Treasury Management

Capital Structure and Company Valuation

 Investment Appraisal - Introduction
When considering an investment project, it is the convention
to assume that the cash outflow in respect of the investment
takes place in the current time period, and hence its money
value is equal to its present value
The project is expected to generate net cash flows in future
periods, and these are normally assumed to occur at the ends
of the period to which they apply
These net cash flows would only be equal to their present
values if a discount rate of a zero was applied, and hence it is
necessary to utilize a discounted cash flow (DCF) method of
analysis in order to appraise the true profitability of the
proposed project
 Investment Appraisal - Introduction
There are four DCF methods available:
1. Net Present Value Method (NPV)
2. Internal Rate of Return
3. Discounted payback method
4. Profitability index
 There are also several other methods of investment appraisal which
are commonly used, but which do not involve DCF calculations
 The major examples here are :
 Normal payback method
 Accounting rate of return
 These methods are often used in conjunction with DCF methods
 However, only net present value and internal rate of return are
relevant for the purposes this study unit
Net Present Value
The net cash flows for each period of the project’s life are
discounted to their present values at the selected discount rate
(usually the company’s cost of capital)
These present value figures are then summed up to give the NPV
of the project
Where the NPV of a project is positive, this means that a profit is
expected in PV terms
Strictly, where there is no limit on available funds, all feasible
projects with positive NPVs would be accepted
However, when a choice has to be made between projects, the
one with the highest NPV for the same initial outflow will be
selected
Net Present Value
Example:
• Project costing Rs1,000 is expected to
yield Rs 500 per year for 2 years. What is
the NPV?
Year Cash flow 10% PVF PV
0 (1,000) 1.000 (1,000)
1 500 0.909 455
2 500 0.826 413
NPV = (132)
Would you accept the project? No
Internal Rate of Return (IRR)
The IRR of a project is that rate of discount, which, when
applied to the expected cash flows from the project, will
generate a zero NPV
Projects are accepted if their IRR is greater than the
company’s cost of capital
Where the number of projects to be undertaken is
restricted, the projects with the largest IRRs are chosen
The IRR can be calculated using following two methods:
 Trial and Error Method
 Interpolation Method
Internal Rate of Return (IRR)
In Trial and Error Method, a discount rate is selected
and the NPV of the project is calculated, If this NPV is
positive, this indicates that the discount rate chosen is
too small
In this case a higher rate is applied
If a negative NPV is generated, the calculation is
repeated using a smaller discount rate
The process is repeated until the NPV comes to zero
This rate is the IRR of the project, clearly this method
may prove to be laborious and time consuming
Internal Rate of Return (IRR)
The IRR may be estimated by interpolating between the NPVs obtained
using two different discount rates, one which gives a positive NPV and the
other which gives a negative NPV. The formula used will be:

IRR = A + a__ x (B-A)

a-b

Where:
A = The rate of discount giving the positive NPV
B = The rate of discount giving the negative NPV
a = the value of the positive NPV
b = the value of the negative NPV
Internal Rate of Return (IRR)
The IRR generated by either of the above methods is
then compared to the appropriate cost of capital of the
company
If the IRR is greater than the cost of capital, the
project is expected to generate a profit
Thus where there is no limit on the amount of funds
available, all projects with an IRR greater than the cost
of capital will be undertaken
Example
XYZ Co plans to buy a new machine to meet expected demand for a new
product, Product T. This machine will cost $250,000 and last for four
years, at the end of which time it will be sold for $5,000. XYZ Co expects
demand for Product T to be as follows:
Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 25,000
The selling price for Product T is expected to be $12.00 per unit and the
variable cost of production is expected to be $7.80 per unit. Incremental
annual fixed production overheads of $25,000 per year will be incurred.
Selling price and costs are all in current price terms. Selling price and
costs are expected to increase as follows:
Increase
Selling price of Product T: 3% per year
Variable cost of production: 4% per year
Fixed production overheads: 6% per year
Example
XYZ Co cost of capital is 11% and pays tax at 30% one year in arrears. It can
claim tax allowable depreciation on a 25% reducing balance basis.

Required

Calculate the net present value of buying the new machine and comment
on your findings
Example
 Years 1 2 3 4 5
Sales 433 509 656 338 
Variable Cost 284 338 439 228 
Contribution 149 171 217 110 
Fixed Production Overheads 27 28 30 32 
Net Cash Flow 122 143 187 78 
Tax   -37 -43 -56 -23
Depreciation Benefit on Tax   19 14 11 30
After-tax Cash flow 122 125 158 33 7
Disposal       5 
After-tax Cash flow 122 125 158 38 7
Discount factor 11% 0.901 0.812 0.731 0.659 0.593
Present Values 110 102 115 25 4

Sum of Present Values 356

Investment 250
NPV 106
Depreciation Working
Depreciation
Year Diminishing Value Dep Rate Amount Tax Benefit
  A B C=AxB C x 30%

1 250,000 25% 62,500 18,750

2 187,500 25% 46,875 14,063

3 140,625 25% 35,156 10,547

4 100,469   100,469 30,141

  Total   245,000  
The Various Components of Capital
To evaluate any proposed investment project, it is
necessary to determine the cost of capital for the
business
This cost of capital is then used to discount the future
cash flows associated with a proposed project
In practice, its not that straightforward to work out
cost of capital
It doesn’t only involve the working of costs of
individual sources of funds and adjusted for taxation
But it also for some sources of funds, there are
different methods available for calculating the costs,
which might lead to significantly different results
The Various Components of Capital
In addition, it is very rare for a business to raise all of
its funds from a single source
A weighted average of all the costs of the individual
components must be calculated
Even if a specific project is to be financed from a single
source, it is only in certain circumstances that it is
acceptable to use the cost of funds from that source as
the cost of capital of the project
In other words, the lender contribute to a pool of
funds, from which the business finance its activities
For every business, there will be an optimal capital
structure at which the cost of capital is minimized
The Various Components of Capital
Thus, the business’s objective in raising a block of new
funds may be to push the capital structure towards
that optimal position and hence to reduce the cost of
capital for all projects
Alternatively, if an optimal position has already been
achieved, the business will attempt to raise additional
funds in such a manner that the optimality is not
compromised
Although this not necessarily mean raising funds from
specific sources pro rata to their position in the
existing pool of funds
The Various Components of Capital
Businesses have many sources from which to raise funds,
The major ones are:
 Loans from banks and other financial institutions (Non-
Marketable Loans)
 Issues of debentures (Marketable Debt)
 Issues of Preference shares
 Issues of ordinary shares
We will go through the costs of each source of funds
individually and will lead to weighted average cost of
capital (WACC)
WACC is a vital concept in relation to investment
appraisal, and is the basic measure of the cost of funds to
the business overall
Cost of Non-Marketable Loans
Where the loan is a fixed rate bank loan, the
calculation is very simple:
Loan Rate x (1 – T) where T = Tax rate
Cost of a 10% loan will be calculated as
10 x (1-0.30) = 7%

The tax rate applicable for companies is the relevant rate

of corporation tax
Cost of Marketable Debt
Many companies issue fixed interest debentures or
loans which are listed on a capital market
The interest payments on these instruments are tax
deductible in virtually every tax regime in the world
It is sometimes the case that the book (or par) value of
marketable debt is used
However, it is recommended to always use the market
value as this is theoretically the superior value to use
Quite simply, the current market value, which reflects
the market views, leads to the generation of a measure
of the cost which would be incurred if new funds were
to be raised by the business
Cost of Marketable Debt
Where a business has a marketable debt outstanding,
the actual cash flows need to be considered in respect
of the position which would occur if an equivalent
debt instrument was to be issued today
When calculating the cost of that debt it is necessary
to ascertain the IRR of the future cash flows and the
present market value
Cost of Marketable Debt - Example
Its currently 31st December. A Specific issue of marketable loan
stock with a 100 par value has a market value of Rs 95. This
stock matures in 5 years time and pays 12% pa interest on par
value. The marginal rate of taxation is 33% for this company.

It is assumed that the cash flows occur at the end of the year
and that tax relief applies to interest payments at the time
they are made. From the company’s point of view, it could
“buy in” the debt at its market value of Rs 95. This would
equate to the initial cash outflow on a conventional
investment appraisal analysis. The company would then save
in future interest payments and on redemption of capital at
maturity. These savings can be looked upon as future inflows
in a conventional investment appraisal analysis.
Cost of Marketable Debt - Example
Year Cash Flow P/V at 6% P/V at 12%

0 (95) (95) (95)

1 8 7.5 7.1

2 8 7.1 6.4

3 8 6.7 5.7

4 8 6.3 5.1

5 108 80.7 61.3

NPV 13.3 (9.4)

Applying standard interpolation formula, we see that the IRR is:

6 + (13.3/22.7 x 6) = 9.5%
Preference Shares
These are similar to most debt instruments in the sense that they
entail a commitment to fixed interest payments (usually referred to
as dividends)
However, being classed as shares, the issuing company is able to
carry forward the dividend in a cumulative manner should it be
unable to afford to pay it in the current period.
Thus financially, preference shares are less risky for the issuing
company than is fixed interest debt, where there is a legal
commitment to pay interest regularly
However, raising funds via this means may prove to be more
expensive than raising an equivalent sum through a normal loan or
debenture issue
This is not only because shareholders expect higher returns of risk
(uncertainty of dividend payments), but also the issuing company is
unable to claim the dividend payments as a tax deductible expense
Preference Shares
kpref = d/p0

where:
kpref = cost of preference shares
d = preference dividend
p0 = market price of shares
Cost of Ordinary Shareholder’s Equity
It is reasonable to suggest that a shareholder in a
company must be satisfied with the return generated
by his shares, otherwise he would sell them and invest
the funds elsewhere, in order to raise his income
Cost of equity capital to the company is therefore
strongly influenced by the minimum returns which
must be paid to the marginal shareholder in order to
satisfy his earnings requirements
There is also the implication that the retained
earnings invested within the company must earn a
return which is sufficient to retain the support of the
shareholder
Cost of Ordinary Shareholder’s Equity
The rate of return on a share can be defined as the sum
of the annual dividends and annual capital growth
A standard approach to measuring the return
expected by the marginal shareholder is to use the
Gordon Growth Model. In this model, the cost of
equity funds is defined as follows:
Re = d1 + g
Po
Where: Re = Rate of return required, d1 = expected
dividend in next period, Po = market price of each share
and g = expected constant growth rate of dividends
Cost of Ordinary Shareholder’s Equity
If expectations are not satisfied in practice, then the
marginal shareholder will be inclined to sell his shares,
which will put downwards pressure on the share price
In theory, other things being equal, it is only if Re is
actually achieved that the share price will remain constant
The major practical problem with the GG Model arises
from the need to find an accurate value for g
It might be necessary to use an average of recent past
growth rates, or a formal forecasting model might be
constructed in order to generate a value for g
It is a simplification to assume that dividend growth rates
are to be constant
Cost of Ordinary Shareholder’s Equity
However, one method of estimating the future
dividend growth is to use the anticipated future return
on profits adjusted by the percentage of net profits
retained in the business. This is known as the r b
method
r = return on new investment
b = proportion of earnings retained
The expected growth rate in dividends can then be
assumed to be rb.
For example, if r = 26% and b = 30%, the growth in
dividends is:
0.26 x 0.30 = 0.078 = 7.8%
Cost of Ordinary Shareholder’s Equity
Shares prices may fluctuate markedly, and hence there
is always serious doubt over the appropriateness of the
share price used in the calculation
If the company has a strategy which involves reducing
dividends in order to retain a higher than normal
proportion of its total profits, this may affect the
market’s perception of the value of the shares and
hence may have a fundamental effect on the price of
the shares and the value of Re
The GG model takes no account of the riskiness of the
company
Capital Asset Pricing Model (CAPM) and
Cost of Equity
An alternative approach to the calculation of the cost of
equity capital is based upon the CAPM
This model divides the return on a share into two parts:
1. The return to be earned on a risk-free investment
2. The additional return required as a premium over the risk-
free return, in order to compensate for the risk associated
with the particular share under investigation
 The basic formula for the cost of capital using the CAPM is:
Re = Rf + β (Rm – Rf)
Where: Rf = current return on a risk-free investment
Rm = Current return on an average security (the return on
the market index)
β = the beta coefficient of the share under investigation
Capital Asset Pricing Model (CAPM) and
Cost of Equity
Rm is the return earned on a share of average
riskiness, which is effectively the return earned on a
perfectly diversified portfolio of shares (giving the
market index)
The beta coefficient of the share under investigation
represents a measure of the variability of the return on
that share relative to the variability of the return on
the market index as a whole
Clearly, the greater is the beta coefficient, the greater
is the relative riskiness of the share, and, as would be
expected, the greater will be the return required by the
holder of that share (Re)
Problems with CAPM
Major practical problems is using the CAPM arise in respect of
calculating the beta coefficients and determining the appropriate
risk-free return to use
Also the usefulness of model ultimately depends upon the validity
of the assumptions underlying its operations
The most important of these assumptions are:
 Capital markets operate perfectly
 Markets are able to evaluate risk
 There is a perfect diversification within the market portfolio and
hence the return on the market index is a true average for all equities
 CAPM assumes that all shareholders hold a diversified portfolio of
equities, although its not possible practically
 Some shares are held by only a small number of shareholders (eg
family controlled firms) whereas CAPM assumes a diversified
shareholder base for all shares
Weighted Average Cost of Capital (WACC)
Since it is most unusual for a business to raise funds exclusively
from a single source, therefore, in order to calculate the true cost
of capital to the business, it is necessary to derive a measure
which takes account of all sources of funds used and their
respective importance within the pool of funds
This measure is known as WACC
In respect of the calculation of the WACC, care should be taken
to:
 Identify each existing source of capital funds – trade credit is
excluded
 Utilize market valuations for debt and equity wherever this is
relevant and feasible, in order to establish market-determined
weights for the sources of funds
 Deduct the tax relief on interest expenses; dividends not being tax
deductible
Example of WACC calculation
The long-term financing position of ABC Ltd at 31,
December is as follows:
Sources of Finance Market Value PKR M Net of Tax cost %
Ordinary Shares and 30 16%
reserves

Preference Shares 5 13%

Debentures 10 11%
Long-Term bank loan 5 10%
Example of WACC calculation
The WACC of ABC Ltd is calculated as follows:
Sources of Market % of total Net of tax Weighted
Finance Value PKR finance Cost % Cost %
M
Ordinary 30 60% 16% 9.6%
Shares and
reserves
Preference 5 10% 13% 1.3%
Shares
Debentures 10 20% 11% 2.2%
Long-Term 5 10% 10% 1%
bank loan
50 100% 14.1
Example
The following is an extract from the statement of financial position of M Co at 31
December 20X9.
$'000
Ordinary shares of 50c each 5,200
Reserves 4,850
9% preference shares of $1 each 4,500
14% loan notes 5,000
Total long-term funds 19,550

The ordinary shares are quoted at 80c. Assume the market estimate of the next ordinary
dividend is 4c, growing thereafter at 12% per annum indefinitely. The preference shares
which are irredeemable are quoted at 72c and the
loan notes are quoted at nominal value. Tax on profits is 33%.

Required: Using the information above, calculate market weighted cost of capital
Example
ke = 4/80 + 0.12 = 17%

kpref = 9/72 = 12.5%

kd = 14(1- 0.33) = 9.4%

100

Market Market Weighted

No in Issue Price Value Cost Weight Cost
Instrument
Equity 10,400,000 0.8 8,320,000 17% 50.24% 8.54%
Preference Shares 4,500,000 0.72 3,240,000 12.50% 19.57% 2.45%
Loan Notes 5,000,000 1 5,000,000 9.40% 30.19% 2.84%
Total 16,560,000     13.82%
Utilizing the WACC in the Investment
Appraisal Process
Having calculated the WACC for the existing base of
funds, this value may be used as the test discount rate
for the evaluation of a proposed capital investment
project
However, care should be taken to apply this WACC
only in appropriate circumstances
Also the limitations of utilizing the WACC in an
unadjusted form for the evaluation of a proposed
project should be recognized
There are number of issues to bear in mind in this
respect
Utilizing the WACC in the Investment
Appraisal Process
Ideally, the proposed project should be marginal relative to
the overall operation of the business
A relatively large project requiring large amounts of new
funds might alter the perceptions of the providers of funds as
to the financial stability of the business, and hence alter the
assumed behavior underlying the calculation of the WACC on
existing funds
This problem could occur even where new funds are raised
from the various sources in precisely the same proportions as
they were raised for the existing pool of funds
The raising of funds to cover a relatively small project, even
from a single source, is likely to have only a marginal effect on
the overall structure of the pool of funds and hence on the
existing WACC valuation
Utilizing the WACC in the Investment
Appraisal Process
It should be recognized that if a project implies a large
increase in the scale of operation of the business, then
new sources of funding, hitherto untapped, may be
opened up to the business
Hence it will probably be appropriate to re-evaluate the
WACC on the assumption that the project goes ahead and
the new sources of funding are utilized
Related to the point above is the problem that as a
business seeks an increasing volume of one particular type
of funds, the unit cost of those funds is likely to alter
After a certain point the cost per unit will begin to rise, as
pressure is placed on suppliers of the funds, and the debt:
equity ratio (the gearing) of the business is altered
Utilizing the WACC in the Investment
Appraisal Process
For the WACC to be applied without any adjustment,
it must be assumed that the riskiness of the proposed
project is of the same general order as that of the
existing projects already being undertaken by the
business
IF the proposed project is thought to have a
significantly different associated riskiness, then the
evaluation of the risk related to lending or investing in
the business is likely to be altered, and hence the costs
of some or all of the sources of funds may be affected,
thus altering the WACC calculated on the existing pool
of funds
Utilizing the WACC in the Investment
Appraisal Process
Where the WACC is calculated for a company as a whole, it
is only acceptable to use this rate for the activities of a
division of the company if the operations of that division
have the same risk characteristics as the company as a whole
If divisions of the company are markedly different in terms
of their operations, to use a company cost of capital in order
to assess divisional investment projects, may not only lead
to distortion in the evaluation of relative profitability’s of
projects, but also may reduce the overall profitability of the
company
Indeed, this point may be extended to suggest that a
separate discount rate should be derived for every major
project in order to avoid distortion of investment decisions
Utilizing the WACC in the Investment
Appraisal Process
In reality, capital structure of many companies are
extremely complex and often involve the issue of
rather sophisticated financial instruments, such as
convertible debentures and share warrants
Many companies also make use of overdraft facilities
for de facto longer-term financing
The existence of such instruments and forms of
financing raises serious qualifications to the basic
WACC calculation
Special Circumstances when the WACC is
Not Appropriate
There are certain circumstances in which the WACC (whether
calculated on the basis of the existing pool of funds or on the
pool of funds which would exist if the proposed project was to
go ahead) is inappropriate as a measure of the cost of capital for
the business
Specially such circumstances are when funds are provided
externally for a project on the strict condition that they are used
only to support that clearly defined project
Thus, for example, a government body may provide funds to
support specific capital investment in a depressed region
The interest rate charged on these funds may be significantly
below the rate which would be determined by the free market
Clearly, the project is assessed in isolation, utilizing the special
cost of capital implied by the official sources of funds
Practice Questions
Question
Following data relates to NNN & Co.
  $ Million
Ordinary Share Capital 50
Preference Share Capital 25
Retained Earnings 19
Long Term Borrowing 20
Trade Payables 22
Other Payables 7

The ordinary shares of the company have a nominal value of 50 cents per share and an ex div
market value of $8.30 per share. Beta of NNN Share is 1.15, Risk free rate is 5% and market
spread on risk free rate is 6%.
The long-term borrowings of NNN Co consist of 7% bonds that are redeemable in six years’
time at their nominal value of $100 per bond. The current ex interest market price of the
bonds is $103.50.
The preference shares of NNN Co have a nominal value of 50 cents per share and pay an
annual dividend of 8%. The ex div market value of the preference shares is 67 cents per
share.
NNN Co pay profit tax at an annual rate of 25% per year. Company pays 6% on its short term
liabilities
Question
Duo Co needs to increase production capacity to meet increasing demand for an existing
product, ‘Quago’, which is used in food processing. A new machine, with a useful life of four
years and a maximum output of 600,000 kg of Quago per year, could be bought for
$800,000, payable immediately. The scrap value of the machine after four years would be
$30,000. Forecast demand and production of Quago over the next four years is as follows:

Year 1 2 3 4
Demand (kg) 1.4 million 1.5 million 1.6 million 1.7 million
Existing production capacity for Quago is limited to one million kilograms per year and the
new machine would onlybe used for demand additional to this.
The current selling price of Quago is $8.00 per kilogram and the variable cost of materials is
$5.00 per kilogram. Other variable costs of production are $1.90 per kilogram. Fixed costs of
production associated with the new machine would be $240,000 in the first year of
production, increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim tax-allowable
depreciation on a 25% reducing balance basis. A balancing allowance is claimed in the final
year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment
projects. It has a cost of equity of 11% and a before-tax cost of debt of 8.6%. The long-term
finance of the company, on a market-value basis, consists of 80% equity and 20% debt.