Q are "inefficient" as they yield a lower risk/return combination than the
market portfolio.
 Portfolio R is "super efficient" as it yields a higher risk/return combination.
 Portfolio S is "efficient" because it lies on the CML and therefore yields a risk/return
combination equivalent to the market.
Securities Market Line
The Securities Market Line (SML) is the same as the CML, apart from the fact that beta co-
efficients are substituted for levels of risk.
In the above example, therefore, a risk level of 4% (the market risk) is equivalent to a beta
co-efficient (|) of 1.0. Similarly, a risk level of 2% would be equivalent to | of 0.5 and so on.
The difference between the two is that the CML measures total risk whilst the SML is related
to market risk only.
The SML and beta co-efficients can be used in two ways.
 If an investor knows the rate of return he or she requires, he or she can use a risk
measurement service to identify the beta co-efficient of suitable shares, i.e. if he or she
required a return of 12%, he or she would obtain shares with a beta co-efficient of 0.5
(i.e. a risk level of 2%).
 If the beta co-efficient of a share is known, it is possible to calculate the return it should
provide, i.e. a beta co-efficient of 1.0 in the above example should yield 16%, and so
Portfolio theory is concerned with selecting and optimising a set of investments by
considering the returns on those investments and the variability of such returns. A "portfolio"
is usually a collection of shares but it could also comprise other investment opportunities.
Planning Diversification
Portfolio theory demonstrates that risk can be diversified away with a carefully selected type
and number of securities. However, if an investor such as a company is obliged to diversify
(say by legislation or similar restrictions), portfolio theory can show that risk will actually
increase. Such investment over larger than optimum numbers of securities is called naïve
We saw above that portfolio theory can be applied to investments other than stocks and
shares, including its use by companies choosing a selection of projects and business
ventures to invest in. Companies will be able to reduce risk and stabilise profits by investing
in businesses with a negative or weak positive correlation between them – for example, a
company which produces central heating systems would reduce its risk by a greater amount
diversifying into paints than by diversifying into winter coats.
The advantages of diversification are:
 Reduced risk of corporate failure due to lower total company risk (and thus lower
potential costs of redundancy).
 More stable internal cash flows, which should help increase debt capacity, thus
reducing the cost of capital and, in turn, increasing shareholder wealth.
 Reduction in systematic risk may arise from investing in foreign markets generally
protected by barriers to trade, thus increasing the risk/return combinations available to
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A company may, however, over-diversify and may experience the following problems:
 Conglomerates often have indifferent returns leaving them vulnerable to takeover. The
Stock Market often values the P/E ratios of individual companies within the group
higher than that of the conglomerate, thus providing an incentive for the buyer of the
group to "unbundle" and sell off parts of the group.
 There will be difficulties in becoming familiar with all the parts of the group and this lack
of knowledge could lead to missed opportunities.
 Companies may lack the skills and expertise to manage all the elements of the group,
and indeed may lack the skills to manage a diversified group.
 Empirical evidence has found that investors can diversify more efficiently than
Companies considering diversification should assess the above points (tailored to their
particular industry). However, in general, some diversification does help to protect against
short-term profit fluctuations, but too much can create severe problems for the group.
Selected versus Random Portfolios
Recent years have seen a market growth in investment trusts, unit trusts, and pension and
insurance funds – all of which are, in effect, investors seeking a portfolio of investments.
How, then, do these portfolio operators fare? How do they perform in relation to, say, a
randomly-selected portfolio?
There have been numerous surveys along these lines. One survey concluded that, on
average, unit trusts performed no better than randomly-selected portfolios in the industries in
which the trusts had invested – i.e. the trust managers probably picked the right branch of
industry to invest in, but not necessarily the right company in that industry.
There is no great condemnation of professional portfolio managers, however. They will
naturally tend to err on the prudent side and go for minimum risk, even though most of their
promotional advertising stresses performance. What is never likely to be clarified is the
extent to which portfolio managers use (or are even aware of) the formal portfolio selection
techniques. Certainly, these large investors tend to have an effect on the shares they
purchase, for large-scale investments inevitably affect the market prices. The main theme of
the findings seems to be that, during times of rising markets, unit trusts do worse than
random investments; in falling markets they do better.
Practical Difficulties
When considering the application of portfolio theory, all sorts of practical difficulties come to
 Can we really measure risk in statistical terms?
 Is the standard deviation of future expected returns the only dimension involved?
 How many investments shall we consider out of the thousands available on the world's
stock exchanges if the sheer volume of computation is not to be prohibitive?
 What about the changing, dynamic nature of investment, taxation provisions and world
 What of transaction costs in amending the portfolio, the marginal value of money to an
investor, inflation, and so on?
Clearly, a great deal of work remains to be done on this topic. Markowitz refined his original
model to cut down the volume of computation. Other writers have built on his basic work,
and this is undoubtedly one area in which future bodies of theory will emerge in a more
refined state than at present.
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Limitations of Portfolio Theory
Portfolio theory is:
(a) Concerned with a single time-period framework. It is not a dynamic model and
therefore can only be revised as the anticipated performance of securities alters or new
ones become available. In this respect, it has no predictive qualities.
(b) Concerned with guesswork to estimate the probabilities of different outcomes, which
may be a particular problem when the model is being used to assess diversification by
the firm into new uncharted markets or products.
(c) Subject to investor attitudes which may be difficult to determine and reflect on when
making decisions, and investor perception or propensity for risk may well change over
(d) Not the most convenient method for considering physical investment in fixed assets or
those generating irregular cash flows. A mix of "paper" and "physical" investments is
best handled by other techniques centred on risk-reward probability theory.
(e) Based on simplifying assumptions:
(i) That investors behave rationally and are risk-averse.
(ii) The agency problem is ignored – managers may be more risk-averse than
shareholders as they may be concerned about job security.
(iii) Legal and administrative constraints are also ignored.
(iv) Taxation, in particular, can give rise to very complex models – for this reason its
effects are often ignored.
(f) Not able to cope with investment policies, such as "selling short" and other leverage
(g) Assuming constant returns to scale and divisible projects, both of which may not occur
in practice.
(h) Ignoring various other aspects of risk, e.g. the risk of bankruptcy.
The volume and type of information required can also be a disadvantage, although this is
now more widely available than used to be the case (at a cost). The quality of information,
however, is still somewhat variable, and in any case, portfolios have to be updated and
revised regularly. (The principle "Garbage in; garbage out" applies here, too!) Each revision
will carry administrative, transaction and switching costs.
A full understanding of the model requires detailed mathematical skills and is therefore in
danger of being seen as too theoretical to be useful and so ignored if its principles are not put
across to sceptical managers in a convincing way.
Individuals and companies invest in securities in order to receive income, the price reflecting
the expected returns; from shares this income comprises dividends and capital gains
(increases in share prices), from loan stock income is received as interest, the redemption
value and perhaps capital gains (arising from an increase in the market value of the stock).
In order to maximise income from such securities, the optimal time for buying and selling
them must be determined in order to maximise capital gains (or minimise capital losses).
The general rule is to purchase cheap and sell dear. To determine the optimal points many
investors enlist the help of stockbrokers and investment advisors who predict share prices
and movements within them, basing their ideas on the following underlying theories.
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Fundamental Analysis Theory of Share Values
This theory uses the dividend yield valuation model we discussed in Study Unit 2 and argues
that the price of a share is the present value of all future expected dividends and capital
gains received from the share. Thus provided all investors and their advisors have the same
information about a company and its prospects, and have identical required returns from the
company's equity, the price of the shares can be predicted.
You will remember that the model used under this method varies with the assumptions used.
The simplest model to use assumes that dividends will remain at a constant level in the
future. The value of a company's shares can be calculated using the following formula:
Market value =
shares the on yield) (or return Expected
pence in Dividend
The market price given is the ex-dividend price – i.e. excluding any dividend that may be
Example 1
Susie Ltd's shareholders expect a dividend yield of 10% and have been told that dividends
per share for the foreseeable future will be 40p. Calculate the market value of Susie's
Using the above formula to calculate the value of one share:
Value = 40p/10% = 400p or £4
However, we have seen that shareholders prefer a constant growth in their dividends. When
the expected growth figure has been determined we can calculate the value of the
company's shares using the Dividend Growth Model or Gordon's Model of Dividend
You will remember that this model states:
= d
) (
) (
g r
g 1
where: P
= the current ex dividend market price
= the current dividend
g = the expected annual growth in dividends
r = the shareholder's expected return on the shares
(Dividends are generally paid as interim dividends part way through the year and as a final
dividend after the year end. However, unless told otherwise, assume that only one dividend
is paid each year.)
Example 2
Bunny Ltd is expecting to pay a dividend of 50p this year, increasing at a rate of 5% per
annum. If its shareholders have a required return of 25%, calculate the current market price.
Using the above formula:
0.05) (0.25
0.05) 50(1
= 262.5p
Note the following two points:
 If you have a market price cum dividend (or cum div), this simply means that there is a
dividend due to be paid soon. In order to calculate the ex div price to use in the
formula, deduct the dividend from the cum div price.
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 You can also apply the same principle to the valuation of debt, using the formulae we
discussed in the last unit.
As with a lot of corporate finance there is only restricted empirical evidence testing the
validity of fundamental analysis, partially because of uncontrollable variations in share prices
caused by day-to-day fluctuations in the economy, interest rates and investor expectations
and confidence. It is therefore difficult for an analyst to predict exactly a company's earnings
and dividends and what the required returns of shareholders are. If the analyst can predict
these things, and in advance of others, then he will be able to advise his clients on which
shares to buy, sell and hold. Difficulties in predicting the uncontrollable variations using the
fundamental theory have led to the development of a body of techniques known as technical
Technical Analysis
Technical analysis, or charting (chartism) as it is also known, assumes that successive price
changes of shares are dependent, and that information about a company's future can be
determined by studying past movements in its share price. It is felt by chartists that past
movements will be repeated.
Models include the Dow Theory, which states that movements in the daily average of one
stock herald similar movements in others. A. G. Ellinger developed similar theories to Dow
which stated that share prices are determined by:
 The yield on fixed interest securities (as interest rates rise, prices of fixed interest
securities fall and exert similar pressure on ordinary shares).
 Dividends on ordinary shares.
 The confidence factor.
Ellinger stated that fundamental analysis is extremely important in deciding which shares to
buy; technical analysis charts (see below) should only be used to determine when, not what,
to buy and sell.
In addition to these systems there is the classic chartist technique of using the statistical
method of moving averages. This technique is used to determine trends and more
importantly, changes in trends in share prices and to remove the day-to-day fluctuations we
discussed above. A 20 day moving average will provide an indication of the underlying trend,
whilst 60, 90 and 240 days will provide indications of longer-term movements. The trends in
share prices will be plotted and the following features highlighted as being of importance.
(a) Head and Shoulders
This is illustrated in Figure 7.10.
The rising price trend is reversed slightly before increasing to a higher level; there is
then a fall in share prices to around the level of the previous low before rising to around
the first high point before falling again. Any falls below the neckline are an indication to
sell; future trends upwards would indicate the reverse. Sometimes this pattern is seen
in reverse, and the chartist would supply the opposite advice.
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Figure 7.10: Head and Shoulders
(b) A Double Bottom
Here, the falling price trend reverses for a while, before falling to the minimum point
again. Following this second fall the price begins to rise. Once the minimum point has
been reached for the second time, the chartist would use past experience to predict
that the price trend was now upwards.
Figure 7.11: Double Bottom
(c) A Double Top
Figure 7.12: Double Top
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Here, the rising price trend reverses for a while before rising again to the maximum
point. Following this second rise the price begins to fall. Once the maximum point has
been reached for the second time, the chartist would use past experience to predict
that the price trend was now downwards.
(d) Resistance Level
Share prices can be seen to fluctuate around a rising or falling trend; once the trend
departs from the line then the chartist would say that the previous trend has passed the
resistance level.
Figure 7.13: Resistance Level
(e) The Hatch System
This theory, an example of a "filter" system, states that as a chart of share price
movement is built up, the potential investor can not know when an exact peak or trough
point has been reached. Thus he will try to sell or buy as near these turning points as
possible (within 10% is considered to be as good as possible).
Figure 7.14: The Hatch System
The investor should average a suitable index, e.g. the Financial Times Share Index, for
every month. When the index is rising he will hold on to a share until the average
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indicates a reading which is 10% below the highest recorded level in chronological
sequence. At this point he should sell.
Conversely, when the average is falling, the investor should not enter the market until
the average reading is 10% above the previously recorded low.
The biggest drawback of this system arises because activating signals may occur too
often with the result that transaction charges will be excessive in relation to the
A major problem with all "systems" is the absence of a really comprehensive indicator of the
state of the market. Conventional indices include only a limited number of securities and
cannot truly reflect the whole market.
In general terms the chartist models are all based around historic data from which attempts
are made to predict the future. Statistically most have been proved to be invalid and lacking
theoretical underpinnings, but it has not limited the market for new ideas and charts and
chartists apparently flourish. This may be because of some very successful chartists who
have had more success than average. However, probably the principal benefit of the use of
charts stems from their clarity and ease of comprehension to the lay person.
Random Walk Theory
In the 1950s Kendall working in the UK, and Roberts working in the USA, found that
successive share price changes are practically independent over time, and that share prices
follow a "random walk", reacting to new information regarding the company as it becomes
available. Research into this "random walk" led to the formulation of the efficient market
hypothesis (EMH).
The random walk theory relies on the stock markets being efficient and displaying perfect
market characteristics. The principles underlying the theory are that:
 The market price of a security represents the market's consensus as to the valuation of
that security.
 Public information is widely available to investors – about the economy, financial
markets, the individual company, its results and prospects.
 Market prices adjust readily and quickly to new situations, e.g. changes in interest rates
or decisions (good or bad) taken by the company.
 No investor is large enough by himself to influence the market price of the share.
 Transaction costs are low or zero.
 There are negligible restrictions on investment.
Efficient Markets Hypothesis
Efficient markets are capital markets which have the following features:
 No individual dominates the market;
 Costs of buying and selling are at a level that does not discourage trading to any
significant extent;
 Share prices change quickly in response to all new information available to buyers and
To fully understand the EMH we will look first at three interrelated measures of efficiency –
allocative, operational and information processing efficiency.
 Allocative efficiency is the optimum allocation of funds within the financial markets,
i.e. that which will maximise economic prosperity.
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 Operational efficiency is the lowest level of transaction costs that are possible and is
present when there is open and free competition within the market.
 Information processing efficiency is the quick and accurate pricing of securities,
preventing speculation pushing prices to unrealistic levels.
In finance a distinction is made between three potential levels of information processing
efficiency – the weak form, the semi-strong form and the strong form.
 The weak form
The information available to investors is historical information on past share prices and
company results. Share prices change as and when this information becomes
 The semi-strong form
The investor has access to all publicly available information about a company including
press releases. Share prices react not only to released information, but also to the
expectation of changes in the company's fortunes. Investors will be able to see beyond
creative accounting or "window dressing" by companies in an attempt to overstate
 The strong form
The share price reflects all available information, including inside information. Acting
on insider information is illegal and so it is very difficult to get an accurate picture of its
There has been a large amount of empirical research on this theory in the UK and the USA,
and the overwhelming evidence is that security markets are efficient in a semi-strong sense
(and thus also in the weak sense) – i.e. that share prices follow a random walk, and react to
all available information and the expectations of information, e.g. of a proposed merger. As
with all theories there are times when it does not appear to hold, e.g. in the Stock Exchange
crash of October 1987 when 40% was removed from the value of shares with no underlying
expectations of falls in the economy or company prospects. (However, the expected fall of
1989 did not occur.)
You may be wondering how the 1987 crash can be explained. One theory proposed by Hill
is that the EMH holds best when the market is stable but, during a bull phase (as in 1987) or
a bear phase the market is driven by speculation and uncertainties. This irrationality can also
be seen when there is an over-reaction in the short term to company and/or economic
events, over-emphasis placed on large companies, and the fact that price movements can
sometimes be related to the time of day, week, month or year.
The EMH and the empirical evidence noted above indicating its validity have implications for
companies, investors and analysts.
(a) The current market price is the best available indicator of a share's intrinsic value –
therefore the fundamental analysts' search for undervalued shares using publicly
available information is a waste of time, and analysts should concentrate more on
efficient diversification for clients.
(b) Individual investors should not worry about investment analysis but should instead
choose a well diversified portfolio consistent with their risk preferences.
(c) NPV techniques should be used for evaluating projects because this is how the market
will evaluate the company.
(d) The market value of the firm will only be as good an estimate of intrinsic value as the
quality of public information available concerning the company permits.
(e) Creative accounting is seen by the market as a sign of weakness rather than strength.
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(f) The timing of new issues is deemed to be unimportant and there is no need to
substantially discount them as they will be correctly priced by the market.
(g) Large premiums paid above the market price on takeover are difficult to justify.
The efficient market hypothesis does not imply perfect forecasting ability, but states that the
market makes a correct evaluation of uncertain future events. Nor does it imply that portfolio
managers are incompetent, even though on average the experts do no better than the
general investor, or that share prices cannot represent fair value because they are
consistently moving up and down – indeed, it is the working of the EMH that is reflected in
fluctuating share prices and which prevents investors/portfolio managers consistently
outperforming the market.
You may be wondering why, if the EMH shows that fundamental analysis does not produce
excess returns, so many people are employed doing fundamental analysis. Firstly, some
people disbelieve the EMH and believe they can outperform the bull market during a bull
phase. Secondly, some investors will be more successful than average while others will not
(but due to chance rather than consistently outperforming the market using publicly available
information), and therefore investors regard "gambling" on the markets as a "fair game".
There is also evidence that unit trusts, whilst doing no better in bull markets, do tend to do
better in falling markets.
Finally, and ironically, it is the continual search for company information by fundamental
analysts which ensures there is an efficient flow of information in the market which is
essential for the EMH to hold.
Alternatives to the EMH
Over the past two decades there have been several financial scandals including the use of
(illegal) insider information. This has led to some experts dismissing the EMH except in its
weakest form and deriving alternative theories of market behaviour.
(a) Speculative Bubble Theory
This theory states that the price of securities moves above their true value creating a
bull market because investors believe they will rise in future. However, eventually the
"bubble" will burst when investors look at all previously available economic and
company information and a crash will occur. Thus rises and falls in the market do not
reflect economic conditions.
There is some empirical research supporting this, including evidence that investors are
risk-seeking in a bear market in an attempt to minimise their losses.
(b) Catastrophe Theory
This developed from the Speculative Bubble Theory and argues that capital markets
have the following characteristics:
 They are dynamic.
 They use "feedback" mechanisms with "critical" levels – when activity reaches
particular levels the equilibrium prices of the market no longer exist.
 Prices in such markets are not based on economic forecasts, and small changes
in the events affecting a company can lead to disproportionately large changes in
its security's prices.
The latter point leads to large scale "chaos" or instability making predictions of prices
impossible except in the short term. The chaos is made worse if there is a large
number of speculators who amplify price movements in their attempts to maximise their
own profit. This, it is argued, is one reason for the phenomenon of short-termism we
discussed in Study Unit 1.
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(c) Coherent Market Hypothesis
Vaga (1991) developed the Catastrophe Theory and stated that the market may be in
one of the four following states:
(1) Coherence
(2) Chaos
These two states are both based on prices being determined by crowd behaviour – the
former in a bull phase and the latter when the markets are more bearish.
(3) Unstable transition
(4) Random walk
These two states are underpinned by economic events, the former market being an
inefficient market and the latter being an efficient market.
Vaga argues that the 1987 crash (see above) was an example of state (2).
Practice Questions
1. Show the effect of perfect positive and perfect negative correlation between the
following investments within a portfolio. (Assume a 40 : 60 ratio.)
Investment A Investment B
Return Probability Return Probability
Best outcome 5% 0.2 7% 0.2
Most likely outcome 15% 0.6 14% 0.6
Worst outcome 25% 0.2 21% 0.2
2. From the following data, draw the CML and show whether portfolios A and B are
efficient or inefficient.
Expected return on the market portfolio = 14%
Risk-free rate of return = 5%
Measure of risk of market portfolio = 6%
Portfolio Expected
Standard Deviation
A 17% 7%
B 10% 4%
Now check your answers with those given at the end of the unit.
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1. Using the formula:
Investment A
Return Probability Expected
(r ÷r ) P(r ÷r )
Best outcome 5% 0.2 1.00 (10) 20
Most likely outcome 15% 0.6 9.00 0 0
Worst outcome 25% 0.2 5.00 10 20
r = 15.00 Variance: 40
Standard deviation = 40 = 6.32
Investment B
Return Probability Expected
(r ÷r ) P(r ÷r )
Best outcome 7% 0.2 1.40 (7) 9.8
Most likely outcome 14% 0.6 8.40 0 0.0
Worst outcome 21% 0.2 4.20 7 9.8
r = 14.00 Variance: 19.6
Standard deviation = 6 19. = 4.43
(a) Under Perfect Positive Correlation
SD = (4.43) )(1)(6.32) 2(0.4)(0.6 + 19.6 (0.6) + 40 4 0
2 2
) . (
= 44 13 06 7 4 6 . . . + +
= 9 26.
= 5.19%
(b) Under Perfect Negative Correlation
SD = .43) 1)(6.32)(4 )( 2(0.4)(0.6 + 19.6 (0.6) + 40 4 0
2 2
÷ ) . (
= 44 13 06 7 4 6 . . . ÷ +
= 02 0.
= 0.14%
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2. The CML, market portfolio (M) and portfolios A and B are shown on the following graph.
Portfolio A is superefficient.
Portfolio B is inefficient.
2 8 6 4
Risk %
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Study Unit 8
The Capital Asset Pricing Model
Contents Page
Introduction 190
A. Risk, Return and CAPM 190
Systematic and Unsystematic Risk 190
Measuring Systematic Risk 191
Market Risk and Return 192
The Beta Factor and Market Risk 193
The Capital Asset Pricing Model Formula 195
Alpha Values 195
The CAPM and Share Prices 195
The CAPM and Gearing 196
B. Calculation of Betas 196
C. Validity of the CAPM 197
CAPMAssumptions 197
Limitations of CAPM 198
D. Practical Applications of CAPM 199
CAPM and Portfolio Management 199
CAPM and Capital Investment Decisions 200
E. The Arbitrage Pricing Model 200
Answers to Practice Question 202
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In the last study unit we discussed portfolio theory and said that it underpins the Capital
Asset Pricing Model (CAPM). CAPM was developed in the 1960s by Sharpe and Litner
building on the work of Markowitz and portfolio theory. The model at its simplest brings
together aspects of share valuations, the cost of capital, and gearing, and thus has important
implications in financial management.
For our purposes, we can make the assumption that there are two basic functions associated
with the CAPM:
 Attempting to establish the "correct" equilibrium market value of a company's shares.
 Calculating the cost of a firm's equity (and thus the weighted average cost of capital),
as an alternative approach to the dividend valuation model which we considered in a
previous unit.
The model also implies equilibrium between risk and the expected return for each security
and can be used by the financial manager in the assessment of risk in either individual
company shares or a portfolio of securities.
There is risk associated with investment in any security, and we said in the last study unit that
the greater the risk, the greater the required return from the investment. However, one type
of stock which has a low risk, and which is assumed in portfolio theory to be risk-free, is
Treasury bills (because, as we have already seen, the Government is unlikely to renege on
its commitments to pay the returns agreed on the bills). The difference between a higher
return and that achieved at the risk-free rate is known as the excess return, and it will differ
between securities depending on the market's perception of the relative risk of each.
The only way for an investor to avoid risk altogether is to invest solely in government
securities, but in doing so the investor will trade off risk for a lower return than might
otherwise have been made.
Systematic and Unsystematic Risk
We showed in the last study unit that risk comprises financial and business risk. We also
saw that investors tend to diversify their portfolios to reduce their risk whilst maintaining their
return. The risk which can be diversified away is known as unsystematic risk, and is unique
to a particular company. It is independent of political and economic factors, and may arise,
for example, as a result of bad labour relations causing strikes, the emergence of improved
competitor products or adverse press reports. It is diversified away because the factors
causing it are different for different companies and cancel each other out.
The risk related to the market, however, cannot be diversified away (if it could then the return
on the market would not be higher than the risk-free rate), and is known as systematic or
market risk. Systematic risk is unavoidable risk. Systematic risk may also vary between
projects. Such risk may arise as a result of government legislation, from adverse trends in
the economy or from other external factors over which the company has no control.
The two types of risk are significant, because in building a portfolio of shares the investor will
want to minimise unsystematic risk.
We noted earlier that research has found that if a portfolio has between 15 and 20 shares
selected at random then the unsystematic risk in the portfolio should be eliminated.
Increasing the size of the portfolio up to this level will certainly reduce the level of
unsystematic risk (see Figure 8.1).
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Figure 8.1: Systematic and systematic risk
Although by definition unavoidable, the degree of systematic risk will be a variable factor
between different industries – shares in different companies will have systematic risk
characteristics which are different from the market average because the market considers
some investments to be riskier than others (for example, food retailers are lower risk than
those in the fashion industry). When an investor holds a portfolio which is balanced
throughout with all available stocks and shares, or a unit trust which mirrors the market, he
will incur systematic risk which is equal to the average systematic risk in the market as a
We can also see that individual investments will have their own levels of systematic or
market risk.
Measuring Systematic Risk
The CAPM is principally concerned with:
 How systematic risk is measured.
 How systematic risk affects the required returns and share price.
In order to measure systematic risk, we use the beta factor ().
The CAPM also includes some fundamental assumptions which we can summarise as
(a) Investors in shares (as opposed to risk-free investments, which are generally
government securities) require a return which is in excess of the risk-free rate as a
form of compensation for taking the systematic risk of the investment.
(b) Investors should not require a premium for unsystematic risk as this may be diversified
and removed from the portfolio (as discussed earlier).
(c) As the systematic risk is higher for some companies (as measured by their  factor)
the investor will expect a greater return and will continue to do so as the  gets larger.
(d) Investors are rational and want to maximise their return.
(e) All information is feely available to investors and they are competent in interpreting
that information.
(f) Investors are able to borrow and lend at the risk free rate.
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(g) Capital markets are perfectly competitive with a large number of buyers and sellers,
no monopolies, no taxes or transaction costs, and no entry or exit barriers to the
The financial manager may, incidentally, adopt a similar approach to investment in one or
more new projects. When a company is considering an investment in a new project, there
will be a degree of risk involved. The greater the perception of risk in the venture, the greater
will be the expected return (assuming, of course, that the directors are willing to sanction the
investment in the first place).
Market Risk and Return
The CAPM was formulated principally to evaluate investments in stocks and shares ("the
market") as opposed to investment projects under consideration by companies. The model is
based on the comparison of systematic risk within individual investments and shares, with
that in the market as a whole (hence systematic risk also being described as market risk).
Market risk, in its simplest form, is the average return of the market.
Market risk is, of course, something which is almost impossible to determine with any degree
of accuracy, as it is based on the total expected market return. As the components of the
market fluctuate consistently, so the systematic risk attached to shares will also change.
Therefore CAPM must make one major and fundamental assumption – that there is a linear
relationship between the return obtained from one single investment and the market average.
Let's look at an example.
Our aim is to demonstrate at a basic level how the return from one investment compares with
the market:
Company A Whole Market
Price at start of period 110 490
Price at end of period 130 510
Dividend paid 6.5 40.1
The return on Company A's shares (R
) and the return on the general market portfolio of
shares (R
) may now be calculated as follows:
period of start at Price
Dividend loss) (or gain Capital 

6.5 110) (130  
 0.24

40.1 490) (510  
 0.12
Statistical analysis of "historical" returns from Company A and from the "average" market may
suggest that a linear relationship exists. Thus, the linear relationship can be demonstrated
through collecting comparative figures from Company A and average market returns (say on
a month by month basis). The results can then be plotted on to a scatter diagram and a line
of best fit can then be drawn with linear regression (see Figure 8.2).
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Figure 8.2: Relationship of returns between one company and the market
This approach to analysis could bring out three important issues, namely:
 The return from Company A (R
) and the return from the market (R
) will tend to rise or
fall together.
 The return from R
may be higher or lower than R
because the systematic risk of an
individual security differs from that of the whole market. Company A is an illustration of
an investment which provides generally higher returns than the market and is therefore
considered more risky than the average.
 The graph may not always produce a line of good fit. This typically happens when
there is insufficient data to be plotted, and the data available is being affected by both
unsystematic and systematic risk.
Negative returns may also be possible, which may happen when share prices drop suddenly.
This will then amount to a capital gains loss, thereby equating to a negative return.
Our example demonstrates the relationship between an individual company's systematic risk
and that of the market fairly predictably. The measure of the relationship between the returns
of the company and those of the market can then be developed in the beta factor () for that
company. The line of best fit, also known as the characteristic line, will dictate the beta
factor – the steeper the line, the greater will be the beta factor.
The Beta Factor and Market Risk
The beta factor is a measure of a share's volatility in terms of market risk.
We can identify three possibilities for that measurement:
 Where  > 1, the shares would be described as aggressive, i.e. they would outperform
the Stock Market whichever way the general trend in prices was moving.
 Where   1, the shares would be described as neutral, i.e. they would follow the
general trend of the Stock Market.
Return from
company A’s shares
Return from whole market (R
Line of best fit
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 Where  < 1, the shares would be described as defensive, i.e. they would be less risky
than the market generally.
As you will see, the market as a whole is assigned the value of "1". If a company's beta
factor is 2, this would indicate that it would return twice as much as the market generally.
Therefore, it would be expected that, if the market return (R
) rose by 5%, then the return in
a company (R
) with a beta factor of 2 would rise by 10%. Variations in the company's return
) outside this would be specifically due to the impact of its own unsystematic risk, which is
unique to that company.
We should remember that another essential characteristic of the CAPM is that unsystematic
risk can be cancelled out by diversification of the portfolio. In a simple example, Company
Y's shares do worse than the average market returns and Company Z's do better (as
originally predicted by the beta factor). The net effect will be self-cancelling and therefore the
unsystematic risk has been removed from this hypothetical portfolio.
In such circumstances, the average return on the portfolio will be dependent upon:
 Changes in the average market return, and
 The beta factors of the shares which make up the portfolio.
We will now look at a further example to highlight these points.
Suppose that:
(a) The return on government stock is 10%.
(b) The average market return is 15%.
(The difference of 5% is therefore the excess return as we described earlier.)
The difference between the risk-free return and the expected return on an individual
investment can be measured as the excess return for the market as a whole, multiplied by
the beta factor of the investment.
Now suppose that we take the example of a company with a  of 1.4, the risk-free return is
9%, and the expected market return is 13%. The expected return on the company's shares
would exceed the expected market return by:
1.4(13  9)%, or 5.6%
(The total expected return would be 14.6% (9  5.6).)
If the market as a whole fell by an average of 3%, to 10%, then the total expected return on
the company would also fall as follows:
9%  1.4(10  9)  10.4%.
(The fall is represented by 1.4  3%  4.2%)
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The Capital Asset Pricing Model Formula
We can now move on to specify the formula for the CAPM.
The formula is based on the risk-free rate of return, the excess rate of return and the beta
factor of the security in question. It is expressed as:
 R
)  (R
 R
or R
 R
 (R
 R
where: R
 expected return from an individual investment
 the risk-free rate of return
 the market rate of return (the return on the all share index)
  the beta factor of the investment.
Alpha Values
The alpha value of a share is used to measure the amount by which the return on that
investment is either above or below what is expected, given its level of systematic risk.
A company's shares have a  of 1.2, and an alpha of 2%. The market return is 10% and the
risk-free rate is 6%.
The expected return  6%  1.2(10  6)%  10.8%.
The current return is 10.8%  2%  12.8%  expected alpha return.
You should note that alpha values are only temporary rates and can be () or (). They will
tend towards zero for shares over time and will for a diversified portfolio actually be zero if
the portfolio is taken as a whole.
Where alpha values are positive, they may attract investors, because of an implied abnormal
return, and the reaction will be a temporary increase in the share price.
The CAPM and Share Prices
The CAPM can also be used to predict share values as well as estimating returns from
investments carrying different levels of risk. This is shown in the example below.
Company A and Company B pay an annual return of 34.04p per share and this is expected to
carry on indefinitely. The risk-free rate is 8% whilst the average market rate is 12%.
Company A's   1.8 and Company B  0.8.
We will now calculate the expected return and predict the market value of each share, as
The expected return for A  8%  1.8(12%  8%)  15.2%.
The expected return for B  8%  0.8(12%  8%)  11.2%.
Using the dividend valuation model, the expected price of the share can be calculated:
Predicted share value in A 
 224p.
Predicted share value in B 
 304p.
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The CAPM and Gearing
Whilst we will look at gearing in detail in the next study unit, you will already be aware that
the level of gearing in a company will affect the risk of its equity. Correspondingly, the 
factor will alter. The extra risk for which the investor is being compensated is systematic risk
which should be reflected in the company's  factor.
We will return to this concept later in your studies.
In the last unit we explained that the slope of the capital market line (also known as the
characteristic line) dictates the beta factor of a security, and as such it can be calculated by
measuring the gradient of the securities market line.
The gradient can be calculated using regression analysis. To calculate the gradient (and
thus the beta) you would use one of the following regression formulae:
(1)  
) variance(m
m) s, covariance (
where: m  return from the market
s  returns from the security.
i.e. the covariance of returns on an individual security with the market as a whole
divided by the variance of the market returns
(2)  
2 2
x) ( x n
y x xy n
  
   
where: n  number of pairs of data for x and y
(3)  
sm s
ρ σ
where: 
 the standard deviation of returns on the market

 the standard deviation of returns of the company's equity

 the correlation coefficient between the total returns on the company's
equity and the total returns on the shares of the individual company.
Returns on Jack plc's shares have a standard deviation of 12% – twice as high as that of the
market. It is estimated that the correlation coefficient of the market and Jack plc's returns is
0.45. If the estimated market return is 17% and the return on government bonds is 9% –
(a) The beta of Jack plc's shares;
(b) The cost of equity for Jack plc.
Using the above formula (3), we can calculate Jack's beta – remember that Jack's standard
deviation is twice that of the market and therefore the market standard deviation is 12/2  6.
 
sm s
ρ σ

45 0 12 . 
 0.9
The beta of Jack plc's shares is therefore 0.9.
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The cost of equity is the return shareholders expect to obtain from holding their shares (i.e. it
is the expected return from the investment) and can be calculated using the capital asset
pricing model:
 R
  (R
 R
Government debt can be assumed (unless told otherwise) to be risk-free, and thus the return
on it is equivalent to the risk-free rate.
 9  0.9(17  9)  16.2
Therefore the cost of equity for Jack plc is 16.2%.
You may feel that this is a very theoretical area, and many of the underlying assumptions
taken from economic theory are unrealistic. However, the lack of realism is unimportant if the
model can correctly predict the return on a security or portfolio for a given level of risk.
We can list the various assumptions underlying the CAPM and assess the validity of each as
 Investors are risk averse and require greater return for taking greater risks.
Empirical evidence supports this.
 There are equal borrowing and lending rates
Generally borrowing rates are higher than lending rates. However, the CAPM can be
modified to incorporate this and the results remain the same.
 There are no transaction costs
The existence of transaction costs means that investors may not undertake all required
transactions to make their portfolios efficient, thus the CML may be a band rather than
a line.
 There are no market imperfections
Market imperfections do exist and may mean that unsystematic risk may be of some
 Homogeneous expectations
Clearly not all investors have the same view on the prospects of securities. However,
when the assumption is relaxed the CAPM has been found to still maintain its
predictive abilities.
 No taxation
The existence of taxation may mean that shareholders prefer capital gains or
dividends. However, when this assumption is relaxed the CAPM has still been found to
maintain its predictive abilities.
 There is no inflation
Inflation clearly exists and may be seen as an additional risk. However, when
incorporated into the model, the model can still predict the required returns accurately.
It is difficult to test the CAPM because the model deals with expected returns and all
securities, and it is only possible to record actual results and those securities included in
market indexes. (Market indexes generally contain only a sample of the securities available
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to investors.) Empirical research suggests that although CAPM is not a perfect model of the
real world it does provide a reasonable model of risk/return trade off. For example, low beta
shares do provide lower expected returns than higher beta shares; however, low beta shares
often provide returns above, and high beta shares returns below, those which the model
would predict. The CAPM is used in practice as a decision-making tool in the choice of
portfolios in both the UK and the US.
Limitations of CAPM
The practical use of CAPM is limited by two major factors. These are:
 the acceptability of the assumptions which are not really applicable to the "real world";
 the problems of using the model, given that the assumptions are accepted. For
example, calculating  by examining past returns is assumed as being valid for
decision making about the future and this is far from being acceptable.
The most critical of the assumptions is that individual investors are able efficiently to diversify
away unsystematic risk. The assumption of efficient diversification is itself dependent on
many other assumptions, including those of a perfect capital market, rationality of investors,
etc. Also, you should remember that CAPM is based on a one-year time period, and its
extension to multiple time periods requires the economic environment and returns on the
project relative to the market to remain reasonably stable. It must therefore be used with
care when evaluating projects over longer periods.
Further problems include those of estimating returns on projects and the market under
different economic conditions; the probabilities of these different conditions occurring; and
the determination of the risk-free rate. There are several government securities and their
return depends on their term to maturity.
There are many reasons why entrepreneurs may not diversify enough as required by CAPM.
One compelling reason is that managers simply do not want to diversify from a business that
they know well, and perceive considerable difficulties in moving outside of their experiences.
Similarly, managers may not wish to be actively restrained from "playing the markets",
whatever the arguments in favour of diversifying away risk. Moreover, there is considerable
effort and overhead involved in an individual investor attempting to manage a portfolio of
investments actively over any length of time. Managers also argue, quite correctly, that it is
for the shareholders to diversify their own risk and construct a portfolio to their own
preferences, rather than any individual company representing a fully balanced portfolio itself.
While these views appear "irrational" from a purist modeller's viewpoint, you can argue that
there is nothing rational in acting against your instincts and preferences.
Outside the very short term, the market imperfections of lack of divisibility of investments,
fixed charges, imperfect opportunities and poor information mean that the model has poor
predictive ability. Furthermore, each investment or project should have its own discount rate
according to its systematic risk as measured by its beta co-efficient. The discount rate in any
one year then depends on the risk-free rate of interest and the market risk premium in that
year. There are ways of forecasting such vagaries but such are the complexities of doing so
that it is beyond the scope of this discussion.
There have been many critics of CAPM such as Rolls (1977) who criticised it as being
untestable because the benchmark market indices employed, such as the FTSE All Share
Index, are poor substitutes for the true market portfolio.
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CAPM and Portfolio Management
The capital asset pricing model has several practical uses, and beta factors of individual
securities are published by a number of analysts (e.g. London Business School) for
investment and other purposes. The capital asset pricing model can be used by investors in
selecting their portfolios of shares, thus reflecting the individual's risk preference. A risk-taker
would select a portfolio with a beta greater than 1 (large gains/large losses) whereas
someone more cautious would select a beta equal to or less than 1. Portfolios of securities
have beta factors which are the weighted average of the betas of the securities within the
Jessica wishes to know the expected return on her portfolio, when the risk-free rate is 7%
and the return on the market is expected to be 20%. Her portfolio is made up as follows:
Security Percentage of
Beta Factor of Security
R plc 15 0.2
S plc 10 1.2
T plc 5 1.8
U plc 30 0.9
V plc 25 0.2
W plc 15 0.8
Firstly, let us calculate the portfolio's beta. This is simply the weighted average of the
individual betas:
Portfolio's beta  (15%  0.2)  (10%  1.2)  (5%  1.8)  (30%  0.9)
 (25%  0.2)  (15%  0.8)
 0.03  0.12  0.09  0.27  0.05  0.12  0.68
The expected return on the portfolio would be
 R
  (R
 R
) so R
 7  0.68(20  7)  15.84%
Whilst considering the above, a general rule for investors is to buy high beta shares in a bull
market and sell them in a bear market (and replace them with shares having low betas in a
bear market).
As discussed above there are several problems with the CAPM which affect its use in
portfolio management:
 Whilst beta factors are fairly stable over time, errors in calculating them and genuine
statistical variations mean that companies should use industry betas rather than
individual company betas in order to obtain reliable results. In addition, changing
market demands (e.g. telephones are now considered more of a necessity than 30
years ago) and changing cost structures in firms (firms tend to have a greater
proportion of fixed costs than in the past) means that a company's beta will not remain
stable over time.
 The risk-free rate is assumed to be equal to returns on government bonds – but there
are several government securities with different terms and interest rates.
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 The model deals with expected returns but it is the historical excess return on the
market (R
 R
) that is used.
 The CAPM and portfolio theory are based on perfect, efficient markets with rational
investors who have diversified away all unsystematic risk. In reality, however, investors
may not have well-diversified portfolios and will thus be concerned about their total risk.
The model also ignores the costs of trading and insolvency – which do exist in the real
world and the investor must consider them.
CAPM and Capital Investment Decisions
If CAPM is accepted, it might be concluded that, when deciding whether to invest in a
particular project, management should be concerned with its systematic risk and not with its
overall risk. If the  factor can be estimated, then it is possible, using the formula given
earlier, to calculate the minimum required return on the project, based on the systematic risk
of the project. The model can thus be used to compare projects of different risk classes,
unlike the NPV method which does not consider risk in its choice of discount rate.
In using the model, management are determining a required rate of return based on market
and risk-free rates of returns, the returns on the project and its variation to the market; in so
doing they are assuming that shareholders wish them to evaluate such projects as though
they were stocks and shares in the market, and that shareholders are fully diversified
themselves and have no desire for the company to diversify on their behalf.
The problems associated with the CAPM have led to the development of other models,
including the Arbitrage Pricing Model (APM).
The CAPM is often criticised for its simplified relationship between risk and return. The APM,
however, assumes that the return on security is based on a number of factors, each of which
is independent of the others; and that the expected rate of return on a security is a function of
the risk premiums discussed below plus the risk-free rate. The model states that:
r  E(r
)  
 
 
 
 ……….e
where: E(r
)  the return expected from the security

 the sensitivity to changes in factor 1
 the difference between the expected and actual values of factor 1

 the sensitivity to changes in factor 2
 the difference between the expected and actual values of factor 2

 the sensitivity to changes in factor 3
 the difference between the expected and actual values of factor 3

 the sensitivity to changes in factor 4
 the difference between the expected and actual values of factor 4
e  a random term
In order to determine the factors to which returns on the securities are sensitive, and which
form the basis of risk factors, factor analysis is undertaken. Key factors identified include:
 Changes in the expected level of industrial production
 Unanticipated changes in the term structure of interest rates
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 Unanticipated changes in inflation
 Changes in the risk premium on bonds
If it is expected that a certain combination of securities will produce higher returns than
indicated by the model then arbitrage trading will occur with the aim of improving expected
returns. When no arbitrage opportunities remain, the expected return on a security will be:
)  r
 
 r
)  
 r
)  
 r
)  
 r
)  ……….
where: r
 the risk-free rate
 the expected return on a portfolio which has unit sensitivity to factor 1 and zero
sensitivity to any other factor
 the expected return on a portfolio which has unit sensitivity to factor 2 and zero
sensitivity to any other factor
 the expected return on a portfolio which has unit sensitivity to factor 3 and zero
sensitivity to any other factor
 the expected return on a portfolio which has unit sensitivity to factor 4 and zero
sensitivity to any other factor
The advantages of APM compared to CAPM are:
 The need to determine the market portfolio is removed.
 Systematic risk is broken into small components which need not be determined initially.
 APM explains the pricing of securities in relation to each other, as opposed to CAPM
which explains pricing in relation to the market as a whole.
The APM, however, does have disadvantages:
 There is a need to identify those factors to which a security is sensitive.
 The model is based on simplifying assumptions including portfolio theory, and perfect
The APM, in common with CAPM, is a method of dealing with risk and return in uncertain
conditions. Empirical evidence has cast doubt upon, but not disproved, either model;
however, Hill (1995) states that CAPM is the model used in practice to determine the
performance of portfolios, mainly because the APM has not as yet been fully developed.
Practice Question
Calculate the return on a particular share with a beta factor of 0.7, given the following data:
Return on government securities: 6.5%
Market return: 9%
What would happen if market return:
(a) Increased to 12%?
(b) Fell to 5%?
Now check your answer with the one given at the end of the unit.
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The return on the share  6.5  0.7(2.5)  8.25%
(a) The result of the increase in market return is that the return on the share rises as
6.5  0.7(5.5)  10.35%
(b) The result of the fall in market return is that the return on the share falls as follows:
6.5  0.7(1.5)  5.45%
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Study Unit 9
Capital Structure
Contents Page
Introduction 204
A. Capital Gearing 204
Gearing Ratios 205
Valuation Basis 207
Scientific Approaches 207
B. Factors Determining Capital Structure 208
Ability of Earnings to Support the Structure 208
Attitudes of Capital Suppliers 209
Patterns of Assets and Trading 210
Demand Patterns 210
Attitudes of Management and Proprietors 211
C. Theory of Capital Structure 211
Traditional View of Capital Structure 211
Modigliani and Miller 212
Impact of Taxation on the Cost of Capital and Capital Structure Decisions 215
D. Capital Gearing and the Effects on Equity Betas 217
E. Operational Gearing 218
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Capital structure relates to the way in which a business is financed by a combination of long
term capital (ordinary shares, reserves, preference shares, debentures, long term bank
loans, convertible loan stock and so on) and short term liabilities (such as bank overdrafts,
short term bank loans and trade creditors).
A high level of debt creates a financial risk which could have an impact on the business from
a number of different perspectives, including both internal and external stakeholders. The
potential problems might typically include:
 The company as a whole could be put in danger of liquidation if it creates high levels of
debt that cannot be repaid.
 If a company goes into debt and is liquidated, then its creditors will suffer as they are
unlikely to be paid in full
 Management and staff will suffer as, with high debt levels, the business is likely to have
to either streamline or close, leaving some or all workers and management redundant.
 If the business has high debts, then the company might not make enough distributable
profits for the shareholders to receive any dividends and this in turn would lead to
market confidence suffering.
 Customers, when faced with a business where consumer confidence is suffering, could
well seek out alternative organisations with which to do business.
Gearing is the proportion of debt within a company's capital structure, measured as
debt/equity generally at market values. We have seen in previous study units that a high
level of gearing increases the financial risk of a firm and the required return of shareholders.
A high level of gearing may also affect the return required on debt. Thus, the level of gearing
of a firm could impact on the company's WACC, and obviously the optimal level of gearing is
where the company's cost of capital is minimised.
However, whether gearing does affect the cost of a company's capital is an area of
debate in finance – the two main schools of thought are the traditional view and the theories
of Modigliani and Miller (known commonly as MM).
Before going on to discuss them we shall consider gearing in some detail – looking at the
principal factors which influence the financial manager in choosing capital instruments to
maintain balance in the overall capital mix. We have also talked about some of the practical
ideas for day-to-day working.
Perhaps the most important point to emerge is that capital gearing is not a simple ratio
calculation with firmly defined ingredients, but more of a multi-dimensional problem. A series
of factors interact to establish a capital mix, and an appreciation of those factors is important
before beginning to attempt financial management in this area.
The mix of the various types of capital employed within a business is referred to as the
capital gearing or leverage of the organisation. Financial gearing measures the
relationship between shareholders capital plus reserves and either prior-charge capital or
borrowings or both. Total fixed and current assets have to be financed. Some will be
financed by equity capital, i.e. the ordinary shares and the reserves belonging to the
shareholders, and some will (usually) be financed by debt capital, i.e. all fixed-interest-
bearing financial instruments.
There are two basic states to be distinguished – high and low gearing.
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 High Gearing
When the proportion of debt compared with equity is high, the structure is said to be
high-geared. Typical examples may arise in heavy manufacturing firms where
investment in long life, high cost plant means that large sums have to be invested using
borrowed funds.
 Low Gearing
When the proportion of debt capital to equity capital is low, the structure is said to be
low-geared. Service industries and supermarket chains generally have low gearing
ratios, because they do not have to invest heavily in plant and machinery.
Supermarkets are typically cash-based entities and will often receive payment from
customers who shop there before they have to settle with their suppliers. As a result,
their need to resort to external financing is minimal unless they embark on a major
store opening, or refurbishment, programme.
The gearing ratio of a business will, therefore, be largely determined by the nature of its
operations. It follows that particular industries will show common characteristics. Where a
prospective investor, or lender, is considering an investment, he or she will look at the typical
gearing ratio for that market sector to compare the efficiency of the business at managing its
financing needs, and will query significant variances which cannot obviously be obtained
from the published accounts.
Generally speaking, the accepted "norm" in the UK is to maintain a balance of debt capital to
total capital of 1:2, i.e. to finance half of the total assets with debt capital.
Gearing Ratios
Capital mix and capital problems can be analysed by a number of different gearing ratios, the
principal ones being:
capital Equity
capital charge Prior
capital charge Prior + capital Equity
capital charge Prior
employed capital Total
capital charge Prior
You should always make it clear which ratio(s) are being used and how any figures are
arrived at.
 Prior charge capital is anything appearing as a charge on the profit of the business
prior to taxation and dividend. The term includes debentures and long-term debt, and
possibly short-term debt.
 Total capital employed, in its simplest form, will be the total assets less current
liabilities. However, you should note that certain items may or may not be included –
examples are deferred tax and minority interests. You should always remember to
state how you have arrived at your assumptions.
The following is a short example to help to clarify these points.
Consider the following balance sheet.
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PQR plc
Balance Sheet at 31 December ....
£000 £000 £000
Fixed assets 4,250
Current assets
Debtors 200
Stock 400
Creditors: amounts falling due within one year
Creditors 100
Bank loans 175
Overdrafts 50 325
Net current assets 275
Net assets 4,525
Creditors: amounts falling due after more than 1 year
Debentures 500
Bank loans 500 (1,000)
Capital and reserves
Ordinary shares 2,000
Profit and loss account 1,000
Preference shares 500
Share premium account 25
Applying the different gearing ratios we get the following interpretations of capital mix.
capital charge Prior

25 000 1 000 2
500 500 500
 
 
, ,

025 3
500 1
 100%  49.59%.
Note that prior charge capital is made up of:
Debentures 500
Bank loans (of more than 1 year) 500
Preference shares 500
If short-term loans and overdrafts were included in prior charge capital, this figure
would become (1,500  175  50)  1,725 and the gearing ratio would rise to 57.02%.
Equity is taken as total capital and reserves excluding preference shares.
capital charge Prior + Equity
capital charge Prior

500 1 025 3
500 1
, ,

 100%  33.15%.
Again, by including short-term borrowings, the gearing ratio would rise to:
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725 1 025 3
725 1
, ,

 100%  36.32%.
employed capital Total
capital charge Prior

525 4
500 1
 100%  33.15%.
It is not really appropriate to include short-term borrowing in this particular ratio
because it has already effectively been allowed for in the calculation of net assets.
Valuation Basis
Opinions are divided as to whether the relevant debt and equity contents should be valued in
terms of book values or market values. Many businesses may well revalue their investment
in bricks and mortar (real property) in view of a decline in market values.
By using market values of ordinary shares, a value will automatically be placed upon the
share capital and the shareholders' reserves, because the market is assumed to have taken
the value of reserves into account in determining the market price of the shares. Similarly,
the market value of debt capital will be taken to reflect more realistically the market opinion
and therefore the risk of that debt. A market-based approach is, of course, dynamic in the
sense that the gearing ratio will alter as soon as market values alter.
This is fine to an extent with quoted companies whose share prices can be readily
determined at any given point in time. Problems occur, however, with the private company,
partnerships and sole traders in view of the difficulty of attempting to arrive at a market
capitalisation. Supporters of the book value approach will, in attempting to take this into
account, argue that market values may not always reflect the real long-term position. For
instance, strike action in a particular industry may have an adverse impact on the securities
of a company in the short term which will, by virtue of the market-based approach, be
reflected in a temporary and unrepresentative gearing ratio.
It is of fundamental importance to see that all assets are correctly valued, and you should
note that book values may not always be realistic, as a result of changes in the property
market impacting on the valuation of land and buildings or customer fashions reducing (or
increasing) stock values, etc. A decision will also have to be made as to whether to include
intangibles such as goodwill, patents and brand names. Goodwill may have arisen through
paying more than the book value to acquire an asset, or group of assets, and it will generally
be deducted from the total asset values since it represents a historic figure which may no
longer apply.
Scientific Approaches
Beyond the simplistic target of financing only 50% of assets, more scientific approaches can
be applied. For example, long-term debt may be limited to a chosen percentage of equity
funds. This approach has the following problems:
 The maximum may become the norm.
 Unless maturity dates for debt finance are widely separated, the cash implications of
finding large sums for redemption may cause problems.
Short-term debt should be restricted to satisfying short-term needs. If a rollover of debt is
required, the financing of changing interest commitments, as well as the possibility of not
being able to arrange refinancing, can lead to difficulties.
Another more scientific approach is to consider the number of times a fixed interest payment
will be covered by annual earnings, which gives an indicator of financial risk. The main
problems here are:
(a) The determination of an optimum financial risk measure for a particular company.
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(b) Earnings may not always be representative of the cash available to meet interest
payments. Debtors cannot be used to finance debt until they have paid.
Because of (b) above, a rather more detailed approach is to base the level of corporate
indebtedness on the ability of the cash flow to support it. A potential debt provider is more
likely to be encouraged to supply funds where he or she can see that the cash flow to fund
the interest payments is planned to be available.
Whilst failing to reach an answer to the optimal gearing level question, the theorists have
highlighted a number of factors a firm should consider, including:
 Its future taxable capacity
 Risk and volatility of future earnings
 Interest cover
 Likely costs of financial distress
 Availability of other sources of finance
 Debt capacity (i.e. assets that can be secured, presence of covenants).
Ability of Earnings to Support the Structure
When the assets to be financed cost £100 and the earnings generated by them are £10, then
such a level of earnings could only service the £100 if the return expected by the ordinary
shareholders for a class of risk of this type was 10%. Thus, all the earnings would have to
be paid out as dividends.
If the dividend required was, say, 12%, then an alternative structure would be necessary to
overcome the problem that the earnings were only £10. Examples of two alternatives are
given below (in both cases we will continue to use our £100 basis).
Capital Earnings Required
£ £
Ordinary shares 50 Ordinary shares at 12% 6
Debentures 50 Debentures at 8% 4
Capital 100 Earnings 10
Or we could have:
Capital Earnings Required
£ £
Ordinary shares 40 Ordinary shares at 12% 4.8
Preference shares 30 Preference shares at 7% 2.1
Debentures 30 Debentures at 8% 2.4
Capital 100 Earnings 9.3
Available for reserves 0.7
Simple though the example is, it should clarify in your mind how the financial manager can
combine securities to arrive at the optimum capital structure for the company. As we can
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see, by using less risky, fixed-interest capital, it should be possible to reduce the demands on
equity amounts. In other words, the earnings expectation can be geared down.
The earnings of the capital, the company's policy in paying dividends or distributing retained
earnings, and the return required by the providers of capital will all influence the pattern of
finance that the business is able to raise. In turn the financial manager will take account of
present, and predicted, future interest rates in an assessment of the most suitable security to
be issued.
Attitudes of Capital Suppliers
Potential suppliers of capital or equity will take account of other factors in addition to the rate
of return offered by the company.
 Providers of debt capital will consider the security offered and the ability of the
business to meet its interest payments (i.e. the interest cover). In the first of our two
examples above, debenture interest is covered 2½ times by the earnings of 10%.
Typically an unsecured lender would look for cover of between three and five times and
we can therefore assume that security would be required in this case.
 Providers of equity capital must allow all other forms of capital to be serviced before
their dividend can be paid. They will look closely at the debt holder's stake as the
volume of debt will significantly affect ordinary dividends in times when earnings fall.
Let us consider the following, which assumes total payout and no retention. Taxation has
been ignored.
Highly Geared
Lowly Geared
Ordinary shares £1,000 £9,000
8% Debentures £9,000 £1,000
Capital £10,000 £10,000
Year 1:
Earnings £1,500 £1,500
Debenture interest £720 £80
Available for dividend £780 £1,420
Dividend % 78% 15.8%
Year 2:
Earnings £720 £720
Debenture interest £720 £80
Available for dividend – £640
Dividend % NIL 7.1%
Debenture interest is, of course, a fixed charge, and the effect of having to service payment
when earnings fall is clearly demonstrated. Ordinary shareholders will only be entitled to
their dividend after this fixed charge has been met. In Year 1 the earnings are high and the
shareholders in the highly geared company obtain a higher return than those in the low
geared business. The reverse position is shown when earnings are low, and in our example
the shareholders in the highly geared company receive nothing.
The effect of the mixture of debt and equity effectively gears up the effect of fluctuating profits
and will generally influence the decision of an ordinary shareholder whether or not to invest.
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Where gearing is high, dividends can be expected to fluctuate in response to profit
fluctuations and it will impact on the share prices in due course.
Hence profit maximisation does not always operate in the best interests of the shareholders'
future wealth. An influx of debt capital may help to generate additional profit, but there will be
a risk that it will disturb the financial gearing ratio, with the result that the market will then
demand a higher return in order to compensate for what it sees as increased risk. This may
result in the share prices falling and the reduction of the shareholders' wealth in capital gains
terms, without a significant increase in future dividend to compensate for the fall.
Concepts of profit maximisation and shareholder wealth must be set against a relative time
background. They should not be viewed as simple, absolute requirements. In planning the
mix of debt and equity capital, the financial manager must take account of the risk attitude of
existing and potential investors.
Patterns of Assets and Trading
To some extent at least, the pattern of assets in most companies will dictate the gearing. The
use of secured debt capital will, for instance, require some tangible assets on which the
security can be perfected. If the business has few tangible assets, it will have to raise its
finance through alternative capital instruments.
A second consideration will be the nature of the principal trade of the firm. A stable, well
established business, such as a bakery, will generally have less difficulty raising debt capital
than, for example, a company engaged in extensive research in aero-engine development
and manufacture. This is because the market will consider the former, being well tried and
tested, to be less risky.
Companies in, or about to enter, risk activities, such as developing new markets overseas,
will be very likely to raise their financing requirements through risk capital (i.e. equity).
Companies planning less risky activities, such as a large new building for their own use, will
often resort to the use of debt capital because of the ease and relative cheapness with which
it can be made available.
Demand Patterns
Progressing from the previous point, the demand for the products of a company, or the
nature of the industry as a whole, will impact on the amount of debt capital which can be
raised. We will consider this under three headings:
(a) Industry and individual demand
When industrial demand does not continue to grow for a protracted period, no matter
how well an individual company is performing within that industry, it will eventually
suffer the same problems as the industry as a whole. Careful thought should be given
to taking on additional debt capital by a buoyant firm in a declining industry, as the
eventual drop in orders may make the financing commitments through interest
payments difficult to maintain. This may not, of course, be the case where a firm in
these circumstances were to raise capital for a diversification project outside the
industry concerned.
(b) Sales stability
A steady sales record is generally considered to be a better pointer to future stability of
sales performance than a volatile record. A steady record will give confidence to
investors and should facilitate raising debt capital.
(c) Competition
Where a company trades in an industry that demands special skills (e.g. computers), or
where a large initial investment has to be made on entry to the market (e.g. steel
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processing), there will be less chance of new competition entering the market. The
established business in such markets should find it relatively easy to raise debt capital,
because the market will be confident in the firm's ability to service its debt payments, as
it is unlikely to be faced with new and aggressive competitors in the future.
Where market entry is easy and relatively cheap, the certainty that income will continue
for a business already established in that industry will be reduced. Investors will
typically be more cautious about providing debt capital because of the uncertainty that
it can be financed into the future.
Attitudes of Management and Proprietors
Many people are instinctively conditioned to avoid borrowing external funds if it can be
avoided. Even where borrowing is inevitable, they will try to minimise the extent of their
commitments. They have an attitude of "I've never owed anybody anything", a view which
perhaps influences their approach to capital gearing.
It is true that secured borrowing, such as a mortgage debenture secured on the company's
premises, may restrict the business in its free use of the building it occupies. Some
managers would prefer to retain absolute control of their assets and only use equity. To them
the difference in the cost of debt and equity would be an opportunity cost of having
unencumbered use of their buildings. Whether the concept of control by suppliers of debt
capital is really valid is open to conjecture, as generally little control is ever exercised until
interest payments are missed.
An alternative way in which some managers approach debt capital is to borrow the maximum
amount available at present interest rates. This is only limited by financing ability, available
security and risk. Such a policy may leave the business open to trouble if interest rates rise
(if the rates are not fixed or capped), if costs rise, or if sales fall. The advantage is that
increased debt financing may enable the business to make full use of its resources in a
profitable way. In addition to which, in conditions of rising inflation, the "real" cost of financing
fixed-rate debt will decrease as payments will be made out of "future" pounds, the value of
which will have been eroded by inflation.
We noted earlier that the two main schools of thought are the traditional view and the
theories of Modigliani and Miller (MM). Both schools of thought are based on a number of
assumptions. To simplify the theories and to highlight their conclusions, we note these
assumptions at the outset (although some are later relaxed).
(a) There is no taxation.
(b) There are constant earnings, which are fully paid out as dividends.
(c) There is a widespread expectation of the prospects of the company.
(d) Business or operating risk is constant.
(e) There are no market imperfections such as transaction costs.
(f) Companies are immediately able to alter gearing, e.g. by redeeming or issuing debt.
Traditional View of Capital Structure
This view states that as the level of gearing increases, the cost of equity increases and the
cost of debt initially remains constant, but once a certain level (not defined) of debt is
reached, it starts to increase. The WACC initially falls due to the increasing levels of the
cheaper debt, but then starts to increase to reflect the increasing cost of equity (and at higher
levels of gearing the increased cost of debt). We can show this graphically (Figure 9.1):
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Figure 9.1: Traditional View of Capital Structure
The minimum cost of capital is shown at point A.
Modigliani and Miller
To understand the work of MM we must first discuss arbitrage. Arbitrage is any transaction
which makes an immediate, risk-free profit, and occurs in a situation when two identical
goods or products (including shares) are sold in the same market but at different prices.
Obviously such a situation would not last very long – traders would buy at the lower price and
sell at the higher price (thus making a profit) until the forces of supply and demand force the
lower and higher price, and thus the market, into equilibrium.
In their 1958 paper MM assumed that there are perfect capital markets (i.e. no taxes or
transaction costs, rational investors and so forth). They concluded that the value of the firm
depends on its assets and the operating income derived from them, and that there is no
optimal capital structure. Firms should thus concentrate on maximising the net present value
of investments.
The theory is based on the principle of arbitrage and can be illustrated by the following
A plc and B plc are identical except that B plc has £60,000 debt outstanding. The cost of the
debt is 5%. If the traditional theory is correct B plc will have the higher cost of equity to offset
the risk of holding debt. The cost of equity (K
) in A plc is 15% and in B plc is 16.5%
A plc B plc
£ £
Net operating income 20,000 20,000
Interest on debt – 3,000
Earnings available to shareholders 20,000 17,000
15% 16.5%
Market value of equity (Earnings/ K
) 133,333 103,030
Market value of debt – 60,000
Total value of firm 133,333 163,030
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MM argue that the difference in market values of two identical (except for financing mix) firms
will not remain because the arbitrage mechanism will bring the value of the firms into
equilibrium. The arbitrage process will occur via investors engaging in home-made
leverage, i.e. they will borrow and invest in A plc thus imitating B plc. Some examples will
show how this works.
Charlie owns 10% of B plc. His investment of £10,303 (10% of the equity value) is made up
as follows:
10% of the value of the firm 16,303
less 10% proportionate share of debt 6,000
Charlie's net return, therefore, is £1,700 (10% of £17,000).
Charlie's wealth could be improved if he:
(a) Sold his equity in B plc for £10,303.
(b) Borrowed £6,000 at 5% (which matches his proportionate share of debt in B plc, and
because MM assume perfect capital markets individuals can borrow at the same rate
as companies).
(c) Invested the £16,303 in A plc.
This would give Charlie a net return of:
Return on equity in A plc (K
 15%  £16,303) 2,445.45
less Interest on debt (5%  £6,000) 300.00
Net return 2,145.45
Clearly other investors would follow Charlie's lead and the forces of supply and demand
would increase the price of A plc shares and thus lower its cost of equity and vice versa for B
plc until their prices were in equilibrium and no arbitrage opportunities remained.
Shareholders therefore can obtain the benefits from gearing on their own account by
duplicating the capital structure of the firm and there is thus no benefit to be obtained to a
firm from simply changing its capital structure.
If a firm cannot change its value by changing its capital structure, then its weighted average
cost of capital (WACC) must remain constant because the value of any firm equals the NPV
of future earnings divided by its costs of capital.
This leads to one of MM's famous "propositions":
 earnings before interest/WACC
where: g  geared
ug  ungeared
The value of the geared firm is thus equal to the value of the ungeared firm which is equal to
the earnings before interest/WACC.
MM then argued that as a company increases its level of gearing the cost of equity increases
due to increased financial risk (financial risk arises because there are more fixed charges to
pay before shareholders can obtain any returns), and the increase equals the savings made
from the lower cost of debt.
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MM's second proposition states that:
The savings from debt
being cheaper than equity

The increase in cost of equity
due to increased risk
The increase in financial risk can be calculated as follows:
 K
where: V
 value of debt
 value of equity in the geared firm
 cost of equity in the ungeared firm
 the cost of debt
We showed above that the WACC of an ungeared and an identical geared firm are the same
and, therefore, the cost of equity in the geared firm must equal the cost of equity in the
ungeared firm plus a premium for the financial risk discussed above. Therefore:
 K
 (K
 K
The model is shown in Figure 9.2:
Figure 9.2: MM Without Tax
Scat plc and Millie plc are identical in every way except that Millie has 25% debt at the risk-
free rate of 9%, whereas Scat is all equity financed. Scat's cost of equity is 12%. Calculate
both companies' WACC.
Scat plc is all equity financed, and therefore its WACC  K
 12%.
For Millie:
 K
 (K
 K
 12%  1/3(12  9)
 13%
Level of Gearing
Cost of Capital
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 25%  9% (debt)  75%  13% (equity)
 12%
Therefore, WACC
There are several criticisms of MM's 1958 theory:
(a) Market imperfections do exist, e.g. there are transaction costs when buying/selling
(b) Personal borrowing cannot be substituted for corporate borrowing because most
individuals do not have the capacity to borrow at the levels companies can, nor can
they obtain the same rates.
(c) Debt cannot be assumed to be risk-free because companies and individuals can
become bankrupt.
(d) MM ignored bankruptcy, and as such their theory may not be valid at very high levels of
gearing where the risk of bankruptcy is greatest.
(e) The 1958 paper ignores taxation.
Impact of Taxation on the Cost of Capital and Capital Structure Decisions
In 1963 MM modified their work to include the effects of corporation taxes. In many countries
(including the UK and the USA) debt interest is allowable against corporation taxes. Tax
relief on debt interest is therefore a gain for the shareholders. MM thus argued that the cost
of capital declines with gearing, and the firm's value increases by the present value of the tax
relief on debt interest.
This can be shown in a graph (Figure 9.3) and illustrated by an example.
Figure 9.3: MM With Tax
Max plc has earnings before interest of £100,000. Its capital structure is made up of 10%
debt at a cost of 5%, and 90% equity. The cost of equity is 10%. Max plc operates in
Connahland which does not allow debt interest against taxation, but is considering doing so
under a new law. Calculate the change in Max plc's WACC and market value if the law is
passed. Corporation tax in Connahland is 25%.
Cost of Capital
after tax
Level of Gearing
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The weighted average cost of capital before the law would be:
 Proportion of equity)  (K
 Proportion of debt)
 10%  90%  5%  10%
 9.5%
Therefore, the value of firm  £100,000/9.5%  £1,052,632
If the law was passed the WACC would be:
 Proportion of equity)  (K
(1  t)  Proportion of debt)
 10%  90%  5 (1  0.25)%  10%
 9.375%
Therefore, the value of firm  £100,000/9.375%  £1,066,667
Thus the cost of capital would reduce by 0.125% and the value of the firm would increase by
Therefore, the cost of equity for a geared company given above becomes:
 K

 K
)(1  t)
and WACC
(1 
E + D
where: D  market value of debt capital in geared company
E  market value of equity in a geared company
In the example of Scat and Millie above, consider what the situation would be if corporation
tax was 35%. Scat plc is all equity financed, and therefore its WACC  Ke  12%
(unchanged from above).
However, for Millie:
 K

 K
)(1  t)
 12%  1/3(12  9)(1  0.35)
 12.65%
and WACC
(1 
E + D
 12(1  (1  0.35)/4
 10.95%
or more traditionally to prove the formula:
 25%  9 (1  0.35)% (debt)  75%  12.65% (equity)
 10.95%
and the conclusion could be drawn that a company should borrow as
much as possible – the value of the geared firm will also be greater than the value of the
ungeared firm by the tax saving on debt.
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However, a firm may reach a point at which it has no taxes to offset debt interest against –
this is known as tax shield exhaustion. When such a point is reached there are no longer
any benefits to be gained by increasing the level of the firm's gearing.
The theory, like the previous one, has its limitations in that it again ignores bankruptcy and
agency costs. It also ignores personal taxation. (In 1977 Miller considered personal taxes
and concluded that there was no optimal debt level.)
Empirical testing of these theories is very difficult in practice and as such the optimal level of
gearing (if one exists) remains an unresolved issue. Strictly speaking, they are all
hypotheses rather than theories.
The level of gearing has a significant impact on a firm's beta and has to be considered when
estimating the required rate of return for a new project.
A company's systematic risk, reflected in its beta, is made up of two main types – operating
risk and financial risk. We saw above that a geared company has a higher financial risk,
and thus a higher beta, than the equivalent ungeared company.
You do not need to be able calculate betas for geared companies, but you should understand
how the calculation is undertaken.
MM show, using their 1963 formula that:

 
[1  V
(1  t)/V
Using this formula it is possible to calculate the operating beta (or equity beta) of a firm. The
operating beta shows the risk of the firm's activities as opposed to its financing structure.
Example 1
Sam plc is an all-equity firm with a beta of 1.5. Sugar plc is identical in all respects except
that it has 50% debt in its structure. If the rate of corporation tax is 30% calculate the beta of

 
[1  V
(1  t)/V

 1.5[1  1(1  0.3)/1]

 2.55
It is important to consider differences in gearing when using one company's beta to estimate
another company's because, as noted above, increasing the level of gearing a firm has
increases its beta. The equity beta of the first company must be found by "ungearing" its
company beta, and then "re-gearing" it to match the second company's capital structure. The
procedure is shown in the next example.
Example 2
Arnold Ltd is about to be floated on the Stock Exchange and wishes to estimate its beta. It is
very similar to Oliver plc which has a beta of 1.4, except that Oliver plc has 30% debt and
Arnold Ltd has 40% debt. Estimate the beta of Arnold using the above information. Assume
the tax rate is 33%.
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First we have to "ungear" Oliver:

 
[1  V
(1  t)/V
1.4  
[1  30 (1  0.33)/70]
1.4  

 1.4/1.287

 1.09
Now we re-gear this equity beta for Arnold Ltd's capital structure:

 
[1  V
(1  t)/V

 109 [1  40 (1  0.33)/60]

 1.58
Note the higher beta for the higher geared firm, illustrating MM's formula.
Whilst this is a useful tool to know you must be aware of the limitations in using the formula
to estimate betas for firms. The limitations include the general limitations of the CAPM that
we discussed above and in the previous unit. In addition, different firms have different cost
structures, opportunities for growth and are of different sizes; as such no one firm can be
seen to be identical to another.
The model assumes that debt is risk-free. However, in reality corporate debt has a beta of
approximately 0.25; it has the effect of overstating geared betas and understating ungeared
Financial gearing is a principle measure of financial risk.
Business risk refers to the risk of making only low profits, or even losses, due mainly to the
nature of the business in which the company is involved. One way of measuring business
risk is by calculating the company's operating (or operational) gearing.
The usual way of measuring a company's operational gearing is by using the following
Operating gearing =
(PBIT) tax and interest before Profit
on Contributi
where: contribution is sales less the variable cost of sales.
The significance of operational gearing is:
 If the contribution is high but PBIT is low, then fixed costs must be high and only just
covered by contribution. This would mean that the business risk, as measured by the
operating gearing, is high.
 If the contribution is not much bigger than PBIT, then fixed costs will be low and
reasonably easily covered. This would mean that the business risk, as measured by
operating gearing, will be low.
Consider the following example which examines the distinction between financial and
operational gearing (and is taken from the June 2003 Corporate Finance examination paper.)
Blackpool Engineering Ltd produces and sells a computer modem. The company has been
in operation for four years and has an issued share capital of £200,000 (par value 25p per
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share). To date, the company has produced only one product. In the year ended 31
December 2000 it sold 20,000 units.
The profit and loss account for the year to 31 December 2000 is as follows:
£000 £000
Sales 1,900
less: Variable expenses (700)
Fixed expenses (400) (1,100)
Earnings before interest and taxation 800
less: Interest payable on 10% debentures (200)
Earnings before taxation 600
less: Corporation tax (198)
Profit after taxation 402
Dividend (160)
Retained profit for the year 242
Recently, Blackpool has been experiencing labour problems and, as a result, has decided to
introduce a new highly automated production process in order to improve efficiency. The
new production process is estimated to increase fixed costs by £150,000 (including
depreciation), but will reduce variable costs by £15 per unit.
The new production process will be financed by the issue of £1,000,000 of debentures at an
interest rate of 12%. If the new production process is introduced immediately, the directors
believe that sales for the forthcoming year will not change. Stocks will remain at the current
level throughout the coming year.
Blackpool's shares currently sell at a P:E ratio of 13:1 and the current corporation tax rate is
(a) Explain the terms "operating gearing" and "financial gearing".
(b) Calculate the change in earnings per share and in share price if the company
introduced the new production process immediately. Explain any assumptions which
you make.
(c) Analyse the implications for share price if Blackpool makes a rights issue at an issue
price of £2.50 per share (ignore issue costs).
(a) Operating gearing may be defined as a measure of the impact of a change in sales
upon earnings before interest and tax (EBIT)
Financial gearing is measured by comparing a company's use of long term finance
relative to equity.
(b) Before the project:
shares of No
4 x 200
= 50.3p
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After the project:
Sales 1,900
VC (400) [(700/20 – 15) x 20,000]
FC (550) [400 + 150]
EBIT 950
Interest (320) [200 + 12% x £lm]
Taxable profit 630
/o (220)
PAT 410
= 51.3p
(i) As this is only a small change in expected EPS, the project might have to be
evaluated on other criteria.
(ii) The solution assumes no repayment of existing debt levels.
(iii) Assuming no change in P:E ratio, the share price will rise:
from (15 x 50.3) = £7.55
to (15 x 51.3) = £7.70
(c) Required funding = £1m
The rights price (deeply-discounted) = £2.50
Ignoring issue costs, need to sell
= 400,000 new shares
Hence, a "one-for-two" rights issue is required.
New number of shares = (800,000 + 400,000) = 1 .2m
Theoretical ex-rights share price:
Before issue:
2 shares@£7.55 15.10
Cash 2.50
After 1-for-2 rights issue:
60 17. £
= £5.87
On a forward-looking basis (including the benefits of the project):
Increase in PAT = £8,000 i.e.: 8/1200 = 0.7p per share.
Valuing this at a P:E ratio of 15:1, share price could increase by (15 x 0.7) = 10p
Ex rights price cum project = £5.87 + 0.10 = £5.97
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Study Unit 10
Corporate Dividend Policy
Contents Page
Introduction 222
A. Key Influences on Dividend Policy 222
Retention Policy 222
Legal constraints 223
Availability of Internal Funds 223
Profit Available for Distribution 223
Profits and Dividend Level 224
Effect on Share Prices 225
Concept of Signalling – Investor and Market Expectations 226
Shareholder Expectations 226
Company Law on Distributable Profits 226
Other Influences 227
B. Theories of Dividend Policy 228
Fundamental Theory of Share Values 228
Clientele Effect 228
Modigliani and Miller’s Dividend Irrelevance Theory 228
Dividend Relevancy Theory 229
C. Practical Aspects of Dividend Policy 229
Share Repurchases 230
Approaches to the Level of Dividend 231
Non-Dividend Transactions 232
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We saw in earlier study units that a firm’s dividend policy is one of the three key decisions it
must make. Corporate dividend policy is the decision between dividends and capital gains
(dividends may include scrip dividends, share splits and other perks).
There is a debate in this area as to whether the market value of a company’s shares (and
thus the value of the firm and shareholder wealth) is affected by its dividend policy. Before
looking at the theoretical arguments, though, we shall consider some of the practical
influences on a company’s choice of dividend policy, including the key decisions of
investment and financing policy..
The major source of internally generated capital is retained profits. Once profits have been
earned, the factor which most affects the amount of retentions is the corresponding amount
declared and paid out as dividends. It is important to remember, though, that the payment of
a dividend to a shareholder is discretionary and this must be balanced against the economic
argument that a shareholder is expecting a return on his or her investment. For this reason
we shall consider retention policy and dividend policy together.
There are, basically, two opposing positions which could be adopted:
 That a company should pay out all its earnings as dividends and go to the market for
additional capital as required. It is said that, in this way, the successful companies with
the higher rates of dividend will be best able to raise capital and to flourish, at the
expense of the less successful.
 That a company should retain all its earnings and pay no dividends. Investors would
maximise their wealth in terms of capital gains, for the company would capitalise its
retentions and issue bonus shares for the shareholder to sell if he wished.
Retention Policy
The company uses its funds in the pursuit of profit and, where that profit is sufficiently large, it
will pay a dividend to shareholders. The surplus then remaining is referred to as retentions
and will be available to finance growth and the replacement, as necessary, of the company’s
These retentions of profits which are ploughed back into the business are internally
generated capital.
Retentions of profit arise in two forms:
(a) As amounts set aside out of profits prior to determining the amount available for
dividends, i.e. provisions of profit.
(b) As the surplus remaining when the shareholders’ dividends have been paid, i.e.
retentions. Equally, we could argue that these funds have been invested by
shareholders through them foregoing dividends.
Naturally the board must consider the desirable levels of retentions in order to fund future
projects and growth. Retained earnings are the most important source of finance for UK
companies, providing most of all funding requirements over recent years.
The main reasons for this may be as follows:
 Company managers often mistakenly believe that there is no cost involved when
retained earnings are used. As we shall see later there is, in fact, an opportunity cost
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derived from the idea that shareholders have consented to re-invest these earnings in
the company, but it is true to say that there is no cost involving the outlay of cash.
 The dividend policy is determined by the directors, who see retained earnings as a
ready source of cash to invest in their favoured projects without the need, trouble or
expense involved in consulting or raising funds from shareholders and other outsiders.
 By using retained earnings the directors avoid the expense of issue costs and, perhaps
more importantly, minimise the risks involved in losing control of the company following
an issue of shares or secured debentures.
These considerations are balanced by the shareholders’ need for at least a minimum return
of the profits and satisfaction of their investment expectations. Equally, though, a company in
search of funds will not be viewed favourably if it is over-generous with its dividends or pays
over-generous salaries to its owner-directors (if a limited company).
Legal constraints
Companies are bound by the Companies Act 1985 to pay dividends entirely out of
accumulated net realised profits, and this includes both profits earned in the current financial
year and those realised historically in previous financial periods.
Whilst the Act does not provide a satisfactory definition of what is meant by accumulated net
realised profits, the Consultative Committee of Accountancy Bodies (CCAB) has issued
guidance that specifies that dividends can be paid out of profit calculated using relevant
Accounting Standards after taking into account any accumulated losses.
Availability of Internal Funds
The obvious advantage of internally generated funds is that they become available without
the formalities of issuing houses, brokers, offering of security and so on. They are
completely free of formality but, obviously, the required volume of capital at the required time
cannot be made available as easily as it can with external funds, i.e. profits arise as the result
of trading and not simply to ordered dates.
Profit Available for Distribution
There are a number of different considerations that need to be taken into account when a
company is considering the profit available for distribution.
The first consideration is in respect of provisions set aside out of profit.
 Depreciation
The annual charge for depreciation in the profit and loss account does not arise due to
an outflow of cash at the time the charge is made. The cash outflow associated with
the procurement of an asset (usually) occurs when the asset is first acquired. The
outflow is treated as capital expenditure and recorded in the balance sheet. Thereafter,
depreciation charges “filter” the capital expenditure from the balance sheet to the profit
and loss account at periodic intervals.
Note, however, that the charge in the profit and loss account which actually represents
a charging of calculating proportions of the original cost of the asset, reduced by any
anticipated scrap value, is not a cash flow-backed item, but a recording of portions of
an historic cost incurred on previous occasions.
 Other Provisions
There are many items where this characteristic of non-cash flow backing occurs, e.g.
provision for doubtful debts; provision for plant maintenance; provision for major
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The effect of creating provisions for depreciation and other items is to reduce the profit
available to pay out dividends and/or make retentions. Because of this, amounts of cash are
held back in the business and are not paid as dividends. They become available for other
uses, e.g. fixed asset purchase.
It is important to note that usually, with provisions, a sum of money is not physically
separated from the rest in the bank account to substantiate the provision made. The cash
not now required for dividends, because provisions have been made, can be put to general
use. Some companies may in fact create a separate fund into which the cash backing for
their provisions is put. This requires cash to be paid out and an investment purchased. In
this case the creation of provisions does not comprise internally generated funds.
Where, however, the creation of provisions, their eventual spending and consequent
replacement is a more or less continuous process, then such provisions represent a
significant proportion of internally generated funds.
In practical terms it is recognised that at least some prudence is necessary, at least in times
of changing prices, to prevent the “real” value of the business being depleted. You can see
this in current cost accounting, where revaluation surpluses and deficits arising from changes
in the prices of fixed assets and stock etc. are taken to a non-distributable reserve. The idea
behind this is that if such amounts were distributed it would imply that the operating capability
of the business had been eroded.
You should not, however, think that the “current cost profit attributable to shareholders”,
apparent from current cost accounts, can prudently be distributed. Other matters must be
considered, such as cash availability, capital expenditure plans, changes in volume of
working capital, the effect on funding requirements of changes in production methods and
efficiency, liquidity, and new financing arrangements, as well as the effect of price changes
on the finance required.
 Taxation liabilities. The level of estimated corporation tax liabilities needs to be
considered as part of the process for determining the level of available funds for
distribution as profits to shareholders.
 Investment opportunities (or a significant percentage) are often funded from retained
profits and it is also important that the company ensures that a correct balance is struck
between leaving enough retained profits to fund much needed investment opportunities
and the payment of dividends to shareholders.
 Liquidity issues. Since dividends are payments of cash out of the business the
directors need to ensure that the company, at all times, has sufficient liquid resources
to make dividend payments and to run their day to day transactions.
Profits and Dividend Level
Assuming that there are sufficient profits available, it is extremely difficult to determine what
influences a board of directors in declaring a particular level of dividends and hence making a
particular level of retentions.
You might think that dividends would be increased in line with increases in profits. However,
there is a noticeable tendency in practice for there to be a time lag before dividends are
increased following an increase in profits. This is because companies like their dividend rate
to be maintained and to increase steadily rather than fluctuate from year to year. Directors
will tend to wait until an increase (or decrease) in profits appears to be sustained before
building it into the rate of dividend. This controlled, stable approach is felt to produce
confidence by investors in the financial management of the company.
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From this approach a behaviour pattern can be determined for the process of fixing dividend
levels. The decision becomes strongly related to past behaviour:
 What was last year’s dividend?
 What are this year’s available profits?
 Should the dividend be increased or decreased?
 If so, by how much?
 Can that position be sustained?
The effect of this cautious behaviour is to produce a time delay between increases in profits
and consequent increases (or decreases) in dividends.
This time delay is important for two reasons:
(a) As a company’s profits increase – and since the directors will tend to delay dividend
increases – retentions will increase. If a company’s profits decrease, retentions will be
(b) Generally, when an increase in dividend rate is announced, it will be fair to assume that
the directors feel that the increased level will be capable of being sustained in the
future. Alternatively, dividend level will only be reduced if the directors feel that the
existing level cannot be maintained in the future.
Effect on Share Prices
The impact on investors of the level of both dividends paid and earnings retained need to be
(a) Dividends
The market price of a share is a single point indicator of all the expectations and
interpretations of the future investment suitability of the company by its shareholders.
“Shareholders” will represent a complete cross-section of the financial institutions and
the investing public, all with their differing motives and requirements from their
shareholding. Thus, so many factors are built into the share price that it is impossible
to isolate any one factor with certainty. Generally, however, in line with reason (b)
stated above, if a dividend rate is increased, the investors will assume that the new
level is likely to be at least maintained and, since the yield from the shares has
increased, and increase in market price will usually follow. In the long term, share
prices tend to follow the yield of the share.
Although not all shareholders will be holding shares for the dividends offered – they will
be primarily interested in capital gains – dividends are undoubtedly a tangible return
from the investment and are likely to have a marked effect upon share prices.
(b) Retentions
To make retentions is to defer the time when shareholders receive dividends. By
making retentions (“ploughing back” profits) the company is growing and will be able to
earn larger profits, pay bigger dividends, grow still bigger and so on. So the promise is
that by retaining funds the company can invest them (in itself) and gain a better return
than if they had paid the funds over to the shareholders for them to invest elsewhere
(i.e. externally to the company).
There is thus an implied promise that dividends in the future will be increased. This
promise may well be seen as more risky than tangible amounts of dividend at the
present moment, and usually a less marked increase in share prices follows
retention than follows increased dividends.
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There have been many surveys and studies on this topic, involving different sized companies
and types of industry with different shareholding patterns, set against varying periods of
economic activity, rates of inflation, world situations and Stock Market confidence. Not
surprisingly, there are conflicting findings by the various authorities, not only because of the
factors indicated but primarily because such studies attempt to quantify, in mathematical
terms, the behaviour of a large and diverse group of human beings.
Concept of Signalling – Investor and Market Expectations
This brings us to the concept of “signalling”. In reality investors do not have perfect
information, particularly about the prospects of the company. The pattern of dividend
payments is therefore taken as a key to estimating future performance.
An increase in dividends is taken as a signal of increased management confidence and leads
investors to increase their estimates of future earnings thereby causing a rise in the share
price. A dividend cut, on the other hand, is taken as a bad sign and the share price may
In practice, many factors are already discounted by the market in the prevailing share price,
so movement only really occurs on the announcement of a dividend if the amount is different
to that which the market was expecting anyway. The dividend announced merely confirms
the market’s expectations. This gives directors the opportunity to enhance expectations by
an unexpectedly high dividend (which must be sustainable in future years) or of reducing
expectations by an unexpectedly low dividend.
Shareholder Expectations
No matter what their preference for dividends as opposed to capital growth in the value of
their shares, all shareholders will hold some expectations about what the dividend should be.
Often this is based on prior dividends and a vague idea of an acceptable pay-out ratio, so
that as profits grow there is an expectation that dividends should keep in step.
Furthermore, it is generally accepted amongst shareholders that dividends should match
those declared last year or show an improvement. A stable dividend is taken (quite wrongly,
perhaps) as a sign of a stable company. This often forces directors to declare too large a
dividend when losses have been incurred in order to “save face” and prevent the share price
falling. Having to “pass” either a final or interim dividend became a subject of great concern
during the recession of the early 1990s.
Company Law on Distributable Profits
The Companies Acts lay down stringent rules which govern the power of a company to
declare a dividend. Under S.263 of the 1985 Act, for instance, it is restricted to the
maximum of the aggregate of accumulated realised profits less accumulated realised losses.
Thus, in this instance, it is the current net balance of distributable reserves which is the
important figure.
In addition, public companies are also constrained by S.264 in that a dividend may only be
paid if net assets, after payment of the dividend, are equal to or greater than the total of
called-up share capital plus any non-distributable reserves. The latter includes:
 Share premium account
 Capital redemption reserve
 Accumulated unrealised profits less accumulated unrealised losses not yet written off
Thus, the difference here is that unrealised profits and losses must also be taken into
consideration, e.g. asset revaluations which have not yet yielded a profit or loss (depending
on whether the revaluation was up or down).
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Public companies usually pay dividends twice a year: an interim dividend after the interim
results, and a final dividend, but only after the final results (and therefore this final dividend)
have been approved by the shareholders.
Remember, shareholders have the power to reduce the dividend payable, but not to increase
it. Company directors are therefore in a strong position and for all practical purposes
shareholders are often obliged to accept the proposed dividend.
Other Influences
(a) Personal taxation of shareholders
Different shareholders will suffer different rates of personal taxation on any dividend
income which they receive. Thus, if a dividend of 10p per share is declared, those
paying basic rate income tax at 20% will receive a net amount of 8p, whereas those
paying 40% will only receive 6p. Therefore, if the rate of capital gains tax is lower (after
the individual’s CGT annual exemption) than the shareholder’s marginal rate of
taxation, he will prefer a situation in which less is distributed as dividend but is instead
retained within the business to provide capital growth.
(b) Government policy: dividend restraint
From time to time the Government has operated a policy of dividend restraint as part of
a (prices and) incomes policy. No such constraints exist at present. Equally
governments could restrict the flow of funds to investors outside its borders or to certain
groups or individuals if they were so disposed.
(c) Profitability
As we have seen, the profitability of a company is a key factor in the amount which can
be paid out in dividends. If profits are volatile it is unwise to commit the firm to a high
(d) Inflation
In times of high inflation dividends based on historic cost profits can lead to distribution
of the company’s capital almost inadvertently, thereby reducing the operating capacity
of the business.
(e) Growth
Rapidly growing companies may prefer to re-invest the bulk of their earnings rather
than distribute them as dividends. This is often the case with newly-formed companies.
Alternatively some companies (perhaps those backed by venture capital) will be
obliged to offer higher dividends because of their relatively riskier investment.
(f) Other sources of finance
Unquoted companies in particular may find it difficult to access other sources of
finance. Retained earnings are important and dividends will therefore tend to be small.
(g) Control
By using internally generated funds ownership or control is not threatened and
directors are free to use such funds as they see fit rather than convince new investors
of the benefits of their schemes.
(h) Cash flow considerations
A company declares a dividend out of its Profits After Taxation. This is a dividend net of
any tax, and the full amount will have to be paid.
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There is a debate as to whether the market value of a company’s shares (and thus the value
of the firm) is affected by its dividend policy. This is reflected in the several theories
regarding dividend policy, all of which have one common premise – that the aim of dividend
policy should be to maximise shareholder wealth (which depends on both current dividends
and capital gains).
Fundamental Theory of Share Values
This model, also known as the traditional model, states that the level of dividends paid is
The fundamental theory of share values (which assumes that the market value of the
company depends on the size and growth rate of dividends paid, and the rate of return
required by shareholders) values the company using the dividend growth model. The
implications of this theory are that shareholders will want management to pursue a
distribution/retention policy which will maximise the level of, and growth in, dividends.
Clientele Effect
There may not, however, be an optimal distribution/retention policy that the firm can adopt to
meet the needs of all shareholders, because of the different taxes (capital gains and income
tax) and tax rates borne by different investors. A company should choose and maintain one
policy which maximises one group of shareholders’ wealth. Shareholders will then migrate to
companies which operate a policy in line with their needs – this is known as the clientele
The changes in the treatment of tax credits in the 1997 Budget has had a major impact on
the preferred dividend policy of pension funds. Until then, pension funds were able to claim
back tax credits on dividends received. As a result of the Budget changes, dividend yield will
reduce in significance, as will the preference for dividends over capital gains by this particular
clientele. Ten years on from the 1997 budget, these changes to the tax treatment of
dividends have been shown to have had a major impact on pension fund valuations and one
of the main reasons for the stopping, in large numbers, of company “final salary” pension
Modigliani and Miller’s Dividend Irrelevance Theory
Modigliani and Miller’s dividend irrelevance theory argues that the value of a company is
determined by the NPV of the investments undertaken by the company, and not by any
distribution policy.
MM showed that changes in the value of a firm’s shares are not dependent on the actual
pattern of dividends paid (you do not need to know the workings of proof for this theory).
They argue that if a company issues a dividend from retained earnings, and then needs to
raise cash for an investment, the loss on shares of the additional finance is exactly equal to
the dividend paid, and a company should therefore be indifferent as to its dividend policy.
Moreover, whilst accepting the existence of the clientele effect, MM state that the type of
clientele a firm has will have no effect on a firm’s value.
This argument assumes perfect capital markets and rational investors, and these
assumptions are the basis of the criticisms of MM’s model:
(a) It assumes that share issue costs are zero, and ignores the potential problems of
capital rationing.
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(b) There is no taxation. In reality:
 The timings of ACT payments discourage high dividend payouts by companies.
 Taxpayers may have a slight preference for capital gains.
 Some taxpayers will be indifferent between capital gains and dividends.
(c) Shareholders receive all relevant information about the company’s reinvestment plans.
This ignores competition and different perceptions of risk.
Dividend Relevancy Theory
There are several arguments that support the idea that the level of dividend will have an
effect on the value of the firm – the dividend relevancy theory.
 The effects that different tax rates have on investors’ preferences.
 Market imperfections mean that a positive NPV project will not be automatically
reflected in the firm’s share price, but its effects will be shown over time, whereas a
reported dividend has a much quicker impact on the share price.
 Empirical evidence shows that investors prefer a constant dividend policy with either
constant dividends or dividends growing at a constant rate helping them plan their
 If capital rationing exists then it may be cheaper (because of issue costs and so forth)
for the firm to retain its earnings and pay a lower level of dividend.
 Uncertainty as to the future means that shareholders may prefer a certain dividend to
an uncertain capital gain.
In practice a company must consider several factors when determining its dividend policy.
Note that it is the directors who determine dividend policy.
 It has to match its dividend policy to its clientele, to prevent a mass buying and selling
of its shares.
 If a company faces a takeover, management might declare an increased dividend as a
defence. The market might perceive the increased dividend as a sign of improved
future profitability of the company and its share price will rise. This makes it more
expensive for any potential takeover bid. In 1996 National Power paid a special
dividend of £1 per share. At the time the company was subject to a hostile takeover bid
from a US electricity company.
 High dividend payouts reduce the risk that shareholders may lose all their investment.
 Dividends act as a signal to indicate the future prospects of the company – a sudden
cut in dividends indicates that the company is experiencing difficulties, and vice versa
for an increase in dividends.
 The market expects companies in general to follow industry practice.
 The company should finance as much investment as possible using retained earnings,
to avoid finance issue costs, and an issue of equity capital may have an impact on the
status quo of shareholding control and may leave the company open to a takeover bid.
 The necessity for companies to repatriate overseas profits.
 The level of profits made and the legal position regarding the payment of dividends in
its country (or countries) of operation.
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 Repayment of debt and any restrictions on dividend payments under loan agreements.
 The liquidity of the company should be considered, together with the timing of cash
flows (the company must remain solvent and have enough cash to pay any dividends it
 The level of inflation affects the level of dividend which can be paid – companies must
ensure they have sufficient capital to maintain their operating capability.
 The company’s gearing level can have an effect on its dividend policy – any reduction
in retained earnings will increase its gearing ratio.
The company may have a large amount of cash which it may wish to return to its
shareholders, especially if its future cash flow predictions are strong. A large amount of
surplus cash was another reason for the 1996 National Power special dividend mentioned
above. This is a payment in excess of the usual amount that would normally be paid to
Share Repurchases
Repurchases, or buy-ins, of shares may be made by companies out of their “distributable
profits”, or out of the proceeds of a new issue of shares made especially for the purpose,
provided they are authorised to do so in the company’s Articles of Association.
A company may not, however, purchase its own shares:
(a) Where, as a result of the transaction, there would no longer be any member of the
company holding other than redeemable shares.
(b) Unless they are fully paid up, and the terms of the purchase provide for payment on
Purchases may be in the market or off-market. An off-market purchase is said to occur
when the shares are purchased not subject to the marketing arrangements of the Stock
Exchange, or other than on a recognised stock exchange. A buy-in of shares by a public
company will be subject to the rules of the Stock Exchange and to the provisions of company
The change in the capital base will cause management to rethink its investment decisions,
gearing, interest cover, earnings, etc. This is particularly important as the financial
institutions focus their attention more towards income and gearing as an indicator of financial
It is important to be aware of the various advantages and disadvantages of share
repurchases. The advantages of share repurchases include the following:
 It may allow a company to prevent a takeover bid. The control by the existing
shareholder group will be increased.
 A quoted company may purchase its shares in order to withdraw from the Stock Market
(see below).
 It can be a useful way of using surplus cash.
 Repurchasing shares will reduce the number in circulation which should allow an
increase in earnings and dividends per share, and should lead to a higher share price.
It will increase future EPS as future profits will be earned by fewer shares.
 Reducing the level of equity will increase the gearing level for a company with debt
which may be considered beneficial by the company.
 If the business is in decline a share repurchase may give the firm’s equity a more
appropriate level.
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The disadvantages of share repurchases are that:
 Repurchasing of shares may be viewed as a failure by the company to manage the
funds profitably for shareholders.
 The company requires cash for the repurchase.
 It may be difficult to fix a price which is beneficial to all involved.
 It requires existing shareholder approval.
 Capital gains tax may be payable by those shareholders from whom the shares are
 It increases gearing.
What Percentage Dividend Payment to Make?
There are a number of different payment options that a company might consider in the
payment of dividends.
A company may pay a constant and fixed percentage of profits in dividend payments. Such a
constant payment percentage sends out a clear message to shareholders about the
expected level of performance and it is also relatively easy and clear to operate. One of the
main problems with this approach, though, is that the company may reduce its ability to fund
much needed investment and have to go to the financial markets when it would perhaps
have preferred to use retained profits.
A company may decide to offer no, or zero, dividends at all. Given that most shareholders
would expect a return on their investment (and this would certainly include all the major
pension funds), then this approach is unlikely to be popular and in the long term would not be
in the best interests of the company.
Some companies like, if possible, to pay an increasing dividend year on year. This is good
for shareholders generally and should attract more shareholders (with some subsequent
possible effect on share price). It is possible, though, that if a company tries to do this year
on year, it is likely to have a negative impact at some stage on the company’s ability to fund
much needed investment. It is also likely that if, for good reasons, the company needed to
reduce the rate of dividend, this would have an adverse effect on the attitudes of both
shareholders and the market generally.
Approaches to the Level of Dividend
Three approaches may be identified.
(a) Dividend cover
This is the earnings per share divided by the net dividend per share. This indicates the
number of times the same dividend could have been paid on the shares from the
current year’s earnings alone.
One dividend policy is to pay out a fixed dividend per share each and every year,
which could be fixed in either real or money terms. This is the most common policy,
with most companies going for stable, slightly rising dividends per share – the “ratchet”
dividend policy.
(b) The pay-out ratio
Pay-out ratio is the relation of dividends paid to ordinary shareholders to the earnings
available to be paid out to ordinary shareholders. As such, it includes previous
cumulative earnings.
Another dividend policy is to maintain a constant pay-out ratio. Naturally the dividend
will fluctuate each year depending on the level of retained earnings and any
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movements in reserves. This policy is quite rate in listed companies, though many
firms may work towards some notional target pay-out ratio.
(c) Residual value
A third, less common, dividend policy is to use retained earnings to fund all projects
which show a positive net present value (NPV) at the firm’s weighted average cost of
capital (WACC) and pay out any remaining funds as dividends.
This is possibly the most objective dividend policy for rational investors but the
concerns of “signalling” (see above) often overrule such a common sense approach.
Non-Dividend Transactions
You should not forget that there are alternatives to cash dividend payouts, as follows.
(a) Scrip issues
A scrip issue, also referred to as a capitalisation, or a bonus issue, involves the
conversion of reserves into capital, causing a fall in the reserves. Shareholders receive
additional shares in proportion to their holding. Unlike a rights issue no additional
funds are brought into the company – the shareholders do not “pay” for these shares.
There is then more equity in circulation with the result that the market value will
generally fall in the short term, thus making it more attractive to potential investors.
The reserves used are either from a credit balance in the profit and loss account, or
from reserves specifically marked for the payment of shares, and authority is required
from the articles of association and the AGM.
(b) Scrip dividends
Scrip dividends are a conversion of profit reserves into issued share capital offered to
shareholders in lieu of a cash dividend. Enhanced scrip dividends are those where
the value of shares is greater than the cash dividend offered as an alternative. Such
dividends are of benefit to the company as they maintain cash within the business.
There may, however, be tax complications arising for individual investors.
(c) Stock split
A stock split is the splitting of existing shares into smaller shares, e.g. each ordinary
share of 50p is split into two of 25p, in order to improve marketability of the company’s
shares. It can also be used to send signals that the company is expecting significant
growth in EPS and dividends per share, and for this reason the resulting market price
of the split shares is higher than the simple split price would be. For example, if a
share with a market value of £10 was split into two shares their price would be higher
than £5. Reserves are not affected.
(d) Shareholder concessions
A number of companies offer discounts of one form or another to their shareholders.
These can be thought of as a dividend in kind and are a useful marketing tool or
publicity exercise – for example, hotel groups often give a concession to shareholders
on room rates
While these are often attractive to small shareholders (institutions rarely qualify, in any
case) they are often not a good reason for investment. The concession can be
removed at any time and often a significant holding must be maintained. To qualify for
concessions, shareholders usually have to hold a minimum number of shares.
An advantage, however, is that they are tax exempt!
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Study Unit 11
Working Capital and Short-Term Asset Management
Contents Page
Introduction 235
A. Working Capital 235
Rate of Turnover of Working Capital 235
Ratios Associated with the Assessment of Working Capital 237
B. Overtrading 243
C. Cash Management 245
Cash Flow Planning 245
Margin of Safety 246
Cash Management Problems 247
Cash Ratios 247
Factors Affecting Cash Resources 248
Cash Management Models 248
D. Management of Stocks 251
Cost of Stockholding 251
Stock Turnover Ratios 252
The 80:20 Rule 252
Economic Order Quantity 253
Just-In-Time (JIT) Method of Procurement 255
E. Management of Debtors 256
Debtors' Turnover Ratio 256
Actions Available to the Company 256
Credit Control 257
Establishing Credit Limits and Terms 258
Debt Recovery and Management 259
Management Control Information 260
Credit Insurance 261
Trading Abroad 262
(Continued over)
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F. Creditor Management 263
G. Short-Term Finance and Investment 263
Management of Short-Term Finance 263
Short-Term Investments 264
Specialist Sources Of Finance 265
Answers to Practice Questions 270
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Funds employed in an organisation can be split for planning purposes into long-term and
short-term funds. As we have seen in an earlier module, the financial manager will attempt
to match the funding available to the business to the life of the investment it is required for.
In this study unit we will consider the management of short-term funds applied to funding
current assets.
We shall start by looking at the definition of working capital, its constituent parts and
relationship to fixed capital, and some common ratios that can be applied as a management
tool. We then go on to consider the implications of cash management. Balance in cash flow
management is very important: too little cash resources highlights impending danger, but too
large a reserve of cash will mean that potential future earnings will be impaired.
The financial manager must predict the needs of the business and make suitable funding or
investment arrangements – planning the effective use of the financial resources, applying to
the working capital of a business. We shall discuss the specialist financial products that are
available to help to reduce the cash tied up in debtors, and look at ways in which the
company can decide on an optimum period of credit to be granted within the general
constraints of the markets in which it operates.
Working capital is the total amount of cash tied up in current (i.e. short term) assets and
current (i.e. short term) liabilities, and is calculated by deducting the total amount of current
liabilities from the total amount of current assets. Thus, if A plc has current assets of £10m
and current liabilities of £6m then its working capital resources are £4m. Working capital is
sometimes expressed as the current ratio (see below) and current assets (less closing
stock) as the quick or acid test or liquidity ratio.
The finance needed to fund a firm's required level of working capital can be either short or
long term.
It is essential to ensure that a firm has sufficient working capital to allow it to operate
smoothly and have sufficient funds to pay its bills when they arise, including taking account of
the effects of inflation and projected future cash flows. However, an organisation should be
careful not to over-provide working capital and cause unnecessary cost, a phenomenon
known as overcapitalisation.
Overinvestment in working capital leading to excessive stocks, debtors and cash, coupled
with few creditors, is known as overcapitalisation. Such a situation will lead to lower return
on investment and the possibility of having to secure long term funding to pay for short term
assets which is not an ideal situation for a business to be in. Indicators of overcapitalisation
include long turnover periods, high liquidity ratios and a low sales/working capital ratio.
Rate of Turnover of Working Capital
An organisation needs to control the rate of turnover of working capital constituents. Whilst
reducing the rate of turnover reduces the level of working capital required, it may lead to
overtrading (see later).
The rate of turnover of working capital can be determined by calculating the working capital
cycle (also called an operating cycle, trading cycle or cash cycle), which shows the
relationship between investment in working capital and cash flow.
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The following is an example of a typical working capital cycle:
Raw materials in stock 20 days
Work-in-progress 21 days
Finished goods stock 38 days
Period between despatch and invoice to customer 10 days
Period from invoicing to customer payment 60 days
Total 149 days
If the supplier of the raw materials required payment after 60 days, the company would need
to fund the cost of the goods sold for a period of 89 days, and of course wages and other
expenses would have to be paid during the period. Steps taken to speed up the rate of
working capital turnover, e.g. reducing stock levels, therefore means reducing the company's
investment in working capital.
To illustrate this point further, let's look at an example.
A company sells £20m of goods throughout the 50 weeks of the working year. As the sales
are partly through retail outlets and partly through mail order, daily sales from Monday to
Friday can be considered to be equal. The firm banks its takings on Thursday of each week
and the incremental cost of banking is £50. The company's account is always overdrawn
and it pays interest on this overdraft of 15% pa (in this example to be applied daily on a
simple interest basis).
Management wish to know whether there will be a benefit to banking twice weekly on
Monday and Thursday. Investigate the possibility.
£20m over 50 weeks of the year gives a turnover of £400,000 per week and £80,000 per day
for a five-day week.
We will now assess the banking alternatives being considered:
Day Receipts Banking Thursday only Banking Monday & Thursday
Days Interest
"£ days"
Days Interest
"£ days"
Monday 80 3 240 0 0
Tuesday 80 2 160 2 160
Wednesday 80 1 80 1 80
Thursday 80 0 0 0 0
Friday 80 6 480 3 240
960 480
Banking only on Thursday has the same effect as having an overdraft of £960,000 for one
day each week. In terms of interest, the cost of this is:
£960,000 × (15% ÷ 365) × 50 = £19,726.*
The annual interest cost of banking twice weekly is:
£480,000 × (15% ÷ 365) × 50 = £9,863.*
(*For interest purposes, we are using a calendar year.)
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Annual incremental banking costs at £50 per time are:
Once weekly, 1 × £50 × 50 = £2,500
Twice weekly, (2 × £2,500) = £5,000.
The total cost of banking on Thursdays only is:
£19,726 + £2,500 = £22,226.
Banking on Mondays and Thursdays costs:
£9,863 + £5,000 = £14,863, a saving of £7,363 pa, assuming constancy of all factors.
There is one even better solution, still banking twice weekly. Can you decide what it is?
Day Receipts Banking Tuesday & Friday
Days Interest
"£ days"
Monday 80 1 80
Tuesday 80 0 0
Wednesday 80 2 160
Thursday 80 1 80
Friday 80 0 0
The calculation is as follows:
£320,000 × (15% ÷ 365) × 50 = £6,575, and the total cost is:
£6,575 + £5,000 = £11,575.
An alternative way to compare the different banking methods would be to count the number
of days interest is charged. Interest is charged when the money is with the business and not
in the bank. Paying takings in more quickly means a reduction in interest charged on the
overdraft (and less risk of loss or theft).
The summary of the days' interest is as follows:
Banking Thursday: 12 days
Banking Monday and Thursday: 6 days
Banking Tuesday and Friday: 4 days
If such an exercise was to be conducted over a period of several years then discounted cash
flows (see later study unit) would be used.
Ratios Associated with the Assessment of Working Capital
In attempting to control working capital a financial manager will use some of the ratios we
discussed earlier in the course. However, unlike someone external to the company he will
not be restricted by balance sheet figures but will be able to monitor the ratios continually.
The main ratios that the financial manager will use in this area are the current ratio, quick
ratio and acid test ratio.
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(a) The current ratio (or working capital ratio) is measured as:
s liabilitie Current
assets Current
, expressed as a ratio, e.g. 2:1
Whilst there is a suggested target ratio of 2:1, the acceptability of the ratio calculated
will depend on the nature of the business, but current liabilities exceeding current
assets generally indicate that the business may have problems. In common with all
ratios it is important to monitor its trend in order to ascertain whether there are
potential problems developing. It is also useful to monitor the ratio by reference to that
of competitors to establish if it is higher than equivalent businesses.
(b) The quick asset ratio removes those items which cannot easily and quickly be
converted into cash at their full value (i.e. stock) and is calculated as:
s liabilitie Current
Stock assets Current ÷
Again there is no ideal ratio; the acceptability of the one calculated depends on the
industry (although the target is 1:1). In addition, it is the trend over time that is
important. Again, it is also useful to compare this ratio with that of competitors to
establish if it is higher than equivalent businesses.
(c) The acid test ratio is the amount of cash which the firm has to service its current
liabilities and is measured as:
s liabilitie Current
s investment Quoted + Deposits + Cash
Again it is the trend that is of most importance and it is also useful to monitor the ratio
against that of competitors to establish if it is higher than equivalent businesses.
Companies with poor acid test ratios need to have standby overdraft facilities in order
to ensure that the short-term need to service payments of current liabilities can be met.
However, remember that too much cash will mean that the firm is under-utilising its
resources and that a better return could be available elsewhere.
The working capital cycle starts with the investment in raw materials which are then used in
the production process and, therefore, become partly finished goods. Eventually, finished
goods are produced which are then held in stock until sold. Some of these goods might be
sold for cash and the rest would be sold on credit with the customer paying days or weeks
later (depending on what arrangements the individual debtor had with the business and
indeed how long each debtor takes to pay). At each stage of the process, expenditure is
needed on labour and other operational requirements. Helping to ease the cash burden are
suppliers who supply credit to the business.
Money tied up at any stage in the working capital cycle has an opportunity cost.
Cash conversion cycle
The cash conversion cycle is a part of the working capital cycle and can be expressed as
"The cash conversion cycle is the length of time elapsing between parting with cash
and getting it back from customers".
How is the cash conversion cycle measured?
There is a need to complete three key working capital ratios:
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x days (365) in year
sales of Cost
x 365
x 365
Cash conversion cycle
The following example has been taken from a question in the Corporate Finance paper for
June 2006.
Lancaster Model Aeroplanes Ltd has become increasingly concerned over its liquidity
position in recent months.
The most recent set of final accounts for the business show the following:
Profit and Loss Account
for the period ended 31
December 2005
£ £
Sales 550,000
less: Cost of sales:
Opening stock 170,000
Purchases 465,000
Closing stock (165,000) (470,000)
Gross profit 80,000
Expenses (90,000)
Net loss (10,000)
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Balance Sheet as at 31
December 2005
Cost Cum. Dep'n NBV
£ £ £
Fixed Assets
Premises 610,000 (300,000) 310,000
Fixtures and fittings 85,000 (40,000) 45,000
Motor vehicles 105,000 (35,000) 70,000
800,000 (375,000) 425,000
Current Assets
Stocks 152,000
Debtors 183,000
Current liabilities
Creditors 146,000
Bank overdraft 174,000
Working capital 15,000
Long term liabilities
Loans (160,000)
Net Assets 280,000
Financed by:
Capital 120,000
Retained profit 160,000
The debtors and creditors were maintained at a constant level throughout the year, and all
transactions were on a credit basis.
(a) Explain, using appropriate ratios, why the business is concerned with its liquidity
(b) Explain the term "operating cash cycle" and state why this concept is important in the
financial management of a business?
(c) Calculate the operating cash cycle for Lancaster Model Aeroplanes Ltd based on the
information given (assume a 365 day year).
(d) State what steps might be taken to improve the operating cash cycle of the company.
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(a) To help illustrate the worsening liquidity position of the company, it is useful firstly to
calculate a number of ratios involving solvency or liquidity:
 Working capital ratio
Current assets : Current liabilities
= 335,000 : 320,000
= 1.05 : 1
 Acid test ratio
Current assets ( less stock ) : current liabilities
= 183,000 : 320,000
= 0.57 : 1
 Debtors days
x 365
x 365 = 121 days
 Creditor days
x 365
x 365 = 115 days
The current ratio shows that the current assets exceed the short term current liabilities.
However, the overall ratio of 1.05 :1 is low and if the current assets were to be
liquidated, they would only have to be sold off at a small discount on the cost to be
insufficient to meet the short term liabilities. The acid test ratio of 0.57 : 1 is also very
low and suggests that the company has insufficient liquid assets to meet its maturing
The comparison of debtor days and creditor days is also worrying. Not only is the
business taking a long time to receive its debtor payments (121 days), it is paying its
creditors slightly quicker (115 days) and having to fund an average of 6 days of its
debtors figure, adding to its liquidity problems.
When interpreting these ratios, it needs to be borne in mind that they are based on
published figures at a point in time and are therefore only representative of that point in
time. They do, though, represent an indication of likely areas of concern and it would
be useful to monitor the trends of these ratios over time.
It would also be useful to prepare a cash flow forecast in order to gain a better
understanding of the estimated liquidity position of the business in the future.
The bank overdraft is the major form of short term finance and the continuing support
of the bank is likely to be of critical importance to the company.
(b) The operating cash cycle of a business represents the time period between the outlay
of cash on the purchase of stocks and the receipt of cash from trade debtors.
The operating cash cycle is important because the longer this period is, the greater the
financing requirements of the business and the greater the risks involved.
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(c) The operating cash cycle for Lancaster Model Aeroplanes Ltd is:
 Average period stocks are held
(to nearest whole day)
sales of cost daily Average
stocks of value Average
65) (470,000/3
165,000)/2 (170,000 +
= 130 days
 Average settlement period for debtors
(to nearest whole day)
sales daily Average
debtors Average
65) (550,000/3
000 183,
= 121 days
 Average settlement period for creditors
(to nearest whole day)
purchases daily Average
creditors of level Average
65) (465,000/3
000 146,
= 115 days
The operating cash cycle for Lancaster Model Aeroplanes Ltd is therefore:
130 days + 121 days – 115 days = 136 days
(d) The operating cash cycle of the business is quite long. It may be reduced by a
reduction in the stocks, extending further the average settlement period for creditors or
some combination of these measures. The stockholding period and average
settlement period for debtors also seems high and needs to be reduced, hopefully
without too much difficulty. The use of a factoring agency could be useful in this
respect. As the average settlement period of creditors is also high, it may be difficult to
extend this further without incurring problems for the company.
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An increase in a company's turnover is basically good, but it should be part of a planned
strategy with a permanent increase being supported by a matching permanent increase in
the working capital of the company. This will most commonly be achieved by retention of
profits and/or an injection of share capital. Inflation could increase the requirement more
than the funding injected.
Overtrading is a common phenomenon for growing companies, and occurs when a business
overextends itself by having insufficient capital to match increases in turnover. Increasing
turnover will result in higher stock and debtor levels which will need to be funded. Another
cause of overtrading is the repayment of a loan when the business has insufficient cash to
fund it. Whilst there will be some corresponding growth in creditors, sustaining growth on
trade credit alone is unlikely to be successful in the longer term.
In such a situation increasing the firm's overdraft and reducing the level of credit allowed to
debtors are other possible sources of finance. However, both will prove difficult in practice;
the latter especially may create problems preventing the required growth the firm desires.
Typical symptoms of overtrading would include the following:
 A significant increase in turnover over the period
 A decrease in gross profit and net profit ratios over the same period
 A deterioration in stock turnover ratios
 Increasing liquidity problems shown by the current asset and acid test ratios
 Increasing reliance on short term finance such as an increase in bank overdraft and
creditors payment period
 A rapid increase in the volume of current assets
 Only a small increase in the owners capital
 Some debt ratios alter significantly
And future action needed to address these issues could include the following:
 Efforts to increase stock turnover, such as an advertising campaign or marketing
 Reduction in expenses to improve net profit percentage
 Seeking of alternative methods of finance to fund any expansion
 Consider a reduction in the rate of raid expansion
 Consider new capital from the owners of the business
 Improve control systems, particularly cost control systems
 Consider having to abandon any ambitious plans for the immediate future
 Look at loan requirements – for example, has the business repaid a loan without
replacing it? This has the effect of reducing the long term capital of the business
 Consider the use of credit and factoring agencies.
Overtrading is illustrated by the following example:
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Year 1 Year 2
£ £ £ £
Fixed Assets 80,000 120,000
Current Assets
Stock 20,000 40,000
WIP 20,000 50,000
Debtors 50,000 80,000
Cash 5,000
95,000 170,000
Current Liabilities
Creditors 45,000 118,000
Bank 20,000 60,000
65,000 178,000
30,000 (8,000)
110,000 112,000
Financed By:
Share Capital 100,000 100,000
Profit & Loss Account 10,000 12,000
110,000 112,000
Sales £500,000 £1,000,000
Gross Profit £100,000 £100,000
Gross Profit % 20% 10%
Net Profit £30,000 £2,000
Net Profit % 6% 0.2%
The important points to note are:
(a) Turnover has doubled, but the gross profit percentage has halved. Discounts for
quicker payment may have caused this, as could lower sale prices to win more orders.
(b) Net profit percentage shows a big decline. Increased wages and bonuses, or writing
off obsolete stock may have caused this.
(c) Stock and WIP have more than doubled. (Has obsolete stock been written off?)
(d) Although sales have risen by 100%, the increase in debtors is only 60%.
(e) Surplus cash from Year 1 has been used and bank borrowing has increased
(f) Creditors have increased by 162% for a rise in turnover of 100%. Credit periods have
extended, and problems could arise if they have not been negotiated.
(g) Whilst fixed assets have increased, it may not be symptomatic of the increased trade.
The expenditure may be part of a planned cycle, and indeed, if the machines are more
productive they will benefit the increased business volumes. It is unwise to increase
capital expenditure from short-term finance such as trade credit and bank overdraft,
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(h) The positive current and quick asset ratios have disappeared, indicating a worsening in
the short-term financing position.
(i) The proprietors' stake for the two years is:
Year 1 Year 2
£ £
Total Assets 175,000 290,000
Financed By:
Capital 110,000 62.9% 112,000 38.6%
Creditors 45,000 25.7% 118,000 40.7%
Bank overdraft 20,000 11.4% 60,000 20.7%
175,000 290,000
There has been a dramatic decline in the proportion funded by the equity holders, and
should the bank limit be reached, no more trade credit be available and debtors be
unwilling to pay more quickly, then the firm could go out of business despite a full order
book and the potential to be successful.
Methods to relieve the situation could include:
 Faster debt collection, although too much pressure may lose customers.
 More efficient stock-holding.
 Slower payment to creditors, but there are limits that will be acceptable.
 Increased bank financing, although the bank will probably expect a capital injection
from outside the business as well.
 Slowing down the rate of growth in turnover, allowing work in progress to be finished
and stock sold, thereby reducing the amount of working capital needed.
Every organisation must have adequate cash resources (including undrawn bank overdraft
facilities) available to it to meet its financial commitments of day-to-day trading (e.g. wages
and taxation). Cash is also required to meet contingencies, to take advantage of discounts
and other opportunities available, and to finance expansion. Firms should, though, avoid
holding too much cash with the resulting under-utilisation of resources.
Cash Flow Planning
In order to understand cash management you need to be aware of the difference between
profits and cash flow. From your accountancy studies you will be aware that profit is the
amount by which income exceeds expenditure when both are matched on a time basis.
Cash flow, however, is the actual flow of cash in and out of the organisation with no
adjustments made for prepayments or accruals.
A business which has insufficient cash may be forced into liquidation by its unpaid creditors
even if it is profitable. A lack of cash can be seen by an increasingly late payment of bills.
Management therefore needs to plan and control cash flow to prevent liquidation. In the
short term this is done by cash flow budgeting, which can be daily, weekly, monthly or yearly,
ensuring that the organisation has sufficient cash inflows to meet its outflows as they become
due. Such budgets should fit in with the overall budgetary scheme that the company
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operates. If a shortage is expected then the firm can arrange finance, perhaps by increasing
its overdraft, to overcome the problem.
Other remedies that can be used to deal with short-term expected cash shortages are:
 Accelerating cash inflows from debtors.
 Postponing cash outflows by delaying payment to creditors; whilst this is considered to
be a cheap alternative (creditors rarely charge interest), such an alternative increases
the risk of insolvency of the firm.
 Postponing capital expenditure (or negotiating extended payment terms with the
 Reversing past investment decisions, such as selling off non-essential assets.
 Rescheduling loan repayments (with the lender's agreement).
 Reducing the level of dividend to be paid.
 Deferring (after discussion with the Inland Revenue) tax payments (but there will be an
interest cost to doing this).
Despite it being bad policy to finance long-term assets with short-term funding, where the
financial manager can determine from the cash budget that sufficient funds will become
available, it may be possible to operate such a funding policy without detriment to the firm.
In order to help cash management of groups, a facility called cash pooling may be
requested from the group's bank. This process of cash pooling allows the offsetting of
surplus and deficits held at the bank by the group's companies using a dummy account. The
net balance is the one on which interest is payable or chargeable, and the group can then
decide how to allocate this cost or income.
For those groups which have overseas subsidiaries involved in intra-group trading, then the
group may net off the transactions between its members on a multilateral basis. Whilst there
are some countries which limit or prohibit netting (e.g. Italy and France), the groups should
benefit from reduced transaction costs.
A further method of cash management that may be adopted by a multinational firm is to
centralise cash management, holding funds in one of the major financial centres such as
London or New York, with only the minimum level required for day-to-day purposes being
held by subsidiaries. The remittance of funds back to the parent can be done via the group's
bank, or telegraphic transfer, but there may be limitations imposed by overseas governments
on the level of remittances.
Margin of Safety
No forecast will ever be 100% accurate and the further into the future the projections are
made, the greater will be the margin of error. In cash budgeting the balance at the end of
each period represents a "margin of safety", whereby the company buys peace of mind at the
expense of profitable utilisation of cash. The size of the balance must be related to the
certainty or otherwise of the predicted inflows and outflows, and the availability of back-up
resources, such as overdraft facilities available. A cash-based business, such as a food
supermarket, will have more certainty of its cash inflows than a business selling principally on
extended trade terms. Where, therefore, cash inflow can be predicted with relative accuracy,
provision for a margin of safety can be smaller.
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Cash Management Problems
There are several reasons why a business may encounter problems with its cash flow,
 Overtrading – which we discussed above.
 Growth – a firm may need to finance new assets to replace old and obsolete ones.
 Loss-making – if a business continually trades at a loss for a protracted period cash
problems will materialise.
 Inflation – the replacement costs of stock will be at a higher price when there is
inflation. However, competitive pressure may prevent a corresponding increase in
selling price.
 Payment delays – either due to the business's inefficiency or external delays.
 Bad debts – a large customer going into liquidation can create severe problems with a
company's cash flow.
 Large items of expenditure – fixed asset purchases or the redemption of loans can
drain cash resources rapidly if insufficient plans have been made.
 Seasonal trading – this can cause short-term difficulty, particularly if a retailer's stock,
bought in especially for seasonal trading (e.g. Christmas), proves unpopular and does
not sell.
A company experiencing problems with its cash flow should ensure that the invoice
department is informed immediately when goods are despatched, and that instructions for
payment are made clearly to customers.
Cash Ratios
Ratio analysis can help in cash management and serve as an indicator of the cash-holding
position. The main ratios are:
(a) Cash Holding – this ratio indicates the proportion of current assets which are held as
cash. Generally, the financial manager will want to keep this figure at the safe
minimum to be able to service immediate current outflows.
The ratio is measured as:
assets Current
The ratio may increase when a business is deliberately accumulating cash to meet
forthcoming needs, e.g. capital expenditure or repayment of debt capital.
(b) Cash Turnover – this ratio is used to determine how frequently cash is turned over
and is expressed as:
balance cash Average
period the during Sales
The ratio assumes that an average cash holding is used, typically calculated as:
balance cash Closing + balance cash Opening
However, note that cash flows will not be constant, especially if there is seasonal trade.
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For example, if sales for the year were £72,000 and the average cash holding was
£9,000 then using the above formula:
balance cash Average
period the during Sales
000 9
000 72
= 8 times
i.e. cash was turned over every 45.6 days.
A higher rate of cash turnover will generally be taken to imply the effective use of cash
– the more frequent the turnover, the lower the level of cash needed. High rates of
turnover, however, will appear as the result of maintaining too low a level of cash, and
as such these ratios should be viewed together, i.e. the maximum turnover rate
consistent with adequate holdings levels. Any proposed measures of improving cash
flow management must be carefully evaluated to ensure that the costs do not outweigh
the benefits.
Cash-based ratios will vary widely in different industries, e.g. turnover of cash in a food
supermarket will be rapid, but in a major engineering concern it may take months to turn over
once. Viewing one set of ratios for just one period will in itself disclose very little about the
management of the firm and its trading prospects, and calculated ratios should be compared
over time, and with industry norms.
Factors Affecting Cash Resources
The amount of cash a firm is holding can be affected by a number of unforeseen events:
 New competitors and/or new products may adversely affect demand for a company's
 Consumers may change their purchasing habits, e.g. people are becoming increasingly
aware of benefits derived from the use of environmentally friendly products.
 Upward movements in interest rates will reduce the amount of cash available to firms
that are in a net borrowing situation.
 Businesses dependent on trading (both buying and selling) will be affected by
movements in foreign exchange rates.
 Strikes or other disasters may halt production, or at least significantly reduce it, with a
resultant fall in sales volume.
There is often a considerable amount of money tied up in the "float", i.e. in the process of
converting the cheque sent by the debtor into cash in the receiver's bank. Delays during the
process are those in receiving the cheque (transmission delay) and in the lodging and
clearing of the cheque. The use of systems such as bank giro, BACS (Bankers' Automated
Clearing Services Ltd), standing orders, direct debits and CHAPS (Clearing House
Automated Payments System) help to reduce these delays. In addition a company could
collect local cheques itself, and should certainly ensure that cheques are banked on the day
of receipt whenever possible.
Cash Management Models
A number of models have been developed to help companies manage their cash. These
range from simple spreadsheet models to more complicated models such as the Miller-Orr
model discussed later. The aim of these models is to trade-off the lost interest of holding idle
cash balances against the problems of having insufficient cash, and thus help companies
determine the optimal minimum and maximum levels of cash holding. The models can
generally be manipulated in order to allow the organisation to determine which factors need
to be carefully managed in order to maintain optimal cash balances. Like all models they
have their drawbacks and rely on good quality information being input to produce worthwhile
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(a) Baumol's or the Inventory Model of Cash Management
This model states that the total cost for holding an average level of cash is minimised
Q =
FS 2
where: Q = total amount of cash needed to raise for the time period
F = fixed cost of obtaining new funds (e.g. issue costs of shares)
S = amount of cash to be used in the time period
i = interest foregone (opportunity cost) of holding cash or near cash
equivalents (this is a variable cost of obtaining funds)
and the average total cost of holding an average level of cash incurred in a period is:
Sooty plc requires £6,000 cash per annum. Any cash raised will have an associated
fixed cost of £300 and an interest rate of 15%. The interest rate on short-term
securities is 10%. Advise Sooty as to the level of finance it should raise at any one
The cost of holding cash for Sooty is the difference between the cost of the funds and
that earned on short-term securities, i.e. 15% ÷ 10% = 5%.
Therefore, substituting into the above formula:
Q =
05 0
000 6 300 2
, × ×
= £8,485
This level should be raised every £8,485/£6,000 = 1.4 years.
Whilst this model provides a good basis for cash management, especially for firms
which use cash at a steady rate, it ignores costs associated with having a cash deficit
(e.g. interest on an overdraft), and any costs which may increase with increases in the
amount of cash held. The model has been found in practice to be poor at predicting
the amounts of cash required in future periods, and of little help in those firms where
there are large and irregular inflows and outflows of cash.
(b) Miller-Orr Model
The Miller-Orr model, which was developed to produce a more useful model than the
Baumol model, sets upper and lower limits to the level of cash a firm should hold.
When these points are reached the firm either buys or sells short-term marketable
securities in order to reverse the trend of cash flows. In order to set these levels, the
variability of cash flows needs to be determined along with the costs of buying and
selling securities, and the interest rate.
The steps in using the model are:
(i) Determine the lower level of cash the firm is happy to have. This is generally set
at a minimum safety level, though in theory it could be zero.
(ii) Determine the variation in cash flows of the firm (perhaps over a three or six
month period).
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(iii) Calculate the spread of transactions, using the following formula:
Spread = 3 ×
rate Interest
cost) n Transactio flow cash of Variance (0.75 × ×
(iv) Calculate the upper limit – this is the sum of the lower limit and the spread.
(v) However, in order to minimise the costs of holding cash, securities should be sold
when a pre-calculated level (the return point) is reached. The return point is the
sum of the lower limit and
of the spread.
We will look at an example to show application of the model. You will only be required
to understand how calculations are undertaken in your examination.
Pat Ltd faces an interest rate of 0.5% per day and its brokers charge £75 for each
transaction in short-term securities. Their managing director has stated that the
minimum cash balance that is acceptable is £2,000, and that the variance of cash flows
on a daily basis is £16,000. What is the maximum level of cash the firm should hold,
and at what point should it start to purchase or sell securities?
Following the above procedure:
(i) Determine the lower level of cash the firm is happy in having; this has been set at
(ii) Determine the variation in cash flows of the firm – this has been found to be
(iii) Calculate the spread of transactions:
Spread = 3 ×
rate Interest
cost) n Transactio cashflow of Variance (0.75 × ×
= 3 ×
75) 16,000 (0.75 × ×
= £1,694
(iv) Calculate the upper limit – this is the sum of the lower limit and the spread:
upper limit = £2,000 + £1,694 = £3,694.
(v) However, in order to minimise the costs of holding cash, securities should be sold
when a pre-calculated level (the return point) is reached. The return point is the
sum of the lower limit and
of the spread = £2,000 +
(1,694) = £2,565.
Thus the firm is aiming for a cash holding of £2,565 (the return point). Therefore, if the
balance of cash reaches £3,694 the firm should buy £3,694 ÷ £2,565 = £1,129 of
marketable securities, and if it falls to £2,000 then £565 of securities should be sold.
The model is useful in that it considers the level of interest rates (the higher the rates
the lower the spread, and thus the less cash that is needed to be held before the return
point and the upper limit is reached), and transaction costs (the higher the transaction
costs the greater the spread and thus the less transactions are needed). In addition,
the variability of cash flows are considered – those which are more variable are allowed
a greater degree of freedom. The major problem of the model is that it does not take
into consideration the fact that several cash flows of the firm can be predicted
accurately (e.g. dividend payments), it having been developed to deal with uncertainty
in cash flow management.
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Stock, or inventory as it is also known, comprises four main types:
 Raw material
 Work-in-progress
 Finished goods
 Miscellaneous items, e.g. tools, stationery, fuel, etc.
As with other working capital items, the problem for the financial manager is that of
maintaining balance. He or she must ensure that:
(a) There will be sufficient raw material stock available to satisfy production needs and
enough finished goods stock to meet customers' requirements.
(b) At the same time, the amount of capital employed in stocks is minimised.
(Stockholding has been called the graveyard of industry by financial commentators in
the past.)
Achieving balance can be particularly difficult in the distributive, wholesaling industries,
where customers expect a range of goods to be carried, but only place orders infrequently
when they need a non-routine item. The distributor is faced with the problem of finding a
balance between his ability (and reputation) for good service, and the need to restrict capital
tied up in slow moving lines.
Cost of Stockholding
Holding stock is generally an expensive cash utilisation of a firm's working capital resources.
Stock is basically money in another form, and some of the principal costs associated with
stockholding will include:
(a) Cost of stock, less any available discount (e.g. for bulk purchasing)
(b) Providing finance – since stock is money, there is the cost of financing it, which may
be taken as the weighted average cost of capital. There is also an opportunity cost of
capital to consider, as funds tied up in stocks cannot be used for other, more profitable
investments and so potential income will be forgone.
(c) Stock handling – included under this heading will be the costs of the stores
installation, which may include racks, bins, paperwork systems, insurance and
maintenance cost, security and so forth.
(d) Holding losses – these costs include evaporation, deterioration, obsolescence, theft,
damage in stores and in transit. There may well be, of course, holding gains,
particularly during times of inflation, but any gain will usually be offset by the usually
higher costs of funds in such periods.
(e) Procurement costs – the costs of obtaining stock. These include:
(i) Clerical and administrative costs of procurement, e.g. salaries, purchasing office,
telephones, letters, etc.
(ii) Transportation costs.
(iii) Related costs of tooling, production, scheduling, etc. associated with internal
order, where stocks are produced internally.
(f) Shortage or stock-out costs – the costs of being without stock for a period of time.
These include
(i) Loss of contribution through the lost sale caused by stock-out.
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(ii) Loss of future custom to competitors.
(iii) Idle time caused by breaks in production.
(iv) Overtime, rescheduling and related costs, arising from the need to expedite a
"rush" order.
(v) Lost production.
(vi) Higher prices.
There are practical problems in quantifying many of these items, since they will
typically be unknown until the effect of stock-out is known.
Stock Turnover Ratios
When turnover, or the throughput, of an item increases, the level of stockholding will
generally be reduced. Management will therefore seek to verify the rate of stock turnover in
order to establish whether the position is satisfactory, or whether they will need to take
action. Like all ratios, the real benefit comes from comparison over successive periods of
time against the overall plan for the business.
The ratio is expressed as:
period the in consumed materials of Cost
period in days of No. period of end at ng Stockholdi ×
= No. of days stock in hand
For example, a company has a closing stock of £32,600 and an annual consumption of stock
of £220,700. Applying the ratio:
700 220
600 32
× 365* = 54 days.
(*This is for a full year.)
If we make some simplifying assumptions to the effect that stock is consumed evenly
throughout the year and the year end position is representative of the remainder of the year
(i.e. there are no seasonal trends) we can say that the stock turned over every 54 days, i.e.
6.8 times. The ratio may also use the average of opening and closing stock as a more
representative figure rather than just closing stock.
In some circumstances, similar calculations can be made expressing the relationship
between stock and sales, again arriving at turnover intervals in terms of days and times. You
should bear in mind that a separate calculation may be required for each type of stock, also
breaking down its constituent parts into raw materials, finished goods and work in progress.
The 80:20 Rule
This rule is known as Pareto's Law after the Italian economist whose career spanned the
late 19th and 20th centuries.
It is often found that a large percentage (the 80%) of stock is made up of only a small number
(the 20%) of physical items. In these circumstances it is usual to adopt the procedure of
dual control. The smaller number of high value items is subjected to a detailed stock control
system. The larger number of low value items is made the subject of a more routine
inventory system based on minimum and maximum reorder levels. The reasoning behind
this is that strict control of 80% of the value should be quite sufficient to maintain an
appropriate rate of stock turnover and control stock availability.
Pareto analysis is sometimes called ABC Analysis (not to be confused with Activity Based
Costing). In this instance stock is broken down into three types depending on its value and
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 A items are those which are probably low volume usage but relatively high cost. In
terms of control they are usually treated on an individual basis. They may represent
20% in number and perhaps 80% of the value.
 B items represent 30% of the items with, say, 15% of the value. In terms of control,
they will typically be monitored by the use of a reorder policy.
 C items are the high volume, low priced items where close control is unimportant.
They can be controlled by bulk issue methods such as "two-bin" systems.
The Pareto rule can also be graphed by comparing the cumulative value of the items (which
could be in terms of cost, turnover, usage, etc.) against the cumulative number of items, as
shown in Figure 11.1.
Note that the proportions can change so that, for instance, the top 80% in value may be
represented by 30% of the items and so on.
Figure 11.1
We may conclude the subject of stock management by noting that this is another area where
the financial manager, in his or her broad overall management capacity, oversees what is, in
fact, a specialist activity. Stock control has grown into an autonomous subject with a
considerable background of mathematical modelling, both deterministic and probabilistic,
seeking to optimise suitable stockholding and holding cost minimisation, against the
background of production difficulties and product prices.
Economic Order Quantity
Economic Order Quantity (EOQ), a deterministic model, is defined by CIMA as:
"A quantity of materials to be ordered which takes into account the optimum
combination of:
 Bulk discounts from high volume purchases
 Usage rate
 Stockholding costs
 Storage capacity
 Order delivery time
 Cost of processing the order".
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There are several assumptions underlying this model:
(a) No bulk discounts.
(b) There is a known, constant stockholding cost.
(c) There is a known, constant ordering cost.
(d) The rates of demand are known.
(e) There is a constant, known price per unit.
(f) No lead time, i.e. replenishment is made instantaneously (the whole batch is delivered
at once).
Hence, the reorder quantity which minimises costs is the amount which minimises the
combination of:
 Stockholding
 Stock reordering.
The combined cost can be expressed algebraically as:
× h) + (C ×
where: h = cost of holding one unit of stock per annum (or other relevant period)
C = cost of ordering a consignment from a supplier
d = annual demand (or other period)
Q = reorder quantity
Therefore Q ÷ 2 is the average stockholding per annum (or other time period).
This can be illustrated graphically as shown in Figure 11.2.
Figure 11.2
From this you can see that the larger the reorder quantity, the larger will be the stockholding
cost. However, as the number of orders during the year decreases, ordering costs will be
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reduced. Alternatively, the smaller the reorder quantity, the smaller the stockholding costs,
but the number of orders will increase, hence ordering costs will increase.
It can be proved that combined costs are minimised, i.e. the reorder quantity is most
economic, when:
Q =
Cd 2
Annual demand for material is 300 units, the ordering cost is £2 per order, the units cost £20
each and it is estimated that the carrying costs will be 15% per annum. Determine the EOQ
and the numbers of orders to be placed per year.
Substituting into the EOQ formula:
C = £2 per order
d = 300 units
h = £20 × 15% = £3 per unit
300 2 2 × ×
= 20 units.
= 15.
Therefore, place 15 orders per year for 20 units.
The EOQ model given above is for replenishment stock in one batch. Where replenishment
takes place gradually, e.g. where items are manufactured internally and placed into stock
when they are completed, the formula must be adjusted slightly as:
where: R is replenishment rate per annum
Firms using the EOQ method may decide, because of uncertainties as to demand or lead
time, to hold a "safety level" of stock to reduce the likelihood of a stock-out caused by
excessive demand or an extra long lead time. The cost of this safety stock would be its
quantity multiplied by the unit stockholding cost. The EOQ is still the quantity ordered.
Just-In-Time (JIT) Method of Procurement
The aim of this method is to minimise the costs of holding stock, and goods are obtained
from suppliers when required rather than holding stocks of materials and components. It is
only suitable where a stock-out would not be disastrous (e.g. a hospital must have sufficient
stocks of drugs and other medical equipment to ensure that it can treat its patients).
In order to introduce JIT production flows need to be even and predictable, a criteria which is
aided if the firm adopts a policy of Total Quality Management (TQM) removing waste and
other bottlenecks. The aim of TQM is to have 100% quality with zero defects.
The advantages of JIT include:
 A reduction in stockholding costs
 Simplification of the accounting for raw materials
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 Materials can be purchased at discounted prices
 A reduction in production lead times
 A reduction in scrap and work returned for correction
 A reduction in labour costs per unit due to increased productivity
 A healthier current ratio, and lower working capital requirements.
Perhaps the management of debtors carries more importance than the management of
stocks. Such an hypothesis will be based on the fact that at least stocks, even when poorly
managed, remain on the premises and under the control of the company. Debtors represent
the capital of the company placed in the hands of others in the form of goods over which the
company has effectively lost all control.
The issue is, in common with all aspects of working capital, one of balance. With debtors,
the factors to be balanced are:
(a) Giving credit or discounts – which acts as an aid to sales and potential profitability –
and the period over which credit is, or has to be, extended.
(b) The cost of giving credit – effectively the company is lending out its precious working
capital resources at 0% interest, thus needing extra capital.
(c) The cost of being unable to use that capital for more profitable projects.
(d) The cost of eventual bad debts should they arise (administrative costs, collection costs,
Debtors' Turnover Ratio
Competent financial managers will need some "rule of thumb" calculations to monitor the
daily position relating to debtors and the debtors' turnover represents such a management
tool. It is expressed as:
year the during made Sales
year the of end the at Debtors
× 365 = No. of days' sales outstanding.*
(*Where the period is for less than one year, the figure of 365 will be adjusted accordingly.)
Therefore a company with debtors of £68,400 and sales during the year of £272,500 has:
500 272
400 68
× 365 = 92 days of sales outstanding and as yet unpaid by debtors.
As with stock turnover, if we assume that the balance sheet level of debtors is representative
of the entire year, and that sales arise evenly through the year with no seasonal trends to
take into account, then we can say that debtors settle on average every 92 days.
Actions Available to the Company
The physical possession of the company's capital passes from its hands when the goods are
transferred. Broadly there are five areas of attention to which the company can pay heed in
attempting to influence the level of indebtedness of its customers and the inherent risks that
this brings. These are:
(a) Checking out the credit standing of the customer, and re-checking for any adverse
changes periodically.
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(b) Setting a limit to the level of credit granted to individual customers and laying out terms
of trading clearly in writing.
(c) Implementing formal collection procedures for delinquent accounts.
(d) Negotiating cash discounts for the most valued accounts.
(e) Taking out credit insurance.
Credit Control
Credit control can be defined as:
"minimising the risks involved in handing over goods upon the strength of a
promise to pay in future".
The importance of the credit control department varies with the nature of the business in
which it functions. Some companies sell entirely for cash – this is generally the case with a
supermarket chain, for example. Companies who deal with small retail traders often have a
major problem in that granting and controlling credit will involve them in a large number of
accounts. This will be a time-consuming process in view of the numbers involved.
Other firms, making large industrial machines, may have few accounts and may even receive
progress (stage) payments from customers as certain stages of the project are completed.
Bearing in mind these variations, the financial manager should consider the volume of
business that will be sold on credit terms, the number of customers requiring credit and the
records to be maintained when organising the credit control department. Important
relationships will develop between credit control, and other departments, notably sales and
marketing who may resent "their" hard won customers being subjected to status checks. We
will now consider some of the most important aspects which affect credit control.
(a) The credit controller
This function may be combined with the sales ledger account department. This is a
convenient arrangement because credit limits and the actual amount permitted from
one period to another can be seen quite easily from the sales ledger records.
(b) Processing customers' orders
When a new customer is involved, it is essential to check his or her creditworthiness
and the following are useful methods:
 Direct methods
(i) Information obtained by the sales person from reports and interviews.
(ii) The credit controller's own judgment, either from local knowledge, or from
studying published accounts (or both).
The accounts will help to identify the length of time taken to pay other
suppliers. A "rule of thumb" check which can be performed is:
Average purchases per day =
materials of purchases Annual
day per purchases Average
creditors Trade
= Number of days purchases in creditors.
(iii) Valuation of the company's fixed assets.
(iv) Establishing a progressive and carefully managed system of credit, based
on the track record of the customer's ability and willingness to pay.
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 Indirect methods
Methods available include:
(i) A report from the customer's bank.
(ii) References from people who have had dealings with the potential
(iii) The use of trade protection associations.
(iv) Consulting official records.
(v) Journals, newspapers and other publications.
(vi) Trade associations.
Generally, it is useful to have a number of opinions before granting credit, and whilst
direct methods can be efficient they are potentially time consuming. Experience will,
however, be needed to interpret the guarded wording in many third party reports. It is
often what they don't say, rather than what they do, that will lead the experienced
credit controller to a safe conclusion.
The merits and otherwise of indirect methods include:
 Bank reports
These are often slow and must be made between two banks. The wording will
always be guarded and remember that the bank may not be aware of all of their
customer's other commitments.
Bank reports possibly have greatest value in foreign trade, where they should be
the best placed of all sources to assess the potential risks of the proposed
 Trade referees
Some buyers "nurse" specific accounts so that they can use them as referees
and may even give friends' names without disclosing the relationship. The best
use of trade references is as a gauge of potential volume.
 Trade protection associations
Information is generally supplied only to members for their own use. Infolink is
one of the major players in this market, and it can provide a status report on any
form of business organisation, including sole traders and partnerships.
 Commercial credit houses
These organisations are commercial firms who specialise in the collection of
credit information. Examples are Stubbs and Kemps, Seyde & Company and
Dun and Bradstreet. As with the trade protection associations, a status report
can be obtained for a reasonable fee. Some only report on incorporated entities,
In addition to the reporting service, credit ratings are set for most businesses
above a certain size and published periodically in books available to members.
The rating systems use symbols, often letters, to indicate the likely credit limit that
could be set for specific companies.
Establishing Credit Limits and Terms
Credit limits may be set in advance, in anticipation of a new account, but often no action will
be taken until the first order on credit terms has been received. At this stage a credit limit
should always be set and this will generally follow enquiries into the affairs of the new
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customer. As well as external reports, some of the factors that may be taken into account in
assessing a new credit limit may include:
 The managerial efficiency and integrity of the business concerned.
 Affording facilities as good as those available from competitors (providing the business
is not being offered because competitors have not been paid!).
 The capital employed in the customer's business.
 The nature of the business and the sector in which it operates.
Consideration may also be given to relaxing the credit period allowed to customers if this is
thought to be a profitable course of action. This may be of particular benefit when interest
rates are low (and therefore the cost of financing is similarly low) in order to rebuild trade
which has fallen off as a result of recession. However, care should be taken to ascertain the
degree of risk in such a course of action. To assess the viability of extending credit periods
given to customers, the company would undertake a calculation along the following lines:
A company plans to extend its credit period from one to two months, with the intention of
increasing its sales by £½m on top of its current level of £1¼m. The current profit is around
5% and the increased sales would require increased working capital of £50,000 (excluding
the debtors). The required rate of return is 15%.
The company assumes that all customers take advantage of the new terms, and it calculates
that the increased level of debtors would be:
1,750,000 = |

× ÷ |

so the total increase in working capital is £(50,000 + 187,500) = £237,500.
The financing costs are £(237,500 × 15%) = £35,625.
The increased profits from the new policy are:
£(500,000 × 5%) = £25,000.
Therefore the new credit policy would not be worthwhile as £10,625 less would be made.
Debt Recovery and Management
An important function of credit control is to ensure that debts are collected as quickly as
possible. In order to induce the customer to pay promptly, it is a common feature for the
terms of payment to include a discount of around 2½% for prompt settlement, say within
seven days.
Whether or not the discount can be justified depends upon the circumstances. If the discount
really does prompt settlement within a much shorter period it may be justified, but, even then,
if the money is simply added to the existing credit balance on current account, it would be
much better to wait for a more usual payment period of 28 days and then receive the full,
undiscounted payment.
An example may serve to underline this point.
A company with annual sales of £1.2m on credit allows two months for payment. It is
considering the introduction of a scheme whereby a 2% discount is offered for the payment
of debts within 15 days from the date of invoicing, thereby reducing the period allowed to one
month. The company would expect annual sales to fall to £1m with 30% of debtors taking
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advantage of the discount. If the company requires a return of 15% on its investments,
would the offer of the discount be worthwhile?
It is possible to answer this question very simply by calculating the implied annual cost of the
discount and then comparing it to the rate that the firm could receive if it possessed the
money. Therefore, in the example, the cost would be:
rd) (100
(rd) discount of Rate
discount) for offered Period period credit (Original
) ( 15 60
= 16.5%.
From this you can see that it would not be worthwhile, as the firm could only earn 15% on the
funds collected.
It is also possible to show the impact of a new policy in a different way:
Current level of debtors: 1.2m ×
= £200,000.
Level of debtors following new policy on discount:

× + |

× £1m of 70
£1m of 30
% % = 12,329 + 58,333 = £70,662.
Therefore the value of debtors is projected to fall by £(200,000 ÷ 70,662) = £129,338.
The value of the reduction in perpetuity is £129,338 × 15% = £19,400.
The cost of the discount to the company is 2% × £300,000 = £6,000, which would appear to
make the offer of a discount worthwhile, but this does not take account of the effect of the fall
in profits as a result of the tighter credit control policy.
Thus, if the company would expect to obtain a profit margin of 7.5% on sales, then, in
addition to the £6,000 cost, it would lose (7.5% × £200,000) = £15,000 in profits, making a
total cost of £21,000. As the value is only £19,400 to the company, the discount is not
Irrespective of discounts, reminders should be sent out periodically unless payment on
invoice is expected. One method of spreading the workload caused by sending out invoices
and statements is known as cycle billing, and this involves sending out bills weekly or daily.
This overcomes problems facing the credit control department when everything is processed,
for example, in the last few days of the month.
When payments are really overdue, it is essential to take action without delay. This may take
one or more of the following forms:
 Sending further reminders
 Asking a sales person to call to collect
 Late reminders threatening legal action
 A call from the credit controller or a debt collector
 A solicitor's letter and, finally, legal action.
Management Control Information
Reports supplied internally to management will include details of any overdue accounts,
potential bad debts emerging, volume of new business transacted on credit, previous
problems since reconciled, and any other specific difficulties affecting credit control.
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Significant ratios will often be included, such as the ratio of debtors to creditors, the ratio of
credit sales to debtors, and the ratio of total sales to credit sales. A statement of outstanding
debtors illustrating the age of those debts will also be included, but may vary considerably
between different industries.
A typical statement of outstanding debtors is illustrated below.
Statement of Outstanding Debtors as at ............
Overdue Accounts Remarks Account
Over 1
Over 2
Over 3
Over 4
Over 5
£ £ £ £ £
Atkins M 40 Cheque promised
Brown B 60 Court action pending
Sales for year to date £................................
Sales for current period £................................
Current balances outstanding £................................
Credit Insurance
The Export Credits Guarantee Department (ECGD) is the UK's official Export Credit Agency.
Its aim is to help UK exporters of capital equipment and project-related goods and services
win business and complete overseas contracts with confidence. The ECGD provides:
 Insurance to UK exporters against non-payment by their overseas buyers
 Guarantees for bank loans to facilitate the provision of finance to buyers of goods and
services from UK companies
 Political risk insurance to UK investors in overseas markets.
The ECGD work closely with exporters, project sponsors, banks and buyers to put together
the right package for each contract. With almost 90 years experience in new and developing
markets across the world, their knowledge can help companies in unfamiliar environments.
Policies which may be taken out will either be:
(a) Whole turnover policies, which cover total sales for the year; or
(b) Specific account policies, which cover a specific account.
Selection of a policy will largely be determined by the nature of the business conducted by
the company and, if the company has a number of substantial accounts, a whole turnover
policy will almost certainly be preferred.
Each proposal will be taken on its merits and insurance cover is given on a sound proposition
where there is a satisfactory prospect that payment will be made.
The risks covered will include:
 The insolvency of the buyer.
 The prevention of, or delay in, the transfer of payment to the merchant in
circumstances outside the control of both the merchant and the buyer.
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 War preventing the export of the goods or performance of contracts, or the delivery of
goods to the buyer's country (contracts and shipments).
 War, revolution or civil disturbance in the buyer's country specifically.
 The failure or refusal of a government buyer to fulfil the terms of the contract.
Trading Abroad
A knowledge of the procedures followed when intending to export goods is essential, and the
main factors are summarised below:
(a) Sell direct or through a merchant
It will be necessary to decide whether to sell direct or through a specialised export
merchant. Exporting is often a complicated process to which the manufacturer can
devote insufficient time. As a result, the company may be well advised to seek help
from a recommended export merchant who understands, and has established
contacts in, the chosen market.
(b) Winning customers
Help can be obtained from the DTI and through Business Link when an exporter is
deciding on where his best market is located. Banks, trade associations and overseas
agents can also fulfil a useful role, but care should be taken in choosing the latter since
he or she may already deal in competing products.
(c) Assessing the credit standing of buyers
An initial appraisal of the credit standing should be made and then a review carried out
at regular intervals.
(d) Complying with regulations
There are government restrictions in most countries, and in Britain an export licence
may be required for certain transactions. Other countries may have regulations
affecting factors such as:
 Exchange controls.
 Trade restrictions on imports.
 Customs duties.
In Europe there are many Directives which lay down minimum requirements.
(e) Securing payment
Once the goods have been sold, the exporter may have to wait a considerable period
before he is paid by the overseas buyer. To be able to operate overseas it is quite
usual to obtain the backing of a bank or an accepting house.
The UK Trade & Investment division of the BERR co-ordinates all government interest in,
and support services for, large overseas projects. It collaborates closely with all appropriate
government departments at home and with the diplomatic service posts abroad. Where
appropriate, the Division can bring the full weight of government support to bear, including
ministerial and diplomatic initiatives.
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A firm needs to determine what policy to adopt in the management of its creditors. In doing
this it must consider the following factors:
 The need to ensure continuing supplies as and when required, by maintaining good
relations with regular suppliers.
 The level of credit required, and the ability to extend it when the firm has a cash flow
 The advantages of having a high level of trade credit as a method of reducing the level
of working capital required.
 The possibility of extending credit, but this provides the firm with a poor credit rating
and problems in obtaining additional credit.
 Whether to accept or reject early payment discounts (this decision is made in the same
way as offering discounts to a firm's customers – the benefits of accepting the discount
(additional cost) must outweigh the costs (interest foregone) of paying the debt early).
This latter point illustrates the often forgotten cost of trade credit which is often assumed to
be free but there is a cost of any early payment discounts foregone. An additional intangible
cost may be the loss of supplier goodwill. In addition, recent legislation now allows suppliers
to charge interest on overdue accounts. This will further add to costs if payments to
suppliers are delayed.
The cost of early payment discounts foregone can be calculated as:
s 100
where: s = the size of the discount offered in percentage terms, and
t = the reduction in payment period required in the payment period.
This gives the cost as a percentage which should then be compared to the interest rate that
the company would obtain for investing the cash for the same number of days as required to
obtain the reduction in payment period.
Management of Short-Term Finance
We have seen that short-term finance is a major source of working capital and that it can be
obtained from a variety of sources, most of which we have already discussed earlier in this
course, i.e.
 Bank overdrafts
 The issuing of short-term debt instruments (for larger companies)
 Taking trade credit from suppliers
There are two further methods available to firms that you need to know about and are
explained here. In addition, there are a number of specialist sources of finance, which we
discuss later in this section..
(a) Bills of Exchange
This method is a common source of finance for international trade. The settlement of
the cost of a trading transaction may be by means of a bill of exchange (also called
trade bills). This occurs when the seller draws a bill on the buyer asking them to pay,
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on a certain future date, the price of the goods supplied, which is then accepted by the
purchaser (by signing and returning it to the seller). The purchaser is thus formally
acknowledging his debt to the seller. The seller can then use the bill of exchange as
security in order to obtain money from the seller's bank.
A bank may also agree to accept a bill from its customer in exchange for an agreement
that the customer will repay the bank. The cost for arranging this finance is the
discount (i.e. the full amount of the bill is not advanced). The more secure the bill (e.g.
from a bank as compared to a trader) the "finer" or lower the discount.
(b) Acceptance Credits
This is a facility offered by banks for large companies with a good reputation. The
company draws bills of exchange on the banks, generally for 60, 90 or 180 days,
denominated in whichever currency most matches the needs of the company. The bills
can be drawn on, as and when required, throughout the length of the agreement which
can be for up to five years, provided the credit limit is not exceeded. The bill is then
sold in the discount market and the proceeds passed to the company (less the bank's
commission). At maturity the company reimburses the bank the full value of the bill,
and the bank pays the holder of the bill.
A major advantage of accepting credits is that they can be sold at a lower discount than
trade bills. The cost of them is also fixed, allowing for easier budgeting and may be
lower in times of rising interest rates than that of an overdraft. The credit is also
guaranteed for the length of the agreement, unlike an overdraft.
Short-Term Investments
We have seen that firms may have a surplus of cash, either deliberately in order to meet
purchase costs in the near future or to take advantage of high interest rates, or because of
higher than expected profit levels or a lack of investment opportunities. These fluctuations in
cash can arise for a variety of reasons, a major one being seasonal fluctuations in trade.
Short-term surplus of funds should be invested in short-term marketable securities.
Treasurers will employ surplus funds to obtain the best possible returns with maximum
security, and in evaluating the alternatives a variety of factors must be taken into account
 Risk
 Liquidity
 Term
 Cost
 Return
 Accessibility – deposits with banks, finance houses and local authorities are only
accessible when the term finishes – debt instruments and equities can, however, be
sold when cash is needed
 Type and level of interest rate
 Taxation
 Complexity
 Minimum/maximum criteria
 Image/policy
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Investment opportunities which are available include:
 Money market deposits
 Treasury bills
 Equities
 Commercial Paper
 Bonds
 Gilts
 Certificates of Deposit
 Bank and other financial institution deposits, the interest rate varying with the
institution, the type of account and the amount deposited
 Longer-term debt instruments
 Eurocurrency deposits
 Finance house deposits
 Local authority deposits
 Sterling Bankers' Acceptances (bank bills)
 Local authority bills
 Bills of exchange (trade bills)
Specialist Sources Of Finance
The exporter may obtain debtor financing through forfaiting. In the home market, factoring,
invoice and block discounting are facilities to cater for the financing of credit afforded to
customers. We will look at each of these in turn.
(a) Forfaiting
This is a specialist form of trade funding, geared to exports, which first emerged during
the 1950s; it is currently growing in popularity as the range of markets in which
forfaiters are prepared to operate is expanding. Forfaiters usually operate from within a
separate department within a bank, and they provide non-recourse finance (essentially
funds which are only repayable if the exporter fails to perform under his contract) to
exporters who seek to boost and secure foreign cash flow.
Forfaiters provide exporters with non-recourse finance by buying trade debts from the
exporter at a discount. The debts are guaranteed (the forfaiter calls this avalised) by
an acceptable bank but, despite this, the forfaiter will closely monitor country risk in all
areas in which he or she is prepared to operate.
For example, a German exporter of machine tools may be offered a series of
promissory notes maturing at, say, six-monthly intervals over a period of five years by
his Algerian customer. Unless the importer (customer) is of undoubted standing and
there is seen to be minimal country risk, the notes must be avalised (guaranteed) in a
form acceptable to the forfaiter. On receiving the notes from the importer, the exporter
may then sell them at a discount to a bank in his own, or in a third, country. At this
point the exporter has no further obligations, other than those relating to quality and
fitness of the products sold and the fulfilment of any contracted service obligations.
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 Essential features of forfaiting
(i) The promissory note must carry a first-class name (of the highest credit
standing), or it must carry the guarantee (aval) of a first class bank.
(ii) The obligation of the importer (or guarantor) to pay must not depend on the
exporter performing under the contract.
(iii) A standard commitment fee of around 1% per month will be payable to the
forfaiter (this may vary with the perceived risk) and discount rates will
reflect current money costs in the market and the length of the period
before the forfaiter receives payment.
 Financial instruments used
The principal financial instruments used in a forfait financing are bills of exchange
drawn by the exporter on the importer, and promissory notes issued by the
importer in favour of the exporter. Promissory notes tend to be favoured by
exporters because, as the endorser of a promissory note, the exporter can free
himself of any liability by means of a without recourse clause in the
endorsement. With a bill of exchange, the exporter must obtain the agreement of
the forfaiter not to take proceedings against him in the event of non-payment by
the importer.
 Security for the forfaiter
Security will be aimed at reducing the forfaiter's risk, and also facilitates
rediscounting the instrument if necessary.
(i) Aval is an irrevocable and unconditional guarantee to pay on the due date.
It is written directly on to the bill or note, rather than being contained within
a separate document. The words "per aval" are written on the instrument,
together with the banker's signature.
(ii) Guarantee is evidenced by a separate document which must not be
conditional upon the performance of the exporter, i.e. it must be an
unconditional obligation. It should also be transferable in order to permit
rediscounting of the forfaited instrument.
(b) Factoring and Invoice Discounting
These facilities are specifically designed to meet the needs of the expanding business
operating in the home market. As a business carries on trade and builds up its
debtor/creditor relationships, value is passed in the form of goods not yet paid for. A
factor (factoring company) will advance money against the security of debts owed to a
business. In this way, cash can be released more swiftly than waiting for the debtors to
pay within normal trade terms.
There are many variations of factoring, the factor's services frequently being tailored to
the customer's needs. The factor may take the entire sales ledger balances, or only
specific, larger debts arising from individual transactions. The factor may actually buy
the debt(s) or he or she may merely collect on the customer's behalf, or the customer
may collect on the factor's behalf.
Factoring grew as a way to facilitate trade credit and is now an important part of
commercial life. Subject to the factor's approval, debts can be purchased free of
recourse and therefore the company passing its debts to the factor will:
 Not have to deal with bad debts.
 Lose the administrative burden of the supervision of trade credit.
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 Have an assured cash flow. Generally, the factor will advance around 80% of the
value of the debt within two or three days of an approved debt being passed to
him or her.
Factoring is particularly useful to firms trading in markets that require a considerable
period of trade credit and to companies that are expanding rapidly, as it will leave other
lines of credit open for use elsewhere in the business.
Costs will vary with the perceived level of risk, the volume of business and the period
over which credit is granted. There will usually be a monthly facility fee payable by the
customer, whether or not funds are drawn from the facility.
(c) Block Discounting
This is also a facility available for companies trading in the home market. It emerged in
the 1960s and is used by companies who offer retail (white and brown) goods on
instalment credit (hire purchase or rental) and initially supported the massive growth in
television rental.
The facility is administered in a similar way to factoring, but the company will lodge its
instalment credit agreements with the block discounter, rather than its invoices. The
facility is usually undisclosed to the end-user customer and the company will collect
rentals and instalments due on behalf of the block discounter.
Because the block discounter has a right to the future cash flows arising under the
terms of approved agreements, he will generally agree to a higher gearing than a
clearing bank, and a financial gearing of 3:1 for a company selling goods extensively
on instalment credit may often be quite acceptable.
(d) Sales Aid Financing
As an alternative to offering their own trade credit, suppliers of capital equipment and
vehicles both to the home market and abroad may offer finance at the point of sale
through a third-party finance company. This is known as sales aid finance and is
especially prevalent in the UK retail motor trade where rates may be subsidised by the
manufacturer, the dealer or both, to attract business and private customers by easing
the burden of expenditure on a major capital item.
Whilst a simple loan document is the most common financial instrument used in the
personal sector, sophisticated financial packages are often negotiated for the business
user, these being based around either hire purchase or leasing, including operating
leasing in the guise of rental or contract hire.
The benefit to the supplier (and the manufacturer when they are not one and the same)
is that the finance company will generally settle at the time the goods are supplied and
there is no need to extend trade credit. Additionally, the payment is received in full,
generally without any recourse in respect of bad debts (other than those arising
through poor quality merchandise). Suppliers will often work in conjunction with the
finance company to present a "financial package" in such a way that less discount is
passed to the customer than would be the case with a cash sale. Commissions may
be generated from the sale of finance and related insurance products, which serve to
boost the profit generated by a credit-based sale.
Larger organisations are often able to persuade the finance company to operate on an
undisclosed basis. In these circumstances, all documentation will be designed in the
supplier's house style and will use the supplier's rather than the finance company's
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Practice Questions
1. The final accounts for Daish, a small trading firm, are given as follows:
Income Statement
Nov 30, 2002 Nov 30, 2001 Nov 30, 2000
£000 £000 £000 £000 £000 £000
Sales 3,860 2,800 2,000
Opening Stock 200 100 100
Purchases 2,700 1,750 1,000
Closing Stock 400 200 100
Cost of Sales 2,500 1,650 1,000
Gross Profit 1,360 1,150 1,000
Operating and Financial Expenses 800 500 400
Net Profit 560 650 600
Balance Sheet
Nov 30, 2002 Nov 30, 2001 Nov 30, 2000
£000 £000 £000 £000 £000 £000
Fixed Assets 1,312 800 600
Current Assets:
Stock 400 200 100
Debtors 220 200 150
Cash 10 630 2 402 30 280
Current Liabilities:
Creditors 350 200 110
Bank Overdraft 380 730 150 350 50 160
Total Assets less Current Liabilities 1,212 852 720
Long Term Liabilities:
Bank Loan 250 250 225
Net Assets = Capital 962 602 495
Daish is concerned about its management of working capital.
(a) Explain the changes in the cash operating cycle for this firm over the years
(b) Do you think the firm is overtrading? Suggest possible future action based on
your analysis.
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2. Babb plc specialises in the manufacture of sportswear. Sales in the current year have
been £5.2 million. The terms of sale are 2% discount 14 days, net 28 days, although
those customers not taking the discount actually take longer than 28 days to pay on
average. The current level of debtors is £500,000, included in which are the one half of
Babb's customers who take advantage of the cash discount. 1% of credit sales
become bad debts. The net operating margin (excluding bad debts and discounts) for
Babb is 25% of sales.
The company is considering a change in its credit policy to 4% discount 14 days, net
28 days. It anticipates the following effects of this change:
 Sales to increase by 10% pa
 75% of customers to take advantage of the discount
 The period of time before payment for customers not taking the discount to
increase by one week
 Bad debts to fall to 0.5% of sales
Babb's cost of finance is 12%.
(a) Calculate the financial implications of this change in credit policy and give your
advice on the proposed change.
(b) Debtors and credit control are, of course, only one aspect of working capital
management. What policies may produce savings in other items of working
capital? Discuss some of the potential difficulties attached to the management of
working capital.
Now check your answers with those given at the end of the unit.
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1. (a) The cash operating cycle is the period between the payment of cash to creditors
and the receipt of cash from debtors. We need to calculate appropriate ratios:
(i) Debtors' payment period = s day 365
sales Credit
debtors Trade
× :
 Year ended Nov 30, 2002: 365
860 3
= 20.8 days
 Year ended Nov 30, 2001: 365
800 2
= 26.1 days
 Year ended Nov 30, 2000: 365
000 2
= 27.3 days
(ii) Creditors' payment period = s day 365
 Year ended Nov 30, 2002: 365
700 2
= 47.3 days
 Year ended Nov 30, 2001: 365
750 1
= 41.7 days
 Year ended Nov 30, 2000: 365
000 1
= 40.1 days
(iii) Stock turnover ratio = s day 365
sales of Cost
stock Average
 Year ended Nov 30, 2002: 365
500 2
2 400 200
÷ +
) (
= 43.8 days
 Year ended Nov 30, 2001: 365
650 1
2 200 100
÷ +
) (
= 33.2 days
 Year ended Nov 30, 2000: 365
000 1
2 100 100
÷ +
) (
= 36.5 days
Cash operating cycle:
 Y/e 30 Nov 2000
Average days before receipt of cash on sales = 36.5 + 27.3 = 63.8 days
Average days before payment of creditors = 40.1 days
Operating cycle = 23.7 days
 Y/e 30 Nov 2001
Average days before receipt of cash on sales = 33.2 + 26.1 = 59.3 days
Average days before payment of creditors = 41.7 days
Operating cycle = 17.6 days
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 Y/e 30 Nov 2002
Average days before receipt of cash on sales = 43.8 + 20.8 = 64.6 days
Average days before payment of creditors = 47.3 days
Operating cycle = 17.3 days
Over the period, it appears that the company has continued to improve the cash
operating period from 23.7 days to 17.3 days. However, a closer look at the
ratios reveals some potential problems:
 Although the company has improved its debt collection procedures and has
reduced the payment period from 27.3 days to 20.8 days, the stock
turnover ratio in the year ended 30 November 2002 is longer, indicating that
it is taking longer to convert stock purchases into actual sales.
 The creditors' payment period in the year ended 30 November 2002 is
longer than previous years, indicating that the company is making more use
of creditors as a source of short-term finance. This can be dangerous in
the long term as liquidity problems can arise.
(b) To consider whether the firm is overtrading we need to look at some ratios:
Year ended
Nov 30 2002
Year ended
Nov 30 2001
Year ended
Nov 30 2000
Turnover £3,860,000 £2,800,000 £2,000,000
Gross Profit Ratio:
860 3
360 1
800 2
150 1
000 2
000 1
= 35.2% = 41.1% = 50.0%
Net Profit Ratio:
860 3
800 2
000 2
= 14.5% = 23.2% = 30%
Quick Asset Ratio:
= 0.3 : 1 = 0.6 : 1 = 1.1 : 1
Acid Test Ratio:
= 0.01 : 1 = 0.006 : 1 = 0.2 : 1
Current Ratio:
= 0.9 : 1 = 1.1 : 1 = 1.8 : 1
The company shows significant signs of overtrading:
 An increase in turnover over the period.
 A decrease in gross profit and net profit ratios over the same period.
 A deterioration in stock turnover ratios.
 Increasing liquidity problems shown by quick asset and acid test ratios.
 Increasing reliance on short-term finance, e.g. increase in bank overdraft
and creditors' payment period.
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Future action should include:
 Efforts to increase stock turnover, e.g. advertising campaign
 Reduction in expenses to improve net profit percentage
 Seeking of alternative methods of finance to finance any expansion, e.g.
bank loan
2. (a) The financial implications are:
(i) Increase in net operating profit
Current level of sales = 25% × £5.2m = £1.3m
After change in policy = 25% × £5.72m = £1.43m
(ii) Increase in discount allowed
Current level = £5.2m × 2% × 50% = £0.052m
After change in policy = £5.72m × 4% × 75% = £0.1716m
(iii) Savings on debtors
Assume average time taken to pay (customers not taking cash discount) =
y weeks
Current situation:
Make up of debtors = (50% ×
× 2) + (50% ×
× y) = £0.5m
y = 8 weeks
New situation (taking one week longer to pay):
Total debtors = (75% ×
× 2) + (25% ×
× 9) = £412,500
Reduction in debtors = £500,000 ÷ £412,500 = £87,500
Savings = 12% × £87,500 = £0.0105m
(iv) Reduction in bad debts
Current level = 1% × £5.2m = £0.052m
After change in policy = 0.5% × £5.72m = £0.0286m
Summary of changes: Saving Increased cost
£m £m
(i) Increase in net operating profit 0.13
(ii) Increase in discount allowed 0.1196
(iii) Savings due to reduced debtors 0.0105
(iv) Reduction in bad debts 0.0234
0.1639 0.1196
Overall benefit = £0.0443m
This is a relatively small benefit given quite favourable assumptions have been
made, e.g. a 10% rise in sales and a 50% reduction of bad debts. The cost of
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discount allowed is high and it is debatable whether the proposed change is
actually viable.
(b) You could base your answer on the following points:
(i) Stock control – improvements using computerised systems and
techniques such as economic order quantity and just-in-time. Achieving
faster stock turnover can reduce costs of stockholding.
(ii) Cash control – use of cash flow forecasts can help identify likely surpluses
and deficits of cash. Surpluses can be invested and short-term overdrafts
arranged to cover deficits.
(iii) Creditors – it may be possible to delay payments to creditors but this can
have adverse effects on relationships with suppliers and the company could
incur interest payments on overdue accounts.
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Study Unit 12
Capital Investment Decision Making 1: Basic Appraisal
Contents Page
Introduction 277
A. Future Cash Flows and the Time Value of Money 277
B. Return on Investment (Accounting Rate Of Return) 278
C. Payback 279
D. Discounted Cash Flow 280
E. Net Present Value (NPV) 281
Future Value Over Time 283
Conventions Used in NPV Calculations 284
Net Terminal Values 284
Annuities or Uniform Series 285
Multiple Time Periods 286
NPV Profile 286
Perpetuities 288
F. Internal Rate of Return 288
Pitfalls with IRR 290
Dual Rate of Return Method 290
G. Cost/Benefit Ratio 291
H. Comparison of Methods 291
Non-Discounted Methods 291
Discounted Methods 291
(Continued over)
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I. Impact of Taxation on Capital Investment Appraisal 292
Capital Allowances 293
Answer to Practice Question 295
Appendix: Discounting Tables 296
Single Payment Compounded Forward Factor 297
Uniform Series Compounded Forward Factor 298
Single Payment Present Worth Factor (Discount Tables) 300
Uniform Series Present Worth Factor (Cumulative Discount Tables) 302
Annuity Tables 304
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At the beginning of this course we saw that one of three major decision areas undertaken in
an organisation is that of investment appraisal, and the financial manager has to employ
appraisal techniques in order to decide which projects to accept and which to reject. In this
and the following study unit, we will consider the financial models and techniques that are
commonly used in capital investment appraisal.
Capital investment decisions will largely shape the future of the business and its ability to
manage its future operations. They are, though, generally difficult and expensive to reverse
and must, therefore, be right first time. Appraisal of the implications of a decision is, then,
The criteria for the appraisal of projects may be based on legal requirements (e.g. to meet
health and safety legislation) or social and staff welfare needs (e.g. the provision of
canteens). However, in the majority of cases, it will be on economic grounds – the key being
that projects accepted meet preset financial criteria, generally a return greater than the cost
of the capital needed to finance it. In addition, they must also seek to maximise shareholder
wealth, by maximising long-term returns.
The methods of capital investment appraisal which we shall examine are as follows:
 Return on Investment (ROI) or Accounting Rate of Return (ARR)
 Payback
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Cost/Benefit Ratio
 Adjusted Present Value (APV) (which we shall consider in the next unit)
These methods do not all fulfil the criteria set above, but they are the most widely used in
practice. A useful exercise for you whilst working through the following sections is to assess
the validity of the different techniques, in view of the above criteria and of the primary
objective of corporate finance, that of shareholder wealth maximisation.
There are several different techniques used in organisations when making the investment
decision. When evaluating an investment opportunity it is important that all cash flows
arising from that opportunity are considered, and that the timing of these different cash flows
is also taken into account.
You may wonder why the timing of cash flows is so important. This is because £1 received
today is worth more than £1 received in 12 months' time, because of the subjective time
preference of investors, i.e. individuals prefer to consume income now rather than in the
There are other reasons sometimes mooted for the existence of the time value of money, but
whilst these have some credence they do not fully explain the situation. The common
reasons are that:
 There is a risk involved in investing. Whilst there is uncertainty involved in capital
investment, techniques have been developed to deal with this within discounted cash
flow (DCF) analysis (see later).
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 There is a risk that inflation will erode buying power during the period under
consideration. However, even if there is zero inflation, techniques which consider the
time value of money are still used in investment appraisal. (We shall consider methods
of dealing with inflation in the next study unit.)
Let us assume that you could deposit your £1 for 12 months at a 10% annual interest rate.
After one year interest of £1 × 10% = 10p would be added to your £1 and your investment
would have grown to £1.10. We can therefore say that the future value of your £1 today, at
an interest rate of 10%, is £1.10.
Cash therefore has a time value and we express the values today (i.e. at the start of an
investment project) of future cash flows as the present value of the investment.
This approach expresses the profit after tax arising from an investment as a percentage of
the total outlay on the investment. The profit is expressed after depreciation as it is argued
that the original capital is being recovered. The result is compared to a predetermined
company (or group, or division) target, an investment being accepted if the result meets or
exceeds the target.
When using ROI to compare projects which are mutually exclusive (i.e. the acceptance of
one prevents the adoption of the other) the project which gives the highest ARR is the one
that should be accepted (provided it meets or exceeds the target ARR).
Difficulties arise with this method when the duration of the investment (and hence the
profitability from it) extends for more than one year, as it then becomes necessary to
determine some representative profit and investment value for the duration of the project.
This is usually achieved by a form of averaging, in view of the difficulty of estimating profit
generation several years in the future.
We will now look at an example to clarify this.
An investment in a new machine costing £1,000 will generate the earnings shown below over
the five years of its projected useful life. Depreciation will be on a straight line basis to reflect
the estimated manner in which the value of the machine will decline over these years.
Year 1 2 3 4 5
Budgeted profits 600 600 500 500 300
less Depreciation (200) (200) (200) (200) (200)
400 400 300 300 100
Tax (say) 120 120 105 105 35
Net profit 280 280 195 195 65
We first need to establish the average profit arising from the investment and then compare
this with the investment:
Average profit =
65 + 195 + 195 + 280 + 280
= £203.
We can then compare this with the original investment to give the rate of return:
investment Original
profit Average
000 1
= 20.3%
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Alternatively we can compare it with the average investment. This has traditionally been
calculated as the original investment divided by 2 – thus, here, it would be £1,000 ÷ 2 = £500.
investment Average
profit Average
× = 40.6%.
This is not a very satisfactory way to make the calculation, because the figure of £500 has no
actual basis in reality. Furthermore, it produces a rate of return which does not represent the
facts of the case. The annual returns on the original investment in our example are as shown
Year 1
000 1
= 28%
Year 2
000 1
= 28%
Year 3
000 1
= 19.5%
Year 4
000 1
= 19.5%
Year 5
000 1
= 6.5%, giving a total of 101.5%.
Dividing this result by 5 gives us (101.5% ÷ 5) = 20.3%, i.e. half the figure of 40.6% which we
calculated by using the traditional formula for counting the investment involved.
Further problems arise because this method fails to recognise that a net profit of £65 in five
years' time is barely significant in today's terms, even when there is a low rate of inflation. In
other words, the method fails to recognise time value of money. This is a cornerstone of
discounted cash flow methods as we shall shortly see.
Another issue with this type of analysis is that profits are the results of receipts and outgoings
and they do not represent cash transactions and the cash flow arising is not taken into
account during the term of the investment.
Probably the greatest merit in this method of analysis is its simplicity, it being based in
conventional accounting terms and requiring only limited analytical skill to carry it out and to
interpret the conclusions that can be drawn from it.
This method simply measures the time period taken until the profits generated from the
investment equal the initial cost of the investment. The aim is to calculate how much time will
elapse before the capital project "pays back" the original amount invested from the profits
generated by it. (Either cash receipts or accounting profits can be used – cash receipts
would be preferable for the reasons noted above.) The result is compared to a
predetermined company (or group, or division) target, an investment being accepted if the
result meets or is less than the target length of time. When comparing different projects the
one with the quicker payback period would be the one chosen.
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Consider the following example.
Project A Project B
Investment outflow Year 0 (600) (600)
Cash inflows Year 1 400 700
Year 2 200 400
Year 3 800 400
Total inflows 1,400 1,500
Payback for Project A is two years, assuming that the cash inflows occur at equal periods
and in equal amounts during each year. Payback in the case of Project B is just over ten
Payback focuses on risk in considering the period during which the investment remains
outstanding. The sooner the investment is returned, the safer the project should be. You
should note, however, that the method takes no account of cash inflows after payback,
neither is there any attempt to consider reinvestment possibilities for incoming funds during
the period prior to payback.
Perhaps, therefore, we should view payback as more of a risk appraisal tool than a
performance measure.
Discounted cash flow (DCF) analysis (also known as present value analysis) is a technique
used to determine the net value of a project in terms of today's money. It considers the time
value of money, and the cost of capital to the organisation. By using a discounted cash flow
method it is possible to convert all future cash flows to their present value and then to assess
them on a like-for-like basis. The net effect of all the cash inflows and outflows resulting from
a project being discounted back to present values is known as a project's net present value
In order to convert cash flows arising from a project into their present values, it is necessary
to establish the cash inflows and outflows arising from it, and what cost of capital should be
used to evaluate such projects.
The cash flows, or sufficient information to determine them, will always be provided as given
information and they should be recorded, and the year in which they occur, in a logical
manner (you will see in this and the next study unit how this is done).
The cost of capital used in evaluating such projects is generally the required rate of return of
those investing in the firm – which we have seen to be its weighted average cost of capital
(WACC). To calculate the cost of equity you should use either the dividend growth model or
CAPM, depending on the information provided. The resulting WACC will be slightly different,
although both methods have advantages and disadvantages because they are based on
different underlying assumptions. (Note that CAPM is generally used in the APV technique
discussed in the next study unit.) However, we will discuss situations where an alternative
rate should be used. Note that you may be presented with the cost of capital to be used, and
you should always consider the information provided when determining the figure to be
chosen or calculated.
This required rate of return forms the basis of the discount factors which are used to convert
cash flows to their present values.
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The formula used for deriving the discount factor is:
i) + 1
where: n represents the number of periods, and
i represents the cost of capital per period.
In practice discount factor tables are available to look up the relevant factor (see the
appendix to this study unit). In order to use the discount factor tables you need to read
across the year, and down from the cost of capital you are considering to obtain the discount
factor. For example, with a cash flow arising 10 years in the future, for a company with a 5%
cost of capital, the discount factor to use would be 0.614, giving a present value of the cash
flow × 0.614.
There are also several computer packages available for the purposes of investment
evaluation. Tables also exist for future cash flows.
In the assessment of the future cash flows generated by investment projects, the two most
commonly used methods which use this discounted cash flow analysis are:
 Net present value (NPV)
 Internal rate of return (IRR)
The DCF methods concentrate on cash inflows and outflows associated with the project over
its full life span, so you can see that they are superior to the other methods discussed so far.
Another major advantage is that they consider the timing of cash flows associated with the
The concept of net present value (NPV) is of vital importance in the field of corporate finance,
and we have already made several references to it in this course.
In order to determine the NPV of a project, we need to list all the cash flows related to the
project. The net cash flows are then discounted at the cost of capital using the formula
shown above.
The decision rule in using the NPV technique is that if the NPV is positive the project should
be accepted, and if the NPV is negative then the project should be rejected. The reasoning
behind this is that when there is a positive NPV, the project offers you a return in excess of
your cost of capital and acceptance of such a project will increase the wealth of the company.
For a negative NPV project, the cost of capital is not covered and acceptance of such a
project will reduce the value of the firm. The primary objective of the firm is, of course, to
maximise shareholder wealth by maximising the value of the firm. The value of a company
will increase by the NPV of a project provided that its WACC remains unchanged. The
increase in wealth will be reflected in the share price because of the efficient market
hypothesis (EMH).
The use of the NPV technique is best seen by considering an example.
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A project has an initial cost of investment of £10,000 in a machine, and the following
expected cash inflows:
Year 1 = £6,000
Year 2 = £6,000
Year 3 = £6,000
Year 4 = £5,000
Year 5 = £5,000
No scrap value is expected from the machine. The cost of capital is expected to be 10%
throughout the five years of the project. Should the project be accepted?
The way to make this decision is to turn these future cash flows into present values by either
the use of discount factor tables (see appendix), or the formula noted above. (Note that we
shall use both of these methods in this study unit.)
Present value of machine revenues:
Year Net Cash Flows Formula Disc. Factor NPV
£ £
0 ÷10,000 - 1 ÷10,000
1 +6,000
1 0 1
) . ( +
0.909 5,454
2 +6,000
1 0 1
) . ( +
0.826 4,956
3 +6,000
1 0 1
) . ( +
0.751 4,506
4 +5,000
1 0 1
) . ( +
0.683 3,415
5 +5,000
1 0 1
) . ( +
0.621 3,105
+18,000 +11,436
In straight cash flow terms, the opportunity presented by the machine purchase is as follows:
Cash revenues resulting 28,000
less Cost of machine 10,000
Cash gain 18,000
This cash gain is received over a period of five years, which for the flows given is the same
as £11,436 now.
(Note that this method deals with liquidity, not profitability, and cash flows are used, not
accounting flows (e.g. capital outlay, not depreciation).
Calculating the discount factor to be used, without the use of discount tables, is a function of
both the company's cost of capital and the number of years over which the individual project
is expected to provide a return.
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If the cost of capital for the above example had been 6% rather than 10%, what would have
been the overall financial effect on the project proposals?
The figures would have been as follows:
Year Net cash flows Disc. Factor NPV
£ £
0 -10,000 1.000 -10,000
1 +6,000 0.943 +5,658
2 +6,000 0.890 +5,340
3 +6,000 0.840 +5,040
4 +5,000 0.792 +3,960
5 +5,000 0.747 +3,735
Total +18,000 +13,733
The lower the discount factor used, then the less impact the inflation rate will have on the
final discounted figure – i.e. the higher the rate of inflation, then the more the value of money
will be affected in the future.
Future Value Over Time
Another way of regarding net present value is to say that, if the cost of capital is 10% over a
five year period:
£11,000 in one year's time is the same as £10,000 now
£12,100 in two years' time is the same as £10,000 now
£13,310 in three years' time is the same as £10,000 now
£14,641 in four years' time is the same as £10,000 now
So the future value of £10,000 now (assuming a constant cost of capital of 10% throughout
the period) is:
Year 1 £11,000
Year 2 £12,100
Year 3 £13,310
Year 4 £14,461
Consider the following calculation. Suppose a company has a machine in mind which will
produce a stream of revenues as follows:
Year 1 400
Year 2 600
Year 3 200
Note that the value of the machine is not £1,200, but is the present value of these cash flows
which, using discount factor tables, are calculated as:
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Cash Flow DF PV of Cash Flow
£ £
Year 1 400 0.9091 363.64
Year 2 600 0.8265 495.90
Year 3 200 0.7513 150.26
The value of the machine is therefore £1,009.80.
In the absence of cost of capital figures the project could be compared with the interest rate
that would be achieved by investing the initial outlay in investments of a similar level of risk.
Conventions Used in NPV Calculations
 Presentation
The best method of answering such questions is to set out all your cash flows and
discount factors in a table, putting each year's cash flows in the same column or row.
Examples of correct presentation are provided throughout this course.
 Signs
The normal method is to regard cash inflows as positive and cash outflows as negative.
 Years
A simplifying assumption is made that all cash flows occur in discrete steps at the end
of the year, but all initial outlays are regarded as occurring at the end of Year Zero, and
thus are not discounted (and are given a discount factor of 1).
 Time periods
Time periods always commence at the present, which is Year 0.
 Relevant figures
The only relevant figures to put into an evaluation are those cash flows arising as a
result of accepting the project. Thus the concept of relevant cost, which you will have
met elsewhere in your studies, is the concept which should be applied in investment
appraisal. Sunk costs and apportioned overheads are, as such, ignored in DCF
Items such as depreciation, which are accounting and not cash flows, are ignored (the
value of fixed assets is already taken into account in the initial outlay required for the
project and in any scrap value from the assets at the end of or during the project).
Interest and repayment of loan principals are not included in the cash flows because
this would be double counting, since the sums have already been included in the cost
of capital used.
Net Terminal Values
If the (opportunity) cost of capital in a business is 10% per annum, this will represent the
required rate of return from the project. This is sometimes referred to as the cut-off rate or
the criterion rate. Where the capital investment (as measured by the internal rate of return,
or yield) is expected to generate less than this return, the viability of proceeding with the
investment, based on the financial analysis, will be open to question since the return will be
less than the cost of financing it.
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An investment in Project R of £20,000 is expected to generate cash receipts of £6,000 at the
end of Year 1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The business
is able to invest money at an annual rate of 10% (the opportunity cost).
From the cash flows below it is clear that Project R produces insufficient return on the
investment. Its net terminal value is ÷£560, and that indicates that greater benefit will accrue
if the money is invested in a security (or with a deposit-taking institution) at the rate of 10%
pa which it is assumed is freely available.
End of: Cash Flow
Factor *
Terminal Value
Year 0 (20,000) 1.331 (26,620)
Year 1 6,000 1.210 7,260
Year 2 8,000 1.100 8,800
Year 3 10,000 1.000 10,000
Net Terminal Value = (560)
* The compound factors reflect the fact that the receipts at the end of Year 1 are
available for investment for two years, and the receipts at the end of Year 2 for one
year, i.e. for Year 2 the formula is calculated as:
(1 + i)
where: i = the interest rate per period; and
n = the number of periods.
Therefore, (1 + 0.1)
= 1.210.
Annuities or Uniform Series
In certain cases the level of cash flow will be uniform from year to year. In such cases there
is an easier method of calculating the net present value than using the discount factor tables.
The easier method is to use cumulative discount tables (provided in the appendix to this
study unit) which are simply the addition of discount factors over a number of years. To use
these tables you need to read down the correct cost of capital column, and across the row for
the number of years the cash flows remain constant, in order to obtain the cumulative
discount factor. You should, however, note that if the uniformity of cash flows does not start
in Year 1, the discount figure you should use would be the difference between the discount
factor at the last year for the constant flows, less that for the year before the flows
commenced. The resulting present value is then discounted at the rate for the year before
the constant cash flows started. An example should help to clarify this.
A company is considering investing in a project which will cost £5,000, and will yield cash
inflows of £2,000 in Year 1 and £3,000 for the following three years. There is no scrap value
at the end of the project. Should the investment be accepted if the company's cost of capital
is 10%?
First we need to set out the cash flows as before:
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Year Cash Outflow Cash Inflow Discount Factor Present Value
£ £ £
0 ÷5,000 1 ÷5,000
1 2,000 0.909 1,818
2 3,000
3 3,000 2.487 × 0.909 6,782
4 3,000
We discount the series of constant cash flows back to Year 1 using the (4 ÷ 1) cumulative
discount factor, and then discount that amount back one year from Year 1 to the present
As the project gives a positive net present value it should be accepted.
Multiple Time Periods
These can be catered for by using the basic annual tables, as follows. Simply divide i by the
number of times in the year that discounting occurs and multiply the years by the number of
periods per year.
For example, find the PV of a uniform series of receipts of £500 discounted half-yearly for the
two years, where i = 8%.
i = 8/2 = 4%
t = 2 × 2 = 4 years £500 × 3.630 = £1,815
You will not normally be requested to deal with other than annual cash flows.
NPV Profile
For any project, a range of costs of capitals can be discounted and the results plotted against
the resulting NPVs. This is often called an NPV Profile Curve, and it is simply a
diagrammatic representation of the NPV possibilities. A profile curve is shown in Figure 12.1.
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Figure 12.1: NPV Profile of Two Projects X and Y
You will note that a study of the NPV profile reveals certain useful information, as follows:
(a) The net present value of a project at any selected cost of capital can be read directly
from the graph, e.g.
(i) Project X has an NPV of £90,000, if the cost of capital is 10% (point "a" on the
(ii) Project Y has an NPV of just below £20,000, if the cost of capital is 17% (point "b"
on the curve).
(b) Where two project curves are shown, any point of intersection marks the spot below
which one project is more profitable than the other, and above which the other project
is more profitable.
The project curves for X and Y intersect at 11.5%. Above this rate of interest Y is more
profitable, below it X is the more profitable project with a higher NPV.
(c) Where the curves cut the horizontal axis, the NPV of each project is nil (£0), the cost of
capital being equal to the project's yield; this is known as a project's internal rate of
return (see later). X has an internal rate of return of 15%, and Y has one of 19%.
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When a project yields a sum for ever then its present value can be calculated as:
PV =
flow Cash
because the cumulative present value of £1 in perpetuity (i.e. each year for ever) is £1/i.
We stated above that the internal rate of return of a project is that cost of capital which
makes the net present value of a project to be equal to zero (the higher the cost of capital the
lower the net present value of cash flows). It is this percentage rate of discount which we
compare with the company's cost of capital. If the cost of capital required to reduce the
future cash flows to zero is greater than the company's cost of capital, then the project will be
accepted because it produces a positive return for the business.
You can see this in Figure 12.2, which represents the approach of taking a number of cash
inflows and outflows and discounting them over a constant period of time at an increasing
discount rate.
Figure 12.2
A discount rate of 0% clearly has no effect. As the percentage rate increases, the NPV falls
until at a particular cost of capital, the NPV is equal to (or approximately equal to) zero, i.e.
NPV = 0. This is the project's internal rate of return. The internal rate of return would then be
compared to the company's cost of capital; if it were higher it would be accepted, and if it
were lower it would be rejected, because it is not generating sufficient funds to satisfy the
needs of the suppliers of the company's finance. This method can also be used to compare
the cost of financing using alternative financial instruments.
Essentially each cash flow is appreciated to have an element of capital and interest within it.
Once the interest element is removed by discounting the instalments by the discount rate, the
payments, now comprising only the capital element, will equal the initial investment at the
IRR point.
The internal rate of return can be found by trial and error – in order to establish the precise
discount rate several attempts will usually be required using different discount rates until the
sum of the cash flows equals the initial investments. Further adjustments may well be
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needed where the cash flow payments required by the transactions are of an uneven nature.
A good starting place for such appraisals is two-thirds of the project's ROI.
An alternative approach is to plot an NPV profile using two or more discount rates and to
read the approximate internal rate of return from the graph. This is known as interpolation.
Example 1
An investment of £20,000 is expected to generate cash receipts of £6,000 at the end of Year
1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The business can invest
money at an annual rate of 10% (its opportunity cost).
Our aim will be to find the discount rate which reduces all the cash flows to zero. In our
example the NPV is almost zero when we use an IRR (discount rate) of 9%, and from the
table below you will see that the return on Project R is just under 9%. As the required rate of
return is 10% (or more), the project would be rejected.
The table below shows the calculations at a discount rate of 9%. (The IRR will be
determined by trial and error.)
End of Year Cash Flows Discount Factor Present Value
£ 9% £
0 (20,000) 1.000 (20,000)
1 6,000 0.917 5,502
2 8,000 0.842 6,736
3 10,000 0.772 7,720
NPV = (42)
We should remember that a project with a higher IRR may not necessarily be better than a
project with a lower IRR. Let's just stop to think why.
The main reasons for this relate to the actual amount of money which is to be returned. A
30% return may sound excellent, but if the investment is only a few hundred pounds, it may
not be worth devoting the time necessary if a larger project with a lower IRR will generate
better cash returns.
It is also important to recognise that IRR assumes that surplus cash flows are to be invested
at the project's own "internal" rate. However, this may not be possible in many months' time
when market forces have changed, with the result that the returns actually available have
It is also important that you are able (given a particular scenario) to calculate for yourself the
Internal Rate of Return.
Consider the following example:
Example 2
A business is considering a project that has an initial outlay of £11m (i.e. a capital outlay of
funds) and the discounted capital inflows of funds would be £12m. How would you calculate
the Internal Rate of Return (i.e. the discounted rate that would give a Net Present Value of
The first thing that you need to do is determine which two percentage figures the actual figure
would fall between and this can only be done by "trial and error". You also need to bear in
mind that capital money going out of the business (i.e. £11m) will be a negative figure and
capital money coming into the business (i.e. £12m), even if discounted, will be a positive
figure in this example.
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Let us first consider, say, 10%. This would give us:
–11 +

+ ) . ( 1 0 1
= £0.881m
Now let us consider, say, 15%. This would give us:
–11 +

+ ) . ( 15 0 1
= –£0.565m
So we now know that the actual rate that gives a NPV of £0 is between 10% and 15%
To calculate the actual IRR would be as follows:
10 + |

+ 0.565 0.881
10) - (15 x 0.881
= 13.046%
Pitfalls with IRR
Before attempting any detailed analysis, it is important to be aware of the potential pitfalls
which can arise when, for instance, the net cash flow changes during the investment period
from positive to negative, or vice versa. When this happens multiple internal rate solutions
are possible, and for the sake of clarity we shall give an example.
An initial investment of £3,950 generates the following cash flows in the next three years:
Year 0 (3,950)
Year 1 13,102
Year 2 (14,500)
Year 3 5,350
The overall return on the initial investment is 2, hardly a significant contribution on the face of
it. However, the cash flows actually satisfy an internal rate of return of 5%, 10% and 15% as
shown below!
Year Cash 5% 10% 15%
£ £ £ £
1 13,102 12,473 11,909 11,398
2 (14,500) (13,151) (11,977) (10,962)
3 5,350 4,622 4,018 3,520
3,952 3,944 3,950 3,956
This problem can arise when the cash flow is positive during one period and negative during
another. Every change of sign gives rise to an additional solution.
Dual Rate of Return Method
It is possible to resolve this potential problem by using the Dual Rate of Return Method
(sometimes known as the Extended Yield Method).
To do this, it is initially necessary to identify all periods in which the cumulative cash flows
produce a cash surplus, when discounted at the internal rate of return. These cash flows are
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then discounted at a predetermined rate (the rate required from the project), in order
subsequently to calculate the internal rate of the remaining cash flows.
This is a particularly important technique when conducting the evaluation of a project which
has surplus cash generated during only a part of its term.
This ratio, sometimes referred to as the Profitability Index (PI), is calculated by the formula:
outflow investment Present
inflow future of PV
(discounted at the cost of capital)
A project offering a PI of greater than 1.0 should be accepted. In the case of competing
projects, the highest over 1.0 will generally be preferred.
Thus, where capital rationing is important, the PI can be used to help to "rank" projects in
order of relative profitability.
As with other areas of financial modelling, each method of investment appraisal has its
drawbacks, and most firms use three or four of the different methods.
Non-Discounted Methods
The ARR ignores both the timing of cash flows and the opportunity cost of capital, but it is
used in practice in approximately half of all companies.
The payback method ignores the time value of money, and total cash flows over a project's
life once the payback period has been reached. It is often used in practice, however, as a
screening device, being considered to provide a fair approximation to NPV if cash flows
follow a pattern. It is useful when firms have liquidity problems or are perhaps producing
novelty products which require a quick repayment of investment.
Discounted Methods
We noted above that it is generally preferable to use a method of investment appraisal that
discounts cash flows, the two main methods being IRR and NPV. Both these techniques are
acceptable in capital investment appraisal if an organisation can accept all projects which are
beneficial to the organisation.
However, when there is capital rationing, NPV is the better method, as IRR can mis-rank the
projects. This superiority can be proven using the incremental approach.
Zak plc has only the space to implement either Project X or Project Y; both projects last one
year and have the following details:
Cash Flow
Yr 0
Cash Flow
Yr 1
@ Cost of Capital 10%
Project X (10,000) 20,000 100% 8,182
Project Y (20,000) 35,000 75% 11,818
NPV and IRR give different rankings. To find which is the better we need to use the
incremental cash flow approach.
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Firstly, let us accept Project X which is the preferred project using the IRR technique. If this
is the correct choice, then the incremental cash flows of Y ÷ X will not produce an IRR which
is acceptable (i.e. it will be lower than the cost of capital).
Consider the differences to cash flows if we move from Project Y to Project X:
Cash Flow
Yr 0
Cash Flow
Yr 1
@ Cost of Capital 10%
Change = (10,000) 15,000 50% 3,636
IRR of 50% is acceptable – therefore using IRR as an appraisal tool we should accept X and
(Y ÷ X), but X + (Y ÷ X) = Y. Thus, Y should be chosen (as per NPV) and we have used IRR
to prove that NPV is the superior method.
NPV is also preferable because it is very useful for evaluating interrelated projects, and it
emphasises the size of return given. IRR also has the problem that it can give multiple IRRs.
The advantage of IRR over NPV is that IRR is better at highlighting the rate of return against
the cost of capital.
Despite the advantages of NPV over IRR, IRR is more popular in practice.
It is important to consider the effects of taxation on investment appraisal – not just as part of
a numerical question, but also because it can affect the outcome of the decision as to
whether to invest.
Taxation should be taken into account in DCF analysis, since tax payments can seriously
affect the cash flows arising over the project's life, and you should always include additional
columns or rows in your DCF analysis to allow for taxation.
Capital investment appraisal is affected by taxation in four main ways:
(a) Annual profits are taxed – in practice nine months after the end of the accounting year
– but you must read the question carefully to see what assumptions the examiner has
made. The tax outflow may be included one year after the year in which the taxable
income arose, i.e. there will be a time lag of one year, making necessary a five-year
table for a four-year investment scheme.
(b) Interest on debt is allowable against corporation tax, and this will affect the discount
rate used.
(c) Tax losses must be included and they will normally be shown as a tax receipt, or
adjustment, one year later.
(d) The existence of grants and capital allowances which help reduce the tax bill – thus
making the project likely to be accepted. (If this arises in an examination question, you
must read the question very carefully for details of any such allowances – see below for
further details.)
When appraising a capital investment scheme you not only need to take taxation into
account, but you must also consider the effect that a change in the tax rate or law (e.g. the
removal of a government grant) would have on a project. You must also consider the
possibility of any additional subsidies the firm may be able to claim, and their effect on the
value of the project and, therefore, of the company.
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Capital Allowances
If you buy plant and machinery (capital assets) such as cars, vans, tools, computers and
office equipment for use in your business, you can claim their cost as capital allowances to
be deducted from your profits. You can also claim capital allowances on some industrial or
agricultural buildings, or hotels, and on items like patents and scientific "know how". (Note
that only part of the allowance can be claimed if an asset is used partly for private, as
opposed to business, purposes.)
The basic principle is that you can claim 25% of the cost of an allowable item in the first year
(the "written down allowance" or WDA) and 25% of the remaining cost in each subsequent
year. However, in the accounting period of purchase, you may be able to claim a higher "first
year allowance" (FCA).
First year allowances
Small businesses can claim 50% of the cost of most plant and machinery purchased in
2006/07 and 2007/08 except cars (up from 40% for 2005/06 purchases). Businesses of any
size can claim 100% on some environmentally friendly equipment and this includes new cars
with CO2 emissions of 120g per kilometre or less bought before 31
March 2008. From 11
April 2007, a business can claim a 100% Business Premises Renovation Allowance for
renovating vacant business premises in disadvantaged areas.
Changes to capital allowances
FromApril 2008, first year allowances for plant and machinery will be replaced by a £50,000
annual investment allowance and the writing down allowance will fall from 25% to 20%.
Allowances on industrial and agricultural buildings will be phased out, but tax credits for
research and development costs will be increased. Capital allowances for business cars are
also currently under review.
Working out allowances
The cost of each new item, after deducting the first year allowance, is added to a "pool" of
expenditure. Some items have to be kept in separate pools, but everything else goes into
one main pool.
In May 2006, Phillips paid £1,500 for energy saving equipment on which he gets a 100% first
year allowance and £6,500 on office equipment to which a 50% allowance applies. He sold
his old equipment for £2,450. His pool value at the start of the period is £4,250.
Calculate his pool value after the above transactions and also the allowances due to be
reduced from his taxable profits.
Allowances Pool
£ £
Pool at start of period 4,250
Sales (2,450)
WDA £1,800 x 25% 450 (450)
Energy saving: £1,500 100% FYA 1,500 0
Other purchases: £6,500 50% FYA 3,250 3,250
To carry forward 5,200 4,600
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To apply capital allowances in practice we should assume, for example, that once an item of
plant and equipment has been purchased, then the corresponding tax allowance at the
current tax rate will effectively reduce the outlay for the item, because there will be less tax to
pay. The payment of tax and, hence, the cash benefit will usually be in the year following the
year in which the asset was acquired.
Practice Question
A project has an initial cost of investment of £25,000. It is expected to produce the following
cash inflows:
Year 1 £3,000
Year 2 £4,500
Year 3 £9,000
Year 4 £11,500
No scrap value is expected. The cost of capital is expected to be 9% over the four years.
Should the project be accepted?
Now check your answer with the one given at the end of the unit.
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Present value of revenues:
Net Cash Flows
Discount Factor NPV
0 (25,000) 1 (25,000)
1 3,000 0.917 2,751
2 4,500 0.842 3,789
3 9,000 0.772 6,948
4 11,500 0.708 8,142
3,000 (3,370)
The project would not be accepted.
You need to note, though, that if the business had to undertake a new investment to replace
out of date technology, or for some other reason, then not accepting a project might not be
an alternative. What would normally happen in these circumstances is that the business
would consider a range of possible alternative investments and either accept the one that
gave the highest positive NPV or, if they were all negative, then the business would
(normally) choose the investment that gave the lowest negative NPV.
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On the following pages you will find sets of discounting tables for:
 £1 compounded annually
 Uniform series (annuity) compounded annually
 Present value of £1
 Present value uniform series (annuity)
 Present value of an annuity
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Single Payment Compounded Forward Factor
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Uniform Series Compounded Forward Factor
(Continued over)
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Uniform Series Compounded Forward Factor (continued)
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Uniform Series Present Worth Factor (Cumulative Discount Tables)
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Annuity Tables
Present value of an annuity of 1, i.e.
r) + (1 1
n ÷
where: r = interest rate and where n = years
Interest Rates
(continued over)
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Annuity Tables (continued)
Interest Rates
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Study Unit 13
Capital Investment Decision Making 2: Further
Contents Page
Introduction 308
A. Allowance for Risk and Uncertainty 308
Limiting the Payback Period 308
Inclusion of a Risk Premium in the Discount Rate 308
Certainty Equivalents 308
Attaching Probabilities to Cash Flows 309
Simulation Models 309
Sensitivity Analysis 310
Other Approaches 310
B. Impact of Inflation and Taxation on Investment Appraisal 311
Inflation 311
Taxation 312
C. Capital Rationing 312
D. Lease Versus Buy Decisions 313
E. Adjusted Present Value (APV) 316
Side Effects of Different Financing Methods 316
F. Use of the Capital Asset Pricing Model 319
G. Worked Examples 319
Answers to Practice Questions 331
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In this study unit we shall continue our look at investment appraisal by considering other
factors that impact on the decision, including inflation and uncertainty. We shall also consider
a further technique of investment appraisal – that of adjusted present value (APV) which
builds upon the work we have already covered on NPV and Modigliani and Miller.
You should note, though, that capital investment appraisal is not, however, a mechanistic
process where data is processed and an irrevocable "correct" answer emerges. The
methods are only as good as the data input to them. Despite the refinement of using risk,
inflation and other allowances, capital investment appraisal still requires the decision-maker –
the human being – to assimilate the available data and take a risk, using human senses
backed with management information.
All investments are subject to risk from unforeseen factors such as new legislation or
changes in fashion, which makes the original estimates of costs and sales, etc. no longer
valid. There are several accepted methods for incorporating risk into a capital investment
appraisal and the more common ones are outlined below.
Note, though, that underlying all these approaches to allowing for risk is the problem that we
are attempting to quantify in real numbers some aspect of the future which is largely
subjective to the person and firm carrying out the appraisal.
Limiting the Payback Period
One common method of dealing with risk and uncertainty is to limit the length of time a
project can pay back its investment. The justification used is that the further into the future
are the estimates of cash flows, the more inaccurate they are likely to be. Alternatives based
on this approach are to state that a project must also have a positive NPV in addition to
meeting its payback criterion, or that the discounted cash flows must pay back within a
certain time period (i.e. the present values of cash flows occurring during the payback period
must be positive).
Where there are constant cash inflows the payback of discounted cash flows can be found by
dividing the initial outlay by the annual cash flow and seeing at what point in time the
resulting figure is less than the cumulative discount factor.
Inclusion of a Risk Premium in the Discount Rate
The inclusion of a risk premium in the discount rate means that, if the normal discount rate to
be used were, say, 12%, then an additional amount – say 4% – might be allowed to cover for
risk, giving a 16% discount rate in total. Obviously the premium added is subjective and is
thus correspondingly weak. Higher discount rates impact more significantly on the more
distant cash flows so that two projects – one short and one long in life-span – would be
treated differently for risk by this method.
Certainty Equivalents
Under this method the expected cash flows arising from a project are subjectively adjusted
by management to their equivalent riskless amounts. Different risk factors can be used for
each cash flow item and for each year – the greater the risk the smaller will be the certainty
equivalent value for cash inflows and the larger the certainty equivalent value for each
outflow. The risk factors are generally expressed as percentages, e.g. 80% of income, 20%
of costs.
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Attaching Probabilities to Cash Flows
Another method of looking at each cash flow separately is to attach individual probabilities to
each cash inflow and outflow.
This method can also be used to calculate the worst possible outcome and its attached
probability, or the probability that the NPV is negative or zero (i.e. it is a measure of risk).
For example:
Value Probability
130 0.2
138 0.6
145 0.2
We are stating probability values for the possible value of the outlay, so the "expected" value
£ £
130 × 0.2 = 26
138 × 0.6 = 83
145 × 0.2 = 29
("Expected", here, is used in its statistical sense.)
Similarly, probabilities can be attached to the other inflows and outflows, to arrive at an
expected NPV. You should note that this procedure is rather more complicated
mathematically; this simple outline is given to indicate the formal methods of allowing for risk
in DCF appraisals.
Simulation Models
An alternative to calculating an expected value when given probability estimates is to use a
simulation model to establish a probability distribution of the project's expected NPV.
Simulation models, such as the Monte Carlo Simulation, are operated on computers using
random numbers. The model of the cash flows is constructed and a range of random
numbers is assigned to each possible value for those variables which are uncertain. The
computer generates a series of random numbers and uses them to assign values to the
variables. The results can then be used (probably by the computer) to calculate the NPV for
each set of random numbers generated. The average, and range, of possible NPVs can be
determined and used in the decision as to whether to accept the project or not. From this we
can move to the distribution of the NPV or IRR and, in the decision-making situation we can
match the means and standard deviations of competing projects, matching expected
revenues (mean) against the risk of achieving the same (standard deviation).
Monte Carlo simulation is often used in general business for risk and decision analysis, to
help make decisions given uncertainties in market trends, fluctuations, and other uncertain
factors. In the science and engineering communities, MC simulation is often used for
uncertainty analysis, optimisation, and reliability-based design, and in manufacturing, MC
methods are used to help allocate tolerances in order to reduce cost. There are certainly
other fields that employ MC methods, and there are also times when MC is not practical
(particularly for extremely large problems where computer speed is still an issue). However,
MC continues to gain popularity and is often used as a benchmark for evaluating other
statistical methods.
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Sensitivity Analysis
This is a technique for determining the outcome of a decision if a key prediction turns out to
be wrong.
Basically, an investment project usually represents, as we have seen, an outflow of cash,
followed at later time intervals by an associated series of inflows. Allowing for risk aims to
quantify the likely effects of the results of the project not conforming to the pattern anticipated
when the project was assessed. Sensitivity analysis is an attempt to add to the number of
dimensions in an appraisal picture by indicating what the picture will look like if certain
dominant items in it are flexed away from their original quantification.
You will also appreciate that each of the pieces of data that collectively form an "investment"
will have a relative order of importance as to the resulting effect (of its being the one to go
wrong) on the overall project. Clearly, some aspects will be vitally important to the project;
others will be only marginally important. Some can go wildly astray; others deviate only a
fraction before the viability of the project is placed in jeopardy.
For example, a particular investment in, say, a drilling machine will not be greatly influenced if
it is found that more water-based coolant is required than was allowed for; but if the
expensive driving belts prove to require unexpectedly frequent renewal that would, obviously,
be more significant.
Here is risk in a new light, then – recognising that the component aspects of an investment
project can all have a probability of occurring as anticipated – and, further, that the various
aspects can have a separate and differing significance to the project.
Sensitivity analysis seeks to provide the decision-maker with more than just a "go/no go"
statement, and aims to bring in all the "maybes" and "ifs", i.e. each aspect of the investment
can be flexed slightly, and then a re-evaluation made, to see if the project is still acceptable
or not.
The decision-maker can be presented with an appraisal which says: "This project is OK as it
stands on paper; costs can be allowed to increase by x% or sales decline by y% before it
becomes an unacceptable project".
The sensitivity of a project to alterations in the original appraisal input data is analysed so
that the horizon of the decision-maker is widened, in order that they can see the proposed
project in its overall situation if things start to vary from those anticipated.
Other Approaches
 A simple approach would be to have a "worst", "likely" and "best" estimate of each
projected cash flow. In this way a project could be appraised in each of the available
 Linear programming (LP) could be used in a situation where a certain number of
constraints and variables exist. Some variables are known to be "slack" and LPs can
be produced with differing values input to these slacks.
It is a technique of operations research for solving certain kinds of problems involving
many variables where a best value or set of best values is to be found. It is most likely
to be feasible when the quantity to be optimised, sometimes called the objective
function, can be stated as a mathematical expression in terms of the various activities
within the system, and when this expression is simply proportional to the measure of
the activities – i.e. is linear – and when all the restrictions are also linear. It is different
from computer programming, although problems using linear programming techniques
may be programmed on a computer.
 Option theory can be used in investment appraisal. When a project is undertaken it
often provides additional options – to abandon a project, to make follow-on investments
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and to wait before undertaking an investment – and such options may need to be
considered when undertaking investment appraisal. Such calculations are best
undertaken using a computer model. (Options and option theory are considered in
detail in the a later unit.)
The rate of inflation can have a major impact on a project and in particular the future cash
flows of a project, and management must be made aware of any inflation assumptions made
in NPV calculations. Remember that any projected inflation figures are only estimates (and
that there are a number of different ways of measuring it), and that the rate of inflation can
vary between different years, and widely between different elements of cost, but to produce
estimates for every element of cost for every year is not cost-effective.
The greater the rate of inflation the greater the minimum rate of return required by investors,
in order to compensate for loss of income due to a declining value of money.
When considering the choice of the cost of capital to use in investment appraisal we need to
discuss the difference between the real and money (or nominal cost) of capital. The real cost
of capital is that in present value terms, whereas the nominal or money cost of capital is that
cash flow actually paid out. If you are asked in the examination about inflationary influences
on DCF calculations, the following formula will be useful to mention:
Real cost of capital =
i + 1
1 m÷
where: m = the money cost of capital, and
i = rate of inflation
When determining which discount factor to use you should note that the money rate of
interest should be used when money cash flows are used, and real rates of interest if the
cash flows are expressed in real terms. Thus, if you are required to adjust cash flows for
inflation, you should use the money rate of interest, and if you are required to ignore inflation,
or to treat all cash flows as real cash flows, then you should use the real cost of capital. It is
essential to read the information provided carefully and state all assumptions – if inflation is
not mentioned then you should state "I am assuming that all cash flows are real cash flows,
and the correct cost of capital to use is the real cost of capital".
Where the decision-maker is aware that inflation is going to occur they may wish to allow for
it in their calculations. The correction may be either specific or general, as with adjustments
for risk.
 Specifically, the cash flows for each year can be adjusted for the rate of inflation
expected to occur during that year, in an attempt to reduce all the data to a common
base level.
 Generally, an allowance can be made in the discount rate to cover the expected rate
of inflation. Expectations about inflation are unlikely to be accurate and if they are
significant to the outcome of the project we should use the risk and uncertainty
techniques discussed above.
Inflation can also have an impact on gearing and the resulting cost of capital. Inflation may
result in a company increasing its selling price, which may have a major impact on demand
for a company's goods or services.
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Payments of tax, or reductions in taxation payments, are cash flows and should ideally be
considered in the DCF analysis.
A company will pay Corporation Tax on their profits usually in the year following that in
which the taxable profits are made. Capital Allowances (the tax equivalent of depreciation of
fixed assets) are available as an allowance that reduces taxable profit and the consequent
saving of a tax payment should be seen as a cost saving in the period in which they arise.
The area of capital allowances is complicated and changes constantly but let us make a
basic assumption, for example purposes, that a writing down allowance (WDA) is given at a
rate of 25% on the cost of plant and machinery on a reducing balance basis.
If an item of machinery cost a business, say, £60,000, then a capital allowance of £15,000
(based on a WDA of 25%) is available on which to reduce taxable profits. If the new piece of
machinery produced an estimated cost saving each year of £20,000 and the Corporation Tax
rate was, say, 30% and the after-tax cost of capital for the business was 6%, then the tax
implications for the DCF calculations would look as follows:
Year Equipment Savings Tax on
Tax saved on
Net cash
Value of
cash flows
£ £ £ £ £ £ £
0 (60,000) (60,000) 1.000 (60,000)
1 20,000 4,500* 24,500 0.943 23,104
2 20,000 (6,000) 3,375** 17,375 0.890 15,464
* £60,000 x 25% WDA x 30% C.Tax rate = £4,500
** (£60,000 – £15,000) x 25% WDA x 30% C.Tax rate = £3,375
The calculations above would carry on for the estimated useful length of life of the project.
An organisation is said to be in a capital rationing situation when it has insufficient funds to
accept all projects with a positive NPV. A decision therefore must be made as to which
projects to choose. The technique used depends on whether capital rationing only exists for
the current period (single period capital rationing) or whether it will be limited for several
periods, and whether the projects being considered are divisible (can be undertaken in whole
or in parts) or non-divisible (can only be undertaken as a whole or not at all).
In a situation where there is single period capital rationing and divisible projects,
management should choose the projects which give the highest NPV per £1 of capital
invested (i.e. maximising the return from the limiting factor).
The management of Rosie Ltd have found that for the following year the company has only
£100,000 available for investment. The company's cost of capital is 20%. They are currently
considering four independent and divisible projects, as set out in the following table.
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Project Investment Required NPV at 20%
£ £
W 100,000 48,000
X 20,000 16,000
Y 30,000 18,000
Z 45,000 21,000
How should Rosie Ltd. proceed?
First we need to calculate the NPV per £1 of capital invested, i.e. the return achieved per unit
of limiting factor, and rank the projects according to the results.
Project Investment Required NPV at 20% NPV/£1 Invested Ranking
£ £
W 100,000 48,000 0.48 3
X 20,000 16,000 0.80 1
Y 30,000 18,000 0.60 2
Z 45,000 21,000 0.47 4
The available £100,000 can now be allocated:
Project Investment NPV
£ £
X 20,000 16,000
Y 30,000 18,000
W (balance use 1/2) 50,000 24,000
100,000 58,000
This combination of projects gives the maximum return to the company and should be
accepted by the management.
If the projects are not divisible then this method may not give the optimal decision because
there is likely to be unused capital. This unused capital could be invested and will earn
interest. The best method of solving such a problem is trial and error by comparing the NPV
available from the different possible combinations of projects, remembering to calculate any
interest that would be received on the unused capital.
For multi-period capital rationing the timing of cash flows from each project is important, but
again management are attempting to maximise NPV per unit of scarce resource – capital.
When there are divisible projects, linear programming can be used, and when there are non-
divisible projects integer programming would be used.
Because purchasing involves a large (in relative terms) capital outlay, which may involve
borrowing, an organisation may consider leasing an asset rather than purchasing it outright.
Purchase also leads to a commitment to particular assets which may succumb to new
technology very quickly; leasing might provide an easier avenue to new technology, as and
when it arrives. When considering whether or not to lease an asset it is assumed that the
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funds would come from borrowing rather than from the general pool of retained earnings,
thus the decision could be seen as one of lease or borrow.
The methods used to consider hire purchase of an asset are the same as for considering
leasing an asset, but when looking at the non-financial aspects of the decision you should
remember that when the HP term is over the asset belongs to the firm.
The methods discussed below are based on finance leases – operating leases are simply a
form of renting and for them the only relevant cash flows are the lease payments and the tax
saved from offsetting these payments against tax. The traditional method of considering the
financial implications of whether or not to lease an asset is done in two stages; first a
decision is made as to whether or not to purchase the asset based on the operating cash
flows arriving from it using the NPV techniques (with the discount factor being the WACC or
other rate generally used by the organisation) that we have already discussed. If it is
decided to purchase the asset (i.e. the NPV is positive) then a decision is made as to how to
finance the asset (i.e. whether to lease it or fund it some other way). This latter decision is
made by discounting the differential cash flows which would arise from leasing at the
company's (after tax – if tax-payers) cost of borrowing.
When considering a lease or buy decision you must be careful to consider all the taxation
implications. The Finance Act 1991 states that depreciation is allowable as an expense
against taxation in the form of capital allowances, as is the interest element of the finance
charge. (Detailed knowledge of capital allowances and their subsequent tax implications are
outside of our present scope, but simple examples are shown both in the calculation above of
the implications of inflation and taxation on investment decisions, and the example which
follows.) If the purchase decision involves borrowing to buy, remember that debt interest is
allowable against tax; lease payments may also be allowable. Again, if you encounter this
type of problem in the examination, it is important to read the information provided very
carefully, and to state any assumptions you make; a generally accepted simplifying
assumption is that lease payments are all fully allowable against tax – something you may
assume unless told otherwise. The accounting rules and regulations for operating and
finance leases are changing with the introduction of the new International Accounting
Standards (IAS), but the basic differences between an operating lease and a finance lease
are as indicated.
You must also be careful to include all cash flows – including the sale of the asset (if bought),
any extension fees of the lease, any maintenance costs and so on. Whilst it is possible to
calculate the comparison in one table you are less likely to make mistakes if you calculate
the NPV of the two options separately, and then compare them.
Other factors that may need to be taken into account are:
 The company's liquidity and cash flow position – it may not be in the position to
purchase an expensive asset outright.
 The choice of lease or buy will have an effect on reported profits, and may affect the
market's view of the firm.
 If the asset was to be purchased outright there would be an opportunity cost of what
other uses the funds could be put to.
 Expenses of maintenance, insurance and so on may differ between leasing and
The costs of leasing may be far lower than a company's cost of capital, and as such there is
a danger in using the traditional approach that a project may be rejected before its financing
decision is considered when it would be worthwhile at the lower cost of capital.
In order to overcome this problem, some financial managers take the decision the other way
round – deciding which is the cheaper method of financing and then evaluating the project at
the cheaper cost.
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A second and more preferable method of overcoming this problem is to evaluate the project
as though it is purchased, and then as though it is leased. The correct decision is the one
which provides the highest NPV. If neither NPV is positive the project should be rejected.
A company is to make the decision whether to lease or buy a new Toyota Corolla car for use
in the business. The cost of the car is £14,000 and it has an estimated useful life of five
years. Due to the very high mileage the car is likely to do in this period, there is no estimated
residual value. Assume tax is payable at 31% on operating cash flows one year in arrears.
Capital allowances of 25% on a reducing balance basis are given on the car.
The company has the option to lease the car under a finance agreement for five years at an
annual cost of £3,200, payable at the year end. If the company were to purchase the car it
would need to borrow the full amount at 12% interest. Which is the most cost-effective
We first need to calculate capital allowances if the car is purchased:
Year 1: 25% × £14,000 3,500
Year 2: 25% × £10,500 2,625
Year 3: 25% × £7,875 1,969
Year 4: 25% × £5,906 1,477
Year 5: £14,000 ÷ £9,571 4,429
We now need to look at the cost of both options.
Assume that lease payments are eligible for a full tax allowance. (Note that the discount rate
of 12% must be adjusted for tax relief on borrowing costs, giving 12% × (100% ÷ 31%) = 8%.
Year Cash Flow Discount Factor NPV
£ 8% £
1 Lease cost (3,200) 0.926 (2,963)
2 Lease cost (3,200) 0.857 (2,742)
Tax saving on lease cost (× 31%) 992 0.857 850
3 Lease cost (3,200) 0.794 (2,541)
Tax saving on lease cost (× 31%) 992 0.794 788
4 Lease cost (3,200) 0.735 (2,352)
Tax saving on lease cost (× 31%) 992 0.735 729
5 Lease cost (3,200) 0.681 (2,179)
Tax saving on lease cost (× 31%) 992 0.681 676
6 Tax saving on lease cost (× 31%) 992 0.630 625
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Year Cash Flow Discount Factor NPV
£ 8% £
0 Cost of car (14,000) 1.000 (2,963)
2 Tax saved (capital allowances)
31% × £3,500 1,085 0.857 930
3 Tax saved 31% × £2,625 814 0.794 646
4 Tax saved 31% × £1,969 610 0.735 448
5 Tax saved 31% × £1,477 458 0.681 312
6 Tax saved 31% × £4,429 1,373 0.630 865
The leasing option is therefore the cheaper one and should be adopted.
Side Effects of Different Financing Methods
Conventional methods of capital investment appraisal (e.g. NPV and IRR) discount the
relevant future cash flows at the organisation's WACC. This is fine for simple, small projects,
but it ignores changes in financing arrangements and differing levels of systematic risk that
may arise from accepting a new project. These changes in financing arrangements often
occur because a new share or debt issue may be raised to pay for the capital project.
The interaction that may occur between the financing and investment decisions can be dealt
with in capital investment appraisal by adjusting the WACC using the CAPM (see earlier in
the course) or by using the adjusted present value technique which considers the above
The steps in using an APV approach are:
(a) Find the ungeared cost of equity for the firm.
(b) Estimate the base case NPV – this is done by discounting the project's cash flows at
the ungeared cost of equity.
(c) Evaluate and discount the side effects of the project and its financing methods,
examples of these being:
 Tax
 Financing
 Issue costs
 Subsidised loans
(d) Add the discounted side effects to the base case NPV to give the APV.
(e) If the APV is positive accept the project.
This process can be best illustrated by an example. Although it is useful for you to
understand these workings you will not be expected to undertake similar calculations
concerning APV in your examination.
Before looking at the example, let us briefly summarise the advantages and disadvantages of
the APV method.
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The advantages are that:
 It is easier to calculate than attempting to adjust the discount rate for all the side
effects, and as such it is versatile and flexible.
 It allows management to evaluate all the effects of the method of financing a project,
and thus to see where the benefits of the investment are coming from. This may be
especially useful if the benefits are arising from, say, a government incentive which
may be withdrawn quickly thus making the project unviable.
The disadvantages of the APV method are that:
 It is dependent on the theories of MM (1963) (as considered in an earlier unit) for its
underlying assumption and thus the problems with MM are also inherent with APV.
 It can be difficult to identify all the costs associated with the method of financing and
choosing a correct interest rate to discount them with.
 It can be long and complicated – as no doubt you may agree after studying the
Amigo is considering investing in a project which will cost £75,000. The cost of the project
will attract writing down allowances at 25% on a reducing balance basis. The project will
have a net cash flow of £37,500 per annum for three years, after which time it will be
scrapped for a minimal sum. To finance this project £15,000 will be taken from retained
earnings, and the remainder will be provided by Amigo's bank for a cost of £1,000. The rate
of interest on the loan is to be 12%.
The industry average beta for projects of this type is 2.5, and its average gearing ratio is 3:4
(debt: equity). The risk-free rate is 10%, and the market return is 15%. Assume corporation
tax is 33%, paid a year in arrears. Assess the project's viability using an APV technique.
Note that it would be very difficult to assess this project with any reliability otherwise than by
The five steps in applying the APV technique are as follows:
(a) Find the ungeared cost of equity for the firm using the following formula:
= |
[1 +
t) (1 V ÷
Using the industry average beta, rather than an individual company's beta, is a good
technique as this removes many of the problems with betas discussed earlier in the
Unless told otherwise assume the debt is risk-free.
= |
[1 + V
(1 ÷ t)/V
2.5 = |
[1 + 3 (1 ÷ 0.33)/4]
2.5 = |
= 2.5/1.5025
= 1.66
Using CAPM 10% + (15% ÷ 10%) 1.66 = 18% = base case discount rate.
(b) Estimate the base case NPV – this is done by discounting the project's cash flows at
the ungeared cost of equity.
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Calculating the writing down allowances:
Timing Book Value WDA Tax Rate Tax Relief
Yr 2 75,000 × 0.25 = 18,750 × 0.33 6,188
Yr 3 56,250 × 0.25 = 14,063 × 0.33 4,641
Yr 4 42,187 (balancing allowance) × 0.33 13,922
Base case present value:
Year 0 1 2 3 4
Outlay (75,000)
Cash flows 37,500 37,500 37,500
Tax (12,375) (12,375) (12,375)
WDA 6,188 4,641 13,992
After tax cash flows (75,000) 37,500 31,313 29,766 1,617
Discount factor (18%) 1 0.8475 0.7182 0.6086 0.5158
PV cash flow (75,000) 31,781 22,489 18,116 834
Base case present value = (1,780) (note that this is negative).
(c) Evaluate and discount the side effects of the project and its financing methods.
(i) Present value of debt arrangement fee = (£1,000) – assume paid in Year 0
Tax relief = £1,000 × 0.33 = £330
Claimed Yr 2 = £330 × 0.7972 (applying 12% discount rate) = £263
(ii) Present value of tax relief, discounted at the pre-tax cost of debt which reflects
the low risk of the tax relief (note that the after-tax rate is not used because this
would double-count the tax relief, and interest is assumed to be allowable against
tax unless stated otherwise):
Interest × Annual tax relief on interest:
£60,000 × 0.12 = £7,200 × 0.33 (tax relief) = £2,376
Year 2: £2,376 × 0.7972 = £1,894
Year 3: £2,376 × 0.7118 = £1,691
Year 4: £2,376 × 0.6355 = £1,510
PV of tax relief = £5,095
(d) Add the discounted side effects to the base case NPV to give the APV.
Adjusted present value:
Base-case present value (1,780)
Present value of tax shield 5,095
Arrangement fee (1,000)
PV of tax relief on arrangement fee 263
Adjusted present value 2,578
(e) As the APV is positive accept the project.
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The principal input that the capital asset pricing approach can make into capital budgeting is
in determining the discount rate. However, there are two important limitations:
 The discount rate is determined as at a point in time, yet most projects run for several
years; and
 There are so many market imperfections that the rate may be influenced more by "real
world" distortions than determined by the model itself.
Furthermore, it is possible to have conflicting outcomes in appraising the same project
depending on the source of the discount rate. If the rate is based on the weighted average
cost of capital (WACC) method, a project may be rejected because it gives insufficient return,
say, whereas under CAPM it would be acceptable because such low return is offset by low
systematic risk.
Rigid use of a cost of capital method will tend towards acceptance of higher risk and avoiding
sufficiently profitable but lower risk projects. Such conflicts are rare, but can occur in
If CAPM is accepted, it might be concluded that, when deciding whether to invest in a
particular project, management should be concerned with its systematic risk and not with its
overall risk. If the beta factor can be estimated, then it is possible, using the formula given
earlier, to calculate the minimum required return on the project, based on the systematic risk
of the project. The model can thus be used to compare projects of different risk classes,
unlike the NPV method which does not consider risk in its choice of discount rate.
In using the model, management are determining a required rate of return based on market
and risk free rates of returns, the returns on the project and its variation to the market; in so
doing they are assuming that shareholders wish them to evaluate such projects as though
they were stocks and shares in the market, and that shareholders are fully diversified
themselves and have no desire for the company to diversify on their behalf.
The following examples are typical of the types of problem you may expect to face in the
Example 1
A company has estimated the expected cash flows for four possible projects as follows:
0 1 2 3 4 5
1 (500) 200 200 300 200 200
2 (400) 100 100 100 100 500
3 (150) 40 50 60 70 100
4 (1,000) 500 400 300 200 100
Note that all figures are in £000s.
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(a) Rank these projects in order of acceptability using:
(i) Payback;
(ii) Net present value at 20% cost of capital;
(iii) Internal rate of return.
(b) Explain which project should be accepted if the projects were mutually exclusive and
there was no capital rationing.
(c) Explain which project(s) should be accepted if the projects were independent and
indivisible, and the company had £1 million to invest.
(d) Explain which project(s) should be accepted if the projects were independent and
divisible, and the company had up to £1.1 million to invest.
(e) Explain briefly the relative advantages and disadvantages of the appraisal methods
used in (a) above.
The following discount factors are provided for use as necessary:
Year Net Present Value Value of an Annuity
20% 30% 20% 30%
1 0.8333 0.7692 0.833 0.769
2 0.6944 0.5917 1.528 1.361
3 0.5787 0.4552 2.106 1.816
4 0.4823 0.3501 2.589 2.166
5 0.4019 0.2693 2.991 2.436
(a) (i) Payback method
Project 1
The £500,000 initial outlay is returned as follows:
(200,000 + 200,000 +
[300,000]) = 2.3 years
Project 2
The £400,000 initial outlay is returned as follows:
(100,000 + 100,000 + 100,000 + 100,000) = 4 years
Project 3
The £150,000 initial outlay is returned
(40,000 + 50,000 + 60,000) = 3 years
Project 4
The £1,000,000 initial outlay is returned as follows:
(500,000 + 400,000 +
[300,000]) = 2.3 years
So the ranking is:
1st equal – Project 1 and Project 4
3rd – Project 3
4th – Project 2
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(ii) With NPV at 20%
Project 1
Year Cash Flow Factor NPV
£000 £000
0 (500) 1.0000 (500.00)
1 200 0.8333 166.66
2 200 0.6944 138.88
3 300 0.5787 173.61
4 200 0.4823 96.46
5 200 0.4019 80.38
Project 2
Year Cash Flow Factor NPV
£000 £000
0 (400) 1.0000 (400.00)
1 100 0.8333 83.33
2 100 0.6944 69.44
3 100 0.5787 57.87
4 100 0.4823 48.23
5 500 0.4019 200.95
Project 3
Year Cash Flow Factor NPV
£000 £000
0 (150) 1.0000 (150.00)
1 40 0.8333 33.33
2 50 0.6944 34.72
3 60 0.5787 34.72
4 70 0.4823 33.76
5 100 0.4019 40.19
Project 4
Year Cash Flow Factor NPV
£000 £000
0 (1,000) 1.0000 (1,000.00)
1 500 0.8333 416.7
2 400 0.6944 277.8
3 300 0.5787 173.6
4 200 0.4823 96.5
5 100 0.4019 40.2
The ranking from Project 1 to 4 runs also from 1 to 4 in order.
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(iii) IRR method
NPV at 30%, when combined with the NPV at 20%, can be used to determine the
IRR by use of a formula:
Project 1
Year Cash Flow Factor NPV
£000 £000
0 (500) 1.0000 (500.00)
1 200 0.7692 153.80
2 200 0.5917 118.30
3 300 0.4552 136.60
4 200 0.3501 70.00
5 200 0.2693 53.90
Project 2
Year Cash Flow Factor NPV
£000 £000
0 (400) 1.0000 (400.00)
1 100 0.7692 76.90
2 100 0.5917 59.20
3 100 0.4552 45.50
4 100 0.3501 35.00
5 500 0.2693 134.70
Project 3
Year Cash Flow Factor NPV
£000 £000
0 (150) 1.0000 (150.00)
1 40 0.7692 30.80
2 50 0.5917 29.60
3 60 0.4552 27.30
4 70 0.3501 24.50
5 100 0.2693 26.90
Project 4
Year Cash Flow Factor NPV
£000 £000
0 (1,000) 1.0000 (1,000.00)
1 500 0.7692 384.60
2 400 0.5917 236.70
3 300 0.4552 136.60
4 200 0.3501 70.00
5 100 0.2693 26.90
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To determine the internal rate of return for each project we can apply the formula:
X +


÷ × X) (Y
b + a
where: X = the lower rate of interest used
Y = the higher rate of interest used
a = the difference between the present values of the outflow and the
inflows at X%
b = the difference between the present values of the outflow and the
inflows at Y%.
If one NPV is positive (i.e. a) and the other negative (i.e. b) the formula is:
X +


÷ ×
X) (Y
b a
So to take each project in turn:
Project 1:
IRR = 20 +


÷ × 20) (30
= 28.3%
Project 2:
IRR = 20 +


÷ × 20) (30
= 25.5%
Project 3:
IRR = 20 +


÷ × 20) (30
= 27.1%
Project 4:
IRR = 20 +


÷ × 20) (30
= 20.3%
This then ranks the projects in the order:
1st – Project 1
2nd – Project 3
3rd – Project 2
4th – Project 4
(b) With mutually exclusive projects and no capital rationing, the company should select
the one with the highest NPV, this being Project 1.
(c) In the situation of independent, indivisible projects where the company had £1 million to
invest, the best approach would be to maximise the NPV obtainable. In this case,
Projects 1 and 2 should be accepted.
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(d) Looking at the situation of divisible, independent projects we would need to consider
the highest profitability index, being:
Project 1 2 3 4
investment Initial
Inflows P/V ÷
99 655.
82 459.
72 176.
8 1004.
= 1.31 1.15 1.18 1.00
We would allocate our money to the most profitable first which would provide the
following portfolio:
Project 1 – investment of £500,000
Project 3 – investment of £150,000
Project 2 – investment of £400,000
(e) Payback is useful in that it has the advantage of showing when the initial investment
has been repaid. However, it also has the disadvantages of:
(i) Ignoring income after the payback period; and
(ii) Ignoring interest.
Net present value provides the advantage of considering both cash flows and interest
over the project life but the disadvantage of ignoring risk.
Internal rate of return provides the advantage of an appraisal as a single percentage
figure and thereby indicates a project yielding the highest return on investment.
However, by the use of such a rate the cash flow effects can be hidden and the risk
aspects ignored.
Example 2
Hurdlevack Ltd relies on the payback method of project evaluation, requiring that investments
repay capital within three years. The board are currently considering the four following
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs 16,000 27,000 15,000 18,000
Depreciation 8,000 40,000 30,000 35,000
Interest 12,000 16,000 9,000 7,000
Initial investment 120,000 160,000 90,000 70,000
Project life 15 years 4 years 3 years 2 years
The engineering department has asked the board to evaluate these opportunities by means
of a discounted cash flow technique. The finance department has been unwilling to use a
discounted cash flow technique, because of difficulty in establishing an appropriate discount
rate. It therefore proposes to calculate each project's internal rate of return, and let the board
determine appropriate hurdle rates.
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(a) Calculate each project's payback and state which of the opportunities is acceptable by
this criterion.
(b) Calculate each project's internal rate of return and using a hurdle rate (the minimum
rate of return acceptable to the company) of 15%, state which of the opportunities is
acceptable by this criterion.
(c) Suggest why the above two project appraisal methods do not give answers which are
consistent with each other for the accept/reject decision.
(d) Briefly outline some of the elements which should be considered when determining the
appropriate hurdle rate for an individual project.
(a) Direct costs, interest charges and flows from sales are used in the calculation of
payback periods, as follows.
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs (16,000) (27,000) (15,000) (18,000)
Interest (12,000) (16,000) (9,000) (7,000)
Net annual cash flow 12,000 32,000 36,000 35,000
As the payback is the time in which the cash flows repay the initial capital outlay, it can
be derived as follows.
Project A B C D
£ £ £ £
Capital outlay 120,000 160,000 90,000 70,000
Net annual cash flow 12,000 32,000 36,000 35,000
Payback period 10 years 5 years 2½ years 2 years
Thus, C and D are acceptable.
(b) When looking at the internal rate of return (IRR) of the projects, we look at cash flows
from sales and direct costs.
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs (16,000) (27,000) (15,000) (18,000)
Net annual cash flow 24,000 48,000 45,000 42,000
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Project A B C D
£ £ £ £
Capital outlay 120,000 160,000 90,000 70,000
Net annual cash flow 24,000 48,000 45,000 42,000
Payback 5 years 3.33 years 2 years 1.67 years
From the annuity
tables, the IRR is
(approximately): 18% 8% 23% 13%
Thus A and C are acceptable.
(c) The cash flows of a project which arise after the payback period are not accounted for
under the payback appraisal method. Thus, where a project takes a relatively long time
to "come on stream", it will be rejected on payback terms, even if it has an acceptable
IRR. As can be seen from the above, Project A is acceptable only under IRR. Payback
emphasises liquidity but, if cash flows cease quickly, as in Project D, the payback
criteria may be met but an adequate return on capital is not seen.
Project B is rejected by both appraisal methods because of the small cash return.
Project C is the opposite, having high cash returns, and it is acceptable under both
appraisal methods.
(d) The inherent risks associated with cash flows deriving from each project should be
assessed in determining hurdle rates. As it is likely that investments will already be
under way, these should also be considered, as they might provide benefits associated
with a new project – i.e. diversification of risks.
In a perfect capital market, flows from a projected project may not be positively
correlated with the earnings stream of the firm, and diversification may still not be wise.
Where there are possibilities for private shareholder diversification, diversification in
private and corporate terms may equate, and there would not be any benefit in
corporate diversification. If this is so, then only the risk associated with the earnings
stream from the project would not be diversified by portfolio investment.
Where the capital market is imperfect, it may be quite acceptable to diversify. A
number of flows from various projects may alter the risk incurred by a firm very little, if
at all. In such cases, the firm's cost of capital may be used as a required rate of return
on investments. However, if the cash flows of a project will significantly affect the risk
of a company on average, where these are taken with the existing earnings stream, it is
necessary to calculate the return on each available project combination linked with the
existing earnings stream. By doing this, the "right" mix of investments can be
assessed, to compensate for any change in earnings with any change in associated
Capital Investment Decision Making 2: Further Considerations 327
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Practice Questions
1. A new polishing machine is required. The polishing machine forms a part of the
production process, and most products manufactured require polishing at various
stages in their production. A polishing facility is expected to be required for as long as
the factory remains in operation, and no closure can be anticipated.
Details of the two machines under consideration are set out below.
Machine A B
Initial cost £50,000 £90,000
Life – years 4 7
Salvage value at end of:
Year 4 – machine A £5,000
Year 7 – machine B £7,000
Annual running costs £10,000 £8,000
Both machines fulfil the same function and have equal capacities. The approximate
discount rate is 10%.
Determine which machine should be purchased. Specify any assumptions made.
To what amount would the initial cost of machine A be required to alter in order for the
two machines to be of equal financial attractiveness?
2. ABC Ltd, which is investigating the possible acquisition of XYZ Ltd, for diversification
purposes, has asked you to advise the firm on the basis of the following information:
Summary Balance Sheet as at 30th September 2002
£000 £000
Ordinary shares 1,500 Land & buildings 900
Reserves 900 Plant (net of depreciation) 600
10% debentures 750 Investments 450
Creditors 300 Stock 600
Debtors 600
Cash 300
£3,450 £3,450
Profits: 2000 – £350,000
2001 – £300,000
2002 – £450,000
You are also told the following:
 It is estimated that the investments have a market value of £675,000, and that the
stock could be sold for £750,000. The other assets have a value as stated in the
balance sheet.
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 All of the investments and plant valued at £225,000 would not be needed by ABC
 The investments have produced annual income of £45,000 per annum for the last
five years, and are expected to continue to do so.
 ABC Ltd would repay the debentures at par, immediately after acquisition.
 ABC Ltd requires a return on capital of 10%.
You are required to calculate the maximum price which ABC Ltd should be prepared to
pay for XYZ Ltd on each of the following bases:
(a) Break-up value.
(b) Profitability.
(c) Discounted cash flow, assuming that the cash flows to be discounted are as
2003 450
2004 600
2005 450
2006 onwards 570
Present value factors at 10%
Year 1 0.90909
Year 2 0.82645
Year 3 0.75131
Year 4 0.68301
(Note that it is normal in both practice and examinations to use discount figures to
only three decimal places – i.e. the above figures would normally be stated as:
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683)
3. Stamford Ltd specialises in the production of plastic sports equipment. The company
has recently developed a new machine for automatically producing plastic cricket bats.
The machine cost £150,000 to develop and install, and production is to commence at
the beginning of next week. It is planned to depreciate the £150,000 cost evenly over
four years, after which time production of plastic cricket bats will cease. Production and
sales will amount to 30,000 bats each year. Annual revenues and operating costs, at
current prices, are estimated as follows.
Sales (£9.60 each) £288,000
Variable manufacturing costs £200,000
This morning, a salesman has called and described to the directors of Stamford Ltd a
new machine, ideally suited to the production of plastic cricket bats. This item of
equipment is distinctly superior to Stamford's own machine, reducing variable costs by
30% and producing an identical product. The cost of the machine, which is also
capable of producing 30,000 cricket bats per annum, is £190,000.
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Assume the following:
 Annual revenues and operating costs arise at the year-end.
 The general rate of inflation is 10% per annum.
 The company's money cost of capital is 21%.
 The existing machine could be sold immediately for £12,000.
 If purchased, the new machine could be installed immediately.
 Either machine would possess a zero residual value at the end of four years.
(a) Calculation of the net present value of the two options open to the management,
using the real cost of capital.
(b) Advice to the management as to which course should be followed, and an
explanation of the significance of your calculations under (a).
Note: Ignore taxation.
Table of Factors for n = 4 Years
Interest Rate
(per cent)
Present Value
of £1
Present Value of £1
Received per Year
r (1 + r)
r) + 1 1
n ÷
÷ (
10 0.68 3.17
11 0.66 3.10
12 0.64 3.04
13 0.61 2.97
14 0.59 2.91
15 0.57 2.85
16 0.55 2.80
17 0.53 2.74
18 0.52 2.69
19 0.50 2.64
20 0.48 2.59
21 0.47 2.54
22 0.45 2.49
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4. An opportunity has arisen for your company to acquire the specialised product stocks
of a bankrupt business for £50,000. The net proceeds from the sale of these stocks
will be influenced by a number of factors originating from outside the company but the
range of possibilities appears to be as follows.
Possible Amounts of
Net Sales Proceeds
£ %
Year 1 24,000 60
20,000 30
36,000 10
Year 2 60,000 50
48,000 30
20,000 20
The estimates for Year 2 are independent of those for Year 1. The company's required
rate of return is 20%.
(a) To calculate the expected net sales proceeds each year; and to state whether on
this basis the project would yield the required rate of return.
(b) To tabulate the possible combinations of sales value over the two years, with their
related probabilities, and from this data to calculate the overall percentage
probability of the rate of return being less than the required 20%.
(c) Without making any further calculations, to explain how you would arrive at the
standard deviation of net present value and the coefficient of variation for this
project, and the use that might be made of those statistics.
Now check your answers with those given at the end of the unit.
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1. The technique known as the equivalent annual cost technique may be used here, as
the service provided by the machines in question is to be required for the foreseeable
future. The present value of operating each machine for its economic life is calculated,
and then expressed as an annual equivalent. This latter figure is achieved by the
following calculation:
period same the for factor Annuity
life economic for machine operating of value Present
Such a figure enables an easier comparison to be made of assets with differing
economic lives, provided that at the end of its life an asset is replaced by a similar one.
An assumption of unchanging technology and constant relative prices is necessary.
On this basis, the present value of the costs is as follows.
£ £
Initial cost 50,000 90,000
Running costs:
£10,000 × 3.170 (4 years at 10%) 31,700
£8,000 × 4.868 (7 years at 10%) 38,944
less Salvage value:
£5,000 × 0.683 (3,415)
£7,000 × 0.513 (3,591)
Present value of cost (a) 78,285 125,353
Annuity factor (b) 3.170 4.868
Equivalent annual cost (a ÷ b) £24,696 £25,750
This shows that machine A should be chosen, as it is the less expensive. At the end of
four years, then eight years, etc., new machines A would be purchased as
To be equally financially attractive, it would be necessary for the initial cost of machine
A to rise until the equivalent annual cost of A was also £25,750. This would mean a
present value total of:
£25,750 × 3.170 = 81,628
less Present value now 78,285
£3,343 increase
So, it would be necessary for the initial cost of machine A to rise to £53,343 for the
machines to be equally attractive.
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2. Maximum prices ABC Ltd would be prepared to pay for XYZ Ltd on the following bases.
(a) Break-up Value
This can be computed in two ways, bearing in mind that, even if the investment
and plant worth £225,000 are not needed by ABC Ltd, they do represent part of
the value of XYZ Ltd and any as yet unrealised profits in them constitute part of
the value. As the company is being acquired as a whole, any sale of assets
surplus to requirements and made subsequently would merely alter the values of
industrial assets, and it would not affect the overall break-up value.
The value is calculated as follows:
Either Or
Value at 30/11/2002 £000 £000
Land and buildings 900 900
Plant 600 375
Investments 675 –
Stock 750 750
Debtors 600 600
Cash 300 300
Sum due on sale of investments/assets or
cash proceeds realised – 900
3,825 3,825
less: Debentures 750 750
Creditors 300 300
Value of business to ordinary shareholder £2,775 £2,775
So, therefore, the break-up value is £2,775,000, which purely puts a value to the
assets as they stand and, to some extent, includes growth in the value of the
assets over the historical cost. Potential future profitability is not reflected in this
figure. To allow for this, a value of goodwill would need to be calculated in terms
of "n" years' purchase of average weekly profits less an allowance for the
projected interest on capital. The number represented by "n" would be that
typical to the particular industry or trade.
(b) Profitability
To obtain a maximum price on this basis, different assessments can be made.
Initially, it should be seen whether "profits" in the terms of the question relates to
profits after payment of debenture interest and including the interest received
from investments. An assumption is made that this is so.
Past profits are usually adjusted, in exercises such as this, in the light of
changing circumstances which will prevail when the purchasing company takes
over – with no investments and repaid debentures.
Two alternative methods can be used, with both unweighted and weighted profits.
The number of years' average profits to be taken into the market value needs to
be assessed.
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As the company specifies a cost of capital, or capitalisation rate, of 10% a P/E
ratio of 10 would be appropriate – i.e.
Market value =
rate ation Crystallis
or Market value = P/E ratio × Earnings
The valuations at 30th November 2002 are as follows:
Method 1 (unweighted)
Annual Profits
£000 £000 £000 £000
2000 350 (45) 75 380
2001 300 (45) 75 330
2002 450 (45) 75 480
£1,100 £(135) £225 £1,190
Average annual unweighted profit is
000 190 1 , , £
= £396,666
Method 2 (weighted)
Adjusted Profit × Weight Weighted Adjusted
£000 £000
2000 380 1 380
2001 330 2 660
2002 480 3 1,440
£1,190 £2,480
Average annual weighted profit is
000 480 2 , , £
= £413,333
So, on a P/E basis of 10, the price would be:
Method 1 – £3,966,666
Method 2 – £4,133,333 (maximum)
The higher values seen here reflect the vendor's ability to make a profit.
(c) Discounted Cash Flow
The cash flows represent the projected flows but excluding investment and
debenture interest. They compare, therefore, with the adjusted profits
assessments of value.
DCF looks at the value of the company as a discounted stream of future cash
flows available to the purchaser.
This gives the net present value, as follows:
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Year Cash Flow DCF Present Value
£000 (10%) £000
2003 450 0.90909 409.1
2004 600 0.82645 495.9
2005 450 0.75131 338.1
2006 onwards 570
Valued at:
rate tion Capitalisa
× 0.75131
1 0
000 570
× 0.75131 = 4,282,500
1,243,100 + 4,282,500 = £5,525,600
This treatment for £570,000 for 2006 onwards presents a value in perpetuity.
Therefore, to sum up:
Maximum value: £000
(a) Break-up value £2,775
(b) Profitability £4,133
(c) DCF £5,525
3. (a) Real cost of capital =
i + 1
i m÷
= %
. .
10 =
1 1
11 0
10 0 + 1
10 0 21 0 ÷
Option 1, using the present machine, gives in real terms:
Sales 288,000
Variable costs of manufacture 200,000
Contribution 88,000
£88,000 for 4 years gives a PV £88,000 × 3.17 = £278,960
Option 2, using the new machine, gives:
Sales 288,000
Variable costs of manufacture 140,000
Contribution 148,000
£148,000 for 4 years gives a PV £148,000 × 3.17 = £469,160
Capital Investment Decision Making 2: Further Considerations 335
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But costs arise on the changeover, as follows:
Cost of machine of greater efficiency £190,000
less Proceeds of sale of old machine 12,000 £178,000
Present value following allowance for net purchase cost £291,160
As regards the development and installation costs of £150,000 relating to the new
machine, this represents money spent. The sum does not come into the
calculations otherwise.
Another way of looking at this is to make the calculations in money terms with an
allowance for the 10% inflation.
Option 1
Year Sales Variable Costs Contribution PV
£ £ £
1 316,800 220,000 96,800 0.826 79,957
2 348,480 242,000 106,480 0.683 72,726
3 383,328 266,200 117,128 0.564 66,060
4 421,661 292,820 128,841 0.467 60,169
Option 2
Year Sales Variable Costs Contribution PV
£ £ £
1 316,800 154,000 162,800 0.826 134,473
2 348,480 169,400 179,080 0.683 122,312
3 383,328 186,340 196,988 0.564 111,101
4 421,661 204,974 216,687 0.467 101,193
less Costs of changeover 178,000
The factors are calculated as (1.21)
(b) The present machine makes a contribution of £88,000 pa for four years –
£278,960 in all. The new and more efficient machine will increase the
contribution level to £148,000 pa. However, there is the high initial cost of
£190,000 less £12,000 sales receipts to be considered. This brings the PV of the
more efficient machine down to £291,160. The marginal superiority in results of
£12,200 needs to be carefully weighed against the risks of the project.
 Will the market for plastic cricket bats continue to be buoyant?
 Might the variable production costs increase?
Either possibility could easily eliminate any advantage, so it is probably better not
to invest in the new machinery.
336 Capital Investment Decision Making 2: Further Considerations
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The payback method is useful here, in the sense that, if we look at the return on
the outlay of £178,000, the contribution pa increases by £60,000. This means
that almost a full three years out of the project life of four years must elapse
before the company is satisfied in payback terms. We must remember also that
we have not considered interest, etc.
4. (a) Expected net sales proceeds:
Possible Cash Flow Probability Expected Value
£ £
Year 1 24,000 0.6 14,400
20,000 0.3 6,000
36,000 0.1 3,600
Year 2 60,000 0.5 30,000
48,000 0.3 14,400
20,000 0.2 4,000
Cash Flow Discount Factor NPV
£ (r = 20%) £
(50,000) 1.0 (50,000)
24,000 0.83333 20,000
48,400 0.69444 33,611
Net present value = 3,611
The project yields a return in excess of 20% and should, therefore, be accepted.
(b) The table of possible combinations of sales values and their related probabilities
are set out on the next page.
From this, the probability of the return being less than 20% is:
+ P
+ P
= 0.12 + 0.06 + 0.02
= 20%
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338 Capital Investment Decision Making 2: Further Considerations
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(c) (i) Standard Deviation
Standard deviation comes from the following formula:
o =
) x p(x ÷ E
where: o = standard deviation
p = probability of a particular outcome
x = particular outcomes possible (i.e. NPVs)
x = expected net present value (i.e. 3,611)
Standard deviation measures the dispersion around the mean value
(expected net present value). Its significance is seen in its size relative to
the mean value. The greater the dispersion, the greater the risk of not
achieving the expected outcome.
(ii) Coefficient of Variation
This can be calculated as follows:
Coefficient of variation =
It is useful in the comparison of the dispersion of two or more distributions
of projects of different sizes; the higher the coefficient, the more widely
dispersed is the distribution.
© ABE and RRC
Study Unit 14
Managing Risk
Contents Page
A. The Nature of Risk 341
Types of Risk 341
Costs of Managing Risk 343
B. Principles of Hedging 343
Short and Long Positions 344
Closing out 344
Developing a Hedging Policy 345
Costs of Hedging 346
C. Interest Rates, Risk and Exposure 346
Interest Rate Structures 346
Impact of Interest Rate Changes 348
Managing Exposure to Interest Rate Risk 349
D. Internal Techniques of Managing Interest Rate Exposure 350
Matching 350
Smoothing 350
E. Futures Contracts 350
Characteristics 350
Hedging Interest Rate Exposure with Futures Contracts 352
F. Forward Rate Agreements (FRAs) 354
Characteristics 354
Hedging Interest Rate Exposure with FRAs 354
G. Interest Rate Swaps 355
Characteristics 355
Operation of Interest Rate Swaps 355
(Continued over)
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H. Options 357
Calls and Puts 358
Option Prices 362
Hedging and Trading Strategies using Options 364
Interest Rate Options 368
Application of Option Theory to Capital Investment Decision making 369
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Types of Risk
We have seen before that all business enterprises face a degree of risk. There are a number
of different types of risk that affect the work of the finance manager and these can be
summarised as follows:
 Business risk
 Insurable risk
 Interest rate risk
 Currency risk
 International trade and finance risk
The last two of these different types of risk are covered in the next (and last) study unit.
Running a business inevitably involves the taking of risks, but there are a number of ways
and techniques in which a finance manager can help to reduce the amount of risk that the
business faces. However, risk reduction can often be costly and the finance manager will
need to balance that cost against the possible financial benefits gained (or losses incurred)
as a result of taking action to reduce the risk.
Business risk
Business risk is that arising from the very nature of the business itself. We can divide this
type of risk into two groups.
 That which is inherent in the conduct of business itself and cannot be reduced or
eliminated without ceasing trading – effectively closing down the business or selling it.
(The owner(s) accept this type of risk in making their investment and expect some form
of financial return as compensation.) For example, sales may reduce because of a
technological breakthrough by a major competitor or there is a recession affecting
overall levels of demand. Also, again for example, any large (or small) delivery firm will
inevitably be worried in the long term about the price of oil and government transport
policy, and thus the costs involved in road haulage.
 That which arises as a consequence of the financial transactions taking place in the
normal course of business. It is this element of risk exposure which the owner can
seek to reduce or eliminate. For example, it is likely that a manufacturer of coffee will
be worried about the future price of coffee beans, and one possible solution to this
worry might be to establish a formal agreement with the coffee bean producers to take
delivery of coffee beans at a future date at a price agreed today. In technical terms,
this would be called a "futures agreement" or a "forward agreement" (see below) for the
supply and price of coffee beans.
Essentially, we are concerned here with the possibility of incurring loss on certain types of
transaction – principally, through making investments or taking out loans, which gives rise to
interest rate risk, and through international trade which gives rise to exchange rate risk.
It is not possible to eliminate such risk completely, but it is possible to reduce it by way of
hedging. Hedging the risk involves taking action now to reduce the possibility of a future
loss, usually at the cost of foregoing any possibility of a gain. A simple example should
explain this.
A firm knows that it will need certain goods in six months' time. It is exposed to the risk that
the price of these goods may rise in the meantime. This risk may be reduced by entering into
a "forward contract" to purchase the goods in six months' time at a price fixed now. However,
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if the price falls below the current price in the meantime, the firm will have lost the opportunity
to make a gain.
The basis of hedging involves offsetting two transactions against each other:
 a cash transaction – the receipt or payment of money arising from normal business
transactions (such as international trade or the management of funds); and
 taking a position on (buying or selling) a derivative instrument linked to the type of
cash transaction.
There are a considerable number of such financial derivatives and in this unit we shall
examine the principles of their operation and strategies for their use in relation to interest rate
risk. (We shall consider the similar range of derivatives and strategies in relation to
exchange rate risk in the next unit.)
The instruments we shall examine here are forwards and futures contracts, swaps and
options. Options are somewhat different in that they offer the possibility of making gains as
well as hedging risk, and we shall consider them in some depth.
Insurable risk
Insurance is an inevitable part of modern life and this applies equally well to a business as it
does to an individual. Insurance can be costly, but it is necessary (and sometimes it is a
legal requirement) to insure the business against such situations as:
 Damage to premises caused by fires or the weather, etc. (buildings cover)
 Accidental damage to plant and machinery
 Polluting the local environment (laying the firm open to claims for damages by affected
persons or organisations)
 Accidents causing injury to staff and visitors (health and safety insurance and
occupier's liability insurance – a legal obligation)
 The sale of faulty goods and services
 Faulty advice provided by professional staff (professional indemnity insurance).
This list is only an illustration of some of the different types of risk that a business might
typically insure against. Whilst the cost of insurance is expensive, the business will need to
balance this costs against the possibility of the event occurring and, hence, the need to make
a claim. For this, the financial manager will need to consider factors such as:
 how to estimate the possibilities of events – for example, judging how likely it is that the
factory might burn down
 a working knowledge of methods that might be used to reduce the risk
 how to calculate if there is any possibility to pool risks.
It is not uncommon in the UK for major competitors and businesses with the same production
methods to share expensive parts of machinery between them. For example, consider two
soft drinks manufacturers and a beer manufacturer. They are very likely to use the same
production processes with the same machinery to produce, bottle and package their goods.
These machines are very expensive and it would not be uncommon for a major part to cost
around £50,000 to replace if broken. The three manufacturers might, then, form an
agreement between themselves to stock different parts that could be used by any of the
parties to the agreement in the event of a breakdown.
Interest rate risk
Interest rate risk is a permanent feature for any business which has loans outstanding and it
is true to say that interest rates cannot be predicted with any degree of certainty. Companies
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with a high degree of loan debt outstanding may be particularly vulnerable to the movements
of interest rates.
Finance managers need to establish a safe level of debt capital, and try to predict interest
rates to work out whether their debt should be at a fixed rate or a variable rate, or a
combination of both. Any individual with a mortgage on their property will fully understand
the financial implications of movements in interest rates.
Costs of Managing Risk
Managing risk is a balance between the costs of reducing the risks and "gambling" on the
risk not happening. There are a number of different costs associated with the practical
management of risk, including:
 Staffing costs – staff will be needed within the business to work on risk strategies and
the implementation of risk reduction policies, and the costs associated with this will
include not only salaries but premises and training costs
 External consultancy fees – where advisors are needed for the more technical and
complex areas of risk management, including dealing with the complex movements of
the currency or derivatives markets
 Costs of the "wrong" decision being made.
Note, too, that the underlying concept behind the Capital Asset Pricing Model (CAPM) is that
the required return on an investment increases with the risk involved and a central theme of
CAPM is that systematic risk, as measured by beta, is the only factor affecting this for a
completely diversified investor. There is now, particularly amongst academics, some
questioning of this theory and, subsequently, this may cause additional costs being incurred
As we noted above, hedging a risk involves taking action now to reduce the possibility of a
future loss, usually at the cost of foregoing any possibility of a gain. It is a process whereby
the exposure to potential loss caused by adverse movements in prices, interest rates and
exchange rates may be limited.
A hedge against exposure to risk is invariably constructed by using a financial derivative.
Again, as we noted above, there are a range of these instruments. They "derive" their value
from the price of underlying assets such as foreign currencies, commodities and fixed income
securities, etc. We can demonstrate the basic concept with an example using one such
instrument – a futures contract – in relation to exchange rate exposure.
A UK firm is going to receive a $100,000 in one month's time as a result of some consultancy
work carried out in the USA. It is exposed to the risk that an (unfavourable) movement in the
£/$ exchange rate before the payment is made will reduce its value. However, it may hedge
this risk by using a futures contract. The futures contract will comprise a transaction to sell
$100,000 in one month's time (the time of its receipt) at a £/$ exchange rate fixed today. The
potential loss of value on the payment is, then, limited to the difference between the current
exchange rate and the agreed rate for the futures contract. This reduces the company's
exposure to any other adverse movements in the exchange rate, but also means that it
cannot take advantage of a favourable movement in the rate.
Futures are one of the derivatives that allow a financial risk to be reduced, but do not
(usually) allow any gain to come from favourable movements in the prices or rates underlying
the instrument. Other such derivatives include forward contracts and swaps. However,
these can be distinguished from option contracts which also allow a risk to be reduced, but
do allow gains to be made from favourable movements.
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Short and Long Positions
We have seen that the basis of hedging involves offsetting two transactions against each
 a cash transaction; and
 buying or selling a derivative instrument linked to the type of cash transaction.
We can examine this relationship further.
When a firm holds cash or securities, it will want to maintain their current value. It is, though,
exposed to the risk that its value will decrease due to adverse movements in prices or
interest or exchange rates. It will, therefore, sell a derivative of equivalent value at a price
fixed today (known as taking a short position on the derivative). This fixes the value of the
cash or securities – possibly at a value less than the current value – but limits the exposure
to any further losses. This position is known as a short hedge. It offsets a long position in
respect of the cash transaction with a short position in respect of the derivative.
Conversely, a firm expecting an inflow of cash or securities at some time in the future (for
example, through payments due or the purchase of an asset) will take out a long hedge to
protect the value of those future cash flows or the asset. This will involve buying a derivative
of equivalent value at a price fixed today – again fixing the value of the future cash/asset and
limiting any further loss due to adverse movements. The effect is to offset a short position in
the cash transaction with a long position on the derivative.
In both cases, the hedge works by ensuring that if the value of the asset/cash/securities falls
below the agreed price, any further loss is counterbalanced by a gain from the selling/buying
of the financial derivative.
Closing out
In the vast majority of cases, the hedge does not lead to delivery of the underlying asset in
the derivative – that is, neither the sale or the purchase of the underlying asset takes place.
Rather, the contract is "closed out" by taking an opposite position in the derivatives market.
Thus, a contract to buy can, in effect, be cancelled by one to sell, and vice versa. This is
known as "reversing the trade".
What this means is that a contract to buy a derivative at a particular price is matched by
another contract to sell the same derivative at a price which may or may not be the same as
in the first contract. The two contracts can then be closed out. If the reverse trade is exactly
equal and opposite to the original, the financial position is neutral. This is, though, unlikely –
in which case, there will be a gain or loss incurred, with a financial settlement being made
between the parties involved.
Note that the transaction in the derivative is undertaken to hedge risk in respect of the
underlying cash transaction. There is, therefore, in most cases, no need to take delivery of
the contract and actually buy or sell the underlying asset – particularly as this may involve
considerable financial costs. Instead, any gain/loss incurred in the process of closing out the
derivatives would be offset against any loss/gain in respect of the underlying position in the
cash market.
Although forward and futures contracts are similar (see later), it is more common to close out
a futures contract than a forward contract. This is because futures contracts are freely
tradable and the holder of a contract to buy, say, a quantity of currency but who no longer
wishes to hold that position can cancel it out by purchasing a contract to sell the same
amount on the same date. Indeed, it is estimated that only about 1% of futures contracts are
settled by actual delivery. You should contrast this with the forward market where the
chances of reversing a position are costly and rare, and as a result approximately 90% of
such contracts are settled by actual delivery.
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An example will illustrate the process in detail.
DeanCo is a purchaser of natural gas and is due to take delivery of 5,000,000 litres in
January. In order to hedge against the possibility of gas prices increasing over the period up
to January, the company takes a long position in a March futures contract. At the time, the
price of March futures contracts is $14.50 per 1,000 litres, with each contract being for
delivery of 1,000 litres. In January, the contract is closed out with both the spot price of gas
and the March futures being $14.75 per 1,000 litres.
How effective is this strategy in hedging the risk?
The transactions involved are:
 buying five March futures contracts (the long position in March futures) each at a price
of $14.50 × 1,000 (1,000 litres per contract);
 selling five March futures contracts in January (to close out the original contracts) each
at a price of $14.75 × 1,000; and
 buying the 5,000,000 litres of natural gas on the spot market at $14.75 per 1,000 litres.
The total gain on closing out the futures contracts is:
(14.75 ÷ 14.50) × 1,000 × 5 = $1,250
The outlay for the 5,000,000 litres on the spot market is:
5,000 × 14.75 = $73,750
The net cost to DeanCo is:
73,750 - 1,250 = $72,500
This equates to a cost of $14.50 per 1,000 litres
The gain from closing out the futures contract offsets some or all of the likely increase in the
price of natural gas on the spot market over the period. The extent of this offset depends
upon the spot price of gas at the time that the futures contract was taken out, which in this
case was not given. If the price of gas had fallen over the period, there would have been a
loss on closing out, but this would again be offset by the lower spot price paid on delivery.
Irrespective of the spot price at the time of delivery, DeanCo is locked into a known price
from the beginning. The effect of the hedge is to guarantee that the company never has to
pay more than the $14.50 per 1,000 litres, although to achieve this guarantee, it has to forgo
the opportunity to pay a lower price.
Developing a Hedging Policy
Hedging exposure to risk can be costly and carries certain risks in itself if the techniques and
instruments are inappropriately used. It needs, therefore, to be applied within a clear
strategic framework which reflects the organisation's objectives.
Whilst each company has to establish its own methods in accordance with the particular
circumstances in which it operates – for example, the nature of the markets traded in and its
attitude towards risk – there are a common set of issues which need to be addressed by all
 Establish and make explicit the exposure to risk – It is essential to know the extent
of exposure to exchange and interest rate risk at all times. This can then form the
basis of decisions as to how to manage that risk.
 Establish lines of responsibility and limits of authority – The way in which
exposure is reported, to whom and who acts on it are key issues. The lines of
responsibility for action, and for reporting, must be clearly stated, understood by all
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concerned and monitored. Similarly, the limits on the volume and amount of derivative
transactions traded need to be made explicit, as do the types of instrument which it is
permitted to use. These must be supported by effective systems and procedures to
monitor and control activities – particularly to prevent unauthorised dealing, which was
one of the factors which undermined Barings Bank.
 Determine how much, and the types of, exposure to hedge – It may not necessarily
be appropriate to adopt a "hedge everything" approach – this may be prohibitively
expensive in relation to the extent of the exposure. However, selective hedging
requires ranking exposure and making decisions as to which risks to hedge, which is
not easy. Some general decisions could be made – for example, focusing on foreign
currency receipts where the company is involved in considerable international trade, or
on interest rate movements if the company is highly geared and is, therefore,
vulnerable to interest rate risk.
 Identify appropriate methods of hedging – This will involve matching different types
of derivative instrument to different types of risk and establishing guidelines for how
long to hedge exposure. Note that there are certain methods of hedging risk internally
(as we shall consider later in the unit) and these are generally far less expensive than
using external methods using derivatives. Only the net exposure, after offsetting
liabilities and assets internally, should be the subject of external hedging.
 Establish and maintain good banking relationships – It is important to develop and
maintain good relationships with one or two specialist banks or other financial
institutions which have the expertise to arrange certain transactions. Even the biggest
and best treasury departments cannot effect all their own transactions and need the
assistance of intermediaries with the facility to set up such devices as currency or
interest rate swaps.
Costs of Hedging
On the face of it, the cost of hedging essentially comprises the premiums paid out on the
derivatives transactions to the facilitating banks and/or exchanges.
However, there is always a risk associated with trading in derivatives, some of which are very
complex and may be inappropriately applied, particularly if the controls noted above are not
effective. Thus, any losses incurred on the derivatives transactions not offset by gains in the
underlying cash transaction must be counted as costs.
In addition to these direct costs, there is a further significant cost in the overheads involved in
the hedging operation. These are tied up with the overheads of treasury management as a
whole, and include not only the operations in respect of external hedging activities, but also
in respect of the application of internal hedging techniques.
Interest rates are an important element of the economic environment and influence the
foreign exchange value of a country's currency, as well as acting as a guide to the sort of
return shareholders might want and expect. Changes in market interest yields affect share
Interest Rate Structures
Every financial instrument has its own interest rate or range of rates. The market
segmentation theory acknowledges that the demand for the great variety of financial
products can be segmented into a number of different types, that different products are
designed for different purposes and the interest charges are a fundamental part of the overall
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The most common quoted rates include:
 Base rate – the "bottom line" rate set by banks. Most lending to individuals, smaller
and medium-sized enterprises is at a certain margin above base rate.
 LIBOR – the London Inter-Bank Offer Rate at which banks lend to each other. Large
and multinational companies' lending is often tied into these more favourable LIBOR
 Treasury bill rates – the rate at which the Bank of England sells Treasury bills to the
discount market and a good indicator of longer-term rates as these bills will not be
redeemed for some years.
 Gilts yield – again, rates attached to government securities and a good indicator of
longer-term rates.
Why are there so many rates?
The reasons include:
 Risk – a higher risk must be compensated for by higher returns (i.e. higher interest
 Need for profit – the "spread" between savings and lending-based products provides
the intermediaries' profit.
 Duration of lending – interest rates may depend on the date to maturity of the product
– for example, Treasury stock might be short, medium or long-dated. The yield on a
type of security varies according to the term (length) of the borrowing period, and
generally, long-term loans yield a higher return than short-term ones.
 Size of loan – economies of scale and negotiating strength all have a part to play here.
 International rates – domestic rates will be influenced by speculators' behaviour and
the movements of funds internationally.
(a) Risk and rates
Borrowers have different risks of default and this is reflected in the differences in the
interest rates they are expected to pay – for example, the government will pay a lower
rate of interest on its borrowing than a small, new company. The additional return
required will be equal to the fall in expected value of the investment taking into
consideration the default risk. We can see this by considering an example.
Jim plc issues 10% loan stock which is redeemable, at par, after 12 months. There is,
however, a 20% chance that Jim will default on payment and there will be no return for
the loan stockholders. If the interest rate on 12 month government stocks is 5%,
calculate the yield on Jim's loan stock. Ignore taxation and market risk.
The expected value of the loan stock after 12 months:
(0.8 × £110) + (0.2 × 0) = £88
Discounting at the rate on government stocks to reflect the additional return for the
additional risks to find the current market price:
05 1
= £83.81
The yield is then:
81 83
÷ 1 = 31.25%
The higher expected yield is required to compensate for the risk of default.
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(b) Nominal (or money) rates and real rates of interest
Nominal rates of interest are those expressed in money terms, whereas real rates
are those adjusted for the rate of inflation. The real rate is therefore a measure of the
increase in the real wealth of the investor or lender.
The real rate is calculated as:
inflation of Rate 1
interest of rate Nominal 1
÷ 1
If the nominal rate was 10% and inflation 5%, the real rate of interest would be:
05 1
10 1
÷ 1 = 4.76%
Real rates of interest are normally positive (i.e. the nominal rate exceeds the rate of
inflation). Investors can therefore be assured that their real wealth is increasing.
In times of high inflation, however, a negative real rate is possible, although nominal
rates will rise, too, as investors want to see a real return on their investments.
(c) Interest rates and financial management
When interest rates are low it might be advisable to:
 Borrow more, increasing the company's gearing at lower fixed rates
 Borrow for longer terms
 Pay back loans with higher rates or roll them over for loans of lower rates.
Alternatively, when interest rates are high it might be advisable to:
 Substitute equity for debt finance and reduce the company's gearing by investing
surplus cash in short-term interest-bearing securities
 Borrow short term rather than at even higher longer-term rates.
Impact of Interest Rate Changes
It is clear that changing interest rates will lead to variations in a firm's cashflows as receipts
and payments fluctuate with movements in those rates. This can cause problems in the
management of working capital. Rising interest rates can cause the value of a firm with a
high level of gearing to fall, and the increased debt repayments may mean it losing
competitiveness and even facing bankruptcy. In addition, rising interest rates may prevent a
company extending its level of gearing.
Two other effects may be observed.
(a) Share prices
When interest rates change, the return expected by shareholders will also change. If a
shareholder expects, say, a 10% return on their investment and the annual dividend
per share was 15p then (ignoring any capital growth) the market value of a share
should be:
p 15
= £1.50
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If interest rates were to rise (to 12%, say) the shareholder would equally expect a
bigger return for his/her shares and the price would have to fall (assuming the dividend
pay out was constant) as follows:
p 15
= £1.25
You can surely calculate what the share value would be if interest rates were to fall
(say to 8%).
(b) Capital gains and losses
A final point to note is that, because of movements in the capital value of an
investment, an increase in interest rates will lead to market values dropping.
As an example, if you hold gilts with a "coupon rate" of 10% at a time when the market
is 10%, your market investment will be equal to the face value of the gilts, say £100.
If interest rates rise to 15%, their market value will drop:
£100 ×
= £66.67
If interest rates drop to 5%, their market value will rise:
£100 ×
= £200
Thus, a firm with any sizeable level of debt is exposed to problems arising from adverse
movements in interest rates and needs to limit the risk associated with such exposure.
Managing Exposure to Interest Rate Risk
Most companies have some form of debt finance and as a consequence are exposed to
interest rate risk.
Interest rates on a loan may be either floating or fixed.
 In the case of floating rates, payments will vary with the rate applied at the time and
the risk is that rates may rise, increasing the cost of the loan and, in turn, affecting
 Fixed rates have the advantage that costs remain constant and they are,
consequently, seen as less risky. However, there remains a risk in that spot rates may
fall below the fixed rate – in which case, a floating rate would be more advantageous.
Interest rate risk also applies to investments. Where companies have funds invested in
interest bearing securities, fluctuations in interest rates will give rise to variations in income.
Where companies have both assets and liabilities that are sensitive to interest rate changes,
gap analysis is the means used to measure the extent of exposure to interest rate risk.
Under this, assets and liabilities which are sensitive to interest rate changes and mature at
the same time are grouped together. The difference between the two represents the firm's
interest rate exposure:
 where interest sensitive assets are greater than liabilities, both with the same time to
maturity, the gap is positive and the firm will lose out if interest rates fall;
 where interest sensitive liabilities are greater than assets, both with the same time to
maturity, the gap is negative and the firm will lose out if interest rates rise.
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The management of interest rate risk will involve hedging against adverse movements in
order to contain the extent of any exposure. As with managing exchange rate risk (which we
deal with in the next unit), this falls into two categories:
 internal, or natural, techniques – those which are effected entirely by the financial
organisation and structure of the company itself; and
 external, or transactional, techniques – those using the range of derivative instruments
which are effected by the use of third party services, such as banks and specialist
Both types of technique provide effective means of covering exposure, depending on the
circumstances. We shall consider internal techniques first and then work through the various
external methods.
There are two main internal means of reducing interest rate exposure.
The principle of internal matching to hedge interest rate exposure essentially involves
offsetting assets with liabilities – for example, increases in borrowing costs can be offset by
increases in interest bearing deposits. For many firms, though, interest rate matching is not
viable because the amounts received as income from interest bearing assets are rarely
sufficient to offset more than a small proportion of their loan payments.
Smoothing refers to the maintenance of a balance between fixed rate and floating rate
Floating rates enable a company to take advantage of any reduction in rates to reduce their
borrowing costs, whereas fixed rates aid cash planning. Both, though, have disadvantages
and it does not follow that one or other method should necessarily dominate. Having a
mixture of fixed and floating rate liabilities means that advantage may be taken of the
benefits of both. Thus, if interest rates rise, the increase in costs from the floating rate
liabilities is to some extent offset by the relatively cheaper fixed rate payments.
These contracts are fixed in terms of rate, delivery period and amount, and provide an
interest rate commitment for a future period that is agreed at the outset.
Before we move on to consider the use of futures in hedging interest rate exposure, we shall
look briefly at certain basic elements of the way in which they operate.
Futures contracts are "exchange traded" derivatives. That means that they are bought and
sold on organised exchanges such as the London International Financial Futures Exchange
(LIFFE). As such, there are certain rules affecting the way in which they are transacted, and
some specific terminology associated with them.
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(Note that option contracts are also exchange traded derivatives and exhibit many of the
same characteristics. Other types of derivatives – notably forward contracts – are not dealt
with on dedicated exchanges and therefore have somewhat different characteristics.)
(a) Margin accounts
All exchanges offering futures contracts require traders to lodge some form of deposit
as security against losses. This is the initial margin paid by the hedger to start a
margin account.
At the end of each trading day, the daily gains or losses on the exchange for each
trader are added to or subtracted from the margin account to arrive at a new balance.
This process is known as marking to market, and the adjustment to the margin
account is termed the variation margin. In most cases, despite the daily fluctuations
in the variation margin, the margin account is sufficient to offset the likely effect of
default. (The system proved its worth in the Barings case, where the SIMEX Exchange
was left largely intact and none of the counterparties to Barings' trade lost out.)
Note that, whilst all futures transactions have a buyer and a seller, because the
exchange is regulating the trade and gains/losses are marked to the market through
the variation margin, the obligation of futures traders is not to the party to their trade,
but to the exchange itself (or, more precisely, to the clearing house holding the margin
(b) Contract size
Futures contracts on a particular exchange are all of a standard size. For example, the
standard size for sterling interest rate futures contracts on LIFFE is £500,000. Thus, in
order to hedge an exposure of £2 million, it would be necessary to take out four
contracts, each of which would be for £½ million.
(Similar standard sizes are also applied to currency futures contracts – for example, on
the IMM Chicago Exchange, sterling contracts are for £62,500 and those for yen are for
(c) Basis points and tick values
The smallest recorded movements in futures prices are expressed in basis points –
one basis point being 0.01% of the amount of the underlying asset (see below).
However, it is more usual to express the price movement of futures contracts
themselves in ticks. The value of a tick will reflect the minimum gain or loss which
may be recorded on a contract. This value varies from contract to contract depending
on the standard size of the contracts traded.
To illustrate this, let us consider currency futures for a moment. The price movements
on the contract are movements in one currency against another, and one basis point is
0.01% of the unit of currency – equating to a movement of 0.01 cent in the case of
dollars or 0.01 pence for pounds, etc. So, for example, the minimum price movement
recorded on a sterling contract on the Chicago exchange will be:
£62,500 × 0.0001$/£ = $6.25
This minimum recorded movement in price represents the minimum gain or loss which
can be made on the contract and is known as the tick value. Thus, the tick value of a
sterling futures contract on the Chicago Exchange is $6.25.
For interest rate futures, the price movements are movements in the interest rates
themselves, and one basis point is a 0.01% change in interest rates. The tick value of
an interest rate futures contract needs to reflect the proportion of the year over which
the contract runs (since interest rates are quoted per annum). Thus, the tick value of a
three month sterling interest rates futures contract on the LIFFE will be given by the
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price movement consequent upon the movement of one basis point for three months of
a year:
Unit of contract × basis point × contract period = tick value
£500,000 × 0.0001 ×
= £12.50
(c) Delivery dates of contracts
Exchange traded contracts – whether futures or options – all have pre-determined
maturity dates on which delivery of the underlying asset occurs. For example, the
contracts quoted on the Chicago Exchange relate to delivery dates at the end of March,
June, September and December. This pattern applies to both currency and interest
rate futures contracts.
As we have seen, most futures contracts are not delivered, but are closed out
beforehand by the taking of an opposite position in the same derivative. Closing out
clearly needs to be effected prior to the maturity date of the contract in order to cancel
the obligation to buy or sell the underlying asset. Thus, the purchase of a December
sterling contract would be closed out with the sale of a December sterling contract,
prior to December.
Where a futures contract is required for a period which falls between the specified
dates of available contracts, the trader will need to opt for the nearest delivery dates.
For example, a company which wishes to hedge an interest rate exposure from
February to May – a period which does not correspond with the available contracts –
will need, in February, to take out a March futures contract and then roll the hedge
forward by simultaneously closing this out in March and taking out a June contract on
the same day. This will then be closed out in May with an equal and opposite trade.
In theory, there is nothing to stop a hedger rolling over the hedge indefinitely, although
this will incur transaction costs every time one is closed out and another opened.
(d) Prices of contracts
The prices of contracts are, as you would expect, a function of interest rates. They are
calculated by reference to an index of 100 less the rate of interest applicable to the
underlying instrument. Thus, an open (current) price of, say, a December contract of
93.070, corresponds to an interest rate 6.93% (100 ÷ 6.93).
Thus, if interest rates rise, the price of an interest rates future contract falls. This
inverse relationship is central to hedging with interest rate futures.
Hedging Interest Rate Exposure with Futures Contracts
Any futures contract involves fixing the price today on a standard quantity of a financial
instrument (in this case, interest rate futures) to be purchased or sold at a fixed future date.
As we know, futures contracts are rarely held to maturity and the underlying asset delivered,
but are closed out by taking an opposite position. Hedging interest rate exposure using
interest rate futures is based on the gain or loss on the closing out of the futures contracts
equating with the loss or gain arising from a change of interest rates on the company's
To fully appreciate the way in which interest rate futures are used, we need to remind
ourselves that taking a short position on interest rate futures (i.e. selling them) hedges a rise
in interest rates. Borrowers, then, will take a short position in order to hedge against higher
interest rates, whilst lenders will take a long position in order to hedge against lower interest
The following example illustrates the process of hedging using interest rate futures.
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A company is going to take out a £2.5m loan in two months time (December) for three
months. The three month LIBOR rate is currently quoted on the London exchange at 7¼%
and the company wishes to hedge against a rise in interest rates in two months time by
locking into an interest rate futures contract. Let us assume that the futures contract is
quoted at 93.07 (as above). In December, it transpires that LIBOR rates had risen to 7½%
and futures contracts were then quoted at 92.80.
To hedge against a rise in interest rates – which would result in a fall in futures prices –
necessitates taking a short position (to sell) the three month December futures contracts at
the price currently quoted. In the solution which follows, the contract runs to expiration and a
cash settlement is received via the exchange's settlement price system. Cash settlement at
expiration is always based on the LIBOR rate on the last day of trading in those futures,
which in this case is 92.80. All contracts are settled net – here, the difference between the
quoted buying price of futures in December and the selling price of those contracts as quoted
when they were entered into (in October).
(The same outcome would be achieved by closing out the original position through an equal
and opposite trade – i.e. to buy December three month futures contracts – in December.
Closing out is necessary when the period of the hedge does not coincide with the exchange's
delivery settlement date. However, in this example, the two dates do coincide which allows a
choice of methods used for settling the profit/loss on the futures contracts.)
The first step is to ascertain the number of futures contracts required to hedge the position.
The contracts available on LIFFE are in denominations of £500,000. So, to hedge the sum of
£2.5m, the company needs to enter into five contracts.
Entering into a contract in October to sell five three month December interest rate futures
fixes the price at 93.07. In December, the price has fallen to 92.80, resulting in a gain on
expiration as follows.
Gain = Number of contracts × movement in ticks × tick value
As we explained above, the tick value on LIFFE sterling futures contracts is £12.50.
Gain = 5 contracts × (92.80 ÷ 93.07) ticks × £12.50
= 5 × 27 × £12.5
= £1,687.50
In December, the company will raise the £2.5m necessary by means of a loan at the now
current three month LIBOR rate of 7½%. This results in an actual borrowing cost of £46,875
(£2.5m × 7.5% for ¼ of a year). We can compare this with the cost of interest at the October
rate (7¼%) and derive the increased cost of the loan as follows:
Cost of increase = £2.5m × (7.5 ÷ 7.25%) ×
= £1,562.50
The efficiency of the hedge (the degree to which the hedge covers the exposure) is:
Efficiency =
50 562 1
50 687 1
. , £
. , £
× 100%
= 108%
The gain from the futures position has more than offset the cost of the ¼% increase in
interest rates. In fact, the success of the hedge results in an effective reduction of the
interest rate on the loan This is shown as the actual interest minus the gain on the futures
position as an annual percentage of the principal:
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£1,687.50 - £46,875
× = 7.23%
The gain on the futures market has more than matched the loss in the cash market, and the
company is only paying, effectively, 7.23% interest, even though interest rates rose over the
two month period.
These are forward contracts which provide for interest rates to be fixed in advance for a
specified period commencing at some agreed future date. They are the interest rate
equivalent of forward currency or commodity contracts, although unlike these forms of
forward contract, there is no intended delivery of a sum of principle.
Forward rate agreements are essentially an agreement between a bank and its customer to
fix a future rate of interest to cover a specified amount of money to be lent or borrowed for a
specified period of time in the future. They relate only to the predetermined rate of interest
on a sum of money and not to the actual sum of money borrowed or lent. (That will be a
separate transaction, conducted in the cash market in the usual way, to borrow/lend the
money at whatever interest rate is prevailing at the time.) All that happens in respect of the
FRA is that either the bank is compensated by the client, or vice versa, if actual interest rates
vary from the pre-set interest rates agreed in the contract.
This means that, although there is an obligation to meet the terms of the interest rate
contract, there is no obligation to actually borrow or lend the money. Provided that the
compensating amount is settled between the two parties on the due date, that is where the
obligation ends.
FRAs are not standard contracts as traded on the futures exchanges, but are tailored to meet
individual needs, though they tend to be only available for up to 12 months and on loans of
£500,000 or more.
Hedging Interest Rate Exposure with FRAs
Where a hedge on future borrowings is required, the purchase of an FRA locks the
repayments on the loan to a specified interest rate and protects against any further rise in
interest rates. On the other hand, selling an FRA provides a hedge on future lending by
locking future cash inflows from the loan to a specified interest rate and protects against any
further fall in interest rates. The rate at which the transaction is locked is a forward interest
rate as quoted today, but taking effect at a specified date in the future.
Consider the following example.
Clock plc is going to take out a 90 day £10m loan in three months' time at an interest rate
linked to the three month LIBOR rate. As a hedge against an increase in interest rates over
the intervening period it also takes out an FRA, the interest rate for which is set at 8% pa.
What would be the consequences if, on taking out the loan, the LIBOR rates had fallen to
Since interest rates have decreased, Clock will have to pay the bank the interest rate
differential on the sum of £10m. This is the amount by which the cost of the loan has fallen
as a consequence of the fall in interest rates from 8% to 5%:
$10m × (0.08 ÷ 0.05) ×
days = £73,972
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In effect, the contract requires Clock to pay over this amount to the bank. However, the
contract has to be settled prior to the start of the loan period (when the interest rate on the
loan is known) and not, as you might expect, when the loan matures. The total amount of the
reduction in costs over the period of the loan will, then, have to be discounted to reflect its
present value. The discount rate will be that applying to the interest rate on the loan:

× +
0.05 1
£73,972 = £73,071
The payment to the bank in three months time is, therefore, £73,071.
Note that Clock plc has not gained financially from the fall in interest rates, but had they
increased, the company would have been compensated by the bank for the interest rate
differential. FRAs only give protection from adverse interest rate movements – it is not
possible to benefit from favourable movements. They do, however, effectively hedge the
An interest rate swap is an agreement between two parties under which each agrees to pay
the other's interest for an agreed period.
The most common form of interest rate swaps involves the exchange of a fixed rate for a
floating rate.
The interest rates are based on a "notional" underlying principal sum of money. Note,
though, that it is not the principal which is swapped – merely the interest rate payments.
(This is in contrast to currency swaps where both the principal and interest is swapped.)
Whatever the form of the exchange, each party remains responsible for servicing its own
debt and has to continue to make payments to its own lender at the agreed rate on the loan.
Thus, a party agreeing to swap a fixed rate of interest for a floating rate would still be
responsible for making the fixed rate payments to the lender of its funds. The effect of the
swap is a compensating payment between the parties to settle the net difference arising from
any differential rates on the interest payments.
Interest rate swaps work on the principle of comparative advantage (see below) and are
more common than their cousins, currency swaps.
Swaps are popular because they are easy and cheap to arrange (with only legal fees to pay),
and are flexible as to the size and duration to which they are applied.
Operation of Interest Rate Swaps
The best way to explain the operation of interest rate swaps is through an example.
Hammer plc has a five year loan of £25m with a floating interest rate of LIBOR + 0.5%. It is
concerned about fluctuating payments over the period of the loan and would like to convert to
a fixed rate. Tongs plc also has a five year loan of £25m with a fixed rate of 7% and is
seeking to reduce its repayments, preferably with a floating rate.
The rates for each party's present agreement and those quoted for the alternative type of
interest payment (fixed or floating), are as follows.
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Company Fixed rate of
Floating rate of
Hammer Plc 6.5% LIBOR + 0.5%
Tongs Plc 7% LIBOR + 1.7%
How could a suitable arrangement be made whereby each party can take advantage of lower
interest rates on each other's loan?
Each company has the choice of either opting for a floating or fixed rate agreement at the
rates quoted by the bank. Hammer has an interest rate advantage over that of Tongs, with
its quoted rates for both fixed and floating rates of interest being lower than those available to
Tongs. The differential interest rate advantage for Hammer is as follows:
 Fixed rate: 7% ÷ 6.5% = 0.5%
 Floating rate: (LIBOR + 1.7%) ÷ (LIBOR + 0.5%) = 1.2%
Combining these two absolute advantages gives an "apparent" advantage of 0.7% (1.2% –
0.5%). Because this apparent advantage exists, gains are possible via an interest rate swap.
If this advantage did not exist, there would be no benefit to either party from a swap
The strategy is for Hammer and Tongs to swap, in part or whole, their respective interest
payments, applying the most advantageous rates to the terms of the swap – those available
to Hammer. Under the swap agreement, Hammer will pay Tongs the fixed rate of 6.5% and
Tongs will pay Hammer the floating rate of LIBOR + 0.5%. However, the swap payments
need to take account of the "apparent" advantage of 0.7% and this will be apportioned
between the two parties on some agreed formula. Let us assume that this will be equally
apportioned (0.35% and 0.35%).
The effect on the interest cashflows of the two companies is shown in the following table.
Cashflow Hammer plc Tongs plc
Obligation to lender negative LIBOR + 0.5% 7%
Swap receipts positive LIBOR + 0.5% 6.15%
(6.5% ÷ 0.35%)
Swap payments negative 6.15%
(6.5% ÷ 0.35%)
LIBOR + 0.5%
Net payment negative 6.15% LIBOR + 1.35%
(÷7% + 6.15% ÷ LIBOR + 0.5%)
The effect, then, is for Hammer to have secured a fixed interest rate 0.35% less than the rate
it had been quoted (6.5%) and for Tongs to have secured a floating interest rate also 0.35%
lower than the rate it had been quoted (LIBOR + 1.7%). The terms of the swap will have
satisfied both parties in that they have acquired the type of rate desired (fixed or floating) and
at a lower rate than originally quoted.
(Note that a different stream of cashflows would apply if the apparent advantage of 0.7% had
been apportioned differently to the 50:50 model illustrated.)
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Remember that each company remains responsible for the payments to their own respective
lenders under the terms of the original loans.
The whole process is illustrated in Figure 14.1.
Figure 14.1: Interest rate swap
Option contracts provide the purchaser of the option with the right – but not the obligation –
to buy or sell the underlying asset or instrument at a price established in the contract. This
price is referred to as the exercise or strike price. The purchaser of the option pays a non-
refundable premium (the price of the option itself) to the seller of the option to establish the
There are a number of different types of option contract available on the various options
exchanges around the world (the main ones being the LIFFE, New York, Philadelphia,
Montreal and Chicago exchanges). These organised exchanges offer standard format
options in which the main elements of the contract are pre-determined:
 size – each option contract relating to a particular volume of the asset/instrument
concerned (for example, traded options in equities are in contract sizes of 1,000 units);
 exercise price – as determined by the market; and
 option period – with an expiry date usually of three months (or in multiples of three
There are two main types of standard format option contracts, as follows.
 Traditional options – These are all three month contracts which must be held to the
expiry date, at which point the right to buy or sell the underlying asset/instrument must
be exercised or allowed to lapse. There is no trading in these types of options.
 Traded options – These types of options may be bought or sold through the exchange
continuously throughout their life. Such options are usually offered with three-month,
six-month or nine-month expiry dates, each with a different exercise price and
It is also possible to establish option contracts outside of the organised exchanges. Such
options are known as "over the counter" (OTC) options, and the individual elements – size,
exercise price, expiry date – maybe negotiated and agreed between the buyer and seller.
Options tend to be more expensive than other derivatives since they offer the possibility of
making gains should the movement in the underlying asset be favourable (in contrast to
futures and forward contracts). Indeed, the attractiveness of options as part of a financial
Hammer plc Tongs plc
Bank Bank
Fixed rate @ 6.15%
Floating rate @
LIBOR + 0.5%
Floating rate @
LIBOR + 0.5%
Fixed rate @ 7%
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strategy derives from the range of pay-off profiles available, depending on whether the option
is to buy or sell the underlying asset/instrument and on whether the investor is the buyer or
seller of the option (respectively, taking a long or short position on the option). The starting
point for understanding the use of options, then, lies in identifying the outcomes associated
with these characteristics.
Calls and Puts
There are two types of option contract:
 a call option – which is an option to buy an asset/instrument; and
 a put option – which is an option to sell an asset/instrument.
(The underlying asset/instrument may be bonds, shares, currency, agricultural products,
interest rate futures, etc., but for now let us assume that it simply refers to equities. So, we
shall consider options as relating to the right to buy or sell a share.)
(a) Call options
These will be purchased where it is anticipated that the price of an asset will rise. The
call option buyer (said to be holding a long call) will only exercise the option (i.e. buy
the asset) if the market price of the asset is above the exercise price.
We can examine the characteristics of these options for both long and short positions
by reference to a call option to buy shares in LTD at the exercise price of £25. We shall
assume that the premium paid for the option (i.e. its price) is £1, which represents the
value of the option at that instant in time.
Long call
For the buyer of a call option, there are two scenarios:
 the share price falls below the exercise price of £25 – in which case the option
will not be exercised, since the shares could be acquired on the market at the
(lower) spot price, and the holder will, therefore, lose the price paid for the option
 the share price rises above the exercise price of £25 – in which case the option
will be exercised, the shares acquired and then resold at the (higher) spot price,
with the result that the holder makes a profit equal to the spot price less the
exercise price (and the premium).
We can show the pay-off profile for this position diagrammatically, as in Figure 14.2.
Figure 14.2: Pay-off profile for a long call
Note that the risk exposure is limited to the amount of the premium in the case of the
asset price falling below the exercise price, whereas the potential return is theoretically
Asset price
Exercise price
Pay-off profile
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Short call
For the seller of a call, the position is the exact opposite of the buyer's position. He/she
is obliged to sell the asset at the exercise price, but will only have to do so where the
option is exercised by the buyer – i.e. if the market price of the asset is above the
exercise price.
The potential profit is limited to the price of the option (here £1), but there is exposure
to the risk of having to sell the shares at what might be a considerable loss.
Again, we can show the pay-off profile for this position diagrammatically (Figure 14.3).
Figure 14.3: Pay-off profile for a short call
(b) Put options
These will be purchased where it is anticipated that the price of an asset may fall. The
buyer of a put option (a long put) will only exercise the option (i.e. sell the asset) if the
market price falls below the exercise price. This establishes a ceiling on any loss
incurred if the option is not exercised, but allows profits to be taken if the price falls and
the option is exercised.
Again, we shall examine the characteristics of these options for both long and short
positions by reference to a put option to buy shares in LTD at the exercise price of £25.
The premium is £1.
Long put
For the put option buyer, there are two scenarios:
 the share price rises above the exercise price of £25 – in which case the option
will not be exercised and the buyer loses the price of the option (£1);
 the share price falls below the exercise price of £25 – in which case the option
will be exercised, since the shares can be sold at the exercise price and then
bought back at the (lower) spot price, with the result that the holder makes a
profit equal to the exercise price less the spot price (and the premium).
Note that, even if the buyer of the put option does not already own the shares at the
expiry date, he/she can still profitably exercise the option by acquiring them on the
open market and then selling them at the (higher) exercise price. The profit is the
We show the pay-off profile for this position in Figure 14.4.
Asset price
Exercise price
Pay-off profile
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Figure 14.4: Pay-off profile for a long put
Note that the risk exposure is limited to the amount of the premium in the case of the
asset price rising above the exercise price, whereas the potential return is the
difference between the exercise price and the (lower) asset price.
Short put
For the seller of a put the position is, again, the exact opposite of the buyer's position.
He/she is obliged to buy the asset at the exercise price, but will only have to do so
where the option is exercised – i.e. if the market price of the asset is below the exercise
Again, profit is limited to the price of the option (the £1 premium), whereas the risk
exposure if the asset price falls is considerable.