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ACCA Paper F9

Financial
Management
Class Notes

Interactive World Wide Ltd, September 2015


All rights reserved. No part of this publication may be reproduced, stored in a
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mechanical, photocopying, recording or otherwise, without the prior written
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Contents
PAGE
INTRODUCTION TO THE PAPER

FORMULAE GIVEN IN THE EXAMINATION PAPER

CHAPTER 1:

FINANCIAL MANAGEMENT: AN INTRODUCTION

11

CHAPTER 2:

FUNDAMENTAL FINANCIAL MATHEMATICS

19

CHAPTER 3:

CAPITAL BUDGETING

27

CHAPTER 4:

INVESTMENT APPRAISAL TECHNIQUES

39

CHAPTER 5:

SOURCES OF LONG TERM FINANCE

55

CHAPTER 6:

COST OF CAPITAL

63

CHAPTER 7:

CAPITAL STRUCTURE FINANCIAL RISK

77

CHAPTER 8:

BUSINESS RISK AND ADJUSTED DISCOUNT RATES

83

CHAPTER 9:

FINANCIAL PERFORMANCE MEASUREMENT

93

CHAPTER 10: RAISING EQUITY FINANCE

105

CHAPTER 11: EFFICIENT MARKET HYPOTHESIS

113

CHAPTER 12: VALUATION

119

CHAPTER 13: RISK

133

CHAPTER 14: WORKING CAPITAL MANAGEMENT

151

SOLUTIONS TO EXAMPLES

173

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Introduction to the
paper

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INTRODUCTION TO THE PAPER

AIM OF THE PAPER


The aim of the paper is to develop knowledge and skills expected of a financial
manager, in relation to investment, financing and dividend policy decisions.

OUTLINE OF THE SYLLABUS


A.

Financial management function

B.

Financial management environment

C.

Working capital management

D.

Investment appraisal

E.

Business finance

F.

Business valuations

G.

Risk management

FORMAT OF THE EXAM PAPER


The syllabus is assessed by a three hour paper-based examination with 15 minutes
of reading time.
Section A of the exam comprises 20 multiple choice questions of 2 marks each.
Section B of the exam comprises three 10 mark questions and two 15 mark
questions.

FAQs
What level of mathematical ability is required in F9?
You will be required to apply formulae either given or memorised. This may require
limited manipulation of formulae. The level of computational complexity is normally
inversely related to the conceptual difficulty of the topic.

What do I need to bring to class?


You will need pen, paper, these notes and revision kit. In addition you will need a
standard scientific calculator which may be purchased in any large newsagents or
supermarket.

Is there any assumed knowledge?


The only real overlap is with basic concepts explored in paper F2 and also elements
of decision making and cost behaviour covered in paper F5.

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Formulae given in the


examination paper

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FORMULAE GIVEN IN TH E EXAMINATION PAPER

FORMULAE
Economic Order Quantity
=

2C0D
CH

Miller-Orr Model
Return point = Lower limit + (1/3 spread)
1

3
3
4 transaction cost variance of cash flows
Spread = 3

interest rate

The Capital Asset Pricing Model


E(ri) = Rf + i (E (rm) Rf)

The Asset Beta Formula

V (1 T)

e
d
a =
e +
d
(Ve Vd(1 T))
(Ve Vd(1 T))

The Growth Model


P0 =

D0(1 g)
D (1 g)
or P0 = 0
(Ke g)
(re g)

Gordons Growth Approximation


g = bre

The weighted average cost of capital

WACC = e ke + d kd (1T)
Ve Vd
Ve Vd

The Fisher formula


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

Purchasing Power Parity and Interest Rate Parity

S 1 = S0

(1 hc )
(1 hb )

F0 = S0

(1 ic )
(1 ib )
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FORMULAE GIVEN IN TH E EXAMINATION PAPER

Present Value Table


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

=
=

-n

discount rate
number of periods until payment
Discount rate (r)

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

0.990
0.980
0.971
0.961
0.951

0.980
0.961
0.942
0.924
0.906

0.971
0.943
0.915
0.888
0.863

0.962
0.925
0.889
0.855
0.822

0.952
0.907
0.864
0.823
0.784

0.943
0.890
0.840
0.792
0.747

0.935
0.873
0.816
0.763
0.713

0.926
0.857
0.794
0.735
0.681

0.917
0.842
0.772
0.708
0.650

0.909
0.826
0.751
0.683
0.621

1
2
3
4
5

6
7
8
9
10

0.942
0.933
0.923
0.914
0.905

0.888
0.871
0.853
0.837
0.820

0.837
0.813
0.789
0.766
0.744

0.790
0.760
0.731
0.703
0.676

0.746
0.711
0.677
0.645
0.614

0.705
0.665
0.627
0.592
0.558

0.666
0.623
0.582
0.544
0.508

0.630
0.583
0.540
0.500
0.463

0.596
0.547
0.502
0.460
0.422

0.564
6
0.513
7
0.467
8
0.424
9
0.386 10

11 0.896
0.804
0.722
0.650
0.585
0.527
0.475
0.429
0.388
0.350 11
12 0.887
0.788
0.701
0.625
0.557
0.497
0.444
0.397
0.356
0.319 12
13 0.879
0.773
0.681
0.601
0.530
0.469
0.415
0.368
0.326
0.290 13
14 0.870
0.758
0.661
0.577
0.505
0.442
0.388
0.340
0.299
0.263 14
15 0.861
0.743
0.642
0.555
0.481
0.417
0.362
0.315
0.275
0.239 15
________________________________________________________________________________
(n) 11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
________________________________________________________________________________
1
2
3
4
5

0.901
0.812
0.731
0.659
0.593

0.893
0.797
0.712
0.636
0.567

0.885
0.783
0.693
0.613
0.543

0.877
0.769
0.675
0.592
0.519

0.870
0.756
0.658
0.572
0.497

0.862
0.743
0.641
0.552
0.476

0.855
0.731
0.624
0.534
0.456

0.847
0.718
0.609
0.516
0.437

0.840
0.706
0.593
0.499
0.419

0.833
0.694
0.579
0.482
0.402

6
7
8
9
10

0.535
0.482
0.434
0.391
0.352

0.507
0.452
0.404
0.361
0.322

0.480
0.425
0.376
0.333
0.295

0.456
0.400
0.351
0.308
0.270

0.432
0.376
0.327
0.284
0.247

0.410
0.354
0.305
0.263
0.227

0.390
0.333
0.285
0.243
0.208

0.370
0.314
0.266
0.225
0.191

0.352
0.296
0.249
0.209
0.176

0.335
6
0.279
7
0.233
8
0.194
9
0.162 10

11
12
13
14
15

0.317
0.286
0.258
0.232
0.209

0.287
0.257
0.229
0.205
0.183

0.261
0.231
0.204
0.181
0.160

0.237
0.208
0.182
0.160
0.140

0.215
0.187
0.163
0.141
0.123

0.195
0.168
0.145
0.125
0.108

0.178
0.152
0.130
0.111
0.095

0.162
0.137
0.116
0.099
0.084

0.148
0.124
0.104
0.088
0.074

0.135
0.112
0.093
0.078
0.065

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3
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FORMULAE GIVEN IN TH E EXAMINATION PAPER

Annuity Table
Present value of an annuity of 1 i.e.

Where

1 - (1 + r)-n
r

r = discount rate
n = number of periods
Discount rate (r)

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

0.990
1.970
2.941
3.902
4.853

0.980
1.942
2.884
3.808
4.713

0.971
1.913
2.829
3.717
4.580

0.962
1.886
2.775
3.630
4.452

0.952
1.859
2.723
3.546
4.329

0.943
1.833
2.673
3.465
4.212

0.935
1.808
2.624
3.387
4.100

0.926
1.783
2.577
3.312
3.993

0.917
1.759
2.531
3.240
3.890

0.909
1.736
2.487
3.170
3.791

1
2
3
4
5

6
7
8
9
10

5.795
6.728
7.652
8.566
9.471

5.601
6.472
7.325
8.162
8.983

5.417
6.230
7.020
7.786
8.530

5.242
6.002
6.733
7.435
8.111

5.076
5.786
6.463
7.108
7.722

4.917
5.582
6.210
6.802
7.360

4.767
5.389
5.971
6.515
7.024

4.623
5.206
5.747
6.247
6.710

4.486
5.033
5.535
5.995
6.418

4.355
6
4.868
7
5.335
8
5.759
9
6.145 10

11 10.37
9.787
9.253
8.760
8.306
7.887
7.499
7.139
6.805
6.495 11
12 11.26
10.58
9.954
9.385
8.863
8.384
7.943
7.536
7.161
6.814 12
13 12.13
11.35
10.63
9.986
9.394
8.853
8.358
7.904
7.487
7.103 13
14 13.00
12.11
11.30
10.56
9.899
9.295
8.745
8.244
7.786
7.367 14
15 13.87
12.85
11.94
11.12
10.38
9.712
9.108
8.559
8.061
7.606 15
________________________________________________________________________________
(n) 11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
________________________________________________________________________________
1
2
3
4
5

0.901
1.713
2.444
3.102
3.696

0.893
1.690
2.402
3.037
3.605

0.885
1.668
2.361
2.974
3.517

0.877
1.647
2.322
2.914
3.433

0.870
1.626
2.283
2.855
3.352

0.862
1.605
2.246
2.798
3.274

0.855
1.585
2.210
2.743
3.199

0.847
1.566
2.174
2.690
3.127

0.840
1.547
2.140
2.639
3.058

0.833
1.528
2.106
2.589
2.991

6
7
8
9
10

4.231
4.712
5.146
5.537
5.889

4.111
4.564
4.968
5.328
5.650

3.998
4.423
4.799
5.132
5.426

3.889
4.288
4.639
4.946
5.216

3.784
4.160
4.487
4.772
5.019

3.685
4.039
4.344
4.607
4.833

3.589
3.922
4.207
4.451
4.659

3.498
3.812
4.078
4.303
4.494

3.410
3.706
3.954
4.163
4.339

3.326
6
3.605
7
3.837
8
4.031
9
4.192 10

11
12
13
14
15

6.207
6.492
6.750
6.982
7.191

5.938
6.194
6.424
6.628
6.811

5.687
5.918
6.122
6.302
6.462

5.453
5.660
5.842
6.002
6.142

5.234
5.421
5.583
5.724
5.847

5.029
5.197
5.342
5.468
5.575

4.836
4.988
5.118
5.229
5.324

4.656
4.793
4.910
5.008
5.092

4.486
4.611
4.715
4.802
4.876

4.327
4.439
4.533
4.611
4.675

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2
3
4
5

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Chapter 1

Financial
management: an
introduction

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

CHAPTER CONTENTS
WHAT IS FINANCIAL MANAGEMENT? --------------------------------- 13

12

THE PRIMARY FINANCIAL OBJECTIVE

13

THE THREE FINANCIAL MANAGEMENT DECISIONS

15

VALUE FOR MONEY 3 ES

17

STAKEHOLDERS

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

WHAT IS FINANCIAL MANAGEMENT?


The management of all matters associated with the cash flow of the organisation
both short and long-term.

The primary financial objective


MAXIMISE SHAREHOLDER WEALTH
What is shareholder wealth?
The share price multiplied by the total number of shares.

Three factors affecting share price?


1.

2.

3.

Share price formula

P0 =

D0 (1+g)
Ke -g

Where:
P0 is

the current value of the share

D0 is

the dividend just paid

g is

the expected constant annual growth in dividend

Ke is

the % annual return required by shareholders (cost of equity)

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

Example 1
CSI Co has just paid a dividend of 23 cents. General expectation is that dividends
will continue to grow at approximately 4% per annum. The risks perceived by the
shareholders of CSI Co lead them to require an annual return (ke) of 12%.
Required:
(a)

Calculate the current expected share price of CSI Co.

(b)

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


will expect a return of 15%. What impact does this have on the share
price from (a)?

(c)

If CSI Co announces changes to working practices which will lead to


higher growth (at 6% per annum) for the foreseeable future, what
impact will that have on the share price from (a)?

(d)

If the directors of CSI Co announce that the previous growth in


dividends of 4% were to stop with no guarantee of any future growth,
but that the dividend will remain constant at 23 cents, what would
happen to the share price?

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

The three financial management decisions


Financial management involves three main areas of decision making:

the investment decision,

the financing decision,

the dividend decision.

1.

The investment decision

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


1.

Capital assets.

2.

Working capital.

3.

Financial assets.

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

Working capital
The decision on the level of inventory to hold and the level of credit given to
customers (receivables).

Financial assets
The company may have surplus cash to invest and should consider the following
factors when deciding how to invest that cash:
1.

Risk.

2.

Return.

3.

Liquidity.

2.

The financing decision

When looking at the financing of a business there are 4 basic questions to consider:
1.

total funding required,

2.

internally generated vs externally sourced,

3.

debt or equity,

4.

long-term or short-term debt.

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

3.

The dividend decision

The amount of return to be paid in cash to shareholders. The level of dividend paid
will be determined by: profits; available cash; and investment opportunities
requiring funding.
Possible dividend policies:

Constant dividend payout


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

Constant payout ratio


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

Residual dividend policy


The company pays out any remaining earnings after all
opportunities increasing shareholder wealth have been financed.

investment

Dividend irrelevance theory


The theory states that shareholders can create a cash dividend if they so
require, or use dividends to purchase more shares if they wish to increase
their capital wealth.

Interrelationship of decisions
Dividend
Decision

Investment
Decision

Long- or short-term

Debt or Equity

Distribute or Retain?

Does use of available


cash give an
adequate return to
investors?

With an attractive
investment
opportunity, where
will funds come from?

Retained earnings
provide a cheap
source of equity
finance.

Risk & Cost of Capital


The financing decision will dictate the
return required by investors.

Objectives of not-for-profit organisations


These organisations are established to provide services to the community. Such
organisations need funds to finance their operations. The major constraint is the
amount of funds that they would be able to raise. Not-for-profit organisations seek
to use the limited funds to obtain value for money.
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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

Value for money 3 Es


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

measures the cost of obtaining the required quality inputs needed


to produce the service. The aim is to acquire the necessary input
at the lowest possible cost.

Effectiveness means doing the right thing. It measures the extent to which the
service meets its declared objectives.
Efficiency

means doing the right thing well. It relates to the level of output
generated by a given input. Reducing the input:output ratio is an
indication of increased efficiency.

Example ---- in refuse collection service,


The service will be economic if it is able to minimise the cost of weekly collection
and not suffer from wasted use of resources.
The service will be effective if it meet its target of weekly collection.
The service will be efficient if it is able to raise the number of collection per vehicle
per week.

Stakeholders
Stakeholders are any party that has both an interest in and relationship with the
company. The responsibility of an organisation is to balance the requirements of all
stakeholder groups in relation to the relative economic power of each group.

Conflict between stakeholder groups


The very nature of looking at stakeholders is that the level of return is finite within
an organisation. There is a need to balance the needs of all groups in relation to
their relative strength.

Agency theory

Principal

Agent
The principal is the shareholder, owning the company. The principals objective is
to increase wealth through income, capital growth and risk management.
The principals appoint directors as their agents to carry out the day-to-day
business of the company. The directors goals are likely to be to maximise their
own remuneration.

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CHAPTER 1 FINANCIAL MANAGEMENT: AN INTRODUCTION

Goal congruence
For an organisation to function properly, it is essential to achieve goal congruence
at all levels. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be carefully designed incentives
for managers and the workforce which would motivate them to take decisions which
will be consistent with the objectives of the shareholders.

Maximising profits
Within organisations it is normal to reward management on some measure of profit.
We would expect a close relationship between profit and shareholders wealth.
There are, however, ways in which they may conflict such as:
1.

Short-termism.

2.

Cash vs accruals.

3.

Risk.

Short-termism
A profit target is normally calculated over one year; it is relatively easy to
manipulate profit over that period to enhance rewards at the expense of future
years.

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

Risk
A manager may be inclined to accept very risky projects in order to achieve profit
targets which in turn would adversely affect the value of the business.

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Chapter 2

Fundamental financial
mathematics

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19

CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

CHAPTER CONTENTS
COMPOUNDING & GROWTH -------------------------------------------- 21
INTEREST

21

INFLATION

21

DISCOUNTING ----------------------------------------------------------- 22
ANNUITIES AND PERPETUITIES --------------------------------------- 25

20

ANNUITIES

25

PERPETUITIES

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

COMPOUNDING & GROWTH


An initial monetary value (PV) will grow at a rate (r) which is constant each time
period (often one year) for a number of periods (n).
A compounding or growth calculation will give us the end value in the future (FV).

FV = PV(1 + r)n
(r is the decimal form of the interest or inflation rate in question).

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

Example 1
Terry Co has $10,000 to invest for 4 years and can put it in an account that will
earn 5% each year.
Required:
Calculate the balance available to Terry Co after 4 years.

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

Example 2
FLT Co is currently paying $12 per unit to produce a product which is then sold for
$30 per unit.
The cost is expected to rise by 6% per annum due to inflation whilst the sales price
is expected to rise by 4.5% each year.
Required:
Calculate the price, cost and contribution per unit for FLT Cos product for
each of the next four years.
Year

Price ($30)
Cost ($12)
Contribution

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

DISCOUNTING
When a required or expected future value (FV) at a certain time (after n periods) is
known, we use a discounting calculation to find the amount that ought to be
invested now (PV), earning a certain rate (r) each period (for n periods).

Example 3
Terry Co expects to make a payment of $12,155 in 4 years time and can put
money in an account now that will earn 5% each year.
Required:
Calculate the maximum that Terry needs to invest now.

Formula
PV = FV(1 + r)-n
All terms as for compounding.

Example 4
Terry Co is able to earn 5%. How much should be invested now in order to receive
a sum of $360,000 after 2 years and a further $280,000 after 5 years?
Year (n)

FV

2
360,000

5
280,000

(1 + r)-n
Present Value

Present value factors


Tables given in the exam show the values of (1 + r)-n for whole number values of r
between 1% and 20% and for time periods until cash flow of 1 to 15.

Time value
In examples 1 and 3, Terry Co will be indifferent between a sum of $10,000 now
and a sum of $12,155 after 4 years. Although the absolute figures are different,
they have the same value to Terry Co due to the time value of money.

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

Cost of capital
The cost of capital is the return that an investor expects from a particular type of
investment. It is stated as a percentage amount and reflects the risk that the
investment carries.

Annuities
An annuity is a cash flow where the same amount is received or paid each time
period for a set number of periods.
Instead of multiplying each cash flow by its present value factor (PVF), the PVFs
can be added together and the sum multiplied by a single value of the annuity.

Example 5
Terry Co expects to receive a payment of $40,000 next year and for the following 4
years. Terry has a cost of capital of 5%.
Required:
Calculate the present value of the annuity:
(i)

using PVFs for each cash flow, and

(ii)

using the shorter approach.

Year
FV

40,000

40,000

40,000

40,000

40,000

PVF
Present Value

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

Annuity factors
A table given in the exam gives the present value factors for annuities when the
cost of capital is r% and the annuity, starting after one year, runs for up to 15
years.

Example 6
An investment is expected to yield constant income of $12,500 each year for the
next 12 years, with the first of these cash flows expected to arise in one years
time.
Required:
(i)

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

(ii)

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


invest $90,000 to earn the 12 year annuity of $12,500.

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

ANNUITIES AND PERPETUITIES


Annuities
Discounting annuities is made easier by having a table of annuity factors.
Annuity factors discount cash flows to a value one time period before the first
payment arises.
Time

Fina
$A
$A
$A
$A
$A
ncin
g
Dec
x Annuity Factor
isio $ VALUE
n
If the first cash flow is at time 1, the annuity factor places the value at time 0 our
present value.
If the first cash flow arises later, say time 4, the value is places at time 3 and a
further discounting adjustment is required to get a present value.

Example 7
AGA Co is considering an investment with cash returns expected to be $100,000
each year for 4 years at a discount rate of 10%.
Required:
Calculate the present value of these cash flows:
(a)

assuming the first arises one year from present time

(b)

assuming the cash flows commenced in:


i.

Year 4,

ii.

Year 0.

Time

Time

Time

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CHAPTER 2 FUNDAMENTAL FINANCIA L MATHEMATICS

Perpetuities
A form of annuity that arises forever (in perpetuity).
In this situation the calculation of the present value of the future cash flows is:
Present value of the perpetuity

Cash flow per annum


Interest rate

Example 8
Reecer Co expects to receive $18,000 each year in perpetuity.
discount rate is 9%.

The current

Required:
1.

Calculate the present value of the perpetuity.

2.

Calculate the value if the perpetuity starts in 5 years.

26

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Chapter 3

Capital budgeting

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CHAPTER 3 CAPITAL BUDGETING

CHAPTER CONTENTS
CAPITAL BUDGETING --------------------------------------------------- 29

28

RELEVANT COSTS FOR DECISION MAKING

29

TAXATION AS A RELEVANT COST

31

WORKING CAPITAL

31

PRO FORMA

32

NET PRESENT VALUE (NPV)

34

INTERNAL RATE OF RETURN (IRR)

35

NPV AND IRR COMPARED

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CHAPTER 3 CAPITAL BUDGETING

CAPITAL BUDGETING
A form of decision-making where the investment occurs in the near future and the
benefits of the investment occur over a longer time, usually a number of years.
We shall use the following example to illustrate capital budgeting.

Relevant costs for decision making


You should remember from F5 that the only costs and revenues considered in our
decision should be relevant, fitting the 3 criteria:

FUTURE

CASH FLOW

INCREMENTAL (or DIRECT RESULT)

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CHAPTER 3 CAPITAL BUDGETING

Future
Only elements of cost and revenue that are yet to arise should be included in any
investment decision.
Costs that have already been incurred (or committed to) are SUNK COSTS and
should be excluded.

Cash flows
Investment decision making should only consider cash costs and revenues. Noncash items such as depreciation, amortisation, absorption or apportionment of costs
should be ignored and replaced with the related cash amounts (if any):

Purchase cost and resale value of non-current assets

Cash cost of overheads.

Incremental
Investment decision making will only consider costs that change as a direct result
of the decision under review.
Costs that will be incurred regardless are identified as COMMITTED COSTS and will
be excluded such as:

A portion of a supervisors salary when the supervisor works on the project


being considered.

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

Opportunity cost
As well as cash flows which our proposal gives rise to, we ought to consider any
other cash flows affected by our decision, such as reduced output and sales of other
lines of production due to us using a scarce resource.

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CHAPTER 3 CAPITAL BUDGETING

Taxation as a relevant cost


If a proposal earns profits, then our company will be due to pay tax on those
profits. The tax payments have to be included as relevant costs.

Tax on operating cash flows


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

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

If there is a net operation loss in one year, there will be a reduction in overall
tax paid by the company, showing as a cash benefit relevant to our
investment.

Workings:

calculate the net relevant operating cash flow for each year

multiply each by the given tax rate

input the result to the indicated year (either a one year delay or in the year of
the cash flow) as a negative figure for profits; a positive figure for losses.

Tax allowable depreciation (capital allowance)


Investment in capital gives rise to tax allowable depreciation. Over the life of an
asset, the total cash benefit of this is: (Investment residual value) x tax rate%
The initial cash benefit is always: (Investment x Allowance rate x Tax rate)
Allowances over the life will be either straight line (all the same) or reducing
balance (each year is a fixed % lower than the previous).
There will be a final balancing adjustment so that the allowances given equal the
total amount expected.

Working capital
When a company holds inventory and makes sales on credit, it has to provide
additional finance so that operating costs may be paid.
This finance is not an expense so has no tax consequence.
It is likely that the amount invested each year will change. The relevant cash flow
is the change in balance from year to year.
All amounts invested throughout a project will be recovered at the end of the
project.

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CHAPTER 3 CAPITAL BUDGETING

Pro forma
Pro-forma (assuming tax paid one year after profits)
1
$

final
$

(X)

(X)

(X)

(X)

(X)

Final + 1
$

Operating Cash-flows
Inflows
Outflows

Taxation
Scrap Proceeds

Capital Allowances
Working Capital

$Net relevant cash flow


Present Value Factors

Present Value

32

(X)

X/(X)

(X)

(X)

(X)

0.xxx

0.xxx

0.xxx

0.xxx

(X)

Cumulative Present Value

Less investment
(capital and working capital)
Net Present Value

(X)
X

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CHAPTER 3 CAPITAL BUDGETING

Example 1
Put the relevant cash flows for Rainer Co into the pro-forma below.

Time

1
$

2
$

3
$

4
$

5
$

Operating Cash-flows
Inflows
Outflows

Taxation
Scrap Proceeds
Capital Allowances
Working Capital

$Net relevant cash flow


Present Value Factors

Present Value

Cumulative Present Value


Less investment
(capital and working capital)

Net Present Value

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CHAPTER 3 CAPITAL BUDGETING

Net present value (NPV)


Decision criterion
The cumulative present value of future cash flows is the maximum that the
company would be prepared to invest in the project; the value to investors of the
project.
If the amount required for investment is lower than the value, then accepting the
project will increase the shareholders wealth.
Thus, if the NPV is positive, the investment should be made.

Advantages
1.

NPV recognises the time value of money.

2.

It is based on relevant cash flows and opportunity costs.

3.

NPV gives a direct indication of the impact upon shareholders wealth.

4.

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

Disadvantage
1.

34

Requires confidence in the estimate of cost of capital.

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CHAPTER 3 CAPITAL BUDGETING

Internal rate of return (IRR)


The rate of return at which the NPV equals zero.

Example 2
The net cash flows of Rainer Cos investment above, discounted at 10% yield a net
present value of $69,000.
Required:
Estimate, on the graph below, the rate at which the NPV would be $NIL.
Time
Operating cash flows
PVF @

1
$000

2
$000

3
$000

4
$000

5
$000

167

212

217

202

PV
Cumulative
Initial investment (non-current assets plus working capital)

$560

NPV
000

69

10%

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r%

35

CHAPTER 3 CAPITAL BUDGETING

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

Interpolated IRR

NL
L
NL - NH

(H - L)

Where:
L

Lower discount rate

Higher discount rate

NL

NPV at lower discount rate

NH

NPV at higher discount rate

Example 3
The net cash flows of Rainer Cos investment above, discounted at 10% yield a net
present value of $69,000. At 18%, the corresponding figure is -$29,000.
Required:
Estimate, using the formula, the IRR of the project.

The IRR can be estimated using any pair of costs of capital. Each pair will give a
slightly different result. Exam marks are awarded for the technique rather than
precisely matching the solution given in the answers. In the Rainer Co example, a
second guess of 15% would give an IRR of 15.3%; a second guess of 20% would
have given 15.8%, and a second guess of 5% would have given an IRR of 14.5%

Decision criterion
If the IRR is greater than the estimated cost of capital, it is assumed that the
project has a positive NPV so should be accepted.

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CHAPTER 3 CAPITAL BUDGETING

Advantages
1.

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

2.

It is based on cash flows, not accounting profits.

3.

IRR can be used in cases where it is not possible to calculate an accurate cost
of capital but only a reasonable estimate can be given. IRR gives a breakeven
figure and, so, a margin of safety for the estimate.

Disadvantages
1.

Does not indicate the size of the investment.

2.

It can give conflicting signals with mutually exclusive projects.

3.

If a project has irregular cash flows there is more than one IRR for that
project (multiple IRRs).

NPV and IRR compared


Single investment decision
A single project will be accepted if it has a positive NPV at the required rate of
return. If it has a positive NPV then, it will have an IRR that is greater than the
required rate of return.

Mutually exclusive projects


Two projects are mutually exclusive if only one of the projects can be undertaken.
In this circumstance the NPV and IRR may give conflicting recommendation.
The reasons for the differences in ranking are:
1.

NPV is an absolute measure but the IRR is a relative measure of a projects


viability.

2.

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


on different assumptions about the rate at which funds generated by the
project are reinvested. NPV assumes reinvestment at the companys cost of
capital, IRR assumes reinvestment at the IRR.

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CHAPTER 3 CAPITAL BUDGETING

38

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Chapter 4

Investment appraisal
techniques

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

CHAPTER CONTENTS
INFLATION AND D.C.F. -------------------------------------------------- 41
THE FISHER EFFECT

41

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


EQUIVALENT ANNUAL COST (EAC)

43

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


HARD CAPITAL RATIONING

45

SOFT CAPITAL RATIONING

45

SINGLE PERIOD CAPITAL RATIONING

46

MULTI-PERIOD CAPITAL RATIONING

48

UNCERTAINTY ----------------------------------------------------------- 49
SENSITIVITY ANALYSIS

49

EXPECTED VALUES

50

ADJUSTED DISCOUNT RATES

51

PAYBACK

51

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


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

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

INFLATION AND D.C.F.


There two ways of dealing with inflation:
1.

Include inflation by inflating the cash flows year on year.

2.

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


Include inflation
(money analysis)

Exclude inflation
(real analysis)

Inflate cash flows by the inflation rates


given

Leave cash flows in current terms

Discount with

Discount with

a money (or nominal) rate of return

a real rate of return

Exam tip
Must use where there is more than one
inflation rate in the question

Exam tip
Can use where a single inflation rate is
given for an easier computation

Must use if there is taxation paid in


arrears

Expected where activity levels are


constant over a long period of time
(an annuity excluding inflation)

Must use if there is tax allowable


depreciation

The Fisher effect


The relationship between real and money interest is given in the formula sheet:
(1 + i) = (1 + r)(1 + h)
It is easier to remember as:

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

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


Where
r
=
m
=
i
=

real discount rate


money (or nominal) discount rate
inflation rate

Example 1
r = 8%

i = 5%

Required:
Calculate the money rate.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Example 2
m = 12.3%

i = 4%

Required:
Calculate the real rate of return.

Example 3
A company has to invest $450,000 in a project. The investment will result in new
product sales of 6,000 units each year for 3 years. There will be no residual value
for equipment used.
The selling price of the new product is $50 per unit and the incremental costs of
sale are $15 per unit, both in current terms.
The companys WACC is 12% and inflation is expected to be 3.6%
Required:
Calculate the NPV using both the money and real analyses.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

ASSET REPLACEMENT
The decision is how to replace an asset, not whether. We aim to adopt the most
cost effective replacement strategy. The comparison may be complicated by having
different asset life cycles for different options.
Key ideas/assumptions:
1.

Cash inflows from trading (revenues) are not normally considered in this type
of question. The assumption being that they will be similar regardless of the
replacement decision.

2.

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


with machines of differing ages.

3.

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


future.

Equivalent annual cost (EAC)


Options with different life cycles are compared by calculating the EAC. It is a
hypothetical payment which, if made annually, would result in the same PV of costs
as the option being considered.
If all options have an EAC, a direct comparison may be made and the least costly
found.
Formula
EAC = PV of assets costs Annuity factor for asset life

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Step 1
Establish the present value of costs of each option.
Year

8% PVF

0.926

0.857

0.794

0.735

0.681

Annual running cost

5,000

5,000

5,000

7,000

11,000

n/a

n/a

18,000

14,000

6,000

PV
Resale Value at year end
PV

Step 2
Use the equivalent annual cost formula & look for the lower amount.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

CAPITAL RATIONING
A limit on the level of funding available to a business.
There are two types:

Hard capital rationing.

Soft capital rationing.

Hard capital rationing


Externally imposed by banks and capital markets, due to:
1.

Wider economic factors (eg a credit crunch).

2.

Company specific factors

Lack of asset security

No track record

Poor management team.

Soft capital rationing


Capital budgeting limits are internally imposed by senior management. This is
contrary to the rational aim of a business which is to maximise shareholders wealth
(ie to take all projects with a positive NPV).
Reasons:
1.

Lack of management skill

2.

Wish to concentrate on relatively few projects

3.

Unwillingness to take on external funds

4.

Only a willingness to concentrate on strongly profitable projects.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Single period capital rationing


There is a shortage of funds in the present period which will not arise in following
periods. Note that the rationing in this situation is very similar to the limiting factor
decision that we know from decision making. In that situation we maximise the
contribution per unit of limiting factor.

Example 7
The funds available for investment are $250,000. All investments must be started
immediately.
Project
Initial investment
NPV
$000s
$000s
A
100
25
B
200
35
C
80
21
D
75
10
Required:
Identify the investment plan which will maximise the value of the
company.

Scenario 1: divisibility
ie each project can be taken in part and the returns (NPV) will be proportionate to
the amount of investment.
Key working: Profitability index (P.I.)
P.I. =
Project

Working

NPV Investment
P.I.

Ranking

A
B
C
D
Funds available

46

Projects undertaken

NPV earned

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Scenario 2: non-divisible projects


The projects are taken as a whole or not at all.
Key
We identify all possible mixes and establish which mix generates the maximum
NPV.

Example 7
Required:
Identify the investment plan to maximise the return to the company
assuming the projects are non-divisible.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Multi-period capital rationing


A more complex environment where there is a shortage of funds in more than one
period. This makes the analysis more complicated because we have multiple
constraints and multiple outputs. Linear programming would have to be employed.

Example 8
Horge Co is reviewing investment proposals that have been submitted by divisional
managers. The investment funds of the company are limited to $800,000 in the
current year. Details of three possible investments, none of which can be delayed,
are given below.
Project 1
An investment of $300,000 in work station assessments. Each assessment would
be on an individual employee basis and would lead to savings in labour costs from
increased efficiency and from reduced absenteeism due to work-related illness.
Savings in labour costs from these assessments in money terms are expected to be
as follows:
Year
Cash flows ($'000)

1
85

2
90

3
95

4
100

5
95

Project 2
An investment of $450,000 in individual workstations for staff that is expected to
reduce administration costs by $140,800 per annum in money terms for the next
five years.
Project 3
An investment of $400,000 in new ticket machines. Net cash savings of $120,000
per annum are expected in current price terms and these are expected to increase
by 3.6% per annum due to inflation during the five-year life of the machines.
Horge Co has a money cost of capital of 12% and taxation should be ignored.
Required:
Determine the best way for Horge Co to invest the available funds and
calculate the resultant NPV:
(a)

on the assumption that each of the three projects is divisible;

(b)

on the assumption that none of the projects are divisible.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

UNCERTAINTY
Consideration of uncertainty is particularly important when performing investment
appraisal due to:
1.

Long timescale

2.

Outflow today, inflow in the future

3.

Large size in relation to the size of the company

4.

Strategic nature of the decision.

Techniques available:
1.

Sensitivity analysis

2.

Expected values

3.

Adjusted discount rates

4.

Payback.

Sensitivity analysis
A technique that considers a single variable at a time and identifies by how much
that variable has to change for the decision to change (from accept to reject).

Example 9
An initial investment of $50,000 is expected to give rise to the following cash flows
for each of years 1 to 3. The discount rate is 10%.
$ per annum
Fixed cost

65,000

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

30,000

Selling price ($12 per unit)

120,000

Required:
(a)

Calculate the NPV for the investment.

(b)

Calculate by how much the values would have to change for the
decision to alter for:
(i)

The unit sales price;

(ii)

The annual sales volume;

(iii) The annual fixed cost.

Key working
Sensitivity
Margin

Net Present Value

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Present Value of the cash flow


under consideration

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Expected values
Where there is a range of possible outcomes which can be identified and a
probability distribution can be attached to those values. In this situation we may
establish some sort of average return. The expected value is the arithmetic mean
of the outcomes as expressed below:

EV = px
Where

p = the probability of an outcome


x = the value of an outcome

Example 10
Toorongs Co is developing a new product, the Wryte which will be launched after
further significant investment in plant and machinery.
If Toorongs makes the Wryte, there are four possible levels of success which will
affect the sales volume; the length of the life cycle and the costs identified with the
investment.
The relevant cash flows of each outcome have been analysed, resulting in the
following NPV figures, along with associated probabilities estimated for each
outcome.
Outcome

NPV ($000)

Probability

1,250

0.12

Moderate success

650

0.30

Marginal success

320

0.25

(750)

0.33

Strong success

Failure

Working (px)

Required:
(a)

What is the expected value of the project?

(b)

Suggest possible problems with basing this decision on expected


values.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

Adjusted discount rates


If an individual investment or project is perceived to be more uncertain than
existing investments, the company could adjust the discount rate up to reflect the
additional risk. The problem in doing so is that any adjustment would be arbitrary.

Payback
The payback period is a measure of how long it takes the income of an investment
to cover the initial outlay. If we consider the payback period, we focus on the
earlier activities of the project, those where there is less uncertainty.

Example 11
The net cash flows of Rainer Cos investment in the last chapter are shown below.
Required:
Calculate the payback period of the project.
Time
Operating cash flows

1
$000

2
$000

3
$000

4
$000

5
$000

167

212

217

202

Cumulative
Initial investment (non-current assets plus working capital)

$560

One criticism of payback is that it doesnt consider time value of money; the cash
flows in year 3 are given the same weighting as those in year 1. It is possible to
modify the working to arrive at a discounted payback period.

Example 12
Required:
Calculate the discounted payback period for Rainers investment project.
Time
Operating cash flows
PVF @ 10%
PV

1
$000

2
$000

3
$000

4
$000

5
$000

167

212

217

202

0.909

0.826

0.751

0.683

0.621

152

175

163

138

Cumulative
Initial investment (non-current assets plus working capital)

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$560

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

LEASE OR BUY DECISION


A specific decision that compares two specific financing options, the use of a finance
lease or buying outright financing via a bank loan.

Key information
1.

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


The rate is given by the rate on the bank loan in the question, if it is pre-tax
then the rate must be adjusted for tax. If the loan rate was 10% pre-tax and
corporation tax is 30% then the after-tax rate would be 7%. (10% x (1 0.3)

2.

Cash flows
Purchase
1/ Cost of the investment

Lease

2/ WDA tax relief on investment

1/ Lease rental
- in advance
- annuity

3/ Residual value

2/ Tax relief on rental

Example 13
Smitcher Co is considering how to finance a new project that has been accepted by
its investment appraisal process.
For the four year life of the project the company can either arrange a bank loan at
an interest rate of 15% before corporation tax relief. The loan is for $100,000 and
would be taken out immediately. The residual value of the equipment is $10,000 at
the end of the fourth year.
An alternative would be to lease the equipment over four years at a rental of
$30,000 per annum payable in advance.
Tax is payable at 33% one year in arrears. Capital allowances are available at 25%
on the written down value of the asset.
Required:
Calculate whether it is financially cheaper to buy or lease the equipment.

Other considerations (leasing or buying)


1.

Who receives the residual value in the lease agreement? It is possible that
the residual value may be received wholly by the lessor or almost completely
by the lessee.

2.

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


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

3.

Are there any additional benefits associated with lease agreement? Many
lease agreements will include within the payments some measure of
maintenance or other support services.

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

ROCE - ARR
One final approach to capital investment decision making is to calculate and
consider the average return on capital employed (ROCE) or accounting rate of
return (ARR) that the proposal will generate over its life.

Advantages
1.

Provides a measure that is consistent with one measure that may be applied
by company analysts and so may be more widely understood by less well
financially aware observers.

Disadvantages
1.

Does not address shareholder wealth maximisation or the time value of


money.

2.

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

3.

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

4.

Unlike NPV or IRR, which have risk-based target figures, there is no reliable
way of finding a target ARR.

Example 14
The net operating profit after tax for Rainer Cos investment in the last chapter is
calculated below (note no tax delay shown). The initial capital investment would be
$515,000 with a residual value of $70,000 after 4 years.
Required:
Calculate the accounting rate of return of the project.
Time

1
$000

2
$000

3
$000

4
$000

180

229

234

142

Corporation tax

54

69

70

43

Tax Allowable Depreciation

39

29

22

44

165

189

186

143

Operating contribution

Profit after Taxation

Average Profit per annum =

Average level of capital employed =

ARR =

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CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES

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Chapter 5

Sources of long term


finance

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

CHAPTER CONTENTS
EQUITY ------------------------------------------------------------------- 57
ORDINARY SHARES

57

PREFERENCE SHARES

57

DEBT ---------------------------------------------------------------------- 58
SECURITY

58

TYPES OF DEBT

58

TYPES OF ISSUED DEBT

59

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


ISLAMIC FINANCE ------------------------------------------------------- 61
WHAT IS ISLAMIC FINANCE?

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

EQUITY
Equity relates to the ownership rights in a business.

Ordinary shares
1.

Owning a share confers part ownership.

2.

High risk investments offering higher returns.

3.

Permanent financing.

Advantages (to the company)


1.

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

2.

No repayment required shareholders will not force liquidation.

3.

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


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

Disadvantages (for the company)


1.

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

2.

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

3.

Problem of dilution of ownership if new shares issued.

4.

A high proportion of equity can increase the overall cost of capital for the
company. (Chapter 4).

Preference shares
1.

Fixed dividend.

2.

Paid in preference to (before) ordinary shares.

3.

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

not tax efficient

no opportunity for capital gain (fixed return).

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

DEBT
The loan of funds to a business without any ownership rights.
1.

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

2.

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

Security
Charges
The debt holder will normally require some form of security against which the funds
are advanced. This means that in the event of default the lender will be able to
take assets in exchange of the amounts owing.

Covenants
A further means of limiting the risk to the lender is to restrict the actions of the
directors through the means of covenants. These are specific requirements or
limitations laid down as a condition of taking on debt financing. They may include:
1.

Dividend restrictions.

2.

Financial ratios.

3.

Financial reports.

4.

Issue of further debt.

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

Bank finance
For companies that are unlisted and for many listed companies the first port of call
for borrowing money would be the banks. These could be the high street banks or
more likely for larger companies the large number of merchant banks concentrating
on securitised lending.
This is a confidential agreement that is by negotiation between both parties.

Traded investments
Debt instruments sold by the company, through a broker, to investors.
features may include:

Typical

1.

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

2.

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

3.

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

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

Types of issued debt


They include:

Debentures
Debt secured with a charge against assets (either fixed or floating), low risk debt
offering the lowest return of commercially issued debt.

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

Mezzanine finance
High risk finance raised by companies with limited or no track record and for which
no other source of debt finance is available. A typical use is to fund a management
buy-out.

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

OTHER SOURCES
Sale and leaseback
1.

Selling good quality fixed assets such as high street buildings and leasing
them back over many (25+) years.

2.

Funds are released without any loss of use of assets.

3.

Any potential capital gain on assets is forgone.

Grants
1.

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

2.

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

3.

They do not need to be paid back.

Retained earnings
The single most important source of finance, for most businesses the use of
retained earnings is the core basis of their funding.

Warrants
1.

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


specified (exercise) price.

2.

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

3.

Warrants are commonly given as additional consideration when issuing debt.

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

Warrants can be separated from the debt and sold by the lender to raise
cash prior to maturity of the loan stock.

If the share price performs well and warrants are exercised, it results in
a cash injection to the company often sufficient to repay the debt.

Convertible loan stock


A debt instrument that may, at the option of the debt holder, be converted into
shares. The terms are determined when the debt is issued and lay down the rate of
conversion (debt:shares) and the date or range of dates at which conversion can
take place.
The convertible is offered to encourage investors to take up the debt instrument.
The conversion offers a possible capital gain (value of shares value of debt).
The difference with warrants is that the convertible debt holders are the ones who
take up the shares; since warrants are separable from loan stock, there could be
two different groups of investors involved.

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

ISLAMIC FINANCE
What is Islamic finance?
A form of finance that specifically follows the teachings of the Quran.
The teachings of the Quran are the basis of Islamic Law or Sharia. Sharia Law is,
however, not codified and as such the application of both Sharia Law and, by
implication, Islamic Finance is open to more than one interpretation.

Prohibited activities
In Shariah Law there are some activities that are not allowed and as such must not
be provided by an Islamic financial institution, these include:
1.

Gambling (Maisir)

2.

Uncertainty in contracts (Gharar)

3.

Prohibited activities (Haram)


Riba
Interest in normal financing relates to the monetary unit and is based on the
principle of time value of money. Sharia Law does not allow for the earning of
interest on money. It considers the charging of interest to be usury or the
compensation without due consideration. This is called Riba and underpins
all aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or
investment to which the finance is related. This is in the form of a
premium being paid for a deferred payment when compared to the
existing value.
There is a specific link between the charging of interest and the risk and
earnings of the underlying assets. Another way of describing it is as the
sharing of profits arising from an asset between lender and user of the
asset.

Forms of Sharia compliant finance


There are some specific types of finance that are deemed compliant and allow
Islamic finance to offer similar financial products to those offered in normal
financing, these include:

Murabaha trade credit


The sale price of goods is agreed to cover all costs and generate a profit
margin. The time value of money is incorporated in the costs. There is a
reassurance that the credit is based on trade and not simply a financing
transaction.

Mudaraba equity finance


A profit sharing contract where one party provides capital and the other the
expertise to invest the capital and manage the activities. There is a preagreed ratio of profit share.

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CHAPTER 5 SOURCES OF LONG TERM FINANCE

Musharaka venture capital


Has more in common with a joint venture than an equity investment. All (or
most) investors will have an active role in managing the business.
Diminishing musharaka allows for business ownership to gradually be
transferred over a period of time to a single owner, in a similar way to
venture capitalists creating an exit strategy based upon sale of shares.

Ijara lease finance


A bank makes an asset available to a customer for a fixed period in exchange
for a fixed price. At the end of the period, the customer often has the option
to pay a fixed price in return for transfer of ownership of the asset from the
bank.

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Sukuk debt finance

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Chapter 6

Cost of capital

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63

CHAPTER 6 COST OF CAPITAL

CHAPTER CONTENTS
INTRODUCTION TO THE COST OF CAPITAL --------------------------- 65
COST OF EQUITY --------------------------------------------------------- 66
1

DIVIDEND VALUATION MODEL

66

THE CAPITAL ASSET PRICING MODEL (CAPM)

69

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


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

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CHAPTER 6 COST OF CAPITAL

INTRODUCTION TO THE COST OF CAPITAL


Risk and return
Risk is the anticipated variability in income from an investment.
Different investments have different degrees of risk. The higher the risk, the higher
the return required to cover that risk. Importantly, this helps as a starting point to
the identification of a cost of capital.

The two main sources of capital


It is likely that a companys total finance comes from a number of sources.
Initially, we will limit our studies to the two main sources of finance:

1.

Equity

Ordinary shareholders make an investment which carries with it all the risks of the
business.
The annual return to ordinary shareholders is in no way guaranteed or predictable
and, so, can be defined as risky.

2.

Debt

Banks and individuals make loans to a company with contractual terms for payment
of interest and repayment of the capital lent. The company is obliged to make any
such payments before being allowed to distribute earnings to shareholders.
The lender often insists on security; the right to seize specified assets should the
borrower default on the loan.
The contractual obligation plus any security make debt a far less risky form of
finance with a correspondingly lower required return from investors.

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CHAPTER 6 COST OF CAPITAL

COST OF EQUITY
This may be calculated in one of two ways:

1.

Dividend Valuation Model (DVM).

2.

Capital Asset Pricing Model (CAPM).

Dividend valuation model


In Chapter 1, we saw that shares may be valued by the market (all shareholders)
based upon future dividends and dividend growth.

P0 =

D0 (1+g)
Ke -g

If our company has a listed share price (P0) and we know what dividend and
dividend growth the shareholders are expecting (as financial managers, we have
told them this), then we can rearrange the formula to find the cost of equity (Ke)
that shareholders must have used to arrive at the share value.

Ke =
where

Note:

D0 (1+g)
P0

+g

a constant rate of growth in dividends

D0 =

current dividend

P0

The current ex-div share price

D0(1+g) finds the dividend expected in one years time (D1)


ex-div is the share price immediately after a dividend has been paid
cum-div is the price immediately before a dividend is paid
The difference between ex-div and cum-div is the value of the
dividend, D0

Example 1
Clarence Co has a share price of $4.00 and has recently paid out a dividend of 20
cents. Dividends are expected to grow at an annual rate of 5%.
Required:
Calculate the cost of equity.

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CHAPTER 6 COST OF CAPITAL

Example 2
Wendyhouse Co has a cum-dividend share price of 369 cents and due to pay out a
dividend of 36 cents per share. Dividends are expected to grow at an annual rate
of 4%.
Required:
Calculate the cost of equity.

Estimating Growth
There are 2 main methods of determining growth:
1

THE AVERAGING METHOD


1

n

D
g = 0
D
n

where

Do

current dividend

Dn

dividend n years ago

Example 3
Sissossokoko Co paid a dividend of 20 cents per share 4 years ago, and the current
dividend is 33 cents. The current share price is $6 ex div.
Required:
(a)

Estimate the rate of growth in dividends.

(b)

Calculate the cost of equity.

Example 4
Masheranno Co paid a dividend of 6 cents per share 8 years ago, and the current
dividend is 11 cents. The current share price is $2.58 ex div.
Required:
Calculate the cost of equity.

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CHAPTER 6 COST OF CAPITAL

GORDONS GROWTH MODEL


g = rb
where

= return on reinvested funds

b = proportion of funds retained

Example 5
The ordinary shares of Tories Co are quoted at $5.00 cum div.
A dividend of 40 cents is just about to be paid.
The company has a return on capital employed of 12% and each year pays out
30% of its profits after tax as dividends.
Required:
Calculate the cost of equity.

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CHAPTER 6 COST OF CAPITAL

The capital asset pricing model (CAPM)


CAPM starts from having a measure of risk () to calculating the required return.
It is particularly useful where our company does not have listed shares and so we
dont have a P0 for the dividend valuation model.

CAPM formula (given in the exam)


E(ri) = Rf + i (E(rm) Rf)
Where:

E(ri)

is

The expected return from investment i"

Rf

is

the return available risk free

is

the beta measuring the risk of investment i"

E(rm) is

The average expected return from the market (all


investments together)

Example 6
The market return is 15%. Cowt Co has a beta of 1.2 and the risk free return is
8%.
Required:
Calculate the cost of equity.

Market premium (E(rm) Rf)


The difference between the average expected return from the market and the risk
free rate is referred to as the market risk premium.

Example 7
The risk-free rate of return is 6%.
The market risk premium is 8%.
The beta factor for Krauch Co is 0.8.
Required:
Calculate the expected annual return.

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CHAPTER 6 COST OF CAPITAL

THE COST OF DEBT


There is only one approach to calculate the cost of debt. We cant call it dividend
valuation model since debt doesnt pay dividends but it follows the same principle
of: future cash flows related to current market value.

A distinction
1.

The Gross Debt Yield is the average annual return to lenders consisting of:
Interest (relative to the amount lent); and,
Capital return (if the amount repaid is different to the amount lent)

2.

The cost of debt is the cost to the company of making the payments to
lenders. It consists of interest and capital return (as above) but also:
tax relief that the company earns on interest payments

Notation
1.

Gross Debt Yield is Kd

2.

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

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

Workings
1.

Traded debt is always quoted in $100 nominal units or blocks. All workings
are done by reference to $100, regardless of the total amount borrowed.

2.

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


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

3.

Debt can be:


(i)

Irredeemable never paid back.

(ii)

redeemable at par (nominal value).

(iii)

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


nominal).

Kd for irredeemable debt


i(1 - T)
P0

Kd =

where

70

interest paid

marginal rate of tax

P0

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

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CHAPTER 6 COST OF CAPITAL

Example 8
The 10% irredeemable loan notes of Raffer Co are quoted at $120 ex int.
Corporation tax is payable at 30%.
Required:
Calculate the cost of debt.

Kd for redeemable debt


The Kd for redeemable debt is found by trial and error to see what cost of capital
must have been used to arrive at P0.
The relevant cash flows would be:
Time
0
1 to n
n

Cash flow
Market value of the loan note
Annual interest payments, net of tax
Redemption value of loan

%
P0
i(1 - T)
RV

Example 9
Wornuck Co has 10% loan notes quoted at $102 ex interest redeemable in 5 years
time at par. Corporation tax is paid at 30%.
Required:
Calculate the cost of debt.
Time

Cash

1-5

I(1-T)

Redemption

P0

%amount

1st PVF

1st NPV

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1st PV

2nd PVF

2nd PV

2nd NPV

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CHAPTER 6 COST OF CAPITAL

Technique
1.

7 columns

2.

Identify the cash flows


Post tax interest as an annuity
Final redemption value
Current ex-interest market value

3.

discount using a first guess percentage

4.

discount using a second guess,

5.

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

NPV

72

r%

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CHAPTER 6 COST OF CAPITAL

WACC WEIGHTED AVERAGE COST OF CAPITAL


The weighted average cost of capital is the average of cost of the companys
finance (equity, loan notes, bank loans, and preference shares) weighted according
to the proportion each element bears to the total pool of funds.

WACC formula (given)

WACC = e ke + d kd (1T)
Ve Vd
Ve Vd
Where:

ke

is the cost of equity

Kd(1-T) is the cost of debt


Ve

is the total market value of equity in the company

Vd

is the total market value of debt in the company

Example 10
The following information is in the statement of financial position of Barrows Co:
$000
9% bonds redeemable in seven years time

8,000

Ordinary Shares, par value 25c

5,000

Retained Earnings

3,000

The ex-div share price of Barrows Co is $3.00. The 9% bonds are trading on an exinterest basis at $85.00 per $100 bond.
The cost of equity has already been calculated at 15% and the cost of debt is 7.6%.
Required:
Calculate the weighted average cost of capital.

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CHAPTER 6 COST OF CAPITAL

Using WACC
WACC can be used to evaluate the companys investment projects if the following
conditions apply:
1.

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

2.

Or the company adopts a pooled funds approach and:


(i)

The company will maintain its existing capital structure in the long run
(ie same financial risk);

(ii)

The project has the same degree of business risk as the company has
now.

Convertible Loan Stock


A loan note with an option to convert the debt into shares at a future date with a
predetermined price. In this situation the holder of the debt has the option
therefore the redemption value is the greater of either:
1.

The share value on conversion, or

2.

The cash redemption value if not converted.

Example 11
Doodeck Co has convertible loan notes in issue that may be redeemed at a 10%
premium to par value in 4 years. The coupon is 10% and the current market value
is $110.
Alternatively the loan notes may be converted at that date into 25 ordinary shares.
The current value of the shares is $4 and they are expected to appreciate in value
by 6% per annum.
The tax rate is 30%.
Required:
Calculate the cost of convertibles.

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CHAPTER 6 COST OF CAPITAL

Preference shares
A fixed rate charge to the company in the form of a dividend rather than in terms of
interest. Preference shares are normally treated as debt rather than equity but
they are not tax deductible. They can be treated using the dividend valuation
model with no growth:
Kp =

d
P0

Example 12
Mahan Cos 9% preference shares ($1) are currently trading at $1.4 ex-div.
Required:
Calculate the cost of the preference shares.

Non-tradable debt
Bank loans and other non-traded loans have a cost of debt equal to the coupon rate
adjusted for tax.
Kd

Interest rate x (1 T)

Example 13
Trory Co has a loan from the bank at 12% per annum. Corporation tax is charged
at 30%.
Required:
Calculate the cost of debt.

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CHAPTER 6 COST OF CAPITAL

Kd for redeemable debt (when redeemed at current market


value)
We could just use the technique outlined above but if the current market value and
the redemption value are the same instead the irredeemable debt formula can be
used.

Example 14
The 10% loan notes of Raffer Co are quoted at $120 ex int. Corporation tax is
payable at 30%. They will be redeemed at a premium of $20 over par in 4 years
time
Required:
What is the net of tax cost of debt using:
(a)

redeemable debt calculation?

(b)

irredeemable debt calculation?

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Chapter 7

Capital structure:
financial risk

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77

CHAPTER 7 CAPITAL STRUCTURE: FINANCIAL RISK

CHAPTER CONTENTS
CAPITAL STRUCTURE AND THE COST OF CAPITAL ------------------- 79
GEARING THEORIES ----------------------------------------------------- 80

78

THE TRADITIONAL VIEW OF CAPITAL STRUCTURE

80

MODIGLIANI AND MILLER NET OPERATING INCOME

81

PROBLEMS WITH HIGH GEARING

82

PECKING ORDER THEORY

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CHAPTER 7 CAPITAL STRUCTURE: FINANCIAL RISK

CAPITAL STRUCTURE AND THE COST OF CAPITAL


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

Impact of debt financing on the WACC


Two competing effects
Reduction in WACC

Increase in WACC

Debt finance is cheaper because:

Debt introduces financial risk which


increases Ke, should lead to an increase
in WACC

Less risky to investor


Tax relief in interest paid

The risk associated with debt


financing is borne by the shareholders

Kd Ke, an increase in debt funding


should lead to a fall in WACC

Financial risk
A shareholders earnings in any company are risky, depending on the nature of
business carried out by the company.
If the company adds debt to the capital structure, by borrowing, the earnings
available to shareholders become even more risky as the lenders will have a prior
charge (often fixed) over the companys earnings.
Illustration
1
12,000

All Equity
2
18,000

3
6,000

1
12,000

Interest

3,000

3,000

3,000

Taxable

12,000

18,000

6,000

9,000

15,000

3,000

Tax (30%)

3,600

5,400

1,800

2,700

4,500

1,200

PAT (Earnings)

8,400

12,600

4,200

6,300

10,500

1,800

x 1.50

x 0.33

x 1.67

x 0.17

Year
PBIT

Year-on-year

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Including Debt
2
3
18,000
6,000

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CHAPTER 7 CAPITAL STRUCTURE: FINANCIAL RISK

GEARING THEORIES
The traditional view of capital structure
Cost of equity
At relatively low levels of gearing the increase in gearing will have relatively low
impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.

Cost of debt
There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises.
Ke
Cost
of
capital
WACC

Kd(1-T)

Gearing (D/E)
Key point
There is an optimal level of gearing at which the WACC is minimised.
Since company value is based on:

P0 =

D0 (1+g)
Ke -g

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

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CHAPTER 7 CAPITAL STRUCTURE: FINANCIAL RISK

Modigliani and Miller net operating income


The basis of this theory is that a company with debt in its capital structure will pay
out a higher total to investors than it would with only equity.
Illustration
1
12,000

All Equity
2
18,000

3
6,000

3,000

3,000

3,000

PAT (Earnings)

8,400

12,600

4,200

6,300

10,500

1,800

Total to Investors

8,400

12,600

4,200

9,300

13,500

4,800

Year
PBIT
Interest

Including Debt
1
2
3
12,000 18,000
6,000

With a higher return available, investors (debt and equity in total) would be
prepared to invest a higher amount, giving the geared company a higher total
value.
Since the operating cash flows and their growth are the same, the only difference
between the two has to be that the geared company has a lower cost of capital
(WACC).

Implication
As the level of gearing rises the overall WACC falls.
having the highest level of debt possible.

The company benefits from

Cost
of
capital

Ke

WACC
Kd(1-t)
Gearing (D/D+E)

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CHAPTER 7 CAPITAL STRUCTURE: FINANCIAL RISK

Problems with high gearing


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

bankruptcy

tax exhaustion

loss of borrowing capacity

risk attitude of potential investors.

Pecking order theory


A reflection that funding of companies does not follow theoretical rules but instead
often follows the path of least resistance.
A suggested order is as follows:
1st
nd

82

retained earnings

bank debt

3rd

issue of equity.

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Chapter 8

Business risk and


adjusted discount rates

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

CHAPTER CONTENTS
CAPM ---------------------------------------------------------------------- 85
LIMITATIONS OF USING CAPM

87

FINDING A BETA

87

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

84

DIFFERING BETA VALUES

89

QUESTION APPROACH

90

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

CAPM
We need to understand the limitations of the Capital Asset Pricing Model and, to do
that, we need a good understanding of the three components of the formula.

The risk-free rate of return Rf


This is an estimate of the future return from risk free investments, such as
government loan stocks.
Is it an amount that we can predict with any degree of certainty?

The expected average return from the market E(Rm)


This is a best guess estimate of the return that all stocks and bonds will return to
investors in the future. If this is over-estimated, the resulting cost of capital would
be too high, possibly resulting in us rejecting worthwhile opportunities. If underestimated, we might accept investment opportunities which do not give sufficient
return to compensate investors for their risk.

Beta
A beta value is calculated using regression analysis of historical data plotting the
total return on a share over a 12 month period against the total return on the
whole market over the same period.
Total return on the share is calculated by looking that the change in share price and
the dividend as a percentage.

Example 1
From the following information about share in Carol Co, calculate the annual return
to June 2011 and the annual return to September 2011.
2010

Share price (cents)


Dividend (paid December)

2011

June

September

June

September

400

480

440

482

10 cents

15 cents

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


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

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

Calculating beta
You will not perform any calculations of beta from historical data but need to be
aware of one critical point.
Regression Analysis finds a straight line of best fit through pairs of data.
Return on
Share

x
x
x

x
x

Return on
Market

The slope of this line is the shares beta value, reflecting business and financial risk
relative to the average in the stock market.
The beta value ignores that most of the pairs of data lie some way off the line of
best fit. The difference between each x and the line of best fit is due to a specific
factor relating to that company at the specific time the data are gathered.

Unsystematic risk
These specific variations are known as the unsystematic risk of the share. In
using CAPM, we assume that shareholders are not affected by (or exposed to)
unsystematic risk.

Diversification
An investor can minimise his exposure to specific risk factors of an industry or a
particular company by spreading his wealth over a diverse range of stocks and
shares, creating a balanced and diversified portfolio of investments.
In a well-diversified portfolio, losses or poor returns on one share will be balanced
by better than expected returns on others. In other words, positive unsystematic
risk factors will be cancelled elsewhere by negative unsystematic risk factors.
An investor with a well-diversified portfolio can, therefore, ignore unsystematic risk
and concentrate on earning the returns indicated by CAPM, reflecting systematic
risk only.

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

Limitations of using CAPM


As well as calculating costs of capital using CAPM, questions will expect you to
explain the circumstances in which CAPM is appropriate.

Criticisms of the CAPM


1.

Using beta assumes that all shareholders invest in well diversified portfolios.
Whilst this may be the case for the majority of companies listed on major
stock exchanges, it is very unlikely to be the case for smaller, family-run
businesses.

2.

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

3.

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

4.

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


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

Finding a beta
Questions will never expect you to calculate a beta from first principles. You will,
however, have to know where to look for the appropriate beta so that you can work
out the correct cost of capital. There are three main scenarios.
1.

A quoted company expanding its current activities


Since it is quoted, it will have its own beta value.
Since it is staying in the same business area, the given beta value reflects the
risks of the new investment.

2.

A quoted company diversifying into new areas of business


The companys current beta does not reflect the business risk of the new
investment so should not be used.
We need to find the beta of a company in the same business sector as the
new activity a proxy company.
(We may need to adjust the proxy companys beta for financial risk
differences).

3.

An unlisted company
Since it has no listed share price, there will be no beta value for the company.
Therefore, we would always have to find a proxy company.

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

Example 2
2shack Co is a listed company whose shares have a beta of 0.7 and a cost of capital
of 17% p.a. rf = 10% and rm = 20%.
A new project has arisen with an estimated beta of 1.3.
Required:
(a)

What is the required return of the project?

(b)

What relationship does this have to the cost of capital to the


company?

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

CAPM AND FINANCIAL GEARING


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

Differing beta values


Risk
equity

Financial Risk

asset

Business Risk for


this industry
Risk Free

debt = 0
Gearing (D/D+E)

Equity beta (equity)


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

Asset beta (asset)


A measure solely of business risk. In a debt-free company, the equity beta would
be the asset beta. The asset beta will be the same for all companies in the same
industry.

Key formula

V (1 T)

e
d
a =
e +
d
(V

V
(1

T))
(V

e
d

e Vd(1 T))

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

Question approach
1.

Equity beta

Identify a suitable equity beta we need a value from a company in the similar
industry. This beta will probably include gearing risk (if the company has any debt
finance).

2.

De-gear

Use the formula given to strip out the gearing risk to calculate the asset beta for
the project. The asset beta will be the same for all companies/ projects in a similar
industry.

3.

Average asset beta

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


number of proxy asset betas. This way a better assessment of the level of
systematic risk suffered by the industry is calculated.

4.

Re-gear

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

5.

Use CAPM

Calculate the cost of equity using the CAPM formula.

Example 3
Foreignin Co is a wooden doll manufacturer with an equity:debt ratio of 5:3. The
corporate debt, which is risk free, has a gross redemption yield of 6%. The beta
value of the companys equity is 1.2. The average return on the stock market is
11%. The corporation tax rate is 30%.
The company is considering a games console project.
companies are currently operating in the gaming industry.

The following three

Company

Equity beta

1.05

1.10

1.18

Debt (%)

30

35

40

Equity (%)

70

65

60

Foreignin Co maintains its existing capital structure after the implementation of the
new project.
Required:
What would be a suitable cost of capital to apply to the project?

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

Example 4
Tush-aq Co, an all equity agro-chemical firm, is about to diversify into the
consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the
average equity of pharmaceutical firms is 1.3. Gearing in the pharmaceutical
industry averages 40% debt, 60% equity. Corporate debt is considered to be risk
free.
Rm = 10%, Rf = 4%, corporation tax rate = 30%.
Required:
What would be a suitable cost of equity for the new investment if Tush-aq
were to finance the new project in each of the following ways:
(a)

30% debt;

(b)

70% debt?

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CHAPTER 8 BUSINESS RISK AND ADJUSTED DISCOUNT RATES

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Chapter 9

Financial performance
measurement

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

CHAPTER CONTENTS
PROFITABILITY RATIOS ------------------------------------------------ 95
RETURN ON CAPITAL EMPLOYED ROCE

95

RETURN ON EQUITY ROE

95

GEARING ----------------------------------------------------------------- 97
COST

97

RISK FROM THE PERSPECTIVE OF THE COMPANY

97

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


CAPITAL GEARING

99

INTEREST COVER

100

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

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

PROFITABILITY RATIOS
The underlying short-term aim of a company.
There are two basic measures:

1.

Return on Capital Employed (ROCE).

2.

Return on Equity.

Return on capital employed ROCE


A measure of the underlying performance of the business before finance.
It considers the overall return before financing. It is not affected by gearing.

ROCE

Operating Profit
Capital employed

100

Operating profit
Also known as PBIT or profit before interest and tax.

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

Return on equity ROE


A measure of return to the shareholders. It is calculated after taxation and before
dividends have been paid out. It will be affected by gearing.

ROE

Profit after tax


Equity

100

Key working
$
PBIT
less Interest
PBT
Less Tax
PAT
Less Dividends
Retained Earnings

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()

()

()

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

Example 1

Case

A company is considering a number of funding options for a new project. The new
project may be funded by $20m of equity or debt. Below are the financial
statements given the project has been funded in either manner.
Statement of Financial Position extract
Equity Finance
Creditors
Debentures

$m
(10%)

Capital
Share Capital (50p)
Share Premium
Reserves

Debt Finance
$m

0.0

20.0

22.0
10.0
10.0
42.0

14.5
4.5
3.0
22.0

Income Statement extract


$m
Turnover
Gross Profit
less expenses
(excluding interest)
Operating Profit

200.0
40.0
(30.0)
10.0

Corporation Tax is charged at 30%.


Required:
Calculate profitability ratios and compare the financial performance of the
company under both equity and debt funding.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

GEARING
Should we finance the business using debt or equity?
There are two basic considerations:
1.

Cost.

2.

Risk.

Cost
Any finance will incur servicing costs, debt will require interest payments and equity
will require payment of dividends or at least capital growth. On the basis of cost of
servicing we would always pick debt over equity. Debt should be less expensive for
two reasons:

1.

Risk

The debt holder is in a less risky position than the shareholder. The lower risk is
due to two factors:
1.

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

2.

Security Charges or covenants against assets.

2.

Tax

Debt is tax deductible because the debt holders are not owners of the business.
Equity however will receive a return after tax because they receive an appropriation
of profits. Debt is therefore tax efficient.

Risk from the perspective of the company


Risk may be split into two elements:
1.

Business risk.

2.

Financial risk.

Business risk
Business risk is inherent to the business and relates to the environment in which
the business operates.
1.

Competition

2.

Market

3.

Legislation

4.

Economic conditions.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

Financial risk (see chapter 4)


If the company finances itself using debt as well as equity then it must generate
sufficient cash flow to pay interest payments as they fall due. The greater the level
of debt, the greater the interest payments falling due and the greater the volatility
of earnings available to shareholders. This is financial risk.
Gearing causes increased risk.
There are two areas of gearing:

1.

Operating gearing

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


Illustration
Year

Low Op Gearing
2
3
+50%
-67%

High Op Gearing
2
3
+50%
-67%

Year-on-year
Turnover

12,000

18,000

6,000

12,000

18,000

6,000

Variable Cost

6,000

9,000

3,000

1,000

1,500

500

Fixed Costs

1,000

1,000

1,000

6,000

6,000

6,000

PBIT

5,000

8,000

2,000

5,000

10,500

(500)

+60%

-75%

+110%

-105%

Year-on-year

The higher the fixed cost, the more volatile the profit before interest and tax. This
is one of the main indicators of business risk.
A financial manager does not aim to affect the cost structure; this is not one of our
3 key decisions. However you must be aware that the level of operating risk will
impact on the level of financial risk that a company is willing to take on.

2.

Financial gearing

Risk associated with debt financing.


Impact
A company can/must accept some level of risk, and is willing to trade additional risk
for additional gain. The effect of risk is cumulative: if a company already has high
operating gearing it will have to be more conservative with its financial gearing.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

FINANCIAL GEARING MEASURES


The mix of debt to equity within a firms permanent capital.
There are two measures:
1.

Capital Gearing a balance sheet measure.

2.

Interest Cover a profit and loss account measure.

Capital gearing
The mix of debt to equity.

Ratio measure (equity gearing)

Gearing

Debt

Equity

100

100

Proportions measure (total or capital gearing)

Gearing

Debt
Debt + Equity

Debt
All permanent capital charging a fixed interest may be considered debt.
1.

Debentures and loans,

2.

bank overdraft (if significant),

3.

preference share capital.

Equity
1.

Ordinary share capital,

2.

share premium,

3.

reserves.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

Example 3
Statement of financial position extract for Wednap Co
$m
Bank overdraft

$m

5.0
9.0
3.0

Long-term liabilities
Debenture 10%

(8.0)
15.0

Capital
Ordinary share capital
Ordinary share premium
Preference share capital
Reserves

8.0
4.0
1.0
2.0
15.0

Required:
Calculate the financial gearing of the business using both methods.

Interest cover
An income statement measure that considers the ability of the business to cover
the interest payments as they fall due.

Interest cover

PBIT
Interest

Example 4
Stan Ltd statement of comprehensive income extract:
Operating Profit
Interest
Profit Before Tax
Tax @ 30%
Profit After Tax

$m
20.0
(4.5)
15.5
(4.65)
10.85

Required:
(a)

Calculate the interest cover.

(b)

Advise whether this level of cover is safe.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

INVESTOR RATIOS
Assessing the financial position of the company using key information from the
financial statements.

Dividend cover/
dividend payout ratio
Earnings per
share/ PAT

DPS/ total
dividend

Price/ earnings
ratio

Dividend yield

Share price/
total MV

Earnings per share (EPS)


EPS

Profit after tax


Number of ordinary shares in issue

Example 6
The Hoopia Co earned profits after tax of $14m.
shares in circulation.

There are 6 million ordinary

Required:
Calculate the EPS for Hoopia.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

Price earnings ratio (P/E ratio)


The P/E ratio is an indicator of future earnings growth expectations; it compares
the market value to the current earnings.

PE Ratio

Current Share Price

Total Market Value (MV)

EPS

Profit After Tax

Example 7
Dan

Steph

200c

80c

10c

8c

Dividend per share

2c

8c

Number of shares

2 million

4 million

Share Price
EPS

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

Dividend payout ratio


The relationship between the dividend paid and the funds available to pay the
dividend, ie the attributable profit.

Dividend cover

Earnings per share

Profit after tax

Dividend per share

Total dividends

Example 7 contd
Required:
Calculate the dividend payout ratio for each company.

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CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT

Dividend yield
Dividend yield =

Dividend per share


Share price

Total dividends
Total market value

The cash return from holding a share. It is theoretically irrelevant because it only
considers part of the return available to the shareholder (the other part being the
capital gain or increase in share price).

Example 7 contd
Required:
Calculate each companys dividend yield.

Total shareholder return (TSR)


A measure covering the two returns an investor will receive as a result of holding
the share, ie the dividend and the capital gain or loss.

TSR

Dividend per share + Capital gain or loss


Share price at the beginning of the year

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

Example 8
Turnover
EPS
DPS
Closing share price
Return on equity

2006
$7.2m
58.1c
24.3c
$7.25
11%

2007
$8.0m
60.2c
26.3c
$8.85
9%

2008
$7.9m
60.1c
27.6c
$7.34

Required:
Compare and contrast the financial performance of the company with the
expected return on equity.

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Chapter 10

Raising equity finance

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CHAPTER 10 RAISING EQUITY FINANCE

CHAPTER CONTENTS
RAISING EQUITY FINANCE -------------------------------------------- 107
UNLISTED COMPANIES

107

LISTED COMPANIES

107

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


RIGHTS ISSUES

106

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CHAPTER 10 RAISING EQUITY FINANCE

RAISING EQUITY FINANCE


Unlisted companies
Fundamental issue
As an unlisted company it will be difficult to raise any equity finance. This is due to
the following reasons:
1.

Lack of audited information.

2.

Marketability.

3.

Higher risk of unlisted companies.

Sources of equity for unlisted companies


1.

Own funds

2.

Retained earnings

3.

Friends and family

4.

Venture Capital

High risk/ high return.

Close relationship between VC and the company being offered finance.

Medium term (5 7 years).

Exit strategy.

5.

Business Angels

6.

Private placing.

Listed companies
The methods of obtaining a listing are:

1.

Fixed price offer for sale

Offered to the general public at a fixed price.


It has the potential to raise the highest possible price for the company by being
offered to the widest possible market.
The problem is the cost associated with floatation which can be prohibitive.
Advantage: The widest market for shares is sought and hence the highest price
should be achieved.

2.

Offer for sale by tender

Investors are able to bid for shares and the shares are issued only to those
investors who have bid at the striking price or above.
Advantage: Useful where it is difficult for the company to assess the value of the
shares on the stock exchange.

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CHAPTER 10 RAISING EQUITY FINANCE

3.

Placing

Shares are placed with / sold to institutional investors, keeping the cost of the issue
to a minimum.
Advantage: Cheaper to issue shares.

4.

Stock exchange introduction

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

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CHAPTER 10 RAISING EQUITY FINANCE

EQUITY ISSUES BY LISTED COMPANIES


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

Rights issues
A rights issue is the right of existing shareholders to subscribe to new share issues
in proportion to their existing holdings. This is to protect the ownership rights of
each investor.

Advantages
1.

Low cost

2.

Protect ownership rights

3.

Rarely fail.

Theoretical ex-rights price (TERP)


The new share price after the issue is known as the theoretical ex-rights price and
is calculated by finding the weighted average of the existing market price and the
issue price, weighted by the number of shares ex-rights.

Theoretical
=
ex-rights
price

MV of shares (cum rights) + Proceeds from


rights issue
Number of shares (ex rights)

Value of a right
The new shares are issued at a discount to the existing market value, this gives the
rights some value.

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


Example 1
Marcus plc, which has an issued capital of 4,000,000 shares, having a current
market value of $2.80 each, makes a rights issue of one new share for every three
existing shares at a price of $2.00.
Required:
Calculate the theoretical ex-rights price and the value of each right.

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CHAPTER 10 RAISING EQUITY FINANCE

Shareholders options
The shareholders options with a rights issue are to:
1.

Take up (buy) the rights

2.

Sell the rights

3.

A bit of both

4.

Do nothing.

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CHAPTER 10 RAISING EQUITY FINANCE

Required:
(a)

Ignoring issue costs and any use that may be made of the funds
raised by the rights issue, calculate:
(i)

the theoretical ex rights price per share;

(ii)

the value of rights per existing share.

(3 marks)

(b)

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


Tirwen as regards the rights issue? Determine the effect of each of
these actions on the wealth of the investor.
(6 marks)

(c)

Calculate the current earnings per share and the revised earnings per
share if the rights issue funds are used to redeem some of the existing
loan notes.
(6 marks)

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CHAPTER 10 RAISING EQUITY FINANCE

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Chapter 11

Efficient market
hypothesis

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CHAPTER 11 EFFICIENT MARKET HYPOTHESIS

CHAPTER CONTENTS
INTRODUCTION TO EMH ----------------------------------------------- 115
DEGREE OR FORMS OF EFFICIENCY ---------------------------------- 116
IMPLICATIONS OF EMH FOR FINANCIAL MANAGERS --------------- 117

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CHAPTER 11 EFFICIENT MARKET HYPOTHESIS

INTRODUCTION TO EMH
A market is efficient if:

The prices of securities traded in that market reflect all the relevant
information accurately and rapidly, and are available to both buyers and
sellers.

No individual dominates the market.

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


trading significantly.

Market efficiency from the perspective of the EMH relates to the efficiency of
information, the better the information received by investors, the better and
more informed the decisions they make will be.

Fundamental value of shares


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

P0 =

D0 (1+g)
Ke -g

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


analysis, then there must be a difference in how the share price is arrived at which
would suggest that the stock market has not processed information in the way that
the theory indicates.
The market would be said to be less than perfectly efficient. Either:

Investors are not receiving full information about the company, or

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


make share buying decisions.

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CHAPTER 11 EFFICIENT MARKET HYPOTHESIS

DEGREE OR FORMS OF EFFICIENCY


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

1.

Weak form

Weak form hypothesis states that current share prices reflect all relevant
information about the past price movements and their implications. If this is true,
then it should be impossible to predict future share price movements from historic
information or pattern.
Share prices only changes when new information about a company and its profits
have become available. Since new information arrives unexpectedly, changes in
share prices should occur in a random fashion, hence weak form can be referred to
as random walk hypothesis.

2.

Semi- strong form

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

all relevant information about past price movement and their implications;
and

(ii)

publicly available information about the company.

Any new publicly accessible information whether comments in the financial press,
annual reports or brokers investment advisory services, should be accurately and
immediately reflected in current share prices, so investment strategies based on
such public information should not enable the investor to earn abnormal profit
because these will have already been discounted by the market.

3.

Strong form

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

past price changes

public knowledge; and

insider knowledge available to specialists or experts such as investment


managers.

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CHAPTER 11 EFFICIENT MARKET HYPOTHESIS

IMPLICATIONS OF EMH FOR FINANCIAL MANAGERS


If capital markets are efficient, the main implications for financial managers are:
1.

The timing of issues of debt or equity is not critical, as the prices quoted in
the market are fair. That is price will always reflect the true worth of the
company, no over or under valuation at any point.

2.

An entity cannot mislead the markets by adopting creative accounting


techniques.

3.

The entitys share price will reflect the net present value of its future cash
flows, so managers must only ensure that all investments are expected to
exceed the companys cost of capital.

4.

Large quantities of new shares can be sold without depressing the share price.

5.

The market will decide what level of return it requires for the risk involved in
making an investment in the company. It is pointless for the company to try
to change the markets view by issuing different types of capital instrument.

6.

Mergers and takeovers. If shares are correctly priced this means that the
rationale behind mergers and takeovers may be questioned. If companies are
acquired at their current market valuation then the purchasers will only gain if
they can generate synergies (operating economies or rationalisation). In an
efficient market these synergies would be known, and therefore already
incorporated into the price demanded by the target company shareholders.

The more efficient the market is, the less the opportunity to make a speculative
profit because it becomes impossible to consistently out-perform the market.
Evidence so far collected suggests that stock markets show efficiency that is at
least weak form, but tending more towards a semi-strong form. In other words,
current share prices reflect all or most publicly available information about
companies and their securities.

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CHAPTER 11 EFFICIENT MARKET HYPOTHESIS

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Chapter 12

Valuation

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CHAPTER 12 VALUATION

CHAPTER CONTENTS
BUSINESS VALUATION ------------------------------------------------- 121
REASONS FOR VALUATION

121

COMPANY ACQUISITION

121

APPROACHES

121

VALUING SHARES ------------------------------------------------------ 122


THE DIVIDEND VALUATION MODEL

122

ASSET BASED VALUATIONS

123

INCOME / EARNINGS BASED METHODS

125

PV OF THE FREE CASH FLOWS

126

VALUATION OF DEBT --------------------------------------------------- 129

120

IRREDEEMABLE DEBT

129

REDEEMABLE DEBT

130

CONVERTIBLE DEBT

130

PREFERENCE SHARES

131

NON-TRADED DEBT

131

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CHAPTER 12 VALUATION

BUSINESS VALUATION
Reasons for valuation
The purpose of conducting the valuation will have an impact on the approach taken
and factors considered in arriving at the value:

Buying a business

Selling a (going concern) business

Selling an unwanted business

Seeking finance.

Company acquisition
When an investor buys a company, the investment involves paying an acceptable
amount for the shares of the company and usually results in the investor assuming
responsibility for any debt carried by the company.
Debt will usually be valued as the present value of future interest and redemption.
The value of shares is open to wider variation in approach. Ultimately, any agreed
price will depend on the arguing positions of the two parties to the acquisition,
rather than the result of a formulaic approach.

Approaches
The three main approaches are:

Dividend valuation model.

Income / earnings basis.

Asset basis.

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CHAPTER 12 VALUATION

VALUING SHARES
The dividend valuation model
Seen earlier, the value of the share is the present value of the expected future
dividends discounted at the cost of equity.
Po

do (1 g)
ke g

FORMULA GIVEN

Advantages
1.

Considers the time value of money and has an acceptable theoretical basis.

2.

Particularly useful when valuing a minority stake of a business.

Disadvantages
1.

Difficulty estimating an appropriate growth rate.

2.

The model is sensitive to key variables.

3.

The growth rate is unlikely to be constant in practice (although the formula


above assumes this to simplify DCF whilst it is possible to forecast and
discount varying cash flows).

Note
VE = Share price x Total number of shares.

Example 1
A company has the following information:
Share capital in issue is 20m ordinary shares, with a 25 par value.
Current dividend per share (paid recently) - 4
Dividend five years ago 2.5
Current equity beta 0.6
Market information:
Current market return 17%
Risk-free rate 6%
Required:
Calculate the market value of the company.

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CHAPTER 12 VALUATION

Example 2
A company has the following information:
Ordinary share capital (10m par value 50c)
Current dividend (ex div) - 16
Current EPS - 20
Current return earned on assets - 20%
Current equity beta 0.9
Current market return 11%
Risk-free rate 6%
Required:
Find the market capitalisation of the company.

Asset based valuations


Weaknesses

Investors do not normally buy a company for the book value of its assets, but
for the earnings / cash flows that the sum of its assets can produce in the
future.

It ignores intangible assets. It is very possible that intangible assets are more
valuable than the balance sheet assets.

Uses for asset based valuations:

Asset stripping.

To identify a minimum price in a takeover.

If the assets are predominantly tangible assets.

Types of asset based measures


Book value
There is never a circumstance where book value is an appropriate valuation base.
It may however be used as a stepping stone towards identifying another measure.

Net realisable value


Only used to establish a minimum value for an asset, it may be difficult to find an
appropriate value over the short term. Used for a company when being broken up
or asset stripped.

Replacement cost
May be used to find the maximum value for an asset. Used for a company as a
going concern.

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CHAPTER 12 VALUATION

Example 3
Below is the most recent Statement of Financial Position for Fagin Co:
$
Non-current assets (carrying value)

625,000

Net current assets

160,000
_______
785,000
_______

Represented by
50c ordinary shares

300,000

Reserves

285,000

6% debentures

200,000
_______
785,000
_______

Notes:

Loan notes are redeemable at a premium of 5%.

The premises have a market value that is $50,000 higher than the book
value.

All other assets are estimated to be realisable at their book value.

Required:
Value the ordinary shares on an assets basis.

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CHAPTER 12 VALUATION

Income / earnings based methods


Of particular use when valuing a majority shareholding:
1.

As majority shareholders, the owners can influence the future earnings of the
company.

2.

With a controlling interest, the investor will dictate the dividend policy,
making earnings more relevant than dividends.

PE method
PE ratios are quoted for all listed companies and calculated as:
PE

Pr ice per share


EPS

This can then be used to value shares in unquoted companies as:


Value of company

Total earnings P/E ratio

Value per share

EPS P/E ratio

using an adjusted P/E multiple from a similar quoted company (or industry
average).

Example 4
H Co is an unlisted company.
Extract from income statement for the year just ended:
$

Profit before taxation

430,000

Less: Corporation tax

110,000
______

Profit after taxation


Less: Preference dividend
Ordinary dividend

320,000
30,000
40,000
______

(250,000)
_______

Retained profit for the year

70,000
_______

The PE ratio applicable to a similar type of business is 10.


Required:
Calculate the value of the shares in H Co on a PE basis.

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Earnings yield
The earnings yield is the inverse of the PE ratio:
Earnings yield

EPS
Pr ice per share

It can therefore be used to value the shares or market capitalisation of a company


in exactly the same way as the PE ratio:
Value of company

Total earnings

Value per share

EPS

1
Earnings yield

1
Earnings yield

Example 5
Company A has earnings of $300,000. A similar listed company has an earnings
yield of 12.5%.
Required:
Calculate a market value for Company A.

PV of the free cash flows


A buyer of a business is obtaining a stream of future operating or free cash flows.
The value of the business is:
PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used.
Method:
1.

Identify relevant free cash flows

operating cash flows

revenue from sale of assets

tax payable

tax relief

synergies from merger (if any).

2.

Select a suitable time horizon.

3.

Identify a suitable weighted average cost of capital.

4.

Calculate the present value over the time horizon.

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Advantages

The best method on a theoretical basis.

May value a part of the company.

Disadvantages

It relies on estimates of both cash flows and discount rates may be


unavailable.

Difficulty in choosing a time horizon.

Difficulty in valuing a companys worth beyond this period.

Assumes that the discount rate and tax rates are constant through the period.

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CHAPTER 12 VALUATION

Example 7
Recent financial information relating to Open Co, a listed company, is as follows.
$m
115
69

Profit after tax (earnings)


Dividends
Statement of financial position information:
$m
Non-current assets
Current assets
Total assets
Current liabilities
Equity
Ordinary shares ($1 nominal)
Reserves

120
705

Non-current liabilities
6% Bank loan
8% Bonds ($100 nominal)

105
190

$m
815
515
1,330
210

825

295
1,330

Forecasts are that the dividends of Open Co will grow in the future at a rate of 3%
per year. The forecast growth rate of the earnings of the company is 4% per year.
Considering the risk associated with expected earnings growth, an earnings yield of
11% per year can be used for valuation purposes.
The cost of equity is 10% per year and the gross redemption yield on debt is 7%.
The ex-dividend share price of the company is $850 per share.
Required:
Calculate the value of Open Co using the following methods:
(a)

net asset value method;

(b)

dividend growth model;

(c)

earnings yield method.

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CHAPTER 12 VALUATION

VALUATION OF DEBT
When valuing debt we assume that
Market price

The discounted cash flows of the debt

The relevant cash flows are interest payments and eventual redemption of the
capital.
The debt is valued based on gross values for cash flow and cost of debt capital.

Irredeemable debt
The company does not intend to repay the principal but to pay interest forever, the
interest is paid in perpetuity.
The formula for valuing a debenture is therefore:
MV

I
r

where:
I

annual interest starting in one years time

MV

market price of the debenture now (year 0)

debt holders required return, expressed as a decimal.

Example 8
A company has issued irredeemable loan notes with a coupon rate of 9%.
gross yield required by investors in this category of debt is 6% per annum.

The

Required:
Calculate the current market value of the debt.

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Redeemable debt
The market value is the present value of the future cash flows, these normally
include:
1.

Interest payments for the years in issue

2.

Redemption value.

Example 9
The 8% Bonds in Open Co (example 7) will be redeemed at nominal value in 4
years time.
Required:
Calculate the market value of the debt.

Convertible debt
The market value of a convertible is the higher of its value as debt (the Floor
Value) and its converted value.

Example 10
WERT Co has $40m convertible loan notes with a coupon rate of 7%. Each $100
loan note may be converted into 16 ordinary shares at any time until the date of
expiry and any remaining loan note will be redeemed at $100.
The debenture has four years to redemption. Investors require a rate of return of
6% per annum.
The current share price of WERT Co is 600 cents which is expected to grow at 4%
per annum.
Required:
Calculate
(a)

The floor value

(b)

The market value, and

(c)

The conversion premium

of the loan stock.

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Preference shares
Similar to irredeemable debt, the income stream is the fixed percentage dividend
received in perpetuity.
The formula is therefore:

P0

D
Kp

where:
D

the constant annual preference dividend

P0

ex-div market value of the share

Kp

cost of the preference share.

Example 11
A company has 11% preference shares in issue with a 50 cent par value.
required return of preference shareholders is 6%.

The

Required:
Calculate the market value of a preference share.

Non-traded debt
Non-traded debt has a value equal to the book value appearing in the statement of
financial position.
In example 7, Open Cos 6% Bank Loan would be valued at $105m in any gearing
or WACC working.

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Chapter 13

Risk

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CHAPTER 13 RISK

CHAPTER CONTENTS
FOREIGN CURRENCY RISK --------------------------------------------- 135
TRANSACTION RISK

135

TRANSLATION RISK

135

ECONOMIC RISK

135

THE EXCHANGE RATE--------------------------------------------------- 136


SPOT RATE

136

SPOT RATE WITH SPREAD

136

HEDGING EXCHANGE RATE RISK ------------------------------------- 137


INTERNAL HEDGING TECHNIQUES

137

EXTERNAL HEDGING TECHNIQUES

138

OTHER CURRENCY HEDGING TECHNIQUES

141

EXCHANGE RATE SYSTEMS -------------------------------------------- 143


FLOATING RATE SYSTEMS

143

MANAGED OR DIRTY FLOAT

143

FIXED (OR PEGGED) RATE SYSTEMS

143

WHAT MAKES EXCHANGE RATES FLUCTUATE? ---------------------- 144


BALANCE OF PAYMENTS

144

CAPITAL MOVEMENTS BETWEEN COUNTRIES

144

INTEREST RATE PARITY THEORY (IRPT)

144

PURCHASING POWER PARITY THEORY (PPPT)

145

THE INTERNATIONAL FISHER EFFECT

146

INTEREST RATE RISK -------------------------------------------------- 147


THE YIELD CURVE (TERM STRUCTURE OF INTEREST RATES)

147

HEDGING INTEREST RATE RISK -------------------------------------- 148


SHORT-TERM MEASURES

148

LONG-TERM HEDGING SWAPS -------------------------------------- 149

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FOREIGN CURRENCY RISK


The risk that the exchange rate may move up or down in relation to other
currencies. It will have a major impact on the predictability of profitability of any
company that buys from or sells to other countries.

Illustration
A company has a foreign asset with a value of 800,000.
The exchange rate is currently 0.7774 /$
The asset, therefore, has a current value of 800,000 0.7774 =

$1,029,071

After some time, the asset is still worth 800,000.


The exchange rate has moved to 0.8000 /$
The asset value in dollars is now 800,000 0.8000
There is an exchange rate loss of

$1,000,000
$29,071

Transaction risk
The risk associated with short-term cash flow transactions.
If the asset of 800,000 is a trade receivable, the risk is classed as transaction risk.
The receipt of 800,000 concludes the transaction; the exchange rate loss
materialises and is irreversible.

Translation risk
Risk associated with the reporting of foreign currency assets and liabilities within
financial statements. The 800,000 asset may be a tangible non-current asset.
There is no cash flow impact of this type of risk. However, the impact on the
financial statements can be severe. In later periods, the exchange rate may move
in the opposite direction, resulting in an exchange rate gain.
There is still
uncertainty, though, about the reported results.
Translation risk may be managed by matching the assets and liabilities within each
country. If 800,000 were financed by borrowing 800,000, the net asset would be
0 and any movement in exchange rate would not affect the translated value.

Economic risk
Long-term cash flow effects associated with asset investment in a foreign country
or alternatively loans taken out or made in a foreign currency and the subsequent
capital repayments.
Economic risk is more difficult to hedge given the longer term nature of the risk
(possibly over 10 or more years). A simple technique would be to adopt a portfolio
approach to investments by currency to spread the risk.

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CHAPTER 13 RISK

THE EXCHANGE RATE


Spot rate
A prevailing rate at a specific point in time usually refers to todays rate
Given as

0.7774 /$

0.7774 per $

This means that the Euro () is expressed in terms of one dollar ($); i.e. how many
Euro equate to one dollar.
May also be given as:

1.2863 $/

1.2863 $ per

Where we have the amount of dollars equivalent to one Euro.

Conversion rule

( and )

1st currency to calculate the 2nd


2nd currency to calculate the 1st

Currency amount

Rate

Conversion

/$

Divide

$/

Multiply

/$

Multiply

$/

Divide

Spot rate with spread


The rate is usually expressed in terms of a bid/offer spread.
eg

0.7770 - 0.7778 /$

Banks will buy currency using the rate that gives them the lower outlay; they will
sell currency at the rate giving them the higher receipt.

Example 1
(a)

(b)

Spot rate 0.7770 - 0.7778 /$


(i)

A US company banks a 300,000 receipt.

(ii)

A US company buys 155,000 to pay a supplier.

Spot rate 1.2857 1.2870 $/


(i)

A European company pays a US supplier $385,710

(ii)

A US company buys 155,000 to pay a supplier

Required:
Calculate the values of the transactions.

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HEDGING EXCHANGE RATE RISK


Hedging is the process of reducing or eliminating risk. It may be achieved by using
internal or external measures.
Internal measures have the advantage of being essentially cost free but at the
same time are unlikely to completely eliminate the risk.
External measures involve a bank or financial market. They will incur cost but may
totally eliminate the risk.

Internal hedging techniques


Invoice in own currency
By invoicing in your own currency you do not suffer the risk of exchange rate
movement.
The risk does not disappear; instead it passes to the other party. It is questionable
whether the other party will be happy to accept this risk.

Matching or netting
If a company makes a number of transactions in both directions it will be able to
net off those transactions relating to the same dates. By doing so a company can
materially reduce the overall exposure, but is unlikely to eliminate it.
In order to perform netting the company must have a foreign currency bank
account in the appropriate country.

Leading or Lagging payments


Leading involves settling trade payables earlier than the terms of trade require.
Although there may be a cost of capital associated with paying early there are
certain benefits relating to exchange rate risk:

The payment is made ahead of a period of uncertainty for the exchange rate.

The company can take advantage of early settlement discounts.

The early payment may be matched to receipt of currency from a trade


customer, netting off and reducing exposure to exchange rate risk.

Lagging is the opposite: delaying payment to a supplier, possibly forgoing


settlement discounts but facilitating netting against an anticipated currency receipt.

Do nothing
Exchange rates will fluctuate up and down. It could be argued that since you win
some and lose some then ignoring the risk would be the best option; particularly if
your company has frequent transactions (imports & exports) in a foreign currency.
As a result you save on hedging costs, the downside being that the exposure to
exchange rates is present in the short-term.

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External hedging techniques


Forward contract
Features:
1.

An agreement with a bank to exchange a fixed amount of currency for a


specific amount at a fixed future date.

2.

It is an obligation that must be completed once entered into.

3.

It is an over the counter (OTC) product which means that it is tailored to the
specific value and date required.

4.

The forward rate offers a perfect hedge because it is for the exact amount
required by the transaction on the appropriate date and the future rate is
known with certainty.

Forward rates
Forward rates are given by the banks and stated in the same way as spot rates,
with a bid-offer spread. The spread for forward rates is wider than that for spot
rates, giving the bank larger profit on forward deals due to the additional risks it
takes.
Spot rate

0.7770

Forward rate
1 month
3 months

0.7781
0.7802

per $

0.7778

spread
0.0008

0.7793
0.7820

0.0012
0.0018

Example 2
Danke Yudle Co, based in the US, expects the following transactions:
In 1 month:
Receipt of

265,000

Payment of

515,000

In 3 months time:
Receipt of

680,000

Payment of

230,000

Required:
Calculate the values of the future transactions using forward contracts.

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CHAPTER 13 RISK

Advantages

Flexibility with regard to the amount to be covered, should lead to a perfect


hedge in terms of amount and date.

Relatively straightforward both to comprehend and to organise.

Disadvantages

Contractual commitment that must be completed on the due date, if the


underlying transaction is in anyway doubtful this may be problem.

The rate is fixed with no opportunity to benefit from favourable movements in


exchange rates. Potential of opportunity cost if the exchange rate moves
favourably.

Money market hedge


Use of the short-term money markets to borrow or deposit funds. The hedge
involves matching future currency assets with liabilities and gives the company the
opportunity to exchange currency today at the prevailing spot rate.

Steps
1.

Match expected asset with liability or liability with asset:


(i)

If expecting a trade receipt (asset); create a liability by borrowing

(ii)

If due to make a payment (liability); create and asset by investing.

Discount value of transaction to present value using money market rate


available.
This ensures that there is no need for future conversion of
currency.
2.

Translate exchange the funds at spot rate avoiding exposure to fluctuations


in the rate.

3.

Use domestic (home) money market and compound to provide comparison


to other hedging approaches.

Advantages

There is some flexibility regarding the date at which the transaction takes
place.

May be available in currencies for which a forward rate is not available.

The final step is not obligatory. The company could use proceeds generated
to earn a better return than that available from the domestic money market
(eg reducing an overdraft).

Disadvantages

May be difficult to borrow/ deposit in some currencies at a risk-free rate.

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Other currency hedging techniques


Currency Futures
The Future is an exchange traded instrument that can be bought or sold on one of
four exchanges (the largest is in Chicago). Futures involve speculation on the
movement of the rate. If movements are guessed correctly, gains can be made at
the expense of those who guessed incorrectly.
The aim is to speculate on futures in such a way as to compliment the underlying
trade. Therefore you will have:
1.

A futures position making a gain when a trade transaction suffers an


exchange rate loss; or,

2.

A futures position suffering a loss when the trade transaction results in an


exchange rate gain.

The linking of the two cancels out the movement of the exchange rate and leads to
the hedge.
Currency futures contracts are only available for a limited number of major
currencies and in predetermined (standardised) volumes. Each /$ futures contract
is for 125,000. Thus a transaction of 450,000 would either involve 3 contracts,
leaving 75,000 exposed to currency risk or 4 contracts with risk over 50,000 in
the futures market.
The future is also standardised financial instrument in terms date. If the underlying
transaction does not fall on one of four dates (March, June, September, December),
there will be an element of risk in the hedge known as basis risk.

Currency options
Options operate as insurance. A premium is paid which ensures that an eventual
receipt does not fall below a specified amount or an eventual payment does not
exceed a specified amount.
If the exchange rate moves favourably, there is no obligation to fulfil the option
contract. Options have the benefit of being a one-sided bet. You can protect the
downside risk of the currency moving against you but still take advantage of the
upside potential.
Standardised traded options (see futures) are available on some markets but
companies may deal in options over the counter, getting a contract that is tailor
made to their currency transaction.

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EXCHANGE RATE SYSTEMS


External hedging techniques are all costly and should be avoided if there is little
currency risk. Whether there is a significant amount of risk will depend on various
factors including the system by which exchange rates between two currencies are
derived.
Exchange rates are a key measure for governments to attempt to control. They will
have direct bearing on the economic performance of the country.

Floating rate systems


Where the exchange rate is allowed to be determined without any government
intervention. It is determined by supply and demand.
The market has a tendency to be volatile to the adverse effect of trade and wider
government policy. This volatility can adversely affect the ability to trade between
currencies.

Managed or dirty float


Where the market is allowed to determine the exchange rate but with government
intervention to reduce the adverse impacts of a freely floated rate.
The government may intervene by:

Using reserves to buy or sell currency. The government can artificially


stimulate demand or supply and keep the currency within a trading range
reducing volatility.

Using interest rates. By increasing the interest rate within the economy the
government makes the currency more attractive to investors in government
debt and will attract speculative funds.

Fixed (or pegged) rate systems

Where a currency is fixed in relation to a dominant currency (eg, $).

The peg may be changed from time to time to reflect the relative movement
in underlying value.

This form of currency management is effective at giving a stable exchange


platform for trade. Pegged rates are typically used and managed by smaller
economies.

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WHAT MAKES EXCHANGE RATES FLUCTUATE?


Balance of payments
The inflows and outflows from trade reflect demand for and supply of the home
currency. If there is a consistent deficit or surplus there will be a continuing excess
supply or demand for the currency that would be reflected in weakness or strength
in the currency.
For major traded currencies this effect is relatively small.

Capital movements between countries


Of far more importance for major currencies are the flows of speculative capital
from one currency to another. An increase in the interest rate of one currency will
lead to an increase of demand for that currency increasing its value.
It is difficult to predict future rates based on this measure.

Interest rate parity theory (IRPT)


The theory that there is a no sum gain relating to investing in government bonds in
differing countries. Any benefit in additional interest is eliminated by an adverse
movement in exchange rates.
IRPT is an unbiased but poor predictor of future exchange rates.
principles of IRPT are used by banks calculating forward rates.

However, the

Example 5
The spot rate is 0.7774 per $.
Annual interest rates are:

7%

$5%

Starting with $1,000,000, show how the capital would grow if invested in $USD or
in EUR.
Required:
Calculate the expected exchange rate after one year.

Now
Interest

$
1,000,000
1.05

Rate
0.7774

1.07

+ 1 year
The predicted exchange rate would be:

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Formula for interest rate parity


F0 = S0

(1 ic )
(1 ib )

F0 = The forward exchange rate (c per b)


S0 = The spot rate (c per b)
ic =

The interest rate for currency c

ib = The interest rate for currency b

Purchasing power parity theory (PPPT)


Based on the law of one price in economic theory. This would suggest that the
relative price of the comparable products remains the same in all currencies.
The theory is that exchange rates will follow price changes to maintain the relative
value of products between two countries.
PPPT is an unbiased but poor predictor of future exchange rates.

Example 6
The spot rate is 0.7774.
AB has $10,000 to spend in the US where inflation is 3.72% per annum.
In Europe, inflation is projected at 5.7% per annum.
Required:
Illustrate how exchange rates might move to maintain purchasing power
parity.

Now
Inflation

$
10,000

Rate (/$)
0.7774

1.0372

1.057

+ 1 year
The baskets of goods that are comparable now will remain comparable after one
year so the predicted exchange rate would be 8,217/$10,372 = 0.7922 per $.
To calculate the impact of PPPT use the following (given) formula:
S1 = S0

(1 hc )
(1 hb )

S1 = The current prediction of the spot rate (c per b) in 1 years time


S0 = The spot rate (c per b)
hc = The inflation rate for currency c
hb = The inflation rate for currency b

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CHAPTER 13 RISK

The international Fisher effect


The assumption that all currencies must offer the same real interest rate. This links
IRPT to Purchasing Power Parity. It is based upon the Fisher effect.
The relative real interest rates should be the same due to the principle of supply
and demand, if a country offers a higher real interest rate investors will invest in
that currency and push up the price of the currency bringing the real rate back to
equilibrium.
The impact is that, although PPPT and IRPT should give the same predicted
exchange rate. Inflation rates are difficult to predict but interest rates are quoted,
making it easier to predict using IRPT.
Remember the Fisher effect:
(1 + i) = (1 + r)(1 + h)

Illustration
(using values from previous illustrations for PPPT and IRPT)

Now

+ 1 year

Real rate of return

PPPT

IRPT

0.7774

0.7774

1.057/1.0372

1.07/1.05

0.7922

0.7922

Euro

US

= 1.07/1.057 - 1

= 1.05/1.0372 1

= 1.23%

= 1.23%

The reason for both PPP and IRP having the same prediction is because the
international Fisher effect holds true.

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INTEREST RATE RISK


A company will be exposed to interest rate risk if it knows today that it expects to
make a financial transaction (borrowing or investing) but not for a few months.
For example, a company has debentures which are due for redemption in 18
months time. The company will maintain its capital structure by taking out new
debt to pay for redemption of the existing debt.
Borrowing rates are currently low but there is speculation that they may rise
substantially over the next two years.
If the company aims to minimise risk, it will take steps now to ensure that the
eventual interest rate is known in advance.

The yield curve (term structure of interest rates)


The relationship between the gross redemption yield of a debt investment and its
term to maturity.
There are 3 elements:

Gross
Redemption
Yield

Term to maturity

1.

Liquidity preference

Investors prefer to be liquid over being illiquid. To encourage investment over the
longer term the long-term debt must offer a higher return over short-term debt.

2.

Market expectations

If interest rates are expected to fall over time long-term rates will be lower than
short-term rates. This would lead to an inverted yield curve.

3.

Market segmentation

Differing parts of the market (short-term vs long-term debt markets) may react to
differing economic information meaning that the yield curve is not smooth but
suffers discontinuities.

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HEDGING INTEREST RATE RISK


We may hedge interest rate risk over the short or the long-term.
Short term hedging

Long-term hedging

Forward rate agreements

Swaps

Interest rate guarantee


Interest rate futures
Interest rate options

Short-term measures
Forward rate agreements (FRA)
The fixing of the interest rate today in relation to a future short-term loan. It is an
obligation that must be taken once entered into. It is OTC and tailored to a specific
loan in terms of:
1.

Date

2.

Amount, and

3.

Term

and offers a perfect hedge. The FRA is wholly separate to the underlying loan.
It will give certainty as regards the interest paid but there is a downside risk that
interest rates may fall and we have already fixed at a higher rate.

Interest rate guarantee (IRG)


Similar to a FRA but an option rather than on obligation. In the event that interest
rates move against the company (eg rise in the event of a loan) the option would
be exercised. If the rates move in our favour then the option is allowed to lapse.
There is a premium to pay to compensate the IRG writer for accepting the
downside risk.

Interest rate futures


An exchange traded instrument that works in a similar manner to a FRA.
trading on the exchange the Future can fix the rate today for a future loan.

By

Exchange traded interest rate options


Similar to an IRG but exchange traded, the option gives protection against the
downside for the payment of a premium.

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LONG-TERM HEDGING SWAPS


A company will borrow either using a variable or a fixed rate. If it wishes to change
its borrowing type it could redeem its present debt and re-issue in the appropriate
form. There are risks and costs involved in doing so.
A swap allows the company to change the exposure (fixed to variable or vice versa)
without having to redeem existing debt.
To prepare a swap we need the following steps:
1.

Identify a counter-party, either another company or bank willing to be the


other side of the transaction. If we want to swap fixed for variable they will
want the opposite.

2.

Agree the terms of the swap to ensure that at the outset both parties are in a
neutral position.

3.

On a regular basis (perhaps annually) transfer net amounts between the


parties to reflect any movement in the prevailing exchange rates.

Advantages of swaps

Allows a change in interest rate exposure at relatively low cost and risk.

May allow access to a debt type that is otherwise unavailable to the company.

May reduce the overall cost of financing in certain circumstances.

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Chapter 14

Working capital
management

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

CHAPTER CONTENTS
WORKING CAPITAL MANAGEMENT AN OVERVIEW --------------- 153
WORKING CAPITAL SEESAW

154

LEVEL OF WORKING CAPITAL

154

MANAGING RECEIVABLES --------------------------------------------- 155


CREDIT MANAGEMENT

155

COST OF FINANCING RECEIVABLES ---------------------------------- 156


DISCOUNTS FOR EARLY PAYMENT

156

FACTORING

157

MANAGING INVENTORY ----------------------------------------------- 158


MATERIAL COSTS

158

ECONOMIC ORDER QUANTITY

158

BULK PURCHASE DISCOUNTS

160

FUNDING THE WORKING CAPITAL REQUIREMENT

161

SHORT-TERM SOURCES OF FINANCE

162

ASSET SPECIFIC SOURCES OF FINANCE

163

MEASURES OF WORKING CAPITAL MANAGEMENT ------------------ 164


LIQUIDITY RATIOS

164

OVERTRADING ---------------------------------------------------------- 165


CASH MANAGEMENT ---------------------------------------------------- 167
THE MILLER-ORR MODEL

167

THE BAUMOL MODEL

168

CASH BUDGET

169

THE TREASURY FUNCTION--------------------------------------------- 171

152

ROLE

171

CENTRALISATION VS. DECENTRALISATION

171

PROFIT CENTRE VS. COST CENTRE

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

WORKING CAPITAL MANAGEMENT AN OVERVIEW


CURRENT
ASSETS

CURRENT
LIABILITIES

MINUS

Inventory

Payables

Receivables
Cash and Bank

Bank overdraft

Require funding
Aim : Minimise
current assets

Provide funding
Aim: Maximise
current liabilities

Cash operating cycle


The cash operating cycle is the length of time between the companys outlay on raw
materials, wages and other expenditures and the inflow of cash from the sale of
goods.

Purchases

Sales
Inventory

Receipt
Receivables

Days

Payables
Payment

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Operating cycle

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Example 1
Statement of Comprehensive Income extract
Turnover
Gross profit
Statement of Financial Position extract
Current Assets
Inventory
Receivables

$
250,000
90,000
$

30,000
60,000
180,000

Current Liabilities
Payables

50,000

Required:
Calculate the current operating cycle.

Working capital seesaw


Have sufficient
working capital
assets to conduct
business

Keep the overall


investment to a
minimum to avoid
the financing cost

Level of working capital


1.

The nature of the business,

2.

Certainty in supplier deliveries,

3.

The level of activity of the business,

4.

The companys credit policy.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

MANAGING RECEIVABLES
Offering credit
encourages
customers to take up
our goods

Offering credit introduces


risk of default, defers
inflow of cash and needs
managing

Credit management
There are three aspects to credit management:
1.

Assessing credit status

2.

Terms

3.

Day to day management.

Assessing credit status


The creditworthiness of all new customers must be assessed before credit is
offered. Existing customers must also be re-assessed on a regular basis. The
following may be used to assess credit status of a company
1.

Bank References

2.

Trade References

3.

Published accounts

4.

Credit rating agencies

5.

Companys own sales record.

Terms
Considerations may include:
1.

Credit limit value

2.

Number of days credit

3.

Discount on early payment

4.

Interest on overdue account.

Day to day management


The credit policy is dependent on the credit controllers implementing a set of
procedures. If the system is not rigorous, those debtors who dont want to pay will
find ways not to pay. A process may be like the following:
SALE

30 days

+30 days

+7 days

+7 days

Credit allowed

Statement
of account

Reminder
notice

2nd
Reminder

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+7 days
Threat of
legal action

+7 days
Instigate
legal action

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

COST OF FINANCING RECEIVABLES


The receivables balance needs to be financed. Any change to the receivables
balance will lead to a change in the financing cost of the business.

Annual financing cost = Receivables balance cost of capital

Receivables Turnover x

Receivables days
365

Example 2
Shanks Limited has sales of $40m for the previous year; receivables at the yearend were $8m. The cost of financing debtors is covered by an overdraft at an
annual interest rate of 14%.
Required:
(a)

Calculate the receivables days for Shanks.

(b)

Calculate the cost of financing receivables.

Discounts for early payment


Cash discounts are given to encourage early payment by customers. The cost of
the discount is balanced against the savings the company receives from a lower
balance and a shorter average collecting period.

Example 3
Shanks as above but a discount of 2% is offered for payment within 10 days.
Required:
Advise whether, on financial grounds, the company should introduce the
discount given that 50% of the customers would be expected to take up
the discount?

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Advantages/Disadvantages
Advantages
1.

Reducing the receivables balance and hence the interest charge.

2.

May reduce the volume of bad debts arising.

Disadvantages
1.

Difficulty in setting the terms.

2.

Greater uncertainty as to when cash receipts will be received.

3.

Customers may pay over normal terms but still take the cash discount.

Factoring
There are three main types of factoring service available:
1.

Debt Collection and Administration

2.

Credit Insurance

3.

Financing.

Example 4
Shanks again but a factor has offered a debt collection service which should shorten
the debt collection period on average to 50 days. It charges 1.6% of turnover but
should reduce administration costs to the company by $175,000.
Required:
Advise whether the company should use the factoring facility.

Advantages/Disadvantages
Advantages
1.

Saving in internal administration costs.

2.

Particularly useful for small and fast growing businesses where the credit
control department may not be able to keep pace with volume growth.

Disadvantages
1.

Could be more costly than an efficiently run credit control department.

2.

Using a factor may suggest your company has money worries.

3.

Customers may not wish to deal with a factor.

4.

It may be difficult to revert easily to an internal credit control.

5.

The company may give up the opportunity to decide to whom credit may be
given.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

MANAGING INVENTORY
Holding inventory is
necessary for operations;
in terms of finished goods
it offers greater choice to
customers

Holding inventory incurs


costs, in particular there is
the opportunity cost of
money tied up in inventory

Material costs
Material costs are a major part of a companys costs and need to be carefully
controlled. There are 4 types of cost associated with inventory:
1.

ordering costs

2.

holding costs

3.

stock-out costs

4.

purchase cost.

Ordering costs
The clerical, administrative and accounting costs of placing an order.
usually assumed to be independent of the size of the order.

They are

Holding costs
Holding costs include items such as:
1.

Opportunity cost of the investment in inventory

2.

Storage costs

3.

Insurance costs

4.

Deterioration.

Stock-out costs
1.

Lost contribution through loss of sale

2.

Lost future contribution through loss of customer

3.

The cost of emergency orders of materials

4.

The cost of production stoppages.

Economic order quantity


The economic order quantity, EOQ, is the regular order size to be placed in order to
minimise inventory related costs.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

As the size of the order increases, the average inventory held increases and holding
costs will also tend to increase.
As the order size increases the number of orders needed decreases and so the
ordering costs fall. The EOQ determines the optimum combination.

Q=

2Co.D
Ch

Co

Cost per order

Annual demand

Ch

Cost of holding one unit for one year.

Cost
Total cost

Cost C

C
o
s
t
s
t
s

Holding Costs

Ordering Costs

EOQ

Reorder Quantity

Example 5
A company requires 10,000 units of material X per month. The cost per order is
$30 regardless of the size of the order. The holding costs are $20 per unit per
annum. It is only possible to buy in quantities of 500, 600 or 700 units at one
time.
Required:
(a)

Calculate the total inventory-related costs at each possible order


quantity.

(b)

Calculate the economic order quantity.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Bulk purchase discounts


The sum of the holding and ordering costs are minimised at the EOQ. There will
however be savings in the purchase cost when the bulk discount volume is taken.
Calculate total costs at each possible level of discount to establish whether the
discount is worth taking.

Example 6
Annual demand is 120,000 units. Ordering costs are $30 per order and holding
costs are $20/unit/annum. The material can normally be purchased for $10/unit,
but if 1,000 units are bought at one time they can be bought for $9,800.
Required:
Calculate the order quantity which will minimise the total cost.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Funding the working capital requirement


Short-term sources of
finance

Long-term sources of
finance

Bank overdraft
Trade creditors

Equity
Long-term debt

Examples

Advantages
1.
2.
3.

Flexible only borrow


what is needed
Cheaper liquidity
preference
Easier to source

1. Secure no need to
constantly replenish
2. Lower financing risk
3. Matching funding to need

Fluctuating
current
assets

Short-term
funds

Current
Assets

Permanent
current assets

Short-term
funds or
Long-term
funds

Time

Financing policies for current assets


Conservative strategy
Where permanent current assets and some fluctuating current assets are financed
long-term to take advantage of the security of the long-term nature of the finance.
Aggressive strategy
Where all fluctuating current assets are financed short-term to take advantage of
the lower cost of short term financing.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Short-term sources of finance


Trade credit
The delay of payment to suppliers is effectively a source of finance.
By paying on credit terms the company is able to fund its inventory and
receivables investment at the expense of its suppliers.

Overdrafts
A source of short-term funding which is used to fund fluctuating working capital
requirements.
Its great advantage is that you only pay for that part of the finance that you need.
The overdraft facility (total limit) is negotiated with the bank on a regular basis
(maybe annually). For a company with a healthy trading record it is normal for the
overdraft facility to be rolled over from one year to the next although theoretically
it is repayable on demand.

Bank loans
Bank loans or term loans are loans over between one and three years which have
become increasingly popular over the past ten to fifteen years as a bridge between
overdraft financing and more permanent funding.

Factoring
As well as providing administrative support, factoring works as a source of financing
as:
a. Efficient credit control brings cash in sooner, reducing the operating cycle.
b. Factors may offer advances on receivables balances.

Invoice discounting
A service also provided by a factoring company.
Selected invoices are used as security against which the company may borrow
funds. This is a temporary source of finance repayable when the debt is cleared.
The key advantage of invoice discounting is that it is a confidential service, the
customer need not know about it.

Bills of exchange
A means of payment whereby by a promissory note is exchanged for goods.
The bill of exchange is simply an agreement to pay a certain amount at a certain
date in the future. No interest is payable on the note but is implicit in the terms of
the bill.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Asset specific sources of finance


Some sources of finance are used to purchase individual assets using the asset as
security against which the funds are borrowed.

Hire purchase
The purchase of an asset by means of a structured financial agreement.
Instead of having to pay the full amount immediately, the company is able to
spread the payment over a period of typically between two and five years.

Finance lease
A type of asset financing that appears initially very similar to hire purchase. Again
the asset is paid for over between two and five years (typically) and again there is
a deposit (initial rental) and regular monthly payments or rentals.
The key difference is that at the end of the lease agreement the title to the asset
does not pass to the company (lessee) but is retained by the leasing company
(lessor). This has important potential tax advantages.

Operating lease
In this situation the company does not buy the asset (in part or in full) but instead
rents the asset.
The operating lease is often used where the asset is only required for a short period
of time such as Plant Hire or the company has no interest in acquiring the asset
simply wishing to use it such as a company vehicle or photocopier.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

MEASURES OF WORKING CAPITAL MANAGEMENT


Liquidity measures

Efficiency measure

Issue

Ensuring sufficient funding to


avoid running out of cash

Measuring the speed of circulation


of cash within the company

Measures

Current ratio

The operating cycle

Quick ratio

Liquidity ratios
Current assets may be financed by current liabilities or by long-term funds. The
ideal current ratio is 2:1. This would mean that half of the current assets are
financed by current liabilities and therefore half by long-term funds. Similarly the
ideal quick ratio is 1:1.

Current ratio
A measure that considers the manner in which current assets are financed. A safe
measure is considered to be 2:1 or greater meaning that only a limited amount of
the assets are funded by the current liabilities. This would arise if the company
adopted a conservative approach to financing.
Current Ratio

Current Assets
Current Liabilities

Quick ratio
A measure of how well current liabilities are covered by liquid assets. A safe
measure is considered to be 1:1 meaning that we are able to meet our existing
liabilities if they all fall due at once.
Quick Ratio =
(or acid test)

164

Current Assets minus Stock


Current Liabilities

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

OVERTRADING
Overtrading is the term applied to a company which rapidly increase its turnover
without having sufficient capital backing, hence the alternative term undercapitalisation.
Output increases are often obtained by more intensive utilisation of existing fixed
assets, and growth tends to be financed by more intensive use of working capital.
Overtrading companies are often unable or unwilling to raise long-term capital and
thus tend to rely more heavily on short-term sources such as overdraft and trade
creditors.
Overtrading is thus characterised by rising borrowings and a declining liquidity
position in terms of the quick ratio, if not always according to the current ratio.

Symptoms of overtrading
1.

Rapid increase in turnover

2.

Fall in liquidity ratio or current liabilities exceed current assets

3.

Sharp increase in the sales-to-fixed assets ratio

4.

Increase in the trade payables period

5.

Increase in short term borrowing and a decline in cash balance

6.

Fall in profit margins.

Overtrading is risky because short-term finance may be withdrawn relatively


quickly if creditors lose confidence in the business, or if there is general tightening
of credit in the economy resulting to liquidity problems and even bankruptcy, even
though the firm is profitable.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

CASH MANAGEMENT

Holding cash is
necessary to be able
to pay the bills and
maintain liquidity

Cash is an idle asset


that costs money to
fund but generates
little or no return

There are three areas associated with managing cash:


1.

The Miller-Orr Model

2.

The Baumol Model

3.

The Cash Budget.

The Miller-Orr model


A model that considers the level of cash that should be held by a company in an
environment of uncertainty. The decision rules are simplified to two control levels
in order that the management of the cash balance can be delegated to a junior
manager.
Maximum level

Cash
balance

spread

Return point

spread
Minimum level

Time
The model allows us to calculate the spread. Given that we have the spread all key
control levels can be calculated.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Minimum level given in the question


Maximum level = minimum level + spread
Return point = minimum level + spread

Example 8
The minimum level of cash is $25,000. The variance of the cash flows is $250,000.
The transaction cost for both investing and en-cashing funds is $50. The interest
rate per day is 0.05%.
Required:
Calculate the:
(a)

spread

(b)

maximum level

(c)

return point.

The Baumol model


The use of the EOQ model to manage cash.

Q=

2Co.D
Ch

Co

Transaction cost of investing/ en-cashing a security

Excess cash available to invest in short-term securities

Ch

Opportunity cost of holding cash

Example 9
A company generates $5,000 per month excess cash. The interest rate it can
expect to earn on its investment is 6% per annum.
The transaction costs
associated with each separate investment of funds is constant at $50.
Required:
(a)

Calculate the optimum amount of cash to be invested in each


transaction.

(b)

How many transactions will arise each year?

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Cash budget
A budget prepared on a monthly basis (at least) to ensure that the company has an
understanding of its cash position going forward. There are 3 considerations:
1.

Inflow and outflows of cash

2.

Ignore non cash flows

3.

Pro forma led

Example 10
Cash flow forecasts from the current date are as follows:
($000)
Cash operating receipts
Cash operating payments
Interest payable on traded bonds
Capital expenditure

Month 1
6,530
5,040

Month 2
5,300
4,750
200

Month 3
4,300
4,600
1,000

The company currently has an overdraft balance of $2,000,000


The director has completed a review of accounts receivable management and has
proposed staff training and operating procedure improvements, which he believes
will reduce accounts receivable days by 18 days. This reduction would take four
months to achieve from the current date, with an equal reduction in each month.
Overdraft interest is payable at a rate of 0.5% per month, with payments being
made each month based on the opening balance at the start of that month. Credit
sales for the year to the current date were $60,500,000 and cost of sales was
$42,320,000. These levels of credit sales and cost of sales are expected to be
maintained in the coming year. Assume that there are 365 working days in each
year.
Required:
Calculate:
(a)

the bank balance in three months time if no action is taken; and

(b)

the bank balance in three months time if the directors proposal is


implemented.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Exam standard working capital management problem


Example 11
Kool Co has annual sales revenue of $7 million and all sales are on 30 days credit,
although customers on average take fifteen days more than this to pay.
Contribution represents 55% of sales and the company currently has no bad debts.
Accounts receivable are financed by an overdraft at an annual interest rate of 8%.
Kool Co plans to offer an early settlement discount of 1.4% for payment within 20
days and to extend the maximum credit offered to 65 days.
The company expects that these changes will increase annual credit sales by 8%,
while also leading to additional variable costs equal to 0.5% of turnover. The
discount is expected to be taken by 35% of customers, with the remaining
customers taking an average of 65 days to pay.
Required:
(a)

Evaluate whether the proposed changes in credit policy will increase


the profitability of Kool Co.

(b)

Tiger Co, a subsidiary of Kool Co, has set a minimum cash account balance of
$2,000. The average cost to the company of making deposits or selling
investments is $50 per transaction and the standard deviation of its cash
flows was $1,000 per day during the last year. The average interest rate on
investments is 9.125%.
Determine the spread, the upper limit and the return point for the
cash account of Tiger Co using the Miller-Orr model and explain the
relevance of these values for the cash management of the company.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

THE TREASURY FUNCTION


A function devoted to all aspects of cash within a company.
This includes:
1.

Investment

2.

Raising finance

3.

Banking and exchange

4.

Cash and currency management

5.

Risk

6.

Insurance.

Role
Treasury management is the corporate handling of all financial matters, the
generation of external and internal funds for business. The management of
currencies and cash flows, and complex strategies, policies and procedures of
corporate finance.

Centralisation vs. decentralisation


In a large organisation there is the opportunity to have a single head office treasury
department or to have individual treasury departments in each of the divisions.
Modern practice would suggest the decentralised route where there is little or no
head office intervention in the workings of an autonomous division. This runs
contrary to treasury practice where large companies tend to have a centralised
function.

Advantages of centralisation
1.

Avoid duplication of skills of treasury across each division. A centralised team


will enable the use of specialist employees in each of the roles of the
department.

2.

Borrowing can be made in bulk taking advantage of better terms in the form
of keener interest rates and less onerous conditions.

3.

Pooled investments will similarly take advantage of higher rates of return than
smaller amounts.

4.

Pooling of cash resources will allow cash-rich parts of the company to fund
other parts of the business in need of cash.

5.

Closer management of the foreign currency risk of the business.

Advantages of decentralisation
1.

Greater autonomy of action by individual treasury departments to reflect local


requirements and problems.

2.

Closer attention to the importance of cash by each division.

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CHAPTER 14 WORKING CAPITAL MANA GEMENT

Profit centre vs. cost centre


Should the treasury department be run as a cost centre or a profit centre?

Cost centre A function to which costs are accumulated.


Profit centre A function to which both costs and revenues are accounted for.
Advantages of using a profit centre
1.

The use of the treasury department is given a value which limits the use of
the service by the divisions.

2.

The prices charged by the treasury department measure the relative efficiency
of that internal service and may be compared to external provision.

3.

The treasury department may undertake part of the hedging risk of a trade
thereby saving the company as a whole money.

4.

The department may gain other business if there is surplus capacity within the
department.

5.

Speculative positions may be taken that net substantial returns to the


business.

Disadvantages of using a profit centre


1.

Additional costs of monitoring. The treasury function is likely to be very


different to the rest of the business and hence require specialist oversight if
run as a profit making venture.

2.

The treasury function is unlikely to be of sufficient size in most companies to


make a profit function viable.

3.

The company may be taking a substantial risk by speculation that it cannot


readily quantify. In the event of a position going wrong the company may be
dragged down as a result of a single transaction.

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Solutions to examples

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SOLUTIONS TO EXAMPLES

CHAPTER
1

INTRODUCTION

FINANCIAL

MANAGEMENT:

AN

3 factors affecting share price:


1.

Cash flows to investors (dividends)

2.

Growth prospects

3.

Risk affecting shareholders required return

Example 1
(a)

P0 =

(b)

P0 =

(c)

P0 =

(d)

P0 =

174

23 x 1.04
0.12-0.04
23 x 1.04
0.15-0.04
23 x 1.06
0.12-0.06
23
0.12

= 299 cents
= 217 cents. More risk makes the share less attractive
= 406 cents. Enhanced growth sees the share price increase

= 192 cents

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SOLUTIONS TO EXAMPLES

CHAPTER 2 FUNDAMENTAL FINANCIAL MATHS


Example 1
10,000 x 1.054 = $12,155

Example 2
Year

Price ($30)

31.35

32.76

34.23

35.78

Cost ($12)

12.72

13.48

14.29

15.15

Contribution

18.63

19.28

19.94

20.63

Example 3
12,155 x 1.05-4 = $10,000

Example 4
Year (n)

FV
(1 + r)-n
Present Value

360,000

280,000

0.907

0.7835

326,520

219,380

Total (326,520 + 219,380) = $545,900

Example 5
Year
FV
PVF
Present Value

40,000

40,000

40,000

40,000

40,000

0.952

0.907

0.864

0.823

0.784

38,080

36,280

34,560

32,920

31,360

Total = $173,200
OR
40000 x (0.952 + 0.907 + 0.864 + 0.823 + 0.784) = $173,200

Example 6
$12,500 x 7.536 = $94,200
Investing $90,000 gives something worth $94,200 in return. The investor makes a
gain in wealth of $4,200.

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SOLUTIONS TO EXAMPLES

Example 7
(a)

PV of 4 year annuity starting after 1 year (100,000 x 3.170)

(b)

(i) Starting at time 4; value at time 3 is

$317,000

$317,000

Value at time 0 (PV) 317,000 x 0.751

$238,067

st

(ii) Starting at time 0; 1 instalment is in PV terms 100,000


2nd to 4th = 3 year annuity (100,000 x 2.487)

247,800

Total Present Value

$348,700

Example 8
1.

Perpetuity value = 18,000 0.09


Starting at time 5; value at time 4 is
Present value (200,000 x 0.708)

176

$200,0002.
200,000
$141,600

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SOLUTIONS TO EXAMPLES

CHAPTER 3 CAPITAL BUDGETING


Example 1
Time
Price
V Cost

3%

30.00

30.90

31.83

32.78

4.50%

12.00

12.54

13.10

13.69

Contribution

18.00

18.36

18.72

19.09

Volume

10000

12500

12500

7500

180000

229500

234000

143175

-54000

-68850

-70200

-42952

38625

28969

21727

44180

Total Contribution
Tax

30%

Capital Allowance
Resale

70000

Working Capital

-12938

-1738

22796

36880

Net Cash

167062

212387

216915

201582

1232

151900

175400

162900

137700

800

327300

490200

627900

628700

Present Value (rounded)

10%

Cumulative
Investment

515000

Working Capital

45000

Net Present Value

68700

Example 2
NPV
000
X
69

10%
-29

15%

18%
20%

r%

IRR appears close to 15.5%

Example 3

69
(18 - 10) 15.6%
10
69
(-29)

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SOLUTIONS TO EXAMPLES

CHAPTER 4 INVESTMENT APPRAISAL TECHNIQUES


Example 1
(a)

3.170 x $100,000 = $317,000

(b)

3.170 x $100,000 = $317,000 lands at time 3


Discounted by 3 further years: $317,000 x .751 = $238,067

(c)

3 future cash flows starting at time 1 have an annuity factor of

2.487

Add the cash flow at time 0

1.000

PV factor for all 4 payments

3.487

PV = $348,700

Example 2
(a)

18,000 0.09 = $200,000

(b)

$200,000 x 0.708 = $141,600

Example 3
(1 + money) = 1.08 x 1.05 = 1.134. Money rate = 13.4%

Example 4
(1 + r) = 1.123 1.04 = 1.0798. Real rate = 8%

Example 5
WACC = 12%; real rate = 8%
Money Analysis
Year

217,560

225,392

233,506

0.893

0.797

0.712

194,281

179,637

166,256

Annual contribution
6,000 x (50 15) inflated
12% PVF
$PV
Cumulative

$540,174

Real Analysis
3 year Annuity 6,000 x (50 15)
8% annuity factor
Present Value

210,000
2.577
$541,170

(same value with rounding difference)

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SOLUTIONS TO EXAMPLES

Example 6
Purchase price = $45,000
Year

8% PVF

0.926

0.857

0.794

0.735

0.681

Annual running cost

5,000

5,000

5,000

7,000

11,000

PV

4,630

4,287

3,969

5,145

7,486

n/a

n/a

18,000

14,000

6,000

14,289

10,290

3,403

Resale Value at year end


PV
Present Value of:

Annuity Factor (8%)


EAC

3 year cycle

4 year cycle

5 year cycle

$43,597

$52,741

$67,114

2.577

3.312

3.993

$16,918

$15,924

$16,808

LOWEST

Example 7 - divisible
Project

Initial investment
$000s

NPV
$000s

PI

Rank

100

25

0.250

200

35

0.175

80

21

0.262

75

10

0.133

Invest
Project

Proportion

Capital

Remaining

NPV

100%

80

270

21

100%

100

170

25

170/200

170

29.8

Total

75.8

Example 7 - indivisible
Feasible combinations: A&C (46); A&D (35); B only (35); C&D (31)

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179

SOLUTIONS TO EXAMPLES

Example 8
(i)

Allocate the $800,000 based upon Profitability Index (NPV per $ invested)
P.I.

Rank

Project 1: $32.7 300 =

0.109

Project 2: $57.6 450 =

0.128

Project 3: $79.2 400 =

0.198

1
NPV

So invest 100% in project 3:

79.2

And the remaining 400 in project 2 (400 450) x 57.6

51.2

Maximum possible NPV


(ii)

130.4

Allocate to affordable combinations:


Projects 1 and 2 (investing 300 + 450) give

32.7+57.6

90.3

Projects 1 and 3 (investing 300 + 400) give

32.7+79.2

111.9

Therefore invest in projects 1 and 3


Workings
Project 1
Discount given nominal (money) values at the nominal cost of capital of 12%
Time

$000

85

90

95

100

95

12% PVF

.893

.797

.712

.636

.567

$PV 75.9

71.7

67.6

63.6

53.9

332.7

Less initial investment

Cumulative

(300.0)

NPV

32.7

Project 2
Discount annuity in nominal terms using the 12% nominal cost of capital
$140.8 x 3.605 =

507.6

Initial Investment

(450.0)

NPV

57.6

Project 3
Either: inflate $120,000 to nominal terms using 3.6% inflation and discount at
nominal 12%;
Or: leave $120,000 as an annuity in real terms and discount at the real cost of
capital (the less complex option).
(1 + i) = (1+r)(1+h)
1.12 = (1+r) x 1.036
1+r = 1.121.036 = 1.082

180

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SOLUTIONS TO EXAMPLES

Use 8% factors
PV = $120.0 x 3.993 =
Initial investments =

479.2
(400.0)

NPV

79.2

Example 9
NPV working (with detail for sensitivity analysis)
Time

Amount

PVF

$PV

1-3

Revenue

2.487

298,440

1-3

Variable Cost

30,000

1-3

Contribution

90,000

2.487

223,830

1-3

Fixed Cost

65,000

2.487

161,655

120,000

Present Value

62,175

Investment

50,000

Net Present Value

$12,175

Sensitivity to:
(i)

Price:

12175 298,440 = 0.041%


Breakeven sales price will be $12 x (1 0.041) = $11.51 per
unit

(ii)

Volume:

12,175 223,830 = 0.054


Breakeven volume = 10,000 x (1 0.054) = 9460 units p.a.

(iii)

Fixed costs:

12175 161,655 = 0.075


Breakeven cost = 65,000 x (1- 0.075) = $60,125 p.a.

Example 10
(a)

Expected NPV
(1250 x 0.12) + (650 x 0.30) + (320 x 0.25) + ((750) x 0.33) = $177,500
Positive NPV suggests accepting the project.

(b)

Ignores the fact that the most likely outcome is to make a whopping big loss.
Relies on probabilities which have no statistical backing.
Even if the probabilities were in any way reliable, this is an average value
which would only be achieved if the decision were repeated frequently and,
everyone knows, Toorongs rarely makes a Wryte once, let alone repeatedly!

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181

SOLUTIONS TO EXAMPLES

Example 11
Time
Operating cash flows

1
$000

2
$000

3
$000

4
$000

5
$000

167

212

217

202

379

596

Cumulative

Initial investment (non-current assets plus working capital)


Cumulative cash flows reach and exceed outlay during 3
within 3 years.

$560
rd

year. i.e. Payback is

Example 12
Time
Operating cash flows
PVF @ 10%
PV

1
$000

2
$000

3
$000

4
$000

5
$000

167

212

217

202

0.909

0.826

0.751

0.683

0.621

152

175

163

138

327

490

628

Cumulative

Initial investment (non-current assets plus working capital)

$560

Discounted payback occurs in fourth year.

Example 13
Discount at after-tax cost of borrowing (15 x (1-0.33)) 10%
Leasing option
Time
Lease payments
33% tax relief
Net
10% PVF
Present Value

0
$000
(30)

1
$000
(30)

(30)

(30)
0.909
(27.3)

(30)

2
$000
(30)
9.9
(20.1)
0.826
(16.6)

3
$000
(30)
9.9
(20.1)
0.751
(15.1)

4
$000

5
$000

9.9
9.9
0.683
6.8

9.9
9.9
0.621
6.1

Total present value of costs

$76,100

Buying option
Time
Purchase/Resale
Tax relief on capital
allowances
10% PVF
Present Value

0
$000
(100)

1
$000

0.909
(100)

2
$000

3
$000

5
$000

6.2

4
$000
10
4.6

8.3
0.826
6.9

0.751
4.7

0.683
10.0

0.621
6.6

Total present value of costs

10.6

$71,800

The better option, in purely financial terms, is to buy the equipment.

182

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SOLUTIONS TO EXAMPLES

Example 14
Average level of profit (165 + 189 + 186 + 143) 4

170,500

Average capital (excluding working capital) (515 + 70) 2

292,500

ARR (170.5 292.5)

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58.3%

183

SOLUTIONS TO EXAMPLES

CHAPTER 5 SOURCES OF LONG TERM FINANCE


No worked examples

184

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SOLUTIONS TO EXAMPLES

CHAPTER 6 COST OF CAPITAL


Example 1
Ke = [(20 x 1.05) 400] +0.05 = 0.1025 OR 10.25%

Example 2
369 cum-div with a dividend of 36 becomes 333 ex-div
Ke = [(36 x 1.04) 333] +0.04 = 15.2%

Example 3
Growth = 0.133
Ke = [(33 x 1.133) 600] +0.133 = 19.5%

Example 4
Growth = 0.079
Ke = [(11 x 1.079) 258] + 0.079 = 12.5%

Example 5
Growth = 70% x 12% = 8.4% OR 0.084
Ex-div P0 is 500 40 = 460
Ke = [(40 x 1.084) 460] + 0.084 = 17.8%

Example 6
Ke = 8 + 1.2 x (15 8) = 16.4%

Example 7
Ke = 6 + 0.8 x (8) = 12.4%

Example 8
Kd = [10 x (1-0.3)] 120 = 5.83%

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185

SOLUTIONS TO EXAMPLES

Example 9
Time

Cash

%amount

1st PVF 7%

1st PV

2nd PVF 5%

2nd PV

1-5

I(1-T)

4.100

28.7

4.329

30.3

Redemption

100

0.713

71.3

0.784

78.4

P0

100

108.7

(102)

(102)

1st NPV

2nd NPV

(2)

6.7

Kd: IRR is approximately 6.5%


NPV at different costs of capital (you only need to work out two)
Rate

4%

5%

6%

7%

8%

9%

10%

NPV

11.4

6.7

2.2

-2

-6.0

-9.8

-13.4

15
10
5
0
4%

5%

6%

7%

8%

9%

10% 11% 12%

-5
-10
-15
-20
-25

Example 10
Value
Equity
Debt
Total

20,000 x $3
8,000 x 85%

60,000
6,800

V (Ve + Vd)
60 66.8

89.9%

6.8 66.8

10.1%

66,800

WACC = (89.9% x 15) + (10.1% x 7.6%) = 14.3%

186

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SOLUTIONS TO EXAMPLES

Example 11
Value of 25 shares after 4 years with 6% growth: 25 x $4 x (1.06)4 = $126.25
Likely outcome is conversion rather than redemption (worth $100).
Time

Cash

1-4

I(1-T)

Redemption

1st PVF 7%

1st PV

2nd PVF 10%

2nd PV

3.387

23.7

3.170

22.2

126.25

0.763

96.3

0.683

86.2

% amount

120
0

P0

108.4

(110)
1st NPV

10

(110)
2nd NPV

(1.6)

Kconv IRR approximately 9.5%

Example 12
Kpref = 9 140 = 6.4%

Example 13
Interest rate = 12%; cost of debt = 12 x (1 0.3) = 8.4%

Example 14
Cost of Debt = [10 x (1 0.7)] 120 = 5.8%

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187

SOLUTIONS TO EXAMPLES

CHAPTER 7 CAPITAL STRUCTURE


No examples.

188

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SOLUTIONS TO EXAMPLES

CHAPTER 8 BUSINESS RISK


Example 1
Year to:

June 2011

Sept 2011

400

480

Share price growth to 2011

40

Dividend Earned (Dec 2011)

10

10

Total return

50

12

12.5%

2.5%

Starting Price

As a % of starting

Example 2
r = 10 + 1.3 x (20 10) = 23%
None. There is different business risk so the companys cost of capital is irrelevant.

Example 3
Need a beta from a gaming company with 37.5% debt (3:5 for Foreignin).
L has 35%; C has 40%, therefore the relevant beta is approximately half way
between Ls (1.1) and Cs (1.18) use 1.14.
Ke = 6 + 1.14 x (11 6) = 11.7%

Example 4
Ignore current beta since it reflects a different business risk to the investment.
Proxy beta = 1.3
Asset beta = 1.3 x [60 (60 + 40(1-0.3))] = 0.886
(a)

Equity beta at 30% debt = 0.886 x [70 + 30(1 - 0.3)] 70 = 1.15


Ke = 4 + 1.15 x (10 4) = 10.9%

(b)

Equity beta at 70% debt = 0.886 x [30 + 70(1 - 0.3)] 30 = 2.33


Ke = 4 + 2.33 x (10 4) = 18%

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189

SOLUTIONS TO EXAMPLES

CHAPTER 9 FINANCIAL PERFORMANCE MEASUREMENT


Example 1
$m
ROCE

Equity Finance

Debt Finance

10/42

10/(20 + 22)

= 23.81%

= 23.81%

10

10

Working
PBIT
Less Interest

PBT

10%

(2)

10

(3)

(2.4)

PAT

5.6

ROE

7/42

5.6/22

= 16.67%

= 25.45%

Less Tax

@30%

Example 3
Financial Gearing
Debt

5 + 8 + 1 = 14

Equity

8 + 4 + 2 = 14

Equity gearing (D/E)

14/14 = 100%

Total gearing (D/D + E)

14/28 = 50%

20/4.5

Example 4
(a)

Interest coverage
=

(b)

190

PBIT/ interest

4.44 X

The level of cover suggest that we can cover our interest payments four times
over, although this may be considered relatively safe it does suggest a high
proportion of the profits generated are used solely to service debt leaving
relatively little available to re-invest in the company or pay out in the form of
dividends.

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SOLUTIONS TO EXAMPLES

Example 5
(a)

Forecast Income Statement


$000s
Sales
+12%
Cost of sales

VC 85%
FC 15%

Gross profit
Admin costs

+ 5%

PBIT
Interest

+500

@30%

PAT
Dividends

Equity financing

56,000

56,000

(28,560)
(4,500)

(28,560)
(4,500)

22,940

22,940

(14,700)

(14,700)

8,240

PBT
Tax

Debt financing

@60%

RE

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(800)

8,240
(300)

7,440

7,940

(2,232)

(2,382)

5,208

5,558

3,125

3,335

2,083

2,223

191

SOLUTIONS TO EXAMPLES

(b)

Evaluation
Financial gearing
= D/E

Debt financing

Equity financing

2,500 + 5,000

2,500

Existing = 11.1%

=
22,560 + 2,083

22,560 + 2,223 +
5,000

30.4%

8.4%

Operational gearing
= FC/TC

Existing = 42%

Interest cover

4,500 + 14,700
33,060 + 14,700
40.2%

8,240

= PBIT/ interest

Existing = 20 X

Earnings per share


= PAT/ No of shares
Existing = 39.9c

800
10.3 X

40.2%
8,240

=
=

300
27.5 X

5,208

5,558

10,000

12,500

= 52.1c

= 49.4c

Comment
The project should be accepted because no matter how it is financed it will
materially increase the companys earnings per share and improve the return
to shareholders.
Financing by debt will have the effect of increasing the earnings per share by
a greater amount but at the expense of increasing financial risk. Both capital
structure and ability to pay interest as it falls due will be worse as a result of
debt. Both measures appear to be safe however as the existing position is
very safe.
Financing
debt. It
structural
payments

by equity will still improve earnings per share but not as much as
will however reduce the financial risk to the company in both
terms as gearing falls to only 8% and ease pressure from interest
on profits.

Example 6
EPS = $14m/6m = 233c per share

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SOLUTIONS TO EXAMPLES

Example 7

P/E Ratio

Dividend payout ratio

Dividend yield

Dan

Steph

200/10

80/8

= 20 X

= 10 X

2/10 x 100

8/8 x 100

= 20%

= 100%

2/200 x 100

8/80 x 100

= 1%

= 10%

Example 8
2006

2007

2008

Dividend (cents)

24.3

26.3

27.6

Share price (cents)

725

885

734

160

(151)

186.3

(123.4)

725

885

=25.7%

=(13.9%)

11%

9%

Capital gain
TSR

ROE

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193

SOLUTIONS TO EXAMPLES

CHAPTER 10 RAISING EQUITY FINANCE


Example 1
Shares

Price

Sum

Existing

$2.8

$8.4

New

$2.0

$2.0

$10.4

TERP = $10.4/ 4shares = $2.6/share


Value of a right
Per new share
$2.6 - $2.0 = $0.6/new share
Per existing share
$2.8 - $2.6 = $0.2/existing share

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SOLUTIONS TO EXAMPLES

Example 2
Tirwen
(a)
Shares

Price

Sum

Existing

$4.00

$20.00

New

$3.40

$3.40

$23.40

TERP = $3.9/ share


Value of a right per existing share

$4 - $3.9 = $0.1/existing share

(b)
In
$

Take up rights
Shares
1,000 x $4
Cash
1,000 x 1/5 x $3.4
Total

4,000

Out
$
Shares
1,000 x 6/5 x $3.9

680
4,680

4,680
4,680

Sell rights
Shares
1,000 x $4

Total

4,000

4,000

Shares
1,000 x $3.9
Cash
1,000 x $0.1

3,900
100
4,000

The existing shareholder has two basic options, to take up the shares or to
sell the rights to those shares. If you consider the implications of these
actions above you will notice that the shareholder will be in a neutral position
in both cases providing the theoretical ex rights price is achieved.

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195

SOLUTIONS TO EXAMPLES

(c)
Current EPS

= share price price earnings ratio


= $4 15.24 = $0.2625/share

Revised earnings per share


Note changes are:
1

issue shares

redeem debt, this will affect the tax paid

no change to underlying company assets therefore the PBIT can be


expected to remain the same.

We may use the statement of comprehensive income to help us.


Current PAT = $0.2625 x 4m = $1,050,000
(000s)

Before

PBIT
Less Interest
PBT
Less tax

After

2,127.5
12% x 4,500 +
7% x 1,250
30%

PAT

627.5
1,500

$
2,127.5

Reduction of 2,500
(see below)

327.5
1,800

450

540

1,050

1,260

Working
Debt redeemed
Total equity raised
Less issue costs
Debt redeemed
Reduction in interest paid @ 12%

$000s
2,720
(220)
2,500
300

Revised EPS = $1,260/4,800 = $0.2625/share

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SOLUTIONS TO EXAMPLES

CHAPTER 11 EFFICIENT MARKET HYPOTHESIS


No worked examples

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197

SOLUTIONS TO EXAMPLES

CHAPTER 12 VALUATION
Example 1
Growth

2.5 x (1+g)5 = 4;

(1+g)5 = 1.60; (1+g) = 1.0985

g (approx.) = 10%
Ke = 6 + 0.6(17 6) = 12.6%
P0 =

4 x 1.10
(0.126-0.10)

= 169 cents per share; Total value = $33,800,000

Example 2
Growth

ROCE 20% x retained earnings (4 20) 20%

g = 4%

Ke = 6 + 0.9(11 6) = 10.5%
P0 =

16 x 1.04
(0.105-0.04)

= 256 cents per share;

Total value = $25,600,000

Example 3
Net Assets less liabilities = 785,000 200,000 = $585,000 (by book value)
Add $50,000 for non-current assets.
Deduct $10,000 for premium on debentures
Net value (585 + 50 10)

$625,000

60% holding

$375,000

Example 4
P/E to use is 10
Earnings available to ordinary shareholders are (320 30) $290,000.
Value is (10 x 290) $2,900,000

Example 5
$300,000 0.125 = $2,400,000

Example 6
Time horizon = foreseeable future; use perpetuity.
Real cost of capital = 10%
Taxation = 30% x (400 150 36 28) = 55.8 p.a.
Free Cash Flow = (400 -150 -36 60 55.8) = $98.2m pa
Total PV of FCF=

$982m

Value of Debt (140 x 1.10)

$154m

Value of Equity

$828m

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SOLUTIONS TO EXAMPLES

Example 7
(i)

Net asset value = 1,330 210 295 =

$825m

(ii)

Dividend Growth = (69 x 1.03) (0.10 0.03) =

$1,015m

(iii)

Earnings Yield = 115 0.11 =

$1,045m

Or (growth model) (115 x 1.04) (0.11 0.04) =

$1,709m

Example 8
MV = 9% 0.06 = 150%

Example 9
Time

Cash

1-4
4

Interest
Redeem

$per 100 NV

7%PVF

$PV

8
100

3.387
0.763

27.1
76.3

Present Value per $100 nominal

103.4

Total Market Value (103.4% x $120m)

$124.1m

Example 10
(a)
Floor Value Expectation is that investors would recover debt capital.
Time

Cash

1-4
4

Interest
Redeem

$per 100 NV

6%PVF

$PV

7
100

3.465
0.792

24.26
79.20

Present Value per $100 nominal

103.46

Total Floor Value (103.46% x $40m)

$41.38m

(b)
Conversion value would be 16 x $6 x (1.04)4 = $112.31 (>$100)
Expectation is that investors would convert to shares.
Time

Cash

1-4
4

Interest
Redeem

$per 100 NV

6%PVF

$PV

7
112.31

3.465
0.792

24.26
88.96

Present Value per $100 nominal


Total Market Value (113.22% x $40m)

113.22
$45.29m

(c)
Conversion premium (45.29 41.38)

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$3.91m

199

SOLUTIONS TO EXAMPLES

Example 11
Div = 11% x 50 cents = 5.5
P0 = 5.5 0.06 = 91.7 cents per share.

200

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SOLUTIONS TO EXAMPLES

CHAPTER 13 RISK
Example 1
(a)

(i)

Currency in ; Rate in so divide


Selling to the bank; the bank pays lower $ so divide by higher rate:
0.7778
Receipt: 300,000 0.7778 = $385,703

(b)

(ii)

155,000 0.7770 = $199,485

(i)

$385,710 1.2857 = $300,000

(ii)

155,000 x 1.2870 = $199,485

Example 2
1 month: Netting off payment of (515-265) 250,000
Buy paying (250,000 0.7781) $321,295
3 month: Net receipt of 450,000
Sell receiving (450,000 0.7820) $575,448

Example 3
Step 1

Match receipt of 450,000 in 3 months time with a liability to be worth


450,000 in 3 months time.
Borrow in paying 7.2% x 3/12 = 1.8%
450,000 1.018 =

Step 2

Convert at spot rate


442,348 0.7778 =

Step 3

442,043

$568,325

Invest in $ money market, earning 4.8% x 3/12 = 1.2%


Amount in 3 months (568,325 x 1.012)

$575,144

The forward contract ($575,448) yields slightly more than the money market.
However, a decision whether Danke Yudle should use the money market would
depend on its ability to (and cost to) borrow in as well as the opportunities it has
for investing the $568,325 to be received immediately.

Example 4
(a)

In one month, the net payment will be 56,098 (100,000 1.7826)


In three months, the net receipt will be 168,067 (300,000 1.7850)
(Working)
Net off any concurrent receipts and payments ie one month, net payment is
$100,000.
The forward rate to buy dollars is the lower end of the spread, so 1.7826.

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SOLUTIONS TO EXAMPLES

Three month rate to sell dollars; higher end of spread = $1.7850.


(b)

Step 1 Borrow an amount in $USD to be paid off, with interest, by the


$300,000 receipt
ie 300,000 1.0135 = $296,004
Note that interest is given annually, so 5.4% becomes 1.35% quarterly
Step 2

Convert that borrowing to sterling ( 1.7822)

166,089

Step 3

Invest in UK money market at 1.15% (x 1.015)

168,580

In this case, the money market yields slightly higher income than the forward
market hedge (168,580 compared to 168,067) and so Inshal should use
the money market to hedge the receipt.
(c)

Currency futures involve trading in a market with instruments (the futures)


whose value rises or falls in connection with the value of a related asset, in
this case, an amount of sterling stated in US dollar terms.
Inshal would, effectively, be betting that the value of the $300,000 receipt
falls below an amount given today in the futures market (lets say
169,000).
If the worst happens and the receipt on the spot market is only 167,500,
then Inshal has won its bet and will gain 1,500 from the futures market,
giving a net of 169,000.
On the contrary, if the spot proceeds were to be 175,000, Inshal would lose
its bet, costing it 6,000 out of the proceeds, netting it 169,000 again.
The futures market is more complex than illustrated. For instance, we cant
simply bet on $300,000. The market trades in multiples of 62,500 so
Inshall would have to trade in either 125,000 of futures (leaving a portion of
the receipt uncovered by the hedge), or 187,500 (with the potential of losses
or gains on the difference between that amount and the expected receipt
of 169,000). Either way, futures would not completely eliminate risk.
Finally, operating a futures hedge requires financial management staff with
expertise and the availability to monitor the position of the contract daily.
This brings with it additional costs compared to forward market or money
market hedging.
Frankly, anybody suggesting a futures hedge for a sum of only $300,000
should probably stay away from the important financial decisions affecting
Inshal.

Example 5

Now
Interest
+ 1 year

Rate

1,000,000
1.05
1,050,000

0.7774

777,400
1.07
831,818

0.7922

831,818 1,050,000 = 0.7922

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SOLUTIONS TO EXAMPLES

Example 6

Now
Inflation
+ 1 year

Rate (/$)

10,000
1.0372
10,372

0.7774

7,774
1.057
8,216

8,216 10,373 = 0.7922

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SOLUTIONS TO EXAMPLES

CHAPTER 14 WORKING CAPITAL MANAGEMENT


Example 1
Operating cycle
Inventory turnover period

Days
Inventory/Cost of sales x 365

68

30,000/160,000 x 365
Receivables period

Receivables/Sales x 365

88

60,000/250,000 x 365
Payables period

Payables/Cost of sales x 365

(114)

50,000/160,000 x 365
42 days

Example 2
(a)

Receivables days = $8m/$40m x 365

(b)

Cost of financing receivables


$8m x 0.14

73 days

$1,120,000

Example 3
Cost of financing receivables
Interest cost
50% pay over normal terms $40m x 0.5 x 73/365 x 0.14
50% pay over discounted terms $40m x 0.5 x 10/365 x 0.14
Discount $40m x 0.5 x 0.02
Total cost

$560,000
$ 76,712
$400,000
$1,036,712

Example 4
Interest cost $40m x 50/365 x 0.14
Factor fee $40m x 0.016
Admin savings
Total cost

204

$767,123
$640,000
($175,000)
$1,232,123

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SOLUTIONS TO EXAMPLES

Example 5
($s)

Order quantities

Ordering cost
120,000/500 x $30
120,000/600 x $30
120,000/700 x $30

d/Q x Co

Holding cost
500/2 x $20
600/2 x $20
700/2 x $20

Q/2 x Ch

500

600

700

7,200
6,000

5,000

5,143

6,000
7,000

Total cost

12,200

12,000

12,143

Order 600 units each time


Economic order quantity = 2 x $30 x 120,000/$20 = 600 units

Example 6
($s)

Order quantities
EOQ
Bulk Disc.
600
1,000

Ordering cost
120,000/600 x $30
120,000/1,000 x $30

d/Q x Co

Holding cost
600/2 x $20
1,000/2 x $20

Q/2 x Ch

6,000
3,600
6,000
10,000

Purchase cost
120,000 x $10
120,000 x $9.8

1,200,000

Total cost

1,212,000

1,176,000
1,189,600

Choose the bulk discount

Example 7
Reasons for the sharp decline in liquidity
Turnover has increased by 33% from 12,000 to 16,000 with no introduction of any
permanent funds. This will put pressure on the company because it will have to
rely on short-term funding to fund the growth of the business and puts the
company at risk of overtrading.
Increase in receivables
The receivables balance has increased by $1m, or 63%, year on year reflecting
increased level of activity (turnover) but longer collection period. Average credit
taken by customers has increased to 59 days.

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SOLUTIONS TO EXAMPLES

Increase in inventory
Inventory has increased by $0.8m or 57% during the year again as a result of
increased levels of activity and also increased turnover period of inventory. The
average holding period for inventory, as at 2012, is 88 days (2011: 73 days).
Increase in payables
Trade payables have increased by 33% - exactly in line with sales activity which
suggests that there has been no additional reliance on payables as a source of
finance.
High level of dividends
Dividend will be paid out at $1.5m this year and $2m next approximately 40% of
earnings available p.a. This is in spite of high growth.
Liquidity ratios
20X2

20X3

Current ratio
CA/CL x 100

4,500/2,000

2.25

4,900/2,400

2.04

Quick ratio
CA inv/CL

4,500-1,400/2,000

1.55

4,900-2,200/2,400

1.13

The current ratio has fallen suggesting that an increasing level of current assets is
being funded using current liabilities, also the quick ratio has fallen suggesting that
the company is less able to pay its bills as they fall due.
Cash position (net)
20X2

$1.5m

20X3

$($0.1m)

The company has re-invested surplus funds and is now operating a modest
overdraft given its current size and health, Ewden is not over-trading.
Payable days
20X2

78 days

20X3

80 days

The number of days has barely moved which suggests that the company is having
no additional problems paying its bills.
The credit period of nearly three months may suggest that the company is
consistently abusing its credit terms which may lead to problems with suppliers
over the longer term.

Example 8
(a)

206

Spread
=

3( x transaction cost x variance of cash flows/daily interest rate)1/3

3( x $50 x $250,000/0.0005)1/3

$7,970

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SOLUTIONS TO EXAMPLES

(b)

(c)

Maximum level
=

Minimum level + spread

$25,000 + $7,970

$32,970

Return point
=

Minimum level + 1/3 spread

$25,000 + 1/3 x $7,970

$27,657

Example 9
(a)

(b)

Optimum cash invested


=

2 x $50 x $60,000/0.06

$10,000 per order

Transactions per annum


$60,000/$10,000 = 6 transactions per annum

Example 10
($000s)
1
Receipts
Payments
Interest on traded bonds
Capital expenditure
Net cash flow
Overdraft interest (0.5%)
Net cash flow

6,530
(5,040)

Month
2
5,300
(4,750)
(200)

3
4,300
(4,600)
(1,000)

1,490
(10)

350

(1,300)

(3)

(1)

1,480

347

(1301)

Balance b/f

(2,000)

(520)

(173)

Balance c/f

(520)

(173)

(1,474)

Reduction in the balance of accounts receivable per day (ie increase in cash)
$60,500,000 x 1/365 = $165,753 $166,000
Reduction per month
$166,000 x 18 days 4 months = $747,000

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207

SOLUTIONS TO EXAMPLES

($000s)

Receipts
Payments
Interest on traded bonds
Capital expenditure
Reduction in receivables
Net cash flow
Overdraft interest (0.5%)
Net cash flow
Balance b/f
Balance c/f

6,530
(5,040)

Month
2
5,300
(4,750)
(200)

3
4,300
(4,600)

747

747

(1,000)
747

2,237

1,097

(553)

(10)
2,227

0
1,097

(2,000)
227

0
(553)

227

1,324

1,324

771

Example 11
(a)

Impact of proposed changes in credit policy


Existing position
Current contribution
$7m x 0.55

Current cost of financing receivables


$7m x 45/365 x 8%

Total

$3,850,000
($69,041)
$3,780,959

Working
Revised sales revenue
$7m x 1.08

$7,560,000

Revised contribution
$7.56m x 0.545

$4,120,200

Revised cost of financing receivables


35% Discounted terms
$7.56m x 0.35 x 20/365 x 8%

($11,599)

65% Extended terms


$7.56m x 0.65 x 65/365 x 8%

($70,008)

Discount
$7.56m x 0.35 x 0.014

($37,044)

Total

$4,001,549

The changes in credit policy should lead to an improvement in overall


profitability.
(b)

208

Spread
=

3( x transaction cost x variance of cash flows/daily interest rate)1/3

3( x $50 x $1,000,000/0.00025)1/3

$15,940

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SOLUTIONS TO EXAMPLES

The range over which the cash balance is allowed to fluctuate.


Maximum level
=

Minimum level + spread

$2,000 + $15,940

$17,940

The maximum level of cash allowed if this balance is breached then a control
action will invest an amount equal to the maximum level minus the return
point.
Return point
=

Minimum level + 1/3 spread

$2,000 + 1/3 x $15,940

$7,313

The balance to which the cash balance will return to after a control action.

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