Financial Management

Revision Workshop
2023-24
Overview - Main topics
 Project appraisals
 CAPM
 Determination of cost of capital
 Required rate of return with gearing adjustment
 Estimating beta
 Capital structure and dividend policy
 Business valuation
 Economic value from merger and acquisition
 Working capital management and financial statement
analysis
 Risk management
 Options, forwards, interest rate swap
2
Project Appraisals
 Identify relevant cash flows
 Relating to the investment decision
 Representing future cash flows
 Incremental to the investment decision

 Timing of cash flows

 Read carefully the planning horizon

 Considerations of different scenarios

 Probability weighted average
 Risk factors
3
Project Appraisals
 Price changes and tax implication
 Apply the price changes to the specific items and use the
nominal discount rate for NPV calculation.
 Real rate is rarely used unless price changes to all items at at
the inflation rate.
 Watch out the different methods to determine the tax
allowances and the timing of tax paid.

 Capital rationing
 Using profitability to rank projects.

 Revision question 1
4
Other considerations
 Accuracy of the estimates – sensitivity analysis

 Strategic alliance

 Options to expand or abandon

5
CAPM and related topics
 Risk and return
 Risk measurement
 Relationships between risk and return

 Implications from the CAPM

6
Risk and Return 1
 Over time, the higher the risk of a financial asset, the
higher the expected return.

 Standard deviation would be an appropriate proxy for

risk if
 Investors have equal preference to both the upside and
downside risk
 Returns of the underlying financial asset follow the normal
distribution

7
Risk and Return 2
 Investors choose a single investment with the
appropriate risk and return characteristics to suit their
own risk preference.

 Standard deviation would be a good proxy for risk

when an investor is focusing on the total risk.

8
Risk and Return 3
 Risk can be diversified if
 Assets are not all perfectly correlated with each other;
 There is a sufficient amount of assets in the portfolio

 The portfolio created with different weights on each

assets lie on a smooth curve known as the efficient
frontier. Investors choose the portfolio to suit their
risk preference.

9
Portfolio Risk and Return
 For a portfolio with only two assets

 Vp =

 The portfolio variance is a function of the coefficient

of correlation; and hence
 V is the smallest when the coefficient = -1
p

 Vp is the largest when the coefficient = +1

10
Example 1
 You manage a large portfolio of Australian companies,
composed of mining and manufacturing stocks.
 The mining stocks have an expected return of 5% and
a standard deviation of 2.3%.
 The manufacturing stocks have an expected return of
8% and a standard deviation of 4.2%.
 The correlation coefficient between the two assets is
0.24.

11
Example 1
 (i) Determine the portfolio’s return and standard
deviation with equal weight the mining and
manufacturing portfolios.

 (ii) What are the weights in the mining and

manufacturing firm portfolios that would give the
lowest variance of the portfolio?

 (iii) What would be the composition of the minimum

variance portfolio?

12
Example 1
Portfolio Return SD Weight
Mining – company 1 5 2.3 0.5
Manufacturing – company 2 8 4.2 0.5
Correlation coefficient 0.24

13
Example 1 (i)
 Expected portfolio return

 = 0.5 x 5 + 0.5 x 8 = 6.5

Portfolio’s standard deviation

V =
p
 = (0.52 x 2.32 + 0.52 x 4.22 + 2 x 0.5 x 0.5 x 0.24 x 2.3
x 4.2)1/2
 2.625

14
Minimum Variance
 To minimise the portfolio variance, an investor will
choose a value for x1 such that
 Mathematically,
V p
 2 x1 12  21  x1  22  21  2 x1 12 1 2  0
x1
 22  12 1 2
 x1  2
 1   22  2 12 1 2
where
1
x1  1 when 12 
2

15
Example 1 (ii)
 Using the derivation on page 15, the weight in the
lower risk stock (i.e. Mining)
 = (2.32 – 0.24 x 2.3 x 4.2) / (2.32 + 4.22 – 2 x 0.24 x
2.3 x 4.2)
 = 0.84

16
Example 1 (iii)
 If x1 = 0.84
 E(Rp) = 0.84 x 5 + 0.16 x 8 = 5.48
 Vp =
 = (0.842 x 2.32 + 0.162 x 4.22 + 2 x 0.84 x 0.16 x 0.24
x 2.3 x 4.2)1/2
 = 4.807
 Standard deviation of the portfolio = 2.193

17
Pause and Think
Stock Expected return Standard
(%) deviation (%)
1 5 5
2 10 10

Given the compositions of the above two stocks, would

any risk-averse individual invest only in 1 if the
coefficient of correlation between Stocks 1 and 2 is 0.4?

18
Pause and Think
 The derivation on page 15 shows that a minimum variance
portfolio can be created by investing 100% in the less risky
stock (i.e. X1 = 1) when the coefficient of correlation is
equal to the ratio of the standard deviations of the two
stocks.

 In this case, if an individual is sufficiently risk averse, they

may choose to invest 100% in the lower risk stock as
diversification would not be able to create value to them.

 You can sketch the efficient frontier and show how this
would be the case.
19
Diversification - General Formula
E R p    i E Ri 
N

i 1
N
 p2   i2 i2   i j ij
i 1 i j
N
1 1
N2
  i2 
i 1 N2

i j
ij

where  i2 is the return variance of stock i

and  ij is the covariance between returns on stock i and j
Define  2 as the average variance
and  ij as the average covariance
1 2  1 
    1   ij
2
p
N  N
20
Portfolio Risk
 Note that the number of covariances in a N stock
portfolio = N2 – N.
 Sum of covariances/N2 = Average covariance x (N2 –
N)/N2
 The variance of an equally-weighted portfolio is given
by:
1 2  1 
    1  ij
2

Np
 N 
 So, when N is sufficiently large, the first term
disappears, leaving the portfolio variance equal to the
average covariance between stocks.
21
Portfolio Forming with Multiple Stocks
 An investor has access to a set of N securities (where
N is large). Each of them has an annual return
variance of 0.5 and the coefficient of correlation
between every pair of the N assets is 0.1.

 The investor wants to build an equally weighted

portfolio of a subset of these N assets that has a return
variance of 0.10 or smaller.

 What is the lowest variance you would be able to

obtain?
22
Portfolio Forming with Multiple Stocks
 Correlation = 0.1
 Covariance = 0.1 x 0.51/2 x 0.51/2 = 0.05*
 Recall that V
p
 = Average variance/N + (1 - 1/N) x average
covariance
 0.1 = 0.5/N + (1 - 1/N) x 0.05
 0.1N = 0.5 + (N - 1) x 0.05
 0.05N = 0.45
N=9
 When N goes to infinity, V = 0.05
p
23
Implications from diversification
 Investors would combine as many securities as
possible in their portfolios to reduce the overall
portfolio risk.

 In a perfect and complete market, where the risk-free

asset is also available, investors will all hold the same
market portfolio.

 Why?

24
Capital Market Line (CML)
 The risk (measured in terms of standard deviation)
and the expected return on any portfolio can then be
expressed as

 E(Rp) = Rf + [E(Rm) – Rf]/SDm x SDp

25
Example 2
 Risk-free return = 5%
 Expected return on the market = 15%
 Standard deviation of the market = 20%

 A stock has a return = 8% and a return standard

deviation = 12%.

 Create a no-risk arbitrage.

26
Example 2
 Create a portfolio with the risk-free and the market that has a
weighted average standard deviation equal to that of the stock.

 122 = 202a2 + 02(1 – a)2 + 2a(1 – a)0 x 20 x 0

 => 122 = 202a2
 => a = 12/20 = 0.6

 The portfolio will have a return

 = 5 x 0.4 + 15 x 0.6 = 11

 We buy the portfolio and sell the stock with the same risk cancelling
out with each other. The arbitrage profit would then be 11 – 8 = 3%.

27
CAPM and Security Market Line (SML)
 If everyone is only holding the market portfolio
(where all securities are combined) and the risk-free,
the market would therefore only price the risk that an
investor would not be able to diversify (the market
risk).

 The CAPM/SML implies that

 E(R ) = R + Beta x [E(R ) – R ]
i f m f

28
Characteristics of the CAPM world
 If asset returns follow the CAPM, then
Ri   i  i Rm  ei
 By construction: the random error is expected to be
zero E(ei)=0
 By assumptions
 The random errors between any stock i and j are
uncorrelated: E(ei, ej)=0
 The random error is not correlated with the realised
return or the expected return on the market:
 E[e (R -E(R ))]=0
i m m

29
Characteristics of the CAPM world
 Variance of a security’s return
 i2   i2 m2   ei2
 Covariance of return between security i and j

ij  i  j 2
m

 See revision questions 2 and 3.

30
Variances
 i2  E Ri  E Ri Ri  E Ri 
 i  i Rm  ei  i  i E Rm 
 E  
 i  i Rm  ei  i  i E Rm 
 E i Rm  E Rm   ei i Rm  E Rm   ei 
 E i Rm  E Rm   2 E i Rm  E Rm ei   E ei
2
 
2

   2 2
i m
2
ei

31
Covariance
 Covariance of returns between security i and j

32
Estimation of Betas
 If market data is available (market prices of the stock and
the equivalent index prices for the ‘market’), we can use
either the covariance-variance method or the regression
model to estimate the beta of a stock.

 But when market data is not widely available, a surrogate

beta would need to be estimated.

 See revision question 4.

33
Uses of the CAPM
 Project appraisals

 Construct portfolios with desired risk

 Arbitrage

34
Example 3 – CAPM and Project Appraisals
 You consider an investment project which has a cost
of $100,000.
 The cash flow of the project is $10,000 per year (CF ),
1
growing at a rate of 2% per year after the first year.
 The cash flow is expected to continue indefinitely.
 The assets of the project has unknown beta, but they
are very similar to the assets of a company which has
already a stock market listing.
 This company has a beta of 1.2. The expected return
on the market index is 12% and the risk-free rate is
5%.
35
Example 3
 Using the CAPM: E(R) = 5 + 1.2 x (12 – 5) = 13.4

 Using the constant growth model => PV of FCF’s =

CF1/ (r – g)

 NPV of the investment

 = -100,000 + 10,000/(0.134 – 0.02)
 = -12,280

36
Example 3
 Suppose the listed company has risky but valuable
growth opportunities (these are new projects which
have not yet been invested in – the assets of these
projects will therefore not be visible on the current
balance sheet).

 You estimate that 20% of the current value consists of

these growth opportunities with beta 2.4, and 80%
consists of assets which are similar to the assets in
your investment project.

37
Example 3
 Using the concept behind the weighted average betas:
 1.2 = 20% x 2.4 + 80% x β => β = 0.9
A A
 E(R) = 5 + 0.9 x (12 – 5) = 11.3
 NPV = -100,000 + 10,000/(0.113 – 0.02) = 7,537

38
Construct a portfolio with a desired beta
 Estimate the beta for each stock you want to combine.

 The portfolio beta is the weighted average of the beta

of each stock.

39
Example 4
 Suppose you have the Stock Beta Return
following stocks. (%)
 Assume the risk-free A 0.5 5.5
rate is 3% and the B 0.7 6.5
market return is 8%. C 0.8 7
 Construct a portfolio D 1.2 8.5
with beta = 0.75 E 1.4 10

40
Pause and Think
 Create an arbitrage based on the information from
Example 4.

41
Evaluation of the CAPM - Conceptually
 The CAPM implies relationships between ex ante
(expected) risk premia and betas that are not directly
observable.

 However, in most empirical work, we implicitly

assume that the realised returns on assets in a given
time are drawn from the ex ante probability
distribution of returns on those assets under rational
expectations.

42
Evaluation of the CAPM - Theoretically
 The set of assumptions are highly unrealistic.

43
Absence of Risk-free Rate
The risk-free rate for both lending and borrowing is not
identical
Þ the Two-Fund Separation Theorem breaks down and
Þ Therefore, not all investors would hold the market
portfolio

But the Put-Call Parity

Þ A risk-free rate can be created by a stock, a call and a
put
Further, if a Zero-Beta portfolio can be constructed, then
the return on the portfolio = risk-free
44
Short-Selling is Forbidden
Short-selling is not allowed
Þ over-priced stocks cannot be sold, short and arbitrage
might not be possible.
Þ CAPM would not be in equilibrium

But using options, a short selling position can be

created. We will discuss options later. In short, using the
Put-Call parity, we have S = C + PV(exercise price) – P

A short selling position can be created by selling a call,

borrowing an amount equal to the PV of the exercise
45price at the risk-free rate, and buying a put.
Non-Marketable Assets
 Non-marketable assets are not traded

 Examples:
 Human resources – you can’t trade your manpower
for future salary

 Therefore, there is no market proxy that would reflect

the ‘true’ market portfolio in the CAPM world. (Cross
reference to Roll’s critique)

46
Evaluation of the CAPM - Empirically
 A large volume of empirical studies appear to indicate
that CAPM does not price risk correctly.

 Risk factors other than the market beta appear to be

significant.

47
Fama and French (1992)
 Fama and French (1992) - Found both Book-to-
market and Size effects. Was beta dead?

48
Testing the CAPM – FF, 1992

Company Size vs. Average Return

Average Return (%)
25

20

15

10

0
Company size

Smallest Largest

49
Testing the CAPM – FF, 1992

Book-Market vs. Average Return

Average Return (%)
25

20

15

10

0
Book-Market Ratio

Highest Lowest

50
Pause and Think
Stock Market Capitalisation Beta Expected
(£m) Return (%)
A 1,260 0.6 8
B 23 0.8 10
C 250 1.2 11
D 10 1.3 12
E 1,500 1.4 12
Suppose you have estimated the expected returns and betas of the above stocks using
annual data available for the last 10 years. The risk-free rate of interest and the expected
return on the market are 5% and 10% per annum respectively. You are also told that the
market size of companies in this market is normally distributed with a mean of £400m
and a standard deviation of £150m.
51
Pause and Think
 Explain carefully the extent to which these data are
consistent with the Capital Asset Pricing Model
(CAPM) and whether there is any risk-free arbitrage
strategy.

52
Counter arguments
 However, empirically it has been shown that the
estimated beta is sensitive to the choice of
 Return intervals
 Measuring periods
 Market proxies
 Accuracy – stability and estimation error (to cancel
out these, estimation precision might increase by
forming portfolios and measuring portfolio betas
instead).
 Testing the validity of the CAPM is a joint test of
market efficiency.
53
Capital Structure
 Can a company change its value by changing its
Weighted Average Cost of Capital (WACC)?

 Value of a company = Expected future cash

flows/WACC

54
Modigliani and Miller (1958)
 Company A is all-equity financed whereas Company
B is partly financed with debts.

 Suppose they have the same perpetual earnings before

interest ($100m).

55
Capital Structure with no Tax
A B
Earnings before interest 100m 100m
Interest (6% x 120m) - 7.2m
Earnings available as dividend 100m 92.8m

Cash return to A’s stakeholders 100

7.2 + 92.8
Cash return to B’s stakeholders = 100
If A and B have the same risk,
=> they have the same value VE = VL
=> the weighted average costs of
capital are identical
56
MM’s with Corporate Tax
 In the world with corporate taxes, a firm which issues
debt would be able to use the interest to reduce the
corporate tax liabilities thereby generating additional
tax advantage to debt financing.

57
MM with Tax
 Proposition1
 VL = VU + TcD
 Where Tc is the corporate tax rate and D is the market
value of debt

 Proposition 2
 Re = Ra + (Ra – Rd)(1 - Tc)D/E

 Where Re is the expected return on equity, Ra the

expected return on assets, Rd, the required return on debt
 D/E is the debt-to-equity ratio (in market value)

58
Capital Structure with Tax
Angel Cherub
Earnings before interest 100m 100m
Interest (6% x 120m) - 7.2m
Earnings before tax 100m 92.8m
Tax (30%) 30m 27.84m
Earnings available as dividend 70m 64.96m

Cash return to Angel’s stakeholders 70m

7.2m +
64.96m =
Cash return to Cherub’s stakeholders 72.16

59
Tax Shield
 Angel: receiving 70m as dividend
 Cherub: receiving 64.96m dividend and 7.2m interest
= 72.16 (Difference = 72.16 – 70) = 2.16

 PV of tax shield
 = T D = 0.3 x 120m = 36m
c
 Or
 = difference in cash return/cost of debt
 = 2.16/0.06 = 36m

60
Trade-off Theory (Tax)
 Higher the debt => higher the tax shield => higher
value

 Higher the debt => higher the risk to equity-holders

 => higher chance of bankruptcy

 Trade-off between tax shield and financial distress

61
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield - PV Costs of Financial
Distress

62
Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
63
Trade-Off Theory
 An optimal capital structure might exist when:

 Themarginal tax shield benefit = the marginal

financial distress cost due to increase in debt.

 Market Value = Value if all Equity Financed + PV Tax

Shield - PV Costs of Financial Distress

64
Incentive to Issue Debts
 What level of debt would you expect from the
following listed companies:

 (i) A well-established public utility company with an

annual profit exceeding US$500 million and having
the national government as the major shareholder.

 Likely advantage from tax shield and low financial

distress cost => high debt
65
Incentive to Issue Debts
 (ii) A newly created information technology company
which only just produces a taxable profit this year
after three years of losses.

 Volatile profit

 Inability to maximise the tax shield via debt interest

 Financial distress cost might be high

 => Low debt

66
Combining CAPM and Capital Structure.
 We can adjust the beta of a firm by taking into
consideration of its capital structure.

 See revision question 5a.

67
Considerations for Debt and Equity
 When a firm is under-valued, how would managers of
high-quality firms have an incentive to signal the true
quality of their firm to the market?

68
Signaling Effect on Debt
 Assumptions:

 firm’s quality is not observable

 high quality firms expect high future cash flows

 low quality firms expect low future cash flows

 Market is not strong form efficient but consistent

with the semi-strong

69
Signaling Effect on Debt
 High Debt Policy =>

 A higher probability of bankruptcy or a potential loss

of the tax shield if there is not sufficient profit in the
future

 Market’s expectation: managers in charge of high-

quality firms are willing to expose to high levels of
debt

70
Ingredients
 Incentive scheme – managers using debt to signal
their firm’s value must be rewarded accordingly.

 On the other hand, low quality firms’ managers who

lie about their firms’ quality would suffer personal
loss.

71
Other possible considerations
 Personal taxes

 Agency costs

72
Miller (1977) - Personal Taxes
 Introduces personal taxes: Te and Td i.e. tax on equity
(dividends) and tax on debts (interest) respectively
 A modification of MM’s proposition 1 in the world of
corporate tax.
 Total after-tax cash flow stream to stakeholders:
 EBIT = earnings before interest and tax
 D = market value of debt
 Rd = return on debt
 Tc, Te, and Td are the tax on corporation’s profit, equity and
debt respectively

73
Miller (1977) - Personal Taxes
 The combined cash flows to stakeholders would then be
C   EBIT  Rd D 1  Tc 1  Te   Rd D 1  Td 
 EBIT 1  Tc 1  Te   Rd D 1  Td   1  Tc 1  Te 

 The first term represents the perpetual payments to equity

holders in an all-equity financed firm and the second term
represents the tax shield effect from debts.

 Discounting the two terms by the appropriate rates, we

will get:
74
Miller (1977) - Personal Taxes
EBIT 1  Tc 1  Te  Rd D1  Td   1  Tc 1  Te 
VL  
ReU
Rd 1  Td 
 1  Tc 1  Te 
 VU  1  D
 1  Td  

 1  Tc 1  Te 
1    0 more advantageous to issue debt
 1  Td  
 1  Tc 1  Te 
1    0 less advantageous to issue debt
 1  Td  

75
DeAngelo and Masulis (1980)
 Other tax shield substitutes
 depreciation
 investment tax credits
 oil depletion allowances

 Marginal corporate tax rate not constant across all

firms

 Firms will choose the level of debt which is

negatively related to the level of other tax shield
substitutes

76
Agency costs of Outside Equity
 Jensen and Meckling (1976)

 Assume 100% equity-financed company.

 The insider equity-holder is also the corporate

manager who undertakes ‘activities’ (or exert effort)
to increase the value to the firm.

 What would happen if a proportion of the equity, , is

sold to outsiders?

77
Agency costs of Outside Equity
 Since an increase in ‘effort’ is costly to manager and
the benefit will be shared between both the outside
and internal equity holders, this induces the manager
to supply lower levels of effort for higher values of .

 Outsiders will lose out for paying too much for the
stake in the firm.

 The agency costs of external equity increase as the

percentage of financing supplied by external equity
goes up.
78
Example 5
 Consider the following example of investment by an
entrepreneurial firm which needs to invest F = $70
million at date 0 and has no resources of its own.

 At t = 2, cash flows will be either $200million or

$32million. The chances of success depend on what
the entrepreneur does at t = 1.

79
Example 5
 If the entrepreneur exerts “high effort”, the project
succeeds (i.e. returns $200million) with a 75%
chance. If no “high effort” is exerted, the project has
only a 25% chance of success.

 Exerting effort is costly for the entrepreneur and

denote by κ the monetary equivalent of this cost.
Investors cannot observe/control the entrepreneur’s
choice of effort.

80
Example 5
 Suppose the manager-owner would not exert any
effort.

 What is the percentage of equity to be sold to outside

equity-holders to raise $70 m?

 The proportion of expected payoff to ‘outsider’ = 70

 =>  x [200 x 0.25 + 32 x 0.75] = 70
 =>  = 0.9459

81
Example 5
 What would be the expected payoff to the manager-
owner in the case with no effort?

(1 – 0.9495) x [200 x 0.25 + 32 x 0.75]

=4

 In this case, by not exerting effort, the manager-owner

would only gain a small amount of value but
effectively selling the majority of the holding to
outsiders

82
Example 5
 What is the maximum cost of effort compatible with
the manager-owner choosing high effort in
equilibrium when the investment is financed with
outside equity?

 If outsiders believe that the manager-owner would

choose high effort, the proportion of their holdings
would be:

  x [200 x 0.75 + 32 x 0.25] = 70

 =>  = 0.443
83
Example 5
 Why would the manager-owner be indifferent
between exerting effort and not exerting effort?

 (1 – 0.443) X [200 X 0.75 + 32 X 0.25] – k = 4

 k = 84

84
Lesson 1
 Higher the cost of effort => Lower the chance to exert
effort

 => lower chance to maximise the value of the firm

 => High agency cost of outside equity

85
Lesson 2
 Higher the , the lower the value to insider equity-
holders

 =>less likely to exert effort to maximise the firm’s

value

 => higher agency cost on outside equity

86
Agency Costs on Debt
 Risk shifting/Asset substitution

 The firm is controlled by equity-holders

 Significant level of debt

 Equity-holders prefer volatile projects whereas debt-

holders prefer safe projects

87
Example 6
Good (50%) Bad (50%)
Project A 27 10
Project B 34 0

Initial investment =6
Assume risk- Financed by debt
neutrality and
zero discount rate

88
Project A
 The value of the firm = 27 x 0.5 + 10 x 0.5 = 18.5

 For debt-holders
 Expected payoffs to debt-holders = 6

 For shareholders:
 Expected payoffs = (27 – 6) x 0.5 + (10 – 6) x 0.5
 = 12.5

89
Project B
 The value of the firm = 34 x 0.5 + 0 x 0.5
 = 17

 Expected payoffs to debt-holders
 = 6 x 0.5 + 0 x 0.5 = 3
 Expected payoffs to shareholders = (34 – 6) x 0.5 + 0
x 0.5 = 14

 Project B leads to a higher expected payoffs to the

shareholders despite the lower value of the firm.
90
Mitigating factors for agency conflicts
 Protective covenants
 Impose managerial inflexibility
 Various forms and clauses

91
Example 7 - Agency cost on debt
 Assume the debtholders are fully aware of the firm’s
possible investment choices.

 They decide to use a bond covenant to stipulate a

variable face value of the debt if the riskier project is
chosen.

 Determine the face value that would apply to the

riskier project to ensure that the entrepreneur would
choose the safer project.

92
Covenant
 Let F be the face value.
 To re-align the payoff to shareholders to be identical
under project A and project B,
 => (34 – F) x 0.5 + 0 x 0.5 = 12.5
 => F = 9

93
Mitigating factors for agency conflicts
 Issue convertible debt

 What is a convertible debt?

 Earning fixed income as a straight debt
 Option to convert the debt into equity

 How does it mitigate the agency conflict?

 If safe projects are taken – straight bond
 If risky projects are taken – converted into equity

94
Convertible bond
 Suppose the debtholders in the previous example are
happy to remove the bond covenant.

 However, if the entrepreneur chooses the riskier

project, they can convert the debt into equity.

 Determine the fraction of the equity that should be

converted from the debt that would ensure that the
safe project is chosen.

95
Convertible bond
 If project B is chosen and the debtholders convert the
debt into equity, the value of the firm = 34 x 0.5 + 0 x
0.5 = 17 (no repayment of the debt).

 If project A is chosen, the entrepreneur will get 12.5.

 The fraction of equity that the debt can be converted

into = (17 – 12.5)/17 = 0.2647

96
Convertible bond
 If the conversion ratio is higher than 0.2647, the
entrepreneur will receive less than what they would
get from choosing project A.

 The convertible serves as a device to re-align the debt-

holders’ and the entrepreneur’s interest.

97
Asymmetric information
 Assume that, in this economy, half the firms are good
with assets in place worth $100m and half the firms
are bad with assets in place worth $50m.

 Only the firm knows whether it is good or bad.

 The capital market only knows the proportion of each

type of firm in the population.

98
Asymmetric information
 Each firm has a new investment opportunity which
costs $60m that must be raised in the capital market
and returns $130m with probability 50% and $0m
otherwise.

 The properties of this investment opportunity are

known to both the firm and the capital market.

99
Financing choices - Equity
 Assume that firms’ managers take this investment
opportunity regardless of the firm’s type by issuing
equity.

 Which percentage of any firm’s equity must original

shareholders give up in exchange for the capital?

100
What does the market expect?
 The PV of the project
 = 0.5 x 130 + 0.5 x 0 = 65 (NPV = 65 – 60 = 5)

 For the good firms after taking the project,

 The market value = 100 + 65 = 165

 For the bad firms after taking the project,

 the market value = 50 + 65 = 115

101
Expected % of outside equity
 The expected value of any firm taking the project
 = 165 x 0.5 + 115 x 0.5 = 140.

 The expected % of equity required to raise 60 from

outsiders = 60/140 = 42.86%.

 Will firms’ managers working on behalf of existing

shareholders take this investment opportunity
regardless of their firms’ types? Explain.

102
Good firms
 If no project is taken, existing equity holders will get
100.

 If the project is taken, existing equity holders will get

165 x (1 – 42.86%) = 94.281.

 Existing equity holders will lose out.

 Outsiders will get 165 x 42.86% = 70.719 (higher

than what they pay).
103
Bad firms
 If do nothing, existing equity holders will get 50.

 If the project is taken, existing equity holders will get

115 x (1 – 42.86%) = 65.711.

 Existing equity holder will gain.

 Outsiders will get 115 x 42.86% = 49.289 (less than

what they pay for).

104
Conclusions
 If managers work for the interest of existing equity
holders,

 Good firms (undervalued by the market) are less

likely to finance the project with outside equity as
existing equity holders will lose out.

 Bad firms (overvalued) are more likely to finance the

project with outside equity as existing equity holders
will gain.

105
Debt financing
 Now suppose that firms can issue debt.

 Is it possible now for firms’ managers working on

behalf of existing shareholders to take this investment
opportunity regardless of their firms’ types?

 Explain.

106
Expected repayment for the debt
 Let F be the face value (repayment value) of the debt.
 For the good firms – debtholders will get F.
 For the bad firms – debtholders will get F in the good
state and 50 in the bad state.
 The expected return to debtholders
 = F x 0.5 + (F x 0.5 + 50 x 0.5) x 0.5 = 60
 => F = 63.33

107
Good firms
State I State II
Do nothing 100 100
Investment 230 100
Debt (= the cost of the investment) (63) (63)
Equity (residual) 167 370

Existing equity-holders = 0.5 x 167 + 0.5 x 37 = 102

Existing equity-holders will be better off than doing nothing

Managers of good firms are more likely to issue debt.

108
Bad Firms
State I State II
Do nothing 50 50
Investment 180 50
Debt (63) (63)
Equity 117 0

Existing equity-holders = 0.5 x 117 + 0.5 x 0 = 58.5 (less than the

gain from equity finance)

But there is a chance that the firms may be forced to liquidate (in
State II).

Managers of these firms are less likely to issue debt.

109
Pecking Order Theory
 Agency theory => outside equity issue is likely to
suggest that share price is over-valued (refer to the
bad firms in the example)

 Financial distress and agency cost on debt => debt

issue is costly; but it generates a tax shield effect and
therefore rank higher than equity in the pecking order.

 Internal funds would be the least costly and less

ambiguous.

110
Pecking Order Theory
Implication:
 Firms with high free cash flows are likely to finance
with low level of debt.
 Building up cash reserve is valuable for future use.

 This suggests that a low payout dividend would be

preferred.
 Contrast the agency theory in dividend

111
Dividend Policy – No Tax
 MM’s argument – equity-holders are indifferent
between share repurchase and cash dividend.

112
Dividend Policy – With Tax
 If tax on share repurchase (capital gain) and tax on
cash dividend are not the same, there might a possible
tax-clientele effect.

 Liquidity requirement

113
Consumption and Tax Effects
 Investors’ consumption pattern over time is different
from the dividend pattern
 * Dividend – Consumption = spare cash for lending
 * Consumption – Dividend = amount to borrow
 => interest earned and interest paid would be different
 Investors pay a higher tax on dividend income than
tax on share purchase
 => low dividend pay-out policy is preferred

114
Dividend Policy - Considerations
 Signaling effect
 Conditions are similar with signaling effect on debt

 Why ↑ dividend => good news

 Lintner’s stylised fact
 ✘ short term changes of dividend
 ↑ dividend => a sustainable policy
 => ↑ confidence of future cash flows

115
Agency conflicts
 Should a firm adhere to a high payout or low payout
policy when it has spare cash (after investments)?

 Corporate managers do not always act for

shareholders’ best interest.
 They are tempted to use spare cash reserve for
personal gains.
 Like buying a business plane and fly their families for
holidays

116
Agency Conflicts – solution
 Drain the company from free cash flows by requesting
a high dividend pay-out policy.
 When the management need additional cash for future
investments, they would have to approach
shareholders for new capital fundings.
 Equity-holders can exercise some degree of control
over their investments by refusing to buy the firm’s
new securities if they are suspicious of managerial
misbehaviour.
 Compare and contrast the implication from the
Pecking Order Theory.
117
Pause and Think
 See revision question 5b

118
Business valuation and cost of capital
 Valuation of equity
 Valuation of bond
 Using CAPM and capital structure to adjust for the
beta calculation.

 Revision questions 6 to 9.

119
Mergers and Acquisitions
 Typical exam questions are around the economic
value created. See revision question 10.
 Where are the values coming from?
 Increased market power
 Cost cutting – economy of scales
 Improved growth rate
 Note that the following are dubious reasons for
mergers and acquisitions
 Diversification
 Improved EPS

120
Market efficiency
 The three forms of efficiency reflect the different
degrees of information incorporated into share prices.

 Weak form: all past information is incorporated into

share prices.

 Semi-strong form: all past and present (current)

information is incorporated into share prices.

 Strong form: all information (including privately

withheld) is incorporated into share prices.
121
 Implications of Market Efficiency -
Investors
 If markets are adhering to the strong form efficiency,
then no one can obtain abnormal return by using any
private or public information.

 Equity research is pointless and that no bargains exist in

the capital markets.

 Investors are best advised to buy a portfolio of shares and

to hold those shares rather than looking for opportunities
to buy ‘cheap’ shares.
Further Implications of Market Efficiency
- Investors
 However, if the market is not adhering to the strong
form efficiency, then for the vast majority of people,
public information cannot be used to earn abnormal
returns.

 Arguably only those investors have superior private

information would gain. The perception of a fair game
market could be improved by more constraints and
deterrents placed on insider dealers.

123
Further Implications of Market Efficiency
- Investors
 Similarly, if the markets are adhering to the semi-
strong form efficiency, fundamental analysis which
looks for the fundamental value of a share would not
add value.

 Instead, investors need to press for a greater volume

of timely information to ensure that stock prices
reflect full public information about companies.

124
Further Implications of Market Efficiency
- Investors
 If the markets are adhering to the weak form
efficiency, then technical analysis which seeks to
predict share prices from studying their historic
movements would be redundant as past stock price
patterns would have already been incorporated in the
current stock prices.
Implications to corporations
 If the market is adhering to the strong form,
manipulating accounting misinformation will not fool
investors in general.
 Attempts by corporate managers to make changes to
the accounting bases, to accounting figures published
in annual reports which have the effect of giving a
changed view of the profit for a period or the assets on
the balance sheet, will not affect the market price of
the business’s shares; provided that the facts
concerning the alterations to the accounting bases are
made public.
126
 Further Implications of Market Efficiency
- Corporations
 If the market is consistent with the strong form, the
timing of issues of new shares by businesses is not an
important question.

 Prices are always correctly reflecting the fundamental

value of a corporation. Managers would not be able to
issue shares to the external market when they are over-
valued.

 Note that in this setting, agency conflicts between equity-

holders and debtholders or insiders and outsiders would
not occur.
Further Implications of Market Efficiency
- Corporations
 If the market is consistent with the semi-strong form
efficient, timely release of corporate information
would help re-aligning the share value.

 This would also enable the use of debt and dividend

as signals.

128
Further Implications of Market Efficiency
- Corporations
 If the market is consistent with the weak form or is
not informationally efficient at all, then it would be
much easier for corporations to fool the market,.

 Insider trading and earning manipulation may be

possible. In this situation , a tighter regulatory
framework is required to ensure that corporations
would not be able to take advantage of its superior
information.

129
Pause and think
 Consider the following scenarios. Determine which
form of market efficiency is adhered to or violated.

 (i) Stock returns tend to be higher on Friday than on

the following Monday.
 (ii) High book-to-market stocks performed
substantially better than low book-to-market stocks in
2022.
 (iii) Zen plc made a bonus issue of shares and the
share price rose by 1%.
 Also see revision question 11.
Inventory management
 A significant amount of a company’s resources is
often tied up in inventory.
 The shorter the time we keep our inventory, the faster
we would be able to turn it into cash flow.
 Therefore, it is important to set an inventory level that
would enable the company to meet the demands of its
products and free up spare capital at the same time.
 Economic modelling has been developed to identify
the minimum level of inventory to enable a company
to balance out the risk of ‘stock-out’ and tied up
working capital.
131
Example 8
Buffer inventory level 100 units
Re-order size 500 units
Fixed order cost £100
Holding cost for one unit per year £2.50
Annual demand 20,000 units
Purchase price £4

Calculate the cost of the current ordering

policy and determine the saving that could
be made by using the economic order
quantity model.

132
Example 8
 Number of orders in a year = 20,000/500 = 40
 Average level of inventory = (100 + 600)/2 = 350
 Total cost = 40 x 100 + 350 x 2.5 = 4,875

 EOQ = (2DC/H)1/2 = (2 x20,000x100/2.5)1/2 = 1,265

 Number of orders in a year = 20,000/1,265 = 15.81
 Average level of inventory = (100 + 1,365)/2 = 732.5
 Total cost = 15.81 x 100 + 732.5 x 2.5 = 3,412.25
 Saving = 4,875 – 3,412.25 = 1,462.75

133
Trade receivables management
 Allowing customers to pay for their purchases on
credit requires some serious management. Typically,
there are five factors to consider:

1. Terms of sales – how long do we allow customers to

pay their invoices? Are we prepared to offer a
discount for quick settlement?

2. Promise to pay – what sort of collateral do we require

from the credit customers?

134
Trade receivables management
3. Credit analysis – how do we assess the
creditworthiness of the customers?

4. Credit decision – how much credit are we prepared to

offer? Are we willing to take risks to extend risk terms
even though there might be a chance of bad debt?

5. Collection policy – how do we ensure that all debts

are collected?

135
Effects on changes in receivables period
 Extending credit terms
 This may increase sales, but receivables may be
higher.

 Offering early settlement discounts

 This may shorten the receivables period, but the
amount received (after discounts) may be lower.

136
Extending credit terms
 Company A produces one type of product.
 It has a cost of capital = 10%.
 Turnover = £1.4m per year
 Average receivables period = 30 days
 Each product:
 Selling price = £50; Contribution per unit = £20
 Proposal:
 Increase the credit term to 45 days.
 Expected increase in sales = £120,000

137
Extending credit terms
 Expected average receivables period = 45 days
 Expected total sales = £1.4m +£120,000 = £1.52m
 Expected end of year receivables
 = £1.52m x 45/365 = £187,397
 Current level of receivables based on the credit terms
of 30 days
 = £1.4m x 30/365 = £115,068

138
Extending credit terms
 Opportunity cost due to the increase in receivables
 = increase in receivables x the cost of capital
 = (£187,397 - £115,068) x 10% = £7,233

 Increase in contribution
 = increase in sales x contribution / selling price
 = £120,000 x 20/50
 = £48,000

 Net effect = £48,000 - £7,233 = £40,767

139
Offering early settlement discounts
 See revision question 12.

140
Debt factoring
 Debt factoring is when a business sells its accounts
receivables to a third party at a discount, enabling
companies to immediately unlock cash tied up in
unpaid invoices without having to wait the usual
payment terms.

141
Trade payables management
 Trade credit from suppliers is an extremely important
source of finance for small businesses in particular.

 Trade credit from suppliers can be a free source of

finance to a business providing the goodwill of the
trade supplier is maintained and providing discounts
for prompt payment are taken.

Failure to maintain supplier goodwill, however, can

lead to a reduced level of service in the future and
failure to take advantage of discounts can have a high
implicit annual interest cost.
142
Example 9
 Suppose trade suppliers offer a 1% discount for
invoices paid from 30 days down to 20 days to
Company B.

 What is the implicit annual interest cost if Company B

is not taking up this offer?

143
Illustration
 For a typical invoice of £100
 Company B can pay £100 within 30 days
 Or
 Company can pay £100 x 99% = £99 within 20 days.
 Effectively, Company B will be saving £1 for every
£99 invoice paid for every 10 days. So, the implicit
cost of credit
 = 1/99 x 365/10 x 100% = 36.9%

 Also see revision question 13.

144
Measures to reduce overdraft
 Reduce purchases
 Inventory control

 Delaying non-essential payments

 Interest payment?
 Capital expenditure?

 Encourage credit customers to pay more promptly

 Negotiate a longer credit term from suppliers

145
Financial Statement Analysis
Alpha Limited 2023 2022
$m $m
Non-Current Assets 3,700 2,860

Current Assets
Inventory 1,280 980
Trade receivables 2,460 2,160
Cash at bank 160 240
3,900 3,380
Total Assets 7,600 6,240

146
Financial Statement Analysis
Current liabilities $m $m
Trade and other payables 1,500 1,380
Tax 190 150
Bank overdraft 220 160
1,910 1,690
Non-current liabilities
Long-term loans 1,600 1,200
3,510 2,890
Equity
Ordinary share capital 1,600 1,600
Retained earnings 2,490 1,750
Total equity 4,090 3,350

Total liabilities and equity 7,600 6,240

147
Financial Statement Analysis
$m $m
2023 2022
Sales 22,400 19,500
Cost of sales 16,920 13,650
Gross profit 5,480 5,850
Expenses 4,390 5,090
Operating profit 1,090 760
Interest payable 160 120
Profit before tax 930 640
Tax 240 160
Profit after tax 690 480

148
Financial Statement Analysis
Ratio Industry average
Gross profit ratio 35%
Operating profit margin 4.2%
Return on capital employed 18.5%
Quick ratio 1.1
Receivables period 35 days
Inventory period 20 days
Payables period 30 days
Gearing (debt/equity) 32%

Comment on the financial performance of Alpha Limited.

149
Financial Statement Analysis
Industry
Ratio
average 2023 2022
Gross profit ratio 35% 24.46% 30%
Operating profit margin 4.20% 4.87% 3.9%
Return on capital employed 18.50% 19.16% 16.7%
Quick ratio 1.1 1.37 1.42
Receivables period (days) 35 40 40
Inventory period (days) 20 28 26
Payables period (days) 30 32 37
Gearing (debt/equity) 32% 39% 36%

150
3-Step Approach
 Identify the trend
 Provide an explanation for the possible causes
 Implications

151
Profitability
 Sales increased in 2022 but GPM fell
 Alpha cut prices in 2022 to stimulate sales?
 The pricing strategy paid off? [GPM is much worse
than the industry average]

 OPM increased in 2022 despite the fall in GPM

 => better control of operating expenses?
 Check GPM – OPM [19.59 for 2022 vs 26.1 for 2021]

152
ROCE = OPM x Asset turnover
Industry
Ratio
average 2022 2021
Asset turnover 4.40 3.93 4.28
Operating profit margin 4.20% 4.87% 3.9%
Return on capital employed 18.50% 19.16% 16.7%

1. Less efficient in using underlying assets to generate sales

2. The increase in ROCE is due to the improvement of
controlling operating expenses

153
Liquidity
Industry
Ratio
average 2022 2021
Quick ratio 1.1 1.37 1.42
Receivables period (days) 35 40 40
Inventory period (days) 20 28 26
Payables period (days) 30 32 37
Working capital cycle or cash
conversion cycle 25 36 29

What is the liquidity situation?

154
Financial Risk
Industry
Ratio
average 2022 2021
Gearing (debt/equity) 32% 39% 36%

Cash at bank 160 240

Bank overdraft 220 160
Net cash equivalent (60) 80

Long term loan 1,600 1,200

How to we link the gearing ratio and the WCC together?

155
Multiple Ratios
 Multiple ratios (for listed companies)
 Altman’s Z-score (1968) = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4
+ 0.999X5
 X1 = Working capital/total assets
 X2 = Retained earnings/total assets
 X3 = PBIT/total assets
 X4 = MV of equity/BV of total liabilities
 X5 = Total sales/total assets
 Z-score > 3 is safe; Z-score < 1.8 suggests failure
Working capital/Total assets
 Working capital is the difference between the current
assets of a company and its current liabilities. The value of
a company’s working capital determines its short-term
financial health. A positive working capital means that a
company can meet its short-term financial obligations and
still make funds available to invest and grow.
 In contrast, negative working capital means that a
company will struggle to meet its short-term financial
obligations because there are inadequate current assets.
 Total assets = Non-current assets + Current assets
Retained Earnings/Total Assets
 The retained earnings/total assets ratio shows the amount
of retained earnings or losses in a company. If a company
reports a low retained earnings to total assets ratio, it
means that it is financing its expenditure using borrowed
funds rather than funds from its retained earnings. It
increases the probability of a company going bankrupt.
 On the other hand, a high retained earnings to total assets
ratio shows that a company uses its retained earnings to
fund capital expenditure. It shows that the company
achieved profitability over the years, and it does not need
to rely on borrowings.
Earnings Before Interest and Tax/Total
Assets
 EBIT, a measure of a company’s profitability, refers to the
ability of a company to generate profits solely from its
operations. The EBIT/Total Assets ratio demonstrates a
company’s ability to generate enough revenues to stay
profitable and fund ongoing operations and make debt
payments.
Market Value of Equity/Total Liabilities
 The market value, also known as market capitalization, is
the value of a company’s equity. It is obtained by
multiplying the number of outstanding shares by the
current price of stocks.
 The market value of the equity/total liabilities ratio shows
the degree to which a company’s market value would
decline when it declares bankruptcy before the value of
liabilities exceeds the value of assets on the balance sheet.
A high market value of equity to total liabilities ratio can
be interpreted to mean high investor confidence in the
company’s financial strength.
Sales/Total assets
 The sales to total assets ratio shows how efficiently the
management uses assets to generate revenues vis-à-vis the
competition. A high sales to total assets ratio is translated
to mean that the management requires a small investment
to generate sales, which increases the overall profitability
of the company.
 In contrast, a low or falling sales to total assets ratio
means that the management will need to use more
resources to generate enough sales, which will reduce the
company’s profitability.
Multiple Ratios
 Multiple ratios (for unlisted companies)
 Z-score = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e

 Where:
 a = Working capital/Total assets
 b = Accumulated retained profits/Total assets
 c = Operating profit/Total assets
 d = Book (statement of financial position) value of
ordinary and preference shares/Total liabilities at book
(statement of financial position) value
 e = Sales revenue/Total assets
 Z > 2.9 safe; < 1.23 distress; in between grey zone
Risk Management
 Forward
 Options
 Money market

 See revision question 14

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