AC3059 Financial Management Subject Guide 2012

Financial management L. Fung AC3059

2012

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

The 2012 edition of this guide was prepared for the University of London International Programmes by: Dr L. Fung, Lecturer in Accounting and Finance, Birkbeck, School of Business, Economics and Informatics It is a revised edition of previous editions of the guide prepared by J. Dahya and R.E.V. Groves, and draws on the work of those authors. This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2012 Reprinted with minor revisions 2013 (Introduction only) The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents Introduction ............................................................................................................ 1 Aims and objectives ....................................................................................................... 1 Syllabus......................................................................................................................... 2 Reading ........................................................................................................................ 4 How to use the subject guide......................................................................................... 4 Online study resources ................................................................................................... 5 Examination advice........................................................................................................ 6 Summary ....................................................................................................................... 7 Abbreviations ................................................................................................................ 7 Chapter 1: Financial management function and environment ............................... 9 Essential reading ........................................................................................................... 9 Further reading.............................................................................................................. 9 Works cited ................................................................................................................... 9 Aims ............................................................................................................................. 9 Learning outcomes ........................................................................................................ 9 Two key concepts in financial management .................................................................... 9 The nature and purpose of financial management ........................................................ 11 Corporate objectives .................................................................................................... 14 The agency problem .................................................................................................... 15 A reminder of your learning outcomes.......................................................................... 15 Practice questions........................................................................................................ 16 Sample examination questions ..................................................................................... 16 Chapter 2: Investment appraisals......................................................................... 17 Essential reading ......................................................................................................... 17 Further reading............................................................................................................ 17 Works cited ................................................................................................................. 17 Aims ........................................................................................................................... 17 Learning outcomes ...................................................................................................... 17 Overview ..................................................................................................................... 17 Basic investment appraisal techniques ......................................................................... 18 Pros and cons of investment appraisal techniques ........................................................ 21 Non-conventional cash flows ....................................................................................... 22 Advanced investment appraisals .................................................................................. 23 Practical consideration ................................................................................................. 33 A reminder of your learning outcomes.......................................................................... 34 Practice questions........................................................................................................ 34 Sample examination questions ..................................................................................... 34 Chapter 3: Risk and return ................................................................................... 37 Essential reading ......................................................................................................... 37 Further reading............................................................................................................ 37 Works cited ................................................................................................................. 37 Aims ........................................................................................................................... 37 Learning outcomes ...................................................................................................... 38 Overview ..................................................................................................................... 38 Introduction of risk measurement................................................................................. 38 i

59 Financial management

Diversification of risk and portfolio theory .................................................................... 40 Applications of the capital market line (CML) ............................................................... 45 Derivation of capital asset pricing model (CAPM) ......................................................... 46 Alternative asset pricing models................................................................................... 51 Practical consideration of CAPM .................................................................................. 51 A reminder of your learning outcomes.......................................................................... 52 Practice questions........................................................................................................ 52 Sample examination questions ..................................................................................... 53 Chapter 4: Capital market efficiency .................................................................... 55 Essential reading ......................................................................................................... 55 Further reading............................................................................................................ 55 Aims ........................................................................................................................... 55 Learning outcomes ...................................................................................................... 55 Capital markets ........................................................................................................... 55 Types of efficiency ....................................................................................................... 56 Efficient market hypothesis (EMH) ................................................................................ 56 A reminder of your learning outcomes.......................................................................... 60 Practice questions........................................................................................................ 60 Sample examination questions ..................................................................................... 61 Chapter 5: Sources of finance .............................................................................. 63 Essential reading ......................................................................................................... 63 Further reading............................................................................................................ 63 Aims ........................................................................................................................... 63 Learning outcomes ...................................................................................................... 63 Introduction ................................................................................................................ 63 Internal funds .............................................................................................................. 63 External funds ............................................................................................................. 64 Flotation ..................................................................................................................... 64 Share issues ................................................................................................................ 65 Rights issues ............................................................................................................... 67 Private issues............................................................................................................... 68 The role of stock markets ............................................................................................. 68 Debt finance................................................................................................................ 68 The issue of loan capital .............................................................................................. 69 A reminder of your learning outcomes.......................................................................... 70 Practice questions........................................................................................................ 70 Sample examination questions ..................................................................................... 70 Chapter 6: Capital structure ................................................................................. 71 Essential reading ......................................................................................................... 71 Further reading............................................................................................................ 71 Works cited ................................................................................................................. 71 Aims ........................................................................................................................... 71 Learning outcomes ...................................................................................................... 71 Introduction ................................................................................................................ 72 Modigliani and Miller’s theory ...................................................................................... 72 Modigliani and Miller’s argument with corporate taxes ................................................. 74 Personal taxes ............................................................................................................. 75 Other tax shield substitutes.......................................................................................... 76 Financial distress ......................................................................................................... 76 Trade-off theory ........................................................................................................... 77 ii

Contents

Signalling effect........................................................................................................... 78 Agency costs on debt and equity ................................................................................. 79 Pecking order theory .................................................................................................... 81 Conclusion .................................................................................................................. 81 A reminder of your learning outcomes.......................................................................... 82 Practice questions........................................................................................................ 82 Sample examination questions ..................................................................................... 82 Chapter 7: Dividend policy ................................................................................... 83 Essential reading ......................................................................................................... 83 Further reading............................................................................................................ 83 Works cited ................................................................................................................. 83 Aims ........................................................................................................................... 83 Learning outcomes ...................................................................................................... 83 Introduction ................................................................................................................ 84 Types of dividend ........................................................................................................ 84 Dividend controversy ................................................................................................... 85 Modigliani and Miller’s argument................................................................................. 85 Clientele effect ............................................................................................................ 86 Information content of dividend and signalling effect ................................................... 87 Agency costs and dividend........................................................................................... 88 Empirical evidence ....................................................................................................... 89 Conclusion .................................................................................................................. 90 A reminder of your learning outcomes.......................................................................... 90 Practice questions........................................................................................................ 91 Sample examination questions ..................................................................................... 91 Chapter 8: Cost of capital and capital investments ............................................. 93 Essential reading ......................................................................................................... 93 Further reading............................................................................................................ 93 Aims ........................................................................................................................... 93 Learning outcomes ...................................................................................................... 93 Introduction ................................................................................................................ 93 Cost of capital and equity finance ................................................................................ 93 Cost of capital and capital structure ............................................................................. 94 A reminder of your learning outcomes.......................................................................... 97 Practice questions........................................................................................................ 98 Sample examination question ...................................................................................... 98 Chapter 9: Valuation of business .......................................................................... 99 Essential reading ......................................................................................................... 99 Further reading............................................................................................................ 99 Works cited ................................................................................................................. 99 Aims ........................................................................................................................... 99 Learning outcomes ...................................................................................................... 99 Introduction ................................................................................................................ 99 Approaches to business valuation ................................................................................ 99 Valuation of debt/bonds ............................................................................................ 102 Valuation of equity .................................................................................................... 103 Conclusion ................................................................................................................ 106 A reminder of your learning outcomes........................................................................ 106 Practice questions...................................................................................................... 106 Sample examination question .................................................................................... 106 iii


Chapter 10: Mergers ........................................................................................... 109 Essential reading ....................................................................................................... 109 Further reading.......................................................................................................... 109 Aims ......................................................................................................................... 109 Learning outcomes .................................................................................................... 109 Introduction .............................................................................................................. 109 Motives for mergers................................................................................................... 110 Conclusion ................................................................................................................ 118 A reminder of your learning outcomes........................................................................ 118 Practice questions...................................................................................................... 118 Sample examination question .................................................................................... 119 Chapter 11: Financial planning and working capital management ................... 121 Essential reading ....................................................................................................... 121 Aims ......................................................................................................................... 121 Learning outcomes .................................................................................................... 121 Introduction .............................................................................................................. 121 Financial analysis....................................................................................................... 121 Cash based ratios ...................................................................................................... 123 Financial planning ..................................................................................................... 128 Short-term versus long-term financing ....................................................................... 131 Working capital management .................................................................................... 132 Trade receivables management .................................................................................. 133 Working capital and the problem of overtrading ......................................................... 136 A reminder of your learning outcomes........................................................................ 138 Practice questions...................................................................................................... 139 Sample examination questions ................................................................................... 139 Chapter 12: Risk management ........................................................................... 141 Essential reading ....................................................................................................... 141 Further reading.......................................................................................................... 141 Works cited ............................................................................................................... 141 Aims ........................................................................................................................ 141 Learning outcomes .................................................................................................... 141 Introduction .............................................................................................................. 141 Reasons for managing risk ......................................................................................... 142 Instruments for hedging risk ...................................................................................... 143 Some simple uses of options ...................................................................................... 144 Put-call parity ............................................................................................................ 145 Corporate uses of options .......................................................................................... 145 Option pricing ........................................................................................................... 146 Futures and forward contracts.................................................................................... 147 Risk management ...................................................................................................... 148 Conclusion ................................................................................................................ 150 A reminder of your learning outcomes........................................................................ 150 Practice questions...................................................................................................... 150 Sample examination questions ................................................................................... 151 Appendix 1: Sample examination paper ............................................................ 153 Example of 8-column accounting paper...................................................................... 157

iv

Introduction

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

Aims and objectives This course aims to cover the basic building blocks of financial management that are of primary concern to corporate managers, and all the considerations needed to make financial decisions both inside and outside firms. This course also builds on the concept of net present value and addresses capital budgeting aspects of investment decisions. Time value of money is then applied to value financial assets, before extensively considering the relationship between risk and return. This course also introduces the theory and practice of financing and dividend decisions, cash and working capital management and risk management. Business valuation and mergers and acquisitions will also be discussed. 1


By the end of this course and having completed the Essential reading and activities, you should be able to: Subject-specific objectives • describe how different financial markets function • estimate the value of different financial instruments (including stocks and bonds) • make capital budgeting decisions under both certainty and uncertainty • apply the capital assets pricing model in practical scenarios • discuss the capital structure theory and dividend policy of a firm • estimate the value of derivatives and advise management how to use derivatives in risk management and capital budgeting • describe and assess how companies manage working capital and shortterm financing • discuss the main motives and implications of mergers and acquisitions. Intellectual objectives • integrate subject matter studied on related modules and to demonstrate the multi-disciplinary aspect of practical financial management problems • use academic theory and research to question established financial theories. Practical objectives • be more proficient in researching materials on the internet and Online Library • be able to use Excel for statistical analysis.

Syllabus The subject guide examines the key theoretical and practical issues relating to financial management. The topics to be covered in this subject guide are organised into the following 12 chapters: Chapter 1: Financial management function and environment This chapter outlines the fundamental concepts in financial management and deals with the problems of shareholders’ wealth maximisation and agency conflicts. Chapter 2: Investment appraisals In this chapter we begin with a revision of investment appraisal techniques. The main focus of this chapter is to examine the advantages of using the discounted cash flow technique and its application in complex investment scenarios: capital rationing, replacement decision, project deferment and sensitivity analysis. Chapter 3: Risk and return We formally examine the concept and measurement of risk and return in this chapter. We also look at the necessary conditions for risk diversification, portfolio theory and the two fund separation theorem. Asset pricing models are discussed and practical considerations in estimating beta will be covered. Empirical evidence for and against the asset pricing models will also be illustrated.

2

Introduction

Chapter 4: Capital market efficiency This chapter discusses the concepts and implications of market efficiency and the mechanism of equity and debt issuance. Chapter 5: Sources of finance In this chapter we focus on how companies raise funds from both the stock and bond markets and discuss the advantages and disadvantages of each type of financing method. Chapter 6: Capital structure This chapter critically reviews the existing leading theories of capital structure. Specifically, the trade-off theory, signalling effect, agency cost of equity and debt and the pecking order theory will be examined. We will also evaluate the practical considerations of capital structure decisions made by corporate managers. Chapter 7: Dividend policy This chapter aims to explore how the amount of dividend paid by corporations would affect their market values. The tax, signalling and agency effects of dividend will be discussed. Chapter 8: Cost of capital and capital investments In this chapter we discuss how the cost of capital can be adjusted when firms are financed with a mixture of debt and equity. Chapter 9: Valuation of business We introduce the valuation of equity, debt, convertibles and warrants in this chapter. Chapter 10: Mergers This chapter focuses on the theory and motives of mergers and acquisitions. The determination of merger value and the defensive tactics against merger threats will also be covered. The empirical evidence of using financial ratios to predict mergers and acquisitions will be discussed. Chapter 11: Financial planning and working capital management The importance of managing cash and short-term financing will be discussed in this chapter. Chapter 12: Risk management This chapter provides an introduction to risk management including: hedging, futures, options and derivatives and their uses in both long-term and short-term situations.

Changes to the syllabus The material contained in this subject guide reflects the syllabus for the year 2012–2013. The field of accounting changes regularly, and there may be updates to the syllabus for this course that are not included in this subject guide. Any such updates will be posted on the virtual learning environment (VLE). It is essential that you check the VLE at the beginning of each academic year (September) for new material and changes to the syllabus. Any additional material posted on the VLE will be examinable.

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Reading Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268]. Hereafter called BMA, this textbook deals with most of the topics covered in this subject guide.

Detailed reading references in this subject guide refer to the edition of the set textbook listed above. New editions of this textbook may have been published by the time you study this course. You can use a more recent edition of this book or of any of the books listed below; use the detailed chapter and section headings and the index to identify relevant readings. Also check the VLE regularly for updated guidance on readings.

Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and the University of London Online Library (see below). Other useful texts for this course include: Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition [ISBN 9780273719069]. Hereafter called ARD, this textbook also covers most of the topics in this subject guide. It is less technical than BMA. Copeland, T.E., J.F. Weston and K.S. Shastri Financial theory and corporate policy. (Harlow: Pearson-Addison Wesley, 2004) fourth edition [ISBN 9780321127211].This is a classic finance textbook pitched at an advanced level. You may use this textbook for reference as it contains some useful updates of empirical studies in the field of corporate finance. Watson, D. and A. Head Corporate finance passnotes. (Harlow: Pearson Education, 2010) first edition [ISBN 9780273725268].This concise version of a passnote neatly summarises the key concepts in financial management. You might find it useful as a revision tool.

Apart from the above textbooks, this subject guide also refers to some of the original articles from which the financial management theories are developing. You should refer to the works cited in each chapter for the full reference of these articles.

How to use the subject guide This subject guide is meant to supplement but not to replace the main textbook. You should use it as a guide to devise a plan for your own study of this subject. Suggested here is one approach in how to use this subject guide. Approach financial management in the same order as the chapters in this subject guide. It is specifically designed to help you build up your understanding of the subject.

4

1.

For each chapter (apart from this Introduction) you should familiarise yourself with the aim and outcomes before reading the materials.

2.

Read the introductory section of each chapter to identify the areas you need to focus on.

Introduction

3.

Carefully read the suggested chapters in BMA, with the aim of gaining an initial understanding of the topics.

4.

Read the remainder of the chapter in the subject guide. You may then approach the Further reading suggested in the subject guide and BMA.

5.

The subject guide is designed to set the scope of your studies of this topic as well as attempting to reinforce the basic messages set out in BMA. Therefore you should pay careful attention to the examples in both the texts and the subject guide to ensure you achieve that basic understanding. By taking notes from BMA, and then from other books you should have obtained the necessary material for your understanding, application and later revision.

6.

Pay particular attention to the practice questions and the examples given in the subject guide. The material covered in the examples and in the activity exercises complements the textbook and is important in your preparation for the examination.

7.

Ensure you have achieved the listed learning outcomes.

8.

Attempt the Sample examination questions at the end of each chapter and the quizzes on the virtual learning environment (VLE).

9.

Check you have mastered each topic before moving on to the next.

10. At the end of your preparations, attempt the questions in the Sample examination paper at the end of the subject guide. Then compare your answers with the suggested solutions, but do remember that they may well include more information than the Examiner would expect in an examination paper, since the guide is trying to cover all possible angles in the answer, a luxury you do not usually have time for in an examination.

Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register. As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page.

The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: • Self-testing activities: Doing these allows you to test your own understanding of subject material. 5


• Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered. • A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. • Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions. • Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available. • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. • Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php

Examination advice Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. The examination paper consists of eight questions of which you must answer four questions. Each question carries equal marks and is divided into several parts. The style of question varies but each question aims to test the mixture of concepts, numerical techniques and application of each topic. Since topics in financial management are often interlinked, it is inevitable that some questions might examine overlapping topics. 6

Introduction

Remember when sitting the examination to maximise the time spent on each question and although, throughout, the subject guide will give you advice on tackling your examinations, remember that the numerical type questions on this paper take some time to read through and digest. Therefore try to remember and practise the following approach. Always read the requirement(s) of a question first before reading the body of the question. This is appropriate whether you are making your selection of questions to answer, or when you are reading the question in preparation for your answer. In the question selection process at the start of the examination, by reading only the requirements, which are always placed at the end of a question, you only read material relevant to your choice, you do not waste time reading material you are not going to answer. Secondly, by reading the requirements first, your mind is focused on the sort of information you should be looking for in order to answer the question, therefore speeding up the analysis and saving time. Remember, it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered.

Summary Remember this introduction is only a complementary study tool to help you use this subject guide. Its aim is to give you a clear understanding of what is in the subject guide and how to study successfully. Systematically study the next 12 chapters along with the listed texts for your desired success. Good luck and enjoy the subject!

Abbreviations AEV

Annual equivalent value

AIM

Alternative investment market

APM

Arbitrage pricing model

ARD

Arnold, 2008

ARR

Accounting rate of return

BMA

Brealey, Myers and Allen

CAPM

Capital asset pricing model

CFs

Cash flows

CME

Capital market efficiency

CML

Capital market line

CPI

Consumer price index

DFs

Discount factors

DPP

Discounted payback period

DPS

Dividend per share

EMH

Efficient market hypothesis

EPS

Earnings per share 7


8

EVA

Economic value added

IPO

Initial public offer

IRR

Internal rate of return

LSE

London Stock Exchange

MM

Modigliani and Miller

MVA

Market value added

NCF

net cash flow

NPV

Net present value

NYSE

New York Stock Exchange

PE

Price earnings ratio

PI

Profitability index

PP

Payback period

ROA

Return on assets

ROC

Return on capital

ROE

Return on equity

S&P

Standard and Poor’s

Std dev

Standard deviation

VLE

Virtual learning environment

WACC

Weighted average cost of capital

Chapter 1: Financial management function and environment

Chapter 1: Financial management function and environment Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 1 and 2.

Further reading Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall; 2008) fourth edition [ISBN 9780273719069]. Chapter 1.

Works cited Fisher, I. The theory of interest. (New York: MacMillan, 1930).

Aims This chapter paves the foundation for you to understand what financial management is about. In particular, we will examine the roles of financial management, the environment in which businesses are operated, and agency theory. More importantly we explain the two key concepts which underpin much of the theory and practice of financial management.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • outline the nature and purpose of financial management • describe the general environment in which businesses operate • explain the relationship between financial objectives and corporate strategies • assess the impact of stakeholders on corporate strategies • discuss the time value for money concept and the risk and return relationship.

Two key concepts in financial management Before we look at what financial management is about, it is essential for us to understand two key concepts which lay the foundation of this subject. The two key concepts are: i. Risk and return. ii. Time value of money.

Risk and return Financial markets seem to reward investors of riskier investments1 with a higher return.2 The following graph indicates this relationship.3

1

Risk is often measured as a dispersion of the possible return outcomes from the expected mean. In Chapter 3 of this subject guide, we will more formally define the concept of risk in financial management and discuss the different methods to quantify risk. 2

Return refers to the financial reward gained as a result of making an investment. It is often defined as the percentage of value gain plus period cash flow received to the initial investment value. 3

The graph has been rescaled in log to fit the page. You should note the vast differences of the cash returns from each investment type.

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Index (Approximate values) Small Cap. (5500) S&P (1800)

1000 Corp. Bonds (55) Long Bonds (39)

10

T Bill (14)

1 0.1 1925

Year 1997 end

Figure 1.1: The cash return from five different investments. Source: BMA.

Suppose we invested $1 in 1925 in each of the following five portfolios: i. the largest quoted companies in the US, Standard & Poor’s (S&P) ii. the smallest quoted companies measured by market capitalisation in the US, Small Capitalisation (Small Cap) iii. corporate bonds iv. long-term US government bonds, Long Bonds v. short-term US government bonds, T Bill. These portfolios have different levels of perceived risk. Arguably, smaller companies have higher varying returns than larger companies. Bonds, on the other hand, are a safer investment to investors. Over time, these portfolios generate cash returns which seem to follow the same order as their respective perceived risk. This leads us to one of the axioms in financial management: The higher the risk, the higher the expected return. Companies and investors should therefore only consider undertaking a riskier investment provided that they are suitably and sufficiently compensated by a higher return. Activity 1.1 What are the main reasons for smaller companies having higher perceived risk? What are the specific risks we are referring to? See VLE for discussion.

Time value of money4 Money (i.e. cash) has different values over time. Holders of money can either spend a sum of money now or delay their consumption by investing the money in different investment opportunities until it is required. Suppose an investor can deposit a sum of money in a bank and earn an annual interest of 5%. The value of money to this investor would then be 5% per annum. If the same investor can invest the same sum of money in a financial asset which gives a return of 10% annually, then the value of money to this investor would be 10% per annum. The future return from 10

4

BMA, Chapter 2 deals with the concept of time value for money and covers in detail how to calculate present and future values.


the money invested now is based on the duration of time, the risk of the investment and inflation. For example, $100 invested today will earn 10% per annum of return (i.e. $110 in one year’s time and $121 in two years’ time). An investor who assumes a 10% return will be indifferent between receiving $100 today and $110 in one year’s time as the two cash flows have identical value to the investor. In the time value of money terminology, the present value of $110 received in one year’s time is exactly $100. Similarly, the present value of $121 received in two years’ time is exactly $100, too. This concept can be applied to convert future cash flows into their present values. Denote the present value of a cash flow as PV and future (t-period) value of a cash flow as FVt. The general relationship between the present and future value is: FVt = PV(1+r)t where r is the time value of money measured as a percentage Re-arranging the above equation, we have: PV =

FVt (1+ r)

where

t

= FVt ×

1 (1 + r )

t

1 (1+ r)

t

is the t-period discount factor

The nature and purpose of financial management Having discussed the two key concepts in financial management, we can now turn our attention to the function of financial management. In general, there are three main tasks that financial managers need to undertake: i. Investing decisions – this is how financial managers select the ‘right’ investments. This can be examined in two stages. First we look at how financial managers invest in and manage short-term working capital (this is covered in Chapter 11 of this subject guide) and then we examine how financial managers may appraise long-term investment projects. ii. Financing decisions – this involves the choice of particular sources of funds which provide cash for investments. The key issues that financial managers should address are how: • these sources of funds can be raised (covered in Chapter 5) • the value of the business may be affected through the combination of different sources of funds (covered in Chapter 6) • the sources of funds may affect the relationship between different stakeholders (covered in Chapter 6). iii. Dividend policy – this concerns the return to shareholders (covered in Chapter 7). So in theory and in practice, how are these decisions being considered by financial managers?

Link between investing, financing and dividend decisions In a perfect and complete capital market where there are no transaction costs and information is widely available to everyone, it is argued that a firm’s investing, financing and dividend decisions are not interlinked. This is known as Fisher’s separation theorem (Fisher, 1930). This is illustrated in the following diagram. 11


C1

C1, a

a Individual 1

Y1

X

C*1

Individual 2 CF1 C1, b

b I1 C*0, a

C*0

Y0 C0, b

C0 W0

Figure 1.2: Fisher’s Separation Theorem

Suppose a firm is operating in a two-period environment (period 0 – now and period 1 – in one year’s time) with an initial cash flow of Y0. It has the opportunity to invest in two types of investments. The first type of project relates to investments which require an initial investment outlay (Ii) and deliver CFi in the next period for each investment (i). For example, investing Ii in period 0 will produce CFi in period 1. Hereafter these types of projects are referred to as production investment projects. The second type of investment is essentially financial, which allows the firm to borrow and lend an unlimited amount at an interest rate of r. In this case, if a firm borrows (or lends) W0 in period 0, it will pay back with interest (or receive with interest) W1 = W0(1+r).

Investing decision What should the firm do in terms of its investments? A firm will logically rank and invest in investment projects in descending order of their profitability (Ri for each i). A production opportunity frontier can be obtained (such as the curve Y0Y1). A firm will invest up to the point where the marginal investment i* yields a return that equals the return from the capital market (i.e. interest rate r). The total investment outlays - the amount represented by C0Y0 - is the sum Ii for all i (i = 1 to i*). Once the investment plan is fixed, the firm will have C*0 in period 0 remaining and a cash return of C*1 in period 1.

12


Dividend policy In this setting, how much should the firm give out as dividend to its shareholders in each period? The answer is simple. It should give out C*0 and C*1 in period 0 and 1 respectively. However, would shareholders be satisfied with these amounts in each period? Suppose we have two individual shareholders 1 and 2. Each of them has their unique utility function of consumption in each period. This can be represented by the indifference curves in Figure 1.2 above. Individual 1 prefers to consume less in period 0 and more in period 1 (the combination at ‘a’). Given the current firm’s dividend policy, how would he be satisfied? There are two ways to achieve it: i. The firm will pay C0,a and invest any excess cash flow (i.e. C*0 – C0,a ) at r in period 0 and give out C*1 + (C*0 – C0,a)(1 + r). Mathematically, it can be proved that it is equal to C1,a. Therefore the firm will pay the exact dividend in each period to individual 1 as he prefers. ii. Alternatively, the firm pays C*0 to individual 1 and he can invest any excess cash flow after his consumption in period 0 in the financial investment earning a return of r and receive the same combined cash flow of C1,a in period 1. This reasoning applies to any individual shareholders with any unique utility functions. Take Individual 2 as an example. Her consumption pattern does not match the firm’s dividend payout. Similarly there are two ways we can satisfy her consumption pattern: i. The firm will borrow C0,b – C*0 at r in period 0 and pay out C0,b to Individual 2. In period 1, the firm will pay out C*1 – (C0,b – C*0) (1 + r). Mathematically, it can be proved that it is equal to C1,b. Therefore the firm will pay the exact dividend in each period to Individual 2. ii. Alternatively, the firm pays C*0 to Individual 2 and she borrows any shortfall to make up to her consumption C0,b in period 0. In period 1, she will receive C*1 less the loan and interest she takes out in period 0. This will leave her with a net amount exactly equal to C1,a. The above argument indicates that financial managers do not need to consider shareholders’ consumption patterns when fixing the investment plan or the dividend policy. The easiest way is to maximise the firm’s cash flows and distribute the spare cash flows as dividends. Shareholders will use the capital markets to facilitate their consumption patterns accordingly.

Financing decision In the beginning, we assume that the firm has an initial cash flow of Y0 and requires a total investment outlay of C0Y0. If any part of Y0 is not contributed by shareholders, the firm’s dividend in period 1 will be reduced by the funds raised from borrowing (at a cost of r) and the interest. However, shareholders can offset this shortfall of dividend in period 1 by investing the fund not contributed in the firm to the capital market and earn a return exactly equal to r. The above argument illustrates the Fisher separation in which investing, financing and dividend decisions are all unrelated. However, if the capital market is imperfect in such a way that external funding is restricted, the Fisher separation might not apply. The following scenarios highlight the practical considerations that financial managers would need to take.

13


Investment A company would like to undertake a large number of profitable investment projects.

Financing It will need to raise funds in order to take up these projects.

Dividends If the company fails to raise sufficient funds from outside the company, it would need to cut dividends in order to increase internal funding.

Dividends A company wants to pay a large dividend to shareholders

Financing A lower level of available internal cash flows might force the company to seek extra funds via external financing.

Investment If external financing is restricted through partially financing the dividend, the company might need to postpone some of the investment projects.

Financing A company has been using a higher level of external funding.

Investment Due to the high cost of financing, the number of attractive investment projects might be reduced.

Dividends The company’s ability to pay dividends in the future may be adversely affected.

Activity 1.2 i. Why would a firm invest up to the point where the return of the marginal investment equals the return from the capital market? ii. What would happen to the Fisher’s separation theorem if the borrowing rate differs from the lending rate? See VLE for solutions.

Corporate objectives BMA, Chapter 1, pp.37–40 discuss the goals of corporation. The general assumption in financial management is that corporate managers will try their best to maximise the value of the shareholders’ investment in the corporation (i.e. shareholders’ wealth maximisation (SHWM)). Maximisation of a company’s ordinary share price is often used as a surrogate objective to that of maximisation of shareholder wealth. In order to achieve this objective, it is argued that corporate managers will maximise the value of all investments undertaken by the firm. This can be illustrated in the following diagram: NPV 1 NPV 2 NPV A 3

Corporate net present value (sum of individual Projects’ NPVs)

NPV 4

(2)

Share price

SHWM

(3)

(4)

(1) Figure 1.3: Shareholders’ wealth maximisation Source: BMA.

However, in practice, corporate objectives vary. For example, HP, a USbased computer corporation, has the following objectives listed on its website:5 14

5 (http://welcome. hp.com/country/uk/en/ companyinfo/corpobj. html)


• customer loyalty • profit • growth • market leadership • leadership capability • employee commitment • global citizenship. While profit maximisation, social responsibility and growth represent important supporting objectives, the overriding objective of a company must be that of shareholders’ wealth maximisation. The financial wealth of a shareholder can be affected by a company’s financial manager’s action. Arguably, when good investment, financing and dividend decisions are made, a company’s market value will increase. The rest of this subject guide will explore how financial managers’ decisions can increase a firm’s value. Activity 1.3 Although shareholders’ wealth maximisation seems to be the overriding objective, corporate managers still face a number of constraints to implement multiple objectives simultaneously. Identify the types of constraint that corporate managers face when assessing long-term financial plans. See VLE for discussion.

The agency problem The agency problem occurs when financial managers make decisions which are not consistent with the objectives of the company’s stakeholders. It arises because: 1. There is a separation of ownership and control: agents (financial managers) are given the power to manage and control the company by the principals (stakeholders: shareholders, creditors and customers). 2. The goals of agents are different from those of the principals.6 3. Principals do not get full information about their company from the agent or the market (asymmetric information). Activity 1.4 What are the signs of an agency problem? What possible actions can be taken to mitigate such a problem? See VLE for discussion.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to:

6

For example, agents may want to increase the size of the company (empire building), strengthen their managerial power, secure their jobs, improve their remuneration and pursue other personal objectives. These objectives may not necessarily be enhancing the value of the company.

• outline the nature and purpose of financial management • describe the general environment in which businesses operate • explain the relationship between financial objectives and corporate strategies • assess the impact of stakeholders on corporate strategies 15


• discuss the time value for money concept and the risk and return relationship.

Practice questions 1. Compute the future value of $1,000 compounded annually for: a. 10 years at 5% b. 20 years at 5% How would your answer to the above question be different if interest is paid semi-annually? 2. Compare each of the following examples to a receipt of $100,000 today: a. Receive $125,000 in two year’s time. b. Receive $55,000 in one year’s time and $65,000 in two year’s time c. Receive $31,555.7 for the next 4 years, receivable at the end of each year. d. Receive $10,000 for each year for an infinite period. Assume the interest rate is 10% per year for the foreseeable future.

Sample examination questions 1. ‘We need to maximise our profit in order for us to maximise the shareholders’ wealth’ – Executive at OverHill Plc. Critically comment on the statement above. 2. Explain, with the aid of a diagram, how a firm’s dividend policy is independent from its investment policy in a perfect and complete world. 3. Identify five different stakeholder groups of a public company and discuss their financial and other objectives.

16

Chapter 2: Investment appraisals

Chapter 2: Investment appraisals Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 5 and 6.

Further reading Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 2–6.

Works cited Graham, J.R. and C.R. Harvey ‘The theory and practice of corporate finance: evidence from the field’, Journal of Financial Economics, 60, 2001, pp.187– 243.

Aims This chapter focuses on the techniques commonly used for investment appraisals in practice. In particular, we concentrate on the pros and cons of the following techniques: • Accounting rate of return (ARR) • Payback period (PP) • Discounted payback period (DPB) • Internal rate of return (IRR) • Net present value (NPV).

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the commonly used investment appraisal techniques • apply the discounted cash flow technique in complex scenarios • evaluate the investment decision process.

Overview As mentioned in Chapter 1, financial managers make decisions about which investment they should invest in to maximise their shareholders’ value. In order to do so, they need to understand how to measure the value of investments they undertake and how these investments help to improve the value of the firm. First, we will examine the basic techniques and evaluate their pros and cons in investment appraisals. We will then compare the relative merits of using NPV over IRR. Thirdly, we consider some of the scenarios when NPV can be applied to deal with the selection of investments. Finally, we discuss the problems relating to the application of these investment appraisal techniques.

17


Basic investment appraisal techniques BMA, Chapter 5 reviews the appraisal techniques and explains them at great length. You should read the relevant sections of the chapter before you carry on with the rest of the material covered here. Here we summarise these commonly used techniques.

Accounting rate of return (ARR) The method is also known as return on capital employed (ROCE) or return on investment (ROI). It relates accounting profit to the capital invested. One widely used definition is:

ARR =

Average annual profit Average investment outlays

× 100 %

Average investment takes into consideration any scrap value. It can be expressed as follows:

Average Investment =

Investment - Scrap value 2

It measures the average net investment outlay of the project.1 Accounting profit is defined as before-tax operating cash flows after adjustment for depreciation. The decision rule is to accept investments with ARR higher than a predetermined target rate of return.

Payback period (PP) Payback period measures the shortest time to recover the initial investment outlay from the cash flows generated from the investment. A company will accept an investment if the PP is less than or equal to a target period.

Discounted payback period (DPP) This is similar to PP except that the cash flows from the investment are first discounted to time 0 and the shortest time to recover the initial investment outlay will then be measured.

Internal rate of return (IRR) The internal rate of return on an investment or project is the annualised effective compounded return rate or discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) generated from a particular investment equal to zero. The decision rule is to accept a project or investment if its IRR is higher than the cost of capital.

Net present value (NPV) NPV combines the present values of all future cash flows and compares the total to the initial investment. If the NPV of a project is positive, it indicates that it earns a positive return over the cost of capital and will therefore increase the shareholders’ value. A firm should invest in all positive NPV projects, so the market value of the firm will increase by the total of the NPVs, once they are announced to the market. To illustrate how these techniques are applied in investment appraisal, let’s look at the following example.

18

1

Some textbooks prefer to calculate ARR by referring to the average level of investment. Consequently, the average investment will be defined as (initial investment + scrap value)/2.


Example 2.1 Suppose we have two mutually exclusive projects, A and B. Each project requires an initial investment in a machine, payable at the beginning of year 0. There is no scrap value for these machines at the end of the project. Suppose the cost of capital (discount rate) is 20% per annum. The following before-tax operating cash flows are also known:

Before-tax operating cash flows ($) Project

Year 0

1

2

3

4

A

(25,000)

5,000

10,000

15,000

20,000

B

(2,500)

2,000

1,500

250

Accounting rate of return Suppose the profit before depreciation for each year is identical to the annual cash flow. The ARR can be determined as follows:

Project

Initial investment

Average Total profit after investment depreciation

Average profit

ARR

A

25,000

12,500

25,000

6,250

50%

B

2,500

1,250

1,250

417

33%

Payback period We can look at the cumulative cash flow at the end of each year to determine the PP.

Cumulative cash flows Project

0

1

2

3

4

PP

A

(25,000)

(20,000)

(10,000)

5,000

25,000

2.67 years

B

(2,500)

(500)

1,000

1,250

1.33 years


Year Project A

0

1

2

3

4

(25,000)

5,000

10,000

15,000

20,000

1

0.833

0.694

0.578

0.482

Present value

(25,000)

4,165

6,940

8,670

9,640

Cumulative cash flows

(25,000)

(20,835)

(13,895)

(5,225)

4,415 4

Cash flows ($) Discount factor (DF) (20%)

Year Project B

0

1

2

3

(2,500)

2,000

1,500

250

1

0.833

0.694

0.578

Present value

(2,500)

1,666

1,041

144.5

Cumulative cash flows

(2,500)

(834)

207

Cash flows ($) Discount factor (DF) (20%)

0.482

For Project A, the payback period occurs in Year 4. If we assume that cash flows arrive evenly throughout the year, we can determine the approximated payback period at 5,225/9,640 = 0.54 year (i.e. PP at 3.54 years). Similarly, for Project B, the PP occurs in 1.8 years.

19

59 Financial management Net present value The NPV can be determined as:

Year Project A Cash flows ($)

0

1

2

3

4

(25,000)

5,000

10,000

15,000

20,000

1

0.833

0.694

0.578

0.482

(25,000)

4,165

6,940

8,670

9,640

4

Discount factor (DF) (20%) Present value NPV

4,415 Year

Project B Cash flows ($)

0

1

2

3

(2,500)

2,000

1,500

250

1

0.833

0.694

0.578

(2,500)

1,666

1,041

144.5


0.482

351.5

Internal rate of return To find the IRRs of these two projects, we can use the extrapolation method. First, we recalculate the NPV of each of the two projects with a higher discount rate. For example, we choose 30% and 35% as the discount rate for Project A and B respectively. This gives, in both cases, negative NPVs.

Year Project A Cash flows ($)

0

1

2

3

4

(25,000)

5,000

10,000

15,000

20,000

1

0.769

0.592

0.455

0.35

(25,000)

3,845

5,920

6,825

7,000


(1,410) Year

Project B Cash flows ($)

0

1

2

3

(2,500)

2,000

1,500

250

1

0.741

0.549

0.407

(2,500)

1,482

824

102


(93)

We then substitute the relevant figures into the following equation:

IRR = R + +

NPVR + NPVR + − NPVR −

(R

−

− R+ )

R+ is the discount rate which gives a positive NPV, NPVR+ R– is the discount rate which gives a negative NPV, NPVR– Consequently, the IRRs for Project A and B are 27.6% and 31.9% respectively.

Activity 2.1 Attempt Question 1, BMA Chapter 5. See VLE for solution.

20


Pros and cons of investment appraisal techniques Example 2.1 highlights the potential problems of using some of these techniques in investment appraisals. Recall the results for Projects A and B respectively: Projects

NPV

IRR

PP

ARR

A

4,415*

27.6%

2.67 years

50%*

B

351.5

31.9%*

1.33 years*

33%

* Indicates the project that will be chosen under the specific appraisal method.

Suppose the main objective is to maximise shareholders’ value. Financial managers would prefer Project A as it provides a higher NPV, and hence it gives the greatest increase to the shareholders’ value. However, if we choose projects based on a higher value of IRR or PP, Project B will be selected. But this project clearly does not produce the greatest value to the company. So why are these techniques still being used in practice? ARR Advantages: • It gives a value in percentage terms which is a familiar measure of return. • It is relatively easy to calculate compared to NPV or IRR. • It considers the cash flows (but only after adjustment for depreciation in profit) arising from the lifetime of the project (unlike PP). • It can be used in selecting mutually exclusive projects. Disadvantages: • It is very much based on the accounting profits and hence technically it does not deal with the actual cash flows arising from the project. • It ignores the timing of the cash flows and hence it does not take into consideration the time value of money. • It is expressed in percentage terms and therefore it does not measure the absolute value of the project. It does not indicate how much wealth the project creates. PP Advantages: • It is computationally straightforward. • It considers the actual cash flows, not profits, arising from a project. Disadvantages: • It ignores cash flows beyond the PP and hence it does not provide a full picture of a project. • It does not consider the time value of money (even though the discounted payback period takes care of that). • The target payback period is somehow arbitrary. IRR Advantages: • It uses all relevant cash flows, not accounting profits, arising from a project. • It takes into account the time value of money. 21


• The difference between the IRR and the cost of capital can be seen as a margin of safety. Disadvantages: The main limitations of using IRR in investment appraisals are that it may not give the correct decision in the following scenarios: • when comparing mutually excusive projects • when projects have non-conventional cash flows • when the cost of capital varies over time • It discounts all flows at the IRR rate not the cost of capital rate.

Mutually exclusive projects Referring to Example 2.1, Project B’s IRR is higher than that of Project A. One would rank Project B as more ‘desirable’ than Project A. However, if we consider the NPV of these projects, there is no doubt that Project A is, by far, more valuable than Project B.

Non-conventional cash flows A typical investment project has an initial cash outflow followed by positive cash flows in subsequent years. However, in some cases, a project (such as oil drilling or mining) may have negative cash flows during its lifetime. Mathematically, each time the cash flow stream of a project changes sign, there is a possibility that multiple IRRs might arise. Example 2.2 Suppose a project requires $100 as an initial investment. Its Year 1 and Year 2 cash flows are $260 and –$165 respectively. Based on this project’s cashflows, it produces two possible IRRs (10% or 50%):

DF

PV

DF

PV

Year

Cash flows

50%

0

–100

1

–100

1

–100

1

260

0.667

173

0.909

236

2

–165

0.445

–73

0.826

–136

Net Present Value

10%

0

0

Suppose the cost of capital for this project is 20%. According to the IRR rule, the project should be accepted (as the cost of capital is less than the higher IRR of 50%). However, it should also be rejected as the cost of capital is higher than the lower IRR of 10%. So for a project with non-conventional cash flows, the IRR decision is sensitive to the cost of capital. Therefore it is argued that IRR does not give an unambiguous decision when dealing with non-conventional projects. To further illustrate this problem, let’s look at the NPV profile of the project. This depicts the relationship of the NPV of the project and its discount rate. In the above example, we know that the NPV of the project is zero at both 10% and 50%. Suppose the cost of capital is 5%, 25% or 70%. The NPV of the project will become –$2, $2 and –$4 respectively. The following diagram shows the NPV profile of the project. We can see that, due to the non-conventional cash flow pattern, the project’s NPV varies at different discount rates. It only provides a positive NPV if the discount rate for the project’s cash flows is between 10% and 50%.

22


3 2 1 0 NPVs 0% -1

10%

20%

30%

40%

50%

60%

70%

80%

-2 -3 -4 -5 Discount rates

Figure 2.1: NPV profile However, if the project we have been examining has the ‘reversed’ cash flow pattern (i.e. receiving $100 and $165 in year 0 and year 2 while paying $260 in year 1), we would only accept it if the cost of capital is either lower than 10% or higher than 50%. Why? This project with the reversed cash flow pattern has the same IRRs (10% and 50%) as the original project. You can verify this result by discounting the cash flows at 10% and 50% separately. However, the NPV profile of this project will be as below.

Time-varying cost of capital If the cost of capital changes over time, NPV can easily accommodate this. Suppose the cost of capital is rt for the tth year. The NPV of a project with different cost of capital over its lifetime can be given in the following equation:

NPV = −I0 +

C1 C2 C3 + + + ... (1+ r1) (1+ r1)(1+ r2 ) (1+ r1)(1+ r2)(1+ r3 )

NPV assumes that cash flows can be reinvested at the cost of capital whereas IRR assumes that cash flows can be reinvested at the IRR which is not a realistic assumption in the real world. The superiority of NPV: • It takes into consideration all cash flows and time value of money. • It can be applied to deal with mutually exclusive projects. • It can deal with non-conventional cash flows. • It has realistic assumptions about how the capital markets work in real life.


Advanced investment appraisals In this section, we look at some of the applications of the discounted cash flow technique in investment appraisals. In particular, we focus on the following scenarios: • capital rationing • inflation and price changes • taxation • replacement decision 23


• sensitivity analysis. BMA, Chapter 5, pp.143–47 deals with capital rationing and Chapter 6 deals with the remaining advanced topics. Before you proceed with the following section, it would be advisable to skim through those sections in the textbook.

Capital rationing A company may have insufficient funds to undertake all positive NPV projects. Due to the shortage of funds, this restriction is more commonly known as capital rationing. There are two types of capital rationing. Hard capital rationing This is where the shortage of funds is imposed by external factors. This might happen in three different ways: 1. Capital markets are depressed. 2. Investors are too risk adverse. 3. Transaction costs are too high. Soft capital rationing This may arise when financial managers impose internal restrictions on: • issuing equity to avoid dilution of original shareholders’ value • issuing debt to avoid fixed interest obligation and transaction cost • investing activities in order to maintain a constant growth. In any case, ranking projects by absolute NPV in these situations may not necessarily give the optimal strategy. Some combinations of smaller projects may give a higher NPV. For each type of capital rationing we can further sub-divide it into two categories. Single period capital rationing If the shortage of funds is only restricted in the first year, the ranking of projects can be done by using the profitability index. Profitability index is defined as the present value of the future cash flows generated by a project divided by its initial investment. It is also called the Present Value Index (PVI) by some authors.

Profitability index, PI =

Present value of future cash flows Initial investment

Example 2.3 Lion plc has the following projects:

Projects

Initial Investment ($)

NPV ($)

A

1,000,000

100,000

B

1,500,000

250,000

C

750,000

50,000

D

500,000

60,000

The company has only $2,500,000 available at year 0. There is no other investment opportunity for the firm with any spare cash which is not invested in the above four projects.

24

Chapter 2: Investment appraisals What would be the best way to allocate the $2,500,000 funding among these four projects? To answer this question, we first convert the NPV into PV (Initial investment + NPV) for each project. We then calculate the PI using the above formula.

Projects

Initial Investment ($)

NPV ($)

PV ($)

PI

Ranking

A

1,000,000

100,000

1,100,000

1.10

3

B

1,500,000

250,000

1,750,000

1.17

1

C

750,000

50,000

800,000

1.07

4

D

500,000

60,000

560,000

1.12

2

In this case, the ranking of the project’s profitability is simple and straightforward. The PI suggests that for every $1 invested in Project B, it produces a present value of $1.17. When this is compared to Project A’s PI, it is obvious that for any $1 available, it is more profitable to invest in Project B than in Project A. When projects are infinitely divisible The optimal plan is to invest all the available cash in the projects according to the ranking of PI. In this case, we will invest in the whole of Project B and Project D (with a combined total initial investment of $2,000,000) and in half of Project A with the remaining $500,000. The maximum NPV of this investment plan is:

1 The optimal NPV = $250,000 + $60,000 + × $ 100 ,000 2 = $ 360 ,000 When projects are not infinitely divisible When projects are not infinitely divisible, the above investment plan might not necessarily be optimal as the spare cash of $500,000 would no longer be investable in only half of Project A. The optimal investment plan would therefore involve a strategy which gives the highest PI to the investment plan. Note that any unused cash in the investment plan, by definition, has a PI = 1 (the present value of the unused cash is the same as the amount of the unused cash itself). We can define the weighted average of the investment plan as: N

WAPI = ∑ω i PIi + ω j i=1

where ω i is the percentage of project i´s initial investment to the total cash available, PI i is the profitability index of project i, and

ωj is the percentage of unused cash to the total cash available.

Weight

Plan

Project

A+B

A+C

A+C+D

B+C

B+D

C+D

A

0.4

0.4

0.4

0

0

0

B

0.6

0

0

0.6

0.6

0

C

0

0.3

0.3

0.3

0

0.3

D

0

0

0.2

0

0.2

0.2

Unused cash

0

0.3

0.1

0.1

0.2

0.5

WAPI

1.14

1.06

1.09

1.12

1.13

1.05

25

59 Financial management The highest combination is to undertake both Projects A and B. This gives a weighted average PI of 1.14. It means for every $1 we invest, we will receive $1.14 of future cash measured at today’s value.

Multiple periods capital rationing When a firm is facing multiple periods of capital rationing, it would not be easy to resolve the optimal investment plan by using the profitability index. In this case, linear programming technique might be useful. Activity 2.3 Attempt Question 7, BMA Chapter 5. See VLE for solution.

Changing prices and inflation The accuracy of NPV depends on the accuracy of the cash flow estimates. In practice, prices change for the following reasons: • inflationary effect • demand and supply • technological changes • manufacturing learning effect • stamp duties, value-added tax and other transaction costs. The easiest way to deal with these external effects is to incorporate the specific changes in the NPV calculation, i.e. the forecast for each period’s flows will be based on each flow item adjusted by its specific inflation to give the project actual net flow for each period. Example 2.4 Suppose Leopard plc has a project that produces 10,000 units of a digital diary per year for the next four years. Each unit sells for $200. The unit production cost is $110. The production requires a brand new machine at year 0. It costs $2,000,000 with a scrap value of $20,000 at the end of year 4. The NPV of this project (assuming no inflation) is determined as follows:

Year 0 Machine

1

2

3

4

(2,000,000)

Revenue

20,000 2,000,000

2,000,000

2,000,000

2,000,000

(1,100,000)

(1,100,000)

(1,100,000)

(1,100,000)

(2,000,000)

900,000

900,000

900,000

920,000

DF

1

0.909

0.826

0.751

0.683

PV

(2,000,000)

818,100

743,400

675,900

628,360

Production costs NCF before tax

NPV

865,760

Example 2.5 Suppose the production cost for each unit will rise by 10% per year from year 2 onward. The revised NPV of this project can be determined by incorporating the price changes to the production costs in Example 2.4.

26


Year 0 Machine

1

2

3

4

(2,000,000)

20,000

Revenue

2,000,000

2,000,000

2,000,000

2,000,000

(1,100,000)

(1,210,000)

(1,331,000)

(1,464,100)

(2,000,000)

900,000

790,000

669,000

555,900

1

0.909

0.826

0.751

0.683

(2,000,000)

818,100

652,540

502,419

379,680

Production costs NCF before tax DF (10%) Present value (PV) Net present value (NPV)

352,739

The effect of this price change to the manufacturing costs reduces the NPV from $865,760 to $352,739. If financial managers fail to recognise and take this price change into consideration, it is very likely that the project’s NPV will be grossly misstated and an incorrect decision might be reached.

Taxation When a firm is making a profitable investment, it is likely that it will be liable for corporate tax. When evaluating a project, the tax effect must be considered. There are two issues relating to the after-tax NPV of a project: The amount of tax payable Different countries have different tax rules. Generally, corporate tax is payable as a percentage of the taxable profit determined by the tax authority. In principle, most items that are charged to the Statement of Comprehensive Income Statement Income (more commonly known as a Profit and Loss Account in the UK) are tax deductible. However, in some countries, the accounting depreciation for capital expenditure is not a recognised expense for tax purposes. If such a depreciation charge is not allowed, the tax authority might give an allowance for capital expenditure. For the purpose of this course, we assume that the taxable profit before capital allowance is identical to the annual net cash flow. Capital allowance is then determined as a percentage of the written down value of the capital expenditure (i.e. initial investment). Example 2.6 Suppose Leopard plc in Example 2.4 pays corporate tax at 45% on taxable profits after capital allowances. We are told that the annual capital allowance is determined at 25% of the written down value at the beginning of each year. Any unrelieved written down value in the final year of the project is given out as capital allowance in full in that year. The following table shows the calculations of the annual capital allowance and tax payable.

Year 0

1

2

3

4

900,000

790,000

669,000

555,900

1,500,000

1,125,000

843,750

Capital allowances (CAs) (25% × WDVs) (500,000) Taxable profit after capital 400,000 allowances

(375,000)

(281,250)

415,000

387,750

(287,850)

Tax (45%)

(186,750)

(174,488)

129,533

Taxable profit before capital allowances Net Cash Flow Written down values (WDVs)

*

2,000,000

(45% × Taxable profit after capital allowances)

(180,000)

unrelieved written down value (843,750) tax relief from initial Investment

27

59 Financial management The first year’s capital allowance is calculated as 25% of the written down value of the initial investment (i.e. 25%  $2,000,000 = $500,000). This is then deducted from the taxable profit before capital allowances (i.e. the net cash flow of year 1) to arrive at the taxable profit after capital allowances (i.e. $900,000 – $500,000 = $400,000). The tax charge for the first year is calculated as 45% of $400,000 (i.e. $180,000). For years 2 and 3, the same approach for the calculation of capital allowances and tax charges applies. However, at the beginning of year 4, the unrelieved written down value of the initial investment ($843,750) will be treated as the capital allowance for that year. This gives rise to a negative figure for the taxable profit after capital allowances. If Leopard plc has sufficient profits from its other operations, it can use this ‘tax relief’ to reduce the tax charge for the other parts of its operations, saving the company from paying taxes of $129,533 (45% of $287,850). Given that this tax saving is generated as a result of this project, it should therefore be considered as a relevant cash flow for this project’s NPV.

The timing for tax payable In Example 2.6, we determined how much tax Leopard had to pay. However, we did not discuss the second issue of when tax should be paid. Why is it important to determine the timing of tax payable? Recall the concept of time value of money. Cash flows, whether positive or negative, arising at different time periods would have an effect on a project’s NPV. Regarding tax payables, the further away from today we settle the tax liabilities, the less impact the tax will have on the project’s NPV. To see this effect, let us consider the following two cases: Case 1: Tax payable in the same year as the profit to which it is related

Year 0 Machine

1

2

3

4

(2,000,000)

Revenue

20,000 2,000,000

2,000,000

2,000,000

2,000,000

(1,100,000)

(1,210,000)

(1,331,000)

(1,464,100)

900,000

790,000

669,000

555,900

(180,000)

(186,750)

(174,488)

129,533

(2,000,000)

720,000

603,250

494,513

685,433

DF

1

0.909

0.826

0.751

0.683

PV

(2,000,000)

654,480

498,285

371,379

468,150

Production costs NCF before tax

(2,000,000)

Tax NCF after tax

NPV

(7,706)

In this case, taxes are paid in the same year as the profits to which they are related. The amount of taxes paid reduces the net cash flow of the project. Note that the tax saving in year 4 is included as a positive cash flow. The after-tax NPV of this project (after discounting) is now –$7,706, suggesting that it should not be accepted. We can clearly see in this case that the tax effect on a project’s acceptability cannot be ignored as it turns the positive NPV into negative.

28

Chapter 2: Investment appraisals Case 2: Tax payable one year in arrears

Year 0 Machine

1

2

3

4

(2,000,000)

Revenue Production costs NCF before tax

20,000 2,000,000

2,000,000

2,000,000

2,000,000

(1,100,000)

(1,210,000)

(1,331,000)

(1,464,100)

900,000

790,000

669,000

(180,000)

(186,750)

(2,000,000)

Tax NCF after tax

5

555,900 Tax Saving (174,488) 129,533

(2,000,000)

900,000

610,000

482,250

381,413

129,533

DF

1

0.909

0.826

0.751

0.683

0.621

PV

(2,000,000)

818,100

503,860

362,170

260,505

80,440

NPV

25,074

In this case, tax is payable one year after the profit to which it is related. The first year’s tax is payable at the end of year 2 and the second year’s tax is payable at the end of year 3 and so on. Despite this being a four-year project it now has cash flow (tax savings) arising in year 5. As we can see from Case 2, paying tax in arrears helps improve the after-tax NPV of the project. Consequently, the project should be accepted. The timing of when tax is paid is therefore crucial for the evaluation of a project’s acceptability.


Replacement decision AEV When considering a scenario where we have to select mutually exclusive projects with different life spans and where each project can be replicated in exact cash flow patterns, the simple NPV rule might not necessarily give the correct advice. To see why this might be the case, let us consider the following example. Example 2.7 Lion plc is considering two different machines in an operation. The following net operating cash outflows for these two machines are given:

$ Machines

Year 0

1

2

3

4

A

(100,000)

(10,000)

(10,000)

(10,000)

(10,000)

B

(75,000)

(15,000)

(15,000)

(15,000)

In this example, both machines have different life spans and cash flow patterns. How do we compare the value of using these two machines in the operations? Suppose Lion plc has a cost of capital of 10% per annum. The NPV of running these two machines can be calculated as follows:

29


$

Year

Machine A

0

1

2

3

4

(100,000)

(10,000)

(10,000)

(10,000)

(10,000)

DF

1

0.909

0.826

0.751

0.683

PV

(100,000)

(9,090)

(8,260)

(7,510)

(6,830)

NPV

(131,690)

NCF

$

Year

Machine B

0

1

2

3

(75,000)

(15,000)

(15,000)

(15,000)

DF

1

0.909

0.826

0.751

PV

(75,000)

(13,635)

(12,390)

(11,265)

NPV

(112,290)

NCF

On the basis of the NPV calculations, it seems to cost the company less to run Machine B ($112,290 compared to $131,690). However, if the operation is a going concern and we have to replace the machine once it has expired, how do we know if Machine B still gives the best value to the company? To answer this question, we need to find a way to compare the two machines’ cash flows in a consistent manner. This can be done by converting a project’s NPV into its annual equivalent value (AEV). Suppose we can hire a machine, C, for $x each year for the next four years. It has the same functionalities as Machine A and the hiring company is responsible for all the running cost of Machine C. What would be the equivalent hiring cost we would be willing to pay if both machines (A and C) have the same value to the company? For these two machines to have the same value to the company, their total running costs (measured at today’s value, i.e. present value) must be identical. Consequently this means:

x x x x + 2 + 3 + 4 = 131,690 1.1 1.1 1.1 1.1 1 1 1 ⎞ ⎛ 1 x⎜ + 2 + 3 + 4 ⎟ = 131,690 ⎝ 1.1 1.1 1.1 1.1 ⎠ x(A10%, 4 years ) = 131,690 x=

131,690 131,690 = = 41,556 3.169 A10%, 4 years

where A10%, 4 years is the annuity factor at 10% for 4 years If we are indifferent between paying the annual hiring cost of $41,556 for Machine C and paying the purchase cost and annual running costs for Machine A, then the hiring cost of $41,556 must be the annual equivalent value of Machine A. From the above calculation, we can define the annual equivalent value of a project as: AEV =

Project's NPV Annuity for the duration of the project

We can now convert Machine B’s NPV into its AEV in the same way as the calculation above: Machine B´s AEV =

30

112 , 290 2 .486

= 45 ,169

Chapter 2: Investment appraisals As long as Machines A and B have identical risk to the company, it would be more advantageous for Lion plc to invest in Machine A since it has a lower annual cost than Machine B. However, we need to apply AEV in project appraisal with care. The comparison of two projects’ AEV is only valid provided that: • Projects can be replicated in exactly the same cash flow patterns whenever they expire. • Projects have similar risk to the company. • Technological changes are unlikely to affect the efficiency of either project. • The expiration of the project will be many years hence (in theory, infinitely). If these conditions are not met, then AEV would not be a sensible method to determine the replacement policy.

Delaying projects In some cases it might be more advantageous for a company to delay the commencement of a project. This might be a result of one of the following: • There might be uncertainty about the outcomes of the project. Delaying its commencement might allow the company to obtain vital information to revise future cash flows which might give a higher NPV. • There might be capital rationing in the current period and the company needs to postpone the project due to shortage of funding. In deciding whether a project should be postponed, we can treat the delay of each project as separate and mutually exclusive. We can then evaluate each option’s NPV accordingly. Example 2.8 Rooster Ltd. is considering a new product, a roast chicken stand. It allows a chicken to be roasted on all sides while maintaining its juiciness. The production requires a new machine which has a purchase price of $100,000 with four years of economic life and no residual value by the end of the fourth year. Each unit of the roast chicken stand is expected to generate a net contribution of $5 (selling price minus variable costs). Market research, which costs $25,000, indicates that future demand will be subject to the state of the economy. If the economy is strong, the demand will be 10,000 units per year for the next five years. However, if the economy is weak, the demand will fall to only 5,000 units per annum. There is an equal chance for each state of the economy to materialise. It is also expected that once the state of the economy is set, it will stay that way for the next four years. Rooster has a choice to delay the production until the end of the year. If it does so, the whole production cycle will be shortened to three years. The same machine will still be required by the end of the year at the same expected purchase price. However, it can be sold for $25,000 at the end of the production process (i.e. three years after the commencement of production). But more importantly, delaying the commencement of production will allow the company to know exactly which way the economy is going to unfold for the next few years. Advise the management on what action should be taken regarding this project. Approach: Introducing probability theory we can calculate the expected net present value, E(NPV), for the project. If Rooster Ltd. commences the production now: Expected demand in the next 4 years = 50%  5,000 units + 50%  10,000 units = 7,500 units 31

59 Financial management Contribution per year = 7,500 units  $5 = $37,500

Year No delay Machine

0

1

2

3

4

37,500

37,500

37,500

37,500

(100,000)

37,500

37,500

37,500

37,500

1

0.909

0.826

0.751

0.683

(100,000)

34,088

30,975

28,163

25,613

(100,000)

Contribution E(NCF) DF E(PV) E(NPV)

18,838

This is the expected NPV that the production could generate. However, the economy is weak, Rooster can only sell 5,000 units per year. What, then, would be the outcome of this state? If Rooster is to face a weak economy for the next four years, the revised NPV will be as follows:

Year Weak state

1

2

3

4

25,000

25,000

25,000

25,000

(100,000)

25,000

25,000

25,000

25,000

DF

1

0.909

0.826

0.751

0.683

PV

(100,000)

22,725

20,650

18,775

17,075

NPV

(20,775)

Machine

0 (100,000)

Contribution NCF

In other words, there is a 50% chance that Rooster will suffer a negative NPV of $20,775. (If the good state had occurred at the outset then the NPV would have been $58,450. (NB. 0.5  $58,450 + 0.5  ($20,775) = $18,838.) Should the company delay the project and wait for the economic situation to materialise before committing to production? If the company delays the production by a year, there are two possible actions that the company will take by the end of the year. It could abandon production if a weak economy materialises. It would not be advantageous to produce if the company could only sell 5,000 units per year in a weak economy. You can check the NPV under this option. However, if a strong economy materialises in year 1, the company will commence production in that year with the following NPV:

Year Delay

0

Machine

1

2

3

(100,000)

Contribution

4 25,000

50,000

50,000

50,000

NCF

0

(100,000)

50,000

50,000

75,000

DF

1

0.909

0.826

0.751

0.683

PV

0

(90,900)

41,300

37,550

51,225

NPV

39,175

The expected NPV of delaying production would then be $19,587.5 (50%  0 + 50%  $39,175). On the basis of the NPV consideration, it seems to be more advantageous for the company to delay production by one year. In this example, deferring the project allows the company to eliminate the possibility of facing a loss in a weak economy. Even though the financial return 32

Chapter 2: Investment appraisals to delay the project seems low ($19,587.5 vs. $18,838), the risk elimination might be treated as more valuable by a more risk-averse company.

Sensitivity analysis This method evaluates the impact of changes in a project’s variables on its NPV. In a single variable situation, we can assess by how much a variable needs to change before a project returns a loss. For example, referring to the data in Example 2.4, we can ask: 1. By how much does the selling price need to drop before the project’s NPV disappears? 2. By how much does the production cost per unit need to rise before the project’s NPV disappears? 3. By how much does the discount rate need to rise before the project’s NPV disappears? To answer any of the above questions, we can use a trial-and-error method. With the aid of a spreadsheet and changing the parameters accordingly, we can see how the NPV will change. See the spreadsheet on the VLE of the demonstration. Alternatively, we can observe the relationship of the variable with the overall NPV. Recall from Example 2.4 that each unit of the product sells at $200 and the NPV of the project stands at $865,760. Let’s assume that the selling price of each unit drops by $x. To make the NPV disappear, the present value of the loss in revenue (or contribution) must be identical to the NPV. We, therefore, can equate the PV of the loss in contribution to the project’s original NPV as follows: 10,000x 10,000x change in price 10,000x + 10,000x + + = 865,760 2 3 4 1.1

1.1

1.1 1.1 10,000x × A10%,4 = 865,760 10,000x × 3.169 = 865,760 x = 27.32

If the selling price drops by $27.32, the NPV will disappear. This gives a safety net for the company as to how much it can afford to reduce the selling price before incurring a loss. You can test each variable using the approach outlined above and determine how sensitive the NPV is to each of the variables considered. This is of benefit to management in both the decision-making phase and the project management phase.

Practical consideration Graham and Harvey (2001) surveyed 392 chief financial officers (CFOs) in the USA. They asked each CFO to rank the importance of each appraisal method in practice. Figure 2.2 below shows the findings of their survey. Watson and Head (2010) summarise the findings as follow: • Discounted cash flow methods appear to be more popular than nonDCF methods. • Payback is used in large organisations in conjunction with other investment appraisal methods. • IRR is more popular than NPV in small companies but NPV is the most popular investment appraisal method in large companies. • ARR, the least popular investment appraisal method, continues to be used with other methods. 33


• Companies tend not to use sophisticated methods to account for project risk. • Most companies allow for inflation when considering projects’ future cash flows. • Almost all companies use sensitivity analysis, an increasing minority of companies use profitability analysis, very few companies use the capital asset pricing model. Appraisal technique

Popularity, % always or almost always

Internal rate of return

75.61

Net present value

74.93

Payback period

56.74

Sensitivity analysis

51.54


29.45

Accounting rate of return

20.29

Profitability index

11.87

Table 2.1: Popularity of evaluation techniques Source: Graham and Harvey (2001)

A reminder of your learning outcomes Having completed this chapter, as well as the Essential readings and activities, you should be able to: • describe the commonly used investment appraisal techniques • apply the discounted cash flow techniques in complex scenarios • evaluate the investment decision process.

Practice questions 1. BMA Chapter 5, Questions 10–15. BMA Chapter 6, Questions 22, 26, 28 and 29.

Sample examination questions 1. Rabbit Inc. is considering the production of Product X and Y. Product X It can only be produced on a new machine, which has an expected cost of $200,000 and a four-year life span. The annual cash savings are expected to be $50,000 in the first year, rising at 20% per annum thereafter until the end of the production. The new machine will attract a capital allowance of 25% on the written down value of the machine in each year. The company can claim any unrelieved capital allowance at the end of the production. Product Y Production of Product Y is expected to last for three years. Sales are expected to be 1,000 units in the first year, 1,200 units in the second year, and 800 units in the third year. Each unit can be sold for $20. It can be produced on an existing machine which has been idle for some time. This existing machine can be sold immediately for $10,000. If the production does go ahead, a one-off modification on the machine will be needed at a cost of $15,000 payable at the beginning of the first year. 34


Each unit of Product Y requires 1 kg of material at $4 per kg and one hour of skilled labour at $4 per hour. These costs are expected to rise in line with inflation. The company has a choice to defer the production of Product Y until the beginning of the second year. If the company defers this production, the first year sales contribution will be lost irrevocably. The company also has an option to purchase a brand new machine for the production of Product Y. It will cost the company $50,000 now or $30,000 in one year’s time. This machine does not qualify for capital allowance. The company’s policy is to depreciate machines over their useful economic life on a straight-line basis. No machine is expected to have any value at the end of its life. The inflation rate is expected to be 5% per annum. The company’s after-tax cost of capital is 10% per annum. Corporate tax rate is 30%, payable one year in arrears. Apart from the cash flows mentioned above, the company can raise an additional fund of $190,000 only at the beginning of year 1. There is no capital restriction in subsequent years. Required: Advise Rabbit Inc. of the best investment plan in the above situation. 2. Assume that you have been appointed as the finance director of Dragon plc. The company is considering investing in the production of an electronic security device, with an expected market life of five years. The previous finance director has undertaken an analysis of the proposed project; the main features of his analysis are shown below. He has recommended that the project should not be undertaken because the estimated annual accounting rate of return is only 12.3%. Proposed electronic security device project

Investment in depreciable fixed assets Cumulative investment in working capital Sales

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 (£’000) (£’000) (£’000) (£’000) (£’000) (£’000) 4,500 300

400

500

600

700

700

3,500

4,900

5,320

5,740

5,320

Materials

535

750

900

1,050

900

Labour

1,070

1,500

1,800

2,100

1,800

Overhead

50

100

100

100

100

Interest

576

576

576

576

576

Depreciation

900

900

900

900

900

3,131

3,826

4,276

4,276

4,276

Taxable profit

369

1,074

1,044

1,014

1,044

Taxation

129

376

365

355

365

Profit after tax

240

698

679

659

679

Total initial investment is £4,800,000. Average annual after-tax profit is £591,000. All the above cash flow and profit estimates have been prepared 35


in terms of present day costs and prices (i.e. no inflation), since the previous finance director assumed that the sales price could be increased to compensate for any increase in costs. You have available the following additional information: a. Selling prices, working capital requirements and overhead expenses are expected to increase by 5% per year. b. Material costs and labour costs are expected to increase by 10% per year. c. Capital allowances (tax depreciation) are allowable for taxation purposes against profits at 25% per year on a reducing balance basis. d. Taxation on profits is at a rate of 35%, payable one year in arrears. e. The fixed assets have no expected salvage value at the end of five years. f. The company’s real after-tax weighted average cost of capital is estimated to be 8% per year, and nominal after-tax weighted average cost of capital 15% per year. Assume that all receipts and payments arise at the end of the year to which they relate, except those in year 0, which occur immediately. Required: a. Estimate the net present value of the proposed project. State clearly any assumptions that you make. b. Calculate by how much the discount rate would have to change to result in a net present value of approximately zero. c. Compare and contrast the NPV and IRR approaches to investment appraisal.

36

Chapter 3: Risk and return

Chapter 3: Risk and return Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 7 and 8.


Works cited Banz, Rolf W. ‘The relationship between return and market value of common stocks’, Journal of Financial Economics 9, 1981, pp.3–18. Basu, Sanjoy ‘The relationship between earnings’ yield, market value and return for NYSE Common Stocks: Further Evidence’, Journal of Financial Economics 12, 1983, pp.129–56. Chen, Nai-Fu, Richard Roll and Stephen A. Ross ‘Economic forces and the stock market’, Journal of Business 59(3) 1986, pp.383–403 Daves, Phillip R., Michael C. Ehrhardt and Robert A. Kunkel ‘Estimating systematic risk: the choice of return interval and estimation period’, Journal of Financial and Strategic Decisions, 13(1) 2000, pp.7–13. Fama, Eugene F. and Kenneth R. French ‘The cross-section of expected stock returns’, Journal of Finance 47(2), 1992, pp.427–65. Fama, Eugene F. and Kenneth R. French ‘Multifactor explanations of asset pricing anomalies’, Journal of Finance 51(1), 1996, pp.55–84. Ferson, Wayne E. ‘Theory and empirical testing of asset pricing models’, Centre of security prices (University of Chicago) 352, 1992. Graham, John R. and Campbell R. Harvey ‘The theory and practice of corporate finance: evidence from the field’, Journal of Financial Economics 60, 2001, pp.187–243. Kim, Dongcheol ‘The errors in the variables problem in the cross-section of expected stock returns’, Journal of Finance 50(5), 1995, pp.1605–34. Kothari, S.P., Jay Shanken and Richard G. Sloan ‘Another look at the crosssection of expected returns’, Journal of Finance 50(1), 1995, pp.185–224. Markowitz, Harry M. ‘Portfolio selection’, Journal of Finance 7(1), 1952, pp.77–91. Reinganum, Marc R. ‘Misspecification of capital asset pricing: empirical anomalies based on earnings’ yields and market values’, Journal of Financial Economics 9(1), 1981, pp.19–46. Roll, Richard ‘A critique of the asset pricing theory’s tests, Part I: on past and potential testability of the theory’, Journal of Financial Economics 4(2), 1977, pp.129–76. Shanken, Jay ‘On the estimation of beta pricing models’, Review of Financial Studies 5(1), 1992, pp.1–33.

Aims In this chapter we formally examine the concept and measurement of risk and return. In particular, we look at the necessary conditions for risk diversification, the portfolio theory and the two fund separation theorem. Asset pricing models are also discussed and practical considerations in estimating beta will be covered. Empirical evidence for and against the asset pricing models will be illustrated. 37


Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the meaning of risk and return • calculate the risk and return of a single security • discuss the concept of risk reduction/diversification and how it relates to portfolio management • calculate the risk and return of a portfolio of securities • discuss the implications of the capital market line (CML) • discuss the theoretical foundation and empirical evidence of the capital asset pricing model (CAPM) and its application in practice.

Overview In Chapter 1, we mentioned that one of the key concepts in financial management is the relationship between risk and return. So how does this concept link to the value creation and project appraisal? In Chapter 2, we discussed the selection of suitable investment projects that would create value for a firm and its shareholders. We assume that those projects’ cash flows are given with certainty. However, in reality, cash flows from an investment project seldom materialise as expected. So how might the variation of the realised cash flows affect an investment’s value? To be able to answer these questions, we will first need to understand what we mean by risk and how corporate managers can measure such risk.

Introduction of risk measurement What is risk? For the purpose of financial management, risk is defined as the deviation of realised return from its expectation. If the returns of an investment follow a normal distribution, then risk can be proxied by its standard deviation. Mathematically, we denote this as: (3.1)

where Rt is the return of an investment at time t (1 to T) and R is the mean return. Example 3.1 Suppose we have an investment that has the following historic returns:

Year

Return (%)

1

10

2

–2

3

0

4

5

5

7

What is the risk of this investment?

38


Answer: This investment has an average return of 4% for the last five years. We can assume that the historic mean return of this investment is 4% (our best estimate in the absence of any further information about this investment). We can calculate the standard deviation of the returns by taking the square root of the average of the squared deviation of each annual return to its mean. The following table lists the results.

Year 1 2 3 4 5 Sum Average Std dev

Return (%) 10 –2 0 5 7 20 4

Deviation = Return – Mean Return 6 –6 –4 1 3

Squared deviation 36 36 16 1 9 98 24.5 4.95

Based on the calculation above, we can say that this investment on average provides a return of 4% per annum. However, none of the past five years’ returns meet the expected return. In years 1, 4 and 5, the realised returns are higher than expected (upside risk). Whereas in years 2 and 3, returns are lower than expected (downside risk). This kind of deviation from the mean (expectation) constitutes the concept of risk in financial management. As long as (i) the returns of an investment follow the normal distribution and (ii) investors have no preference toward the upside and downside risks, standard deviation will be a neat measurement of risk for this type of investment.

Activity 3.1 Attempt Question 3 of BMA, Chapter 7. See VLE for solution.

Implications of using standard deviation as a risk measure Using standard deviation as a proxy for risk allows us to explore the statistical property of a given investment. It enables us to estimate the probability of obtaining a particular return. Take a look at the following example. Example 3.2 a. In Example 3.1, what is the probability that an investor will receive a return of 10% from the investment? b. What is the probability that an investor will not suffer a loss in the investment? Answers a. The probability of a outcome from a normal distribution can be expressed as: (3.2)

where μ is the mean, σ is the standard deviation and x is the outcome of the function. 39


Given in Example 3.1 that we have x = 10%,  = 4% and  = 4.95, we have:

Prob (x ) =

1 2πσ

2

e

−

(x − μ ) 2 2σ 2

(10−4 ) − 1 = e 2×24.5 2 × 3.1416 × 24.5 = 0.038

2

b. The probability for an investor not suffering from a loss is equal to the probability that the return is equal to or larger than 0%. Given that a normal distribution curve is symmetrical at the mean value, we can easily see that the probability of returns equal to and larger than 4% would be 50%. So what is the probability that a return is between 0% and 4%? To answer this, we first define the z-value as:

In this example, z = (0 – 4)/4.95 = 0.808. Using the table ‘Area under the standardised normal distribution’1, we can determine the probability of return between 0% and 4% as 0.291. Therefore the probability for an investor not suffering from a loss in this case would be equal to 0.791 (0.5 + 0.291). Activity 3.2 What would be the probability for an investor to earn a return of 8% in Example 3.1? See VLE for solution.

Diversification of risk and portfolio theory What can we do about the risk of an investment? If we put all our money in one single investment, we will be facing the entire risk of that investment. Consequently, if the investment turns out to be lossmaking, there is not much we can do about it. However, if we spread our money across different investments in the first place, there might be a chance that one investment’s loss is compensated by another investment’s gain. The overall variation of the realised return on a portfolio of investments might therefore be reduced. This is the concept of risk diversification. Markowitz (1952) argues that combining different investments in a portfolio can reduce the overall standard deviation below the level obtained from a simple weighted average calculation provided that the investments are not all positively correlated. In general, the expected return on a portfolio with N investments and its variance can be expressed as follows: (3.3a) and (3.3b) where E(.) is the expectation function, ωi is the weight in investment i, σij is the covariance of returns between investment i and j. 40

1

This table can be found in Arnold (2008), Appendix 5.


Two-asset portfolio Let’s first examine how the risk of a portfolio with two securities can be calculated. Example 3.3 Suppose that you are considering an investment portfolio with two stocks, Rose Plc and Thorn Plc. The returns of these two stocks for the last five years are in columns 1 and 2 of the table below.

1

2

Rose, Rx

Year

3

Thorn, Ry

Rx–E(Rx)

4

5 2

[Rx – E(Rx)]

Ry–E(Ry)

6

7 2

[Ry–E(Ry)]

[Rx–E(Rx)][Ry– E (Ry)]

1

4

2

0

0

–1

1

0

2

11

–2

7

49

–5

25

–35

3

13

6

9

81

3

9

27

4

–8

–1

–12

144

–4

16

48

5

0

10

–4

16

7

49

–28

Sum

20

15

100

12

Mean

4

3

25

Covariance = 3

Standard deviation

290 Variance

72.5

Variance

8.5

5

Coefficient of correlation

0.07

Note that the variance and covariance are calculated using the following formulas: 2 T

(3.4a) t =1 2 T

y

t =1

T

t =1

(3.4b)

x

(3.4c)

To see the diversification effect, we first calculate the standard deviation of the two companies and their covariance. Covariance measures the co-movement of the two stocks. At first glance, Rose and Thorn are not moving in the same direction all the time, suggesting that they are not perfectly correlated. To see the extent of their co-movement, we compute the covariance and coefficient of correlation. Next, we combine the two stocks with different weights in a portfolio. Using equations 3.3a and 3.3b we can compute the portfolio’s risk and expected return based on different weights as follows:

41


Weight in Rose

Weight in Thorn

Portfolio’s risk

Portfolio’s E(Rp)

1

0

8.5

4

0.9

0.1

7.7

3.9

0.8

0.2

7

3.8

0.7

0.3

6.2

3.7

0.6

0.4

5.6

3.6

0.5

0.5

5.1

3.5

0.4

0.6

4.7

3.4

0.3

0.7

4.5

3.3

0.2

0.8

4.5

3.2

0.1

0.9

4.6

3.1

0

1

5

3

The portfolio’s expected return is simply the weighted average of the two companies’ returns. The portfolio’s risk is determined by using the general formula and we can see that it gradually decreases as the weight in the lower risk company (i.e. Thorn) increases. We should also note that the portfolio’s risk falls below 5% when the weight in Thorn exceeds 0.5. We could plot the portfolio’s risk against the expected return at different weights (see Figure 3.1). The solid line represents the efficient frontier which consists of all efficient portfolios that can be formed between Rose and Thorn.2 Investors can decide which composition they want to take. 4.5

Rose

4

Return (%)

3.5 3

Thorn

2.5 2 1.5 1 0.5 0 0

1

2

3

4 5 6 Risk (standard deviation)

7

8

9

Figure 3.1: Efficient frontier of portfolios formed by two assets.

Activity 3.3 Suppose we have two stocks, A and B with the following characteristics: Return

Risk

A

10

10

B

5

5

Sketch the efficient frontier of a portfolio which consists of stock A and B, assuming that the coefficient of correlation equals: a. 1 b. 0 c. –1 See VLE for solution.

42

2 An efficient portfolio is one that maximises expected return for a given risk.


Multi-asset portfolio The above analysis can be extended to a multi-asset scenario. Suppose it is free to buy and sell assets to form a portfolio. An investor may want to combine more assets in her portfolio if more risk can be diversified. To see how this may work, let’s take a look of the analysis below. Recall equations 3.3a and 3.3b

where i2 is the return variance of stock i and ij is the covariance between returns on stock i and j. Suppose we put equal weight in each asset, the portfolio’s risk will be reduced to (3.5a) ⎯

⎯

Define σ2 as the average variance and σij as the average covariance,

V p2

1 2 § 1 · V ¨1 ¸V ij © N ¹ N

(3.5b)

If N is sufficiently large (i.e. N → ∞), then

§ 1 · 1 2 V o0 and ¨1 ¸V ij oV ij © N ¹ N That implies

V p2

V ij

(3.5c)

The portfolio’s risk is therefore determined by the average covariance among the stocks in the portfolio.

Implications There are a few key implications from the above analysis worth noting. i. As an investor combines more assets in a portfolio, the limiting portfolio’s risk will gradually be reduced as both the first and second term in equation 3.5a will slowly disappear. Consequently, the shape of the efficient frontier will change and move more to the north-western quadrant of the mean-variance space. In Figure 3.2, each half-egg shell represents the possible weighted combinations for two assets. The composite of all assets constitutes the efficient frontier. The area underneath the efficient frontier consists of feasible but not efficient portfolios.

43


Expected Return (%)

Standard Deviation

Figure 3.2: Efficient frontier of portfolios formed by multiple assets.

ii. The portfolio’s risk will be minimised when a sufficiently large number of assets are included in the portfolio. iii. If there is no transaction cost involved in portfolio forming, then a rational and sensible investor will combine all possible assets in her portfolio. Ultimately, the portfolio is composed of and reflects the entire market. The risk of such a portfolio must be the same as the risk of the market. Using equation 3.5c, the market’s risk must be equal to the average covariance of the assets in the market: 2 market

=

ij

iv. If one can lend or borrow at some risk-free rate of interest, an investor, who previously holds a risky portfolio on the efficient frontier, may now combine the risk-free asset with the market portfolio. This can be represented graphically: Expected Return (%)

M

wi rro o B

ng

ing nd e L

rf

Standard Deviation Figure 3.3: Efficient frontier and risk-free asset.

This is known as the two fund separation theorem. No matter what risk attitude an investor has, he or she will always seek to form a portfolio by combining the risk-free and a risky market portfolio on the efficient frontier. Given the two fund separation theorem and the implications of the portfolio theory, any efficient portfolio will lie on the capital market line (CML), which has the following form: 44


E Rp

Rf

E Rm R f

Vm

(3.6)

Vp

Activity 3.4 Equation 3.6 required that there is a single risk-free rate in the capital markets. In practice, investors could seldom borrow and lend at the same risk-free rate. How would this affect the capital market line? See VLE for discussion.

Applications of the capital market line (CML) The CML equation gives investors an idea of how much return should be expected for any given portfolio risk. Example 3.4 It is expected that the market has an average return of 10% and the risk-free asset has a return of 5%. The standard deviation of returns on the market has been 7% in the past. What is the expected return of a portfolio with a standard deviation of 10%? Using equation 3.6, we have

E Rp

Rf

E Rm R f

Vm

Vp

10 5 u 10 7 12.14 5

Activity 3.5 Attempt Question 5 of BMA, Chapter 8. See VLE for solution. In the above analysis, we address the issue of risk and return relating to a portfolio. We now turn our attention to individual assets. At the beginning of the chapter, we defined risk and return for a single investment. When an investor holds a single investment (or asset), he or she faces the entire variation of returns of that asset. Consequently, the standard deviation will be a good proxy for risk to such an investor. However as we have seen in the discussion of portfolio theory and diversification of risk, a sensible investor should form portfolios with many assets in order to eliminate ‘risk’. The relationship between the number of assets and portfolio risk is depicted in Figure 3.4.

45


Porolio’s standard deviaon

Unique risk reduces as the number of securies increases

Market risk (non-diversifiable) 0

Number of securies

15

Figure 3.4: Risk diversification and the number of securities.

Figure 3.4 depicts two types of risk: risk that can be diversified (specific or unique risk) and risk that cannot be diversified (market or systematic risk). Empirically, an investor who holds 15 or more stocks in a portfolio would probably hedge most of the specific risk. Arguably the only risk in the portfolio would be from the market (the undiversifiable risk). If transaction costs are negligible, investors would combine all assets in their portfolios. Ultimately, everyone will hold the same most diversified portfolio (the market portfolio). If this is the case, then how would investors price a new asset in the market? Activity 3.6 Given Figure 3.4, what is the implication for small investors who have only a small amount of capital to invest? See VLE for discussion.

Derivation of capital asset pricing model (CAPM) BMA does not deal with the theoretical derivation for the capital asset pricing model. Here you can find a simple numerical derivation. Suppose an investor holds a portfolio which combines a% of an asset i and (1–a)% of the market portfolio. The expected return and standard deviation of the portfolio p are (3.7) and (3.8) where 2i is the variance of the return on the risky asset i; m2 is the variance of the return on the market portfolio; and im is the covariance of returns between asset i and the market portfolio. The marginal rate of substitution (MRS) between the expected return and risk of the market portfolio is

46


defined as the ratio of the partial differentiation of its expected return over the partial differentiation of its expected risk of the portfolio with respect to a. In equilibrium, all marketable assets are included in the market portfolio and there is no excess demand or supply for any individual asset. This implies that: (3.9) Also note that the MRS at the point of the market portfolio on the efficient frontier is the same as the slope of the capital market line (CML) at the point of tangency to the efficient frontier. It can be shown that: (3.10)

f

Rearranging the equation 3.10, we have:

[

[

(3.11)

where i = im / m. Equation 3.11, also known as the equation of CAPM or security market line, shows that there is an exact linear relationship between an asset’s return and its beta. This beta measures the risk of an asset relative to the market. We can from now on call it the market risk of an asset.

Return

Efficient Portfolio

Risk Free Return = R f 1.0

BETA

Figure 3.5: The CAPM and the security market line.

Activity 3.7 Attempt Question 7 of BMA, Chapter 8. See VLE for solution.

Estimation of beta Equation 3.11 depicts that there is a linear relationship between risk and return on individual assets. The risk is measured in terms of its risk relative to the market (beta) and return is what investors and the market would expect to receive given this level of market risk. Consequently knowing beta would allow us to estimate the expected return on an asset or security. How do we estimate the beta for a company? The following example demonstrates a simple approach which can be used in practice.

47


Example 3.5 SpringTime plc is an all-equity financed company on the London Stock Exchange. For the last five years, its stock returns and the returns on FTSE100 are as follows:

Year

Returns on SpringTime (%)

Returns on FTSE100 (%)

1

10

8

2

6

1

3

-4

10

4

24

12

5

19

14

The risk-free rate is 5% per annum. Using the above information, we can estimate beta and the expected return on SpringTime. The approach is as follows: 1. Compute the mean return of SpringTime and FTSE100 (Column I and II). 2. Determine the deviation of each observation from its mean (Column III and IV). 3. Calculate the covariance of returns between SpringTime and FTSE100 by averaging the sum of the products of each pair of deviations (Column V). 4. Calculate the variance of returns on FTSE100 (being the average of the sum of the squared deviations of Column VI). 5. Estimate the beta. 6. Substitute beta into the CAPM equation.

I

II

III

IV

V

VI

Year

SpringTime’s return

FTSE100’s return

DEV, S

DEV, M

III  IV

IV  IV

%

%

%

%

%

%

1

10

8

-1

-1

1

1

2

6

1

-5

-8

40

64

3

-4

10

-15

1

-15

1

4

24

12

13

3

39

9

5

19

14

8

5

40

25

Sum

55

45

105

100

Mean

11

9

Covariance Variance

Beta is defined as the market risk of a company. This implies that we measure the covariance of the return relative to the risk of the market. In other words, beta can be calculated as follows:

Covariance Substituting in the CAPM equation we have

= 5 + 1.05  (9 – 5) = 9.2 48

21 20


Activity 3.8 Attempt Question 15 of BMA, Chapter 8. See VLE for solution. There are a few aspects of estimating beta worth noting here: i. In the absence of any information about the expected return on the market (i.e. the return on FTSE100 in the above example), the average historic return will be the only sensible proxy for the expected return. ii. In the above analysis, we have not adjusted for the small sample error. If we do, the analysis will be as follows: I

II

III

IV

V

VI

SpringTime’s return

FTSE100’s return

DEV, S

DEV, M

III  IV

IV  IV

%

%

%

%

%

%

1

10

8

-1

-1

1

1

2

6

1

-5

-8

40

64

3

-4

10

-15

1

-15

1

4

24

12

13

3

39

9

5

19

14

8

5

40

25

Sum

55

45

105

100

Mean

11

9

Covariance

26.25

Year

Variance

25

You can see that the differences lie on the calculation of the covariance and variance. We re-calculate the covariance and variance using equations 3.4a – 3.4c. However, the beta remains unchanged (26.25/25 = 1.05). iii. The estimation of beta is sensitive to both the return intervals and the sample periods. Daves, Ehrhardt and Kunkel (2000) have the following conclusion: ‘Financial managers can estimate the cost of equity via the CAPM approach. If the financial manager estimates the firm’s beta... then the financial manager must select both the return interval and the estimation period. Regarding return interval... the financial manager should always select daily returns because daily returns result in the smallest standard error of beta or greatest precision of the beta estimate. However, regarding estimation period, the financial manager faces a dilemma. While a longer estimation period results in a tighter standard error for the estimate of beta, a longer estimation period also results in a higher likelihood that there will be a significant change in the beta. Thus, the beta estimated over longer estimation periods is more likely to be biased and of little use to the financial manager.’

Conceptual issues with CAPM • The CAPM implies relationships between ex ante (expected) risk premia and betas that are not directly observable. However, in most empirical work, we implicitly assume that the realised returns on assets in a given time are drawn from the ex ante probability distribution of returns on those assets under rational expectations. 49


• Empirical tests use time-series data to calculate mean excess rates of return and betas; however, it is unlikely that risk premia and betas of individual assets are stationary over time. This issue is addressed by explicitly forming portfolios that are stationary over time or conditioning risk premia and betas on information sets. • Many assets are not marketable and tests of the CAPM are inevitably based on proxies for the market portfolio. The test of the CAPM becomes a test whether the proxy is mean-variance efficient (Roll, 1977).

Empirical evidence and evaluation Both BMA Chapter 8 (pp.223–27) and Arnold Chapter 8 (pp.295–99) discuss the empirical evidence of the CAPM. The key question one must ask is whether the CAPM is indeed the true model for explaining the risk and return of individual companies. The summary of empirical evidence from the textbooks and the text given in this section both indicate that the cross-sectional returns are not explained solely by the market risk factor, beta. There appear to be other risk factors which explain the expected returns of individual companies. It is advised that you read and make notes from BMA Chapter 8 (pp.223– 27) and Arnold Chapter 8 (pp.295–99) before proceeding with the rest of this section. An extensive body of empirical research has provided evidence contradicting the prediction of the CAPM. This research documents that deviations from the linear CAPM risk-return trade-off are related to, among other variables, firm size (defined as the natural logarithm of the market value of a firm), earnings yield (defined as the earnings per share of a firm over its share price value), leverage (measured as the ratio of debt to equity) and the book-to-market ratio (defined as the net book value of a firm over its market value). Ferson (1992) provides an extensive summary of these empirical tests on the CAPM and its anomalies up to 1991. Other notable works include: Banz (1981), Basu (1983), and Reinganum (1981) show that the firm size and earnings yield can explain the cross-sectional returns in conjunction with the market beta, suggesting that beta is not the only risk factor. Fama and French (1992) show that by employing a new approach for portfolio grouping, there is only a weak positive relation between average monthly stock returns and market betas over the period from 1941 to 1990. This relation virtually disappears over a shorter period from 1963 to 1990. However, firm size and the book-to-market equity ratio have considerable power. The findings in this paper cast serious doubt over the validity of the CAPM as the true cross-sectional asset pricing model and has stirred up a new wave of empirical attention on the CAPM. However in any CAPM test, there are two issues that need to be resolved: i. Is the data for measuring or testing the expected returns taken from a complete set which has no bias? Kothari, Shanken and Sloan (1995) argued that if portfolios are formed from a data set which contains only the surviving firms, the CAPM test might not be conclusive. ii. How can we be sure that the betas were correctly estimated in Fama and French (1992) if significant estimation errors are found in the estimated betas? If such estimation errors exist, then the tests on the significance of the betas in cross-section regression would be undermined (Kim, 1995). Debate about whether the CAPM is the true pricing model is still going on. 50


The following section outlines the alternative pricing models.

Alternative asset pricing models BMA Chapter 8 (pp.227–31) discusses the alternative pricing models. Read this section in the textbook before continuing with this section. Multifactor models can be divided into three types: statistical, macroeconomic and fundamental factor models. Statistical factor models derive their pervasive factors from factor analysis of the panel data set of security returns. Macroeconomic factor models use observable economic time series, such as inflation and interest rates, as measures of the pervasive shocks to security returns. Fundamental factor models use the returns on portfolios associated with observed security attributes such as dividends yield, the book-to-market ratio, and industry identifiers. The basic model takes the following form:

One of the most cited literatures on macroeconomic variable model is Chen, Roll and Ross (1986). They observe that asset prices are driven by exogenous forces as daily experience seems to support the view that prices react to unexpected news. If these forces are not diversifiable, the market will compensate investors for bearing those risks. They find that, most notably, the industrial production, changes in the risk premium, twists in the yield curve, and somewhat more weakly, measures of unanticipated inflation and changes in expected inflation during periods when these variables were highly volatile are significant. Contrary to previous belief, they find that the market return is not priced despite its high content of explanatory power. Fama and French’s three factor model is a good example of a fundamental factor model. BMA Chapter 8 (pp.229–31) explains how this model can be estimated. Activity 3.9 Attempt Question 21 of BMA, Chapter 8. See VLE for solution.

Practical consideration of CAPM Despite the highly unrealistic assumption underpinning the CAPM and the empirical evidence against the model, practitioners remain faithful to the CAPM. Harvey and Graham (2002) examine what CFO’s use in practice to estimate the cost of capital for their companies. Over 70% of the respondents rank the CAPM as the most popular tool to estimate the cost of capital. Estimation method for cost of capital

Popularity, % always or almost always

CAPM

73.49

Average historic return

39.41

CAPM with extra risk factors

34.29

Discounted dividend model

15.74

Investors’ expectation

13.93

Regulatory decisions

7.04

Table 3.1: Popularity of methods of calculating the cost of equity capital. Source: Graham and Harvey (2001) 51


A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • describe the meaning of risk and return • calculate the risk and return of a single security • discuss the concept of risk reduction/diversification and how it relates to portfolio management • calculate the risk and return of a portfolio of securities • discuss the implications of the capital market line (CML) • discuss the theoretical foundation and empirical evidence of the capital asset pricing model (CAPM) and its application in practice.

Practice questions 1. Suppose we have the following inflation rates, stock markets and US Treasury Bill returns between 2006 and 2010: Year

Inflation (%)

S&P 500 Return (%)

T-bill Return (%)

2006

3.3

23.1

5.2

2007

1.7

33.4

5.3

2008

1.6

28.6

4.9

2009

2.7

21.0

4.7

2010

3.4

-9.1

5.9

a. What was the real return on the S&P 500 in each year? b. What was the average real return? c. What was the risk premium in each year? d. What was the average risk premium? e. What was the standard deviation of the risk premium? 2. Is standard deviation an appropriate measure of risk for financial investments or projects? Discuss. 3. A game of chance offers the following odds and payoffs. Each play of the game costs £100, so the net profit per play is the payoff less £100: Probability

Payoff

Net Profit

0.1

£500

£400

0.5

£100

0

0.4

£0

–£100

What are the expected cash payoff and expected rate of return? Calculate the variance and standard deviation of this rate of return. 4. What do you understand by the term ‘risk and return’ in the context of financial management?

52


Sample examination questions 1. Suppose that you are considering investing in only two companies, Rose Plc and Thorn Plc. Their returns for the last five years are as follows: Year

Return on Rose Plc (%)

Return on Thorn Plc (%)

–5

8

6

–4

20

7

–3

16

8

–2

4

–1

–1

12

10

Required: a. Calculate the expected return and standard deviation to the nearest percentage of both Rose and Thorn. b. Calculate the coefficient of correlation between the return of Rose and Thorn. c. Suppose you combine 50% of Rose and 50% of Thorn in a portfolio. Calculate the portfolio’s expected return and standard deviation. d. Suppose that the risk-free rate is 6%. Explain, with the aid of a graph, the composition of an optimal portfolio. 2. James, who is a risk averse investor, is deciding how to divide his money between two assets, peppers and corn, which have the following characteristics: Peppers

Corn

Expected return

10

10

Standard deviation

5

5

If the returns on Peppers are independent of those on Corn, what will be the composition of his optimal portfolio? Would the composition of the portfolio be different if a risk-free investment is available to James? 3. What are the necessary conditions for an efficient diversification of risk? a. What is the relationship between the number of available securities and the gains from diversification? b. Does this relationship have any implication for the small investor? c. ‘In theory, an investor in risky securities is presumed to select an investment portfolio which is on the efficient frontier and touches one of his indifference curves at a tangent. But in practice, neither the efficient frontier nor the indifference can be estimated with high degree accuracy. Therefore, the portfolio theory is redundant.’ Explain the terms in bold in the above statement. Critically assess their validity. 4. Suppose that you have estimated the expected returns and betas of the following five stocks using annual data available for the last 10 years:

53


Stock

Market Size (£m)

Beta

Expected Return (%)

A

360

0.6

8

B

23

0.8

10

C

250

1.2

11

D

10

1.3

12

E

500

1.4

12

The risk-free rate of interest and the expected return on the market are 5% and 10% respectively. You are also told that the market size of the companies in this market is normally distributed with a mean of £400m and a standard deviation of £150m. Required: a. Explain carefully the extent to which these data are consistent with the capital asset pricing model and whether there is any optimal investment strategy. b. What would you advise an investor who would like to hold a portfolio with a beta equal to 1? c. ‘The risk of a company depends upon much more than how well the stock market is doing. Beta only captures the co-movement of a company’s share price with the market; and hence fails to capture various sources of risk.’ Critically assess the validity of the capital asset pricing model and its use as a benchmark for project appraisals.

54

Chapter 4: Capital market efficiency

Chapter 4: Capital market efficiency Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 13.

Further reading Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 14.

Aims The first part of this chapter introduces you to the theory and practice of capital markets. It considers the concept of an efficient capital market with its implications for the raising of capital and the assurances for a fair game situation for the transfer of funds between investors. The types and the degrees of efficiency have been tested in many various ways with more recent research findings highlighting certain anomalies which give support to those who have questioned the concept. Discrepancies in types and degrees of efficiency between different international markets have also been identified. The efficient market hypothesis has important implications for all market operators and their agents.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis, its different levels, the anomalies and deviations between theory and practice as well as summarise the evidence that has been produced both in support for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them (e.g. investors, companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity.

Capital markets The primary function of the capital markets is to enable investors and companies to raise funds. The secondary function is to provide opportunities for providers of funds to liquidate their investments. Note that this latter function is vitally important because, without the facility to exit from an investment, few people or institutions would be prepared to make investment funds available. Thus the marketplace is providing the needed interface for investors to interact with companies, through their management, that wish to raise funds as well as other investors who may wish to buy or sell existing financial assets. 55


You should learn the assumptions underpinning the definition of a perfect capital market and how the economist’s perfect market becomes the financial manager’s efficient capital market and the necessary conditions for that. Note you should also use and understand how the notion of being involved in a fair game proves the basis for discussion here.

Types of efficiency An efficient market needs operational, allocational and informational efficiency. A perfect market requires that trading is costless, that information is costless and freely available, and that no single investor is dominant. • Operational efficiency – means that transaction costs should be as low as possible and that sales are quickly effected. • Allocational efficiency – means that capital markets allocate funds to their most productive use. • Informational efficiency – means that security prices fully and fairly reflect all relevant information so that they are fair prices. When discussing efficiency, the majority of the research findings in the literature relate to pricing efficiency. It is to this that the efficient market hypothesis (EMH) relates.

Efficient market hypothesis (EMH) There are three forms or levels of informational efficiency: 1. Weak form – prices reflect all past information. This means that one cannot consistently earn better-than-expected (abnormal) investment returns as a result of studying past patterns of prices for particular securities. This implies that people who draw charts of past share price movements, and try to detect patterns of share price movements, would not gain as a result. Share prices in a market which are consistent with the weak form should behave like a ‘random walk’ (i.e. share prices do not follow any particular pattern). Prices are moved only when relevant information about the securities arrive in the market. Since the arrival of new information does not normally follow any particular pattern, this has the effect that share prices follow an apparently random walk. BMA shows the random pattern (random walk) of Microsoft’s share prices in Figure 13.2 on p.344. The ‘random walk hypothesis’ suggests that there is no connection between successive share price movements. Early empirical work supports this view, meaning that capital markets are weak form efficient. 2. Semi-strong form – prices reflect all publicly available information. This means that no one can earn abnormal returns based on the study of publicly available information about the enterprise. For example, the publication of a company’s accounting reports would not be expected to be advantageous. 3. Strong form – prices reflect all public and private information. This means that no one can obtain abnormal return by trading private information. Security prices would have already incorporated the information content of any valuable private information about a company. 56


It is important to understand that, if a market is efficient in the strong form, it must also be efficient in the semi-strong form and the weak form. Similarly, if a market is efficient in the semi-strong form, it must also be efficient in the weak form. These distinctions are useful. This is because evidence, which consists of the results of a large number of research studies, tends to suggest that the world’s capital markets are efficient in the weak and semistrong form, but not in the strong form. In other words, those who have relevant information that is not generally known can expect to earn better than average investment returns. Note carefully what is meant by efficient market hypothesis (EMH). EMH does not require that the markets are perfect in the sense that they are referred to by economists, nor does EMH require that any investors have perfect knowledge of the future. EMH is concerned with the extent to which the knowledge which does exist about a particular security is fully taken account of in its market price. Thus the price at which a security is traded today may, with the advantage of information which may subsequently come to light, be above or below the true worth of the security. EMH requires that the price at which that security is traded today rationally reflects all of the information which is available today. Activity 4.1 Look at a local paper which quotes daily share prices. Select a company and plot the closing share prices for the five days in one week with time on the x axis. Draw a line of best fit through those five points. Then plot the next Monday’s closing price. By reading the paper about Monday’s market activities try to explain why the plot for Monday’s price is where it is, on, above or below the trend line you have drawn. Is your explanation drawn from the weak, semi-strong or strong form? See VLE for discussion.

Foundation of market efficiency To ensure that information can be reflected in security prices, the following assumptions must be upheld: Rationality Investors are rational. They seek returns to compensate for their investment risk and would avoid unnecessary risk wherever possible. The stock market is rational in the sense that stock prices reflect their fundamental values. If such rationality is in place, it is argued that investors and the market will value securities based on their fundamentals. Independent deviations from rationality Efficient markets allow individuals to deviate from the principle of rationality from time to time. As long as their irrational trading behaviour is random, it is argued that the effects of their irrational actions will cancel each other out without affecting the efficient price level. Arbitrage Arbitrage is possible to ensure securities that are out of price would be aligned to their fundamental values. Even if most investors are irrational in the same way, as long as some rational investors can arbitrage and eliminate the influence of the irrational traders’ actions, then prices can be restored to their efficient level. However, if arbitrage is not possible, any mispricing in securities would not be adjusted. 57


Activity 4.2 Identify and explain which forms of efficiency are adhered to and/or violated in each of the following situations: i. Stock returns tend to be lower in December than in January. ii. Small capitalised stocks perform substantially better than the market while large capitalised stocks perform significantly worse than the market in 2006. iii. The London Stock Exchange has recently published a report on insider trading. It has been found that there is no evidence for any insider trading. iv. BAC plc has just announced a record profit but its share price falls by 10%. v. Mrs Smith announced on national TV that she can predict stock returns better than the capital asset pricing model. See VLE for discussion.

Tests of the efficient market hypothesis Chapter 13 of BMA, pp.346–54 and Chapter 14 of Arnold, pp.570–96 cover a good deal of the testing of EMH. You should read the relevant sections in the textbooks and familiarise yourself with the evidence for and against market efficiency. In general, we can summarise the testing on market efficiency in 3 areas: i. Weak form testing Researchers have conducted the greatest number of tests on the weak form efficiency. Tests have looked for data patterns that might have particular properties similar to different frequency distributions – random-walk, sub-martingale,1 simple sequences of increases or declines – all with the aim of being able to derive a trading rule which would enable the investor to out-perform the market using a simple buy and hold strategy. The tests have been performed on numerous different markets, over different time periods, etc. The results have not been uniform in outcome. The differences in results can be explained by many features – developed country markets versus developing country markets, monthly versus daily versus weekly prices, upward versus downward price trends etc. ii. Semi-strong form testing The tests on the semi-strong form have also been numerous and again produced results lacking in consistency. The tests using data from developed country markets have tended to support the conclusion that the market adjusts quickly (i.e. efficiently) to publicly available information. Results from developing market studies have been much fewer and have tended to suggest a lower degree of efficiency. iii. Strong form testing The strong form tests have been least successful in their proof of the strong form of efficiency in the markets. Clearly there are still circumstances that exist where investors under the strong form could, and do, earn above average profits. This is in spite of legislation in some countries in the markets outlawing particular operations (e.g. insider trading).

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1

A sub-martingale is a process in which the expected next period’s value, based on the current period’s information, is greater than or equal to the current period’s value.


Anomalies, fads, insider trading and doubts concerning efficiency There are now many published articles on the anomalies of EMH (e.g. day-of-the-week effect, trading-hours-of-the-day effect, even month of the year effect, size anomalies and small company effect). These anomalies may help to explain why certain investors can obtain abnormal profits. However, there is no evidence of consistent abnormal gains accruing to investors who have based their trading upon these anomalies. There is also sufficient anecdotal evidence of investors following fads and engaging in insider trading. This casts doubts on market efficiency.

Implications of EMH Investors If markets are adhering to the strong form efficiency, then no one can obtain abnormal returns by using any private or public information. Equity research is pointless and no bargains exist on the capital markets. Investors are best advised to buy a portfolio of shares and to hold those shares rather than look for opportunities to buy ‘cheap’ shares. This is because securities reliably reflect all known information about a business, so if shares look cheap it is illusory – all that will happen is that the investor will waste time and money seeking out the ‘cheap’ shares, then spend money on agents’ fees etc. to sell part of the existing portfolio and replace it with the ‘cheap’ shares. However, if the market is not adhering to the strong form efficiency, then for the vast majority of people, public information cannot be used to earn abnormal returns. Arguably only those investors who have superior private information would gain. The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers. Similarly, if the markets are adhering to the semi-strong form efficiency, fundamental analysis (which looks for the fundamental value of a share) would not add value. Instead, investors need to press for a greater volume of timely information to ensure that stock prices reflect full public information about companies. If the markets are adhering to the weak form efficiency, then technical analysis (which seeks to predict share prices from studying their historic movements) would be redundant as past stock price patterns would have already been incorporated in the current stock prices. Companies Accounting misinformation will not fool investors generally. There is a body of evidence which suggests that attempts by corporate managers to make alterations to the accounting bases, to figures published in annual accounts which have the effect of giving a changed view of the profit for a period or the assets on the balance sheet, will not affect the market price of the business’s shares; this is provided that the facts concerning the alterations to the accounting bases are made public. However not everything may be made public and in any case some manipulation may be possible within the guidelines and thus not published. There are numerous reasons why management wants financial information presented in a particular way (e.g. income smoothing because of the link with a management remuneration scheme). The timing of issues of new shares by businesses is not an important question. It seems that corporate managers are frequently concerned not to issue shares at a point where share prices are historically low, since in 59


order for the issue to be successful the new issue would have to be at a low price; this is irrational if current share prices reflect all that is known about the business. Only where the businesses’ managers have economic information about the business that they have yet to release into the public domain would delay be justified. Again, anecdotal evidence can show in specific instances where businesses did lose out by having to issue at the wrong time. Possibly the shift in research findings reflects a genuine lessening of CME over recent times, perhaps caused by an effective decline in the number of individual investors active in the market. Possibly it reflects the use of more sophisticated research techniques in recent studies, which are leading to a truer view of things. Activity 4.3 Summarise the six lessons of market efficiency on pp.358–61 of BMA, Chapter 13. In your opinion, how far do you agree that the capital markets are informationally efficient? See VLE for discussion.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis, its different levels, the anomalies and deviations between theory and practice as well as summarise the evidence that has been produced both in support for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them (e.g. investors, companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity.

Practice questions Critically comment on each of the following statements: 1. ‘The stock market is depressed at the moment. This is a very bad time for our business to make an issue of new shares to the public.’ 2. ‘If stock market prices are efficient, it means that all investors have complete information about all of the shares quoted in that market.’ 3. ‘The stock market cannot be semi-strong efficient, otherwise you wouldn’t have all those well paid analysts spending most of their working day poring over business reports and other published information.’

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Sample examination questions 1. a. Explain clearly the following terms: i. weak form efficiency ii. semi-strong form efficiency iii. strong form efficiency. b. Discuss and identify which form of efficiency the following markets are adhered to and/or violated: i. Stock returns tend to be higher in January than in other months. ii. Some stocks perform substantially better than the market while some stocks perform significantly worse than the market in any given month. iii. Roughly half of a group of professional portfolio managers ‘beat the market’ during 2000. iv. Consistently superior returns are earned by buying a company’s stock the day after an announcement of good news, for example, after an increase in earnings. v. Mr Solaree announced on national TV that he has discovered a trading strategy that can outperform the market by 3% on average. c. Why is it important to ensure that the market is informationally efficient? 2. a. What are the main implications of market efficiency to: i. investors ii. companies/financial managers. b. What empirical evidence do we have for and against the following forms of market efficiency? i. weak form ii. semi-strong form iii. strong form.

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Notes

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Chapter 5: Sources of finance

Chapter 5: Sources of finance Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 14 and 15.


Aims In this chapter we focus on the main reasons why firms raise funds from capital markets and discuss the main methods of raising equity and debt. We will also discuss the pros and cons of each method of fund-raising.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • discuss how the financial markets operate, particularly with respect to the provision of funds for companies • outline the range of securities used to generate funds for companies, including a more in-depth insight of the main forms of debt and equity.

Introduction In Chapter 2 we discussed why firms engage in financial investments. In order to maximise the value of a firm, managers must come up with sufficient cash flows to undertake all positive NPV projects. A firm may rely on two sources of funds: internal and external.1

Internal funds The main source of internal funds comes from retained earnings. Firms set aside resources by retaining part of their yearly earnings for future investment purposes. It is often argued that internal funds are much more preferred to external funds because:

1

We will discuss more thoroughly the theory of capital structure in Chapter 6. In particular the pecking order theory will be covered.

• retained earnings are seen as a ready source of cash or cash equivalent • there is no issue or transaction cost involved with retained earnings (as opposed to equity or debt issues – see below) • there is no dilution of control with retained earnings • no public scrutiny of why the funds are needed and how they are to be used.

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External funds External funds can be roughly divided into equity finance and debt finance. 1. Equity finance Equity finance can be raised by selling ordinary shares to existing shareholders or new investors. These shares can be sold or bought in stock exchanges around the world. Ordinary shareholders are the ultimate bearers of risk in a company, as they are at the base of the creditor hierarchy and stand to lose everything in the event of liquidation. They therefore demand a higher return to compensate for the risk they bear. Ordinary shares have a nominal (or par) value which gives every shareholder an equal voting right. An ordinary share is normally issued at a price higher than the par value. The difference is called the share premium. However, the issued price is not normally the same as the market price of a share and the share price fluctuates on the basis of how stock markets value the company. 2. Debt finance Debt finance refers to the borrowings of a company to finance its operations. We will cover this on page 68. Activity 5.1 On 4 May 2010, Essar Energy, an Indian oil and gas producer, issued ordinary shares at £4.20 for a total of £5,470m on the main London Stock Exchange. Its share price as on 1 November was £2.97. (Sources: www.essarenergy.com/ and www.newissuecentre.co.uk/2010issues.htm) Why would a company such as Essar Energy issue ordinary shares on a stock exchange? Why did the share price of Essar fall after the issue on 4 May 2010? See VLE for discussion.

Flotation Many companies, such as Essar, would like to issue shares on stock exchanges. The main reasons for companies to do so are to: • raise funds for current and future investments, ease out liquidity shortages and reduce debts • gain easier access to equity and other sources of finance in the future • use quoted shares in various ways, such as in a take-over bid. However, flotation of shares in stock exchanges is not without consequences. Some of the concerns are listed below: • Meeting investors’ expectations – it is evident that once a company is floated on a stock exchange, it will be more heavily scrutinised by the public and especially existing investors. As share prices are supposed to reflect the investors’ expectations about the company’s future dividends, managers must try hard to ensure that this expectation is met. • Costs of flotation – the process of flotation is a very expensive exercise for a company. It is often thought that most companies would at some point in their life cycle have to consider flotation in the stock markets. The attraction or benefits from a flotation must outweigh the limitations. 64


• Increased financial transparency and stock exchange’s requirements – the costs of flotation are not confined to the payments made to sponsors, stockbrokers, underwriters and other professionals. Once a company is listed on a stock exchange, the requirement for a high degree of transparency and reporting requirements might threaten its continued listing.2 Activity 5.2 Read the following article from The Daily Telegraph, 4 November 2007: www.telegraph.co.uk/finance/markets/2818853/Virgin-in-training-for-1bn-flotation-ofgyms-division.html

2

Olympus was threatened with delisting from the Tokyo Stock Exchange if it failed to file a quarterly report by 14 December 2011. See www.bbc.co.uk/news/ business-15669164

Discuss the pros and cons of flotation on the stock market. See VLE for discussion.

Why do companies seek listing on more than one stock exchange? Some companies may seek flotation on more than one stock exchange. Some of the main reasons are listed below: • Broaden the investor base – it allows companies to tap into a wider base of investors with the hope that more funds can be raised in the future. • Domestic stock exchange is too small – it is argued that when the domestic markets are too small, companies might seek listing elsewhere. • Reward to employees – employees of foreign-owned companies may receive shares in their parent company as part of their remuneration. If shares are quoted in the domestic market, it is argued that these employees could be able to manage their share value better, appealing more to them as a result. • Better understanding in the foreign market (price stabilisation). • Raising awareness of the company (Chinese and Russian companies quoted on stock exchanges such as the Hong Kong Stock Exchange and the London Stock Exchange). Activity 5.3 Read the following article: www.fundinguniverse.com/company-histories/DaimlerChrysler-AG-Company-History.html In your opinion, why did Daimler-Benz (the luxurious car maker) seek listing on the New York Stock Exchange? See VLE for discussion.

Share issues We have discussed at great length the pros and cons of issuing shares in stock markets. In the following section, we will look at the mechanism of issuing shares to the public.

Initial public offer (IPO) This is when a firm issues shares to the public for the first time. It is a major step for a firm to ‘go public’.

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Issuing process Given the complexity of raising funds in the stock markets, it is often considered to be essential that advisers should be appointed. These advisers fall into the following categories: • Sponsor This is normally an investment banker, stockbroker or another professional who possesses all the necessary expertise and is approved by the local listing agents to act as an adviser to issuing firms. The sponsor (commonly known as the issuing house) will first examine and assess if going public is the appropriate corporate objective by taking into consideration the composition of the board. The sponsor will also advise on the issue price and the number of shares to be issued given the market conditions and the method and timing of the equity issue. • Underwriters Since it is difficult to estimate the precise demand of the new shares, an issuing company will normally appoint an underwriter (or a syndicate of underwriters) to underwrite any unsubscribed shares. If the price set by the sponsor is too high, the demand will be less than supply and the issuing firm will be left with unwanted shares. This implies that the firm will not be able to raise sufficient funds for its use. To ensure that this is not going to happen, a firm will pay the underwriters a sum of money (acting like an insurance premium). In return, the underwriters will guarantee to buy back any unwanted shares. The price of the unwanted shares that the underwriters will buy back from the issuing firm will be lower than the original issue price to the public. • Other professionals Accountants and lawyers provide reports about the issuing firm’s financial position and advise on legal matters relating to the equity issue. In considering issuing shares to the public, a company might need to take the following factors into account: Price stability – a newly floated firm should ensure that its share price is stable to give investors additional confidence. Therefore it is important that after listing, the issuing firm has the continuing obligation to release any price-sensitive information to the market as soon as possible. Timing – market timing for new share issues is crucial to determine if the issue is going to be fully subscribed. The Industrial and Commercial Bank of China (ICBC) simultaneously floated its shares on both the Hong Kong Stock Exchange and the Shanghai Stock Exchange. It was the world’s largest IPO at that time. Due to the favourable market timing, the shares were heavily over-subscribed and the share price ended up some 15% over the initial offer price by the end of the first trading day. Initial returns – investors are drawn to the prospect of receiving ‘good’ returns from their IPO shares. Companies which seek to float their shares for the first time might need to consider underpricing their shares to attract investors.3 Long-term performance – even though there are investors who often look for ‘bargain’ or short-term profit from their investment, the majority of them are looking for sustainable long-term returns

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3

See BMA pp.400–401 and Figure 15.3.


on their investment. A new IPO firm would need to prove itself to be a worthwhile investment by showing solid and good long-term performance.

Rights issues Apart from issuing shares to the public, a company can also raise funds directly from its existing investors. This is known as a rights issue. In a rights issue, new shares are issued pro-rata to existing shareholders which preserves the existing patterns of ownership and control. It is cheaper than an offer for sale, but is limited by funds at the disposal of existing shareholders. Shares in a rights issue are usually offered at a discount (around 15% to 20%) on the current market price, making them more attractive to shareholders and allowing for any adverse share price movements. After a rights issue, shares would be traded at the theoretical ex-rights price. The theoretical ex-rights price is given by: P N + PN N N Pe = 0 0 N Where: P0

is the share price before the rights issue

N0

is the number of old shares

N

is the total number of shares after the rights issue

PN

is the issued price of the rights issue

NN

is the number of new shares created from the rights issue

Example 5.1 TLC plc’s current share price is £10 each. There are 1m ordinary shares in issue. The company considers a one for four rights issue at an issuing price of £8 per new share. What is the theoretical share price after the rights issue?

P0 N 0 + PN N N N 1,000,000 250,000 = £10 × + £8 × 1,250,000 1,250,000 = £9.60.

Pe =

Rights can be sold to investors: the value of rights is the difference between the theoretical ex-rights price and the rights issue price. If shareholders either buy the offered shares or sell their rights, there is no effect on their wealth. In the case when a shareholder accepts the rights and buys the share, her net worth is £9.60  5 – £8 = £40 which is the same value before she subscribes to the new share (i.e. £10 for each of the 4 shares she owns). If she sells the rights, she should have (under the no arbitrage assumption) the same wealth. Consequently, the value of the rights must be calculated as £10  4 – £9.60  4 = £1.60. However, the actual ex-rights price will be different from the theoretical exrights price due to market expectations about the economy, the company and dividends.

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Private issues Sometimes it is more advantageous for a company to issue shares privately to potential shareholders. Some of the possible ways of offering shares to private investors are listed below: • Placement or placing – this involves issuing blocks of new shares at a fixed price to institutional investors. It is a low-cost issuing method involving little risk. There is no limit on the amount to be placed. It is a popular choice for small to medium-sized share issues. • Offer for sale – this is when the issuing firm’s sponsor offers the shares by inviting institutional and individual investors. Normally the offer is at a fixed price usually for large issues of new equity and involves offering shares to the public through an issuing house or a sponsoring investment bank. A variation to this is the offer for sale by tender. Here investors are invited to state at what price they are willing to buy the shares. The sponsor will gather all information and determine a price (the strike price) that will guarantee all shares are sold. This strike price will be the selling price for all the shares. Those investors who submit a bid price higher than the strike price will be allocated shares, while those who submit a price lower than the strike price will not be allocated any shares. This method is popular when the actual issued price is difficult to determine.

The role of stock markets • Allow firms to raise funds and grow – stock markets enable companies to find investors to raise funds to finance their investments. • Allow investors to buy and sell stocks – well-organised stock markets enable investors to buy and sell stocks whenever they want. A stock market is said to be liquid if investors can easily buy or sell their shares at the prevailing market prices. • Status and publicity – due to the heavy scrutiny by regulators and stock exchanges, companies which are floated on well-organised stock exchanges are often regarded as more valuable. • Mergers – one of the requirements for companies to be floated on stock exchanges is that they would need to file quarterly financial information. This more regular reporting process helps companies to disseminate financial information more readily to investors. It is argued that this makes companies’ financial status more transparent and hence under-valued companies are easier to identify. This might encourage under-valued companies to be take-over targets. • Improve corporate behaviour – the heavy regulations and scrutiny by the markets are often seen as the ‘invisible hand’ which helps steer financial managers’ action to maximise shareholders’ wealth.

Debt finance Advantages of debt financing The issue of loan capital (debt) can bring certain advantages to a business and its shareholders. These advantages include: • By employing loan capital to help finance the business, the returns to equity shareholders will increase, providing the returns from the funds invested exceed the cost of servicing the loan. 68


• Loan capital is normally perceived as being less risky by investors than equity shares as loan interest is payable before share dividends and security is normally provided by the business for the loan – this lower level of risk results in lower expected returns by lender than equity shareholders. • In most countries, interest on loan capital is viewed as an allowable business expense which can be offset against profits for taxation purposes – this is not the case for dividend payments. • The degree of sophistication and variety now available in bond or quasi-bond securities has grown enormously in recent years through the increasing competitiveness within financial markets. Examples of these new types are junk bonds, deep discounted bonds, mezzanine finance, interest-rate swaps and debt-equity swaps.

Disadvantages of debt financing The use of loan capital to finance a business, however, also brings certain disadvantages: • The higher the level of borrowing, the higher the level of financial risk associated with the business. The level of borrowing is also known as the amount of gearing. Interest must be paid irrespective of the profit level and capital must be repaid on maturity of the debt. Also in a winding up, administration or receivership, an unsecured lender is repaid before a shareholder. This higher level of risk is likely to mean that equity shareholders will seek higher returns in compensation. • The business may also be required to accept loan covenants as part of the loan agreement (e.g. maintaining a certain level of liquidity, seeking permission from existing lenders before raising new loan capital, etc.) which will restrict management’s freedom of action. • Although interest rates are generally lower than equity returns, there can be occasions when the returns on loan capital are higher than those on equity capital.

The issue of loan capital Long-term debt is likely to be issued by a business when some of the following conditions prevail: • earnings are relatively stable over time or on an increasing trend • adequate security for the debt exists • the existing level of gearing is fairly low for the particular business sector • there is a risk of a change in the pattern of control from the issue of new equity shares. However, the level of borrowing (gearing) will also be influenced by the company’s profitability and the present and future underlying economic conditions. If the economic conditions are poor, then the risk attached to paying the interest due increases and interest rates may be higher. The higher the gearing, the greater the gains in earnings for shareholders in times of increasing profits. Conversely, in times of declining profits the higher the gearing, the faster the decline in earnings per share. Thus, simplistically, it is better to be low geared in low profit or declining profit periods; in growth and high profit periods it is better for the company to be highly geared. 69


A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • discuss how the financial markets operate, particularly with respect to the provision of funds for companies • outline the range of securities used to generate funds for companies, including a more in-depth insight of the main forms of debt and equity.

Practice questions BMA, Chapter 15, Questions 10, 14, 15 and 16.

Sample examination questions 1. a. Why are the costs of debt financing less than those of share issues? Why do companies still seek flotation on a stock exchange? b. Outline the reasons why companies seek flotation on more than one stock exchange. c. Why does shareholders’ wealth remain unchanged regardless of whether they take up the shares in a rights issue? What factors are there to motivate shareholders to take up the rights shares?

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Chapter 6: Capital structure

Chapter 6: Capital structure Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 17 and 18.


Works cited Altman, Edward I. ‘A further empirical investigation of the bankruptcy cost question’, Journal of Finance 39, 1984, pp.1067–89. DeAngelo, H. and R.W. Masulis ‘Optimal capital structure under corporate and personal taxation’, Journal of Financial Economics 8, 1980, pp.3–29. Graham, J.R. and C.R. Harvey ‘The theory and practice of corporate finance: evidence from the field’, Journal of Financial Economics 60, 2001, pp.187– 243. Jensen, M.C. and W.H. Meckling ‘Theory of the firm: managerial behavior, agency costs and ownership structure theory of the firm’, Journal of Financial Economics 3, 1976, pp.305–60. Miller, M. ‘Debt and taxes’, Journal of Finance 32, 1977, pp.261–75. Modigliani, F. and M.H. Miller ‘The cost of capital, corporate finance and the theory of investment’, American Economic Review 48, 1958, pp.261–96. Modigliani, F. and M.H. Miller ‘Taxes and the cost of capital: a correction’, American Economic Review 53, 1963, pp.433–43. Warner, J.B. ‘Bankruptcy costs: some evidence’, Journal of Finance 32, 1977, pp.337–47.

Aims We have discussed the reasons for companies to raise funds from external sources in Chapter 5. In this chapter we will look more formally at how different sources of funds raised by companies may affect their values. In particular we will examine the various contrasting theories on capital structure.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe and assess how Modigliani and Miller’s arguments on capital structure with and without taxes might affect the way we look at optimal capital structure • examine thoroughly concepts of risky debt, signalling effect and agency costs of both equity and debt in the capital structure theory • discuss the implications of the pecking order theory.

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Introduction We discussed in Chapter 5 how firms raise funds from equity and debt. In this chapter we examine the capital structure theory and attempt to provide an answer to the following question: Can a firm create additional value through the use of a financing policy which does not change the nature of the assets held by the firm? If the answer to the above question is ‘no’, then corporate managers should only be focusing on maximising the firm’s value by undertaking all positive Net Present Value (NPV) projects. This is the conclusion we arrived at in Chapters 1 and 2. However, if the answer is ‘yes’, then the financing policy becomes important and an optimal way of funding projects must be found.

Modigliani and Miller’s theory BMA, Chapter 17, pp.446–52 begins with an explanation of the irrelevance of capital structure. The key points of Modigliani and Miller’s arguments are summarised below: Assumptions: • Capital markets are frictionless with no transaction costs. • Individuals and corporations can borrow and lend at the risk-free rate. • All firms are in the same risk class and all cash flow streams are perpetuities (i.e. no growth). • There is no taxation in the world (no corporate tax nor personal taxes). • There is no cost on bankruptcy (i.e. debt is risk free). • Corporate insiders and outsiders share the same set of information (i.e. no signalling opportunities). • Managers always maximise shareholders’ wealth (i.e. no agency costs). This is a highly unrealistic and restrictive set of assumptions. But to understand Modigliani and Miller’s (1958) argument, we will, for the time being, be content with this setting. Under this setting where there are no taxes and capital markets are functioning properly, Modigliani and Miller (MM) argue that it makes no difference whether a firm or an individual shareholder borrows. The market value of a company does not depend on its capital structure. To see why this is the case, let’s consider the following example. Example 6.1

Earnings

A

B

$’000

$’000

1,000

1,000

Interest Earnings available for dividends

(100) 1,000

900

Suppose Company A and B are identical in every respect except in their capital structure. Company A is an all-equity financed firm whereas Company B is partly financed with debt. Given that they are identical, both companies generate the same cash flows. Suppose they pay out all earnings, after interest and tax, to shareholders as dividend. Shareholders in Company A will receive $1,000,000 as dividends at the end of the period while stakeholders of Company B who have claims on both the debt and equity would have a 72

Chapter 6: Capital structure combined cash return of $1,000,000 as well. Since the cash returns to both stakeholders are the same, the value of their investments must be identical (to avoid arbitrage in an efficient market); and hence we have MM’s proposition I (without tax): The value of an unlevered firm is equal to the value of a levered firm: Vu = VL

(6.1)

Proposition I tells us that regardless of how a firm is financed, its value will always be independent of the level of debt. The average return on assets will be identical across all firms in the same risk class. However, as the percentage of debt (relative to equity) increases, a larger share of earnings would be distributed to debt-holders as interest. Shareholders’ potential return will thus be affected. This increases the shareholders’ financial risk. The required rate of return by shareholders will need to increase to compensate for the higher financial risk. However, the weighted average cost of capital (WACC) remains constant as the value of the company remains unchanged.

R

Re

Re: return on equity

Ro

WACC

Rd Rd: return on debt D/E Figure 6.1: Cost of capital and debt-equity ratio Since assets are financed by a mixture of debt and equity, the average return on assets must be the same as the WACC. Ra =

D

D+ E where

Rd +

E D+ E

Re

(6.2)

R a is the average return on assets R d and R e are the return on debt and equity respectively D and E are the market value of debt and equity respectively Rearranging this equation we have proposition 2 with tax

Re = Ra +

D (R − Rd ) E a

(6.3)

Figure 6.1 indicates the relationship of proposition 2. As the debt to equity ratio increases, shareholders require a higher return to compensate for the increased risk. This can be seen as the straight part of the line of Re. However, as the debt to equity ratio becomes too high, debt-holders’ risk increases as well. At some point, shareholders can walk away from their investments and they would not see the increased debt ratio as an additional source to their risk. In this case, shareholders would actually drop their required rate of return.

73


Example 6.2 A firm has £2 million of debt and 100,000 of outstanding shares at £30 each. If investors can borrow at 8% and the shareholders require 15% return, what is the firm’s WACC? Answer: The value of debt, D = £2 million. The value of Equity, E = 100,000 shares  £30 per share = £3 million.

D E R + R D+ E d D+ E e 2 3 = × 8% + × 15% 2+3 2+3 = 12.2%

Ra =

Activity 6.1 Attempt Question 3 of BMA, Chapter 17, p.463. See VLE for solution.

Modigliani and Miller’s argument with corporate taxes We now turn our attention to the world with taxes. Suppose that both companies in Example 6.1 pay corporate taxes at 20% on their earnings after interest. Example 6.3

Earnings Interest Earnings before tax Tax Dividend

A $’000 1,000 1,000 (200) 800

B $’000 1,000 (100) 900 (180) 720

The after-tax cash return to a 100% shareholder in Company A is $800,000. The after-tax cash return to an investor who owns all the debt and equity of Company B would be $820,000 ($100,000 of interest + $720,000 of dividend). Given that the cash returns are not identical, the value of these two companies must be different (in order to avoid arbitrage in an efficient market). By how much would the value of B be different from A? In most countries, interest on debt is deducted before corporate tax is calculated. This tax deductibility of debt interest provides an additional aftertax cash flow to the stakeholders in B. The difference of the after-tax cash return between B and A is exactly the same as the tax saving arising from the interest (i.e. interest  tax rate = $100,000  20% = $20,000). So over the lifetime of the debt, the amount of tax savings interest would be: ∞

∑ i=1

Interest × Tc

(1+ rd )

i

= Tc D

This tax saving represents the value of a levered firm over an unlevered firm. Consequently, the MM proposition 1 in the world with tax will become:

VL = Vu + Tc D

74

(6.4)

Chapter 6: Capital structure Where Tc is the corporate tax rate and D is the market value of debt. Similar to the previous explanation, shareholders will demand a higher return to compensate for the increased risk due to higher level of debt. However, the tax deductibility of interest allows the company to save up taxes for shareholders. The perceived risk, which increases as a result of higher levels of debt, would to some extent be offset by the tax shield. Consequently the MM Proposition 2 will become:

Re = Ra + (Ra − Rd )(1 − Tc )

(6.5)

D E

What is the implication of the above argument? According to the tax argument, a firm can maximise its value by using all debt financing.

Activity 6.2 Discuss what the following companies should do with their debt policy: 1. Company A has a substantially high corporate tax rate. 2. Company B is a large, established company with a high taxable profit level. 3. Company C is a newly established company. See VLE for discussion.

Personal taxes We have discussed the effect of corporate tax on debt policy. We now turn our attention to personal taxes. Suppose investors pay taxes on their investment income. The total after-tax cash return to stakeholders in a levered firm can be represented as follows: C = (EBIT – Rd D)(1–Tc) (1–Te) + Rd D(1–Td) = EBIT(1–Tc)(1–Te) + Rd D [(1–Td) – (1–Tc) (1–Te)]

(6.6)

Where: EBIT = earnings before interest and tax D = market value of debt Rd = return on debt Tc, Te and Td are the tax rates on the corporation’s profit, equity and debt respectively. Miller (1977) argues that the first term represents the payments to equityholders in an all-equity financed firm and the second term represents the tax shield effect from debts. If these cash flows are perpetual, the total value of the levered firm can then be calculated by discounting the two terms by the appropriate rates. Consequently, it can be represented by the following mathematical expression: VL =

[

]

EBIT (1 − Tc)(1 − Te ) Rd D (1 − Td ) − (1 − Tc)(1 − Te ) + RUe Rd (1 − Td )

(6.7)

⎡ (1 − T )(1 − T )⎤ c e ⎥D = VU + ⎢1 − ⎢⎣ (1 − Td ) ⎥⎦

It should be noted that the discount rate for the after-tax dividend income to equity-holders is the required rate of return by the equity-holders whereas the discount rate for the after-tax debt interest income should be discounted by the effective required rate of return by debt-holders. We can 75


see from equation (6.7) that an incentive to issue debt is provided if:

⎡ (1 − T )(1 − T )⎤ c e ⎢1 − ⎥ > 0 more advantageous to issue debt ⎢⎣ (1 − Td ) ⎥⎦ ⎡ (1 − T )(1 − T )⎤ c e ⎢1 − ⎥ < 0 less advantageous to issue debt ⎢⎣ (1 − Td ) ⎥⎦ Activity 6.3 In many countries, the tax rate for both income from dividends and capital gain is the same. How would that affect equation 6.7 and what advice would you give to companies about their debt policy? See VLE for discussion.

Other tax shield substitutes DeAngelo and Masulis (1980) argue that a company’s depreciation, investment credits and oil depletion allowance may serve as another form of tax shield substitute. The more of these other tax shield substitutes a company has, the less it will be inclined to issue debt. Consequently, firms will choose the level of debt which is negatively related to the level of other tax shield substitutes. They also argue that there will be an optimum trade-off between the marginal expected benefits of interest tax shield and the marginal expected cost of bankruptcy. Activity 6.4 What level of debt would you expect to find in the following companies (based on DeAngelo and Masulis, 1980)? 1. A national utility company (such as a water company) which has a long-term plan for substantial capital investment. 2. An oil exploration company which hires most of the equipment. 3. A pharmaceutical company which has committed itself to a high level of research and development activities. See VLE for discussion.

Financial distress So far we have assumed that corporate debt is relatively risk free. In reality, only a small percentage of corporations receive the AAA rating from credit agencies. If corporate debt is not risk free, then how significant is the potential cost of bankruptcy? Warner (1977) looks at data from 11 railroad bankruptcies between 1933 and 1955 in the USA. He measures only direct costs of bankruptcy (i.e. legal and professional fees and managerial time spent in administering the bankruptcy). He finds out that the bankruptcy cost represents 1% of the market value of the firm seven years prior to bankruptcy, and it rises to 5.3% immediately before the bankruptcy. Altman (1984) examines the indirect costs of bankruptcy of 19 companies which experienced financial distress between 1970 and 1978. He measures mainly the loss of profit opportunities. He finds out that these costs of financial distress represent about 8.1% of the average firm’s value three years prior to bankruptcy and they rise to 10.5% in the year of

76


bankruptcy. He also identifies that the direct bankruptcy costs measured as a percentage of a firm’s value seem to decrease relative to the size of the bankruptcy firm. Overall these two studies indicate that the costs of financial distress are not trivial. Activity 6.5 Attempt Question 17 of BMA, Chapter 18. See VLE for solution.

Trade-off theory In the previous sections, we discuss the benefits of debt issues and how the interest on debt can provide a tax shield effect. However, debt also increases the probability of financial distress and the cost of administering bankruptcy. An optimal capital structure may exist when the marginal tax shield benefit equals the marginal cost of financial distress. Market Value

Value of levered firm (with tax shields only)

Maximum value of firm

Cost of financial distress

Value of levered firm (with tax shields and financial distress)

PV of tax shields

Value of unlevered firm

D/E rao Opmal debt rao

Figure 6.2: Trade-off theory

Figure 6.2 shows the trade-off theory. As the debt increases, the value of a firm increases as the tax shield of debt interest kicks in. However, as the level of debt increases, the potential cost of financial distress also increases. Part of the tax shield benefit is cancelled out by the cost of financial distress. The net increase in the firm’s value will be smaller than the tax shield effect alone. The optimal capital structure is reached when the marginal cost of financial distress equals the marginal tax shield benefit, the firm should stop issuing more debt. Activity 6.6 Attempt Question 7 of BMA, Chapter 18. See VLE for solution.

77


Signalling effect The trade-off theory appears to have provided a solution for corporate managers to form the optimal capital structure. However, in reality, suppose there are two types of firms in the market: good quality firms characterised by high future cash flows, and poor quality firms with low future cash flows. The true quality is not observable by the market. Investors would not be able to distinguish the true quality between these two types of firms. Consequently, they will all be valued at the same price. The question is: How do managers of good quality firms signal their firms’ true quality to the market? It is argued that a carefully selected debt policy might be able to signal the true quality of a good firm. Let’s consider the following scenario: A firm with a high level of debt implies that there is a higher probability of bankruptcy. If this is a poor quality firm, it would not have sufficient profit to absorb the potential tax shield from debt interest and it would have insufficient funds to pay the debt interest and would thus be insolvent. Therefore, only managers who are in charge of good quality firms would be willing to adhere to a high level of debt. The market sees this as a signal sent by the financial managers about the true quality of their firm. Its share price would rise accordingly. However, in order to ensure that the debt can be signalled effectively, the following conditions must be met: 1. The market must adhere to the semi-strong but not strong form; otherwise the firm’s value can be observed. 2. There is an incentive for the managers in a good quality firm to signal the firm’s true value. 3. The penalty of using a misleading signal by managers in a poor firm is more costly than the short-term gain. So what incentive do we have for ‘good’ and ‘bad’ managers telling the truth? If the signal is linked with a manager’s compensation scheme, M, such that: M = (1 + r) 0 V0 + 1 V1 ≥ B or M = (1 + r) 0 V0 + 1 (V1 – C) if V1 < B where 0, 1

= positive weights

r

= the one-period interest rate

V0, V1 = the current and future value of the firm B

= the face value of debt

C

= a penalty paid if bankruptcy occurs, i.e. V < B.

A manager’s compensation is based on the realised value of the firm at time 0 and 1. Suppose that B* is the maximum amount of debt that a poor quality firm (type B) can carry. Managers from a good quality firm (type A) will set a debt level higher than B* at time 0. The value of the firm at time 1 will be V1a, and the value of the firm at time 0, V0a is the discounted value of V1a. Managers will receive the following positive compensation:

M = (1 + r ) γ 0

V1a + γ 1V1a 1+ r

If managers of a poor quality firm try to raise the debt level above B*, the value of the firm at time 0 will be the same as that of the good quality 78


firm, V0a. However, the value of the firm at time 1 when the market realises that this is a poor quality firm will be V1b. If this value is less than B*, managers of the poor quality firm will receive the following compensation:

M = (1+ r)γ 0V0b + γ1(V1b − C ) This compensation is negative if:

(1+ r)γ 0V0b + γ1(V1b − C ) < 0 V1a + γ (V − C ) < 0 1+ r 1 1b ⇒ γ 0V1a + γ1V1b < γ1C ⇒ (1+ r)γ 0

In other words, the penalty exceeds the total incentive payments over the period.

Agency costs on debt and equity Equity Suppose we have a 100% equity-financed firm and all the shares are held by the owners who also work in the firm (owner-managers). In the event that the firm expands and the owner-managers have run out of additional capital to invest in the firm, additional shares would have to be offered to the outsiders. Suppose now that a proportion of equity, , is held by outsiders (not the management). Jensen and Meckling (1976) argue that the owner-managers are less likely to make a full effort to increase the value of the firm as this will be shared by the outside equity-holders as well. This implies that owner-managers will supply lower levels of effort for higher values of . Outsiders will incur monitoring costs to ensure that owner-managers act in their interest. Owner-managers may also make sub-optimal decisions which might not benefit the company as a whole. This direct monitoring cost and the sub-optimal effect together represent the agency costs of external equity. They rise as the percentage of financing supplied by external equity goes up. To reduce these agency costs of external equity, it is argued that more debt financing should be used. Consequently, the higher the debt-to-equity ratio, the lower the agency costs of (external) equity. But one needs to take into account the proportion of an agent’s personal wealth held in the equity of his company of employment when considering his actions.

Agency costs on debt On the other hand, an increase in debt may also increase the agency costs of debt. Debt-holders may insist on various types of protective covenants and monitoring devices to ensure that their wealth is being protected. Debt-holders may demand a higher return. These costs may increase as a function of the level of debt. More importantly, managers may make investment decisions which might be biased towards the equity-holders’ interest. When a firm is in financial trouble, both equity-holders and debt-holders would like to recover their investments. Let’s consider the following two scenarios:1 1. Risk shifting Suppose a firm, C, has $50m debt and $50m equity. Let’s assume that, due to some financial problems, the value of assets falls to $20m. If debt-holders force the firm into liquidity, the best they can get is $20m.

1

Refer to BMA Chapter 18 (pp.482–83) for the other possible sub-optimal managerial actions in the event of financial distress.

79


Suppose the firm has an investment opportunity which requires $10m as the initial investment outlay and generates $90m of PV with a 10% chance and $0m with a 90% chance. Should financial managers of this firm go for this investment? First we should consider whether this is a positive NPV project or not. The NPV of this project can be calculated as: E(NPV) = $90m  10% + $0m  90% – $10m = ($1m) It is clear to see that this is a sub-optimal project and under normal circumstances, the firm should reject it. However, given that the firm is in serious financial distress, financial managers who are supposed to work for the best interest of their shareholders may attempt to undertake this project using the existing cash resources from the firm. There are two possible outcomes from this investment decision: • Worst case – the project does not pay off and the value of the firm falls to $10m (being the original value less the investment outlay which is not recovered from the investment). Shareholders will get nothing in the event of liquidation. • Best case – the project pays off with $90m PV, the value of the firm rises to $100m (being the original value, $20m less the investment outlay, $10m plus the pay-off from the project, $90m). Shareholders will get $50m in the event of liquidation after paying off the outstanding debt. The expected pay-off to each stakeholder is as follows: Worst

Best

Expected

Do nothing

Difference

$m

$m

$m

$m

$m

Debt-holders

10

50

14

20

(6)

Shareholders

0

50

5

0

5

Firm’s value

10

100

19

20

(1)

The expected pay-off is the probability weighted average of the outcomes of the two cases. From the above table we can see that shareholders gain at the expense of the debt-holders. 2. Underinvestment Suppose Firm C in the above example is faced with a safe investment which requires an initial investment outlay of $10m and generates a fixed PV of $15m instead. Would managers undertake this project? Let’s look at the expected pay-offs to the stakeholders in this case. Do nothing

Invest

Difference

$m

$m

$m

Debt-holders

20

25

5

Shareholders

0

0

0

Firm’s value

20

25

5

Debt-holders, in this case, would hope that managers will undertake this investment and their debt value will go up by $5m. However, shareholders are not going to receive anything in any case. If managers work for the best interest of their shareholders only, then it is likely that debt-holders will lose out once again.

80


How do agency costs of debt arise? In the above two scenarios, we can see that a firm with high level of debt is likely to undertake sub-optimal investment decisions. These actions will reduce the value of a firm. In order to avoid risk shifting from equity-holders to debt-holders, debt-holders would need to impose more restrictions on their loan agreements (covenants) and introduce monitoring systems to ensure that their interests are protected. These agency costs will reduce the tax shield benefits of higher debt levels. Putting both agency cost of equity and debt together As we increase the level of debt, the agency cost of equity will decrease while the agency cost of debt rises. To minimise these costs, one should set a debt level such that the aggregate agency costs are at their lowest. Activity 6.7 Agency costs relate to both the direct and indirect monitoring costs on the agents’ behaviour and the indirect costs of sub-optimal agents’ action. How can we measure these costs in practice? See VLE for discussion.

Pecking order theory BMA Chapter 18, Section 18.4 (pp.488–92) discusses the pecking order of financing. In short, the pecking order theory is: • Firms prefer internal finance. Firms can build up an internal cash reserve to avoid external financing. External financing involves issuing costs and indirect effects on share values such as the agency costs on debts and equity discussed on p.79. It is the preferred source of finance. • Debt finance is better than equity finance. The signalling effect on debt discussed on p.78 indicates that managers in a good quality firm prefer to issue debt. Therefore it is often argued that managers who issue equity must know that their company’s shares are over-valued. If the market is efficient and investors are rational, the equity issue must be viewed as a pessimistic signal about the firm’s long-term value.

Conclusion The search for an optimal capital structure continues. This chapter outlined several theories on capital structure. MM argued that a firm’s value is not affected by its capital structure. However, tax and financial distress lead us to the trade-off theory. When information is not shared equally between managers and investors (asymmetric information), the signalling effect on debt and equity may lead us to the pecking order theory.

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Debt policy factors

Percentage of CFOs identifying factor as important or very important

Financial flexibility

59.38

Credit rating

57.10

Earnings and cash flow volatility

48.08

Tax advantage of interest deductibility

44.85

Transactions costs and fees

33.52

Comparable firm debt levels

23.40

Bankruptcy/distress costs

21.35

Customer/supplier comfort

18.72

Debt restricted so project profits can be captured fully by shareholders and not paid to debt holders

12.57

Investor’s personal tax costs when they receive interest income

4.79

Enough debt not to be a takeover target

4.75

Table 6.1: Factors affecting the decision to issue debt Source: Graham and Harvey (2001)

In practice, however, managers seem to value financial flexibility more in consideration of debt or equity issue. Graham and Harvey (2001) found that in a survey of 392 CFOs asked about whether they had any target debt-to-equity ratio, 37% of them indicated that they had a flexible target and 17% had no target at all. When these CFOs were asked about the factors which influenced them in deciding the debt issue, financial flexibility appears to be the most important factor. This seems to suggest that agency costs on debt might be one of the main considerations for capital structure.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential readings and activities, you should be able to: • describe and assess how Modigliani and Miller’s arguments on capital structure with and without taxes might affect the way we look at optimal capital structure • examine thoroughly concepts of risky debt, signalling effect and agency costs of both equity and debt in the capital structure theory • discuss the implications of the pecking order theory.

Practice questions BMA Chapter 18, Questions 18, 19 and 27.

Sample examination questions 1. Explain clearly how the value of a levered firm, VL can be linked with the value of an unlevered firm, VU in a world with corporate tax, TC and personal taxes on income from equity and income from debt, TE and TD, as discussed in Miller (1977). 2. Outline briefly the effects of the following situations: a. a cut in corporate tax rate for all companies b. unifying personal taxes such that TE = TD. 82

Chapter 7: Dividend policy

Chapter 7: Dividend policy Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 16.


Works cited Black, F. and M. Scholes ‘The effects of dividend yield and dividend policy on common stock prices and returns’, Journal of Financial Economics, 1(1), 1974, pp.1–22. Brav, A., J.R. Graham, C.R. Harvey and R. Michaely ‘Payout policy in the 21st century’, Journal of Financial Economics 77, 2005, pp.483–527. Elton, E. and M. Gruber ‘Marginal stockholders’ tax rates and the clientele effect’, Review of Economics and Statistics 52(2), 1970, pp.68–74. Fama, E.F. ‘The empirical relationships between the dividend and investment decisions of firms’, American Economic Review 64(3), 1974, pp.304–18. Fama, E.F. and H. Babiak ‘Dividend policy: an empirical analysis’, Journal of the American Statistical Association 63(324), 1968, p.1132. Gordon, M.J. ‘Dividends, earnings and stock prices’, Review of Economics and Statistics 41(2), 1959, pp.99–105. Lintner, J. ‘Distribution of incomes of corporations among dividends, retained earnings and taxes’, American Economic Review 46, 1956, pp.97–113. Litzenberger, R. and K. Ramaswamy ‘The effects of personal taxes and dividends on capital asset prices: theory and empirical evidence’, Journal of Financial Economics 7(2), 1979, pp.163–95. Modigliani, F. and M.H. Miller ‘The cost of capital, corporate finance and the theory of investment’, American Economic Review 48, 1958, pp.261–96.

Aims Corporate dividend policy, or how companies can provide a return to shareholders by way of a cash distribution or other means, is one of the more important financial decisions management has to make. So this chapter will cover how a firm’s value can or cannot be affected by the chosen dividend policy. It starts by mentioning the different types of dividend and follows on with the irrelevancy argument before discussing and describing other theories such as the clientele effect, the information content of dividends and the agency costs on dividends. Some practical aspects concerning the determination of the policy in practice – such as what are non-cash dividends and whether they should be paid – are covered.

Learning outcomes dividend clientele theory, agency cost theory, and signalling theory By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy 83


• describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision.

Introduction In Chapter 16 of BMA you will be exposed to the theory and practices associated with corporate dividend policy. We will present opposing views of the effects of dividend policy on the valuation of shares and discuss the significance of the traditional view of dividends. This chapter also addresses informational aspects of dividend payments and potential clientele effects and how dividend payments are set in practice. The general intention of this chapter is to provide an in-depth discussion on the controversial question of how dividend policy affects firm value. Dividend policy has been the source of some controversy over the years. In this chapter we consider the nature of that controversy and the factors that influence dividend policy in practice. We also consider alternatives to dividend payments which a business might consider.

Types of dividend [Forms of Dividend Payments] Corporations can pay out cash to their shareholders roughly in three ways: 1. Cash dividend Investors look for a return from their investment holding in corporations. It is therefore natural for corporations to pay dividends on a regular basis (yearly, half-yearly or quarterly) as a return to their shareholders. Some corporations pay a high percentage of their corporate earnings as dividend whereas some choose to keep the dividend payout ratio low.1 However in some cases, a corporation may choose to pay a one-off special dividend. 2. Stock2 repurchase Another way for a corporation to pay out to shareholders would be through a stock repurchase. Figure 16.1 of BMA shows the history of dividend and stock repurchases in the USA between 1980 and 2008. One emerging fact is that the absolute amount of stock being repurchased by corporations from their shareholders has increased significantly over that period. What is the main reason for that? There are four ways to repurchase shares from shareholders:3 i. open market ii. tender offer iii. auction iv. private negotiation. 3. Scrip dividend Scrip dividend (or bonus shares) is an issue of shares (not for cash) to existing shareholders. Activity 7.1 Read BMA p.422. Identify the main advantages and disadvantages of the four methods of stock repurchase described above. See VLE for discussion. 84

1

See Securities Investors Association (Singapore) for a list of top paying companies: http:// www.sias.org.sg/index. php?option=com_co ntent&view=article &id=248%3Adivide nd-payout-ratio-top-50companies&catid=20%3 Apress-releases&Itemid=43 &lang=en

2

The term ‘Stock’ is often used in the United States to refer to shares issued by companies.

3

See BMA p.422.


Dividend controversy The key question is what effect would a change in the cash dividend paid have on the value of a firm, given its capital budgeting plan and borrowing decision. To examine the controversy surrounding dividend policy, we must isolate dividend policy from other issues in financial management. If we fix the investment outlays and the level of borrowings, the only possible source of cash to increase dividend would be the issue of new shares. So here we consider dividend policy as a trade-off between retained earnings vs. paying out cash dividends and issuing new shares.

Modigliani and Miller’s argument [alternative views on the effect of dividend policy] The argument put forward by Modigliani and Miller (MM) (1958) concerning the irrelevance of dividends is particularly important and you should study it carefully. The most important aspect of their argument concerns the notion that share values are not influenced by the particular dividend policy of the firm. They argue that the value of a firm depends on the level of corporate earnings (net operating income or cash flows) and the firm’s investment policy. Rational shareholders are indifferent to whether they receive a capital gain (the price at which the share is disposed of is higher than the price originally paid for it) or dividend on their shares. A firm will optimise its value by investing in all positive NPV opportunities regardless. Dividends will be paid out if there are any internal funds left over. Dividends are thus a residual payment. If no dividend is paid out due to cash flows being used for the optimal investment plan, the market value of the firm will increase to reflect the expected future dividend payments or increasing share prices resulting from its investment returns. If shareholders want cash, they can generate a ‘home-made’ dividend by selling part of their shareholding. To illustrate this argument, let’s focus on the following example. Example 7.14

4

Bear Inc. is currently traded at $10 each with 1,000,000 shares in issue. It has $1,000,000 of cash and $9,000,000 of other assets (measured at their market value). Suppose the firm has an investment opportunity which requires $1,000,000 of initial investment outlay and can produce a net present value of $2,000,000. If Bear Inc. is to undertake this investment, its value (in an efficient market) will go up to $12,000,000.

Adapted from BMA, Chapter 16.

$’000 Original value ($10  1,000,000 shares) Investment opportunity (NPV) New value New share price ($12,000,000/1,000,000)

10,000 2,000 12,000 $12

Suppose Bear Inc. has now earmarked the $1,000,000 in the cash account for investment. If existing shareholders would like to receive a dividend of $1 per share, what should Bear Inc. do? To raise the amount necessary for the cash dividend, Bear Inc. would need to issue $1,000,000 of shares. It should be noted that the cash raised from the share issues is distributed out immediately as a cash dividend to shareholders. The value of the firm would therefore remain at $12,000,000.

85

59 Financial management But what would happen to the share price after the share issue and cash dividend payment? Let x be the number of new shares issued and p be the new share price after the new share issue and dividend payment. We have the following two conditions: (1) xp = 1,000,000 (2) (x + 1,000,000) = 12,000,000 (1) represents the $1,000,000 raised from the share issue (2) indicates the value of the firm after the share issue. Solving (1) and (2) simultaneously, we can easily see that the new price, p is equal to $11 and the number of new shares issued is 90,909 ($1,000,000/$11). What this example illustrates is that the shareholder’s value remains unchanged. If the firm invests and pays out no dividend, each share entitles the existing shareholder to a value of $12 (equal to the share value). However, if the firm invests but pays out dividend from a new share issue, the same shareholder will have a value of $12 (equal to the new share value of $11 + $1 of dividend received). Therefore dividend policy does not alter a shareholder’s value. If the existing shareholder would like to receive a dividend (but the firm does not pay out), he or she can sell their shares to generate a ‘home-made’ dividend. But MM’s argument is based on some restrictive assumptions! First they assume that there is no transaction cost for shareholders to sell their shares should they wish to generate a ‘home-made’ dividend. Second, MM assume that shareholders do not pay any tax on investment income. If these two assumptions are not valid, the irrelevancy argument of dividend might not hold. So let’s see how these might change our understanding of dividend policy.

Clientele effect

● Factors affecting how companies decide on dividend payments → Clientele effect 1. Buying and selling shares incur transaction costs (such as stamp duty, ⇨ 1. Tax consideration brokerage fees etc). ⇨ 2. Liquidity requirement 2. Income from either the cash dividend or selling the shares is treated as→ Signalling effect ⇨ poor VS good quality firms taxable income. → Agency costs and dividend 3. Investors have different income requirements and consumption ⇨ 1. shareholders and bondholders' interest patterns. ⇨ 2. managers and shareholders Given these constraints, investors must consider their liquidity requirement (subject to the consumption pattern) and their tax position before deciding in which company they would like to invest. In reality, investors are often facing the following scenarios:

Tax consideration It is often argued that different investors are attracted to shares of different businesses on the basis of their particular dividend policy. Investors should consider their tax position before deciding which company to invest in. We can easily hypothesise that those investors who have a higher marginal tax rate on dividend income (than capital gain) would prefer to invest in a firm which has a low dividend payout policy, and those who have a lower tax rate on dividend income would prefer to invest in a firm with a high dividend payout policy. Those who do not have to pay any taxes or have the same marginal tax rate on both dividend income and capital gain would naturally be indifferent to the different dividend payout options.

86


So, given these three groups of investors, each type of firm (classified by the level of dividend payout) caters to its own ‘clientele’ of investors. It can be seen that any change in the dividend payout level by a firm may upset its investors as they may be subject to higher tax. If they are, they will sell their shares and re-invest in firms which cater for their tax consideration. The firm which alters its dividend policy may therefore witness price changes in its shares. What it means is that dividend policy might be relevant in this tax clientele context.5 Activity 7.2 In most countries the tax rate on dividend income and capital gain is identical. Does it imply that the tax clientele effect is irrelevant? See VLE for discussion.

5

Also clientele effect relates to investors’ preference for specific payout patterns such as fixed percentage payout of profits, fixed percentage growth in annual dividend etc.

Liquidity requirement Some investors – such as pensioners, institutional investors and insurance companies – require regular dividends as a source of income to meet their consumption and liquidity requirement. They would prefer companies to pay dividends. If selling shares to generate cash flows incurs unnecessary transaction cost, these tax-paying investors may prefer to hold dividend paying shares. As a result, similar to the tax clientele effect, firms will attract different clientele of investors. If a firm changes its dividend policy, it might upset its investors and its share price will fall as a result when investors rebalance their portfolios. Activity 7.3 On 18 November 2003 Vodafone announced a £2.5bn share repurchase and an increase of dividends by 20% to £1.5bn. Its share price went up by 6.4% on the day. In Chapter 4 we discussed the market efficiency hypothesis. Share prices react to new information in a semi-strong form efficient market. So what information arrived on 18 November 2003 that caused the share price of Vodafone to move up by 6.4%? What does the share repurchase have to do with the share price? What information does the increase in dividend convey to the market? See VLE for discussion.

Information content of dividend and signalling effect Lintner (1956) interviewed a sample of managers from US corporations and his research findings can be summarised into the following four stylised facts: 1. Managers seem to have a long-term target dividend payout ratio. 2. This ratio is measured as a proportion of long-term earnings. 3. Managers focus more on dividend changes than on the absolute level of dividend. 4. Managers are reluctant to make dividend changes that might have to be reversed. Dividend changes follow shifts in long-term, sustainable levels of earnings rather than short-run changes in earnings. If Lintner’s stylised facts about how managers might formulate their dividend payout are true, it means that an increase in dividend signals managers’ confidence about their firm’s future. Share price will rise accordingly like in the case of Vodafone.

87


Is dividend an effective signal? Suppose we have a market with two types of firms – good quality firms are characterised with high future cash flows, while poor quality firms are characterised with low future cash flows. For dividends to act as an effective signal, we need to meet the following three conditions: 1. Good quality firms are undervalued and their true values are not unobservable. What this means is that good firms are not valued correctly relative to the poor firms. The market fails to recognise the mispricing. So how could we provide an incentive to managers to signal the true value of their firms? In this case, managers of a good quality firm would want to signal the firm’s true value to the market provided that they will be suitably rewarded by telling the truth about the firm’s value. Normally this is done if their remuneration is linked to the value of the firm. 2. The market is consistent with the semi-strong form efficiency but does not adhere to the strong form efficiency. Under this condition, an increase in dividend sends good news about future cash flows and earnings. Share prices will rise. On the other hand, a dividend cut sends bad news as it indicates that managers are less confident about the firm’s future than the market and a high dividend payout policy will be costly to firms that do not have the cash flow to support it. Share prices will fall accordingly. 3. A penalty will be imposed on managers of poor quality firms who mishandle their firms. This condition is necessary to stop managers of poor quality firms from using high dividend payouts as a signal. Given that the market cannot observe the true value of firms or distinguish the quality, an increase in dividend by a manager of a poor firm might be mistaken as a positive signal of the firm’s value. But we know that poor quality firms do not have sufficient cash flow to sustain this high dividend policy. Eventually the firm will collapse if it continues to pay out high dividends. So in order to stop managers of poor firms lying about their firm’s value, there must be a penalty system which discourages them from lying to the market in the first place. This can be done as long as the reward they get by temporarily increasing the firm’s value (as a result of the increase in dividend) is outweighed by the penalty they will have to pay when the true value of the poor firm is reviewed. Activity 7.4 What are the main reasons why a firm’s true quality cannot be observed? Does it imply that a higher degree of transparency of information is needed? See VLE for discussion.

Agency costs and dividend

1. shareholders and bondholders' interest 2. managers and shareholders When the ownership and control of a firm are separated, managers who run the firm might behave opportunistically. This problem is further intensified when there are conflicts between shareholders and bondholders’ interest. For example, if a firm is facing financial difficulty, managers might choose to pay out a large cash dividend to shareholders instead of investing in positive NPV projects. This action will increase shareholders’ value at the expense of debt-holders. In this case, paying out a large dividend will actually suppress the share price.

88


To mitigate this problem, as one may recall in the section above, managers in a poor quality firm would not increase dividend payouts as the penalty of managing a bankrupt firm would be severe. Secondly, bondholders would foresee that every firm has a chance of running into financial difficulty. So before they lend, they would impose all kind of restrictions to stop managers from paying out large dividends when the firm is suffering financial distress. Another possible conflict would be between managers and shareholders. So far we assume that managers work for the best interest of their shareholders. So what if they don’t? Managers might engage in suboptimal investment decision-making and use any spare cash (which is not invested) to pay for private uses (new office, company cars, etc.). As the control over such a firm is lost as shareholders don’t participate in day-to-day operations, the only thing shareholders can do, would be to vote against the re-appointment of the managers or sell their shares as a protest. However, these actions might come too late to recover the loss that shareholders might have already suffered. To mitigate this problem, one might opt to drain the company of cash by requesting a high dividend payout. When management need cash for future investments, they have to approach shareholders for capital funding. Shareholders can exercise some control over their savings by refusing to buy the firm’s new securities if they are suspicious of managerial behaviour, but then there are the transaction costs to be paid for raising the cash this way.

Empirical evidence The importance of dividend decisions Lintner (1956), Fama and Babiak (1968) and Fama (1974) concluded that managers prefer a stable dividend policy and are reluctant to increase dividends to a level which cannot be sustained. Gordon (1959) finds positive correlation between a high payout ratio (dividend per share/earnings per share) and high price to earnings (market price/earnings per share) ratio among firms. He argues that investors value companies more with high payout ratios. However, the two ratios in his analysis contain the earnings per share as the denominator, so when earnings move, both variables move. If a company’s earnings are volatile (high risk), it tends to have lower PE. This company is likely to have a low payout ratio to reduce exposure to volatile earnings shifts. Dividends and tax implications Black and Scholes (1974) do not find any positive relationship between high dividend yields and before-tax return. But Litzenberger and Ramaswamy (1979) find a statistical relationship between dividend yields and beforetax return. Elton and Gruber’s (1970) work shows evidence that there is a relationship between high payout ratio and low marginal rates of tax. Determining dividend policy in practice The early empirical evidence and casual observation seem to suggest that managers consider the dividend decision to be very important and that the maintenance of a stable dividend policy is preferred over time. There seems to be a high degree of reluctance in firms to raise dividend levels unless the directors of the firm are confident that the higher payout 89


ratio can be sustained over a long time period. Similarly, there is usually reluctance for firms to cut dividends because of the (adverse) signals which such an action may send out. There is also evidence to suggest that managers of a firm consider the firm’s level of earnings to be the most important influence on the dividend decision. However, a more recent survey conducted by Brav, Graham, Harvey and Michaely (2005) indicated that: ...maintaining the dividend level is on par with investment decisions, while repurchases are made out of the residual cash flow after investment spending. Perceived stability of future earnings still affects dividend policy as in Lintner (1956). However, 50 years later, we find that the link between dividends and earnings has weakened. Many managers now favour repurchases because they are viewed as being more flexible than dividends and can be used in an attempt to time the equity market or to increase earnings per share. Executives believe that institutions are indifferent between dividends and repurchases and that payout policies have little impact on their investor clientele. In general, management views provide little support for agency, signalling and clientele hypotheses of payout policy. Tax considerations play a secondary role.

Conclusion BMA, Chapter 16 has a good summary of the theories we discussed in this chapter of the subject guide. In short, what we know about dividend policy is that it seems to link with the life cycle of a firm. A young and fast growing firm is likely to pay no dividend or repurchase no shares. It is possibly that it will prefer to rely on internal funding for future investments. As it matures and profitable investment opportunities become less available, it will be forced to pay out dividend or repurchase shares to avoid the agency cost of dividends and improve the signalling effect on dividend.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy • describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision.

90


Practice questions BMA, Chapter 16, Questions 9, 10, 12, 23, 24, 26 and 29.

Sample examination questions 1. Despite enjoying the success of iMac and iPhone, Apple Inc. has not been paying out dividends for several years. The latest figures show that Apple Inc.’s net income to common shares is increasing:

Net income applicable to common shares

2007

2008

2009

$3,496,000,000

$4,834,000,000

$5,704,000,000

Required: a. What are the pros and cons of paying dividends? b. Explain clearly, using appropriate financial theories when applicable, how companies determine their dividend policy. Explain why companies such as Apple Inc. might decide not to pay dividends. 2. Critically discuss how a change of dividend policy may affect a company’s equity price. 3. Explain, with the aid of a diagram, how a firm’s dividend policy is independent from its investment policy in a perfect and complete world. You should include discussion of both Modigliani and Miller’s argument on dividend and Fisher’s separation theorem in your answer. 4. Using arguments based on the signalling theory and tax clientele effect of dividends, to what extent would you conclude that dividend policy is irrelevant to corporate value?

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Notes

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Chapter 8: Cost of capital and capital investments

Chapter 8: Cost of capital and capital investments Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 19.


Aims This chapter focuses on how leveraged firms measure their cost of capital.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • calculate and explain the cost of debt, both before and after tax • calculate the weighted average cost of capital (WACC) for a firm and explain the meaning of the number produced • explain the difficulty of using WACC to appraise investment projects in practice.

Introduction In Chapter 2 of this subject guide we discussed how managers select projects based on projects’ NPVs. In this chapter we discuss how corporate managers choose the discount rate for projects when they are financed with debt and equity. BMA’s Chapter 19 begins with a good summary of how projects should be evaluated. You should read that before proceeding with the rest of this chapter.

Cost of capital and equity finance If a firm is financed 100% with equity, its investments will also be financed with equity. Corporate managers will choose projects which maximise equity-holders’ wealth. These projects may have different levels of risk but equity-holders will ultimately bear the combined risk from these projects. So how do we measure the risk of these projects and the firm itself? If the CAPM is valid, then each project must have its market risk. Let j be the market risk of project j and e be the market risk of equity. We have: (8.1)

N

βe = ∑ω j β j j =1

where j is the weight of project j in the company. Consequently, the return on equity must be the weighted average of the returns on all projects: N

( )

E (Re ) = ∑ω j E R j = E (Ra ) j =1

(8.2) 93


Example 8.1 Suppose ABC Ltd., a 100% equity financed company, has three projects, A, B and C. Their betas and values are as follows: Projects

Betas

Values (£’000)

Weights

A

0.6

60

60/200 = 0.3

B

0.8

80

80/200 = 0.4

C

1.2

60

60/200 = 0.3

Suppose the risk-free rate is 5% per annum and the expected market return is 10% per annum. The weighted average beta of the three projects is (which is also the equity beta):   = 0.3  0.6 + 0.4  0.8 + 0.3  1.2 = 0.86 = e The expected return on the average project is: E(Ra) = Rf + a[E(Rm) – Rf] = 5 + 0.86  [10 – 5] = 9.3 = E(Re) You should note that the expected return of the three projects can also be calculated using the CAPM equation. Projects

Betas

E(R)

A

0.6

5  0.6  (10 – 5) = 8

B

0.8

5  0.8  (10 – 5) = 9

C

1.2

5  1.2  (10 – 5) = 11

Using the weighted average cost of capital to appraise these three projects simply ignores the respective project risk. The estimated NPV of each project will be grossly inaccurate.

Cost of capital and capital structure We now turn our attention to companies which finance themselves with a mixture of debt and equity. Given that projects are financed with debt and equity, the average return of projects must be the same as the weighted average return on debt and equity. Since debt interest in most countries is tax deductible, we have the following equation: WACC

E (Ra ) =

E D E (Re )+ (1 − t c )E (Rd ) E +D E +D

(8.3)

where E and D are the market value of equity and debt and t c is the corporate tax rate If the linear relationship depicted in the CAPM holds, the average beta of a firm must be the weighted average of the equity and debt:

PROBLEM!! Formula error?

βa =

E D (1 − t c ) βd βe + E +D E +D

(8.4)

Equation (8.3) is known as the weighted average cost of capital (WACC). The no-tax equivalent to equations (8.3) and (8.4) are:

E (Ra ) =

E ED E (Re )+ E (Rd ) E +D E +D

(8.5)

and

relationship between a firm’s equity beta and its debt level βe = βa + (βa − βd)(1 − t c )

94

D E

(8.6)

Chapter 8: Cost of capital and capital investments

Example 8.2 Make-it-easy plc has 100,000 shares at the current market price of £10 each. It also has £500,000 worth of debt. The expected return on equity is 12%. The debt is estimated to be relatively risk free and has a return of 5%. Corporate tax rate is 40% per annum. Calculate the WACC. Answer:

500 1,000 × 12 + × 5 × (1 − 0.4 ) 1,000 + 500 1,000 + 500 =9

WACC =

This WACC can be used as a discount rate for appraising average projects in the company. So under what circumstances can we use WACC as an effective discount rate? Projects do not need to be financed at exactly the same ratio of debt and equity each time when funds are raised. WACC can still be used as long as the company adheres to a fixed debt and equity ratio over time (i.e. the weights on debt and equity remain unchanged). The risk of each project is not fundamentally different from each other. New projects to be undertaken are not going to change much of the risk profile of the company. If a company is undertaking a significant project with very different risk level to the existing investment portfolio, the WACC might not be effective.

Example 8.3 Using the information from Example 8.2, suppose Make-it-easy plc decides to venture into a risky operation. It requires £1,500,000 as an initial investment outlay. It is expected to generate £200,000 per annum of perpetual net cash flows. This risky operation has an estimated beta of 2. The company intends to raise the funds from existing equity-holders. Assume that the market return is 10% per annum. If Make-it-easy uses the WACC (9% as in Example 8.2) to evaluate this risky operation, the net present value of the risky operation will be calculated as:

CF 200,000 −1,500,000 = 722,222 NPV = WACC 0.09 Make-it-easy will accept this venture as the NPC is higher than zero. However, the risk of this venture is significantly higher than the company’s average project risk. Consequently, a higher discount rate should be used to compensate for the increased risk. Using the CAPM, the expected return on a project with a beta equal to 2 should be

( )

E Rrisky = 5 + 2 × (10 − 5) = 15 Using this risk-adjusted rate, the risky operation’s NPV should be:

NPV =

200,000 −1,500,000 = −1,666,667 0.15

If WACC is inappropriately used to evaluate risky projects as in Example 8.3, a company risks making incorrect decisions about investment plans. In general the problem with WACC in project appraisals can be highlighted in the following diagram.

95


Return (%)

Over investment

SML

WACC

Rf

Under investment Risk

Figure 8.1: The problem of using WACC in project appraisals.

When WACC is used to appraise a project with a lower risk than the company, the project’s NPV is likely to be understated. On the other hand, the use of WACC on projects with higher risk than the company would result in overstating the project’s NPV (such as the example of Make-iteasy above). Activity 8.1 Consider the three projects in Example 8.1. Identify whether their NPVs are over- or under-estimated if the WACC is used as the discount rate. See VLE for solution.

The effect of debt financing a project BMA (Section 19.4) introduces the concept of adjusted present value (APV). It is defined as: APV = Base – case NPV + sum of PV’s of financial side effect See the example in BMA, pp.514–18 for an illustration of the use of APV.

Capital structure and beta We have seen that equation (8.6) captures the relationship between a firm’s equity beta and its debt level. In practice, when market data is limited, a firm’s equity can be estimated by using equity beta from other companies. The following example illustrates this technique. Example 8.4 The managers of Grand plc would like to estimate their firm’s equity beta. Grand has only had a stock market quotation for two months. Managers fear that the lack of market data for their firm may make it difficult to estimate the correct beta for Grand plc. As a result they decide to use some existing firms’ data as it would be inappropriate to attempt to estimate beta from Grand’s actual share price behaviour over such a short period. Instead it is proposed to ascertain, and, where necessary, adjust the observed equity betas of other companies operating in the same industry, and with the same operating characteristics as Grand, as these should be based on similar levels of systematic risk and be capable of providing an accurate estimate of Grand’s beta.

96

Chapter 8: Cost of capital and capital investments Two companies have been identified as firms having operations in the same industry as Grand that utilise identical operating characteristics. However, only one company, Big plc, operates exclusively in the same industry as Grand. The other two companies have some dissimilar activities or opportunities in addition to operating characteristics that are identical to those of Grand. Details of the three companies are: i.

Big plc It operates exclusively in the same industry as Grand plc. Its observed equity beta is 1.12. It is financed with 60% equity and 40% debt.

ii. Large plc It has an observed equity beta of 1.11. It has two divisions. Division A represents 30% of Large plc and has an equity beta equal to 1.9. Division B shares very similar operating characteristics with Grand plc. Large plc is financed entirely by equity. iii. Grand plc is financed entirely by equity. It has a tax rate of 40%. Assume that all debts are virtually risk free; determine three possible estimates of the likely equity beta of Grand plc, based on the information provided for Big and Large. Approach: i.

Using the data from Big plc and equation (8.6), we first ‘de-gear’ Big plc’s beta:

βe = βa + (βa − βd )(1 − t c ) 1.12 = βa + (1 − 0.4)

D E

40 β assume that the debt is risk free 60 a

βa = 0.8 The de-geared beta of Big plc can be a proxy for Grand’s all equity beta. ii. Both Grand and Large are all equity financed. However, only Division B of Large shares the same operating characteristics of Grand. So one may argue that the beta for Division B would be a good proxy for Grand’s asset beta. Given that Large’s equity beta would be a weighted average of the divisional betas, we have:

βe = aβA + (1 − a)βB 1.11 = 0.3 × 1.9 + 0.7 × βB

βB = 0.77 Grand’s equity beta can be proxied as 0.77.

Activity 8.2 Suppose that the risk-free rate and the expected return on the market in Example 8.4 are 5% and 10% respectively. Estimate the expected return of Grand plc. See VLE for solution.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • calculate and explain the cost of debt, both before and after tax • calculate the weighted average cost of capital (WACC) for a firm and explain the meaning of the number produced • explain the difficulty of using WACC to appraise investment projects in practice. 97


Practice questions BMA, Chapter 19, Questions 6, 17, 18 and 28.

Sample examination question BMA, Chapter 19, Question 27.

98

Chapter 9: Valuation of business

Chapter 9: Valuation of business Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 3, 4 and 21.

Further reading Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 15–18 and 20.

Works cited Rappaport, A. Creating shareholder value. (New York: Free Press, 1998) Revised and updated edition [ISBN 9780684844107].

Aims In this chapter we focus on three main methods of valuing a business. They are: 1. Asset based. 2. Earning based. 3. Cash flow based.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • apply the three methods of valuing a business • explain how the value of equity and bond can be measured and calculated • discuss the key issues of measuring business in real life.

Introduction Business valuation is an important topic in finance management. We have seen in previous chapters that managers need to focus on value creation when taking on positive NPV projects, valuing businesses in mergers and acquisition activities, developing capital structure and dividend policies. In this chapter we will more formally address the issues of valuation. There are three broad approaches to business valuation. They are: 1. Asset based valuation. 2. Earnings based valuation. 3. Cash flow based valuation.

Approaches to business valuation Asset based valuation The statement of financial position (balance sheet) of any company provides a useful starting point for us to estimate a firm’s value. The 99


statement consists of all ‘recognisable and quantifiable’ assets and liabilities that a business has. The net asset value (i.e. total assets – total liabilities) would then give an idea of the value of the firm and hence the value to the owners (i.e. shareholders). Activity 9.1 Examine the financial statements of Coca Cola. Determine a value for the company using the asset based valuation method. Why might the value you determine differ from the stock market’s valuation (i.e. share price  number of shares in issue)? See VLE for discussion. The statement of financial position only reports what accountants can deem to be ‘recognisable’ and ‘quantifiable’. It is for this reason that some of the valuable assets might not necessarily be accounted for in the statement. For example, innovative knowledge may probably be one of the most important assets for Apple Inc.; brand awareness is the most important asset of Coca Cola; and British Airways’s world-wide established contacts with airports, clients and authorities are their competitive advantage. Knowledge, brand and customer relationships are valuable to a company but might not be easily quantifiable. These resources are often not reported on financial statements. As a result, the asset-based method is unlikely to indicate the true value of a business. Nevertheless, asset based valuations are often used in practice as a basis for adaptation. For example, a bidder might be looking for a value to start within a set of takeover bid negotiations using the asset based valuations.

Earnings based method This method requires us to estimate the earning power of a company. Typically we use the price-to-earning ratio (PER) as a surrogate. PER is defined as: Current market price of share p (9.1) Historic PER = = t Last year's earnings per share E t −1 The following table shows some UK retailers and their historic PER. Retailers

PER

Alliance Boots

23.6

Debenhams

11.6

DSG International

17.5

HMV

10.5

JJB Sports

24.0

Kingfisher

21.6

Marks and Spencer

21.0

Next

16.4

Table 9.1: UK retailers and their historic PER. Source of information: Financial Times, 5 May 2007 (also Arnold, 2008).

How do we use PER in business valuation? PER tries to measure the earning potential of a company. For a company with a high PER, the market is expecting it to show a faster growth in earnings in the future. Investors can analyse the historic PER of a company and determine the future price. With Next it could be argued that you are buying 16.4 years of constant profits.

100


Example 9.1 The following data relates to Company A plc:

2007

2008

2009

2010

£

£

£

£

6

8.4

11

9.18

Earnings per share

0.6

0.8

1.0

0.9

PER

10

10.5

11

10.2

Price per share

The average PER between 2007 and 2010 is 10.425. If the estimated earnings per share for 2011 is £0.75, the estimated share price (based on the historic PER) would be £0.75  10.425 = £7.82. But this analysis is extremely crude and unsophisticated. It suffers from the following problems: i. We assume that the PER of a company stays constant over time. But history tells us that PER fluctuates (See diagram on p.764, Arnold, 2008). ii. We assume that the stock market knows how to value companies correctly in the past and that the PER has been correctly computed (as in the table above). This assumption that stock market analysts have a view of an appropriate PER for each company seems to be unfounded. A good example of this is the internet bubble between 1998 and 2000. Prices for some internet companies were too high relative to their earnings. We therefore need to explore a much more intellectually rigorous approach to valuing a business.

Discounted cash flow method This method uses the technique of discounted cash flow we addressed in Chapter 2 to evaluate a company. A company is typically engaged in a number of investments or activities that are financed by, roughly speaking, two types of funds. The following balance sheet depicts this relationship: $

$

Investment 1

X Equity (shares)

X

Investment 2

X Debt (borrowings)

X

Investment 3

X

…. Total value of investments

XX Total value of capital

XX

If a company is made up of a number of investments, each investment’s net present value can be computed using the discounted cash flow technique we introduced in Chapter 2. The value of the company would then be the sum of the NPV of all investments. N

V = ∑ NPVi for all investments i

(9.2)

i=1

On the other hand, these investments are funded by the company’s two types of finance – mainly equity (shares) and debt (borrowings). The value of the business can therefore be evaluated by measuring the sum of the value of these two types of finance.

101


Valuation of debt/bonds A company which borrows would need to set out i. how long the borrowing is for ii. the amount it borrows iii. the interest it promises to pay during the life time of the borrowing. A lender will receive a certain sum of cash flows over the life of the debt depending on the terms and structure of the above three aspects. The value of such debt (borrowing) to the lender will therefore be the discounted value of the cash flows that the lender can receive from the borrowing firm. Consequently, the expected market value of redeemable fixed interest debt will be found by discounting interest payments and redemption value by the cost of debt: T

D=∑

I

t =1 (1+ Rd )

t

+

RV

(1+ Rd )

T

(9.3)

Where: D = market value of the debt T = number of years to maturity Rd = rate of return (before tax) required by debt investors RV = redemption value I = interest paid. Example 9.2 What is the value of a 5 year 10% bond if the yield to maturity is 15% per annum? Assume that the face value is $100. Answer: The annual interest received by a bondholder is $100 × 10% (face value × coupon rate) = $10. The yield to maturity is the required rate of return by the lender for a bond of this kind. It is also the discount rate for the valuation purpose. Putting these together we have:

10 10 10 10 10 100 + + + + + 1.15 1.15 2 1.15 3 1.15 4 1.15 5 1.15 5 = 10 × A 5,15% +100 × DF5,15%

D=

= 10 × 3.352 +100 × 0.497 = 83.22 Activity 9.2 What would be the value of the same debt in Example 9.2 if the yield to maturity were now 5% per annum? See VLE for solution. In the previous example, we considered a bond which needs to be repaid by the issuing company within a fixed period of time. What if the bond is irredeemable? If a bond is irredeemable, the redemption value of the bond is equal to zero. Consequently, the valuation formula will be reduced to: ∞

D=∑

I

t =1 (1+ Rd )

102

t

=

I Rd

(9.4)


Where: D = ex-interest market value I = annual interest paid Rd = rate of return required by debt investors. Example 9.3 Consider the case of a 5% irredeemable bond of £100 par value where bond investors require a yield of 10% per annum. The expected market value of the bond will be:

D=

I £5 = = £50 Rd 0.1

A more complex debt structure which provides varying cash flows to bondholders can be evaluated by the same discounted cash flow technique. But of course the computation will be much more burdensome.

Valuation of equity We now turn our attention to the value of equity (shares). A shareholder who owns a share in a company will receive cash flow in terms of the resale value of the share and/or dividend paid by the company. Suppose that at the end of the period, the price for a quoted share is Pt. Assume that shareholders receive dividends Divt at the end of each time period t. Let the discount rate (or the required rate of return) by the shareholders be r%. The value of a share can then be computed as:

P0 =

E (Div1 ) E (P1 ) + 1+ r 1+ r

But the expected one period share price is the discounted value of the expected dividend receivable and the resale value of the share in year 2: P0 =

E (Div1 ) E (Div 2 ) E (P2 ) + + (1+ r)2 (1+ r)2 1+ r

By forward substitution, the share price can be rewritten as:

P0 = =

E (DIV1 ) E (DIV2 ) E (P2 ) + + (1+ r) (1+ r)2 (1+ r)2 E (DIV1 ) E (DIV2 ) E (DIV3 ) E (P3 ) + 2 + 3 + 3 (1+ r) (1+ r) (1+ r) (1+ r) ... ... ∞

=∑ t =1

E (DIVt )

(1+ r)t

(9.5)

This is the discounted dividend model for the valuation of shares. To use this model to estimate share prices in reality, we will need to estimate a company’s future dividend and its cost of equity. In Chapter 3 we discussed how one can use the capital asset pricing model (CAPM) to estimate the required rate of return by equity-holders. If this estimation process provides us with the correct discount rate, the remainder of our work is to estimate the forecasted dividend.

103


Suppose we observe a company has been paying a constant dividend of Div each year in the past. It is natural to assume that it is going to pay the same constant dividend in the future. Given that the future dividend is going to be constant, equation (9.5) will become:

P0 =

Div r

(9.6)

Now suppose a company’s dividend has been growing by g% each year in the past. If we believe that the same constant growth rate is going to be persistent in the future, equation (9.5) will become: P0 =

(1+ g) Div0 r−g

(9.7)

Equations (9.6) and (9.7) are known as the constant dividend model and Gordon’s growth model. Activity 9.3 Sunlight plc paid the following dividends for the last 5 years: £1.30, 1.40, 1.55, 1.70 and 1.90. The company’s current cost of capital is 14% per annum. Suppose dividend is expected to grow at the historic growth rate of the last 5 years for the foreseeable future, what would be the estimated share price of Sunlight? If dividend is only expected to grow at the historic rate for the next 3 years and thereafter stays constant, what will be the revised share price? Answer: We first calculate the historic growth rate of dividend. Given that Div (0) was £1.30 and Div (4) was £1.90. We can depict this relationship as follows: Div(4) = Div (0) × (1+ g) 4 ⇒ g = 10% 1 Case 1 – when dividend is growing at 10% infinitely. Using the constant growth model, the share price is: P0 =

(1+ g)D0 (1+ 0.1) × 1.90 2.09 = = = 52.25 r−g 0.14 − 0.1 0.04

Case 2 – when dividend only grows at 10% for 3 years and thereafter stays constant, the share price is: Div1 Div 2 Div 3 P3 P0 = + 2 + 3 + 3 (1+ r ) (1+ r ) (1+ r ) (1+ r ) Note that P3 is the terminal price at the end of year 3. Those who obtain a share at that time would be entitled to dividend from year 4 to infinity. Therefore the terminal price is: Div 4 Div 5 Div 6 P3 = + + ...... 2 + (1+ r) (1+ r) (1+ r)3 =

Div 3 since all future dividends are identical to dividend in year 3 r

Substituting P3 into the discounted dividend equation and taking the growth for the first three years’ dividend, we have:

P0 = =

1.1 × 1.90 1.12 × 1.90 1.13 × 1.90 1.13 × 1.90 0.14 + + + (1.14) (1.14)2 (1.14)3 (1.14)3 2.09 2.299 2.5289 2.5289 0.14 + + + (1.14 ) (1.14 )2 (1.14 )3 (1.14)3

= 1.833 +1.769 +1.707 +12.192 = 17.501

104

1

For examination purposes, you can assume that the growth on dividend is not compounded. Consequently we have Div(4) = Div(0)  (1 + 4g)  g = 11.5%


Practical considerations This section is based on Arnold (2008) Chapters 15–18. We often think that an increase in earnings over time must be a good indicator of value creation. However, measurement of value creation based on earnings can be misleading: • the accounting rules which define the earnings figures can be distorting and subject to judgments and manipulation • the investment required to generate the earnings growth is often not adequately represented • the time value of money is not included in the consideration • the risk of the company is not being considered thoroughly.

Value-based management The recent talk about value-based management brings together three important aspects of corporate management: finance function, strategy of a firm and organisational capabilities. There are three steps to create value to shareholders: 1. Mission statement with value for shareholders at its core. 2. Measuring shareholder value for the entire corporation. 3. Actively managing to create shareholder value.

How is value created? In simple terms, shareholder value is created when the return on investment is higher than the return on capital provided. So how do we ensure that the return on investment can be higher than the return on capital provided in the long run? Arnold identifies a five-step approach: i. increase the return on existing capital through efficiency ii. raise capital and place in positive investment iii. divest assets which are not effectively producing the required return iv. extend the planning horizon v. lower the required return on capital through careful capital structure planning.

How do we measure the value? We can summarise how we measure value as follows: 1. In Chapter 2 we discussed how a firm’s value is based on the aggregate of a firm’s projects’ NPVs. 2. The value of a firm can also be proxied as the sum of the value of the financial instruments. We discuss this in Chapter 6 and this chapter. 3. A free cash flow approach which is discussed below. Rappaport (1998) defines free cash flow (FCF) within the planning period as: FCF

= sales – operating costs – tax – incremental investment in fixed capital – incremental investment in working capital

The corporate value is then defined as: Corporate value = PV of free cash flow within the planning period + PV of free cash flow after the planning period + the current value of marketable securities and other non-operating investment. 105


A forecasted free cash flow is estimated and then discounted accordingly to take into consideration the time value of money.

Conclusion It is not easy to estimate correctly how much a business is worth. In this chapter we showed three different approaches to estimate a value of a business. Each method, based on different assumptions, provided different valuations of a business. We should try to understand the advantages and disadvantages of each of those three methods.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • apply the three methods of valuing a business • explain how the value of equity and bond can be measured and calculated • discuss the key issues of measuring business in real life.

Practice questions BMA Chapter 3, Questions 4, 9, 18 and 31. BMA Chapter 4, Questions 16, 18, 24 and 29.

Sample examination question Falcon Ltd. is a private company in the UK. Its balance sheet on 31 December 2011 shows the following information: £’000 Share capital @ £1 par value

10,000

Share premium

5,000

Revaluation reserve

2,500

Retained profits

12,500

Shareholders’ funds

30,000

5% bonds, matured in 2019

20,000

Capital employed

50,000

Falcon paid the following dividends in the last 5 years: £ 2006

0.51

2007

0.60

2008

0.68

2009

0.77

2010

0.90

The risk-free rate is assumed to be 4% per annum and the expected market’s return is set to be 10% for the foreseeable future. Required: a. What is the balance sheet value of Falcon Ltd.? b. What is the market value of the bond in Falcon, assuming that the market risk, beta, of the bond is 0.5. 106


c. Suppose a similar quoted company to Falcon Ltd. has an observed beta of 1.1. Estimate the equity value of Falcon. d. What is the value of Falcon based on (b) and (c) above? e. Why is your answer to (a) different from (d)? f. What reservations do you have in terms of the value you calculate in (d)?

107


Notes

108

Chapter 10: Mergers

Chapter 10: Mergers Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 31.


Aims Most companies are involved in either a merger or a takeover at some time during their corporate existence, so understanding the motives and tactics behind mergers is very important. There are waves of merger activity and an explanation for this is given in this chapter. The motives and theories behind mergers and takeovers are also described. To achieve success in taking over a company requires knowledge of appropriate tactics, as well as knowledge of defence tactics should a company not wish to be taken over – these are explained. We then move onto a section which looks at corporate restructuring and divesting.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the motives for a merger • explain the tactics employed in attempting to bring about a merger or to defend against a merger • express the advantages and disadvantages of alternative methods of financing mergers • describe the merger process and the main regulatory constraints • investigate the benefits derived from a merger • appreciate a merger as an investment decision, a financing decision and a dividend decision.

Introduction This chapter focuses on trying to explain the motives and tactics involved in merger and acquisition activity. During periods of intense merger activity, financial managers spend a great deal of time searching for firms to acquire or they spend time worrying about firms that are likely to take their firm over. When one firm buys another, it is exactly the same as undertaking any ordinary investment. Therefore, from our earlier studies of financial management we will know that the investment should only proceed if there is going to be a net contribution to shareholder wealth. The only problem is that mergers are very difficult to evaluate because the benefits and costs may not be easy to measure and due to tax they are more complicated than, say, buying a machine, as legal and accounting regulations need to be followed. 109


The terms merger and takeover are used interchangeably. This is because in many instances it is not clear whether one or the other is occurring. Strictly, a merger is when two companies of equal size come together and continue to have an interest in the combined business. A merger supports the idea of the combination while, in a takeover or acquisition, a larger company makes a bid for a smaller company, and the directors of the smaller company do not recommend that shareholders sell their shares to the purchaser and neither the pre-bid shareholders nor the directors of the company have any interest in the combined firm. In a merger, the accounting rules emphasise the continuity of ownership, while in a takeover, the emphasis is rather on a purchase and discontinuity of ownership; the main differences between the accounting rules are concerned with the treatment of goodwill, value of shares exchanged and pre-acquisition profits.

Motives for mergers BMA Chapter 31, pp.820–28, explains the main motives for mergers and acquisitions. Some of these motives are explained here.

Economies of scale You may have come across this term in your earlier studies. In short, economies of scale can be found in the following areas: • In production – a larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units. • In finance – a large firm may be able to reduce its per unit administrative cost when administrating finance issues. Internalisation of transactions This usually occurs when firms vertically integrate (vertical integration backwards occurs by the acquisition of firms that supply raw materials and vertical integration forwards occurs when firms are acquired nearer the selling of the product). It is an important form of merger as it eliminates transaction costs when firms have to deal with each other. One drawback is that by merging two large firms, extra costs may result. For example, suppliers may be less inclined to compete with one another, leading to higher prices paid by the merged entity. Another problem is that firms may be over-integrating. In this case, the benefits of reducing transaction costs may be outweighed by the increase in costs of mergers. Market power During the boom of 1979–85, it was estimated that 3% of assets in the UK changed hands as a result of vertical integration, while 57% were a result of horizontal integration (horizontal integration occurs where firms acquired are at the same stage of the production process, and the merger leads to a greater share of a particular market). This is an attractive feature for firms as it has been shown that a concentration in an industry leads to a greater level of profit. Entry into new markets/industries A merger may allow the acquiring firm to enter into markets where the acquired firm has the know-how. As the growth through a takeover is quick, it can provide, almost instantly, the necessary size for a firm to become an effective and formidable competitor.

110

Chapter 10: Mergers

Elimination of misguided management There is a substantial separation between the ownership and management of large firms. Shareholders do not appoint or supervise the firm’s management; they only elect directors who are agents responsible for the choosing and monitoring of the top management of the firm. Mergers as a use for surplus funds If a firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of its funds. Complementary resources Merging may result in each firm filling in the ‘missing pieces’ of their firm with pieces from the other firm. For example, an accounting firm merges with a consultancy firm to provide an all-round one stop service to clients. Similarly, a merger may take place when one firm’s loss can be used to offset another firm’s profit for tax purposes within the group.

Dubious reasons for mergers • Risk diversification During the conglomerate merger boom of 1979–85, the rationale for the mergers was said to be diversification, which would eventuate in the stability of future cash flows. As firms in different industries experience booms and slumps in their profits and cash flows at different times, it was felt safer for firms to conglomerate to reduce this volatility. From this point of view takeovers reduce risk for companies. However, it is costly to merge or acquire another firm. Apart from the direct costs that a firm needs to pay to its advisors and other professional teams, there might be other restructuring costs which need to be considered. If the merger is simply reducing the overall risk to investors, it is argued that this might not be a sensible reason as shareholders can achieve the same level of diversification by rebalancing their portfolios. Arguably it is much cheaper for shareholders to do so via stock exchanges. • Bootstrapping This was particularly important during the conglomerate merger booms of the 1960s. If Firm A possesses a high stock market rating relative to another Firm B, then the former company is able to purchase the latter firm on advantageous terms, as banks and financial institutions are more likely to support a takeover bid from a company with a better stock market rating. A

B

EPS

£1

£1

P/E

10

5

Share Price

£10

£5

No. of shares

10m

1m

Market value

£100m

£5m

Earnings

£10m

£1m

Suppose Firm A acquires Firm B for £5m in cash and there is no synergy created from the merger. Both companies have identical risk. 111


After the acquisition, the total market value of the combined firm: = £100m (value of Firm A) – £5m (cash paid out) + £5m (value of Firm B) = £100m Total earnings of the combined firm: = £10m + £1m = £11m Total outstanding shares: = 10m (only Firm A’s shares are counted as Firm B’s shares will be cancelled on acquisition) New share price of the combined firm: = £100m/10m = £10 New earnings per share, EPS: = new earnings/number of shares = £11m/10m = £1.10 It seems that the merger has created a higher EPS for the combined firm. One might think that the combined firm has become more profitable than before the merger. However, as we assume that there is no synergy involved in this merger, the increase in EPS is only cosmetic. It should not be regarded as a merger benefit. One should also note that the P/E ratio of the combined firm will be reduced to: £100m/£11m = £9.09 Activity 10.1 Attempt Question 1 and 2 of BMA, Chapter 31, p.845. See VLE for solution.

Financing a merger In the previous section, we discussed the main reasons for mergers and acquisitions. In this section, we turn our attention to the ways that these mergers and acquisitions should be financed. A firm can finance a merger using a combination of the following methods: 1. Cash purchase. 2. Equity exchange. A firm can purchase another company in cash. Cash can be raised from an internal cash reserve, by issuing new shares to existing shareholders, or by issuing additional debt. Each of these methods presents different benefits to, and is met with different reservations by, the shareholders in both the acquired and acquiring firms. We have discussed the relative advantages of financing with internal cash, debt and equity in Chapter 6 on capital structure. You should revise that chapter and familiarise yourself with the concept. In short, the relative advantages can be summarised as follows:

112

Chapter 10: Mergers

Cash offer • Acquired firm’s shareholders In a cash offer, the shareholders of the acquired firm will receive a certain sum of cash flow in selling their shares to the acquiring firm. While they can calculate the actual return of the investment, the sale of the shares will be deemed as a disposal which normally will attract capital gain taxes. There is therefore a tax consideration that the acquired firm’s shareholders would need to take into account when accepting the offer price from the acquired firm. • Acquiring firm and its shareholders • If the firm is using idle cash, both free cash flow theory and pecking order theory suggest that this will increase the value of the firm. • If the firm can afford to purchase another firm with cash despite the cash flow implication, it might suggest that the acquiring firm might still have sufficient cash flows for other future investment. Based on our discussion of the signalling effect on debt and dividend, this might suggest that it is a good quality firm. Once again its value might further be enhanced. • Another advantage of using cash in acquiring another firm is that there is no dilution effect to the existing shareholders’ holding in the acquiring firm. Share issues • Issuing new shares to raise additional cash for acquisitions has very similar advantages as in the cash offer above. • However, according to the pecking order theory, issuing shares might lead the market to believe that the existing shares are overpriced. This might have an adverse effect on the share value if the acquiring firm issues new shares to raise funds for the acquisition. • There can be difficulties for the market when trying to evaluate the resultant combination if it perceives that the target company has part or all of its operations in a different risk class or classes from that of the acquiring company. Debt issues According to our discussion in the trade-off theory, as long as the firm’s marginal tax shield benefit exceeds the marginal cost of financial distress, the debt financing will increase the value of the firm. In a similar way, a firm which issues debt to finance an acquisition might also increase its value due to this financial effect. Share exchange In this mode of financing an acquisition, the acquiring firm issues new shares to the shareholders of the acquired firm in exchange for the control of the acquired firm’s net assets. In return, the shareholders of the acquired firm will surrender their shares in the acquired firm. The relative advantages and disadvantages of this method to the different stakeholders can be summarised as below: • Acquiring firm and its shareholders • There is no immediate outflow of cash and therefore it reduces the burden of raising additional finance. This is especially valuable when the acquiring firm is facing a capital rationing problem. 113


• However, the shareholders of the acquired firm will now be holding shares in the combined company. There is therefore a dilution effect of the shareholding among the existing shareholders of the acquiring firm. • Acquired firm’s shareholders • The surrender of the shares by the shareholders in the acquired firm is not deemed as a sale or disposal of shares. Therefore there is no capital gains tax to be paid by the acquired firm’s shareholders. • However, the value of the shares in the combined firm after the acquisition is completed fluctuates and it will be dependent on how well the firms are merged and whether the synergies can be created as planned. Therefore the merger value to the shareholders of the acquired firm is more uncertain in this case than in the cash offer. • In practice, an immediate premium is usually offered to the target company’s shareholders as an incentive to them to surrender their shares. At the same time it provides the market and existing shareholders a benchmark against which they can review efforts of their management as well as realising the potential of their investment operating on its own. Activity 10.2 Examine several recent mergers and identify the principal financing options in each case.

Impact of mergers1 There is a significant volume of academic and practitioner research on mergers and their impact. In Arnold, the impact on different types of stakeholder is discussed. Here is a brief summary: Society Society will benefit from mergers provided that the combined firms will produce cheaper products as a result of economies of scale and improved managerial efficiency. Empirical findings seem to suggest that at best mergers are neutral to society. Shareholders of acquired firms In practice, a significant premium is often paid over the pre-bid price of the acquired firm. The empirical evidence seems to overwhelmingly suggest that shareholders of the acquired firm gain from mergers. Shareholders of the acquiring firms Empirical evidence seems to suggest that the majority of mergers result in a poorer than expected return to the acquiring firms. Why do mergers fail to generate value for acquiring shareholders? Different mergers have their different reasons for possible failure. However, there seems to be some common explanatory factors: 1. Misguided strategies Companies engage in mergers in the hope of gaining larger market shares. However, some of these mergers might be carried out at the wrong time. For example, Daimler-Benz merged with Chrysler to create a global car producer and found itself in a high-tech recession in 2001, and lost over 90% of its share value.

114

1

See Arnold (2008), pp.887–93.

Chapter 10: Mergers

2. Over-optimism Acquiring managers often over-estimate the benefits of a merger and its cost. This explains why acquiring firms seem to lose value in mergers. 3. Failure of integration management Coopers & Lybrand (1993) surveyed the UK’s top 100 companies and interviewed senior executives and found that the most commonly cited reasons for merger failures are: • Target management attitudes and cultural differences (85%). • Little or no post-acquisition planning (80%). • Lack of knowledge of industry or target (45%). • Poor management and poor management practices in the acquired company (45%). • Little or no experience of acquisitions (30%). Employees In most merger cases, operating units of the merged firms are fused and redundancy is inevitable. However, in some cases, mergers actually create competitive strength in the combined firm and allow jobs to be saved or created. Directors The directors of the acquiring firm will normally enjoy an increase in status and power in the combined firm. Their salary and remuneration are increased as a result. On the other hand, the directors of the acquired firm will often be sacked as they are regarded as the failed managers. However, these directors are often given a good redundancy package and are often able to find jobs in other companies. Financial institutions Financial institutions benefit from mergers greatly as they are usually paid handsome fees for providing advice to both the acquired and acquiring firms during merger talks.

Estimating economic gain The economic gain of a merger is defined as the value of the combined firm less the aggregate value of the individual firms. N

Gain = PVCombined − ∑ PVi i=1

The net gain of a merger is defined as the gain over the cost of acquisition. The cost of acquisition is the sum of the cash paid and value of securities issued for the acquisition. Net cost is the cost of acquisition less the original value of the acquired firm. The gain generally comes from the synergies created from the merger. Examples of synergies are: • Revenue enhancement • marketing gains • strategic benefits • market or monopoly power. 115


• Cost reduction • elimination of inefficient management • economies of scale • complementary resources. A bidder is typically estimating the value of a target company using some of the valuation methods we outlined in Chapter 9. The following example illustrates how the cost and gain of a merger can be estimated. Example 10.1 Wardour plc is a 100% equity financed company. It is considering acquiring the net assets and full control of Frith plc. Currently Frith is expected to have a dividend growth of 6% per annum. Under the management of Wardour plc, this growth rate is expected to increase to 8% per annum without any additional investment.

Wardour

Frith

Earnings per share

50p

15p

Dividend per share

30p

8p

No. of shares

40m

24m

Share price

£9

£2

Wardour plc has the following three financing options: i.

Cash offer – pays £2.50 for every share in Frith.

ii. Share exchange – Wardour offers one of its own shares in exchange for 3 shares in Frith. iii. Debt issue – raise £60m via a 5% irredeemable debt. The corporate tax rate is 30% for both companies. Calculations: The gain of the acquisition can be calculated using Gordon’s Growth Model: Old share price of Frith before the merger: P = Div(1)/(r – g)  200p = 8p  (1.06)/(r – 0.06)  r = 0.1024 The new share price of Frith, P*, under the new management is: P*= 8p  1.08/(0.1024 – 0.08) = 386p The gain of acquisition: = New value of Frith – Old value of Frith = (£3.86 – £2)  24m = £44.64m Cash offer The cost of the acquisition if Wardour plc pays £2.50 for each of Frith’s shares: = Cash offer per share × number of shares in Frith = £2.50  24m = £60m Net cost of acquisition to Wardour: = Cost of acquisition – Old value of Frith = £60m – £2  24m = £12m

116

Chapter 10: Mergers Net gain of acquisition to Wardour: = gain – net cost = £44.64m – £12m = £34.64m Share exchange One of Wardour’s shares is exchanged for every three of Frith’s shares: The market value (MV) of the combined firm: = MV of Wardour + MV of Frith after acquisition = £9  40m + £3.86  24m = £452.64m Number of shares after the acquisition in the combined firm: = Old shares + New shares = 40m + 24/3m = 48m New share price for the combined firm: = New MV/number of shares = £452.64m/48m = £9.43 Cost of acquisition to Wardour: = £9.43 8m = £75.44m Net cost of acquisition to Wardour: = £75.44m – £2  24m = £27.44m Gain of acquisition to Wardour: = as before = £44.6m Net gain of acquisition to Wardour: = £44.6m – £27.44m = £17.16m Debt issue The debt issue has a very similar effect on the merger as the cash offer. However, according to Modigliani and Miller’s argument, the debt interest attracts tax shield benefits. Assuming that the debt is risk free and the acquisition does not change the risk profile of the combined firm, the gain of acquisition will be the same as the cash offer; i.e. £44.64m. However, the value of the combined firm will be: = Value of Wardour + Value of Frith + Gain of acquisition + Financing effect = £9  40m + £2  24m + £44.64m + TcD (where Tc = tax rate and D = market value of the debt) = £360m + £48m + £44.64m + £60m  0.3 = £470.64m


117


Conclusion In this chapter we discussed the main reasons for companies merging with each other. We also looked at how the gains of a merger can be estimated. In short this is an area in which corporate managers need to make three key decisions: • Investment decision – does the target company provide benefits to the merged firm? We can view it as an investment project which should be appraised in line with Chapter 2. • Financing decision – how should the acquisition be financed? Does it add value to the merged firm with the different methods of financing? This links with what we discussed in Chapter 6. • Strategic decision – the success of a merger depends on how well the merger plan can be executed. Coopers & Lybrand (1993) provide a list of common factors for merger success: • Detailed post-acquisition plans and speed of implementation. • A clear purpose for making the acquisition. • Good cultural fit. • High degree of management cooperation. • In-depth knowledge of the acquired firm and its history.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • describe the motives for a merger • explain the tactics employed in attempting to bring about a merger or to defend against a merger • express the advantages and disadvantages of alternative methods of financing mergers • describe the merger process and the main regulatory constraints • investigate the benefits derived from a merger • appreciate a merger as an investment decision, a financing decision, and a dividend decision.

Practice questions BMA Chapter 31, Questions 12, 13, 16 and 17.

118

Chapter 10: Mergers

Sample examination question Bei plc is an all-equity financed conglomerate in the UK. It is considering taking over the operation of Jing Ltd. The following information is available: Bei plc

Jing Ltd.

Number of shares issued at £1 each

20,000,000

2,000,000

Market price per share

£10

£12.5

Earnings after tax per share

£0.875

£1.5

Beta

0.9

1.8

The Board of Directors have identified the following options to finance the proposed acquisition of Jing Ltd. 1. Raise £28 million of new shares to acquire the total control of Jing Ltd. from its existing shareholders. 2. Raise £28 million of 10% perpetual debentures with £20 million face value to acquire the total control of Jing Ltd. from its existing shareholders. The Board expect that, after the acquisition, the combined company could reduce operational costs by £4,000,000 while maintaining the same level of operations as before. Currently both companies are paying corporation tax at the rate of 30%. The risk-free rate is expected to be 5% per annum for the foreseeable future. The current market return is 10% per annum. Required: a. What are the main motives for mergers and acquisitions? b. What are the effects on Bei plc’s stock price, capital structure, return on equity and return on debt under each of the two funding options? Advise whether the acquisition should go ahead and which funding option would maximise the company’s value. Explain your answer carefully and state any assumptions that you make.

119


Notes

120

Chapter 11: Financial planning and working capital management

Chapter 11: Financial planning and working capital management Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 25 and Chapters 28–30.

Aims This chapter examines the importance of financial planning and how carefully chosen techniques may improve the value of a firm.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the core concepts of financial planning • evaluate the approaches to, and methods of, financial planning • explain the importance of working capital management • discuss techniques used to assist planning and management.

Introduction This chapter covers three key areas in financial planning: 1. Financial analysis. 2. Financial planning. 3. Working capital management.

Financial analysis A company’s financial statements provide shareholders, bondholders, bankers, suppliers, employees and management with information about how well their interests are protected. Naturally, it is important for each of these stakeholders to understand the performance of their company. In 25 Principles of accounting, you would have already come across how we can use financial ratios to assess a firm’s performance. BMA Chapter 28 provides a very detailed explanation of how these common financial ratios can be calculated and used in interpreting a firm’s profitability, efficiency, liquidity, financial risk and leverage. We are not going to repeat this material here. You should revise Chapter 28 thoroughly before proceeding with the rest of this section. In particular, you should refer to the summary of financial ratios on p.748. A company’s set of accounts, its profit and loss account, cash flow statement and balance sheet are only of limited value when read in isolation and without analysis and evaluation. Therefore it is important to give meaning to results portrayed by accounts via analysis and interpretation. The analysis of financial information can perhaps be best broken down into two elements, each with their own parts. These are the process and the context elements, and each influences the other. 121


The process of analysis will be heavily influenced by its mode and its purpose. The structure, depth and detail of work undertaken will be influenced similarly. A very detailed review will start by strategically analysing the company and then use the ratios to address strategic elements within each area of enquiry. Most books delineate four areas: profitability, liquidity and solvency, activity and efficiency, and financial structure. Each of these areas can be broken down further, for example in the case of profitability it can cover trading profitability, the margin on sales, the proportions of sales taken by the different types of costs, etc. Profitability also includes the return on the investment made. As to what constitutes investment depends on the reviewers’ perspective. Is it the return on the long-term funds invested – capital employed ‒ or is it the return on the total assets used to generate the profit or the return to the ordinary shareholders for their investment in the company? Each of the areas has its own family of ratios, providing information for answers to the appropriate strategic questions. Remember the process is generally to prepare a set of ratios, analyse them, and use them for a review of the past performance with the view of helping in the projections for the future. Also a comparison with competitors or industry sector benchmarks can be useful. The following table summarises the key ratios and their interpretation. Ratios

Definition

Interpretation

Economic value added (EVA)

After-tax interest + net income – cost of capital  capital1

Measures the extra value added to shareholders and bondholders after accounting for the cost of capital.

Return on capital (ROC)

After-tax interest + net income2/total capital

Measures the potential return to shareholders and bondholders on their investment in the company.

Return on equity (ROE)

Net income/equity

Measures the potential return to shareholders on their investment in the company.

Profitability

122

Return on assets (ROA)

After-tax interest + net income/total assets

This measure focuses on how profit would be generated from the utilisation of assets employed in the company.

Market value added (MVA)

Market value of equity – book value of equity

Measures the difference between the market value of shareholders’ investment and their cumulative investment in the company.

Gross profit margin

Gross profit/sales

Measures how much gross profit a company can generate from every £ of sales.

Operating profit margin

Operating profit/sales

Measures how much operating profit a company can generate from every £ of sales.

1

An alternative definition of EVA is (profit after tax + before tax interest) – cost of capital  capital. The difference depends on whether interest is tax deductible. 2 It should be noted that BMA define net income as the profit after tax. Some UK authors (such as Arnold, 2008) define ROC as profit before interest and tax / capital. Both the US and UK definitions are acceptable.


Efficiency Asset turnover

Sales/total assets3

Measures how well the company generates revenues from its assets employed in the year.

Inventory holding period

Average4 inventory/cost of sales  365 days

Provides an estimate of how long on average goods purchased from suppliers would be held in the company before they are sold.

Debtors collection period

Average debtors/credit sales  365 days

This measure indicates on average how long it takes for a company to collect its debts from credit customers.

Creditors payment period

Average creditors/credit purchases5  365 days

Measures on average how long it takes for a company to pay its debts to credit suppliers.

Current assets/current liabilities

Indicates how much a company can cover its obligations in the next 12 months using its current assets.

Current assets (less inventory)/current liabilities

This measure excludes the inventory from the calculation. Effectively we are measuring how well a company can cover its liabilities in the next 12 months using current assets other than inventory.

Gearing ratio

Long-term debt/(long-term debt + equity)

Measures the reliance of a company’s finance on long-term debt.

Interest cover

Earnings before interest and tax/Interest payment

Measures how much interest a company can cover from its operating profit before interest.

Liquidity Current ratio

Quick ratio

3

We can also define asset turnover as sales/ average level of total assets for the year. 4 In most cases, the year-end figures are used for debtors (trade receivables), creditors (trade payables) and closing stock (inventory) instead.

5 In the case when credit purchases are not available from the financial statements, the cost of sales figure can be used instead.

Financial risk

Table 11.1: Key ratios and interpretations.

Cash based ratios Apart from the ratios listed above, there are also cash ratios that focus on a company’s cash management. Cash return on net assets (or cash return on capital employed) = Net operating cash flow/total assets less current liabilities. Cash interest cover = Net operating cash flow/interest payment. Cash dividend cover = Net operating cash flow less tax and interest payments/dividend payment. Internally generated investment = Net free cash flow/investment. The Du-Pont system (which is based on a pyramid of ratios, each level interlocking with the next) is helpful in providing pointers for investigation derived from the inter-relationships. For example return on net assets is the product of operating profit margin (return on sales) and net asset turnover. This causes the analyst to look at the profit margin change, say 123


in a price war between competitors, and see if it has helped improve the net asset turnover enough to result in an overall improvement in return to the net assets employed. Example 11.1 (This example is adapted from the 2008 subject guide) The accounts for Chemistrand plc for the two financial years ended 31 December 2007 and 2008 are given below.

CHEMISTRAND PLC Profit and loss account for years ended 31 December 2008 and 2007

Turnover Variable cost of sales

2008

2007

£’000

£’000

12,000

13,200

5,700

6,660

Fixed production costs

1,320

1,200

Administration costs

1,020

1,080

Selling and distribution costs

1,320

1,290

Research and development costs

300

270

Interest

108

–

9,768

10,440

2,232

2,760

642

960

1,590

1,800

Dividend paid (during years)

900

900

Profit retained

690

900

Net profit before tax Taxation Net profit after tax

Balance Sheets as at 31 December 2008 and 2007 2008

2007

£’000

£’000

Leasehold property (note 1)

6,750

6,900

Plant and equipment (note 2)

1,620

1,080

8, 370

7,980

Fixed assets

Current assets Stock

1,140

1,020

Debtors

1,320

1,140

–

60

2,460

2,220

Bank

124


Less Creditors due within one year Tax creditors

600

540

Taxation

630

1,470

Bank

720

–

Net current assets Net assets

510

210

8,880

8,190

6,000

6,000

Ordinary share capital (£1 shares) – called up Profit and loss account

Note 1 Leasehold property (cost) Accumulated depreciation Balance Note 2 Plant and Equipment (NBV) Additions

2,880

2,190

8,880

8,190

7,200

7,200

450

300

6,750

6,900

1,080

1,140

720

60

Depreciation for year

(180)

(120)

Closing balance (NBV)

1,620

1,080

Note 3 No sales of assets took place during the year (NBV – Net Book Value) Note 4 All dividends were paid during the financial year at the rate of £0.15 per share. Cash flow statement for the year ended 31 December 2008

Cash flow from the operating activities

2008

2007

£’000

£’000

2,430

2,460

(108)

–

(1,482)

(240)

(720)

(6,060)

120

(3,840)

(900)

(900)

(780)

(4,740)

–

–

–

3,000

(780)

(1,740)

Returns on investments and servicing of finance Interest paid Taxation Capital expenditure Equity dividends paid Management of liquid resources Financing Share issue Increase/(Decrease) in cash in the period

125

59 Financial management The following information from a credit rating agency for the industry is also available for the two years 2008 and 2007.

2008

2007

LQ

M

UQ

LQ

M

UQ

15.0

20.0

25.0

15.0

20.0

25.0

Net assets turnover (times)

1.0

1.5

1.7

1.1

1.5

1.7

Current ratio (times)

1.0

1.9

2.8

1.1

2.0

3.4

Acid test (times)

0.8

1.2

2.1

0.7

1.2

2.0

Collection period (days)

30

45

65

35

50

70

Total owing to total assets (%)

20

50

65

25

49

67

5

15

40

5

15

35

11.5

13.3

14.7

11.0

13.3

14.7

Return on net assets (%)

Long-term debt to capital employed (%) Return on sales

LQ – Lower Quartile (25% of group had ratios same as or lower than figure given) M – Median (50% of group had ratios same as or lower than figure given) UQ – Upper Quartile (75% of group had ratios same as or lower than figure given) Required: a. Compute a full set of basic financial ratios which will help give a rounded assessment of Chemistrand’s performance in 2008. b. Using a subset of the ratios calculated in (a) above, comment on the performance of Chemistrand plc in comparison with the statistics provided by the agency. c. Write a short commentary on what additional information has been obtained from the results of the computations in (a) which were not used in (b) above.

Solution to Example 11.1 a. Profitability

2008

2007

Return on net assets

2,232 × 100 8,880

= 25.2%

33.7%

Return on sales

2,232 × 100 12,000

= 18.6%

20.9%

Net asset turnover

12,000 8,880

= 1.35×

1.61×

Return on equity

1,590 × 100 8,880

=17.9%

22.0%

Gross profit margin

(12,000 – 7,020) × 100 12,000

= 41.5%

40.5%

Other ratios such as the various costs can be computed as percentages of turnover, or annual growth rates of turnover, profit etc. Divisional and regional breakdowns of profit, turnover and net assets can be evaluated similarly if it is useful to the task.

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Solvency and liquidity Current ratio

2,460 1,950

= 1.26×

1.10×

Acid test (quick ratio)

1,320 1,950

= 0.68×

0.60×

Debtors collection period

1,320 × 365 12,000

= 40.2 days

31.5 days

Stock holding period

1,140 × 365 7,020

= 59.3 days

47.4 days

Creditors payment period

600 × 365 7,020

= 31.2 days

25.1 days

Long-term gearing

0 × 100 8,880

= 0%

0%

Total owing to Total Assets

1,950 × 100 (8,370 + 2,460)

= 18%

19.7%

Interest cover

(2,232 + 108) 108

= 21.7×

n/a

Dividend cover

1,590 900

= 1.77×

2.0×

Earnings per share (EPS)

1,590 6,000

= £0.265

£0.30

Dividend per share

900 6,000

= £0.15

£0.15

Cash return on net assets

2,430 × 100 8,880

= 24.7%

30.0%

Cash interest cover

2,430 108

= 22.5×

n/a

Cash dividend cover

840 900

= 0.93×

23.6×

0%

21.8%

Activity ratios

Financing ratios

Cash based ratios

Internally funded investment

N.B. The above ratios incorporate many more ratios and computations than what you would be expected to compute in an examination answer. An appropriate number could be the eight to be analysed in (b) below. b. The decline in the return on capital employed appears to have been caused by falling operating profit margins and the declining level of sales which is also reflected in the falling asset turnover. Even so Chemistrand is still in the upper quartile for its profitability both in its operations and on its capital base. However compared to the rest of the industry it is below average in turning its assets over (i.e. its marketing activities perhaps need reviewing). Chemistrand’s solvency ratios are below average which could be due to efficient management of current assets. It could also be due to increasing current liabilities at a rate which could cause future problems. Since the collection period is below average (i.e. the Sales ledger) it’s doing a better than average job of getting in the money, and the overdraft has suddenly emerged and grown, so the company’s liquidity and solvency is perhaps to be put under the spotlight. Note how over the past two years the cash flow statement shows significant outflows of cash. Turning to the financial structure, the two ratios, total owing to total assets and the long-term debt to capital employed, reinforce what is obvious from 127

59 Financial management the balance sheet, namely that there is no long-term debt. The company is distinctly under-geared compared with its competitors. Not knowing what the future holds, or what the present lending situation is like, one can probably still recommend that the company takes out a long-term loan. This would improve the gearing, probably cost less than short-term borrowing and reduce the risk of financial distress. Given the asset cover and the fact that the assets are recent acquisitions bankers would, in the light of the company’s overall profitability, be more than willing to make a medium or long-term loan to the company. c. To complete the analysis and interpretation this section was added to give the reader further insight into interpreting the accounts. Additional operating profitability ratios indicating how different types of costs have changed in proportion to turnover would have been useful. Note that gross profit had actually improved so perhaps the company has some internal strengths and some weaknesses, since return on sales had declined (i.e. could it be that production had become more efficient, but the administration and selling etc. had got less effective?). The increase in collection and inventory periods reinforces this point though the financial effects of this are lessened by the effects of increasing the creditor period. The shareholders will not be pleased, as return on equity and earnings per share declined, not something you wish to see when a company has just doubled its called up share capital. So even though the cash dividend cover hinted at insufficient funds to maintain the dividend level it was probably felt necessary in order to steady the share price. Notice how the introduction of the cash based ratios has provided much more meaningful information on interested dividend cover. The cash interest cover highlights the security lenders can feel over sufficient cash for the payment of interest.

N.B. Note when answering these sorts of questions you may have to make some reasonable assumptions in order to make your interpretations. If so, state the assumptions. Do remember when you are asked to interpret, do not just describe a change or an event, try to give the actual, or a possible, reason for it. Activity 11.1 Attempt Questions 2–4 of BMA, Chapter 28, p.753. See VLE for solution.

Financial planning Managers need to ensure that their firm does not run out of cash. Therefore it is important to understand how cash can be generated from its operations and how it can be managed. In 25 Principles of accounting, you would have already learned the concept of cash budgeting and its use in internal management. The key points are summarised here: 1. There are three main sources of cash. They are cash flows from operating activities, investment activities and financing activities. 2. Operating activities involve the purchase of raw materials and other goods for resale, the selling of finished goods and receipts from trade receivables and payments to trade payables. 3. A cash cycle (operating effect) measures the period during which a company receives cash from its customers to the point when it has to pay its suppliers. The longer the cash cycle, the more working capital would have to be raised to finance the company in the short run. 128


4. The cash cycle is defined as: Cash cycle = Average inventory holding period + average collection period – average payment period. 5. Average inventory holding period is defined as:

days It measures the average duration for a firm to hold its inventory before selling. 6. Average collection period is defined as:

days It measures the average duration for an average debtor to pay up. 7. Average payment period is defined as

days It measures the average duration for a firm to pay its debt to its trade creditors. 8. A cash budget provides a forecast of cash inflows and outflows based on the company’s estimates of the sales, collection of debts, purchases (including inventory policy) and payments to suppliers. It also incorporates other planned expenses such as capital expenditure, administration and operating charges. Any forms of distribution of profits, interest and taxes are also considered. A full example is available in BMA, Chapter 29 (pp.766–67). 9. The cash budget should provide an indication of how much cash would be available to the business. Corporate managers should then develop a short-term and long-term financing plan. 10. A short-term financing plan should identify how a company may utilise surplus cash flows to reduce the burden of short-term working capital and long-term finance. On the other hand, short-term cash flow deficit should draw managers’ attention to the need for raising short-term finance such as bank overdraft, short-term bank loans or extended credit terms from suppliers. 11. A long-term financing plan focuses on three functions: a. Contingency planning – would the company have sufficient finance to cover an unexpected shortfall of cash in the long run? Would the company be able to cope with unexpected changes in government’s fiscal policies, tax rates and competitive environment? b. Flexibility and options – would the company have sufficient cash flows for future investments should it decide to expand its current operations or extend its existing investments beyond their intended investment periods? Would the company be able to repay the long-term loans when they fall due? c. Alignment – the long-term financing plan should be consistent with the company’s long-term objectives and link strategic goals together.

129


Example 11.2 (This example is adapted from the 2008 subject guide) Plantree plc prepares long-term financial plans. In order to achieve its longterm financial objectives the planning team will be faced with decisions on investment policy, financing policy and dividend policy. Required: a. Comment on the nature of these three types of decisions. b. Comment on the interrelationship of these three types and how they will be affected by the choice of the long-term financial objective(s) of the business. c. Describe briefly some of the main examples of forecast information needed for each type of decision.

Solution to Example 11.2 1. a. Investment policy decisions This type of decision requires an understanding of the corporate strategy as to how the funds should be apportioned between the strategic groupings – replacement needs, new product investments, expansion investments, etc. The levels of required return from the investments and their risk levels must be considered. The potentially different cash flow patterns of returns from existing and new investments may need assessment; similarly what effects will the withdrawal or sell off of a major investment produce. b. Financing decisions The amount and type of funds required will be dependent not only upon the selection of investments made, but also the financial market place conditions and availability, combined with the present situation of the business. Possible types of finance will include new equity, retained earnings, loans, leasing and sale of assets. The different costs of funds and their characteristics will also be of relevance here in the selection. c. Dividend decisions Whether or not to pay, if so how much, when and how are all very important and relevant decisions here since they reflect the returns to the shareholders, the owners of the business. They also provide the market place with information on one of its major decision criteria. 2. Interrelations The three types of decisions are interrelated. People making decisions whether to invest require the opportunity cost of funds for final evaluation, they also need to know the availability of funds. In reality, these are not always available precisely when investors want them. The amount of dividend paid per share, the size of the earnings per share and the annual growth rate of these variables along with the size of profit and its return on investment will influence the availability and cost of funds. Thus one can see some of the interrelationships amongst the three decision types. Likewise, theory would suggest businesses should be aiming to maximise share price, while practice might add some other objectives like profit, profit growth, sales, market share, earnings per share, dividend per share, etc. Whatever a business’s objective(s), whether it be one or all of those listed, it will influence the plan. For example, profit growth and thus dividend payment may be targeted at the expense of cash flow in order to influence equity market perceptions if the finance plan requires a share issue as the next major source of long-term capital. Increasing dividend payout may, in the shorter term, reduce availability of funds perhaps restraining or deferring new investment.

130

Chapter 11: Financial planning and working capital management 3. a. Main forecast needs of investment decisions will include: • predictions of cash flows, their timings and the influence of inflation • the degree of variability in the cash flow estimates • the opportunity cost of capital to be used that is appropriate for the business risk of the project • the impact on the accounting profit profile • the interactions (if any) with existing or new projects. b. For financing decisions the main forecast needs are: • predictions of funds available and type of source – equity, debt, etc. • the trend of costs of funds – increasing costs of loans or equity • market perceptions of gearing, present corporate position vis-à-vis target gearing level, share price, risk classification for loans • cost of raising different forms of capital. c. For dividend decisions the business needs predictions on: • the level of profits available for distribution over the planning period • the market’s expectations of the business • the expectations of the payout behaviour of competing businesses • internal sources should provide estimates of the needs for retained profits along with the cash flow predictions of the business.


Short-term versus long-term financing The mix of finance used to acquire the total assets of a firm is a very company-specific and time-specific selection. BMA go through the rationale behind the matching of maturities of assets and liabilities. Since a firm’s asset base grows irregularly over time, one would expect the mix also to vary. Generally, though, firms will attempt to choose whether they will be conservative and predominantly financed by long-term sources or more aggressive and have a much higher proportion funded with shortterm sources. The level of financial distress will be greater the higher the proportion of short-term funds, since, of necessity, they will be interest bearing and not equity. However, they can be repaid more easily and quickly. No period of notice or penalty would normally be attached to repayment, which can be done to best advantage.

Bank borrowing You should note the type of loans that the clearing banks and merchant banks are prepared to make. When making a decision concerning a business loan application, a bank will take a number of factors into account. These include the: • quality and integrity of the management of the business • quality of the case made in support of the loan application • period of the loan and the security being offered • nature of the industry in which the business operates • financial position and performance of the business. 131


Specialist finance There are numerous short and medium-term sources available which are only provided with a specific end in view. For example, there are a number of ways of getting money to support exports, or finance for specific projects, or the more general hire purchase. General knowledge of their existence is all that is required.

Leasing Read BMA, Chapter 25 (pp.653‒67). When reading these sections you should note carefully the distinction between an operating and a finance lease and the reasons put forward to explain the growth of this form of financing in recent years. In addition, you should study carefully the techniques of lease evaluation. In brief, a company that arranges to hire an asset under a finance lease agreement is effectively borrowing from the lessor the equivalent of the lower of the fair value of the asset and the present value of the lease payments. Therefore the decision whether to lease or buy rests upon the cash planning of the company. Sale and lease back arrangements offer an opportunity for a business with valuable property to raise new finance. You should compare the advantages and disadvantages of this form of financing with that of a mortgage. Activity 11.3 Attempt Question 24 of BMA, Chapter 25, p.672. See VLE for solution.

Working capital management Inventory management A significant amount of a company’s resources is often tied up in inventory. Previously, we mentioned the inventory holding period. The shorter the time we keep our inventory, the faster we would be able to turn it into cash flow. Therefore it is important to set an inventory level that would enable the company to meet the demands of its products and free up spare capital at the same time. Economic modelling has been developed to identify the minimum level of inventory to enable a company to balance out the risk of ‘stock-out’ and tied up working capital. BMA, Chapter 30 (pp.786–88), describes how such minimum inventory level may be modelled. We briefly explain the rationale behind this model. Suppose we have a constant demand of D units for a product in a year. We order from our suppliers Q units each time when we run out of inventory. Each order incurs a handling/delivery charge, C, and there is no lead time between the ordering and the delivery of the goods. The average of stock level is Q/2. Suppose we incur an annual cost of storage per unit, H. Given the above information, the total ordering cost and the total holding cost per annum are D/Q  C and Q/2  H respectively. To minimise the total cost, we have:

132


Example 11.3 Suppose the annual demand of a product is 10,000 units. The cost per order, C, is £300 and the annual unit storage cost is £5. The economic order quantity (EOQ) is therefore:

Activity 11.4 In BMA, Chapter 30, p.788, the authors mentioned the terms just-in-time and buildto-order. Explain what these terms are and what potential problems a company may encounter if it introduces these concepts of inventory management in its operations. See VLE for discussion.

Trade receivables management Allowing customers to pay for their purchases on credit requires some serious management. Typically, there are five factors to consider: 1. Terms of sales – how long do we allow customers to pay their invoices? Are we prepared to offer a discount for quick settlement? 2. Promise to pay – what sort of collateral do we require from the credit customers? 3. Credit analysis – how do we assess the creditworthiness of the customers? 4. Credit decision – how much credit are we prepared to offer? Are we willing to take risks to extend risk terms even though there might be a chance of bad debt? 5. Collection policy – how do we ensure that all debts are collected? See debt factoring below. BMA, Chapter 30 (pp.788–94) covers these five points in detail. You should read through those pages and understand the key points. Example 11.4 (This example is adapted from the 2008 subject guide) Pinewood Supplies Ltd. produces a pine bookcase which is sold to retailers throughout Scotland. The accountant of Pinewood Supplies Ltd. has provided the following information concerning the product:

£ Selling price Variable costs Fixed cost apportioned Net profit

£ 70

42 6

48 22 133

59 Financial management The annual turnover of the business is currently £1.4m and it is believed that this can be increased in the forthcoming year by increasing the time given for trade debtors to pay. All sales are on credit and the average collection period for the business is 40 days. The business is considering an increase in the average collection period by 15 days, 30 days or 45 days. The effect on sales from adopting each option is as follows:

Option Increase in average collection period (days) Expected increase in sales (£,000)

1

2

3

15

30

45

£120

£150

£325

The cost of capital to Pinewood Supplies is 12% per annum. assumption: for both Short term and Long term financing charge Required: Explain, with supporting calculations, which credit policy option should be offered to customers.

Solution to Example 11.4 The profitability of each option can be determined by weighing the costs of the additional investment in debtors against the benefits from the expected sales.

Contribution per unit £ Selling price Less

70 Variable cost

42

Contribution per bookcase

28

Rate of contribution 28/70 = 40% Option Projected sales (£m) Projected debtor period (days) (40 + 15)

1

2

3

1.52

1.55

1.725

55

70

85

Projected debtors 1.52m × 55/365

229,041

1.55m × 70/365

297,260

1.725m × 85/365

401,712

Less: Current debtors 1.4m × 40/365 Increase projected

153,425

153,425

153,425

£75,616

£143,835

£248,287

(9,074)

(17,260)

(29,794)

48,000

60,000

130,000

£38,926

£42,740

£100,206

Cost of additional investment in debtors (12% × increase) Increase in contribution (40% × sales increase) Increase in profits

The calculations shown above indicate that extending the credit limit by 45 days provides the most profitable option. The expected profit of £100,206 is considerably higher than the other two options. The choice of option based on these figures is, therefore, unlikely to be very sensitive to any inaccuracies in the underlying assumptions and estimates.

134


Debt factoring Read BMA, Chapter 30(p.793). When reading the relevant sections on debt factoring note the services offered by a factor and the fee structure employed. You must be clear about the distinction between debt factoring and invoice discounting. Debt factoring is often a long-term arrangement because of the administrative arrangements required to deal with the transfer of the sales ledger accounting function. Invoice discounting, on the other hand, may be a temporary arrangement. Factoring can prove to be expensive and so it is important to identify the relevant costs and benefits before entering into such an arrangement. Study the worked example below. Example 11.5 (This example is adapted from the 2008 subject guide) Aztec Electronics Ltd. has an annual turnover of £25 million of which £0.2 million prove to be bad debts. Credit controls within the business have been weak in recent years and the average settlement period for its trade debtors is currently 70 days. All sales are on credit and turnover has been stable in recent years. The retrenchment of business has been approached by a debt factoring business, which has offered existing staff's salary to provide an advance equivalent to 80% of its debtors (based on an average settlement period of 30 days) at an annual interest charge of 14%. The factor will take responsibility for the collection of credit sales and will charge a fee of 2.5% of sales turnover for this service. The use of a factoring service is expected to lead to cost savings in credit administration of £120,000 per annum and will reduce bad debts by half. The settlement period for debtors will be reduced to an average of 30 days which is in line with the industry norm. The business currently has an overdraft of £6.2 million and pays interest at the annual rate of 15%.

do not affect calculation even if not given Required:

Calculate the net annual cost or savings resulting from a decision to employ the services of the factor. cost benefit analysis Solution to Example 11.5

(+ve) - customer owe less - incurr lower financing charge - save on admin fee (-ve) - need to pay factor interest + service fee

£’000

£’000

Existing investment in trade debtors {(70/365)£25m}

4,795

Expected future investment in trade debtors {(30/365)£25m}

2,055

Reduction in investment

2,740

Factor costs 2.5% of sales turnover

625

Interest charge on advance {(£2,055,000 × 80%)14%}

230 855

Factor savings Bad debt savings (£0.2m × 0.5)

100

Credit admin savings

120

Reduction in trade debtors (£2,740,000 × 15%)

411

Reduction in overdraft interest through advance {(2,055,000 × 80%)15%}

247

Net annual savings

878 23

135

59 Financial management We can see that, in this case, the employment of a factor will lead to net savings for the business.

Trade payables management Trade credit from suppliers is an extremely important source of finance for small businesses in particular. It can be described as a spontaneous source of finance as it results from normal business operations (i.e. increases in sales lead, in turn, to increases in purchases on credit from suppliers). Trade credit from suppliers can be a free source of finance to a business providing the goodwill of the trade supplier is maintained and providing discounts for prompt payment are taken. Failure to maintain supplier goodwill, however, can lead to a reduced level of service in the future and failure to take advantage of discounts can have a high implicit annual interest cost. Suppose trade suppliers offer a 2% discount for invoices paid within seven days and, if payment is not made within seven days, the payment period for invoices is 28 days (with no discount being allowed). The implicit annual interest cost of a business paying at the end of 28 days rather than at the end of seven days is:

We can see that the cost of foregoing discounts can be very high and, therefore, other forms of short-term finance may prove to be cheaper. When reading the relevant sections on trade credit you should note in particular, the five factors which determine the length of the credit period given to customers. Activity 11.5 Attempt Question 21 of BMA, Chapter 30, p.815. See VLE for solution.

Cash management Read BMA, Chapter 30 (pp.794–810). Cash has been described as the ‘lifeblood’ of a business. In order to survive, a business must retain an uninterrupted capacity to pay its maturing obligations. The efficient management of cash is, therefore, of critical importance to a business. When reading the relevant chapter you should note the importance of controlling the cash collection and payments cycle and the cash transmission techniques available.

Working capital and the problem of overtrading Overtrading will arise where the level of working capital and fixed assets employed by a business is insufficient for its level of operations. Overtrading often occurs when a new business expands its trading operations quickly but is unable to find the necessary finance to invest in fixed assets and working capital. The consequences of overtrading are liquidity problems and difficulties in supplying customers (through an inability to purchase the necessary stock). At the extreme, a business may be forced to cease trading because it lacks the cash to meet maturing obligations. Financial ratios may help detect the symptoms of overtrading. The financial statements of a business which is overtrading may reveal low liquidity ratios, high asset/ sales ratios and a poor average creditors’ payment period. 136


Overtrading is a reflection of weak financial management. It may arise through such factors as poor forecasting of profits and cash flows, failure to control costs or a failure to attract finance at the appropriate times. To deal with the problem of overtrading it is necessary to bring the level of operational activity into line with the level of finance available (even if this does lead to the rejection of profitable opportunities in the short-term). Careful monitoring and control of fixed asset utilisation and working capital is essential. Example 11.6 (This example is adapted from the 2008 subject guide) Danton Ltd. began trading recently on 1 April 2008 with a balance at the bank of £300,000. The business is both a wholesaler and retailer of carpets and floor coverings. During the first month of trading the business will make payments for fixtures and fittings of £15,000 and £8,000 for motor vehicles. In addition, the business will acquire an initial stock on credit costing £24,000. The business has agreed with its bank an overdraft facility of £20,000 to cover the first year of trading. Danton Ltd has provided the following estimates: 1. The gross profit percentage on all goods sold will be 25%. 2. Sales during April are expected to be £10,000 and to increase at the rate of £4,000 per month until the end of July. From August onwards, sales are likely to remain at a stable level of £24,000 per month. 3. The business is concerned that supplies will be difficult to obtain later in the year and so, during the first six months of the year, it intends to increase the initial stock level of £24,000 by purchasing an additional £2,000 worth of stock each month in addition to the monthly purchases required to satisfy monthly sales. All stock purchases, including the initial stock, will be on one month’s credit. 4. 60% of sales are expected to be on credit with the remainder being for cash. Credit sales will be paid two months after the sale has been made. 5. Administration expenses are likely to be £1,000 per month and selling and distribution expenses will be £700 per month. Included in the administration expenses is a charge of £200 per month for depreciation and included in selling and distribution expenses is a charge for £300 per month depreciation. Administration expenses and selling and distribution expenses are payable in the month incurred. 6. The business intends to buy more fixtures and fittings in June for £8,000 cash. 7. The initial bank balance arose from the issue of 60,000 ordinary shares payable in instalments. The second instalment of £0.50 per share is payable in September 2008. Required: a. Prepare a cash flow forecast for the six months ended 30 September 2008 showing the cash balance at the end of each month. b. State what problems the business is likely to face in the forthcoming six months and how might these be dealt with?

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Solution to Example 11.6 a. Cash flow forecast for the six months to 30 September 2008

Apr £’000

May £’000

June £’000

July £’000

Aug £’000

Sept £’000

Receipts Share issue

30.0

Credit sales Cash sales

6.0

8.4

10.8

13.2

4.0

5.6

7.2

8.8

9.6

9.6

4.0

5.6

13.2

17.2

20.4

52.8

Payments Fixtures Motor vehicles

15.0

8.0

8.0

Initial stock

24.0

Purchases

9.5

12.5

15.5

18.5

20.0

Admin expenses

0.8

0.8

0.8

0.8

0.8

0.8

Selling expenses

0.4

0.4

0.4

0.4

0.4

0.4

24.2

34.7

21.7

16.7

19.7

21.2

(20.2)

(29.1)

(8.5)

0.5

0.7

31.6

Opening balance

30.0

9.8

(19.3)

(27.8)

(27.3)

(26.6)

Closing balance

9.8

(19.3)

(27.8)

(27.3)

(26.6)

5.0

Cash surplus /(deficit)

Notes: 1. Purchases represent 75% of the sales for the relevant month plus an extra £2,000 for stockbuilding. 2. Depreciation is a non-cash item and therefore is excluded from the relevant expense figures. b. The cash flow forecast above reveals that the agreed overdraft limit of £20,000 will be exceeded in three consecutive months. However, the proceeds of the second instalment of the share issue will bring the business into cash surplus by the end of the six month period under review. It may, therefore, be possible to negotiate an increase in the overdraft limit to deal with this short-term problem. If this is not possible the business must consider other options. For example, it may be possible to defer the purchase of the fixtures and fittings in June until a later date. (It is this purchase which pushes the business over its overdraft limit.) However, if this is not possible, then the business might consider other options such as the deferring of payments to trade suppliers, reducing the credit period to customers, and reducing the level of credit sales. These options, however, may involve some cost to the business.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential readings and activities, you should be able to: • describe the main focuses of financial planning • evaluate the approaches to, and methods of, financial planning • explain the importance of working capital management • discuss techniques used to assist planning and management.

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Practice questions BMA, Chapter 29, Question 24. BMA, Chapter 30, Questions 14 and 23.

Sample examination questions 1. Consider the advantages and disadvantages of funding all of a company’s current assets from bank advances or other short-term sources. 2. How might a firm go about determining its target cash balance? Evaluate the model(s) you have recommended. 3. Consider the derivation and implementation of an optimal trade credit policy. Discuss. 4. BMA, Chapter 28, Questions 2, 4, 22 and 28. 5. BMA, Chapter 29, Questions 21–22. 6. BMA, Chapter 30, Questions 24 and 38–41.

139


Notes

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Chapter 12: Risk management

Chapter 12: Risk management Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 20–22, 26 and 27.

Further reading Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 24 and 25.

Works cited Haushalter, D, ‘Financial policy, basis risk and corporate hedging’, Journal of Finance 55, 2000, pp.107–52.

Aims Companies undertake investments with various levels of risk. In Chapter 3 we discussed how risk could be diversified. In this chapter, we examine other techniques in risk management.

Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • describe the reasons for companies managing risk • identify the different risks that companies are exposed to • evaluate the techniques to reduce risk exposure.

Introduction Managing financial risk of a company is essential. There are roughly three types of financial risk which companies need to focus on: 1. Interest rate risk management Companies with mainly floating (variable) rate debt face the risk of increase in interest rates. If interest rates do rise, these companies will be faced with higher interest payments (increased financial risk and decreased cash flows). Those companies with mainly fixed interest debt also face the risk that interest rates may fall. This decreases their comparative advantage compared to companies with mainly floating rate debt. It is therefore important for companies to manage interest rate risk. 2. Exchange rate risk management Exchange rate fluctuations may cause losses to multinational companies. There are three types of exchange risk: • Transaction risk: Companies which expect foreign currency receipts face the risk that the foreign currency may depreciate against the domestic currency. On the other hand, companies which expect to settle future payments in foreign currency face the risk that the foreign currency appreciates against the domestic currency. 141


• Translation risk: This is the risk that a company may face when translating foreign currency based assets, liabilities and profits on consolidation. Exchange rate movements may result in the company experiencing a gain or loss. Even though the translation gain or loss is only an accounting treatment on paper, it may affect investors’ perception of the profitability of those companies. • Economic risk: This is the risk relating to the long-term exchange rate movements affecting a multinational company’s competitive advantage or reducing the NPV of its operations. This is a risk that companies would probably not be able to avoid. Therefore it is important to manage exchange rate risk to stabilise operating cash flows. 3. Delivery price risk management Companies which buy or sell commodities such as crude oil, copper, cocoa, cotton and metal might find it advantageous to manage their exposure to the price changes of these commodities.

Reasons for managing risk The following reasons for managing risk are given as sensible by BMA: • Reducing the risk of cash shortfalls or financial distress. Stable cash flows and reduced risk of financial distress are often seen favourably by bondholders. The ability of a company to reduce or hedge risk in order to stablise cash flows would provide bondholders with additional confidence. This allows a company to tap into the bond market. Haushalter (2000) finds that those firms which hedge risk have higher debt ratios and low dividend payouts. It seems that hedging programmes help these firms to access debt finance and to reduce the possibility of financial distress. Years

Nominal

Inflation-adjusted

2000

$27.39

$35.76

2001

$23.00

$29.23

2002

$22.81

$28.50

2003

$27.69

$33.86

2004

$37.66

$44.81

2005

$50.04

$57.57

2006

$58.30

$65.03

2007

$64.20

$69.51

2008

$91.48

$95.25

2009

$53.48

$55.96

2010

$71.21

$73.44

Table 12.1: The annual average crude oil price from 2000 to 2010. Note: Prices are adjusted for inflation to April 2011 prices using the Consumer Price Index (CPI-U) as presented by the US Bureau of Labor Statistics. Figures are price per barrel.

Source: http://inflationdata.com/inflation/inflation_rate/historical_oil_prices_table.asp © 2010 Timothy McMahon.

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• Agency costs may be mitigated by risk management. A company’s profit may increase without the effort of internal management. For example, oil prices have risen a lot in the first decade of the twenty-first century (see Table 12.1). During the same period, airline companies’ profits plummeted, whereas oil companies made record-breaking profits. The question is how much of the increase (or decrease) in profit is due to the effort (or lack of effort) by internal management? It is argued that risk management will reduce the chance of speculative profit and therefore the effect of managerial effort will be revealed more readily. Activity 12.1 Attempt Question 13 of BMA, Chapter 26, p.699. See VLE for solution.

Instruments for hedging risk Options An option gives a right to buy or sell an asset or security at a predetermined (exercise) price at or before a predetermined (expiry) date. An option which gives the right to buy is known as a call option. An option which gives the right to sell is a put option. A European option is an option which can only be exercised on the expiry date whereas an American option allows holders to exercise during the lifetime of the option. Options can be written on different types of assets or securities. For example, there are options on shares, stock indices, bonds, commodities, foreign currency exchange rates and interest rates. The following table gives the relationship between the buyer and seller of options. Buyer

Seller

Call option

Right to buy

Obliged to sell

Put option

Right to sell

Obliged to buy

An option is said to be in-the-money if it would lead to a profit for its holder when it is exercised. An option is said to be out-of-the-money if it would be unprofitable for its holder when it is exercised. Example 12.1 A typical option written on a stock can be traded on the Chicago Board Options Exchange. It might have different exercise prices such as the options below:

Options

Expiry

Exercise price

Call price

Put price

1

May 2011

45

10.50

1.97

2

May 2011

50

6.75

3.15

3

May 2011

55

3.85

5.25

Pay-off of an option The pay-off of an option depends on the cash position at the time when the option is exercised. Suppose the price of the underlying asset on which the call option is written is ST at any time T. Upon exercising the option, the buyer will get either 0 (if the asset price is lower than the 143


exercise price) or ST – X if the asset price is higher than the exercise price. Consequently the pay-off of a call option is Max [0, ST – X]. The pay-off of a put option, on the other hand, is Max [0, X – ST]. The value of an option at the expiry date can be expressed as a function of the stock price and its exercise price. Example 12.2 Suppose today is 1 February 2011. Option 3 in Example 12.1 expires in three months’ time. It has an exercise price of $55. The pay-offs of a call and a put against the future share price in three months’ time are:

Stock price

$30

$40

$50

$60

$70

$80

Call

0

0

0

5

15

25

Put

25

15

5

0

0

0

When the share price is equal to or less than the exercise price, the call option will not be exercised. The pay-off is therefore zero. However, when the share price is higher than $55, the call option will be exercised. The pay-off of the call option will be ST – 55. On the other hand, when the share price is below the exercise price, the put option will be exercised and the pay-off will be $55 – ST. The pay-off diagram for the above scenario would be:

Pay-off ($)

20

0

55 Pay-off to a call holder

75

Share price

Figure 12.1: Pay-off to a call holder diagram

Activity 12.2 Now try to draw the pay-off diagrams for Options 1 and 2 in Example 12.1. See VLE for solution.

Some simple uses of options • Suppose an investor has a portfolio of shares in the FTSE100 index. He or she could cap the downside risk of this portfolio by writing a put option. This strategy is called a ‘protective put’, which has the following pay-off. When the FTSE index falls below the exercise price, the investor could exercise the put option. The pay-off from the put will cancel out the loss in value of the portfolio. • Suppose the FTSE100 index is going to be very volatile in the next three months. An investor can write a call and a put on the index with the same exercise price. He or she will gain from the pay-off of the call or the put whichever direction the FTSE100 index may go. Similarly, an investor who is already holding the FTSE100 as an investment portfolio could reduce the market volatility by writing a call and a put. 144


Put-call parity Suppose we have a call and a put (both with the same exercise price = X) and both are written on the same underlying stock, S. We can combine them to form a riskless portfolio. Let’s look at the pay-off of the following strategy:

T0

T1 S1 < X

S1 = X

S1 > X

Write a call

–C

0

0

S1 – X

Sell a put

P

– (X – S1)

0

0

Sell the stock

S

– S1

– S1

– S1

Net cash flows

S+P–C

–X

Cash flows

Buy

–X

As long as the future share price moves away from the exercise price, this strategy will ensure that an investment will earn a positive cash flow at T0 and repay X at T1. The cash flow at T0 is equivalent to a risk-free borrowing of X/(1 + rf). Therefore we have the put-call parity:


Corporate uses of options Apart from having options written on corporate shares and stock market indices, options can often be found implicitly in corporate financial instruments: Share option schemes – Corporations give share options to their employees to reward their services. Employees who receive such a share option have the right to buy shares from their firms at a predetermined price. Unlike a call option written on a share, this share option does require the issuing of the new shares if it is exercised. Warrants – This is an instrument very similar to a share option. A firm can issue warrants to both private and public investors for an issue price. Holders of warrants can exercise the right to buy shares from the firm if they wish, within a set period of time. Physical shares must be created, issued and delivered to the investors. Convertible bonds – A convertible bond is an instrument which has two financial components. It allows the holder to earn a fixed (or variable) interest on the face value of the bond but also gives the right to the holder to ‘convert’ it into shares. Effectively, it is a straight bond with a warrant but without any outlay. Rights issues – A rights issue is an issuance of shares to a firm’s existing shareholders. It gives the right to the shareholders to buy shares from the firm at a pre-set price based on the percentage of their shareholdings in the firm. Share underwriting (put option) – We have discussed underwriting in Chapter 5. A firm who appoints an underwriter in a share issue has effectively purchased a put option to sell shares (the unsubscribed shares in a share issue) to the underwriters at the pre-determined price. Real options – In Chapter 2 we discussed project appraisals. Most of the examples we looked at are fixed-term projects. However, in real life, most 145


projects or investments can be extended if the company wishes. Therefore, effectively, a project’s true NPV should be based on the NPV of the project based on the fixed term estimates plus the value which can be derived from extending its life. The value from the extension of life is effectively the value of the option implicit in it. Taking control of a company – Shareholders who invest in a firm which has both debt and equity are effectively holding a call option over the firm’s assets. If the asset value is below the face value of the debt, they would not exercise the option and allow it to expire.

Option pricing An option (call or put) gives the rights to the holders to buy or sell an asset at a pre-determined price within a pre-determined period. It derives its value from the underlying asset on which it is written. Example 12.3 (based on BMA, pp.554–57) A call option with an exercise price of £100 is written on a share with a current price at £100. The share price is expected to rise to either £105 or fall to £95 in three months’ time. The effective risk-free rate for the next three months is 3%. Suppose one writes a call option on this share (i.e. buy a call option which gives us the rights to buy the share at £100 in 3 months’ time). The cash flow implication is as follows:

T1 Buy a call

T0

S = £105

S = £95

–C

S – X = £105 – 100 = £5

Not exercise, £0

Now consider an alternative investment – borrow £45/1.03 now and buy half a share at £50. The cash flow implication of this alternative would be:

T1 T0

S = £105

S = £95

Buy half a share

– £50

£52.5

£47.5

Borrow then repay

+£47.5/1.03

– £47.5

– £47.5

– £50+47.5/1.03

£5

£0

Since the future cash flows of buying a call now and buying half a share and borrow at the risk-free rate are identical, the initial cash positions must be identical, too (in an efficient market where arbitrage opportunity is eliminated). The cost of the call value must be: C = 50 – 47.5/1.03 = 3.88 How do we know how many shares we need to buy and how much we need to borrow to create a replicated portfolio for the call? Assume that we can rewrite C as: (12.1)

B = The PV of the difference between the pay-offs from the option and the payoffs from ∆ of the share.

146

Chapter 12: Risk management A more formal derivation of an option based on the binomial distribution (share prices go up and down in each period by exact percentages) can be found in BMA pp.558–62. Suppose we can define the price changes of an asset over an infinitely small interval. The equation (12.1) can be approximated by the Black-Scholes formula. The value of a call = ∆S + Bank Loan

where (12.2)


Futures and forward contracts A forward contract is an agreement between two parties to conclude a transaction at a fixed date at a fixed price. It is a custom-made contract that is only traded ‘over-the-counter’. A futures contract is similar to a forward contract but it is traded on an exchange. It is therefore a standardised contract. Both futures and forward contracts require parties to deliver the underlying asset or commodity. However, a futures contract requires investors to mark-to-market. The following table shows the main differences of options, forward and futures contracts. Options

Forward

Futures

Structure

Standardised: on stock and bond indices, stock, bonds, interest rate, commodities and currency

Custom-made, can be created on any items

Standardised: on stock and bond indices, stock, bonds, interest rate, commodities and currency

Markets

Traded on exchanges with transparent prices

Over-the-counter

Traded on exchanges with transparent prices

Cash flows

Require payment of an initial premium (i.e. the price of a call or a put)

Not require an initial premium

Not require an initial premium

Physical delivery

No delivery of the underlying asset required but the pay-off is transacted

Delivery required

Delivery required

Table 12.2: Differences between options, forward and futures contracts.

Pricing You should refer to BMA Chapter 26, pp.684–88. It should be noted that the pricing formulae are different for a commodity and financial futures contract.

147



Risk management Interest rate risk Internal management Interest rate risk can be hedged internally by the following techniques: Smoothing – This involves a balanced financing with floating and fixed rate debt. When the interest rate rises, the increased cost of floating rate debt is cancelled by the lower cost of fixed rate debt. Likewise, when the interest rate falls, the higher relative cost of fixed rate debt will be balanced out by the decreased cost of floating rate debt. Matching – This involves matching assets and liabilities with similar interest rates. When the interest rate changes, the change in values of both assets and liabilities will be cancelled out by each other. Matching is mainly used by financial institutions. External management Companies can purchase futures to hedge against a fall in interest rates and sell futures to hedge against a rise in interest rates. Interest rate futures often run in a three-month cycle (March, June, September and December) and are priced by subtracting the interest rate from 100. A futures contract with an interest rate of 5% is sold at £95. Profits and losses are calculated from the changes in the futures prices. Example 12.4 A firm is going to borrow £950,000 in three months’ time for three months. The current interest rate is 5% and is expected to rise in the future. Current position

• The interest rate future is traded at £95 (100 – 5). • Number of contracts sold to hedge the total borrowing = £950,000/95 = 10,000 contracts. • A one tick price change = the value of the futures contract  one tick1  number of months covered by the contracts/12; i.e. £950,000  0.0001  3/12 = £23.75. Future position

• Suppose the interest rate has risen to 7% in three months’ time. The futures price will be 93 (100 – 7). • Gain on futures = No. of ticks  the price change per tick = 200  £23.75 = £4,750 • Increase in borrowing cost = Amount of borrowing  increase in interest rate  number of months of the loan/12 = £950,000  0.02  3/12 = £4,750 Interest rate hedge has exactly offset the higher borrowing cost. This is a perfect hedge.

148

1

One tick is equivalent to 1 basis point; i.e. 0.01%


Exchange risk Internal management Matching – Translation risk can be hedged if foreign currency based assets and liabilities are matched. Transaction risk can be hedged if inflows and outflows are in the same currency. Netting – Companies can net off foreign currency transactions that occur at the same time and in the same currency, and hedge only the net exposure. Invoicing in the domestic currency – One easy way to reduce exchange rate risk is to avoid receipts and payments in foreign currency. An exporter who purchases and pays for supplies in domestic currency may invoice foreign customers in its own domestic currency. External management Forward/futures contracts. Example 12.5 Suppose a UK exporter is expecting to receive a payment of $100,000 from a US customer in three months’ time. The current (spot) exchange rate is £1 to $1.60. A forward contract to sell $ in three months gives a rate of £1 to $1.65. The exporter can engage in this forward contract and lock into an exchange rate of £1 to $1.65. So in three months’ time, the exporter, upon receiving $100,000, would then sell it at £1:$1.65. Effectively he will receive £60,606 in three months’ time. Alternatively the exporter can hedge the exchange risk via the money markets. Knowing that he will receive $100,000 in three months’ time, the exporter can borrow $X now at a borrowing rate of r% for three months. When the loan is due, the exporter will repay the loan plus interest (i.e. $X(1+r)) out of the proceeds from the US customer. If this payment can be covered entirely by the $100,000 expected to be received from the US customer in three months’ time, then we have a perfect hedge. The exporter can borrow $X now and convert it into £ at the spot rate and the repayment of the loan and interest will be covered by the future receipt.

Activity 12.6 How much should the exporter borrow now in Example 12.5? See VLE for solution. In an efficient market when any arbitrage opportunity is eliminated, the two hedging exercises should give identical outcomes. Suppose the three month interest rate in $ is r % and the three month interest rate in £ is R%. If we hedge via the money market, we must repay $100,000 in three months. It means that we must borrow $100,000/ (1+r %) now. Convert this amount into £ at the spot exchange rate (i.e. $100,000/(1+r %)/1.6) and deposit into a £ account for three months. In three months we will get $100,000/(1+r %)/1.6 x (1+R%). This sum must be identical to the cash flow the exporter will get in three months from his forward contract position. Therefore we have:

100,000 u 1 R 60,606 1 r 1.6 1 r 1 R

100,000 1.65

1.65 1.6 149


What it implies is that the ratio of the interest rate in $ to £ must be identical to the ratio of the future to spot exchange rates. Advantages and disadvantages of using futures to hedge risk Advantages: • Unlike options, futures contracts do not require payment of an initial premium. • Unlike forwards, futures are tradable and have transparent prices. • Contracts are marked-to-market on a daily basis thereby reducing the potential loss on default. Disadvantages: • There is a cash flow implication from the mark-to-market requirement. The significant variation margin might cause a company to run out of cash. See the case of Barings and Nick Leeson.2 • It is difficult to construct a perfect hedge. In Example 12.4 we construct a perfect interest rate hedge. However, if the borrowing amount was £1,000,000, we would have needed to have sold £1,000,000/95 = 10,626.3 contracts. Since futures contracts cannot be traded in fractions, we would have to either sell 10,626 or 10,627 contracts. In either case, it would not be a perfect hedge. Apart from interest rates and currency, options and futures can be created on stock market indices, commodity prices and precious metals.

Conclusion Risk management is a very advanced topic in financial management. In this chapter we have only briefly discussed the various methods that a firm may engage in to hedge risk against price movements. We examined the use of options, forwards and futures contracts in risk management and discussed their advantages and disadvantages. You should work through the practice questions and familiarise yourself with the risk management concept.

A reminder of your learning outcomes Having completed this chapter, as well as the Essential reading and activities, you should be able to: • describe the reasons for companies managing risk • identify the different risks that companies are exposed to • evaluate the techniques to reduce risk exposure.

Practice questions BMA Chapter 26, Questions 3, 4 and 16. BMA Chapter 27, Questions 5, 6, 8 and 9.

150

2 www.riskglossary.com/ link/barings_debacle. htm


Sample examination questions 1. Explain clearly the factors that affect the price of a European put option. 2. Explain how you can use options in the following situations: a. Suppose you don’t own a share, how would you create a share position without buying a share? b. Suppose you now own a share, how do you insure it against any fluctuation in the share price? c. Suppose you do not own a share. You expect the share price might go up and down in the next period. How would you use options to bet on this share’s volatility? 3. What is a financial futures contract? Explain the main use of it in risk management. Give examples to illustrate your argument.

151


Notes

152

Appendix 1: Sample examination paper

Appendix 1: Sample examination paper Important note: The format and structure of the examination may have changed since the publication of this subject guide. You can find the most recent examination papers on the VLE where all changes to the format of the examination are posted. Time allowed: three hours Candidates should answer FOUR of the following EIGHT questions. All questions carry equal marks. Workings should be submitted for all questions requiring calculations. Any necessary assumptions introduced in answering a question are to be stated. 8-column accounting paper is provided at the end of this question paper. If used, it must be detached and fastened securely inside the answer book. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given in the Regulations The make and type of machine must be clearly stated on the front cover of the answer book. Question 1 (Answer both parts) a. Outline the main factors that a company should consider if it wants to offer its shares to the public for the first time (Initial Public Offer)? (10 marks) b. Discuss the pros and cons of each of the following three methods in valuing a company’s share. i. Asset-based method ii. Earning-based method iii. Discounted dividend method (15 marks) Total 25 marks Question 2 Yamamoto Ltd. has the following three bonds outstanding on 31 December 2009: Maturity (years)

Coupon (%)

Face value, £’000

Bond A

5

10

1,000

Bond B

20

12

3,000

Bond C

15

0

2,500

The company’s financial director believes that Yamamoto is a financially sound company and it would have at least an Aa rating for its bonds. Currently a one-year UK gilt has an expected return of 5% per annum. Required: a. Based on the information given above, calculate the value of each of

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the three bonds. What further information would you require in order to refine your valuation of these bonds? (15 marks) b. Explain clearly why companies such as Yamamoto Ltd. might issue bonds with different maturities, coupon rates and face value? (10 marks) Total 25 marks Question 3 Lion plc is a newly set up IT company. It has very few capital assets. However, the directors are committed to spend a significant amount on research and development activities every year. Currently the company is operating at a loss. The profit forecast indicates that it will become profitable in three years’ time. Profit will rise rapidly at a rate of 20% per annum thereafter for a period of no more than 5 years. It is then expected to have a more moderate growth of 5% per annum. The company has a cost of capital of 10% and it is 100% equity financed. Required: Advise the management of Lion plc what capital structure policy it should adopt for the next 3, 8 and 20 years. Your advice must include an explanation of the appropriate financial theory on capital structure. (25 marks) Total 25 marks Question 4 (Answer both parts) a. Explain clearly the following terms: i. Weak form efficiency. ii. Semi-strong form efficiency. iii. Strong form efficiency. What are the implications for the market to be informationally efficient to both the investors and companies? (13 marks) b. Identify and explain which forms of efficiency are adhered to and/or violated in each of the following hypothetical situations: i. Weekly returns appear to be weakly but positively correlated with each other. ii. The top 10 investment funds in the UK out-performed the UK market by an average of 5% in 2009. iii. A group of students from a famous Business School has created a trading rule which appears to out-perform the UK market. iv. Royal Petrol plc has just revealed that it has discovered a new method to turn domestic waste into petrol. Its share price rises by 5%. (12 marks) Total 25 marks Question 5 Apple Inc. is one of the most talked-about companies in recent years. From

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its success in iPod to the latest iMac, the company has enjoyed a healthy increase of earnings for the past years. However, the company has decided to maintain its no dividend policy. Required: Critically discuss the various financial theories on dividend policy. In your answer, you should also discuss the implications of a no dividend policy, such as the one adopted by Apple Inc., on the company and its investors. (25 marks) Total 25 marks Question 6 (Answer all parts) a. Explain clearly the factors that affect the price of a European call option. (8 marks) b. Suppose Shadow plc, a construction company financed by both debt and equity, is considering a project. If the project succeeds, the value of the company in one year’s time will be £25 million. If the project fails, the company’s value in one year’s time will only be worth £16 million. The current value of Shadow plc is £20 million which takes into consideration the prospect of the proposed new project. The company has an outstanding zero-coupon bond which matures in one year’s time with a face value of £19 million. The company pays no dividends and a UK gilt that matures in a year has a yield of 7%. Using the binomial (or two-state) option-pricing model, find the value of the bond and equity of Shadow plc respectively. (8 marks) c. Explain how you can use options and futures to hedge risk. Give examples to illustrate your argument. (9 marks) Total 25 marks Question 7 West Central plc has been quoted on the London Stock Exchange for 10 years. A regression analysis using the last 10 years of data reveals the observed equity beta of 1.20 for the company. The company has 60% of equity and 40% debt. The current market value of West Central plc is £100 million. The company is going to undertake a risky project which has an estimated beta of 2.5. The project is expected to be financed entirely by equity. As a result of this financing option and the undertaking of the project, the company will have 70% of equity and 30% of debt measured at market values. The risk-free rate is expected to be 5% per annum and the expected return on the market is approximated to be 10% per annum. West Central plc pays corporate tax at 40%. The company’s debt is thought to be risk-free. Required: a. Calculate the company’s beta before the proposed project. (4 marks) b. Calculate the company’s market value after the proposed project and the funding option. (5 marks) c. Calculate the net present value of the project.

(2 marks)

d. Calculate the company’s beta after the project.

(4 marks)

e. Advise the management if the project should be funded entirely with 155


equity. What further information would you seek before you finalise your advice? (10 marks) Total 25 marks Question 8 (Answer all parts) a. What are the main motives for mergers and acquisitions?

(8 marks)

b. As a finance director of Tudor plc, you are examining a proposal to acquire Windsor plc. The following current data is available:

Earnings per share Dividend per share No. of shares Share price

Tudor 100p 60p 20m £18

Windsor 30p 16p 12m £4

Assume that Windsor is expected to have a dividend growth rate of 6% per annum, but that under the management of Tudor plc, the growth rate would increase to 8% without any additional investment. i. Calculate the gain from the acquisition.

(6 marks)

ii. Calculate the net gain of the acquisition if Tudor plc pays £5 for each of Windsor’s shares. (3 marks) iii. What is the gain of the acquisition if one of Tudor’s shares is (6 marks) exchanged for every three of Windsor’s shares? iv. How would your answer to (ii) and (iii) alter if Tudor plc failed to increase the growth rate of Windsor plc? (2 marks) Total: 25 marks

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Example of 8-column accounting paper

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Notes

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Notes

Notes

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Notes

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AC3059 Financial Management Subject Guide 2012

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