financial management -...

ACCA Paper F9

Financial Management

Class Notes

June 2015

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Contents

PAGE INTRODUCTION TO THE PAPER 5 FORMULAE GIVEN IN THE EXAMINATION PAPER 7 CHAPTER 1: CHAPTER 2:

CHAPTER 3: CHAPTER 4: CHAPTER 5: CHAPTER 6: CHAPTER 7:

CHAPTER 8: CHAPTER 9: CHAPTER 10: CHAPTER 11: CHAPTER 12:

CHAPTER 13: CHAPTER 14:

FINANCIAL MANAGEMENT: AN INTRODUCTION 11 FUNDAMENTAL FINANCIAL MATHEMATICS 19

CAPITAL BUDGETING 27 INVESTMENT APPRAISAL TECHNIQUES 39 SOURCES OF LONG TERM FINANCE 55 COST OF CAPITAL 63 CAPITAL STRUCTURE – FINANCIAL RISK 77

BUSINESS RISK AND ADJUSTED DISCOUNT RATES 83 FINANCIAL PERFORMANCE MEASUREMENT 93 RAISING EQUITY FINANCE 105 EFFICIENT MARKET HYPOTHESIS 113 VALUATION 119

RISK 133 WORKING CAPITAL MANAGEMENT 151

SOLUTIONS TO EXAMPLES 173

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Introduction to the

paper


INTRODUCTION TO THE PAPER

AIM OF THE PAPER

The aim of the paper is to develop knowledge and skills expected of a financial

manager, in relation to investment, financing and dividend policy decisions.

OUTLINE OF THE SYLLABUS

A. Financial management

B. Financial management

function

environment

C. Working capital management

D. Investment appraisal

E. Business finance

F. Business valuations

G. Risk management

FORMAT OF THE EXAM PAPER

The syllabus is assessed by a three hour paper-based examination with 15 minutes

of reading time.

Section A of the exam comprises 20 multiple choice questions of 2 marks each.

Section B of the exam comprises three 10 mark questions and two 15 mark

questions.

FAQs

What level of mathematical ability is required in F9?

You will be required to apply formulae either given or memorised. This may require

limited manipulation of formulae. The level of computational complexity is normally

inversely related to the conceptual difficulty of the topic .

What do I need to bring to class?

You will need pen, paper, these notes and revision kit. In addition you will need a

standard scientific calculator which may be purchased in any large newsagents or

supermarket.

Is there any assumed knowledge?

The only real overlap is with basic concepts explored in paper F2 and also elements

of decision making and cost behaviour covered in paper F5.


Formulae given in the

examination paper


FORMULAE GIVEN IN THE EXAMINATION PAPER

FORMULAE

Economic Order Quantity

= 2CD

H

Miller-Orr Model

Return point = Lower limit + (1/3 spread)

1

3transaction cost varianceof cash flows

3

Spread = 3 interest rate

The Capital Asset Pricing Model

E(r ) = R + ßi (E (rm) – R )

The Asset Beta Formula

V V (1T)

(V V (1T)) e(V V (1T))

d

The Growth Model

D (1 g) 0

(Ke g)

or D (1 g)

0 (re g)

Gordon’s Growth Approximation

g = bre

The weighted average cost of capital

WACC = V V

ke + V V

kd (1–T)

The Fisher formula

(1 + i) = (1 + r)(1 + h)

Purchasing Power Parity and Interest Rate Parity

(1h ) 1 0

(1h )

(1 ic) 0 0

(1 i )

P = 0 P = 0

0 C

4

i f f

a e d

ß = + e d e d

e d e d

e d

V V

S = S c

b

F = S b


Present Value Table

Present value of 1 i.e. (1 + r)-n

Where r

n

Periods

= discount rate

= number of periods until payment

Discount rate (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943

2 0.980 0.961 0.943 0.925 0.907 0.890

3 0.971 0.942 0.915 0.889 0.864 0.840

4 0.961 0.924 0.888 0.855 0.823 0.792

5 0.951 0.906 0.863 0.822 0.784 0.747 6 0.942 0.888 0.837 0.790 0.746 0.705

7 0.933 0.871 0.813 0.760 0.711 0.665

8 0.923 0.853 0.789 0.731 0.677 0.627

9 0.914 0.837 0.766 0.703 0.645 0.592

10 0.905 0.820 0.744 0.676 0.614 0.558 11 0.896 0.804 0.722 0.650 0.585 0.527 12 0.887 0.788 0.701 0.625 0.557 0.497 13 0.879 0.773 0.681 0.601 0.530 0.469

0.935 0.926 0.917

0.873 0.857 0.842

0.816 0.794 0.772

0.763 0.735 0.708

0.713 0.681 0.650 0.666 0.630 0.596

0.623 0.583 0.547

0.582 0.540 0.502

0.544 0.500 0.460

0.508 0.463 0.422 0.475 0.429 0.388 0.444 0.397 0.356 0.415 0.368 0.326

0.909 1

0.826 2

0.751 3

0.683 4

0.621 5 0.564 6

0.513 7

0.467 8

0.424 9

0.386 10 0.350 11 0.319 12 0.290 13

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14

15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

________________________________________________________________________________ (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862

2 0.812 0.797 0.783 0.769 0.756 0.743

3 0.731 0.712 0.693 0.675 0.658 0.641

4 0.659 0.636 0.613 0.592 0.572 0.552

5 0.593 0.567 0.543 0.519 0.497 0.476 6 0.535 0.507 0.480 0.456 0.432 0.410

7 0.482 0.452 0.425 0.400 0.376 0.354

8 0.434 0.404 0.376 0.351 0.327 0.305

9 0.391 0.361 0.333 0.308 0.284 0.263

10 0.352 0.322 0.295 0.270 0.247 0.227 11 0.317 0.287 0.261 0.237 0.215 0.195

12 0.286 0.257 0.231 0.208 0.187 0.168

13 0.258 0.229 0.204 0.182 0.163 0.145

14 0.232 0.205 0.181 0.160 0.141 0.125

15 0.209 0.183 0.160 0.140 0.123 0.108

0.855 0.847 0.840

0.731 0.718 0.706

0.624 0.609 0.593

0.534 0.516 0.499

0.456 0.437 0.419 0.390 0.370 0.352

0.333 0.314 0.296

0.285 0.266 0.249

0.243 0.225 0.209

0.208 0.191 0.176

0.178 0.162 0.148

0.152 0.137 0.124

0.130 0.116 0.104

0.111 0.099 0.088

0.095 0.084 0.074

0.833 1

0.694 2

0.579 3

0.482 4

0.402 5 0.335 6

0.279 7

0.233 8

0.194 9

0.162 10 0.135 11

0.112 12

0.093 13

0.078 14

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Annuity Table

Present value of an annuity of 1 i.e. 1 - (1+r)-n

Where r =

n = discount rate

number of periods

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943

2 1.970 1.942 1.913 1.886 1.859 1.833

3 2.941 2.884 2.829 2.775 2.723 2.673

4 3.902 3.808 3.717 3.630 3.546 3.465

5 4.853 4.713 4.580 4.452 4.329 4.212 6 5.795 5.601 5.417 5.242 5.076 4.917

7 6.728 6.472 6.230 6.002 5.786 5.582

8 7.652 7.325 7.020 6.733 6.463 6.210

9 8.566 8.162 7.786 7.435 7.108 6.802

10 9.471 8.983 8.530 8.111 7.722 7.360 11 10.37 9.787 9.253 8.760 8.306 7.887 12 11.26 10.58 9.954 9.385 8.863 8.384 13 12.13 11.35 10.63 9.986 9.394 8.853

0.935 0.926 0.917

1.808 1.783 1.759

2.624 2.577 2.531

3.387 3.312 3.240

4.100 3.993 3.890 4.767 4.623 4.486

5.389 5.206 5.033

5.971 5.747 5.535

6.515 6.247 5.995

7.024 6.710 6.418 7.499 7.139 6.805 7.943 7.536 7.161 8.358 7.904 7.487

0.909 1

1.736 2

2.487 3

3.170 4

3.791 5 4.355 6

4.868 7

5.335 8

5.759 9

6.145 10 6.495 11 6.814 12 7.103 13

14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14

15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15

________________________________________________________________________________ (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862

2 1.713 1.690 1.668 1.647 1.626 1.605

3 2.444 2.402 2.361 2.322 2.283 2.246

4 3.102 3.037 2.974 2.914 2.855 2.798

5 3.696 3.605 3.517 3.433 3.352 3.274 6 4.231 4.111 3.998 3.889 3.784 3.685

7 4.712 4.564 4.423 4.288 4.160 4.039

8 5.146 4.968 4.799 4.639 4.487 4.344

9 5.537 5.328 5.132 4.946 4.772 4.607

10 5.889 5.650 5.426 5.216 5.019 4.833 11 6.207 5.938 5.687 5.453 5.234 5.029

12 6.492 6.194 5.918 5.660 5.421 5.197

13 6.750 6.424 6.122 5.842 5.583 5.342

14 6.982 6.628 6.302 6.002 5.724 5.468

15 7.191 6.811 6.462 6.142 5.847 5.575

0.855 0.847 0.840

1.585 1.566 1.547

2.210 2.174 2.140

2.743 2.690 2.639

3.199 3.127 3.058 3.589 3.498 3.410

3.922 3.812 3.706

4.207 4.078 3.954

4.451 4.303 4.163

4.659 4.494 4.339

4.836 4.656 4.486

4.988 4.793 4.611

5.118 4.910 4.715

5.229 5.008 4.802

5.324 5.092 4.876

0.833 1

1.528 2

2.106 3

2.589 4

2.991 5 3.326 6

3.605 7

3.837 8

4.031 9

4.192 10 4.327 11

4.439 12

4.533 13

4.611 14

4.675 15


r

Chapter 1

Financial management: an

introduction


CHAPTER 1 – FINANCIAL MANAGEMENT: AN INTRODUCTION

CHAPTER CONTENTS

WHAT IS FINANCIAL MANAGEMENT? ----------------------------------13

THE PRIMARY FINANCIAL OBJECTIVE 13

THE THREE FINANCIAL MANAGEMENT DECISIONS 15

VALUE FOR MONEY – 3 ES 17

STAKEHOLDERS 17



WHAT IS FINANCIAL MANAGEMENT?

The management of all matters associated with the cash flow of the organisation

both short and long-term.

The primary financial objective

MAXIMISE SHAREHOLDER WEALTH

What is shareholder wealth?

The share price multiplied by the total number of shares.

Three factors affecting share price?

1.

2.

3.

Share price formula

P0 = ( )

-

Where:

P0 is the current value of the share

D0 is the dividend just paid

g is the expected constant annual growth in dividend

Ke is th % annual r turn r quir d by shar hold rs (“cost of quity”)



Example 1

CSI Co has just paid a dividend of 23 cents. General expectation is that dividends

will continue to grow at approximately 4% per annum. The risks perceived by the

shareholders of CSI Co lead them to require an annual return (ke) of 12%.

Required:

(a) Calculate the current expected share price of CSI Co.

(b) If market factors make the shares in CSI Co more risky, shareholders

will expect a return of 15%. What impact does this have on the share

price from (a)?

(c) If CSI Co announces changes to working practices which will lead to

higher growth (at 6% per annum) for the foreseeable future, what

impact will that have on the share price from (a)?

(d) If the directors of CSI Co announce that the previous growth in

dividends of 4% were to stop with no guarantee of any future growth,

but that the dividend will remain constant at 23 cents, what would

happen to the share price?



The three financial management decisions

Financial management involves three main areas of decision making:

● the investment decision,

● the financing decision,

● the dividend decision.

1. The investment decision

A company may invest its funds in one of three basic areas:

1. Capital assets.

2. Working capital.

3. Financial assets.

Capital assets

A critical decision because of the strategic implications of many investments.

Working capital

The decision on the level of inventory to hold and the level of credit given to

customers (receivables).

Financial assets

The company may have surplus cash to invest and should consider the following

factors when deciding how to invest that cash:

1. Risk.

2. Return.

3. Liquidity.

2. The financing decision

When looking at the financing of a business there are 4 basic questions to consider:

1. total funding required,

2. internally generated vs externally sourced,

3. debt or equity,

4. long-term or short-term debt.


Investment

Dividend Decision

Decision

Long- or short-term

Does use of available

cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where

will funds come from?

Distribute or Retain?

Retained earnings

provide a cheap

source of equity

finance.

Risk & Cost of Capital

The financing decision will dictate the

return required by investors.

Fina isio N L D D n 0 D

Profit after tax

Number of ordinary shares in issue

=

Dividend per share + Capital gain or loss Share price at the beginning of the year

R Theoretical

MV of shares (cum rights) + Proceeds from

ex-rights = rights issue

price Number of shares (ex rights) P

o


3. The dividend decision

The amount of return to be paid in cash to shareholders. The level of dividend paid

will be determined by: profits; available cash; and investment opportunities

requiring funding. Possible dividend policies:

● Constant dividend payout

The company pays out the same dividend each year (this may be adjusted for

inflation).

● Constant payout ratio

The company pays out the same proportion of available earnings each year.

● Residual dividend policy

The company pays out any remaining earnings after all investment

opportunities increasing shareholder wealth have been financed.

● Dividend irrelevance theory

The theory states that shareholders can create a cash dividend if they so

require, or use dividends to purchase more shares if they wish to increase

their capital wealth.

Interrelationship of decisions

Objectives of not-for-profit organisations

These organisations are established to provide services to the community . Such

organisations need funds to finance their operations. The major constraint is the amount of funds that they would be able to raise.

to use the limited funds to obtain value for money.

16

Not-for-profit organisations seek

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Value for money – 3 Es

Value for money means getting the best possible service at the least possible cost .

Economy measures the cost of obtaining the required quality inputs needed

to produce the service. The aim is to acquire the necessary input

at the lowest possible cost.

Effectiveness means doing the right thing. It measures the extent to which the

service meets its declared objectives.

Efficiency means doing the right thing well. It relates to the level of output

generated by a given input. Reducing the input:output ratio is an

indication of increased efficiency.

Example ---- in refuse collection service,

The service will be economic if it is able to minimise the cost of weekly collection

and not suffer from wasted use of resources.

The service will be effective if it meet it s target of weekly collection.

The service will be efficient if it is able to raise the number of collection per vehicle

per week.

Stakeholders

Stakeholders are any party that has both an interest in and relationship with the

company. The responsibility of an organisation is to balance the requirements of all

stakeholder groups in relation to the relative economic power of each group.

Conflict between stakeholder groups

Th v ry natur of lookin at stak hold rs is that th l v l of „r turn‟ is finit within

an organisation. There is a need to balance the needs of all groups in relation to

their relative strength.

Agency theory

Principal

Agent

The principal is the shareholder, owning the company. Th principal‟s objective is

to increase wealth through income, capital growth and risk management.

The principals appoint directors as their agents to carry out the day-to-day

business of the company. Th dir ctors‟ oals ar lik ly to b to maximis th ir

own remuneration.



Goal congruence

For an organisation to function properly, it is essential to achieve goal congruence

at all levels. All the components of the organisation should have the same overall

objectives, and act cohesively in pursuit of those objectives.

In order to achieve goal congruence, there should be carefully designed incentives

for managers and the workforce which would motivate them to take decisions which

will be consistent with the objectives of the shareholders.

Maximising profits

Within organisations it is normal to reward management on some measure of profit .

W would xp ct a c los r lationship b tw n profit and shar hold rs‟ w alth.

There are, however, ways in which they may conflict such as:

1. Short-termism.

2. Cash vs accruals.

3. Risk.

Short-termism

A profit target is normally calculated over one year; it is relatively easy to

manipulate profit over that period to enhance rewards at the expense of future

years.

Cash vs accruals

As we will see later, wealth is calculated on a cash basis and ignores accruals.

Risk

A manager may be inclined to accept very risky projects in order to achieve profit

targets which in turn would adversely affect the value of the business.


Chapter 2

Fundamental financial

mathematics


CHAPTER 2 – FUNDAMENTAL FINANCIAL MATHEMATICS

CHAPTER CONTENTS

COMPOUNDING & GROWTH ---------------------------------------------21

INTEREST 21

INFLATION 21

DISCOUNTING ------------------------------------------------------------22

ANNUITIES AND PERPETUITIES----------------------------------------25

ANNUITIES 25

PERPETUITIES 26



COMPOUNDING & GROWTH

An initial monetary value (PV) will grow at a rate (r) which is constant each t ime

period (often one year) for a number of periods (n).

A compounding or growth calculation will give us the end value in the future (FV).

FV = PV(1 + r)n

(„r‟ is th d cimal form of th int r st or inflation rat in qu stion).

Interest

Growth could be due to the PV being invested in an interest -bearing account.

Example 1

Terry Co has $10,000 to invest for 4 years and can put it in an account that will

earn 5% each year.

Required:

Calculate the balance available to Terry Co after 4 years.

Inflation

Prices and/or costs may grow from year to year due to inflation.

Example 2

FLT Co is currently paying $12 per unit to produce a product which is then sold for

$30 per unit.

The cost is expected to rise by 6% per annum due to inflation whilst the sales price

is expected to rise by 4.5% each year.

Required:

Calculate the price, cost and contribution per unit for FLT Co’s product for

each of the next four years.

Year 1 2 3 4

Price ($30)

Cost ($12)

Contribution



DISCOUNTING

When a required or expected future value (FV) at a certain time (after n periods) is

known, we use a discounting calculation to find the amount that ought to be

invested now (PV), earning a certain rate (r) each period (for n periods).

Example 3

T rry Co xp cts to mak a paym nt of $ 2, 55 in 4 y ars‟ tim and can put

money in an account now that will earn 5% each year.

Required:

Calculate the maximum that Terry needs to invest now.

Formula

PV = FV(1 + r)-n

All terms as for compounding.

Example 4

Terry Co is able to earn 5%. How much should be invested now in order to receive

a sum of $360,000 after 2 years and a further $280,000 after 5 years?

Year (n) 1 2 3 4 5

FV

(1 + r)-n

Present Value

360,000

280,000

Present value factors

Tables given in the exam show the values of (1 + r)-n for whole number values of r

between 1% and 20% and for time periods until cash flow of 1 to 15.

Time value

In examples 1 and 3, Terry Co will be indifferent between a sum of $10,000 now

and a sum of $12,155 after 4 years. Although the absolute figures are different,

they have the same value to Terry Co due to the time value of money.



Cost of capital

The cost of capital is the return that an investor expects from a particular type of

investment. It is stated as a percentage amount and reflects the risk that the

investment carries.

Annuities

An annuity is a cash flow where the same amount is received or paid each time

period for a set number of periods.

Instead of multiplying each cash flow by its present value factor (PVF), the PVFs

can be added together and the sum multiplied by a single value of the annuity.

Example 5

Terry Co expects to receive a payment of $40,000 next year and for the following 4

years. Terry has a cost of capital of 5%. Required:

Calculate the present value of the annuity:

(i) using PVFs for each cash flow, and

(ii) using the shorter approach.

Year 1 2 3 4 5

FV

PVF

Present Value

40,000

40,000

40,000

40,000

40,000



Annuity factors

A table given in the exam gives the present value factors for annuities when the

cost of capital is r% and the annuity, starting after one year, runs for up to 15

years.

Example 6

An investment is expected to yield constant income of $12,500 each year for the

n xt 2 y ars, with th first of th s cash flows xp ct d to aris in on y ar‟s

time. Required:

(i) Calculate the present value of the annuity with a cost of capital is 8%.

(ii) Advise whether an individual with a cost of capital of 8% should

invest $90,000 to earn the 12 year annuity of $12,500. 24 w w w .s tudyinte ract ive .o rg


ANNUITIES AND PERPETUITIES

Annuities

Discounting annuities is made easier by having a table of annuity factors.

Annuity factors discount cash flows to a value one time period before the first

payment arises.

Time

ncin

$A

$A

$A

$A

$A

g

Dec x Annuity Factor

n $ VALUE

If the first cash flow is at time 1, the annuity factor places the value at time 0 – our

“pr s nt valu ”.

If the first cash flow arises later, say time 4, the value is places at time 3 and a

further discounting adjustment is required to get a present value.

Example 7

AGA Co is considering an investment with cash returns expected to be $100,000

each year for 4 years at a discount rate of 10%.

Required:

Calculate the present value of these cash flows:

(a) assuming the first arises one year from present time

(b) assuming the cash flows commenced in:

i. Year 4,

ii. Year 0.

Time 0 1 2 3 4 5 6 7 8 9

Time 0 1 2 3 4 5 6 7 8 9

Time 0 1 2 3 4 5 6 7 8 9


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M

Inventory Receivables

Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M

Days

Payables

365 Maximum level


Perpetuities

A form of annuity that arises forever (in perpetuity).

In this situation the calculation of the present value of the future cash flows is:

Present value of the perpetuity = Cashflowperannum

Interestrate

Example 8

Reecer Co expects to receive $18,000 each year in perpetuity. The current

discount rate is 9%.

Required:

1. Calculate the present value of the perpetuity.

2. Calculate the value if the perpetuity starts in 5 years.


Chapter 3

Capital

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budgeting

27

CHAPTER 3 – CAP ITAL BUDGETING

CHAPTER CONTENTS

CAPITAL BUDGETING ----------------------------------------------------29

RELEVANT COSTS FOR DECISION MAKING 29

TAXATION AS A RELEVANT COST 31

WORKING CAPITAL 31

PRO FORMA 32

NET PRESENT VALUE (NPV) 34

INTERNAL RATE OF RETURN (IRR) 35

NPV AND IRR COMPARED 37


CHAPTER 3 – CAPITAL BUDGETING

CAPITAL BUDGETING

A form of decision-making where the investment occurs in the near future and the

benefits of the investment occur over a longer time, usually a number of years.

We shall use the following example to illustrate capital budgeting.

Example 1

Rainer Co is considering purchasing new equipment costing $515,000, which will

produce a new product line. Rainer Co has conducted extensive research, costing

$30,000, into the market for the new product line and predicts the following expected sales:

Year 1

Sales volume (units) 10,000

2 3 4

12,500 12,500 7,500

The sales price in year 1 is expected to be $30 per unit with a variable production

cost of $12 per unit. Sales prices are subject to inflation of 3% per annum while

variable costs are expected to rise by 4.5% per annum.

After 4 years the equipment will be sold for an expected $70,000.

The new product will require an immediate investment in working capital of

$45,000 which will change in line with sales revenue.

Corporation tax is at the rate of 30%, payable one year in arrears, and writing

down allowances are available on a reducing balance basis at 25%.

The relevant discount rate for this project is 10%.

Required:

Advise whether the equipment should be purchased on financial grounds

only.

Relevant costs for decision making

You should remember from F5 that the only costs and revenues considered in our

d cision should b “r l vant”, fittin th 3 criteria:

FUTURE

CASH FLOW

INCREMENTAL (or DIRECT RESULT)



Future

Only elements of cost and revenue that are yet to arise should be included in any

investment decision.

Costs that have already been incurred (or committed to) are SUNK COSTS and

should be excluded.

Cash flows

Investment decision making should only consider cash costs and revenues. Non-

cash items such as depreciation, amortisation, absorption or apportionment of costs

should be ignored and replaced with the related cash amounts (if any):

● Purchase cost and resale value of non-current assets

● Cash cost of overheads.

Incremental

Investment decision making will only consider costs that change as a direct result

of the decision under review.

Costs that will be incurred regardless are identified as COMMITTED COSTS and will

be excluded such as:

● A portion of a sup rvisor‟s salary wh n th sup rvisor works on th proj ct

being considered.

● A share of head office cost or building rent & rates.

Opportunity cost

As well as cash flows which our proposal gives rise to, we ought to consider any

other cash flows affected by our decision, such as reduced output and sales of other

lines of production due to us using a scarce resource.



Taxation as a relevant cost

If a proposal earns profits, then our company will be due to pay tax on those

profits. The tax payments have to be included as relevant costs.

Tax on operating cash flows

Questions will give (simplified) tax rules for the scenario in question; the workings

will be straightforward:

● If there is a net operating profit in one year, there will be a cash payment

due.

● If there is a net operation loss in one year, there will be a reduction in overall

tax paid by the company, showing as a cash benefit relevant to our

investment.

Workings:

● calculate the net relevant operating cash flow for each year

● multiply each by the given tax rate

● input the result to the indicated year (either a one year delay or in the year of

the cash flow) as a negative figure for profits; a positive figure for losses.

Tax allowable depreciation (capital allowance)

Investment in capital gives rise to tax

allowable depreciation. Over the life

of an asset, the total cash benefit

of this is:

The initial cash benefit is always:

(Investment – residual value) x tax rate% (Investment x Allowance rate x Tax rate)

Allowances over the life will be either straight line (all the same) or reducing

balance (each year is a fixed % lower than the previous).

There will be a final balancing adjustment so that the allowances given equal the

total amount expected.

Working capital

When a company holds inventory and makes sales on credit, it has to provide

additional finance so that operating costs may be paid.

This finance is not an expense so has no tax consequence.

It is likely that the amount invested each year will change. The relevant cash flow

is the change in balance from year to year.

All amounts invested throughout a project will be recovered at the end of the

project.



Pro forma

Pro-forma (assuming tax paid one year after profits)

Operating Cash-flows

Inflows

Outflows

Taxation

Scrap Proceeds

Capital Allowances

Working Capital

$Net relevant cash flow

Present Value Factors

Present Value

1 …

$ $

X X

(X) (X)

X X

(X)

X

(X) (X)

X X

0.xxx 0.xxx

X X

final Final + 1

$ $

X

(X)

X

(X) (X)

X

X X/(X)

X

X (X)

0.xxx 0.xxx

X (X)

Cumulative Present Value X

Less investment (X)

(capital and working capital) Net Present Value X



Example 1

Put the relevant cash flows for Rainer Co into the pro-forma below.

Time 1 2 3 4 5

$ $ $ $ $ Operating Cash-flows

Inflows

Outflows Taxation

Scrap Proceeds

Capital Allowances

Working Capital

$Net relevant cash flow

Present Value Factors

Present Value

Cumulative Present Value

Less investment

(capital and working capital) Net Present Value



Net present value (NPV)

Decision criterion

The cumulative present value of future cash flows is the maximum that the

company would be prepared to invest in the project; the value to investors of the

project.

If the amount required for investment is lower than the value, then accepting the

proj ct will incr as th shar hold rs‟ w alth.

Thus, if the NPV is positive, the investment should be made.

Advantages

1. NPV recognises the time value of money.

2. It is based on relevant cash flows and opportunity costs.

3. NPV iv s a dir ct indication of th impact upon shar hold rs‟ w alth.

4. Can be flexible with different timings of cash flow & different risk for different

projects.

Disadvantage

1. Requires confidence in the estimate of cost of capital.



Internal rate of return (IRR)

The rate of return at which the NPV equals zero.

Example 2

The net cash flows of Rain r Co‟s inv stm nt abov , discount d at % yi ld a n t

present value of $69,000.

Required:

Estimate, on the graph below, the rate at which the NPV would be $NIL.

Time

Operating cash flows

1 2

$’000 $’000

167 212

3 4 5

$’000 $’000 $’000

217 202 1

PVF @ %

PV

Cumulative

Initial investment (non-current assets plus working capital) $560

NPV

„

69 x

10% r%



Linear interpolation

We can estimate the IRR by linear interpolation. This uses the following formula.

Interpolated IRR = L NL - NH

(H - L)

Where:

L = Lower discount rate

H = Higher discount rate

NL = NPV at lower discount rate

NH = NPV at higher discount rate

Example 3

Th n t cash flows of Rain r Co‟s inv stm nt abov , discounted at 10% yield a net

present value of $69,000. At 18%, the corresponding figure is -$29,000. Required:

Estimate, using the formula, the IRR of the project. The IRR can be estimated using any pair of costs of capital. Each pair will give a

slightly different result. Exam marks are awarded for the technique rather than

precisely matching the solution given in the answers. In the Rainer Co example, a

second guess of 15% would give an IRR of 15.3%; a second guess of 20% would

have given 15.8%, and a second guess of 5% would have given an IRR of 14.5%

Decision criterion

If the IRR is greater than the estimated cost of capital, it is assumed that the

project has a positive NPV so should be accepted. 36 w w w .s tudyinte ract ive .o rg

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P D a e d ß

= + e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= + e d

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= +

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P D a e d ß = + e d

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= + e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level


Advantages

1. Like the NPV method, IRR recognises the time value of money.

2. It is based on cash flows, not accounting profits.

3. IRR can be used in cases where it is not possible to calculate an accurate cost

of capital but only a reasonable estimate can be given. IRR gives a breakeven

figure and, so, a margin of safety for the estimate.

Disadvantages

1. Does not indicate the size of the investment.

2. It can give conflicting signals with mutually exclusive projects.

3. If a project has irregular cash flows there is more than one IRR for that

project (multiple IRRs).

NPV and IRR compared

Single investment decision

A single project will be accepted if it has a positive NPV at the required rate of

return. If it has a positive NPV then, it will have an IRR that is greater than the

required rate of return.

Mutually exclusive projects

Two projects are mutually exclusive if only one of the projects can be undertaken.

In this c ircumstance the NPV and IRR may give conflicting recommendation.

The reasons for the differences in ranking are:

1. NPV is an absolut m asur but th IRR is a r lativ m asur of a proj ct‟s

viability.

2. Reinvestment assumption. The two methods are sometimes said to be based

on different assumptions about the rate at which funds generated by the

project are reinvested. NPV assum s r inv stm nt at th company‟s cost of

capital, IRR assumes reinvestment at the IRR.


CHAPTER 3 – CAP ITAL BUDGETING 38 w w w .s tudyinte ract ive .o rg

Chapter 4

Investment appraisal

techniques


CHAPTER 4 – INVESTMENT APPRAISAL TECHNIQUES

CHAPTER CONTENTS

INFLATION AND D.C.F.---------------------------------------------------41

THE FISHER EFFECT 41

ASSET REPLACEMENT ----------------------------------------------------43

EQUIVALENT ANNUAL COST (EAC) 43

CAPITAL RATIONING ----------------------------------------------------45

HARD CAPITAL RATIONING 45

SOFT CAPITAL RATIONING 45

SINGLE PERIOD CAPITAL RATIONING 46

MULTI-PERIOD CAPITAL RATIONING 48

UNCERTAINTY ------------------------------------------------------------49

SENSITIVITY ANALYSIS 49

EXPECTED VALUES 50

ADJUSTED ISCOUNT RATES 51

PAYBACK 51

LEASE OR BUY DECISION------------------------------------------------52

ROCE - ARR----------------------------------------------------------------53


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i

Profit after tax


=


R Theoretical




o 1 1 I

Days


INFLATION AND D.C.F.

There two ways of dealing with inflation:

1. Include inflation by inflating the cash flows year on year.

2. Exclude inflation (and take the cash flows in current terms).

Include inflation

(money analysis)

Inflate cash flows by the inflation rates

given

Discount with

a money (or nominal) rate of return

Exam tip

Must use where there is more than one

inflation rate in the question

Must use if there is taxation paid in

arrears

Must use if there is tax allowable

depreciation

Exclude inflation

(real analysis)

Leave cash flows in current terms

Discount with

a real rate of return

Exam tip

Can use where a single inflation rate is

given for an easier computation

Expected where activity levels are

constant over a long period of time

(an annuity excluding inflation)

The Fisher effect

The relationship between real and money interest is given in the formula sheet:

(1 + i) = (1 + r)(1 + h)

It is easier to remember as:

(1 + m) = (1 + r) (1 + i)

or

(1 + nominal) = (1 + real) (1 + inflation)

Where

r = real discount rate

m = money (or nominal) discount rate

i = inflation rate

Example 1

r = 8% i = 5%

Required:

Calculate the money rate.



Example 2

m = 12.3% i = 4%

Required:

Calculate the real rate of return.

Example 3

A company has to invest $450,000 in a project. The investment will result in new

product sales of 6,000 units each year for 3 years. There will be no residual value

for equipment used.

The selling price of the new product is $50 per unit and the incremental costs of

sale are $15 per unit, both in current terms.

Th company‟s WACC is 2% and inflation is xp ct d to b 3.6%

Required:

Calculate the NPV using both the money and real analyses.



ASSET REPLACEMENT

The decision is how to replace an asset, not whether. We aim to adopt the most

cost effective replacement strategy. The comparison may be complicated by having

different asset life cycles for different options.

Key ideas/assumptions:

1. Cash inflows from trading (revenues) are not normally considered in this type

of question. The assumption being that they will be similar regardless of the

replacement decision.

2. The operating efficiency of machines will be similar with differing machines or

with machines of differing ages.

3. The assets will be replaced in perpetuity or at least into the foreseeable

future.

Equivalent annual cost (EAC)

Options with different life cycles are compared by calculating the EAC. It is a

hypothetical payment which, if made annually, would result in the same PV of costs

as the option being considered.

If all options have an EAC, a direct comparison may be made and the least costly

found.

Formula

EAC = PV of ass t‟s costs ÷ Annuity factor for ass t lif



Example 6

A company has to decide on the optimal replacement cycle for a fleet of delivery

vehicles. Each will be used for a minimum of 3 years.

The purchase cost (in current terms) is $45,000 per vehicle. The resale value and

running costs of the different options is given in the following table:

Year

Annual running cost

Resale Value at year end

1 2 3

5,000 5,000 5,000

n/a n/a 18,000

4 5

7,000 11,000

14,000 6,000

Required:

Using the equivalent annual cost method, calculate whether the company

should replace its fleet after three, four or five years. Use a cost of capital

of 8%.

Step 1

Establish the present value of costs of each option.

Year

8% PVF

Annual running cost

1 2

0.926 0.857

5,000 5,000

3 4 5

0.794 0.735 0.681

5,000 7,000 11,000

PV

Resale Value at year end n/a n/a 18,000 14,000 6,000

PV

Step 2

Use the equivalent annual cost formula & look for the lower amount.



CAPITAL RATIONING

A limit on the level of funding available to a business.

There are two types:

● Hard capital rationing.

● Soft capital rationing.

Hard capital rationing

Externally imposed by banks and capital markets, due to:

1. Wider economic factors (eg a credit crunch).

2. Company specific factors

● (a) Lack of asset security

● (b) No track record

● (c) Poor management team.

Soft capital rationing

Capital budgeting limits are internally imposed by senior management. This is

contrary to th rational aim of a busin ss which is to maximis shar hold rs‟ w alth

(ie to take all projects with a positive NPV).

Reasons:

1. Lack of management skill

2. Wish to concentrate on relatively few projects

3. Unwillingness to take on external funds

4. Only a willingness to concentrate on strongly profitable projects.



Single period capital rationing

There is a shortage of funds in the present period which will not arise in following

periods. Note that the rationing in this situation is very similar to the limiting factor

decision that we know from decision making. In that situation we maximise the

contribution per unit of limiting factor.

Example 7

The funds available for investment are $250,000. All investments must be started

immediately. Project

A

B

C

D

Initial investment NPV

$000s $000s 100 25

200 35

80 21

75 10

Required:

Identify the investment plan which will maximise the value of the

company.

Scenario 1: divisibility

ie each project can be taken in part and the returns (NPV) will be proportionate to

the amount of investment.

Key working: Profitability index (P.I.)

P.I. = NPV ÷ Investment

Project Working P.I. Ranking

A

B

C

D

Funds available Projects undertaken NPV earned



Scenario 2: non-divisible projects

The projects are taken as a whole or not at all.

Key

We identify all possible mixes and establish which mix generates the maximum

NPV.

Example 7 Required:

Identify the investment plan to maximise the return to the company

assuming the projects are non-divisible.



Multi-period capital rationing

A more complex environment where there is a shortage of funds in more than one

period. This makes the analysis more complicated because we have multiple

constraints and multiple outputs. Linear programming would have to be employed.

Example 8

Horge Co is reviewing investment proposals that have been submitted by divisional

managers. The investment funds of the company are limited to $800,000 in the

current year. Details of three possible investments, none of which can be delayed,

are given below.

Project 1

An investment of $300,000 in work station assessments. Each assessment would

be on an individual employee basis and would lead to savings in labour costs from

increased efficiency and from reduced absenteeism due to work-related illness.

Savings in labour costs from these assessments in money terms are expected to be as follows:

Year 1 2

Cash flows ($'000) 85 90

3 4 5

95 100 95

Project 2

An investment of $450,000 in individual workstations for staff that is expected to

reduce administration costs by $140,800 per annum in money terms for the next

five years.

Project 3

An investment of $400,000 in new ticket machines. Net cash savings of $120,000

per annum are expected in current price terms and these are expected to increase

by 3.6% per annum due to inflation during the five-year life of the machines.

Horge Co has a money cost of capital of 12% and taxation should be ignored.

Required:

Determine the best way for Horge Co to invest the available funds and

calculate the resultant NPV:

(a) on the assumption that each of the three projects is divisible;

(b) on the assumption that none of the projects are divisible.



UNCERTAINTY

Consideration of uncertainty is particularly important when performing investment

appraisal due to:

1. Long timescale

2. Outflow today, inflow in the future

3. Large size in relation to the size of the company

4. Strategic nature of the decision.

Techniques available:

1. Sensitivity analysis

2. Expected values

3. Adjusted discount rates

4. Payback.

Sensitivity analysis

A technique that considers a single variable at a time and identifies by how much

that variable has to change for the decision to change (from ac cept to reject).

Example 9

An initial investment of $50,000 is expected to give rise to the following cash flows

for each of years 1 to 3. The discount rate is 10%.

Fixed cost

$ per annum

65,000

Variable costs (10,000 units at $3/unit)

Selling price ($12 per unit)

30,000

120,000

Required:

(a) Calculate the NPV for the investment.

(b) Calculate by how much the values would have to change for the

decision to alter for:

(i) The unit sales price;

(ii) The annual sales volume;

(iii) The annual fixed cost.

Key working

Sensitivity

Margin =

Net Present Value

Present Value of the cash flow

under consideration



Expected values

Where there is a range of possible outcomes which can be identified and a

probability distribution can be attached to those values. In this situation we may

stablish som sort of „av ra ‟ r turn. The expected value is the arithmetic mean of the outcomes as expressed below:

EV = px

Where p = the probability of an outcome

x = the value of an outcome

Example 10

Toorongs Co is developing a new product, the Wryte which will be launched after

further significant investment in plant and machinery.

If Toorongs makes the Wryte, there are four possible levels of success which will

affect the sales volume; the length of the life cycle and the costs identified with the

investment.

The relevant cash flows of each outcome have been analysed, resulting in the

following NPV figures, along with associated probabilities estimated for each outcome.

Outcome

Strong success

Moderate success

Marginal success

Failure

NPV ($‟ )

1,250

650

320

(750)

Probability Working (px)

0.12

0.30

0.25

0.33

Required:

(a) What is the expected value of the project?

(b) Suggest possible problems with basing this decision on expected

values.



Adjusted discount rates

If an individual investment or project is perceived to be more uncertain than

existing investments, the company could adjust the discount rate up to reflect the

additional risk. The problem in doing so is that any adjustment would be arbitrary.

Payback

The payback period is a measure of how long it takes the income of an investment

to cover the initial outlay. If we consider the payback period, we focus on the

earlier activities of the project, those where there is less uncertainty.

Example 11

Th n t cash flows of Rain r Co‟s inv stm nt in th last chapt r ar shown b low.

Required:

Calculate the payback period of the project.

Time


Cumulative

1 2

$’000 $’000

167 212

3 4 5

$’000 $’000 $’000

217 202 1


On critic ism of payback is that it do sn‟t consid r tim valu of mon y; th cash

flows in year 3 are given the same weighting as those in year 1. It is possible to

modify the working to arrive at a discounted payback period.

Example 12

Required:

Calculate the discounted payback period for Rainer’s investment project.

Time


PVF @ 10%

PV

Cumulative

1 2

$’000 $’000

167 212

0.909 0.826

152 175

3 4 5

$’000 $’000 $’000

217 202 1

0.751 0.683 0.621

163 138 1




LEASE OR BUY DECISION

A specific decision that compares two specific financing options, the use of a finance

lease or buying outright financing via a bank loan.

Key information

1. Discount rate = after tax cost of borrowing, Kd(1 – T)

The rate is given by the rate on the bank loan in the question, if it is pre-tax

then the rate must be adjusted for tax. If the loan rate was 10% pre-tax and

corporation tax is 30% then the after-tax rate would be 7%. (10% x (1 – 0.3)

2. Cash flows

Purchase Lease

1/ Cost of the investment

2/ WDA tax relief on investment

3/ Residual value

1/ Lease rental

- in advance

- annuity 2/ Tax relief on rental

Example 13

Smitcher Co is considering how to finance a new project that has been accepted by

its investment appraisal process.

For the four year life of the project the company can either arrange a bank loan at

an interest rate of 15% before corporation tax relief. The loan is for $100,000 and

would be taken out immediately. The residual value of the equipment is $10,000 at

the end of the fourth year.

An alternative would be to lease the equipment over four years at a rental of

$30,000 per annum payable in advance.

Tax is payable at 33% one year in arrears. Capital allowances are available at 25%

on the written down value of the asset.

Required:

Calculate whether it is financially cheaper to buy or lease the equipment.

Other considerations (leasing or buying)

1. Who receives the residual value in the lease agreement? It is possible that

the residual value may be received wholly by the lessor or almost completely

by the lessee.

2. There may be restrictions associated with the taking on of leased equipment.

The agreements tend to be much more restrictive than bank loans.

3. Are there any additional benefits associated with lease agreement? Many

lease agreements will include within the payments some measure of

maintenance or other support services.



ROCE - ARR

One final approach to capital investment decision making is to calculate and

consider the avera r turn on capital mploy d (ROCE) or „accountin rat of

r turn‟ (ARR) that th proposal will n rat ov r its lif .

Advantages

1. Provides a measure that is consistent with one measure that may be applied

by company analysts and so may be more widely understood by less well

financially aware observers.

Disadvantages

1. Does not address shareholder wealth maximisation or the time value of

money.

2. As a percentage (relative measure), ARR does not indicate the size of the

investment.

3. It is based upon accounting profits rather than relevant cash flows.

4. Unlike NPV or IRR, which have risk-based target figures, there is no reliable

way of finding a target ARR.

Example 14

The net operating profit after tax for Rain r Co‟s inv stm nt in th last chapter is

calculated below (note no tax delay shown). The initial capital investment would be

$515,000 with a residual value of $70,000 after 4 years.

Required:

Calculate the accounting rate of return of the project.

Time

Operating contribution

Corporation tax

Tax Allowable Depreciation

Profit after Taxation

1 2

$’000 $’000

180 229

54 69

39 29

165 189

3 4

$’000 $’000

234 142

70 43

22 44

186 143

Average Profit per annum =

Average level of capital employed =

ARR =


CHAPTER 4 – INVESTMENT 54

APPRAISAL TECHNIQUES


Chapter 5

Sources of long term finance


CHAPTER 5 – SOURCES OF LONG TERM FINANCE

CHAPTER CONTENTS

EQUITY --------------------------------------------------------------------57

ORDINARY SHARES 57

PREFERENCE SHARES 57

DEBT -----------------------------------------------------------------------58

SECURITY 58

TYPES OF DEBT 58

TYPES OF ISSUED DEBT 59

OTHER SOURCES----------------------------------------------------------60

ISLAMIC FINANCE--------------------------------------------------------61

WHAT IS ISLAMIC FINANCE? 61



EQUITY

Equity relates to the ownership rights in a business.

Ordinary shares

1. Owning a share confers part ownership.

2. High risk investments offering higher returns.

3. Permanent financing.

Advantages (to the company)

1. No fixed charges (e.g. interest payments).

2. No repayment required – shareholders will not force liquidation.

3. Shares in listed companies can be easily disposed of at a fair value, making

them more attractive and, therefore, more valuable, than unlisted companies.

Disadvantages (for the company)

1. Issuing equity finance can be expensive in the case of a public issue (see

later).

2. Carries a higher cost than loan finance, both for risk and for giving no tax

relief.

3. Problem of dilution of ownership if new shares issued.

4. A high proportion of equity can increase the overall cost of capital for the

company. (Chapter 4).

Preference shares

1. Fixed dividend.

2. Paid in preference to (before) ordinary shares.

3. Not very popular, it is the worst of both worlds, ie:

● not tax efficient

● no opportunity for capital gain (fixed return).



DEBT

The loan of funds to a business without any ownership rights.

1. Paid out as an expense of the business (pre-tax).

2. Risk of default if interest and principal payments are not met.

Security

Charges

The debt holder will normally require some form of security against which the funds

are advanced. This means that in the event of default the lender will be able to

take assets in exchange of the amounts owing.

Covenants

A further means of limiting the risk to the lender is to restrict the actions of the

directors through the means of covenants. These are specific requirements or

limitations laid down as a condition of taking on debt financing. They may include:

1. Dividend restrictions.

2. Financial ratios.

3. Financial reports.

4. Issue of further debt.

Types of debt

Debt may be raised from two general sources, banks or investors.

Bank finance

For companies that are unlisted and for many listed companies the first port of call

for borrowing money would be the banks. These could be the high street banks or

more likely for larger companies the large number of merchant banks concentrating

on „s curitis d l ndin ‟.

This is a confidential agreement that is by negotiation between both parties.

Traded investments

Debt instruments sold by the company, through a broker, to investors. Typical

features may include:

1. The debt is denominated in units of $100, this is called the nominal or par

value.

2. Interest is paid at a fixed rate on the nominal or par value.

3. The debt has a lower risk than ordinary shares. It may be protected by the

charges and covenants.



Types of issued debt

They include:

Debentures

Debt secured with a charge against assets (either fixed or floating), low risk debt

offering the lowest return of commercially issued debt.

Unsecured loans

No security meaning the debt is more risky requiring a higher return.

Mezzanine finance

High risk finance raised by companies with limited or no track record and for which

no other source of debt finance is available.

buy-out.


A typical use is to fund a management

59


OTHER SOURCES

Sale and leaseback

1. Selling good quality fixed assets such as high street buildings and leasing

them back over many (25+) years.

2. Funds are released without any loss of use of assets.

3. Any potential capital gain on assets is forgone.

Grants

1. Often related to regional assistance, job creation or for high tech companies.

2. Important to small and medium sized businesses (i.e. unlisted).

3. They do not need to be paid back.

Retained earnings

The single most important source of finance, for most businesses the use of

retained earnings is the core basis of their funding.

Warrants

1. An option to subscribe for shares at a specified point in the future for a

specified (exercise) price.

2. The warrant offers a potential capital gain where the share price may rise

above the exercise price.

3. Warrants are commonly given as additional consideration when issuing debt.

● Warrants are issued (granted) with the debt to make lending more

attractive.

● Warrants can be separated from the debt and sold by the lender to raise

cash prior to maturity of the loan stock.

● If the share price performs well and warrants are exercised, it results in

a cash injection to the company – often sufficient to repay the debt.

Convertible loan stock

A debt instrument that may, at the option of the debt holder, be converted into

shares. The terms are determined when the debt is issued and lay down the rate of

conversion (debt:shares) and the date or range of dates at which conversion can

take place.

The convertible is offered to encourage investors to take up the debt instrument.

Th conv rsion off rs a possibl capital ain (valu of shar s › valu of d bt).

The difference with warrants is that the convertible debt holders are the ones who

take up the shares; since warrants are separable from loan stock, there could be

two different groups of investors involved.



ISLAMIC FINANCE

What is Islamic finance?

A form of financ that sp cifically follows th t achin s of th Qu‟ran.

Th t achin s of th Qu‟ran ar th basis of Islamic Law or Sharia. Sharia Law is,

however, not codified and as such the application of both Sharia Law and, by

implication, Islamic Finance is open to more than one interpretation.

Prohibited activities

In Shariah Law there are some activities that are not allowed and as such must not

be provided by an Islamic financial institution, these include:

1. Gambling (Maisir)

2. Uncertainty in contracts (Gharar)

3. Prohibited activities (Haram)

Riba

Interest in normal financing relates to the monetary unit and is based on the

principle of time value of money. Sharia Law does not allow for the earning of

interest on money. It considers the charging of interest to be usury or the

„comp nsation without du consid ration‟. This is called Riba and underpins

all aspects of Islamic financing.

Instead of interest a return may be charged against the underlying asset or

investment to which the finance is related. This is in the form of a

premium being paid for a deferred payment when compared to the

existing value.

There is a specific link between the charging of interest and the risk and

earnings of the underlying assets. Another way of describing it is as the

sharing of profits arising from an asset between lender and user of the

asset.

Forms of Sharia compliant finance

There are some specific types of finance that are deemed compliant and allow

Islamic finance to offer similar financial products to those offered in normal

financing, these include:

● Murabaha – trade credit

The sale price of goods is agreed to cover all costs and generate a profit

margin. The time value of money is incorporated in the costs. There is a

r assuranc that th „cr dit‟ is bas d on trad and not simply a financin

transaction.

● Mudaraba – equity finance

A profit sharing contract where one party provides capital and the other the

expertise to invest the capital and manage the activities.

agreed ratio of profit share.


There is a pre-

61

CHAPTER 5 – SOURCES OF LONG TERM FINANCE ● Musharaka – venture capital

Has more in common with a joint venture than an equity investment. All (or

most) investors will have an active role in managing the business.

„ iminishin musharaka‟ allows for busin ss own rship to radually b

transferred over a period of time to a single owner, in a similar way to

venture capitalists creating an exit strategy based upon sale of shares.

● Ijara – lease finance

A bank makes an asset available to a customer for a fixed period in exchange

for a fixed price. At the end of the period, the customer often has the option

to pay a fixed price in return for transfer of ownership of the asset from the

bank.

● Sukuk – debt finance


Chapter 6

Cost of capital


CHAPTER 6 – COST OF CAPITAL

CHAPTER CONTENTS

INTRODUCTION TO THE COST OF CAPITAL----------------------------65

COST OF EQUITY----------------------------------------------------------66

1 IVIDEND VALUATION MODEL 66

2 THE CAPITAL ASSET PRICING MODEL (CAPM) 69

THE COST OF DEBT -------------------------------------------------------70

WACC – WEIGHTED AVERAGE COST OF CAPITAL---------------------73


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


INTRODUCTION TO THE COST OF CAPITAL

Risk and return

“Risk” is the anticipated variability in income from an investment.

Different investments have different degrees of risk. The higher the risk, the higher

the return required to cover that risk. Importantly, this helps as a starting point to

the identification of a cost of capital.

The two main sources of capital

It is lik ly that a company‟s total financ com s from a numb r of sourc s .

Initially, we will limit our studies to the two main sources of finance:

1. Equity

Ordinary shareholders make an investment which carries with it all the risks of the

business.

The annual return to ordinary shareholders is in no way guaranteed or predictable

and, so, can b d fin d as „risky‟.

2. Debt

Banks and individuals make loans to a company with contractual terms for payment

of interest and repayment of the capital lent . The company is obliged to make any

such payments before being allowed to distribute earnings to shareholders.

Th l nd r oft n insists on „s curity‟; th ri ht to s iz sp cifi d ass ts should th

borrower default on the loan.

The contractual obligation plus any security make debt a far less risky form of

finance with a correspondingly lower required return from investors.



COST OF EQUITY

This may be calculated in one of two ways:

1. Dividend Valuation Model (DVM).

2. Capital Asset Pricing Model (CAPM).

1 Dividend valuation model

In Chapter 1, we saw that shares may be valued by the market (all shareholders)

based upon future dividends and dividend growth.

P0 = ( )

-

If our company has a listed share price (P0) and we know what dividend and

dividend growth the shareholders are expecting (as financial managers, we have

told them this), then we can rearrange the formula to find the cost of equity (Ke)

that shareholders must have used to arrive at the share value.

= ( )

P

where g =

D0 =

a constant rate of growth in dividends

current dividend

P0 = Th curr nt “ x-div” shar pric

Note: D0(1+g) finds the dividend expect d in on y ar‟s tim ( 1)

“ x-div” is th shar pric imm diat ly after a dividend has been paid

“cum-div” is th pric imm diately before a dividend is paid

Th diff r nc b tw n “ x-div” and “cum-div” is th valu of th

dividend, D0

Example 1

Clarence Co has a share price of $4.00 and has recently paid out a dividend of 20

cents. Dividends are expected to grow at an annual rate of 5%.

Required:

Calculate the cost of equity.



Example 2

Wendyhouse Co has a cum-dividend share price of 369 cents and due to pay out a

dividend of 36 cents per share. Dividends are expected to grow at an annual rate

of 4%. Required:


Estimating Growth

There are 2 main methods of determining growth:

1 THE AVERAGING METHOD

1

g = 1

n

where Do =

Dn =

current dividend

dividend n years ago

Example 3

Sissossokoko Co paid a dividend of 20 cents per share 4 years ago, and the current

dividend is 33 cents. The current share price is $6 ex div. Required:

(a) Estimate the rate of growth in dividends.

(b) Calculate the cost of equity.

Example 4

Masheranno Co paid a dividend of 6 cents per share 8 years ago, and the current

dividend is 11 cents. The current share price is $2.58 ex div. Required:


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b

Days

Payables

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R

Profit after tax


=


R Theoretical




o 1 1 I D

Days

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R

Profit after tax


=


R Theoretical




o 1 1 I D

Days


2 GOR ON‟S GROWTH MO EL

g = rb

where r = return on reinvested funds

b = proportion of funds retained

Example 5

The ordinary shares of Tories Co are quoted at $5.00 cum div.

A dividend of 40 cents is just about to be paid.

The company has a return on capital employed of 12% and each year pays out

30% of its profits after tax as dividends. Required:




2 The capital asset pricing model (CAPM)

CAPM starts from having a measure of risk (ß) to calculating the required return.

It is particularly useful where our company does not have listed shares and so we

don‟t hav a P0 for the dividend valuation model.

CAPM formula (given in the exam)

E(r) = Rf + ßi (E(rm) – Rf)

Where: E(r ) is Th xp ct d r turn from inv stm nt “i"

f is th r turn availabl “risk fr ”

ßi is th b ta m asurin th risk of inv stm nt “i"

E(rm) is The average expected return from the market (all

investments together)

Example 6

The market return is 15%. Cowt Co has a beta of 1.2 and the risk free return is

8%.

Required:


Market premium (E(rm) – Rf)

The difference between the average expected return from the market and the risk

fr rat is r f rr d to as th „mark t risk pr mium‟.

Example 7

The risk-free rate of return is 6%.

The market risk premium is 8%.

The beta factor for Krauch Co is 0.8.

Required:

Calculate the expected annual return.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P D

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level


THE COST OF DEBT

There is only one approach to calculate the cost of debt. W can‟t call it “divid nd”

valuation mod l sinc d bt do sn‟t pay divid nds but it follows th sam principl

of: future cash flows related to current market value.

A distinction

1. The “Gross bt Yi ld” is the average annual return to lenders consisting of:

Interest (relative to the amount lent); and,

Capital return (if the amount repaid is different to the amount lent)

2. The cost of debt is the cost to the company of making the payments to

lenders. It consists of interest and capital return (as above) but also:

tax relief that the company earns on interest payments

Notation

1. Gross Debt Yield is Kd

2. Cost of Debt is noted in formulae as Kd(1-t)

However, the cost of debt calculation is more complicated than this may suggest .

Workings

1. Traded debt is always quoted in $100 nominal units or blocks. All workings

are done by reference to $100, regardless of the total amount borrowed.

2. Interest paid on the debt is stated as a percentage of nominal value ($100 as

stated). This is known as the „coupon rate‟. It is not the same as the cost of

debt.

3. Debt can be:

(i) Irredeemable – never paid back.

(ii) redeemable at par (nominal value).

(iii) or redeemable at a premium or discount (for more or less than

nominal).

Kd for irredeemable debt

Kd = i(1- T)

0

where i =

T =

P0 =

interest paid

marginal rate of tax

ex interest (similar to ex div) market price of the loan stock.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.



Example 8

The 10% irredeemable loan notes of Raffer Co are quoted at $120 ex int.

Corporation tax is payable at 30%. Required:

Calculate the cost of debt.

Kd for redeemable debt

The Kd for redeemable debt is found by trial and error to see what cost of capital

must have been used to arrive at P0 .

The relevant cash flows would be:

Time Cash flow %

0 Market value of the loan note P0 1 to n Annual interest payments, net of tax i(1 - T)

n Redemption value of loan RV

Example 9

Wornuck Co has 10% loan notes quoted at $102 ex interest r d mabl in 5 y ars‟

time at par. Corporation tax is paid at 30%. Required:

Calculate the cost of debt.

Time Cash %amount 1s t PVF 1s t PV 2nd PVF 2nd PV

1-5 I(1-T)

5 Redemption

0 P0

1s t NPV 2nd NPV www .s tudyinte ract ive .org 71


Technique

1. 7 columns

2. Identify the cash flows

Post tax interest as an annuity

Final redemption value Current ex-interest market value

3. discount using a first guess percentage

4. discount using a second guess,

5. Estimate where, between the two guesses, the NPV would be zero.

NPV

0 r%



WACC – WEIGHTED AVERAGE COST OF CAPITAL

Th w i ht d av ra cost of capital is th av ra of cost of th company‟s

finance (equity, loan notes, bank loans, and preference shares) weighted according

to the proportion each element bears to the total pool of funds.

WACC formula (given)

WACC = V V

ke + V V

kd (1–T)

Where: ke is the cost of equity

Kd(1-T) is the cost of debt

Ve is the total market value of equity in the company

Vd is the total market value of debt in the company

Example 10

The following information is in the statement of financial position of Barrows Co:

$’000

9% bonds r d mabl in s v n y ars ‟ tim 8,000

Ordinary Shares, par value 25c 5,000

Retained Earnings 3,000

The ex-div share price of Barrows Co is $3.00. The 9% bonds are trading on an ex-

interest basis at $85.00 per $100 bond.

The cost of equity has already been calculated at 15% and the cost of debt is 7.6%.

Required:

Calculate the weighted average cost of capital.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P D

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P D a

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level


Using WACC

WACC can b us d to valuat th company‟s investment projects if the following

conditions apply:

1. The project is insignificant relative to the size of the company;

2. Or th company adopts a „pool d funds‟ approach and:

(i) The company will maintain its existing capital structure in the long run

(ie same financial risk);

(ii) The project has the same degree of business risk as the company has

now.

Convertible Loan Stock

A loan note with an option to convert the debt into shares at a future date with a

predetermined price. In this situation the holder of the debt has the option

therefore the redemption value is the greater of either:

1. The share value on conversion, or

2. The cash redemption value if not converted.

Example 11

Doodeck Co has convertible loan notes in issue that may be redeemed at a 10%

premium to par value in 4 years. The coupon is 10% and the current market value

is $110.

Alternatively the loan notes may be converted at that date into 25 ordinary shares .

The current value of the shares is $4 and they are expected to appreciate in value

by 6% per annum.

The tax rate is 30%.

Required:

Calculate the cost of convertibles.



Preference shares

A fixed rate charge to the company in the form of a dividend rather than in terms of

interest. Preference shares are normally treated as debt rather than equity but

they are not tax deductible. They can be treated using the dividend valuation

model with no growth:

Kp = d

0

Example 12

Mahan Co‟s 9% pr f r nc shar s ($ ) ar curr ntly tradin at $ .4 x-div.

Required:

Calculate the cost of the preference shares.

Non-tradable debt

Bank loans and other non-traded loans have a cost of debt equal to the coupon rate

adjusted for tax.

Kd = Interest rate x (1 – T)

Example 13

Trory Co has a loan from the bank at 12% per annum. Corporation tax is charged

at 30%. Required:

Calculate the cost of debt. www .s tudyinte ract ive .org 75

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P D a e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


Kd for redeemable debt (when redeemed at current market

value)

We could just use the technique outlined above but if the current market value and

the redemption value are the same instead the irredeemable debt formula can be

used.

Example 14

The 10% loan notes of Raffer Co are quoted at $120 ex int . Corporation tax is

payable at 30%. Th y will b r d m d at a pr mium of $2 ov r par in 4 y ars‟

time Required:

What is the net of tax cost of debt using:

(a) redeemable debt calculation?

(b) irredeemable debt calculation?


Chapter 7

Capital structure: financial risk


CHAPTER 7 – CAP ITAL STRUCTURE: F INANCIAL RISK

CHAPTER CONTENTS

CAPITAL STRUCTURE AND THE COST OF CAPITAL--------------------79

GEARING THEORIES------------------------------------------------------80

THE TRADITIONAL VIEW OF CAPITAL STRUCTURE 80

MODIGLIANI AND MILLER – NET OPERATING INCOME 81

PROBLEMS WITH HIGH GEARING 82

PECKING ORDER THEORY 82


CHAPTER 7 – CAP ITAL STRUCTURE: FINANCIAL RISK

CAPITAL STRUCTURE AND THE COST OF CAPITAL

WACC can only be used if the capital structure (financial risk) of a company

remains unchanged.

Impact of debt financing on the WACC

Two competing effects

Reduction in WACC

Debt finance is cheaper because:

Less risky to investor

Tax relief in interest paid

Increase in WACC

Debt introduces financial risk which increases Ke, should lead to an increase

in WACC

The risk associated with debt

financing is borne by the shareholders

Kd ‹ e, an increase in debt funding

should lead to a fall in WACC

Financial risk

A shar hold r‟s arnin s in any company ar risky, d p ndin on th natur of

business carried out by the company.

If the company adds debt to the capital structure, by borrowing, the earnings

available to shar hold rs b com v n mor risky as th l nd rs will hav a „prior

char ‟ (oft n fix d) ov r th company‟s arnin s.

Illustration

All Equity Including Debt

Year

PBIT

Interest

Taxable

Tax (30%)

PAT (Earnings)

1 2 3

12,000 18,000 6,000

- - -

12,000 18,000 6,000

3,600 5,400 1,800

8,400 12,600 4,200

1 2 3

12,000 18,000 6,000

3,000 3,000 3,000

9,000 15,000 3,000

2,700 4,500 1,200

6,300 10,500 1,800

Year-on-year x 1.50 x 0.33 x 1.67 x 0.17



GEARING THEORIES

The traditional view of capital structure

Cost of equity

At relatively low levels of gearing the increase in gearing will have relatively low

impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.

Cost of debt

There is no impact on the cost of debt until the level of gearing is prohibitively high.

When this level is reached the cost of debt rises.

Ke

Cost

of

capital

WACC

Kd(1-T)

Gearing (D/E)

Key point

There is an optimal level of gearing at which the WACC is minimised.

Since company value is based on:

P0 = ( )

-

the value of the company is maximised with a minimum cost of capital.


CHAPTER 7 – CAP ITAL STRUCTURE: FINANCIAL RISK

Modigliani and Miller – net operating income

The basis of this theory is that a company with debt in its capital structure will pay

out a higher total to investors than it would with only equity.

Illustration

Year

PBIT

All Equity 1 2 3

12,000 18,000 6,000

Including Debt 1 2 3

12,000 18,000 6,000

Interest

PAT (Earnings)

Total to Investors

- - -

8,400 12,600 4,200 8,400 12,600 4,200

3,000 3,000 3,000

6,300 10,500 1,800 9,300 13,500 4,800

With a higher return available, investors (debt and equity in total) would be

prepared to invest a higher amount, giving the geared company a higher total

value.

Since the operating cash flows and their growth are the same, the only dif ference

between the two has to be that the geared company has a lower cost of capital

(WACC).

Implication

As the level of gearing rises the overall WACC falls.

having the highest level of debt possible.

Cost

of capital

The company benefits from

Ke

WACC

Kd(1-t)

Gearing (D/D+E)



Problems with high gearing

It is rare to find firms who seek to have very high gearing. This is due to problems

such as:

● bankruptcy

● tax exhaustion

● loss of borrowing capacity

● risk attitude of potential investors.

Pecking order theory

A reflection that funding of companies does not follow theoretical rules but instead

oft n follows th „path of l ast r sistanc ‟.

A suggested order is as follows:

1s t retained earnings

2nd bank debt

3rd issue of equity.


Chapter 8

Business risk and

adjusted discount rates


CHAPTER 8 – BUSINESS RISK AND ADJUSTED DISCOUNT RATES

CHAPTER CONTENTS

CAPM-----------------------------------------------------------------------85

LIMITATIONS OF USING CAPM 87

FINDING A BETA 87

CAPM AND FINANCIAL GEARING ---------------------------------------89

IFFERING BETA VALUES 89

QUESTION APPROACH 90


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


CAPM

We need to understand the limitations of the Capital Asset Pricing Model and, to do

that, we need a good understanding of the three components of the formula.

The risk-free rate of return Rf

This is an estimate of the future return from risk free investments, such as

government loan stocks.

Is it an amount that we can predict with any degree of certainty?

The expected average return from the market E(Rm)

This is a „b st u ss‟ stimat of th r turn that all stocks and bonds will r turn to

investors in the future. If this is over-estimated, the resulting cost of capital would

be too high, possibly resulting in us rejecting worthwhile opportunities. If under-

estimated, we might accept investment opportunities which do not give sufficient

return to compensate investors for their risk.

Beta

A beta value is calculated using regression analysis of historical data plotting the

total return on a share over a 12 month period against the total return on the

whole market over the same period.

Total return on the share is calculated by looking that the change in share price and

the dividend as a percentage.

Example 1

From the following information about share in Carol Co, calculate the annual return

to June 2011 and the annual return to September 2011.

2010 2011

June

Share price (cents) 400

September June

480 440

September

482

Dividend (paid December) 10 cents 15 cents

This data is historical and, therefore, not a reliable indicator of future

performance. However, it forms the basis of our calculation of beta.



Calculating beta

You will not perform any calculations of beta from historical data but need to be

aware of one critical point.

Regression Analysis finds a straight line of best fit through pairs of data.

Return on

Share x

x

x

x x

x

x x x

x x

Return on Market

Th slop of this lin is th shar ‟s b ta valu , r fl ctin busin ss and financial risk

relative to the average in the stock market.

The beta value ignores that most of the pairs of data lie some way off the line of

best fit. Th diff r nc b tw n ach „x‟ and th lin of b st fit is du to a specific

factor relating to that company at the specific time the data are gathered.

Unsystematic risk

Th s sp cific variations ar known as th „unsyst matic risk‟ of th shar . In

using CAPM, we assume that shareholders are not affected by (or exposed to)

unsystematic risk.

Diversification

An investor can minimise his exposure to specific risk factors of an industry or a

particular company by spreading his wealth over a diverse range of stocks and

shares, creating a balanced and diversified portfolio of investments.

In a well-diversified portfolio, losses or poor returns on one share will be balanced

by better than expected returns on others. In other words, positive unsystematic

risk factors will be cancelled elsewhere by negative unsystematic risk factors.

An investor with a well-diversified portfolio can, therefore, ignore unsystematic risk

and concentrate on earning the returns indicated by CAPM, reflectin “systematic

risk” only.



Limitations of using CAPM

As well as calculating costs of capital using CAPM, questions will expect you to

explain the circumstances in which CAPM is appropriate.

Criticisms of the CAPM

1. Using beta assumes that all shareholders invest in well diversified portfolios.

Whilst this may be the case for the majority of companies listed on major

stock exchanges, it is very unlikely to be the case for smaller, family -run

businesses.

2. Any beta value calculated will be based on historic data which may not be

appropriate currently.

3. The market return may change considerably over short periods of time.

4. CAPM assumes an efficient investment market where it is possible to diversify

away risk. This is not necessarily the case meaning that some unsystematic

risk may remain.

Finding a beta

Questions will never expect you to calculate a beta from first principles. You will,

however, have to know where to look for the appropriate beta so that you can work

out the correct cost of capital. There are three main scenarios.

1. A quoted company expanding its current activities

Since it is quoted, it will have its own beta value.

Since it is staying in the same business area, the given beta value reflects the

risks of the new investment.

2. A quoted company diversifying into new areas of business

Th company‟s curr nt b ta do s not r fl ct th busin ss risk of th n w

investment so should not be used.

We need to find the beta of a company in the same business sector as the

new activity – a “proxy” company.

(W may n d to adjust th proxy company‟s b ta for financial risk

differences).

3. An unlisted company

Since it has no listed share price, there will be no beta value for the company.

Therefore, we would always have to find a proxy company.



Example 2

2shack Co is a listed company whose shares have a beta of 0.7 and a cost of capital

of 17% p.a. rf

= 10% and rm

= 20%.

A new project has arisen with an estimated beta of 1.3. Required:

(a) What is the required return of the project?

(b) What relationship does this have to the cost of capital to the

company? 88 w w w .s tudyinte ract ive .o rg


CAPM AND FINANCIAL GEARING

If we introduce debt financing, the level of risk will rise and hence the cost of equity

Ke will rise.

Differing beta values

Risk

βequity

Financial Risk

β asset

Business Risk for

„this‟ industry

Risk Free βdebt = 0

Gearing (D/D+E)

Equity beta (βequity)

A measure of risk incorporating both business risk and financial risk.

Asset beta (βasset)

A measure solely of business risk. In a debt-free company, the equity beta would

be the asset beta. The asset beta will be the same for all companies in the same

industry.

Key formula

V V (1T)

(V V (1T)) e(V V (1T))

d

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.



Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.



Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.





Question approach

1. Equity beta

Identify a suitable equity beta – we need a value from a company in the similar

industry. This beta will probably include gearing risk (if the company has any debt

finance).

2. De-gear

Use the formula given to strip out the gearing risk to calculate the asset beta for

the project. The asset beta will be the same for all companies/ projects in a similar

industry.

3. Average asset beta

To calculate a meaningful asset beta it is useful to use a simple average of a

number of proxy asset betas. This way a better assessment of the level of

systematic risk suffered by the industry is calculated.

4. Re-gear

Re-work the same formula to add back the unique gearing relating to the project.

5. Use CAPM

Calculate the cost of equity using the CAPM formula.

Example 3

Foreignin Co is a wooden doll manufacturer with an equity:debt ratio of 5:3. The

corporate debt, which is risk free, has a gross redemption yield of 6%. The beta

valu of th company‟s quity is .2. The average return on the stock market is

11%. The corporation tax rate is 30%.

The company is considering a games console project. The following three

companies are currently operating in the gaming industry.

Company

Equity beta

Debt (%)

Equity (%)

T L C

1.05 1.10 1.18

30 35 40

70 65 60

Foreignin Co maintains its existing capital structure after the implementation of the

new project.

Required:

What would be a suitable cost of capital to apply to the project?



Example 4

Tush-aq Co, an all equity agro-chemical firm, is about to diversify into the

consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the

average equity of pharmaceutical firms is 1.3. Gearing in the pharmaceutical

industry averages 40% debt, 60% equity. Corporate debt is considered to be risk

free.

Rm = 10%, R = 4%, corporation tax rate = 30%. Required:

What would be a suitable cost of equity for the new investment if Tush-aq

were to finance the new project in each of the following ways:

(a) 30% debt;

(b) 70% debt? www .s tudyinte ract ive .org 91

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e d V V P D a e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

CHAPTER 8 – BUSINESS RISK AND ADJUSTED DISCOUNT RATES 92 w w w .s tudyinte ract ive .o rg

Chapter 9

Financial performance measurement


CHAPTER 9 – FINANCIAL PERFORMANC E MEASUREMENT

CHAPTER CONTENTS

PROFITABILITY RATIOS-------------------------------------------------95

RETURN ON CAPITAL EMPLOYED – ROCE 95

RETURN ON EQUITY – ROE 95

GEARING ------------------------------------------------------------------97

COST 97

ISK – FROM THE PERSPECTIVE OF THE COMPANY 97

FINANCIAL GEARING MEASURES---------------------------------------99

CAPITAL GEARING 99

INTEREST COVER 100

INVESTOR RATIOS ----------------------------------------------------- 102


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level


PROFITABILITY RATIOS

The underlying short-term aim of a company.

There are two basic measures:

1. Return on Capital Employed (ROCE).

2. Return on Equity.

Return on capital employed – ROCE

A measure of the underlying performance of the business before finance.

It considers the overall return before financing. It is not affected by gearing.

ROCE = Operating Profit

X 100 Capital employed

Operating profit

Also known as PBIT or profit before interest and tax.

Capital employed

The total funds invested in the business, it includes Equity and Long-term Debt.

Return on equity – ROE

A measure of return to the shareholders. It is calculated after taxation and before

dividends have been paid out. It will be affected by gearing.

ROE = Profit after tax

X 100

Equity

Key working

$

PBIT

less Interest ()

PBT

Less Tax ()

PAT

Less Dividends ()

Retained Earnings


Example 1 Case

A company is considering a number

project may be funded by $20m

statements given the project has be

Statement of Financial Position extr

Equity Creditors

Debentures (10%) Capital Share Capital (50p)

Share Premium

Reserves

Income Statement extract

$m Turnover

Gross Profit

less expenses (excluding interest)

Operating Profit

Corporation Tax is charged at 30%.

Required:

Calculate profitability ratios an

company under both equity and

of fu

of e

en fu

act

Fina $m

0.0

nding options for

quity or debt . nded in either ma nce Deb

) 0

pare the

financ funding.

a ne

Belo

nner. t

Fina $m 20.0

w project . The

new w are the

financial nce erformance of the

22.0

10.0

10.0

14.5

4.5

3.0 42.0

22.0

200.0

40.0 (30.

0

10.

d com

debt

ial p



GEARING

Should we finance the business using debt or equity?

There are two basic considerations:

1. Cost.

2. Risk.

Cost

Any finance will incur servicing costs, debt will require interest payments and equity

will require payment of dividends or at least capital growth. On the basis of cost of

servicing we would always pick debt over equity. Debt should be less expensive for

two reasons:

1. Risk

The debt holder is in a less risky position than the shareholder. The lower risk is

due to two factors:

1. Fixed terms – A legal obligation to pay interest and repay debt on stated

dates.

2. Security – Charges or covenants against assets.

2. Tax

Debt is tax deductible because the debt holders are not owners of the business .

Equity however will receive a return after tax because they receive an appropriation

of profits. Debt is therefore tax efficient.

Risk – from the perspective of the company

Risk may be split into two elements:

1. Business risk.

2. Financial risk.

Business risk

Business risk is inherent to the business and relates to the environment in which

the business operates.

1. Competition

2. Market

3. Legislation

4. Economic conditions.



Financial risk (see chapter 4)

If the company finances itself using debt as well as equity then it must generate

sufficient cash flow to pay interest payments as they fall due. The greater the level

of debt, the greater the interest payments falling due and the greater the volatility

of earnings available to shareholders. This is financial risk.

Gearing causes increased risk.

There are two areas of gearing:

1. Operating gearing

Risk associated with the level of fixed costs within a business.

Illustration

Year

Year-on-year

Low Op Gearing 1 2 3

+50% -67%

High Op Gearing 1 2 3

+50% -67%

Turnover

Variable Cost

Fixed Costs

PBIT

12,000 18,000 6,000

6,000 9,000 3,000

1,000 1,000 1,000

5,000 8,000 2,000

12,000 18,000 6,000

1,000 1,500 500

6,000 6,000 6,000

5,000 10,500 (500)

Year-on-year +60% -75% +110% -105%

The higher the fixed cost, the more volatile the profit before interest and tax. This

is one of the main indicators of business risk.

A financial manager does not aim to affect the cost structure; this is not one of our

3 key decisions. However you must be aware that the level of operating risk will

impact on the level of financial risk that a company is willing to take on.

2. Financial gearing

Risk associated with debt financing.

Impact

A company can/must accept some level of risk, and is willing to trade additional risk

for additional gain. The effect of risk is cumulative: if a company already has high

operating gearing it will have to be more conservative with its financial gearing.



FINANCIAL GEARING MEASURES

Th mix of d bt to quity within a firm‟s p rman nt capital.

There are two measures:

1. Capital Gearing – a balance sheet measure.

2. Interest Cover – a profit and loss account measure.

Capital gearing

The mix of debt to equity.

Ratio measure (equity gearing)

Gearing = Debt

X 100 Equity

Proportions measure (total or capital gearing)

Gearing = Debt

X 100 Debt + Equity

Debt

All permanent capital charging a fixed interest may be considered debt.

1. Debentures and loans,

2. bank overdraft (if significant),

3. preference share capital.

Equity

1. Ordinary share capital,

2. share premium,

3. reserves.



Example 3

Statement of financial position extract for Wednap Co

$m $m

Bank overdraft 5.0

9.0

3.0

Long-term liabilities Debenture 10% (8.0)

15.0 Capital

Ordinary share capital 8.0

Ordinary share premium 4.0

Preference share capital 1.0

Reserves 2.0 15.0

Required:

Calculate the financial gearing of the business using both methods.

Interest cover

An income statement measure that considers the ability of the business to cover

the interest payments as they fall due.

Interest cover = PBIT

Interest

Example 4

Stan Ltd statement of comprehensive income extract :

$m

Operating Profit 20.0

Interest (4.5)

Profit Before Tax 15.5

Tax @ 30% (4.65)

Profit After Tax 10.85

Required:

(a) Calculate the interest cover.

(b) Advise whether this level of cover is safe.



Example 5

It is 2012. Arwin plans to raise $5m in order to expand its existing chain of retail

outlets. It can raise the finance by issuing 10% loan notes redeemable in 2019, or by a rights issue at $4.00 per share.

as follows.

Income statement for the last year

Sales

Cost of sales

Gross profit

Administration costs

Profit before interest and tax

Interest

Profit before tax

Taxation at 30%

Profit after tax

Dividends

Retained earnings

The current financial statements of Arwin are

$'000

50,000

30,000

20,000

14,000

6,000

300

5,700

1,710

3,990

2,394

1,596

Statement of Financial Position (Balance sheet) extract $'000

Net non-current assets 20,100

Net current assets 4,960

12% loan notes 2014 2,500

22,560

Ordinary shares, par value 25c 2,500

Retained profit 20,060

22,560

The expansion of business is expected to increase sales revenue by 12% in the

first year. Variable cost of sales makes up 85% of cost of sales. Administration

costs will increase by 5% due to new staff appointments. Arwin has a policy of

paying out 60% of profit after tax as dividends and has no overdraft. Required:

(a) For each financing proposal, prepare the forecast income statement

after one additional year of operation.

(b) Evaluate and comment on the effects of each financing proposal on

the following:

(i) Financial gearing;

(ii) Operational gearing;

(iii) Interest cover;

(iv) Earnings per share.

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n

Profit after tax


=


R Theoretical




INVESTOR RATIOS

Assessing the financial position of the company using key information from the

financial statements.

Dividend cover/ dividend payout ratio

Earnings per share/ PAT

Price/ earnings ratio

DPS/ total dividend

Dividend yield

Share price/ total MV

Earnings per share (EPS)

EPS =

Example 6

The Hoopia Co earned profits after tax of $14m. There are 6 million ordinary

shares in c irculation.

Required:

Calculate the EPS for Hoopia.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P D a e d ß

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


Price earnings ratio (P/E ratio)

The P/E ratio is an indicator of future earnings growth expectations; it compares

the market value to the current earnings.

PE Ratio Current Share Price

EPS

Total Market Value (MV)

Profit After Tax

Example 7

Share Price

EPS

Dividend per share

Number of shares

Dan

200c

10c

2c

2 million

Steph

80c

8c

8c

4 million

Required:

Which company is seen to have a better future by the market?

Dividend payout ratio

The relationship between the dividend paid and the funds available to pay the

dividend, ie the attributable profit.

Dividend cover = Earnings per share

Dividend per share

Profit after tax

Total dividends

Example 7 cont’d Required:

Calculate the dividend payout ratio for each company.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D

Profit after tax


=


R Theoretical




o 1


Dividend yield

Dividend yield = Dividend per share

Share price

Total dividends

Total market value

The cash return from holding a share. It is theoretically irrelevant because it only

considers part of the return available to the shareholder (the other part being the

capital gain or increase in share price).

Example 7 cont’d Required:

Calculate each company’s dividend yield.

Total shareholder return (TSR)

A measure covering the two returns an investor will receive as a result of holding

the share, ie the dividend and the capital gain or loss.

TSR =

Capital gain = current share price - share price at the beginning of the year.

Example 8

2006 2007 2008

Turnover $7.2m $8.0m $7.9m

EPS 58.1c 60.2c 60.1c

DPS 24.3c 26.3c 27.6c

Closing share price $7.25 $8.85 $7.34

Return on equity 11% 9% Required:

Compare and contrast the financial performance of the company with the

expected return on equity.


Chapter 10

Raising equity finance


CHAPTER 10 – RAISING EQUITY FINANCE

CHAPTER CONTENTS

RAISING EQUITY FINANCE-------------------------------------------- 107

UNLISTED COMPANIES 107

LISTED COMPANIES 107

EQUITY ISSUES BY LISTED COMPANIES----------------------------- 109

IGHTS ISSUES 109


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


RAISING EQUITY FINANCE

Unlisted companies

Fundamental issue

As an unlisted company it will be difficult to raise any equity finance. This is due to

the following reasons:

1. Lack of audited information.

2. Marketability.

3. Higher risk of unlisted companies.

Sources of equity for unlisted companies

1. Own funds

2. Retained earnings

3. Friends and family

4. Venture Capital

● High risk/ high return.

● Close relationship between VC and the company being offered finance.

● Medium term (5 – 7 years).

● Exit strategy.

5. Business Angels

6. Private placing.

Listed companies

The methods of obtaining a listing are:

1. Fixed price offer for sale

Offered to the general public at a fixed price.

It has the potential to raise the highest possible price for the company by being

offered to the widest possible market.

The problem is the cost associated with floatation which can be prohibitive.

Advantage: The widest market for shares is sought and hence the highest price

should be achieved.

2. Offer for sale by tender

Investors are able to bid for shares and the shares are issued only to those

investors who have bid at the striking price or above.

Advantage: Useful where it is difficult for the company to assess the value of the

shares on the stock exchange.



3. Placing

Shares are placed with / sold to institutional investors, keeping the cost of the issue

to a minimum.

Advantage: Cheaper to issue shares.

4. Stock exchange introduction

Shares are introduced to the exchange without any new shares being issued.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D

Profit after tax


=


R Theoretical




o 1


EQUITY ISSUES BY LISTED COMPANIES

A listed or quoted company is better able to raise equity finance.

Rights issues

A rights issue is the right of existing shareholders to subscribe to new share issues

in proportion to their existing holdings. This is to protect the ownership rights of

each investor.

Advantages

1. Low cost

2. Protect ownership rights

3. Rarely fail.

Theoretical ex-rights price (TERP)

The new share price after the issue is known as the theoretical ex-rights price and

is calculated by finding the weighted average of the existing market price and the

issue price, weighted by the number of shares ex-rights.

Value of a right

The new shares are issued at a discount to the existing market value, this gives the

rights some value.

Value of a right = Ex-rights price - Issue price

Example 1

Marcus plc, which has an issued capital of 4,000,000 shares, having a current

market value of $2.80 each, makes a rights issue of one new share for every three

existing shares at a price of $2.00.

Required:

Calculate the theoretical ex-rights price and the value of each right.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D

Profit after tax


=


R Theoretical




o


Shareholders’ options

Th shar hold r‟s options with a ri hts issu ar to:

1. Take up (buy) the rights

2. Sell the rights

3. A bit of both

4. Do nothing.

Example 2 Tirwen

Tirwen is a medium-sized manufacturing company which is considering a 1 for 5

rights issue at a 15% discount to the current market price of $4.00 per share.

Issue costs are expected to be $220,000 and these costs will be paid out of the

funds raised. It is proposed that the rights issue funds raised will be used to

redeem some of the existing loan stock at par. Financial information relating to

Tirwen is as follows: Current statement of financial position (balance sheet)

$'000 $'000

Non-current assets 6,550

Current assets

Inventory 2,000

Receivables 1,500

Cash 300

3,800

10,350

Ordinary shares (par value 50c) 2,000

Reserves 1,500

12% loan notes 2X12 4,500 Current liabilities

Trade payables 1,100

Overdraft 1,250

2,350

10,350 Other information:

Price/earnings ratio of Tirwen: 15.24

Overdraft interest rate: 7%

Tax rate: 30%

Sector averages: debt/equity ratio (book value): 100% interest cover: 6 times


Required:

(a) Ignoring issue costs and any use that may be made of the funds

raised by the rights issue, calculate:

(i) the theoretical ex rights price per share;

(ii) the value of rights per existing share. (3 marks)

(b) What alternative actions are open to the owner of 1,000 shares in

Tirwen as regards the rights issue? Determine the effect of each of

these actions on the wealth of the investor. (6 marks)

(c) Calculate the current earnings per share and the revised earnings per

share if the rights issue funds are used to redeem some of the existing loan notes.


(6 marks)

111

CHAPTER 10 – RAISING EQUITY FINANCE 112 w w w .s tudyinte ract ive .o rg

Chapter 11

Efficient market

hypothesis


CHAPTER 11 – EFFICIENT MARKET HYP OTHESIS

CHAPTER CONTENTS

INTRODUCTION TO EMH----------------------------------------------- 115

DEGREE OR FORMS OF EFFICIENCY ---------------------------------- 116

IMPLICATIONS OF EMH FOR FINANCIAL MANAGERS -------------- 117



INTRODUCTION TO EMH

A market is efficient if:

● The prices of securities traded in that market reflect all the relevant

information accurately and rapidly, and are available to both buyers and

sellers.

● No individual dominates the market.

● Transaction costs of buying and selling are not so high as to discourage

trading significantly.

● Market efficiency from the perspective of the EMH relates to the efficiency of

information, the better the information received by investors, the better and

more informed the decisions they make will be.

Fundamental value of shares

As seen in chapter 1, the theoretical value of a share is based upon the dividends,

growth and risk:

P0 = ( )

-

If the market price of a share is different to that calculated using fundamental

analysis, then there must be a difference in how the share price is arrived at which

would suggest that the stock market has not processed information in the way that

the theory indicates.

The market would be said to be less than perfectly efficient. Either:

● Investors are not receiving full information about the company, or

● Investors do not use fundamental analysis, perhaps relying on speculation to

make share buying decisions.



DEGREE OR FORMS OF EFFICIENCY

For the purpose of testing, EMH is usually broken down into 3 forms as follows:

1. Weak form

Weak form hypothesis states that current share prices reflect all relevant

information about the past price movements and their implications. If this is true,

then it should be impossible to predict future share price movements from historic

information or pattern.

Share prices only changes when new information about a company and its profits

have become available. Since new information arrives unexpectedly, changes in

share prices should occur in a random fashion, hence weak form can be referred to

as random walk hypothesis.

2. Semi- strong form

Semi-strong form hypothesis state that current share prices reflects both

(i) all relevant information about past price movement and their implications;

and

(ii) publicly available information about the company.

Any new public ly accessible information whether comments in the financial press,

annual reports or brokers investment advisory services, should be accurately and

immediately reflected in current share prices, so investment strategies based on

such public information should not enable the investor to earn abnormal profit

because these will have already been discounted by the market.

3. Strong form

The strong form hypothesis states that current share prices reflect all relevant

information available from

● past price changes

● public knowledge; and

● insider knowledge available to specialists or experts such as investment

managers.



IMPLICATIONS OF EMH FOR FINANCIAL MANAGERS

If capital markets are efficient, the main implications for financial managers are:

1. The timing of issues of debt or equity is not critical, as the prices quoted in

th mark t ar „fair‟. That is price will always reflect the true worth of the

company, no over or under valuation at any point.

2. An entity cannot mislead the markets by adopting creative accounting

techniques.

3. Th ntity‟s shar pric will r fl ct th n t pr s nt valu of its futur cash

flows, so managers must only ensure that all investments are expected to xc d th company‟s cost of capital.

4. Large quantities of new shares can be sold without depressing the share price.

5. The market will decide what level of return it requires for the risk involved in

making an investment in the company. It is pointless for the company to try

to chan th mark t‟s vi w by issuin diff r nt typ s of capital instrum nt.

6. Mergers and takeovers. If shares are correctly priced this means that the

rationale behind mergers and takeovers may be questioned. If companies are

acquired at their current market valuation then the purchasers will only gain if

they can generate synergies (operating economies or rationalisation). In an

efficient market these synergies would be known, and therefore already

incorporated into the price demanded by the target company shareholders.

The more efficient the market is, the less the opportunity to make a speculative

profit because it becomes impossible to consistently out -perform the market.

Evidence so far collected suggests that stock markets show efficiency that is at

least weak form, but tending more towards a semi-strong form. In other words,

current share prices reflect all or most publicly available information about

companies and their securities.


CHAPTER 11 – EFFICIENT MARKET HYP OTHESIS 118 w w w .s tudyinte ract ive .o rg

Chapter 12

Valuation


CHAPTER 12 – VALUATION

CHAPTER CONTENTS

BUSINESS VALUATION------------------------------------------------- 121

REASONS FOR VALUATION 121

COMPANY ACQUISITION 121

APPROACHES 121

VALUING SHARES ------------------------------------------------------ 122

THE DIVIDEND VALUATION MODEL 122

ASSET BASED VALUATIONS 123

INCOME / EARNINGS BASED METHODS 125

PV OF THE FREE CASH FLOWS 126

VALUATION OF DEBT--------------------------------------------------- 129

IRREDEEMABLE DEBT 129

REDEEMABLE DEBT 130

CONVERTIBLE DEBT 130

PREFERENCE SHARES 131

NON-TRADED DEBT 131



BUSINESS VALUATION

Reasons for valuation

The purpose of conducting the valuation will have an impact on the approach taken

and factors considered in arriving at the value:

● Buying a business

● Selling a (going concern) business

● Selling an unwanted business

● Seeking finance.

Company acquisition

When an investor buys a company, the investment involves paying an acceptable

amount for the shares of the company and usually results in the investor assuming

responsibility for any debt carried by the company.

Debt will usually be valued as the present value of future interest and redemption.

The value of shares is open to wider variation in approach. Ultimately, any agreed

price will depend on the arguing positions of the two parties to the acquisition,

rather than the result of a formulaic approach.

Approaches

The three main approaches are:

● Dividend valuation model.

● Income / earnings basis.

● Asset basis.



VALUING SHARES

The dividend valuation model

Seen earlier, the value of the share is the present value of the expected future

dividends discounted at the cost of equity.

d (1g) o ke g

FORMULA GIVEN

Advantages

1. Considers the time value of money and has an acceptable theoretical basis.

2. Particularly useful when valuing a minority stake of a business.

Disadvantages

1. Difficulty estimating an appropriate growth rate.

2. The model is sensitive to key variables.

3. The growth rate is unlikely to be constant in practice (although the formula

above assumes this to simplify DCF whilst it is possible to forecast and

discount varying cash flows).

Note

VE = Share price x Total number of shares.

Example 1

A company has the following information:

Share capital in issue is 20m ordinary shares, with a 25¢ par value.

Current dividend per share (paid recently) - 4¢

Dividend five years ago – 2.5¢

Current equity beta 0.6

Market information:

Current market return 17%

Risk-free rate 6%

Required:

Calculate the market value of the company.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P D a

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point


Example 2

A company has the following information:

Ordinary share capital (10m par value 50c)

Current dividend (ex div) - 16¢

Current EPS - 20¢

Current return earned on assets - 20%

Current equity beta 0.9

Current market return 11%

Risk-free rate 6%

Required:

Find the market capitalisation of the company.

Asset based valuations

Weaknesses

● Investors do not normally buy a company for the book value of its assets, but

for the earnings / cash flows that the sum of its assets can produce in the

future.

● It ignores intangible assets. It is very possible that intangible assets are more

valuable than the balance sheet assets.

Uses for asset based valuations:

● Asset stripping.

● To identify a minimum price in a takeover.

● If the assets are predominantly tangible assets.

Types of asset based measures

Book value

There is never a circumstance where book value is an appropriate valuation base.

It may however be used as a stepping stone towards identifying another measure.

Net realisable value

Only used to establish a minimum value for an asset, it may be difficult to find an

appropriate value over the short term. Used for a company when being broken up

or asset stripped.

Replacement cost

May be used to find the maximum value for an asset.

going concern.


Used for a company as a

123


Example 3

Below is the most recent Statement of Financial Position for Fagin Co:

Non-current assets (carrying value)

Net current assets

Represented by

50c ordinary shares

Reserves

6% debentures

Notes:

$

625,000

160,000

_______

785,000

_______

300,000

285,000

200,000

_______

785,000

_______

● Loan notes are redeemable at a premium of 5%.

● The premises have a market value that is $50,000 higher than the book

value.

● All other assets are estimated to be realisable at their book value.

Required:

Value the ordinary shares on an assets basis.



Income / earnings based methods

Of particular use when valuing a majority shareholding:

1. As majority shareholders, the owners can influence the future earnings of the

company.

2. With a controlling interest, the investor will dictate the dividend policy,

making earnings more relevant than dividends.

PE method

PE ratios are quoted for all listed companies and calculated as:

PE = Price pershare

EPS

This can then be used to value shares in unquoted companies as:

Value of company

Value per share

= Total earnings P/E ratio

= EPS P/E ratio

using an adjusted P/E multiple from a similar quoted company (or industry

average).

Example 4

H Co is an unlisted company.

Extract from income statement for the year just ended:

Profit before taxation

Less: Corporation tax

Profit after taxation

Less: Preference dividend

Ordinary dividend

Retained profit for the year

$ $

430,000

110,000

______

320,000

30,000

40,000

______ (250,000)

_______

70,000

_______

The PE ratio applicable to a similar type of business is 10.

Required:

Calculate the value of the shares in H Co on a PE basis.



Earnings yield

The earnings yield is the inverse of the PE ratio:

Earnings yield = EPS

Price pershare

It can therefore be used to value the shares or market capitalisation of a company

in exactly the same way as the PE ratio:

Value of company

Value per share

= Total earnings Earningsyield

= EPS Earningsyield

Example 5

Company A has earnings of $300,000. A similar listed company has an earnings

yield of 12.5%.

Required:

Calculate a market value for Company A.

PV of the free cash flows

A buyer of a business is obtainin a str am of futur op ratin or „fr ‟ cash flows.

The value of the business is:

PV of future cash flows

A discount rate reflecting the systematic risk of the flows should be used.

Method:

1. Id ntify r l vant „fr ‟ cash flows

● operating cash flows

● revenue from sale of assets

● tax payable

● tax relief

● synergies from merger (if any).

2. Select a suitable time horizon.

3. Identify a suitable weighted average cost of capital.

4. Calculate the present value over the time horizon.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level


Example 6

The following information has been taken from the financial statements of Prince

Co:

Revenue Production expenses

Administrative expenses

Tax allowable depreciation Capital investment – annual outlay

Corporate debt

$400m

$150m

$36m

$28m

$60m $140m trading at 110% of par value

Corporation tax is 30%.

The WACC is 16.6%. Inflation is 6%.

These cash flows are expected to continue every year for the foreseeable future.

Required:

Calculate the value of equity.

Advantages

● The best method on a theoretical basis.

● May value a part of the company.

Disadvantages

● It relies on estimates of both cash flows and discount rates – may be

unavailable.

● Difficulty in choosing a time horizon.

● Difficulty in valuing a company‟s worth b yond this p riod.

● Assumes that the discount rate and tax rates are constant through the period. www .s tudyinte ract ive .org 127


Example 7

Recent financial information relating to Open Co, a listed company, is as follows.

$m

Profit after tax (earnings) 115

Dividends 69

Statement of financial position information:

$m $m

Non-current assets 815

Current assets 515

Total assets 1,330 Current liabilities 210

Equity Ordinary shares ($1 nominal) 120

Reserves 705 825

Non-current liabilities 6% Bank loan 105

8% Bonds ($100 nominal) 190 295

1,330

Forecasts are that the dividends of Open Co will grow in the future at a rate of 3%

per year. The forecast growth rate of the earnings of the company is 4% per year.

Considering the risk associated with expected earnings growth, an earnings yield of

11% per year can be used for valuation purposes.

The cost of equity is 10% per year and the gross redemption yield on debt is 7%.

The ex-dividend share price of the company is $8·50 per share.

Required:

Calculate the value of Open Co using the following methods:

(a) net asset value method;

(b) dividend growth model;

(c) earnings yield method.



VALUATION OF DEBT

When valuing debt we assume that

Market price = The discounted cash flows of the debt

The relevant cash flows are interest payments and eventual redemption of the

capital.

The debt is valued based on gross values for cash flow and cost of debt capital.

Irredeemable debt

The company does not intend to repay the principal but to pay interest forever, the

interest is paid in perpetuity.

The formula for valuing a debenture is therefore:

MV r

where:

I = annual int r st startin in on y ar‟s tim

MV = market price of the debenture now (year 0)

r = d bt hold rs‟ r quir d r turn, xpr ss d as a d cimal.

Example 8

A company has issued irredeemable loan notes with a coupon rate of 9%. The

gross yield required by investors in this category of debt is 6% per annum.

Required:

Calculate the current market value of the debt.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c

Days

Payables


Redeemable debt

The market value is the present value of the future cash flows, these normally

include:

1. Interest payments for the years in issue

2. Redemption value.

Example 9

The 8% Bonds in Open Co (example 7) will be redeemed at nominal value in 4

y ars‟ tim .

Required:

Calculate the market value of the debt.

Convertible debt

Th mark t valu of a conv rtibl is th hi h r of its valu as d bt (th “Floor

Valu ”) and its conv rt d valu .

Example 10

WERT Co has $40m convertible loan notes with a coupon rate of 7%. Each $100

loan note may be converted into 16 ordinary shares at any time until the date of

expiry and any remaining loan note will be redeemed at $100.

The debenture has four years to redemption. Investors require a rate of return of

6% per annum.

The current share price of WERT Co is 600 cents which is expected to grow at 4%

per annum.

Required:

Calculate

(a) The floor value

(b) The market value, and

(c) The conversion premium

of the loan stock.



Preference shares

Similar to irredeemable debt, the income stream is the fixed percentage dividend

received in perpetuity.

The formula is therefore: P0 Kp

where:

D = the constant annual preference dividend

P0 = ex-div market value of the share

Kp = cost of the preference share.

Example 11

A company has 11% preference shares in issue with a 50 cent par value. The

required return of preference shareholders is 6%.

Required:

Calculate the market value of a preference share.

Non-traded debt

Non-traded debt has a value equal to the book value appearing in the statement of

financial position.

In xampl 7, Op n Co‟s 6% Bank Loan would b valu d at $ 5m in any arin

or WACC working.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= +

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

CHAPTER 12 – VALUATION 132 w w w .s tudyinte ract ive .o rg

Chapter 13

Risk


CHAPTER 13 – RISK

CHAPTER CONTENTS

FOREIGN CURRENCY RISK--------------------------------------------- 135

TRANSACTION RISK 135

TRANSLATION RISK 135

ECONOMIC RISK 135

THE EXCHANGE RATE -------------------------------------------------- 136

SPOT RATE 136

SPOT RATE WITH SPREAD 136

HEDGING EXCHANGE RATE RISK ------------------------------------- 137

INTERNAL HEDGING TECHNIQUES 137

EXTERNAL HEDGING TECHNIQUES 138

OTHER CURRENCY HEDGING TECHNIQUES 141

EXCHANGE RATE SYSTEMS -------------------------------------------- 143

FLOATING RATE SYSTEMS 143

MANAGED OR „DIRTY‟ FLOAT 143

FIXED (OR PEGGED) RATE SYSTEMS 143

WHAT MAKES EXCHANGE RATES FLUCTUATE?---------------------- 144

BALANCE OF PAYMENTS 144

CAPITAL MOVEMENTS BETWEENCOUNTRIES 144

INTEREST RATE PARITY THEORY (IRPT) 144

PURCHASING POWER PARITY THEORY (PPPT) 145

THE INTERNATIONAL FISHER EFFECT 146

INTEREST RATE RISK -------------------------------------------------- 147

THE YIELD CURVE (TERM STRUCTURE OF INTEREST RATES) 147

HEDGING INTEREST RATE RISK -------------------------------------- 148

SHORT-TERM MEASURES 148

LONG-TERM HEDGING – SWAPS-------------------------------------- 149


CHAPTER 13 – RISK

FOREIGN CURRENCY RISK

The risk that the exchange rate may move up or down in relation to other

currencies. It will have a major impact on the predictability of profitability of any

company that buys from or sells to other countries.

Illustration

A company has a foreign ass t with a valu of €8 , .

Th xchan rat is curr ntly .7774 €/$

The asset, therefore, has a current value of 800,000 ÷ 0.7774 = $1,029,071

Aft r som tim , th ass t is still worth €8 , .

Th xchan rat has mov d to .8 €/$

The asset value in dollars is now 800,000 ÷ 0.8000

There is an exchange rate loss of

= $1,000,000

$29,071

Transaction risk

The risk associated with short-term cash flow transactions.

If th ass t of €8 , is a trad r c ivable, the risk is classed as transaction risk.

Th r c ipt of €8 , conclud s th transaction; th xchan rat loss

materialises and is irreversible.

Translation risk

Risk associated with the reporting of foreign currency assets and liabilities within

financial statements. Th €8 , ass t may b a tan ibl non-current asset.

There is no cash flow impact of this type of risk. However, the impact on the

financial statements can be severe. In later periods, the exchange rate may move

in the opposite direction, resulting in an exchange rate gain. There is still

uncertainty, though, about the reported results.

Translation risk may be managed by matching the assets and liabilities within each

country. If €8 , w r financ d by borrowin €8 , , th n t ass t would b

€ and any mov m nt in xchan rat would not aff ct th translat d valu .

Economic risk

Long-term cash flow effects associated with asset investment in a foreign country

or alternatively loans taken out or made in a foreign currency and the subsequent

capital repayments.

Economic risk is more difficult to hedge given the longer term nature of the risk

(possibly over 10 or more years). A simple technique would be to adopt a portfolio

approach to investments by currency to spread the risk.


CHAPTER 13 – RISK

THE EXCHANGE RATE

Spot rate

A prevailing rate at a specific point in time – usually r f rs to “today‟s” rat

Given as

This m ans that th Euro (€) is

.7774 €/$

xpr ss d in t rms of on

.7774 € p r $

dollar ($); i. . how many

Euro equate to one dollar.

May also be given as: .2863 $/€ .2863 $ p r €

Where we have the amount of dollars equivalent to one Euro.

Conversion rule (÷ and ×) ÷ 1st currency to calculate the 2nd

× 2nd currency to calculate the 1

st

Currency amount Rate

€ €/$

€ $/€

$ €/$

$ $/€

Conversion

Divide

Multiply

Multiply

Divide

Spot rate with spread

The rate is usually expressed in terms of a bid/offer spread.

eg 0.7770 - .7778 €/$

Banks will buy currency using the rate that gives them the lower outlay; they will

sell currency at the rate giving them the higher receipt.

Example 1

(a) Spot rate 0.7770 - .7778 €/$

(i) A US company banks a €3

(ii) A US company buys € 55,

, r c ipt.

to pay a suppli r.

(b) Spot rate 1.2857 – .287 $/€

(i) A European company pays a US supplier $385,710

(ii) A US company buys € 55, to pay a supplier

Required:

Calculate the values of the transactions.


CHAPTER 13 – RISK

HEDGING EXCHANGE RATE RISK

Hedging is the process of reducing or eliminating risk. It may be achieved by using

internal or external measures.

Internal measures have the advantage of being essentially cost free but at the

same time are unlikely to completely eliminate the risk.

External measures involve a bank or financial market. They will incur cost but may

totally eliminate the risk.

Internal hedging techniques

Invoice in own currency

By invoicing in your own currency you do not suffer the risk of exchange rate

movement.

The risk does not disappear; instead it passes to the other party. It is questionable

whether the other party will be happy to accept this risk.

Matching or netting

If a company makes a number of transactions in both directions it will be able to

net off those transactions relating to the same dates. By doing so a company can

materially reduce the overall exposure, but is unlikely to eliminate it.

In order to perform netting the company must have a foreign currency bank

account in the appropriate country.

Leading or Lagging payments

Leading involves settling trade payables earlier than the terms of trade require.

Although there may be a cost of capital associated with paying early there are

certain benefits relating to exchange rate risk:

● The payment is made ahead of a period of uncertainty for the exchange rate.

● The company can take advantage of early settlement discounts.

● The early payment may be matched to receipt of currency from a trade

customer, netting off and reducing exposure to exchange rate risk.

Lagging is the opposite: delaying payment to a supplier, possibly forgoing

settlement discounts but facilitating netting against an anticipated currency receipt.

Do nothing

Exchange rates will fluctuate up and down. It could be argued that since you win

some and lose some then ignoring the risk would be the best option; particularly if

your company has frequent transactions (imports & exports) in a foreign currency.

As a result you save on hedging costs, the downside being that the exposure to

exchange rates is present in the short -term.


CHAPTER 13 – RISK

External hedging techniques

Forward contract

Features:

1. An agreement with a bank to exchange a fixed amount of currency for a

specific amount at a fixed future date.

2. It is an obligation that must be completed once entered into.

3. It is an over the counter (OTC) product which means that it is tailored to the

specific value and date required.

4. The forward rate offers a perfect hedge because it is for the exact amount

required by the transaction on the appropriate date and the future rate is

known with certainty.

Forward rates

Forward rates are given by the banks and stated in the same way as spot rates,

with a bid-offer spread. The spread for forward rates is wider than that for spot

rates, giving the bank larger profit on forward deals due t o the additional risks it takes.

Spot rate

€ p r $ spread

0.7770 0.7778 0.0008

Forward rate

1 month

3 months

0.7781 0.7793 0.0012

0.7802 0.7820 0.0018

Example 2

Danke Yudle Co, based in the US, expects the following transactions:

In 1 month:

Receipt of €265,

Payment of €5 5,

In 3 months’ time:

Receipt of €68 ,

Payment of €23 ,

Required:

Calculate the values of the future transactions using forward contracts.


CHAPTER 13 – RISK

Advantages

● Flexibility with regard to the amount to be covered, should lead to a perfect

hedge in terms of amount and date.

● Relatively straightforward both to comprehend and to organise.

Disadvantages

● Contractual commitment that must be completed on the due date, if the

underlying transaction is in anyway doubtful this may be problem.

● The rate is fixed with no opportunity to benefit from favourable movements in

exchange rates. Potential of opportunity cost if the exchange rate moves

favourably.

Money market hedge

Use of the short-term money markets to borrow or deposit funds. The hedge

involves matching future currency assets with liabilities and gives the company the

opportunity to exchange currency today at the prevailing spot rate.

Steps

1. Match expected asset with liability or liability with asset:

(i) If expecting a trade receipt (asset); create a liability by borrowing

(ii) If due to make a payment (liability); create and asset by investing.

Discount value of transaction to present value using money market rate

available. This ensures that there is no need for future conversion of

currency.

2. Translate – exchange the funds at spot rate avoiding exposure to fluctuations

in the rate.

3. Use domestic (home) money market and compound to provide comparison

to other hedging approaches. Advantages

● There is some flexibility regarding the date at which the transaction takes

place.

● May be available in currencies for which a forward rate is not available.

● The final step is not obligatory. The company could use proceeds generated

to earn a better return than that available from the domestic money market

(eg reducing an overdraft). Disadvantages

● May be difficult to borrow/ deposit in some currencies at a risk-free rate. www .s tudyinte ract ive .org 139

CHAPTER 13 – RISK

Example 3

Danke Yudl Co, bas d in th US, xp cts a n t r c ipt of €45 , in thr

months‟ tim .

Spot rate is 0.7770 - .7778 €/$

The annual money market rates are:

Borrowing rate

Deposit rate

€ $

7.2% 5.2%

6.75% 4.8%

Required:

Calculate the expected receipt using the money market hedge. Compare

this to the expected receipt using the forward market hedge (in example

2).


CHAPTER 13 – RISK

Other currency hedging techniques

Currency Futures

The Future is an exchange traded instrument that can be bought or sold on one of

four exchanges (the largest is in Chicago). Futures involve speculation on the

movement of the rate. If movements are guessed correctly, gains can be made at

the expense of those who guessed incorrectly.

The aim is to speculate on futures in such a way as to compliment the underlying

trade. Therefore you will have:

1. A futures position making a gain when a trade transaction suffers an

exchange rate loss; or,

2. A futures position suffering a loss when the trade transaction results in an

exchange rate gain.

The linking of the two cancels out the movement of the exchange rate and leads to

the hedge.

Currency futures contracts are only available for a limited number of major

currencies and in predetermined (standardised) volumes. Each €/$ futur s contract

is for € 25, . Thus a transaction of €45 , would ith r involv 3 contracts,

l avin €75, xpos d to curr ncy risk or 4 contracts with risk ov r €5 , in

the futures market.

The future is also standardised financial instrument in terms date. If the underlying

transaction does not fall on one of four dates (March, June, September, December),

there will be an element of risk in the hedge – known as “basis risk”.

Currency options

Options operate as insurance. A premium is paid which ensures that an eventual

receipt does not fall below a specified amount or an eventual payment does not

exceed a specified amount.

If the exchange rate moves favourably, there is no obligat ion to fulfil the option

contract. Options have the benefit of being a one-sided bet. You can protect the

downside risk of the currency moving against you but still take advantage of the

upside potential.

Standardised traded options (see futures) are available on some markets but

compani s may d al in options “ov r th count r”, ttin a contract that is tailor

made to their currency transaction.


CHAPTER 13 – RISK

Example 4

Inshal Co is a UK-based company which has the following expected transactions.

One month:

One month:

Three months:

Expected receipt of $40,000

Expected payment of $140,000

Expected receipts of $300,000

The finance manager has collected the following information:

Spot rate ($ per £):

One month forward rate ($ per £):

Three months forward rate ($ per £):

Money market rates for Inshal Co:

1.7820 ± 0.0002

1.7829 ± 0.0003

1.7846 ± 0.0004

One year sterling interest rate:

One year dollar interest rate:

Borrowing

4.9%

5.4%

Deposit

4.6

5.1

Required:

(a) Calculate the expected sterling receipts in one month and in three

months using the forward market. (3 marks)

(b) Calculate the expected sterling receipts in three months using a

money-market hedge and recommend whether a forward market

hedge or a money market hedge should be used. (5 marks)

(c) Discuss how sterling currency futures contracts could be used to

hedge the three-month dollar receipt. (5 marks)


CHAPTER 13 – RISK

EXCHANGE RATE SYSTEMS

External hedging techniques are all costly and should be avoided if there is little

currency risk. Whether there is a significant amount of risk will depend on various

factors including the system by which exchange rates between two currencies are

derived.

Exchange rates are a key measure for governments to attempt to control. They will

have direct bearing on the economic performance of the country.

Floating rate systems

Where the exchange rate is allowed to be determined without any government

intervention. It is determined by supply and demand.

The market has a tendency to be volatile to the adverse effect of trade and wider

government policy. This volatility can adversely affect the ability to trade between

currencies.

Managed or ‘dirty’ float

Where the market is allowed to determine the exchange rate but with government

intervention to reduce the adverse impacts of a freely floated rate.

The government may intervene by:

● Using reserves to buy or sell currency. The government can artificially

stimulate demand or supply and keep the currency within a trading range

reducing volatility.

● Using interest rates. By increasing the interest rate within the economy the

government makes the currency more attractive to investors in government

debt and will attract speculative funds.

Fixed (or pegged) rate systems

● Where a currency is fixed in relation to a dominant currency (eg, $).

● Th „p ‟ may b chan d from tim to tim to r fl ct th r lativ mov m nt

in underlying value.

● This form of currency management is effective at giving a stable exchange

platform for trade. Pegged rates are typically used and managed by smaller

economies.


CHAPTER 13 – RISK

WHAT MAKES EXCHANGE RATES FLUCTUATE?

Balance of payments

The inflows and outflows from trade reflect demand for and supply of the home

currency. If there is a consistent deficit or surplus there will be a continuing excess

supply or demand for the currency that would be reflected in weakness or strength

in the currency.

For major traded currencies this effect is relatively small.

Capital movements between countries

Of far more importance for major currencies are the flows of speculative capital

from one currency to another. An increase in the interest rate of one currency will

lead to an increase of demand for that currency increasing its value.

It is difficult to predict future rates based on this measure.

Interest rate parity theory (IRPT)

The theory that there is a no sum gain relating to investing in government bonds in

differing countries. Any benefit in additional interest is eliminated by an adverse

movement in exchange rates.

IRPT is an unbiased but poor predictor of future exchange rates. However, the

principles of IRPT are used by banks calculating forward rates.

Example 5

Th spot rat is € .7774 p r $.

Annual interest rates are: €7% $5%

Starting with $1,000,000, show how the capital would grow if invested in $USD or

in €EUR.

Required:

Calculate the expected exchange rate after one year.

$ Rate €

Now 1,000,000 0.7774

Interest × 1.05 × 1.07

+ 1 year

The predicted exchange rate would be:


CHAPTER 13 – RISK

Formula for interest rate parity

(1 i ) 0 0

(1 i )

F0 = The forward exchange rate (c per b)

S0 = The spot rate (c per b)

ic = The interest rate for currency c

ib = The interest rate for currency b

Purchasing power parity theory (PPPT)

Based on the law of one price in economic theory. This would suggest that the

relative price of the comparable products remains the same in all currencies.

The theory is that exchange rates will follow price changes to maintain the relative

value of products between two countries.

PPPT is an unbiased but poor predictor of future exchange rates.

Example 6

The spot rate is 0.7774.

AB has $10,000 to spend in the US where inflation is 3.72% per annum.

In Europe, inflation is projected at 5.7% per annum.

Required:

Illustrate how exchange rates might move to maintain purchasing power

parity.

$

Now 10,000 Rat (€/$) €

0.7774

Inflation × 1.0372 × 1.057

+ 1 year

Th „bask ts of oods‟ that ar comparabl now will r main comparabl after one

y ar so th pr dict d xchan rat would b €8,2 7/$ ,372 = .7922 € p r $.

To calculate the impact of PPPT use the following (given) formula:

(1h ) 1 0

(1h )

S1 = The current prediction of the spot rate (c per b) in 1 year‟s tim

S0 = The spot rate (c per b)

hc = The inflation rate for currency c

hb = The inflation rate for currency b


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= + e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= + e d e d

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


= + e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Return point

Minimum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.

CHAPTER 13 – RISK

The international Fisher effect

The assumption that all currencies must offer the same real interest rate. This links

IRPT to Purchasing Power Parity. It is based upon the Fisher effect.

The relative real interest rates should be the same due to the principle of supply

and demand, if a country offers a higher real interest rate investors will invest in

that currency and push up the price of the currency bringing the real rate back to

equilibrium.

The impact is that, although PPPT and IRPT should give the same predicted

exchange rate. Inflation rates are difficult to predict but interest rates are quoted,

making it easier to predict using IRPT.

Remember the Fisher effect:

(1 + i) = (1 + r)(1 + h)

Illustration

(using values from previous illustrations for PPPT and IRPT)

PPPT IRPT

Now 0.7774 0.7774

× 1.057/1.0372 ×1.07/1.05

+ 1 year

Real rate of return

0.7922

Euro

= 1.07/1.057 - 1

= 1.23%

0.7922

US

= 1.05/1.0372 –1

= 1.23%

The reason for both PPP and IRP having the same prediction is because the

international Fisher effect holds true.


CHAPTER 13 – RISK

INTEREST RATE RISK

A company will be exposed to interest rate risk if it knows today that it expects to

make a financial transaction (borrowing or investing) but not for a few months.

For example, a company has debentures which are due for redemption in 18

months‟ tim . The company will maintain its capital structure by taking out new

debt to pay for redemption of the existing debt.

Borrowing rates are currently low but there is speculation that they may rise

substantially over the next two years.

If the company aims to minimise risk, it will take steps now to ensure that the

eventual interest rate is known in advance.

The yield curve (term structure of interest rates)

The relationship between the gross redemption yield of a debt investment and its

term to maturity.

There are 3 elements:

Gross

Redemption

Yield

Term to maturity

1. Liquidity preference

Investors prefer to be liquid over being illiquid. To encourage investment over the

longer term the long-term debt must offer a higher return over short -term debt.

2. Market expectations

If interest rates are expected to fall over time long-term rates will be lower than

short-term rates. This would lead to an inverted yield curve.

3. Market segmentation

Differing parts of the market (short-term vs long-term debt markets) may react to

differing economic information meaning that the yield curve is not smooth but

suffers discontinuities.


CHAPTER 13 – RISK

HEDGING INTEREST RATE RISK

We may hedge interest rate risk over the short or the long-term.

Short term hedging

Forward rate agreements

Long-term hedging

Swaps

Interest rate guarantee

Interest rate futures

Interest rate options

Short-term measures

Forward rate agreements (FRA)

The fixing of the interest rate today in relation to a future short -term loan. It is an

obligation that must be taken once entered into. It is OTC and tailored to a specific

loan in terms of:

1. Date

2. Amount, and

3. Term

and off rs a „p rf ct h d ‟. The FRA is wholly separate to the underlying loan.

It will give certainty as regards the interest paid but there is a downside risk that

interest rates may fall and we have already fixed at a higher rate.

Interest rate guarantee (IRG)

Similar to a FRA but an option rather than on obligation. In the event that interest

rates move against the company (eg rise in the event of a loan) the option would

be exercised. If the rates move in our favour then the option is allowed to lapse.

There is a premium to pay to compensate the IRG writer for accepting the

downside risk.

Interest rate futures

An exchange traded instrument that works in a similar manner to a FRA. By

trading on th xchan th Futur can „fix‟ th rat today for a futur loan.

Exchange traded interest rate options

Similar to an IRG but exchange traded, the option gives protection against the

downside for the payment of a premium.


CHAPTER 13 – RISK

LONG-TERM HEDGING – SWAPS

A company will borrow either using a variable or a fixed rate. If it wishes to change

its borrowing type it could redeem its present debt and re-issue in the appropriate

form. There are risks and costs involved in doing so.

A swap allows the company to change the exposure (fixed to variable or vice versa)

without having to redeem existing debt.

To prepare a swap we need the following steps:

1. Identify a counter-party, either another company or bank willing to be the

„oth r sid ‟ of th transaction. If we want to swap fixed for variable they will

want the opposite.

2. Agree the terms of the swap to ensure that at the outset both parties are in a

neutral position.

3. On a regular basis (perhaps annually) transfer net amounts between the

parties to reflect any movement in the prevailing exchange rates.

Advantages of swaps

● Allows a change in interest rate exposure at relatively low cost and risk.

● May allow access to a debt type that is otherwise unavailable to the company.

● May reduce the overall cost of financing in certain circumstances.


CHAPTER 13 – RISK 150 w w w .s tudyinte ract ive .o rg

Chapter 14

Working capital

management


CHAPTER 14 – W ORKING CAPITAL MANAGEMENT

CHAPTER CONTENTS

WORKING CAPITAL MANAGEMENT – AN OVERVIEW--------------- 153

WORKING CAPITAL SEESAW 154

LEVEL OF WORKING CAPITAL 154

MANAGING RECEIVABLES --------------------------------------------- 155

CREDIT MANAGEMENT 155

COST OF FINANCING RECEIVABLES---------------------------------- 156

ISCOUNTS FOR EARLY PAYMENT 156

FACTORING 157

MANAGING INVENTORY ----------------------------------------------- 158

MATERIAL COSTS 158

ECONOMIC ORDER QUANTITY 158

BULK PURCHASE DISCOUNTS 160

FUNDING THE WORKING CAPITAL REQUIREMENT 161

SHORT-TERM SOURCES OF FINANCE 162

ASSET SPECIFIC SOURCES OF FINANCE 163

MEASURES OF WORKING CAPITAL MANAGEMENT------------------ 164

LIQUIDITY RATIOS 164

OVERTRADING---------------------------------------------------------- 165

CASH MANAGEMENT---------------------------------------------------- 167

THE ILLER-ORR MODEL 167

THE BAUMOL MODEL 168

CASH BUDGET 169

THE TREASURY FUNCTION -------------------------------------------- 171

ROLE 171

CENTRALISATION VS. DECENTRALISATION 171

PROFIT CENTRE VS. COST CENTRE 172


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L

Profit after tax


=

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N

Profit after tax


=

CHAPTER 14 – WORKING CAPITAL MANAGEMENT

WORKING CAPITAL MANAGEMENT – AN OVERVIEW

CURRENT ASSETS

MINUS CURRENT

LIABILITIES

Inventory Payables

Receivables

Cash and Bank

Require funding

Aim : Minimise

current assets

Bank overdraft

Provide funding

Aim: Maximise

current liabilities

Cash operating cycle

The cash op ratin cycl is th l n th of tim b tw n th company‟s outlay on raw

materials, wages and other expenditures and the inflow of cash from the sale of

goods.

Purchases

Payment


Sales

Operating cycle

Receipt

153


Example 1

Statement of Comprehensive Income extract

Turnover Gross profit

$

250,000

90,000

Statement of Financial Position extract $

Current Assets Inventory 30,000

Receivables 60,000

Current Liabilities

Payables

$

180,000 50,000

Required:

Calculate the current operating cycle.

Working capital seesaw

Have suffic ient

working capital

assets to conduct

business

Keep the overall

investment to a

minimum to avoid

the financing cost

Level of working capital

1. The nature of the business,

2. Certainty in supplier deliveries,

3. The level of activity of the business,

4. Th company‟s cr dit policy.



MANAGING RECEIVABLES

Offering credit encourages

customers to take up our goods

Offering credit introduces risk of default, defers

inflow of cash and needs managing

Credit management

There are three aspects to credit management:

1. Assessing credit status

2. Terms

3. Day to day management.

Assessing credit status

The creditworthiness of all new customers must be assessed before credit is

offered. Existing customers must also be re-assessed on a regular basis. The

following may be used to assess credit status of a company

1. Bank References

2. Trade References

3. Published accounts

4. Credit rating agencies

5. Company‟s own sales record.

Terms

Considerations may include:

1. Credit limit value

2. Number of days credit

3. Discount on early payment

4. Interest on overdue account.

Day to day management

The credit policy is dependent on the credit controllers implementing a set of

procedures. If th syst m is not ri orous, thos d btors who don‟t want to pay will

find ways not to pay. A process may be like the following:

SALE 30 days +30 days +7 days +7 days +7 days +7 days

Credit allowed Statement of account

Reminder notice

2nd

Reminder

Threat of legal action

Instigate legal action



COST OF FINANCING RECEIVABLES

The receivables balance needs to be financed. Any change to the receivables

balance will lead to a change in the financing cost of the business.

Annual financing cost = Receivables balance cost of capital

Receivables Turnoverx Receivables days

Example 2

Shanks Limited has sales of $40m for the previous year; receivables at the year-

end were $8m. The cost of financing debtors is covered by an overdraft at an

annual interest rate of 14%.

Required:

(a) Calculate the receivables days for Shanks.

(b) Calculate the cost of financing receivables.

Discounts for early payment

Cash discounts are given to encourage early payment by customers. The cost of

the discount is balanced against the savings the company receives from a lower

balance and a shorter average collecting period.

Example 3

Shanks as above but a discount of 2% is offered for payment within 10 days.

Required:

Advise whether, on financial grounds, the company should introduce the

discount given that 50% of the customers would be expected to take up

the discount?


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d e d e d V V P

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level


Advantages/Disadvantages

Advantages

1. Reducing the receivables balance and hence the interest charge.

2. May reduce the volume of bad debts arising.

Disadvantages

1. Difficulty in setting the terms.

2. Greater uncertainty as to when cash receipts will be received.

3. Customers may pay over normal terms but still take the cash discount.

Factoring

There are three main types of factoring service available:

1. Debt Collection and Administration

2. Credit Insurance

3. Financing.

Example 4

Shanks again but a factor has offered a debt collection service which should shorten

the debt collection period on average to 50 days. It charges 1.6% of turnover but

should reduce administration costs to the company by $175,000.

Required:

Advise whether the company should use the factoring facility.

Advantages/Disadvantages

Advantages

1. Saving in internal administration costs.

2. Particularly useful for small and fast growing businesses where the credit

control department may not be able to keep pace with volume growth.

Disadvantages

1. Could be more costly than an efficiently run credit control department.

2. Using a factor may suggest your company has money worries.

3. Customers may not wish to deal with a factor.

4. It may be difficult to revert easily to an internal credit control.

5. The company may give up the opportunity to decide to whom credit may be

given.



MANAGING INVENTORY

Holding inventory is

necessary for operations;

in terms of finished goods

it offers greater choice to

customers

Holding inventory incurs

costs, in particular there is the opportunity cost of

money tied up in inventory

Material costs

Mat rial costs ar a major part of a company‟s costs and n d to b car fully

controlled. There are 4 types of cost associated with inventory:

1. ordering costs

2. holding costs

3. stock-out costs

4. purchase cost.

Ordering costs

The clerical, administrative and accounting costs of placing an order. They are

usually assumed to be independent of the size of the order.

Holding costs

Holding costs include items such as:

1. Opportunity cost of the investment in inventory

2. Storage costs

3. Insurance costs

4. Deterioration.

Stock-out costs

1. Lost contribution through loss of sale

2. Lost future contribution through loss of customer

3. The cost of emergency orders of materials

4. The cost of production stoppages.

Economic order quantity

The economic order quantity, EOQ, is the regular order size to be placed in order to

minimise inventory related costs.


CHAPTER 14 – WORKING CAPITAL MANAGEMENT As the size of the order increases, the average inventory held increases and holding

costs will also tend to increase.

As the order size increases the number of orders needed decreases and so the

ordering costs fall. The EOQ determines the optimum combination.

Q= 2Co.D

Ch

Co = Cost per order

D = Annual demand

Ch = Cost of holding one unit for one year.

Cost

Total cost

Holding Costs

Ordering Costs

EOQ Reorder Quantity

Example 5

A company requires 10,000 units of material X per month. The cost per order is

$30 regardless of the size of the order. The holding costs are $20 per unit per

annum. It is only possible to buy in quantities of 500, 600 or 700 units at one

time. Required:

(a) Calculate the total inventory-related costs at each possible order

quantity.

(b) Calculate the economic order quantity.



Bulk purchase discounts

The sum of the holding and ordering costs are minimised at the EOQ. There will

however be savings in the purchase cost when the bulk discount volume is taken.

Calculate total costs at each possible level of discount to establish whether the

discount is worth taking.

Example 6

Annual demand is 120,000 units. Ordering costs are $30 per order and holding

costs are $20/unit/annum. The material can normally be purchased for $10/unit,

but if 1,000 units are bought at one time they can be bought for $9,800.

Required:

Calculate the order quantity which will minimise the total cost.



Funding the working capital requirement

Short-term sources of

finance Examples

Bank overdraft

Trade creditors

Long-term sources of

finance

Equity

Long-term debt

Advantages

1.

2.

3.

Flexible – only borrow

what is needed

Cheaper – liquidity

preference Easier to source

1. Secure – no need to

constantly replenish 2. Lower financing risk 3. Matching funding to need

Fluctuating

current

assets

Current

Assets

Short-term

funds

Permanent

current assets

Short-term

funds or

Long-term

funds

Time

Financing policies for current assets

Conservative strategy

Where permanent current assets and some fluctuating current assets are financed

long-term to take advantage of the security of the long-term nature of the finance.

Aggressive strategy

Where all fluctuating current assets are financed short-term to take advantage of

the lower cost of short term financing.



Short-term sources of finance

Trade credit

The delay of payment to suppliers is effectively a source of finance.

By payin on cr dit t rms th company is abl to „fund‟ its inv ntory and

receivables investment at the expense of its suppliers.

Overdrafts

A source of short-term funding which is used to fund fluctuating working capital

requirements.

Its great advantage is that you only pay for that part of the finance that you need.

The overdraft facility (total limit) is negotiated with the bank on a regular basis

(maybe annually). For a company with a healthy trading record it is normal for the

ov rdraft facility to b „roll d ov r‟ from on y ar to th n xt althou h th or tically

it is „r payabl on d mand‟.

Bank loans

Bank loans or term loans are loans over between one and three years which have

become incr asin ly popular ov r th past t n to fift n y ars „as a brid ‟ b tw n

overdraft financing and more permanent funding.

Factoring

As well as providing administrative support, factoring works as a source of financing

as:

a. Efficient credit control brings cash in sooner, reducing the operating cycle.

b. Factors may offer advances on receivables balances.

Invoice discounting

A service also provided by a factoring company.

Selected invoices are used as security against which the company may borrow

funds. This is a temporary source of finance repayable when the debt is c leared.

The key advantage of invoice discounting is that it is a confidential service, the

customer need not know about it.

Bills of exchange

A m ans of paym nt wh r by by a „promissory not ‟ is xchan d for oods.

The bill of exchange is simply an agreement to pay a certain amount at a certain

date in the future.

the bill.

162

No interest is payable on the note but is implicit in the terms of



Asset specific sources of finance

Some sources of finance are used to purchase individual assets using the asset as

security against which the funds are borrowed.

Hire purchase

The purchase of an asset by means of a structured financial agreement.

Instead of having to pay the full amount immediately, the company is able to

spread the payment over a period of typically between two and five years.

Finance lease

A type of asset financing that appears initially very similar to hire purchase. Again

the asset is paid for over between two and five years (typically) and again there is

a deposit (initial rental) and regular monthly payments or rentals.

The key difference is that at the end of the lease agreement the title to the asset

does not pass to the company (lessee) but is retained by the leasing company

(lessor). This has important potential tax advantages.

Operating lease

In this situation the company does not buy the asset (in part or in full) but instead

rents the asset.

The operating lease is often used where the asset is only required for a short period

of time such as Plant Hire or the company has no interest in acquiring the asset

simply wishing to use it such as a company vehicle or photocopier.



MEASURES OF WORKING CAPITAL MANAGEMENT

Liquidity measures Efficiency measure

Issue

Measures

Ensuring sufficient funding to

avoid running out of cash Current ratio

Measuring the speed of c irculation

of cash within the company The operating cycle

Quick ratio

Liquidity ratios

Current assets may be financed by current liabilities or by long-term funds. The

“id al” curr nt ratio is 2: . This would mean that half of the current assets are

financed by current liabilities and therefore half by long-term funds. Similarly the

ideal quick ratio is 1:1.

Current ratio

A measure that considers the manner in which current assets are financed. A safe

measure is considered to be 2:1 or greater meaning that only a limited amount of

the assets are funded by the current liabilities. This would arise if the company

adopted a conservative approach to financing.

Current Assets

Current Ratio = Current Liabilities

Quick ratio

A measure of how well current liabilities are covered by liquid assets . A safe

measure is considered to be 1:1 meaning that we are able to meet our existing liabilities if they all fall due at once.

Quick Ratio =

(or acid test)

Current Assets minus Stock

Current Liabilities



OVERTRADING

Overtrading is the term applied to a company which rapidly increase its turnover

without havin suffici nt capital backin , h nc th alt rnativ t rm “und r-

capitalisation”.

Output increases are often obtained by more intensive utilisation of existing fixed

assets, and growth tends to be financed by more intensive use of working capital.

Overtrading companies are often unable or unwilling to raise long-term capital and

thus tend to rely more heavily on short -term sources such as overdraft and trade

creditors.

Overtrading is thus characterised by rising borrowings and a declining liquidity

position in terms of the quick ratio, if not always according to the current ratio.

Symptoms of overtrading

1. Rapid increase in turnover

2. Fall in liquidity ratio or current liabilities exceed current assets

3. Sharp increase in the sales-to-fixed assets ratio

4. Increase in the trade payables period

5. Increase in short term borrowing and a decline in cash balance

6. Fall in profit margins.

Overtrading is risky because short-term finance may be withdrawn relatively

quickly if creditors lose confidence in the business, or if there is general tightening

of credit in the economy resulting to liquidity problems and even bankruptcy, even

though the firm is profitable.



Example 7

Ewden plc is a medium-sized company producing engineering products which it

sells to wholesale distributors. Recently, its sales have begun to rise rapidly

following a general recovery in the economy. It is concerned about its liquidity

position. Ewd n‟s accounts for th past two y ars ar summaris d b low. Income Statement for the year ended 31 December

2011 2012

$000 $000

Sales 12,000 16,000

Cost of sales 7,000 9,150

Operating profit 5,000 6,850

Interest 200 250

Profit before tax 4,800 6,600

Taxation (after capital allowances) 1,000 1,600

Profit after tax 3,800 5,000

Dividends 1,500 2,000

Retained profit 2,300 3,000

Statement of Financial Position as at 31 December

Fixed assets (net)

Current assets

Inventory

Receivables

Cash

Current liabilities

Overdraft

Trade payables

Other creditors

10% loan stock

Net assets

Capital and reserves

Ordinary shares (50p)

Profit and loss account

2011 $000 $000

9,000

1,400

1,600

1,500

4,500

–

1,500

500

(2,000)

(2,000)

9,500

3,000

6,500

9,500

2012 $000 $000

12,000

2,200

2,600

100

4,900

200

2,000

200

(2,400)

(2,000)

12,500

3,000

9,500

12,500

Required:

(a) Identify the reasons for the sharp decline in Ewden’s liquidity and

assess the extent to which the company can be said to be exhibiting

the problem of ‘overtrading’.


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n

Profit after tax


=


R Theoretical




CASH MANAGEMENT

Holding cash is

necessary to be able

to pay the bills and

maintain liquidity

Cash is an idle asset that costs money to fund but generates little or no return

There are three areas associated with managing cash:

1. The Miller-Orr Model

2. The Baumol Model

3. The Cash Budget.

The Miller-Orr model

A model that considers the level of cash that should be held by a company in an

environment of uncertainty. The decision rules are simplified to two control levels

in order that the management of the cash balance can be delegated to a junior

manager.

Cash balance

⅔

spread

⅓ spread

Time

The model allows us to calculate the spread.

control levels can be calculated.


Given that we have the spread all key

167


Minimum level – given in the question

Maximum level = minimum level + spread

Return point = minimum level + ⅓ spread

Example 8

The minimum level of cash is $25,000. The variance of the cash flows is $250,000.

The transaction cost for both investing and en-cashing funds is $50. The interest

rate per day is 0.05%.

Required:

Calculate the:

(a) spread

(b) maximum level

(c) return point.

The Baumol model

The use of the EOQ model to manage cash.

Q= 2Co.D

Ch

Co = Transaction cost of investing/ en-cashing a security

D = Excess cash available to invest in short -term securities

Ch = Opportunity cost of holding cash

Example 9

A company generates $5,000 per month excess cash. The interest rate it can

expect to earn on its investment is 6% per annum. The transaction costs

associated with each separate investment of funds is constant at $50.

Required:

(a) Calculate the optimum amount of cash to be invested in each

transaction.

(b) How many transactions will arise each year?



Cash budget

A budget prepared on a monthly basis (at least) to ensure that the company has an

understanding of its cash position going forward. There are 3 considerations:

1. Inflow and outflows of cash

2. Ignore non cash flows

3. Pro forma led

Example 10

Cash flow forecasts from the current date are as follows:

($000) Cash operating receipts

Cash operating payments Interest payable on traded bonds

Capital expenditure

Month 1 Month 2 Month 3

6,530 5,300 4,300

5,040 4,750 4,600 200

1,000

The company currently has an overdraft balance of $2,000,000

The director has completed a review of accounts receivable management and has

proposed staff training and operating procedure improvements, which he believes

will reduce accounts receivable days by 18 days. This reduction would take four

months to achieve from the current date, with an equal reduction in each month.

Overdraft interest is payable at a rate of 0.5% per month, with payments being

made each month based on the opening balance at the start of that month. Credit

sales for the year to the current date were $60,500,000 and cost of sales was

$42,320,000. These levels of credit sales and cost of sales are expected to be

maintained in the coming year. Assume that there are 365 working days in each

year.

Required:

Calculate:

(a) the bank balance in three months’ time if no action is taken; and

(b) the bank balance in three months’ time if the director’s proposal is

implemented.



Exam standard working capital management problem

Example 11

Kool Co has annual sales revenue of $7 million and all sal s ar on 3 days‟ cr dit,

although customers on average take fifteen days more than this to pay .

Contribution represents 55% of sales and the company currently has no bad debts .

Accounts receivable are financed by an overdraft at an annual interest rate of 8%.

Kool Co plans to offer an early settlement discount of 1.4% for payment within 20

days and to extend the maximum credit offered to 65 days.

The company expects that these changes will increase annual credit sales by 8%,

while also leading to additional variable costs equal to 0.5% of turnover. The

discount is expected to be taken by 35% of customers, with the remaining

customers taking an average of 65 days to pay. Required:

(a) Evaluate whether the proposed changes in credit policy will increase

the profitability of Kool Co.

(b) Tiger Co, a subsidiary of Kool Co, has set a minimum cash account balance of

$2,000. The average cost to the company of making deposits or selling

investments is $50 per transaction and the standard deviation of its cash

flows was $1,000 per day during the last year. The average interest rate on

investments is 9.125%.

Determine the spread, the upper limit and the return point for the

cash account of Tiger Co using the Miller-Orr model and explain the

relevance of these values for the cash management of the company.



THE TREASURY FUNCTION

A function devoted to all aspects of cash within a company.

This includes:

1. Investment

2. Raising finance

3. Banking and exchange

4. Cash and currency management

5. Risk

6. Insurance.

Role

„Tr asury mana m nt is th corporat handlin of all financial matt rs, th

generation of external and internal funds for business. The management of

currencies and cash flows, and complex strategies, policies and procedures of

corporat financ .‟

Centralisation vs. decentralisation

In a large organisation there is the opportunity to have a single head office t reasury

department or to have individual treasury departments in each of the divisions.

Modern practice would suggest the decentralised route where there is little or no

head office intervention in the workings of an autonomous division. This runs

contrary to treasury practice where large companies tend to have a centralised

function.

Advantages of centralisation

1. Avoid duplication of skills of treasury across each division. A centralised team

will enable the use of specialist employees in each of the roles of the

department.

2. Borrowin can b mad „in bulk‟ takin advanta of b tt r t rms in th form

of keener interest rates and less onerous conditions.

3. Pooled investments will similarly take advantage of higher rates of return than

smaller amounts.

4. Pooling of cash resources will allow cash-rich parts of the company to fund

other parts of the business in need of cash.

5. Closer management of the foreign currency risk of the business.

Advantages of decentralisation

1. Greater autonomy of action by individual treasury departments to reflect local

requirements and problems.

2. Closer attention to the importance of cash by each division.



Profit centre vs. cost centre

Should the treasury department be run as a cost centre or a profit centre?

Cost centre – A function to which costs are accumulated.

Profit centre – A function to which both costs and revenues are accounted for.

Advantages of using a profit centre

1. The use of the treasury department is giv n „a valu ‟ which limits th us of

the service by the divisions.

2. The prices charged by the treasury department measure the relative efficiency

of that internal service and may be compared to external provision.

3. The treasury department may undertake part of the hedging risk of a trade

thereby saving the company as a whole money.

4. The department may gain other business if there is surplus capacity within the

department.

5. Speculative positions may be taken that net substantial returns to the

business.

Disadvantages of using a profit centre

1. Additional costs of monitoring. The treasury function is likely to be very

different to the rest of the business and hence require specialist oversight if

run as a profit making venture.

2. The treasury function is unlikely to be of sufficient size in most companies to

make a profit function viable.

3. The company may be taking a substantial risk by speculation that it cannot

readily quantify. In the event of a position going wrong the company may be

dragged down as a result of a single transaction.


Solutions to examples


SOLUTIONS TO EXAMPLES

CHAPTER 1 – FINANCIAL MANAGEMENT: AN

INTRODUCTION

3 factors affecting share price:

1. Cash flows to investors (dividends)

2. Growth prospects

3. Risk – aff ctin shar hold rs‟ r quir d r turn

Example 1

(a) P0 = 2

. 2- . 4 = 299 cents

(b) P0 = 2

. 5- . 4 = 217 cents. More risk makes the share less attractive

(c) P0 = 2

. 2- . 6 = 406 cents. Enhanced growth sees the share price increase

(d) P0 = .

3

2 = 192 cents


Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M


Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin


Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D M

Days

Payables

365 Maximum level

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fin

a isio N L D D n 0 D D i i R P e d e d e

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S c b D

Days

Payables

365

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.




Fina isio N L D D n 0 D D i i R P e d

Profit after tax


=


R Theoretical




o 1 1 I D F = S c b S = S

Days

Payables


CHAPTER 2 – FUNDAMENTAL FINANCIAL MATHS

Example 1

10,000 x 1.054 = $12,155

Example 2

Year 1 2 3 4

Price ($30)

Cost ($12)

Contribution

31.35

32.76

34.23

35.78

12.72

13.48

14.29

15.15

18.63

19.28

19.94

20.63

Example 3

12,155 x 1.05-4 = $10,000

Example 4

Year (n) 1 2 3 4 5

FV

(1 + r)-n

Present Value

360,000

280,000

0.907

0.7835 326,520

219,380

Total (326,520 + 219,380) = $545,900

Example 5

Year 1 2 3 4 5

FV

PVF

Present Value

40,000

40,000

40,000

40,000

40,000

0.952

0.907

0.864

0.823

0.784

38,080

36,280

34,560

32,920

31,360

Total = $173,200

OR

40000 x (0.952 + 0.907 + 0.864 + 0.823 + 0.784) = $173,200

Example 6

$12,500 x 7.536 = $94,200

Investing $90,000 gives something worth $94,200 in return.

gain in wealth of $4,200.


The investor makes a

175


Example 7 (a) PV of 4 year annuity starting after 1 year (100,000 x 3.170) $317,000

(b) (i) Starting at time 4; value at time 3 is

Value at time 0 (PV) 317,000 x 0.751

(ii) Starting at time 0; 1s t instalment is in PV terms

2nd to 4th = 3 year annuity (100,000 x 2.487)

Total Present Value

$317,000

100,000

247,800

$238,067

$348,700

Example 8 1. Perpetuity value = 18,000 ÷ 0.09

Starting at time 5; value at time 4 is

Present value (200,000 x 0.708)

$200,0002.

200,000

$141,600 176 w w w .s tudyinte ract ive .o rg

Investment

Dividend Decision

Decision

Long- or short-term


cash give an

adequate return to

investors?

Debt or Equity

With an attractive

investment

opportunity, where



Retained earnings

provide a cheap

source of equity

finance.






Example 1

Time

Price V

Cost

Contribution

Volume

Total Contribution

Tax

Capital Allowance

Resale

Working Capital

Net Cash

Present Value (rounded)

Cumulative

Investment

Working Capital

Net Present Value

1 2

3% 30.00 30.90

4.50% 12.00 12.54

18.00 18.36

10000 12500

180000 229500

30% -54000

38625

-12938 -1738

167062 212387

10% 151900 175400

327300

3 4 5

31.83 32.78

13.10 13.69

18.72 19.09

12500 7500

234000 143175

-68850 -70200 -42952

28969 21727 44180

70000

22796 36880

216915 201582 1232

162900 137700 800

490200 627900 628700

515000

45000

68700

Example 2

NPV

000

X

69

10% 15% 20%

r%

-29 X

IRR appears close to 15.5%

Example 3

10 69 - (-29)

(18 - 10) 15.6%


Investment

Dividend Decision

Decision

Long- or short-term

Debt or Equity




Example 1

(a) 3.170 x $100,000 = $317,000

(b) 3.170 x $100,000 = $317,000 lands at time 3

Discounted by 3 further years: $317,000 x .751 = $238,067

(c) 3 future cash flows starting at time 1 have an annuity factor of 2.487

Add the cash flow at time 0 1.000

PV factor for all 4 payments 3.487

PV = $348,700

Example 2

(a) 18,000 ÷ 0.09 = $200,000

(b) $200,000 x 0.708 = $141,600

Example 3

(1 + money) = 1.08 x 1.05 = 1.134. Money rate = 13.4%

Example 4

(1 + r) = 1.123 ÷ 1.04 = 1.0798. Real rate = 8%

Example 5

WACC = 12%; real rate = 8%

Money Analysis

Year

Annual contribution

6,000 x (50 – 15) inflated

12% PVF

$PV

Cumulative

Real Analysis

3 year Annuity 6,000 x (50 – 15)

8% annuity factor

Present Value

1

217,560

0.893

194,281

2

225,392

0.797

179,637

$540,174

210,000

2.577

$541,170

3

233,506

0.712

166,256

(same value with rounding difference)



Example 6 Purchase price = $45,000

Year

8% PVF

Annual running cost

PV

Resale Value at year end

1 2

0.926 0.857

5,000 5,000

4,630 4,287

n/a n/a

3 4 5

0.794 0.735 0.681

5,000 7,000 11,000

3,969 5,145 7,486

18,000 14,000 6,000

PV 14,289 10,290 3,403

Present Value of:

Annuity Factor (8%)

EAC

3 year cycle

$43,597

2.577

$16,918

4 year cycle

$52,741

3.312

$15,924

LOWEST

5 year cycle

$67,114

3.993

$16,808

Example 7 - divisible Project

A

B

C

D

Invest

Initial investment NPV PI Rank

$000s $000s

100 25 0.250 2

200 35 0.175 3

80 21 0.262 1

75 10 0.133 4

Project

1 C

2 A

3 B

Total

Proportion

100%

100%

170/200

Capital

80

100

170

Remaining NPV

270 21

170 25

- 29.8

75.8

Example 7 - indivisible Feasible combinations: A&C (46); A&D (35); B only (35); C&D (31)



Example 8 (i) Allocate the $800,000 based upon Profitability Index (NPV per $ invested)

Project 1: $32.7 ÷ 300 =

Project 2: $57.6 ÷ 450 =

Project 3: $79.2 ÷ 400 =

So invest 100% in project 3:

P.I. Rank

0.109 3

0.128 2

0.198 1

NPV

79.2

And the remaining 400 in project 2 (400 ÷ 450) x 57.6 51.2

Maximum possible NPV 130.4

(ii) Allocate to affordable combinations:

Projects 1 and 2 (investing 300 + 450) give

Projects 1 and 3 (investing 300 + 400) give

Therefore invest in projects 1 and 3

Workings

Project 1

32.7+57.6 90.3

32.7+79.2 111.9

iscount iv n nominal („mon y‟) valu s at th nominal cost of capital of 2%

Time

$000

12% PVF

$PV 75.9

Less initial investment

NPV

Project 2

1 2 3

85 90 95

.893 .797 .712

71.7 67.6 63.6

4 5

100 95

.636 .567

53.9 332.7

Cumulative

(300.0)

32.7

Discount annuity in nominal terms using the 12% nominal cost of capital

$140.8 x 3.605 =

Initial Investment

NPV

Project 3

507.6

(450.0)

57.6

Either: inflate $120,000 to nominal terms using 3.6% inflation and discount at

nominal 12%;

Or: leave $120,000 as an annuity in real terms and discount at the real cost of

capital (the less complex option).

(1 + i) = (1+r)(1+h)

1.12 = (1+r) x 1.036

1+r = 1.12÷1.036 = 1.082 180 w w w .s tudyinte ract ive .o rg

SOLUTIONS TO EXAMPLES Use 8% factors

PV = $120.0 x 3.993 =

Initial investments =

NPV

479.2

(400.0)

79.2

Example 9 NPV working (with detail for sensitivity analysis)

Time Amount

1-3 Revenue

1-3 Variable Cost

1-3 Contribution

1-3 Fixed Cost

Present Value

Investment

120,000

30,000

90,000

65,000

PVF $PV

2.487 298,440

2.487 223,830

2.487 161,655

62,175

50,000

Net Present Value $12,175

Sensitivity to:

(i) Price:

(ii) Volume:

(iii) Fixed costs:

12175 ÷ 298,440 = 0.041%

Breakeven sales price will be $12 x (1 – 0.041) = $11.51 per

unit

12,175 ÷ 223,830 = 0.054

Breakeven volume = 10,000 x (1 – 0.054) = 9460 units p.a.

12175 ÷ 161,655 = 0.075

Breakeven cost = 65,000 x (1- 0.075) = $60,125 p.a.

Example 10 (a) Expected NPV

(1250 x 0.12) + (650 x 0.30) + (320 x 0.25) + ((750) x 0.33) = $177,500

Positive NPV suggests accepting the project.

(b) Ignores the fact that the most likely outcome is to make a whopping big loss.

Relies on probabilities which have no statistical backing.

Even if the probabilities were in any way reliable, this is an average value

which would only be achieved if the decision were repeated frequently and,

everyone knows, Toorongs rarely makes a Wryte once, let alone repeatedly!



Example 11

Time


Cumulative

1 2

$’000 $’000

167 212

379

3 4 5

$’000 $’000 $’000

217 202 1

596


Cumulative cash flows reach and exceed outlay during 3rd year. i.e. Payback is

within 3 years.

Example 12

Time


PVF @ 10%

PV

Cumulative

1 2

$’000 $’000

167 212

0.909 0.826

152 175

327

3 4 5

$’000 $’000 $’000

217 202 1

0.751 0.683 0.621

163 138 1

490 628


Discounted payback occurs in fourth year.

Example 13 Discount at after-tax cost of borrowing (15 x (1-0.33)) 10%

Leasing option

Time Lease payments

33% tax relief

Net 10% PVF

Present Value

0 1

$’000 $’000

(30) (30) (30) (30)

0.909 (30) (27.3)

2 3 4 5

$’000 $’000 $’000 $’000 (30) (30) 9.9 9.9 9.9 9.9

(20.1) (20.1) 9.9

9.9 0.826 0.751 0.683 0.621

(16.6) (15.1) 6.8 6.1

Total present value of costs $76,100

Buying option

Time 0 1

$’000 $’000 Purchase/Resale (100)

Tax relief on capital

allowances 10% PVF 0.909

Present Value (100)

2 3 4 5

$’000 $’000 $’000 $’000 10

8.3 6.2 4.6 10.6 0.826 0.751 0.683 0.621

6.9 4.7 10.0 6.6

Total present value of costs $71,800

The better option, in purely financial terms, is to buy the equipment.


Example 14 Average level of profit (165 + 189 + 186 + 143) ÷ 4

Average capital (excluding working capital) (515 + 70) ÷ 2

ARR (170.5 ÷ 292.5)


170,500

292,500

58.3%

183



No worked examples




Example 1

Ke = [(20 x 1.05) ÷ 400] +0.05 = 0.1025 OR 10.25%

Example 2

369 cum-div with a dividend of 36 becomes 333 ex-div

Ke = [(36 x 1.04) ÷ 333] +0.04 = 15.2%

Example 3

Growth = 0.133

Ke = [(33 x 1.133) ÷ 600] +0.133 = 19.5%

Example 4

Growth = 0.079

Ke = [(11 x 1.079) ÷ 258] + 0.079 = 12.5%

Example 5

Growth = 70% x 12% = 8.4% OR 0.084

Ex-div P0 is 500 – 40 = 460

Ke = [(40 x 1.084) ÷ 460] + 0.084 = 17.8%

Example 6

Ke = 8 + 1.2 x (15 – 8) = 16.4%

Example 7

Ke = 6 + 0.8 x (8) = 12.4%

Example 8

Kd = [10 x (1-0.3)] ÷ 120 = 5.83%



Example 9

Time Cash %amount 1s t PVF 7% 1s t PV 2nd PVF 5% 2nd PV

1-5

5

0

I(1-T)

7

4.100

28.7

4.329

30.3

Redemption

100

0.713

71.3

0.784

78.4

P0

1s t NPV

100

2nd NPV

108.7

(102)

(102)

(2)

6.7

Kd: IRR is approximately 6.5%

NPV at different costs of capital (you only need to work out two)

Rate 4% 5%

NPV 11.4 6.7

6% 7% 8%

2.2 -2 -6.0

9% 10%

-9.8 -13.4

15

10

5

0

4% 5% 6% 7% 8% 9% 10% 11% 12%

-5

-10

-15

-20

-25

Example 10

Value

V ÷ (Ve + Vd)

Equity

20,000 x $3

60,000

60 ÷ 66.8

89.9%

Debt

8,000 x 85%

6,800

6.8 ÷ 66.8

10.1%

Total

66,800

WACC = (89.9% x 15) + (10.1% x 7.6%) = 14.3%



Example 11

Value of 25 shares after 4 years with 6% growth: 25 x $4 x (1.06)4 = $126.25

Likely outcome is conversion rather than redemption (worth $100).

Time Cash % amount 1s t PVF 7% 1s t PV 2nd PVF 10% 2nd PV

1-4

4

0

I(1-T)

7

3.387

23.7

3.170

22.2

Redemption

126.25

0.763

96.3

0.683

86.2

P0

1s t NPV

120

2nd NPV

108.4

(110)

(110)

10

(1.6)

K onv IRR approximately 9.5%

Example 12 Kpref = 9 ÷ 140 = 6.4%

Example 13 Interest rate = 12%; cost of debt = 12 x (1 – 0.3) = 8.4%

Example 14 Cost of Debt = [10 x (1 – 0.7)] ÷ 120 = 5.8%


c


CHAPTER 7 – CAPITAL STRUCTURE

No examples.



CHAPTER 8 – BUSINESS RISK

Example 1

Year to:

Starting Price

Share price growth to 2011

Dividend Earned (Dec 2011)

Total return

As a % of starting

June 2011

400

40

10

50

12.5%

Sept 2011

480

2

10

12

2.5%

Example 2

r = 10 + 1.3 x (20 – 10) = 23%

None. Th r is diff r nt busin ss risk so th company‟s cost of capital is irr l vant .

Example 3

Need a beta from a gaming company with 37.5% debt (3:5 for Foreignin).

L has 35%; C has 40%, therefore the relevant beta is approximately half way

b tw n L‟s ( . ) and C‟s ( . 8) – use 1.14.

Ke = 6 + 1.14 x (11 – 6) = 11.7%

Example 4

Ignore current beta since it reflects a different business risk to the investment.

Proxy beta = 1.3

Asset beta = 1.3 x [60 ÷ (60 + 40(1-0.3))] = 0.886

(a) Equity beta at 30% debt = 0.886 x [70 + 30(1 - 0.3)] ÷ 70 = 1.15

Ke = 4 + 1.15 x (10 – 4) = 10.9%

(b) Equity beta at 70% debt = 0.886 x [30 + 70(1 - 0.3)] ÷ 30 = 2.33

Ke = 4 + 2.33 x (10 – 4) = 18%



CHAPTER 9 – FINANCIAL PERFORMANCE MEASUREMENT

Example 1

$m Equity Finance

ROCE 10/42

Debt Finance

10/(20 + 22)

= 23.81% = 23.81%

Working

PBIT 10 10

Less Interest 0 10% (2)

PBT 10 8

Less Tax @30% (3) (2.4)

PAT 7 5.6

ROE 7/42 5.6/22

= 16.67% = 25.45%

Example 3

Financial Gearing

Debt

Equity

= 5 + 8 + 1 = 14

= 8 + 4 + 2 = 14

Equity gearing (D/E)

Total gearing (D/D + E)

= 14/14 = 100%

= 14/28 = 50%

Example 4

(a) Interest coverage

= PBIT/ interest = 20/4.5 = 4.44 X

(b) The level of cover suggest that we can cover our interest payments four times

over, although this may be considered relatively safe it does suggest a high

proportion of the profits generated are used solely to service debt leaving

relatively little available to re-invest in the company or pay out in the form of

dividends.



Example 5

(a) Forecast Income Statement

$000s Debt financing Equity financing

Sales

+12% Cost of sales VC 85%

FC 15%

56,000

(28,560)

(4,500)

56,000

(28,560)

(4,500)

Gross profit 22,940 22,940

Admin costs + 5% (14,700) (14,700)

PBIT 8,240 8,240

Interest +500 (800) (300)

PBT 7,440 7,940

Tax @30% (2,232) (2,382)

PAT 5,208 5,558

Dividends @60% 3,125 3,335

RE 2,083 2,223 www .s tudyinte ract ive .org 191

SOLUTIONS TO EXAMPLES (b) Evaluation

Financial gearing

= D/E

Debt financing

2,500 + 5,000

= 22,560 + 2,083

Equity financing

2,500

= 22,560 + 2,223 +

5,000

Existing = 11.1% = 30.4% 8.4%

Operational gearing

= FC/TC

Existing = 42%

Interest cover

= PBIT/ interest

Existing = 20 X

4,500 + 14,700

= 33,060 + 14,700

= 40.2% = 40.2%

8,240 8,240

= = 800 300

= 10.3 X = 27.5 X

Earnings per share

5,208 5,558

= PAT/ No of shares 10,000 12,500

Existing = 39.9c = 52.1c = 49.4c

Comment

The project should be accepted because no matter how it is financed it will

mat rially incr as th company‟s arnin s p r shar and improv th r turn

to shareholders.

Financing by debt will have the effect of increasing the earnings per share by

a greater amount but at the expense of increasing financial risk. Both capital

structure and ability to pay interest as it falls due will be worse as a result of

debt. Both measures appear to be safe however as the existing position is

very safe.

Financing by equity will still improve earnings per share but not as much as

debt. It will however reduce the financial risk to the company in both

structural terms as gearing falls to only 8% and ease pressure from interest

payments on profits.

Example 6 EPS = $14m/6m = 233c per share



Example 7

Dan Steph P/E Ratio 200/10 80/8

= 20 X = 10 X

Dividend payout ratio 2/10 x 100 8/8 x 100

= 20% = 100%

Dividend yield 2/200 x 100 8/80 x 100

= 1% = 10%

Example 8

2006 2007 2008 Dividend (cents)

Share price (cents)

Capital gain

TSR ROE

24.3 26.3

725 885

160

186.3

= 725

=25.7%

11%

27.6

734

(151)

(123.4)

885

=(13.9%)

9%




Example 1

Shares Price Sum

Existing

New

3 $2.8 $8.4

1 $2.0 $2.0

4

TERP = $10.4/ 4shares = $2.6/share

Value of a right

Per new share

$2.6 - $2.0 = $0.6/new share

Per existing share

$2.8 - $2.6 = $0.2/existing share

194

$10.4



Example 2 Tirwen

(a)

Shares Price Sum

Existing 5

New 1

$4.00 $20.00 $3.40 $3.40

6

TERP = $3.9/ share

Value of a right per existing share

$23.40

$4 - $3.9 = $0.1/existing share

(b)

Take up rights

Total

Sell rights

In

$ Shares

1,000 x $4 4,000

Cash 1,000 x 1/5 x $3.4 680

4,680 Shares 1,000 x $4 4,000

Out

$ Shares

1,000 x 6/5 x $3.9 4,680

4,680

Shares 1,000 x $3.9 3,900

Cash 1,000 x $0.1 100

Total 4,000 4,000

The existing shareholder has two basic options, to take up the shares or to

sell the rights to those shares. If you consider the implications of these

actions above you will notice that the shareholder will be in a neutral position

in both cases providing the theoretical ex rights price is achieved.



(c)

Current EPS

= share price ÷ price earnings ratio

= $4 ÷ 15.24 = $0.2625/share

Revised earnings per share

Note changes are:

1 issue shares

2 redeem debt, this will affect the tax paid

3 no change to underlying company assets therefore the PBIT can be

expected to remain the same.

We may use the statement of comprehensive income to help us.

Current PAT = $0.2625 x 4m = $1,050,000

(000s) Before $ After $

PBIT 2,127.5 2,127.5

Less Interest

PBT

12% x 4,500 +

7% x 1,250 627.5 Reduction of 2,500 327.5

(see below) 1,500 1,800

Less tax 30% 450 540

PAT 1,050 1,260

Working

Debt redeemed $000s

Total equity raised 2,720

Less issue costs (220)

Debt redeemed 2,500

Reduction in interest paid @ 12% 300

Revised EPS = $1,260/4,800 = $0.2625/share



CHAPTER 11 – EFFICIENT MARKET HYPOTHESIS

No worked examples




Example 1

Growth 2.5 x (1+g)5 = 4; (1+g)5 = 1.60; (1+g) = 1.0985

g (approx.) = 10%

Ke = 6 + 0.6(17 – 6) = 12.6%

4 x . 0

( . 26- .

) = 169 cents per share; Total value = $33,800,000

Example 2

Growth ROCE 20% x retained earnings (4 ÷ 20) 20% g = 4%

Ke = 6 + 0.9(11 – 6) = 10.5%

P0 = ( .

6

5-

.

. 4) = 256 cents per share;

Total value = $25,600,000

Example 3

Net Assets less liabilities = 785,000 – 200,000 = $585,000 (by book value)

Add $50,000 for non-current assets.

Deduct $10,000 for premium on debentures

Net value (585 + 50 – 10)

60% holding

$625,000

$375,000

Example 4

P/E to use is 10

Earnings available to ordinary shareholders are (320 – 30) $290,000.

Value is (10 x 290) $2,900,000

Example 5

$300,000 ÷ 0.125 = $2,400,000

Example 6

Tim horizon = “for s abl futur ”; us p rp tuity.

Real cost of capital = 10%

Taxation = 30% x (400 – 150 – 36 – 28) = 55.8 p.a.

Free Cash Flow = (400 -150 -36 – 60 – 55.8) = $98.2m pa

Total PV of FCF=

Value of Debt (140 x 1.10)

Value of Equity

198

$982m

$154m

$828m


P =

x 4


Example 7 (i) Net asset value = 1,330 – 210 – 295 =

(ii) Dividend Growth = (69 x 1.03) ÷ (0.10 – 0.03) =

(iii) Earnings Yield = 115 ÷ 0.11 =

Or (growth model) (115 x 1.04) ÷ (0.11 – 0.04) =

$825m

$1,015m

$1,045m

$1,709m

Example 8 MV = 9% ÷ 0.06 = 150%

Example 9

Time Cash

1-4 Interest

4 Redeem

$per 100 NV 7%PVF $PV

8 3.387 27.1

100 0.763 76.3 Present Value per $100 nominal

Total Market Value (103.4% x $120m)

103.4

$124.1m

Example 10

(a)

Floor Value Expectation is that investors would recover debt capital.

Time Cash

1-4 Interest

4 Redeem


7 3.465 24.26

100 0.792 79.20

Present Value per $100 nominal

Total Floor Value (103.46% x $40m)

103.46 $41.38m

(b)

Conversion value would be 16 x $6 x (1.04)4 = $112.31 (>$100)

Expectation is that investors would convert to shares.

Time Cash

1-4 Interest

4 Redeem


7 3.465 24.26

112.31 0.792 88.96

Present Value per $100 nominal

Total Market Value (113.22% x $40m)

(c)

Conversion premium (45.29 – 41.38)


113.22

$45.29m

$3.91m

199


Example 11 Div = 11% x 50 cents = 5.5

P0 = 5.5 ÷ 0.06 = 91.7 cents per share. 200 w w w .s tudyinte ract ive .o rg


CHAPTER 13 – RISK

Example 1

(a) (i) Curr ncy in €; Rat in € so divide

Selling to the bank; the bank pays lower $ so divide by higher rate:

0.7778

R c ipt: €3 , ÷ .7778 = $385,703

(ii) € 55, ÷ .777 = $199,485

(b) (i) $385,710 ÷ 1.2857 = $300,000

(ii) € 55, x .287 = $199,485

Example 2

1 month: Netting off – payment of (515-265) €25 ,

Buy € payin (25 , ÷ .778 ) $321,295

3 month: N t r c ipt of €45 ,

S ll € r c ivin (45 , ÷ .782 ) $575,448

Example 3

Step 1 Match r c ipt of €45 , in 3 months‟ tim with a liability to b worth

€45 , in 3 months‟ tim .

Borrow in € payin 7.2% x 3/ 2 = .8%

450,000 ÷ 1.018 =

Step 2 Convert at spot rate

442,348 ÷ 0.7778 =

Step 3 Invest in $ money market, earning 4.8% x 3/12 = 1.2%

Amount in 3 months (568,325 x 1.012)

€442,043

$568,325

$575,144

The forward contract ($575,448) yields slightly more than the money market.

However, a decision whether Danke Yudle should use the money market would

d p nd on its ability to (and cost to) borrow in € as w ll as th opportuniti s it has

for investing the $568,325 to be received immediately.

Example 4

(a) In one month, the net payment will be £56,098 (100,000 ÷ 1.7826)

In three months, the net receipt will be £168,067 (300,000 ÷ 1.7850)

(Working)

Net off any concurrent receipts and payments– ie one month, net payment is

$100,000.

The forward rate to buy dollars is the lower end of the spread, so 1.7826.



Three month rate to sell dollars; higher end of spread = $1.7850.

(b) Step 1 Borrow an amount in $USD to be paid off, with interest, by the

$300,000 receipt

ie 300,000 ÷ 1.0135 = $296,004

Note that interest is given annually, so 5.4% becomes 1.35% quarterly

Step 2 Convert that borrowing to sterling (÷ 1.7822)

Step 3 Invest in UK money market at 1.15% (x 1.015)

£166,089

£168,580

In this case, the money market yields slightly higher income than the forward

market hedge (£168,580 compared to £168,067) and so Inshal should use

the money market to hedge the receipt.

(c) Curr ncy futur s involv tradin in a mark t with instrum nts (th „futur s‟)

whose value rises or falls in connection with the value of a related asset, in

this case, an amount of £sterling stated in US dollar terms.

Inshal would, effectively, be betting that the value of the $300,000 receipt

falls below an amount iv n today in th futur s mark t (l t‟s say

£169,000).

If the worst happens and the receipt on the spot market is only £167,500,

then Inshal has won its bet and will gain £1,500 from the futures market,

giving a net of £169,000.

On the contrary, if the spot proceeds were to be £175,000, Inshal would lose

its bet, costing it £6,000 out of the proceeds, netting it £169,000 again.

The futures market is more complex than illustrated. For instanc , w can‟t

simply „b t‟ on $3 , . The market trades in multiples of £62,500 so

Inshall would have to trade in either £125,000 of futures (leaving a portion of

the receipt uncovered by the hedge), or £187,500 (with the potential of losses

– or gains – on the difference between that amount and the expected receipt

of £169,000). Either way, futures would not completely eliminate risk.

Finally, operating a futures hedge requires financial management staff with

expertise and the availability to monitor the position of the contract daily.

This brings with it additional costs compared to forward market or money

market hedging.

Frankly, anybody suggesting a futures hedge for a sum of only $300,000

should probably stay away from the important financial decisions affecting

Inshal.

Example 5

$ Rate €

Now

Interest

+ 1 year

1,000,000

× 1.05

1,050,000

0.7774 777,400

× 1.07 0.7922 831,818

831,818 ÷ 1,050,000 = 0.7922 202 w w w .s tudyinte ract ive .o rg


Example 6

$ Rate (€/$) €

Now

Inflation

+ 1 year

10,000 0.7774 7,774

× 1.0372 × 1.057 10,372 8,216

8,216 ÷ 10,373 = 0.7922 www .s tudyinte ract ive .org 203



Example 1

Operating cycle Days

Inventory turnover period Inventory/Cost of sales x 365 68

30,000/160,000 x 365

Receivables period Receivables/Sales x 365 88

60,000/250,000 x 365

Payables period Payables/Cost of sales x 365 (114)

50,000/160,000 x 365

42 days

Example 2

(a) Receivables days = $8m/$40m x 365

(b) Cost of financing receivables

$8m x 0.14

= 73 days

= $1,120,000

Example 3

Cost of financing receivables

Interest cost

50% pay over normal terms $40m x 0.5 x 73/365 x 0.14

50% pay over discounted terms $40m x 0.5 x 10/365 x 0.14

Discount $40m x 0.5 x 0.02 Total cost

$560,000

$ 76,712

$400,000 $1,036,712

Example 4

Interest cost $40m x 50/365 x 0.14

Factor fee $40m x 0.016 Admin savings

Total cost

204

$767,123

$640,000

($175,000) $1,232,123



Example 5

($s) Order quantities Ordering cost d/Q x Co

120,000/500 x $30 120,000/600 x $30

120,000/700 x $30 Holding cost Q/2 x Ch

500/2 x $20 600/2 x $20

700/2 x $20

500 600 700 7,200

6,000

5,143 5,000

6,000 7,000

Total cost 12,200 12,000 12,143

Order 600 units each time

Economic ord r quantity = √ 2 x $3 x 2 , /$2 = 6 units

Example 6

($s) Ordering cost d/Q x Co

120,000/600 x $30

120,000/1,000 x $30

Order quantities

EOQ Bulk Disc.

600 1,000

6,000 3,600

Holding cost Q/2 x Ch

600/2 x $20 6,000

1,000/2 x $20 10,000

Purchase cost

120,000 x $10

120,000 x $9.8 Total cost

Choose the bulk discount

1,200,000

1,212,000

1,176,000

1,189,600

Example 7

Reasons for the sharp decline in liquidity

Turnover has increased by 33% from 12,000 to 16,000 with no introduction of any

permanent funds. This will put pressure on the company because it will have to

rely on short-term funding to fund the growth of the business and puts the

company at risk of overtrading. Increase in receivables

The receivables balance has increased by $1m, or 63%, year on year reflecting

increased level of activity (turnover) but longer collection period.

taken by customers has increased to 59 days. www .s tudyinte ract ive .org

Average credit

205

SOLUTIONS TO EXAMPLES Increase in inventory

Inventory has increased by $0.8m or 57% during the year again as a result of

increased levels of activity and also increased turnover period of inventory. The

average holding period for inventory, as at 2012, is 88 days (2011: 73 days). Increase in payables

Trade payables have increased by 33% - exactly in line with sales activity which

suggests that there has been no additional reliance on payables as a source of

finance. High level of dividends

Dividend will be paid out at $1.5m this year and $2m next – approximately 40% of

earnings available p.a. This is in spite of high growth. Liquidity ratios

Current ratio

CA/CL x 100 Quick ratio

CA – inv/CL

4,500/2,000 4,500-1,400/2,000

20X2 20X3

2.25 4,900/2,400 2.04 1.55 4,900-2,200/2,400 1.13

The current ratio has fallen suggesting that an increasing level of current assets is

being funded using current liabilities, also the quick ratio has fallen suggesting that

the company is less able to pay its bills as they fall due. Cash position (net)

20X2 $1.5m

20X3 $($0.1m)

The company has re-invested surplus funds and is now operating a modest

overdraft given its current size and health, Ewden is not over-trading. Payable days

20X2 78 days

20X3 80 days

The number of days has barely moved which suggests that the company is having

no additional problems paying its bills.

The credit period of nearly three months may suggest that the company is

consistently abusing its credit terms which may lead to problems with suppliers

over the longer term.

Example 8

(a) Spread

= 3(¾ x transaction cost x variance of cash flows/daily interest rate)1/3

= 3(¾ x $50 x $250,000/0.0005)1/3

= $7,970 206 w w w .s tudyinte ract ive .o rg

SOLUTIONS TO EXAMPLES (b) Maximum level

= Minimum level + spread

= $25,000 + $7,970

= $32,970

(c) Return point

= Minimum level + 1/3 spread

= $25,000 + 1/3 x $7,970

= $27,657

Example 9

(a) Optimum cash invested

= √ 2 x $5 x $6 , / . 6

= $10,000 per order

(b) Transactions per annum

$60,000/$10,000 = 6 transactions per annum

Example 10

($000s)

Receipts

Payments Interest on traded bonds

Capital expenditure Net cash flow Overdraft interest (0.5%)

Net cash flow Balance b/f

Balance c/f

1 6,530

(5,040) 1,490

(10)

1,480 (2,000)

(520)

Month

2 5,300

(4,750) (200)

350

(3)

347

(520)

(173)

3 4,300

(4,600) (1,000) (1,300)

(1)

(1301)

(173)

(1,474)

Reduction in the balance of accounts receivable per day (ie increase in cash)

$60,500,000 x 1/365 = $165,753 ≈ $166,000

Reduction per month

$166,000 x 18 days ÷ 4 months = $747,000 www .s tudyinte ract ive .org 207


($000s)

Receipts

Payments Interest on traded bonds

Capital expenditure

Reduction in receivables

Net cash flow

Overdraft interest (0.5%)

Net cash flow

Balance b/f

Balance c/f

1

6,530

(5,040)

747

2,237

(10)

2,227

(2,000)

227

Month

2

5,300

(4,750) (200)

747

1,097

0

1,097

227

1,324

3

4,300

(4,600) (1,000)

747

(553)

0

(553)

1,324

771

Example 11

(a) Impact of proposed changes in credit policy

Existing position

Current contribution

$7m x 0.55

Current cost of financing receivables

$7m x 45/365 x 8%

Total

= $3,850,000

= ($69,041)

$3,780,959

Working

Revised sales revenue

$7m x 1.08

Revised contribution

$7.56m x 0.545

Revised cost of financing receivables

35% Discounted terms

$7.56m x 0.35 x 20/365 x 8%

65% Extended terms

$7.56m x 0.65 x 65/365 x 8%

Discount

$7.56m x 0.35 x 0.014

Total

$7,560,000 $4,120,200

($11,599)

($70,008)

($37,044)

$4,001,549

The changes in credit policy should lead to an improvement in overall

profitability. (b) Spread

= 3(¾ x transaction cost x variance of cash flows/daily interest rate)1/3

= 3(¾ x $50 x $1,000,000/0.00025)1/3

= $15,940



The range over which the cash balance is allowed to fluctuate.

Maximum level

= Minimum level + spread

= $2,000 + $15,940

= $17,940

The maximum level of cash allowed if this balance is breached then a control

action will invest an amount equal to the maximum level minus the return

point.

Return point

= Minimum level + 1/3 spread

= $2,000 + 1/3 x $15,940

= $7,313

The balance to which the cash balance will return to after a control action.


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