CF

London School of Commerce
CORPORATE FINANCE
COURSE MANUAL
MANUAL CONTENTS
Page Session 1 Session 2 : An Introduction to Corporate Finance : Investment Decisions 4 16
Session 3 & 4
Session 5 Session 6 & 7 Session 8
: Investment Project Appraisal (1)

: Investment Project Appraisal (2) : The Companys Cost of Capital : Debt Financing
37
64 80 104
Page
Page Session 9 Session 10 Session 11 : : : Large Corporation Debt Financing Equity Financing Managing Corporate Financial Risk 123 142 159
Session 12
Financial Derivatives and Options
180
Session 13
Forwards, Futures and Swaps as Key Mechanisms for Derivatives Trading Concluding with Shareholders Value
198
Session 14
214
Page
ANNEX
Annex 1
Seminars
Annex 2 :
Recommended Reading
Annex 3
: Sample Assignment Questions
Page
SESSION 1
AN INTRODUCTION TO CORPORATE FINANCE

WHAT IS FINANCE
WHAT IS CORPORATE FINANCE CORPORATE FINANCIAL DECISIONS -- INVESTMENT DECISIONS -- FINANCING DECISIONS

S 1 / 01 . 12
PERPETUAL CHALLENGES WHAT ARE THE OBJECTIVES OF THE FIRM DISCUSSION QUESTIONS KEY TERMS
Page 4
WHAT IS FINANCE ?
At the most basic level Finance is a subject attributed to the following scenarios : -
SCENARIO 1
People and Organisations, with surplus funds in search of ideas to use their money, known as INVESTORS,
SCENARIO 2
People and Organisations with many ideas but insufficient funds to implement their ambitions
The subject of Finance therefore sets up an economy between those contained in Scenario 1 with those in Scenario 2, whereby investors supply money for individuals and organisations to fund projects, which in turn and overtime, give a return on their investments made from the commercial cash flow generated.
S 1 / 02 . 12
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The notion of cash flow is hence central to the subject of finance.
The investor will have an initial CASH OUTFLOW and the borrowing individual or
organisation will receive a CASH INFLOW.
Through the deployment of the CASH received, it would be expected for a cash surplus to be generated from which to payback the investors, pay government taxes and then retain cash for
working capital.
In simple terms, those in SCENARIO 2 must take a FINANCING DECISION upon where and how to find the sources of finance required, whereas those in SCENARIO 1 are making
INVESTMENT DECISIONS to decide where to place their surplus funds.
S 1 / 03 . 12
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WHAT IS CORPORATE FINANCE ? Corporate Finance therefore can be explained as all investment decisions and financial decisions taken by corporations. TYPICAL CORPORATE INVESTMENT AND FINANCING DECISIONS Investment Decisions Investment in new production plant Acquisition of a competitor Retail site expansion Diversification into new business Geographic market expansion New logistics & IT infrastructure Integrated, global customer relationship management system Financing Decisions Internal project funding from retained earnings Forms of borrowing Raising new equity Issuing bonds Extending bank credit lines Cash flow management Interest rate management Foreign exchange risk exposure Dividend payments
As can be seen the nature of Corporate Finance decisions is diverse.

S 1 / 04 . 12
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THE INVESTMENT DECISION
Investment decisions are concerned with the assessment of identified investment opportunities, which may vary in scope and scale. Investments can be made in both tangible assets as well as intangible assets.
Such investment decisions are often referred to as CAPITAL BUDGETING DECISIONS, simply because most corporations will have systematic capital budgetary control systems to enable and progress capital investment decisions. Fundamentally such decisions are based upon the notion of the return being greater than the amount invested.
S 1 / 05 . 12
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THE FINANCING DECISION Financing decisions are concerned with raising funds which are needed for : New Investments AND Day-to-day operations Hence the purpose to be served will thereby determine the type of financing decisions to be taken.
Equity financing decisions are, for example, where Equity Investors will take a stake (or ownership) in the investment.
Debt financing decisions are normally taken for day-to-day operations to support working capital management. Debt financing is obtained from Debt investors who are in fact lenders who must be repaid. Both Equity Investors and Debt Investors will thus face a level of risk in their decisions taken.
S 1 / 06 . 12
Page
In companies, the balance between Corporate Debt Financing and Equity Financing is often referred to as their CAPITAL STRUCTURE. This is a term used to refer to the mix and sources of finance being used by a company to fund business intentions and operations. The term raising capital in fact means obtaining the finance needed for investments and operations, both long as well as short-term (for less than one year).
The choices available to raise capital are numerous and these will be explained in later sessions of this manual.
Where long-term strategic investment decisions are being taken, this is often referred to capital budgeting for which capital budgeting decisions are taken.
S 1 / 07 . 12
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10
PERPETUAL CHALLENGES Arising from this basic platform of investment and financing decisions, there are perpetual challenges to be faced in the field of corporate finance : CHALLENGE 1. Where should investments be made using our shareholder funds ? CHALLENGE 2. How can incremental shareholder value be created and sustained ? CHALLENGE 3. What type of finance is needed and from where can it be obtained to fund new projects ? CHALLENGE 4. How can the associated risk exposure be managed ? These challenges have a core underlying managerial motive to be reconciled and that is to add value to the corporation.
The scope of corporate finance can therefore be defined as the principles, policies, institutions and managerial challenges that shape corporate investment and financing decisions for achieving long-term shareholder value.
S 1 / 08 . 12
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WHAT ARE THE OBJECTIVES OF THE CORPORATION The ultimate ambition of the corporation is to maximise shareholder value.
This is driven by the need in many organisations to separate ownership from management so that the owners, (ie. the shareholders) elect a board of directors to run the corporation.
In this way the company management is said to be an agent to its owners and thereby manages the business on behalf of the shareholders (the principal) ie. corporations owned by shareholders but run by management.
In so doing, the objectives of the corporation as a whole should be aligned with those of corporate financial management. Herein lies a perpetual environment challenge ie. how can sales maximisation, cost minimisation, profit targets, customer satisfaction & employee welfare as well as the need for corporate social responsibility all be kept in balance !?? These are just some of the realities for top management to address and resolve.
S 1 / 09 . 12
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There is clearly a need for clarity of Vision, Mission, Core Values, Required Competencies, Corporate Objectives and Resource Planning embedded into a mindset for corporate Strategic Management so that intelligent finance decisions can be taken wisely and with a clear sense of purpose. In this way Corporate Financial Management serves the designated purpose to be achieved and thereby enables the financial health and stability required for survival, growth and sustainability. In this context, additional responsibilities to the following stakeholders must also be upheld (as distinct from shareholders) : To Customers To Creditors To Employees To Management To Society To Government
all within emerging frameworks and regulations for CORPORATE GOVERNANCE.

Today, the pervasive Managerial Challenge is a need for the reconciliation of such objectives and responsibilities and overall clarity for the strategic intent of the corporation supported by a managerial cohesion for corporate finance and financial management, all of which is now being driven by performance management cultures and systems.
As can now be appreciated Corporate finance is concerned mainly with Investment Decisions and Financing Decisions. Session 2 will open the subject of Investment Decisions.
S 1 / 10 . 12
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QUESTIONS 1. Can you distinguish clearly between Investment Decisions and Financing Decisions, give examples from your own experience.
2. Explain the terms : Debt Financing Equity Financing
3. Elaborate upon the key challenges faced in the domain of corporate finance.
4.
Why is it difficult to reconcile the outcomes of the role of corporate finance with the diverse objectives of the corporation ?
S 1 / 11 . 12
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14
KEY TERMS
CAPITAL BUDGETING CAPITAL STRUCTURE CASH FLOW CASH OUTFLOW CASH SURPLUS CORPORATE FINANCE DEBT AND EQUITY FINANCING DIVIDEND PAYMENTS FINANCE FINANCING DECISIONS FOREIGN EXCHANGE RISK EXPOSURE INVESTMENT DECISIONS INVESTORS OBJECTIVES OF THE CORPORATION PAYBACK RAISING CAPITAL
S 1 / 12 . 12
SHAREHOLDER FUNDS SHAREHOLDER VALUE THE AGENT AND PRINCIPAL IN CORPORATE FINANCE THE RETURN
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15
SESSION 2

S 2 / 01 . 21
INVESTMENT DECISIONS
WHAT IS AN INVESTMENT
RISK AND RETURN INVESTMENT SELECTION & DECISION TAKING INVESTMENT IN CORPORATE PROJECTS OPPORTUNITY COST THE TIME VALUE OF MONEY DISCUSSION QUESTIONS KEY TERMS
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WHAT IS AN INVESTMENT ? An investment can be defined as a current (or future) commitment of funds (or other assets) with the ambition for yielding future returns which is in excess of the original investment to be made. In simple terms, an investment is a sacrifice made for something better in the future.
However, there is often an element of Risk in making any investment, so therefore an assessment of RISK AND RETURN is always an essential consideration before an investment decision is taken. Actual (or realised) Returns received may of course be different from the projected return. It is usually the case that the higher the return, the greater will be the risk to be taken.
The risk of a negative return is always possible, not all investments are sound investments. Therefore any significant investment decision will require risk analysis, risk mitigation and risk management to attempt to match the risk to be taken with the return to be received.
S 2 / 02 . 21
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In fact any investment which has been made should aim to compensate the investor for : the time period for which the funds have been invested inflation over the time of the investment the probability of the certainty that future payments will be received, against the level of risk being taken an expected rate of return on the principal amount of the investment made WHO ARE INVESTORS ? Investors may be individuals or organisations such as corporations, governments, pension funds and other financial institutions, in fact anyone who is prepared to make a sacrifice of monies held for a return in excess of the money to be invested.
WHAT ARE INVESTMENTS ? Investments maybe in fixed (real) or intangible assets, as well as in financial assets such as stocks, shares, bonds and securities. (This subject will be dealt with later in the manual)
S 2 / 03 . 21
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WHAT CAN INVESTORS EXPECT ? The investor will expect a rate of return on the investment(s) made which relates to :
Historical Rates of Return received to date on previous investments A Return for the Investment Holding Period during which money is tied up
An anticipated yield
The Portfolio of Investments currently held Their Current Risk Appetite The Risk Premium to compensate for the financial, liquidity, exchange rate and country risk being taken by the business Taxation exposure obligation and compliance
S 2 / 04 . 21
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19
These factors, related to the rate of return, have to be weighed against other considerations as well, namely : -
Capital Preservation to minimise loss arising from unwise investment

Capital Appreciation from future capital gains which could be received in the longer term
Additional earnings from the additional income received from the investment to support cash flow needs
The total return, being an aggregate of income supplements and together with capital appreciation.
S 2 / 05 . 21
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20
INVESTMENT & DECISION TAKING Investment Decision Taking can be explained as proceeding through a set of Inputs, Processes and Outputs. These are outlined below : INPUTS 1. The Strategic Intent 2. The Investment Budget These key inputs into the investment decision are therefore firstly the overall strategy of the investor, where the investment should fit into the overall asset portfolio of the organisation. This is essential in order for a Strategic Rationale to be achieved to justify the investment relevance. In so doing a strategic fit can be achieved between organisational investment decision options with the strategic purpose of the enterprise. From this standpoint, priorities can be determined and then the contribution of the selected investment can be ascertained.
S 2 / 06 . 21
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The Budget for Investment will need to be aligned to this Strategic Intent and in fact be influenced by it. It is the Investment Budget which becomes a decision driver before the following typical investment processes can be engaged.
PROCESSES
1. Idea Generation
2. Management Review
3. Evaluation and Screening 4. Investment Approaches 5. Investment Decision & Implementation
S 2 / 07 . 21
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22
1.
Idea Generation is needed to produce a pool of investment alternatives to support long term investment strategy. In this way, the process of idea generation for investments may be a perpetual process.
2.
A Management Review maybe undertaken to consider alternative investment projects proposed by categories for example cost reduction, asset replacement, revenue generation, innovation, governance, corporate social responsibility and so on.
The Top Management team will thereby look into the need for further assessment of these investment proposals in relation to the value to be added to the organisation as well as to ensure alignment with their corporate strategic vision & mission. Such projects will compete for financial and manpower resources and therefore a management review is needed to decide which of the investment projects presented should be given further consideration.
S 2 / 08 . 21
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23
3. Evaluation and Screening of Investment Proposals A well-established Investment Decision System will require a set of criteria for evaluation whereby new proposals can be appraised and then be subsequently prioritised for a more thorough investment appraisal. Within a well-conceived system, these criteria maybe standardised to save management time during the screening process. It is common policy for corporations to set minimum levels of internal returns pre-determined for investment project screening.
4. Investment Appraisal It is at this stage, that the investment appraisal process is critical. There is a basic need therefore to review net cash flow forecasts as a basis for a series of Investment Appraisal Techniques to be employed. (To be outlined later in the manual)
S 2 / 09 . 21
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24
The outcome of the Investment Appraisal process will usually lead to a proposal to top management to secure a mandate for authorisation.
5. The Investment Decision and Implementation

A Capital Investment Budget will have had to be approved to finance selected investment projects. This budget is in fact a management tool to be used to monitor and control levels of investments agreed against that which was originally agreed, so that the investment can be tracked as being on-time and on-budget.
For Capital Investments Decisions, this will usually be a main board decision or an empowered committee where agreed limits to the levels of investment authority gave already been conferred.
The actual decision is a GO NO GO Decision which can be taken quickly, provided the processes for investment project due diligence have been completed.
S 2 / 10 . 21
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OUTPUTS The following outputs from Investment Decision Systems could be expected : A successfully secured investment which is in accordance with the investment proposals agreed and which have met the investment criteria for evaluation, subject to any contingencies and related adjustments required. A lessons learned report for future investment appraisal and decision taking. Reinforcement of financial and management controls for investment proposals.
A Follow-up Investment Audit.
A simple value chain approach to Investment Selection & Decision Taking can be seen in Figure 2.1.
S 2 / 11 . 21
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26
INVESTMENT SELECTION & DECISION TAKING

FIGURE 2.1
STRATEGIC INTENT INVESTMENT BUDGET
IDEA GENERATION
SCREENING
INVESTMENT APPRAISAL
IMPLEMENTATION
&
INVESTMENT PROPOSALS EVALUATION INVESTMENT SELECTION
REVIEW &
FOLLOW THROUGH
Types of Investment in line with Strategic Intent Capital Investment Budget
Opportunity Analysis Forming Proposals
Criteria for Evaluation Discount Rates Internal Rate of Return Time Value of Money
Payback Net Present Value Profitability Index Decision Rules & Protocols
Capital Investment Budget Adjustments Monitoring of Cash Flows Tracking Processes Investment Project Management Reviews
NOTE : INVESTMENT APPRAISAL WILL BE EXPAND IN DETAIL IN SESSIONS 3 & 4.
S 2 / 12 . 21
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27
INVESTMENT IN CORPORATE PROJECTS Investments in projects for the corporation requires an understanding of the internal and external environment which has driven the need for change. A compliant culture and aligned organisational climate for investment will be required for progress to be achieved and this cannot succeed without leadership for investment. Investment of shareholder funds is a strategic management decision and to therefore make such decisions requires relevant, timely and accurate information in the form of a financial appraisal. Classical Techniques for project appraisal are known as DISCOUNTED CASHFLOW techniques, which will be outlined herein. Such techniques are usually employed for long-term capital investment, which is commonly known as CAPITAL BUDGETING. Investment Project Appraisal is simple in its essence. The fundamental purpose is to determine that more money is to be derived from that which was put into the project. In other words, more cash is returned from the project than has been invested into it.
S 2 / 13 . 21
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The key issue is to determine how much more will be returned !
Investment Appraisal techniques are designed to assess this critical point. An investor may have alternative projects from which to decide where to invest and hence such techniques are useful in making informed decisions. Once an investment is committed, the money has been pledged and in fact this denies investment in other investment alternatives.
This process introduces another concept, the Investors Opportunity Cost. This is the cost of the opportunity that has been foregone as a result of deciding upon the chosen investment. Investment Appraisal techniques will help to decide the opportunity cost between investment project alternatives and therefore they are very useful as part of the investment screening process. When using shareholder funds for investment, the best investment decisions options must be taken in order to minimise the opportunity cost to be incurred.
S 2 / 14 . 21
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29
Once an investment is implemented, the impact upon CASH FLOW has to be managed because money is now tied up in the investment before any returns maybe realised. Discounted cash flow investment project appraisal techniques are also designed to project future net cash flows to be derived from alternative investment projects.
S 2 / 15 . 21
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30
THE TIME VALUE OF MONEY This simple concept of the time value of money is central to taking informed investment decisions. When an investment is made, the money is deployed into the selected investment, thereby denying alternative uses of the funds invested for the duration of the investment. In fact this means that a sacrifice has been made, furthermore other investment (or even consumption) from monies held has been halted as a result of the investment decision taken. Therefore this sacrifice for the time the money is tied up has to be reconciled against the opportunities foregone, the inability to consume, the rate of inflation, foreign exchange exposure and of course the risk exposure. All of these factors are time dependent, and can be explained as the time value of money. For Example
To compensate for the time value of money, an investor needs to achieve the following : 1 Some benefit from the sacrifice made from the inability to consume, nominally at a pure rate of interest, say 1% per annum
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S 2 / 16 . 21
The cost of the time eroded which has been impacted by inflation and also for the loss of purchasing power during the time of the investment, say 3.2% per annum as an estimate for inflation.
This means that 10,000 investment today must at least yield 10,000 + 4.2% interest. BUT is this time value of money sufficient for the sacrifice made ? This figure of 4.2% is the RISK-FREE RETURN which should be sufficient to induce the investment, but is this attractive enough, especially considering the opportunity cost that would be incurred !!?? This calculation of risk free return is a benchmark from which to now add in the element of risk. THIS MEANS THAT THE TIME VALUE OF MONEY ( THE NET RETURN ON INVESTMENT REQUIRED)
S 2 / 17 . 21
THE RISK FREE RETURN
A RISK PREMIUM
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32
So now to give compensation for the risk taken, an additional amount is need for the risk element, lets say 6% as an example.
CONCLUSION This means that the time value of money must at least return 4.2% + 6% = 10.2% per annum, otherwise the investment is not a viable option. The time value of money must therefore answer the question : What is the minimum return that must be achieved to compensate for the sacrifice made in relation to inability to use the funds invested, the rate of inflation and the level of risk exposure ?? In this example, is it okay to invest 10,000 today for a return of 10.2% in a years time, ie. 11,020 ?
S 2 / 18 . 21
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With world interest rates at current levels and with the impending threat of incremental inflation this puts pressure on the level of risk-free return that is required to stimulate investment. Furthermore with turbulent economic environments in selected parts of the globe, which has an impact on global financial markets, the risk premium has to be considered with care. The use of discounted cash flow techniques can be used to accommodate the time value of money for investment project appraisal and will be outlined in Session 3.
S 2 / 19 . 21
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34
QUESTIONS
1. Upon what basis would you decide to make a substantial investment.
2. Using an example of your own choice, explain the principle of Opportunity Cost.
3.
The time value of money is a well-known technical term, what does it mean in the real world of investment.
S 2 / 20 . 21
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35
KEY TERMS CAPITAL APPRECIATION CAPITAL PRESERVATION CASH FLOW DISCOUNTED CASH FLOW FINANCIAL ASSETS INVESTMENT INVESTMENT APPRAISAL INVESTMENT DECISION TAKING OPPORTUNITY COST PROJECT INVESTMENT RATE OF RETURN REAL AND INTANGIBLE ASSETS REALISED RETURN RISK AND RETURN RISK FREE RETURN RISK PREMIUM THE INVESTMENT BUDGET TIME VALUE OF MONEY
S 2 / 21 . 21
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SESSIONS 3&4
INVESTMENT PROJECT APPRAISAL (1)
CAPITAL BUDGETING
INVESTMENT PROJECT APPRAISAL TECHNIQUES SIMPLE CASH FLOW DISCOUNTED CASH FLOW PRESENT VALUE AND DISCOUNTING
NET PRESENT VALUE

PROFITABILITY INDEX INTERNAL RATE OF RETURN
S 3&4 / 01 . 27
DISCUSSION QUESTIONS KEY TERMS

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CAPITAL BUDGETING
Capital Budgeting is a term used for the managerial decision making process adopted to evaluate and confirm longer term capital investment projects. Capital budgeting decisions will often impact the corporation for some years and hence require careful management, planning and review. It is usually the case that larger scale projects will take time to implement, therefore part of the capital budgeting decision taking is the timing for investment. The fundamental premise of capital budgeting is in fact INCREMENTAL CASH FLOW, [not accounting income or earnings.] In fact the main anchor for corporate finance usually stressed is cash flow.
S 3&4 / 02 . 27
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38
Investment Projects to which investment appraisal techniques are often applied can be classified using a number of common terms, namely : Replacement Projects for Asset renewal or Asset upgrading Business Development Projects for business expansion through product development, market development or even diversification
Re-engineering Projects for process streamlining and the associated business efficiencies to be derived
Independent Projects or Special Projects usually within the domain of top management planning & control Regardless of the hope of investment, each project classification should yield real value to the corporation.
S 3&4 / 03 . 27
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The ultimate challenge is in the estimation of future net cash flows, as well as an accurate assessment of the corporations cost of capital. The outcome from the capital budgeting process of selecting between project alternatives will be concluded in a capital budget which is a list of planned investment outlays on designated and mandated projects. The process of allocating capital for investment will be influenced by project investment appraisal techniques, but it will be reinforced by managerial decision analysis taking into account wider non-financial variables. Where appropriate, more knowledge building may be needed to achieve the level of corporate confidence required for investment funds to be committed. This done, levels of uncertainty about designated projects is reduced. Arising from the newly acquired facts, top management may then decide to look again at all their options, before committing funds. This could lead to delays or deferment of project(s), or even abandonment it on the rationale that the added value to the corporation is not optimised at this point in time. Such decisions are common. Therefore investment decisions and hence capital budgeting cannot be based purely upon financial criteria alone. To support capital budgeting decisions, a range of investment project appraisal techniques are commonly used and these will now be explained.
S 3&4 / 04 . 27
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INVESTMENT PROJECT APPRAISAL TECHNIQUES The range of techniques used can be classified into those with the time value of money factored in and those without, as follows : WITH THE TIME VALUE OF MONEY DISCOUNTED CASH FLOWS NET PRESENT VALUE INTERNAL RATE OF RETURN PROFITABILITY INDEX
WITHOUT THE TIME VALUE OF MONEY
PAY BACK
BAIL OUT PAYBACK
S 3&4 / 05 . 27
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41
SIMPLE CASH FLOW AND DISCOUNTED CASH FLOW A simple cash flow is shown in Table 3.1 below.
INVESTMENT PROJECT EXODUS CASH FLOWS ( 000s) NOTES
Table 3.1
YEARS
0 1 2 3 4
(Today) (One year from today) (Two years from today) (Three years from today) (Four years from today)
- 200 + 10 + 20 + 100 + 120
The initial outlay

Positive cash flows are estimated to grow up to a four year period to recover the initial outlay and yield a return.
S 3&4 / 06 . 27
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42
At a glance, the initial outlay of 200,000 has repaid 250,000 over 4 years, so on the surface this may be attractive, but these conclusions are all based upon future estimated cash flows. Some probability of certainty must be applied so that there is confidence in the simple cash flow statement. One thing is quite clear, ie. the future net cash flows are worth different amounts to the investor as at today.
DISCOUNTED CASH FLOW To take this process of Simple Cash Flow to Discounted Cash Flow we need to take into account the effect of modified compound interest principles. Hence the future value of the different levels of cash flow in each year are taken into account by also allowing for an interest rate to be applied which reflects the gain to be achieved (or the desired rate of return). Consider the formula below : -
S 3&4 / 07 . 27
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43
Future Value
Present Value Interest Rate Over The Number Of Years Defined
This can be stated as :
F
where F P i
=
= = =
P( 1 + i ) n
Future Value Present Value Interest Rate
Number of years through which compounding of the interest

can be applied
For example if 1000 was placed on a deposit account paying 6% per annum for 4 years, the amount in the account at the end of 4 years would be F
S 3&4 / 08 . 27
1000 ( 1 + 0.06 )
= 1,297
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NOTE that the compounding effect would also pay interest on interest. [See Page 57 for sample compound interest tables ] The formula can now be adjusted to understand the concept of discounting (ie. the reverse of compounding). The question to be answered is therefore How much must be invested today at 6% per annum if I wish to receive 1297 in 4 years time ? The formula would be P = F ( 1 + i )n
= P
1,279
( 1 + 006 ) 4
1000
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45
Now 6% may not really represent the Time Value of Money adequately to take into account the investment criteria discussed previously. Therefore a target rate of return can be set to compensate for all factors which should be taken into account, which is then discounted for the life of the investment as shown in Table 3.2 below. A figure of 15% has been determined as the target rate to be met in order to accept the investment project.
INVESTMENT PROJECT EXODUS ( 000s )
YEARS 0 1 2 NET CASH FLOWS - 200 + 10 + 20 10 1 + 0.15 20 (1 + 0.15) 2 100 (1 + 0.15) 3 120 (1 + 0.15) 4 0.8696 0.7561 F (1+i)n Discount Factor * for Present Value Present Value - 200,000 + 8696 + 15122 Table 3.2 DISCOUNTED CASH FLOWS @ 15% PER ANNUM
3 4
+ 100 + 120
0.6575 0.5718
+ 65,750 + 68,616 ( 41, 816)
S 3&4 / 10 . 27
* See Appendix A Page 59 and Page 57
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46
As can be seen, a very different assessment emerges. From a simple cash flow (shown in Table 2.1) Project Exodus would return 50,000 in excess of the original amount invested, which on the surface may appear attractive. However, when a target rate of return of 15% per annum is set to compensate for the time value of money, then Project Exodus is unattractive, by providing a shortfall of 41,816. This means the target rate has not been achieved and the realised rate of return from Project Exodus is much less. This in simple terms tells us that at the 15% per annum return target, Project Exodus does not payback. It shows that the net preset value of 200,000 invested today is (41,816 !)
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47
WHAT DOES THIS TARGET RATE OF RETURN REALLY MEAN ? In simple terms, yes it is the time value of money, but it is also THE OPPORTUNITY COST OF INVESTED CAPITAL !!
This is the amount that can be regarded as the minimum return required for any investment project to be undertaken, simply because other opportunities which may be accountable would yield 15% per annum or more.
Also because the 200,000 would be tied up 15% annual return would be the target figure for compensations for the sacrifice made by having 200,000 capital tied up for 4 years.
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48
PRESENT VALUE AND DISCOUNTING To clarify these terms : THE NET PRESENT VALUE or NPV is the preset value of total projected net cash inflows minus the current value of the cost of the investment. The present value is calculated using discount tables for the determined opportunity cost of capital, multiplied by the net cash flow for the designated period (usually each year for the life of the project). The process of calculating the future value of cash flows is called DISCOUNTING, which is in fact the opposite of compounding. The steps to be taken to apply the NPV technique is explained below.
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DECISION RULES FOR APPLYING NET PRESENT VALUE 1. Know the investment outlays and the timing for the release of funds during the life of the investment.
2. Forecast conservatively the expected cash flows for the life of the investment.
3. Determine the opportunity cost of capital as the required minimum rate of return. Factor into this amount the risk premium required. This then becomes a target rate of return.
4. Apply the NPV formula for the projected net cash flows and the target cost of capital (using Discount Tables).
5. Aggregate the Present Values for each period into a Net Present Value figure.
6. The investment decision is based upon the rationale that the investment project adds value if the NPV > 0 and erodes value if NPV < 0.
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50
EXAMPLES Consider two investments with an outlay of 1,000,000 called Project Omega 7 and Project Orion 5, both with different forecasted cash flows, but with an opportunity cost of capital of 10%.
PROJECT OMEGA 7
YEARS 0 CASH FLOWS - 1,000,000 Discount Factor 1.0000 Table 3.3 Present Value (1,000,000)
1
2 3 4 5
800,000
600,000 400,000 200,000 100,000
0.9091
0.8264 0.7513 0.6830 0.6209 Net Present Value
727,273
495,868 300,526 136,602 62,092 722,361
* See Appendix A Page 59 and Page 57
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PROJECT ORION 5
YEARS 0 1 2 3 4 5 CASH FLOWS - 1,000,000 100,000 200,000 400,000 600,000 800,000 Discount Factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 Net Present Value
Table 3.4 Present Value 1,000,000 90,909 165,289 300,526 409,808 496,737 463,269
Even though both projects exceed the opportunity cost of capital, theoretically both should be accepted assuming they were independent projects, but if they were mutually exclusive projects then Omega 7 should be adopted , moreover the risk of late net cash flows from Orion 5 would also render it more risk prone.
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PROFITABILITY INDEX For comparing the profitability index of each project, the following formula can be applied.
TOTAL PRESENT VALUE OF FUTURE CASH FLOW STREAMS

INITIAL CASH OUTLAY FOR THE INVESTMENT
PROJECT OMEGA 7
PROJECT ORION 5
1,722,361 1,000,000
1,463,269 1,000,000
= 1.722
= 1.463
Clearly Project Omega is way ahead of Project Orion using this approach to prioritise projects.
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53
The NPV method can thus be employed for projects of dissimilar capital outlays, life span, residual values and varying net cash flows, this making it a versatile tool for capital investment project appraisal.
INTERNAL RATE OF RETURN The Internal Rate of Return (IRR) is a popular DCF technique which also takes into account the time value of money. The purpose of the IRR is to achieve, with some precision, the rate of interest to be gained from investing in a project, rather than specifying a target rate of return on the Opportunity Cost of capital as employed using the NPV approach. Using the IRR method, the actual internal rate of return is that which is equal to the net present value at the time the original outlay is regained.
S 3&4 / 18 . 27
Page
54
The IRR formula this may be expressed as : C F0 + C F1 1 + r Where CF =
= 0
Cash Flow at time zero
CF
r
=
=
Cash Flow at Time one ( t i ) yearly for t i to t n

Trial rate of return
Example
For an investment real estate project costing 22 million today which in a years time could be sold for 24 million, can be assessed using the internal rate of return.
S 3&4 / 19 . 27
Page
55
To calculate the true rate of return a process of Interpolation is required between two percentage points so the exact discount rate can be achieved. Therefore by trial and error we can try 9% and 10%.
So by applying the above formula
- 22
24
1 + 0.10 = (0.1818) (or 181,800)
which shows, as a result of the negative figure produced that the return is less than 10%.
S 3&4 / 20 . 27
Page
56
So now applying the equation at 9%, the formula can again be applied and the figures transposed as follows : 24 + - 22 = + 0.18348 or 18,348 1 + 0.90
The actual rate of return is neared to 9% than 10%. Now by interpolation, the exact rate of return can be achieved. IRR = 9%
18,348 18,348 + 181,800
(10 9)
9.09% , therefore the Internal Rate of Return is at 9.09% where the NPV now equals zero.
S 3&4 / 21 . 27
Page
57
The process of interpretation is to find the point on the line between the two discount rates and express this as a proportion between one positive and one negative NPV, thereby achieving the NPV of zero (see the diagram below).
INTERPOLATION Discount Rate ( r ) 9% IRR ? 10%
NPV at
Net Present Value of Cash Flows + 18,348 - 181,800
The IRR lies at a distance of 18,348 from the 9% discount rate. The adjustment therefore is 9%
S 3&4 / 22 . 27
18348 18348 + 181800
( 10 9 )
9.09 %
Page
58
Some companies, in order to simplify the initial screening of projects will specify the IRR at a level, so that projects which do not achieve the minimum target IRR set would automatically be rejected from further consideration. The IRR can also be used to set the Opportunity Cost of Capital by factoring in the Time Value of Money. For the above example, the IRR at 9.09% gives a clear calculation of the return from the project, but is this really enough ? To invest 22 million for a 9.09% return in one years time maybe unattractive simply because of the time value of money and hence the opportunity cost of the capital to be invested will probably far exceed 9.09%.
The IRR, when set well in advance of any investment decision can be useful to assess the initial financial feasibility of the project. Larger corporations may use the IRR as a threshold figure from which any future projects must exceed this specified return, in order to be considered.
Session 5 will now feature Investment Project Appraisal Techniques which DO NOT factor in the time value of money.
S 3&4 / 23 . 27
Page 59
EXAMPLES OF COMPOUND INTEREST TABLES THE FUTURE VALUE OF 1

INTEREST RATE PER ANNUM YEARS 1 2 3 4 5 3% 1.0300 1.0609 1.0927 1.1255 1.1593 5% 1.0500 1.1025 1.5726 1.2155 1.2763 10% 1.1000 1.2100 1.3310 1.4641 1.6105 15% 1.1500 1.3225 1.5209 1.7490 2.0114
EXAMPLES OF PRESENT VALUE TABLES WITH DISCOUNT % FACTORS THE PRESENT VALUE OF 1
INTEREST RATE PER ANNUM YEARS 1 2 3% 0.9709 0.9426 5% 0.9524 0.9070 10% 0.9091 0.8264 15% 0.8696 0.7561
3
4 5
S 3&4 / 24 . 27
0.9151
0.8885 0.8626
0.8638
0.8227 0.7835
0.7513
0.6830 0.6209
0.6575
0.5718 0.4972
Page 60
QUESTIONS 1. Why do you consider it important for corporations to conduct Capital Budgeting ?
2. How does the time value of money contribute to investment project appraisal ?
3. What is the difference between compounding and discounting ? 4. What is the fundamental Difference between the Internal Rate of Return and the Net Present Value approaches to investment appraisal ?
5. According to the NPV discounted cash flow methodology, when the Net Present Value equals zero, then a project should be accepted because the forecasted target investment returns have been met. Outline other wider managerial considerations to be taken into account before such an investment project is agreed.
S 3&4 / 25 . 27
Page
61
APPENDIX A
DISCOUNT TABLES
PRESENT VALUE FACTORS
S 3&4 / 26 . 27
Page
62
KEY TERMS CAPITAL BUDGETING CAPITAL BUDGET COST OUTLAY COMPOUND INTEREST COMPOUND INTEREST AND PRESENT VALUE TABLES INCREMENTAL CASH FLOW INDEPENDENT PROJECTS INTERNAL RATE OF RETURN (IRR) INTERPOLATION MUTUALLY EXCLUSIVE PROJECTS NET CASH FLOW NET PRESENT VALUE (NPV) PROFITABILITY INDEX SIMPLE CASH FLOW THE OPPORTUNITY COST OF CAPITAL THE TARGET RATE OF RETURN THE TIME VALUE OF MONEY
S 3&4 / 27 . 27
Page 63
SESSION 5
INVESTMENT PROJECT APPRAISAL (2)

S 5 / 01 . 16
PAY BACK DISCOUNTED PAY BACK ACCOUNTING RATE OF RETURN ESTIMATING CASH FLOWS DISCUSSION QUESTIONS KEY TERMS
Page 64
PAYBACK The payback period is simply the number of periods, usually measured in years, that is required for the original sum of an investment to be repaid. Clearly the managerial investment decision under such conditions would be to accept any investment project which pays back earlier or on a target date set. For example if a capital investment of 5,000,000 is expected to be recovered in 3 years, but the estimates of payback are 2.5 years, then the simple payback decision rules can be applied. Of course, the probability of the net cash flows to recover the initial investment must be factored in. It is wise to allow for contingency time within the payback period and also allow for irregularities of cash flows within the time period.
The payback method in this simple form does not take into account the time value of money.
S 5 / 02 . 16
Page
65
Where mutually exclusive projects are involved then the decision will be to invest in the project with the shortest payback period. This of course mitigates against long term projects and leads to a short-term investment planning horizon should payback be used as a single appraisal criteria. The notion of payback also leads to a managerial mindset about the cut-off point for the investment. Rightly one should also consider market conditions and the prevailing level of risk.
The notion of payback is used by many managers, especially in smaller companies because it is easy to apply, easy to communicate and maybe favours the shorter term entrepreneurial mindset. Projects that payback quickly will soon thus contribute to the companys cash flow management and associated liquidity.
S 5 / 03 . 16
Page
66
For example, if a company in the coffee caf business knows with certainty that each new outlet will payback the original investment in 9 months. It is this simple notion which drives investment because after the 9 month period, each outlet will inject positive cash flow into the overall business. The focus however is usually on the payback period, not the incremental cash flows beyond it, and this is why the simplicity of payback cannot be the only consideration.
For example, when taking a decision to buy a second home for rental, the rule of thumb would be to repay the investment within 10 years from the net rentals received. The investor knows the house will be paid for in 10 years. This is the driver behind the investment.
However there will be continued flows of rental receipts in perpetuity if the property is retained, maintained and rented out. Furthermore, inevitably there will be capital appreciation gained from the increase in house prices over the longer term.
It can be seen that payback alone cannot be the sole criterion for investment, but only one principle the investment decision it has to consider.
S 5 / 04 . 16
Page
67
DISCOUNTED PAYBACK One of the drawbacks of the payback method is that it ignores the time value of money. To overcome this important consideration, a modification to the payback method has been developed called discounted payback. The approach taken is to discount the future cash flows before calculating the payback period. These are then summated to determine the payback period by dividing the total discounted future cash flows into the current amount to be invested. Consider Table 5.1 below.
S 5 / 05 . 16
Page
68
PROJECT JULIANNE -- PAYBACK ANALYSIS

TABLE 5.1
UNDISCOUNTED CASH FLOW ( MILLIONS) CUMULATIVE CASH FLOW ( MILLIONS) DISCOUNTED CASH FLOWS @ 10% PER ANNUM * DISCOUNT FACTOR DISCOUNTED CASH FLOWS CUMULATIVE NET CASH FLOWS
0 1 2 3 4 5
(10) 5 3 1 1 3
(10) (5) (2) (1) 0 3
1.000 0.9091 0.8264 0.7513 0.6430 0.6209
(10,000) 4,545 2,479 751 683 1,863
(10,000) (5455) (2976) (2225) (1542) 321
USING UNDISCOUNTED CASHFLOW THE PROJECT JULIANNE PAYS BACK IN 4 YEARS. * See Appendix A Page 59 and Page 57 S 5 / 06 . 16
USING DISCOUNTED CASHFLOW TO TAKE INTO ACCOUNT THE TIME VALUE OF MONEY, PROJECT JULIANNE PAYS BACK TOWARDS THE END OF YEAR 5.
Page 69
By using DISCOUNTED PAYBACK, a more conservative payback period will be achieved and perhaps a more conservative note for investment.
This is an important step forward because the opportunity cost of the capital to be invested can be appreciated and in turn allowances made for the time value of money. It has still to be noted that the certainty of the cash flows and their irregularities would need to be based upon wellconceived assumptions. BOTH Payback and Discounted Payback should be considered as tools in the investment appraisal toolbox, which should be used together to provide inputs into the investment decision. This simplistic approach should not be considered as the primary investment project appraisal technique, a hybrid approach using a number of well-conceived techniques would be advised.
S 5 / 07 . 16
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70
ACCOUNTING RATE OF RETURN The Accounting Rate of Return is an accounting calculation to express the amount of profit to be derived from a project investment. It is expressed as a percentage of the amount invested.
An investor would probably have a target rate of return in mind, known as a hurdle rate, so if the Accounting Rate of Return, when calculated, passes the hurdle rate then the notion would be based on this criteria alone to adopt the investment.
However there are a multitude of methods to determine the accounting rate of return (which is also known as the ROI or Return on Investment. At the most basic level THE ACCOUNTING RATE OF RETURN ( ARR ) =
PROFIT INVESTMENT
S 5 / 08 . 16
Page
71
BUT, what profit figure is to be taken ? Depreciation must be considered, but then there maybe other charges to be made against the profit figure, eg. tax. So a consistent approach is needed to determine which profit calculation to use so a real comparison can be made between alternative investments apple to apple. Equally, the investment figure may be taken as : initial investment total investment including working capital during the life of the project average annual investment
Once again, it is essential to be clear on the basis for determining the investment and profit figures.
S 5 / 09 . 16
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72
DIFFERENT APPROACHES The following options are among those which could be considered, but recognise they will all offer different calculations and have different interpretation, so forewarned is forearmed. 1. TOTAL PROFIT FOR THE LIFE OF THE INVESTMENT TOTAL INVESTMENT MADE 2. AVERAGE ANNUAL PROFIT INITIAL INVESTMENT OUTLAY 3. AVERAGE ANNUAL PROFIT AVERAGE ANNUAL INVESTMENT OUTLAY Whichever approach is decided, it must be remembered that the decision rule will apply upon a hurdle rate , which may in fact be the companies cost of capital. The ARR approach does not take into account the time value of money.
S 5 / 10 . 16
Page 73
From a corporate finance perspective, CASH is KING and cash flow is the lifeblood of the organisation, so then in assessing alternative investments, the appraisal techniques which favour cash flow based investment analysis have more merit. This is simply because from an accounting perspective, profit is a measure of performance and is variously defined ; Cash and cash inflows and outflows have no ambiguity.
S 5 / 11 . 16
Page
74
ESTIMATING CASH FLOWS
As seen from the earlier comment about the importance of cash and cash flow, one real challenge for many investment project appraisal techniques is how should cash flow be estimated.
In essence, the calculation of cash flow relevant to investment project analysis should only factor in cash flows that will influence the overall cash position. So therefore the ACTUAL cash flow must be tracked and assessed at the time it occurs. In making projections for future cash flows where costs and even prices may increase then the cash flow estimates are made on a nominal basis. Allowance must be made for inflation and then factor this into the cost of capital to be employed in the investment.
S 5 / 12 . 16
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75
With the further potential for cash inflows and outflows crossing borders then a base currency should be used for the calculations.
There may be some debate upon the inclusions of certain cash movements as being relevant for charging into the investment project. This will have a bearing upon cash flow volumes and measurement.
So therefore it is cash movements that are relevant that must be factored in. One issue concerns sunk costs, these are outlays that have been made regardless of the investment decision and for which there is no alternative use. So the decision to be made is where to charge them. Equally the charging of overhead cash expenses to an investment project has to be undertaken on an equitable basis. Estimating cash flows for an investment project should be done for the ECONOMIC life of the project. This may be different from the accounting approach when fixed assets are depreciated for reporting purposes.
S 5 / 13 . 16
Page
76
The essential cash flows to be considered when making investment project cash flow projections would be : -
CAPITAL EXPENDITURE RELATED TO THE PROJECT (CAPEX)

WORKING CAPITAL REQUIREMENTS FOR OPERATING EXPENDITURE (OPEX) RELEVANT CASH IN FLOWS AND OUT FLOWS TAXATION AS APPROPRIATE DEDICATED PROJECT RELATED COSTS RESIDUAL VALUE IF ANY All of which must be charged into the principal sum of the investment to get an understanding of total investment cost.
S 5 / 14 . 16
Page 77
QUESTIONS
1. The simple payback method of investment project appraisal is nave. Discuss.
2.
Under what circumstances would you recommend using the discounted payback appraisal technique.
3. Why does the Accounting Rate of Return offer challenges of interpretation ?
4. Why Is forecasting future cash flows really just gazing into a crystal ball ?
S 5 / 15 . 16
Page
78
KEY TERMS ACCOUNTING RATE OF RETURN (ARR) ACTUAL & NOMINAL CASH FLOWS CAPEX and OPEX CUT OFF POINT DISCOUNTED PAYBACK
ECONOMIC LIFE HURDLE RATE INVESTMENT PLANNING HORIZON OVERHEAD CASH EXPENSES PAYBACK RESIDUAL VALUE ROI (RETURN ON INVESTMENT) SUNK COSTS
S 5 / 16 . 16
Page
79
SESSIONS 6&7
THE COMPANYS COST OF CAPITAL
THE COST OF CAPITAL

THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) THE WACC FORMULA
WACC IN SUMMARY
THE CAPITAL ASSET PRICING MODEL COST OF DEBT CAPITAL
DISCUSSION QUESTIONS
KEY TERMS
S 6&7 / 01 . 24
Page
80
THE COST OF CAPITAL

From what we have studied so far it is clear than all investors have an opportunity cost of capital. This concept also applies to shareholders who have invested their funds into a form of ownership in a company from the shares they purchase and currently hold.
In fact these funds tied up in shares also have an opportunity cost associated with them, which is why shareholders may decide to look for better returns through buying and selling shares.
At the most fundamental level, a companys cost of capital is the amount paid, in terms of interest to a lending institution to obtain finance. However, this cost can only be taken into account as a floor figure. If a risk premium is taken into account then a risk adjusted figure may affect this floor amount. There are in fact many considerations required to calculate a true cost of capital and it may be difficult to obtain a precise calculation.
S 6&7 / 02 . 24
Page
81
From a company management perspective, it may not be the absolute value calculated which is really vital, but what is important is to know the variables which constitute the true cost of capital, so that these can be best managed for corporate wealth generation. Herein lies an important insight, it is the managerial concept of cost of capital which is as important as the final calculation. Also, from a practical standpoint, it may be useful to work on the cost of capital within an approximate range to allow for a margin of safety, say the cost of capital is between 18% to 22% for example. This may have a woolly feel and appear vague, but maybe more like the managerial reality than calculating an absolute cost of capital and then making an error of judgment on an important investment decision. What is therefore important is to use the cost of capital as a benchmark or threshold figure against which to assess the rate of return.
S 6&7 / 03 . 24
Page 82
Now it must be realised that the rate of return will be different between equity capital and debt capital. Equity Capital is risk capital and therefore in the short-term there may be little or no return at all until business flourishes and pays dividends to its equity shareholders. In the case of Debt Capital, it is a different matter because the cost of borrowing will depend upon the credit rating given to the company seeking debt finance and furthermore there may be convernants attached to the loan to which company management will be required to comply. One example would be restrictions on gearing or legal charges on assets held as a result of having to pledge assets. Such restrictions are to protect the lender, but in turn drive up the true cost of capital. The cost of company capital would normally be a threshold level set by the Finance Manager which sets the minimum expected rate of return from company investments made. In turn it will be made up of a number of components related to Equity Capital and Debt Capital costs as well as the opportunity cost to be incurred.
S 6&7 / 04 . 24
Page 83
THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) Another way to determine the cost of capital is to assess the return the company has received to date on multiple projects and then weight the returns commensurate with the investments made. From the aggregate values achieved, divided by the number of projects assessed, the WACC can then be determined. Once again the WACC provides a threshold cost of capital from which anticipated returns which exceed the WACC can be considered for investment. It must be remembered that the WACC is made up of multiple projects with different risk profiles and therefore by smoothing this data may present a different assessment of the cost of capital than otherwise would be realistic. A wise use of WACC is to firstly determine it and then set it as the minimum rate of return expected on future average risk investment projects, in order to provide a fair return to shareholders. The mistake which is often made is to apply this average as a standard across the organisation for an investment return threshold. This may simply be convenient, but in reality adjustments will have to be made, otherwise attractive investment projects maybe denied an opportunity,
S 6&7 / 05 . 24
Page 84
CALCULATING THE WACC The following components are needed : 1. ABSOLUTE VALUE OF DEBT 2. ABSOLUTE VALUE OF EQUITY 3. TOTAL CAPITAL 4. CAPITAL STRUCTURE 4.1 4.2 PROPORTION OF EQUITY PROPORTION OF DEBT E/V D/V D E V
5. INTEREST RATE ON DEBT

6. INTEREST RATE ON EQUITY 7. CORPORATE TAX RATE
r r
debt
equity
S 6&7 / 06 . 24
Page
85
THE FORMULA
WACC (After tax)
D V
( 1T ) r c debt
r equity
S 6&7 / 07 . 24
Page
86
EXAMPLE : METAMAX PLC Capital Structure ( m ) Long Term Debt Ordinary Shares Total Capital (D) (E) (V) 200 600 800 D/V = 0.25 E/V = 0.75
Interest Rate on Debt Interest Rate on Debt Paid in Dividends

Corporation Tax
r debt r equity
8% 11%
30%
S 6&7 / 08 . 24
Page
87
WACC
[
[
D V
( 1 Tc ) r debt
]
]
r equity
0.25
( 1 0.30 ) 8%
+ +
0.75 11%
1.4
8.25
WACC
9.65%
S 6&7 / 09 . 24
Page
88
If the equity is further divided between ordinary shares and preference shares, then the WACC equation is extended accordingly,
WACC (After tax)
( 1 Tc ) r debt V
P
V
r preferred
E
V
r equity
S 6&7 / 10 . 24
Page
89
To take a simple example for Alexis Engineering Ltd where no company tax is paid, long-term debt is 195,000, paid up ordinary shares capital is 500,000 giving a total capital of 695,000. The cost of debt is 7% but the company shareholders expect a return of 13%. Then the WACC = = =
D V
( 0.28 7% ) + 1.96% 11.32 % 195 695 +
( 0.72 13 % ) 9.36%
Where
= 0.28
E
V
500 695
= 0.72
It follows that where the capital structure changes and the cost of debt or equity also changes that the WACC will be sensitive to such change.
S 6&7 / 11 . 24
Page 90
If through company trading, the business does not return 11.32%, then the debt interest would be paid first, leaving the Equity Share Capital owners with less than they expect. This means that for any investment project to be adopted then the target rate of return must exceed 11.32% but with a further margin of safety to protect the interests of shareholders as well as to pay off the cost of debt.
REBALANCING THE CAPITAL STRUCTURE TO INCREASE SHAREHOLDER RETURNS In order to protect shareholder interests, and by examining the formula used to calculate WACC, there is a way to protect shareholder return and still use WACC as the investment threshold.
S 6&7 / 12 . 24
Page
91
This can be achieved by increasing the level of debt, provided that it is cheaper than the expected return on equity. This requires a review of the financial gearing ie. the proportion of debt in relation to equity, which is important to know and will be considered in more detail later. The downside of increasing the gearing, ie. the proportion of debt to equity, then the company will have a higher risk profile and this in turn may put pressure on shareholder return. So at the end of the day, it is about the optimal balance between debt and equity and their respective capital costs which determine the optimal WACC. But, proportions and costs will change because financing is dynamic and hence the WACC will be subject also to change. Therefore it is a financial policy decision to adopt or not to adopt WACC as a financial performance metric.
S 6&7 / 13 . 24
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92
WACC IN SUMMARY The WACC provides companies with a benchmark discount rate for investment project evaluation on the assumption that there is no special level of high or low risk attached to the investment. The formula is easy to apply and can be adjusted for different types of debt as well as for tax adjustments. The use of WACC sensitises the corporation to the importance of capital gearing and hence the need to review capital structures to determine the optimal position between debt and equity capital. The cost of debt will be the market rate of interest charged on different forms of financial debt securities. Therefore only the new rate of interest to be paid on future investment projects should be selected for the WACC calculation.
S 6&7 / 14 . 24
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93
The cost of equity is more difficult to estimate because the stock market value of shares fluctuates, so therefore the cost of equity should be viewed as the expected rate of return by shareholders on their investment in the firm. Also, share dividends provide a basis for calculating future cost of equity. In this sense, an Industry based WACC benchmark is also useful.
Where capital structure change and capital costs change then so will the WACC.
S 6&7 / 15 . 24
Page
94
COST OF EQUITY USING THE CAPITAL ASSET PRICING MODEL Ordinary shareholders will not receive a specified rate of return, but in making their investment in shares, there is an implicit return in mind, otherwise the investment will not be made. Investors who buy ordinary shares really look for two things : A return which exceeds that of risk free investments, such as government backed securities.
A risk premium which reflects the level risk taken and increases incrementally, the more risk then, the greater the expected return. This is in fact the market risk, or what is known as SYSTEMATIC RISK.
The CAPITAL ASSET PRICING MODEL (CAPM), defines systematic risk as beta ( ).
S 6&7 / 16 . 24
Page
95
BETA The Beta ( ) value is the relationship between the returns on a particular share and the overall market as a whole. So for example how the returns offer company XYZ Plc relate to the overall FTSE all share index. Therefore the Beta values will reflect the exposure of a particular share to general share market movements. So, an individual share with a calculated Beta value of 1.0 would be expected to move with the general market trend as shown by the FTSE all share index. Similarly any share with a beta value in excess than to would swing in value greater than the moment in the general index. For example if a beta value for company XYZ was 2.0 and the market rises by 10%, then the expectation of share premium would be 20%. The converse applies, when the market falls, the shares would fall greater than the share market index.
S 6&7 / 17 . 24
Page
96
By deduction, for shares with a beta value of less than 1.0 would not fluctuate so much and will not even move in line with the FTSE all share market index. Therefore the Beta value gives an assessment of share price swing in relation to the share markets as a whole. There is a general principle, it cannot be taken as any form of precise assessment of future value. However, the investor will be able to assess the risk profile of a company by checking the beta values. The Beta value from a company perspective will also give an assessment of share market returns in relation to overall market returns.
S 6&7 / 18 . 24
Page
97
CALCULATING THE RETURN FROM A GIVEN LEVEL OF BETA The following formula can be used : KE The Expected Return = = r f
+
+
( rm -
r f )
The Risk Free Rate
The Expected Return Minus The Risk Free Rate ie. The Risk Premium
So, for example a risk free rate of 1.5%, a beta value of 1.75 where the market return of 9.5% is estimated for a beta value of 1.0 would give an expected return of KE = = 1.5 + 1.75 ( 9.5% - 1.5 ) 15.5 % the market return at a beta value of 1.0
Page 98
Note r m =
S 6&7 / 19 . 24
What is central to the thinking here is the risk premium which should be realised over and above the risk free rate as a result of the beta calculation. To obtain a clear picture of expected returns from selected shares using the CAPITAL ASSET PRICING MODEL then just three figures are required : -
1. THE RISK FREE RATE OF RETURN FROM THE MARKET

2. THE RISK PREMIUM FROM THE MARKET ( r m r f )
3. THE BETA VALUATION FOR THE SHARE AVAILABLE ON FINANCIAL WEBSITES OFTEN BASED UPON SYSTEM HISTORICAL DATA
To determine the valuation of beta for any particular share will depend upon historical data for a selected period of the share return on the all share market index, and expressed it in the form of a statistical regression, where the link of best fit will determine the beta value (such calculations are not needed for this programme.)
S 6&7 / 20 . 24
Page
99
THE TREATMENT OF RETAINED EARNINGS The profits held in the business known as returned earnings are an important source of capital. In fact they are owned by the shareholders as shareholder funds, but also must be considered from a cost perspective. There is an opportunity cost attended to retained earnings if these are not adequately deployed into existing and future investment.
THE COST OF DEBT CAPITAL Much of this session has been devoted to the cost of equity capital and indeed there is more content to be explained, but we should also consider the cost of dept capital.
S 6&7 / 21 . 24
Page
100
In general terms, the cost of debt capital is governed by the current interest rates charged by financial institutions on their loan products. In addition the cost of debt capital may in certain circumstances extend to the cost of debt recovery in the event of default. From a Financial Management perspective, the interest incurred on forms of long and short term loans is tax deductible, so there is a form of advantage which can be made from acquiring debt capital to finance the business. For debt capital, which is untraded, such as bank loans, the interest rate mechanism and the basis for it will be discussed in other sessions dealing with the financial markets.
S 6&7 / 22 . 24
Page
101
Define a companys cost of capital and its main components.
Why is the companys cost of capital important to know and how it may be applied in corporate finance decisions.
What is the weighted average cost of capital and how it is calculated.
Explain the importance of Beta ( ) in the capital asset pricing model.
S 6&7 / 23 . 24
Page
102
KEY TERMS BETA CAPITAL STRUCTURE CORPORATE TAX RATE DEBT CAPITAL DISCOUNT RATE EQUITY CAPITAL FINANCIAL GEARING FTSE ALL SHARE INDEX INTEREST RATES LONG TERM DEBT ORDINARY SHARES RATE OF RETURN RETAINED EARNINGS RISK FREE RATE RISK PREMIUM THE CAPITAL ASSET PRICING MODEL (CAPM) THE COST OF CAPITAL THE FLOOR FIGURE THE WACC, THE WACC FORMULA
S 6&7 / 24 . 24
Page 103
SESSION 8
FINANCING DECISIONS DEBT FINANCING
S 8 / 01 . 19
DEBT FINANCING
LOANS OVERDRAFT FACILITY REVOLVING CREDIT FACILITY TRADE CREDIT FACTORING INVOICE DISCOUNTING HIRE PURCHASE LEASING BILLS OF EXCHANGE

Page 104
FINANCING DECISIONS As we have seen from the beginning of this Corporate Finance module, there are two strategic decision areas that are critical : Investment Decisions Financing Decisions
We now turn our attention to Financing Decisions, which will be considered as Debt Financing Equity Financing
It is to be noted that all financing decisions must be undertaken with one underlying agenda and that is to add value to the corporation.
S 8 / 02 . 19
Page
105
DEBT FINANCING The common means by which small, medium and large companies finance debt is by way of : LOANS OVERDRAFT(S) TAKING TRADE CREDIT FACTORING LEASING HIRE PURCHASE
But large businesses will also finance debt through a wide range of financial products from the financial markets, which we will review later in Session 9.
S 8 / 03 . 19
Page
106
LOANS In order to trade and to grow, most companies will need to incur debt to support the working capital of the business. Such debt obviously has to be repaid, normally with interest charges relevant to the form and time duration of borrowings incurred.
Repayment therefore would be made over an agreed time period for the principle amount in instalments to which interest would be applied. The cost of debt financing is thus made up of two components : 1. The repayment pf the principle sum
2. The interest to be paid The interest charged is a tax deductible expense applied to the annual tax year in which the interest has been paid. Interest paid is considered as a trading expense, however the repayment of the loan is treated as a capital item and is not reflected in the profit & loss account (or income statement).
S 8 / 04 . 19
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Such debt financing, normally provided by commercial banks, will be released subject to the banks assessment of the risk they are taking. To reduce the banks risk exposure, a request for security may be required, for example through a financial charge on the companys assets.
In the event of non-repayment of the debt, the bank then has the right to dispose of the companys assets, so charged, to secure the loan advanced together with appropriate interest payable.
The company seeking debt financing must therefore consider very carefully their position if assets are pledged in this way. Similarly the bank has to take a firm position in relation to their risk exposure arising from the probability of payment default. Providing that a balance can be achieved between the company needing debt finance and the bank as the leader then the procedures for achieving such sources of finance is usually speedy, flexible, relatively lost cost and are often further negotiable should business conditions change.
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THE COSTS TO BE INCURRED FOR DEBT FINANCING LOANS Apart from a one-off charge payable to the bank for their arrangement fees, the incremental cost of debt finance is just the interest charges to be paid. The prevailing rates of interest will normally be based upon : 1. The Banks Base Rate 2. Or The London Inter-Bank Offered Rate (LIBOR) to which the bank will add their own % mark up, for example 2.5% over base rate or 3% over LIBOR. Both the banks base rate charged and LIBOR are a function of the financial market environment which in turn is affected by the countrys national bank policy on interest rates set to govern to respective countrys economy (eg. Bank of England). LIBOR may be charged on an average of the current rolling 3 months to determine the LIBOR rate.
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The interest rate charged by the lending institutions will also be determined by the time period for the loan, ie. short, medium and long term which, from an accounting perspective would relate to loans for less than 1 year for short term loans. Term loans are normally for periods of 3 years and above.
OVERDRAFT An overdraft, as distinct from a loan, is a facility granted by a bank for an agreed limit to be drawn to finance short-term debt.
The overdraft is therefore used as a cash reserve for paying creditors when there are insufficient funds flowing into the account at the time payment to creditors must be made.
The overdraft facility will therefore be used as and when needed, the amount being used will therefore change depending upon the use of the OD FACILITY .
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The arrangement of the OD facility , by negotiation with the bank concerned maybe for a short time, depending upon the requirements, or can be a standing limit for a longer period. The important fact to realise is that the overdraft is an important source of finance to find short term debt and that bank interest is charged only upon the amount of the facility used. This charge is usually made monthly based upon the daily usage of the OD facility. This gives the overdraft user considerable flexibility upon how and when to make use of the facility. In real terms, the overdraft if used correcting is a relatively low cost form of finance, normally a few percentage points above the prevailing back base interest rate, or LIBOR as applicable. The arrangements for an overdraft facility are normally straightforward and will usually depend upon : The existing relationship with the bank
Bank Account Management

Cash flow and cash flow forecasts
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Credit worthiness Security offered (if required)
Track record
Other Bank products used
It should be known that the overdraft is a facility that the bank could withdraw at any point in time. This may not happen, but could happen so it is important to use an overdraft facility with care and also to be clear about the conditions of the overdraft which could be : A fixed or floating charge over the companys assets Personal guarantees
This means that if the overdraft facility is withdrawn at any point in time, then the bank have a claim over the companys assets and/or ask the directors who have given personal guarantees to repay the overdraft, quickly.
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A REVOLVING CREDIT FACILITY A more sophisticated form of overdraft is for the bank to offer a revolving credit facility to the company as the borrower. This is usually set up for a longer term than the conventional overdraft facility. The company having the use of a revolving credit facility (RCF) can then borrow up to a fixed amount agreed with the bank for the duration agreed. For any amount of repayment made, then this frees up borrowing capacity for a later time but within the time limit agreed for the RCF. In fact, amounts that are repaid can be used again, so it does offer considerable flexibility over and above a term loan with fixed repayment amounts and time intervals. In fact the company using a RCF has a more flexible source of finance. TRADE CREDIT For many companies engaged in trading which will depend upon bought in goods & services, then the most common source of finance is to take trade credit from their suppliers. These suppliers then become the companies creditors, simply because they have extended the trade credit for a given period.
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Normally 30 days credit would be extended, or by special arrangement up to 90 days depending upon the business, industry norms and location of the business. In this way, trade credit is a free use of funds for the business. It is now common procedure for such creditors to either offer a discount on invoices settled by early payment, say within 7 days or to impose a change on late payment, say 2.5% for amounts outstanding over 60 days. Trade credit is a well established convention used by almost all businesses.
It is to be appreciated that there is a cost of extending trade credit to customers which has to be borne by the supplier. The supplier opportunity cost of extending trade credit will normally be recovered from within their profit margin.
But where debtors are slow in paying, the supplier of trade credit may face cash flow challenges and in turn have to resort to some additional source of finance to keep the company liquid.
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FACTORING One source of supplementary debt finance is factoring, whereby a company with unpaid invoices can receive quick cash to bridge a cash shortage. These function is to provide financial cover to companies needing to get paid from their outstanding debtors in order to meet their current cash obligations. Factoring services are available from specialist finance companies but also this is of growing importance as a source of business for the high street banks, often handled by corporate banking departments or finance subsidiaries. [ Factoring services not yet fully developed in emerging countries. ] In this way the bank moves towards providing a total solution to financing company needs for debt financing requirements. The way in which factoring works is that, for example, a bank providing factoring services will advance money against the security of unpaid invoices, usually up to 80% of the invoice value.
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The bank charges for this service will be based upon a fee and interest at a level similar to current overdraft interest rates. Both fees and interest rates charged for factoring services will depend upon the volume of work involved and their risk assessment of the unpaid invoices being factored. The bank acting as a factor will be paid directly by the companies debtor(s) for the invoices which have been factored. In this way the bank takes the risk, the borrower received cash but this will depend upon the bank accepting the invoices as being clean and unencumbered debts .
To support the company using factoring services, some factoring services companies offer credit sales administration as a value added service to clients, whereby the company in fact outsources their sales administration to the finance company.
The business of factoring has really developed, initial services offered by factors was that of invoice discounting but now also extends to Trade Credit Insurance whereby it is possible to insure against the risk of non-payment of invoices, a charge of which is usually less than 1% of the value of the invoice.
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The usual conditions for factoring is that the factor takes the credit risk, but they will require close working relationships with the company (their clients) to recover outstanding payments.
One downside is that business relationship between such companies and their customers can be challenged because the factor has one objective ie. to ensure outstanding invoices are paid. This can affect customer relationships and damage future business potential. Some clients of factoring companies may need to avoid a trade risk and may therefore retain the credit risk from factoring in the interests of their own business futures.
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HIRE PURCHASE (HP) Hire purchase is an option often used for companies to purchase relatively low value assets needed for business operations. Under a hire purchase agreement, the HP company buys and owns the item (eg. machinery, office equipments, commercial vehicles etc) and then hires them to the firm who is now their customer in return for regular repayments. At the end of the hire period when all payments are made, the hirer will own the item, often for a final purchase payment. Normally HP is easy to arrange, quick to put into place, only requires a small upfront payment and has fixed payment amounts & periods, interest on HP payments is also tax deductible to the year in which it was incurred.
LEASING
This is a similar source of finance to HP, the only major difference is that the leasing company retains the legal title to the item being leased. It is common for companies to lease similar items that are available under HP contracts.
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Leasing contracts are normally short and will be for a period less than the useful life of the item being leased. Computer hardware and software, photocopiers, office furniture, company cars are all commonly leased today.
BILLS OF EXCHANGE
The arrangement for gaining finance using a bill of exchange is similar to invoice discounting or factoring. The main difference is that bills of exchange are used for financing export business. In such an export contract, the goods are shipped together with the bill of exchange to the customer who acknowledges and signs for the debt and the time for repayment. This signed Bill of Exchange is sold to a discount house for a sum less than its realisable face value. Cash is then given to the seller and the discount house is paid by the overseas customer.
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IN SUMMARY As can now be appreciated, there are a number of key sources of finance available to all companies for debt financing, both in the short term (eg, Overdraft, Trade Credit or Factoring) and in the medium term (Term loans, HP & Leasing). We now turn to Debt Financing products from the FINANCIAL MARKETS available to larger organisations.
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1.
When taking important financial decisions related to debt financing, what are the main considerations ?
2.
What viable options are available to a successful Small to Medium Size Enterprise to secure debt financing ?
3.
As a business start-up, what forms of debt financing would you consider and why ?
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KEY TERMS BANK BASE RATE BILLS OF EXCHANGE CHARGE ON COMPANY ASSETS CLEAN AND UNENCUMBERED DEBT CREDIT RISK CREDIT WORTHINESSS DEBT AND DEBT FINANCING LOANS DEFAULT FACTORING HIRE PURCHASE INVOICE DISCOUNTING LEASING LIBOR OVERDRAFT OD FACILITY PERSONAL GUARANTEES PRINCIPLE
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REPAYMENT REVOLVING CREDIT FACILITY TAX DEDUCTIBLE EXPENSE TERM LOANS TRADE CREDIT
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SESSION 9
LARGE CORPORATION DEBT FINANCING
INTRODUCTION TO THE FINANCIAL MARKET PLACE

BONDS
SYNDICATED LOANS
CONVERTIBLE BONDS
S 9 / 01 . 19
FOREIGN & INTERNATIONAL BONDS

PROJECT FINANCING
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SESSION 9
LARGE CORPORATION DEBT FINANCING
SALE AND LEASE BACK

SECURITISATION
KEY TERMS
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INTRODUCTION
What is a Financial Market ? Any market place comprises buyers and sellers who come together with an intention for commercial transactions to occur for mutual benefit. A financial market also conforms to this basic definition. In a financial market context, large volumes of transactions take place daily across a global market arena, so vast that it is a challenge to estimate the value but it would be in the scale of hundreds of trillions of US Dollar equivalent.
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At the most fundamental level, the financial market place is where prices are set and where financial value is created in an exchange process between buyer & seller. This market place is also where large companies can raise debt capital for :
Funding New Projects Replacing Fixed Assets Sourcing and Securing Finance for Business Expansion Obtaining Working Capital during seasonal downturns or at times of business turbulence which creates cash flow disparaties
The financial market is a place to invest funds and source for them. The market place offers a wide range of financial products which provide debt financing opportunities to the buyer, most of which have an associated level of risk attached. The range of financial products for debt financing is diverse and complex, a challenge for any large corporation which has to determine the optimal financial product mix to best suit evolving business needs.
Companies taking advantage of the offerings in the financial market should have therefore a sound knowledge and provision for financial risk management in relation to the offerings of the financial market place.
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BONDS The business in bonds is for both borrowers and investors, whereby the company can invest in bond products for a guaranteed return or use the bond as a financial instrument for debt financing. The terminology surrounding bonds as often complex and subject to different interpretation between UK and USA financial markets.
What does a bond mean ? A bond is an agreement, a guarantee or a contract between the bondholder and the company in fact a form of IOU between the parties whereby the company as a borrower repays the bond issuer a series of payments known as coupons for the interests to be paid until the bond matures when the principal amount is then repaid at the date of maturity. This principal amount to be repaid on maturity is often known as the par or face value of the bond. So a bond in layman terms is an agreement for stage payments of interest over an agreed time period at the end of which the sum borrowed is repaid.
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Bonds are also classified as FIXED INTEREST SECURITIES and are in fact the most widely used for all financial instruments. The size of the global bond market now approaches US$100 trillion. In simple finance terms the bond is a debt security, which by contract, enables the bond issuer to receive interest payments (coupons) through the life of the bond and then make repayment of the amount borrowed at a specified time (the maturity date). Bonds are commonly issued by Governments and large corporations to raise debt capital. Corporate bonds are one of the largest sources of debt capital in the private sector debt market, although the issuing of such bonds are governed by country regulations. The issuing of bonds must then state at least the following : The financial position of the issuer The reason why the debt is being sold, and the debt obligations The bond values sought
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The duration of the bond (in years normally) The interest to be paid and the time intervals The principal repayment date The security offered to bond holders
All such information and promises have to be carefully prepared because investors who may be providing capital when purchasing bonds must assess the level of risk and return.
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Large companies seeking to issue bonds will need to appoint and pay underwriters (which could be an investment bank for example) to issue and market their bonds to investors at optimum interest rates.. In addition, a rating will often be sought from a risk rating agency to give investors confidence in the bonds being offered.
The level of sophistication in bond markets has become diverse, but each bond issue will have the following : The Maturity Date known as The Term expected in years
The Coupon which is the Fixed Annual Interest Rate stated at the time of issue
The Current Yield The Yield to Maturity showing the return on investment
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DEBENTURES AS BONDS
The debenture, is a term the student may be familiar with actually also a form of bond whereby a company can raise debt finance through agreeing to sign a debenture. The debenture (or bond) holder will release the loan capital subject to a fixed or floating change on the companys specified assets.
This raises capital for the company as a borrower and protects the debenture holder (a bank) in any case of re-payment default. Banks will often take a mortgage debenture over, for example, the titles of commercial property or use debentures for property re-financing.
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CONVERTIBLE BONDS This unique type of bond can be issued as a financial instrument to obtain debt finance, but has the flexibility to convert debt financing into equity financing. The advantage to the bond issuer is that the dynamics of financial gearing can be rebalanced, financial risk be offset and capital structures can be optimised. In this respect the companies debt to equity ratio can be adjusted according to financial ambitions and policies. The convertible bond at product level may have a number of value added features to the investor, but has underlying benefit to the company from the perspective to support financial strategy. The convertible bond, as a product offers the right to the bond holder, at specified future intervals of time to exchange the bond for equity shares in the company.
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This offers the chance for the investor to become a partial owner through the shareholding achieved. This is just an option, the bond holder is not forced to exercise it, but it adds substance as a debt financing product and may in so doing add to the market appeal of the bond because it is convertible to equity. The technical mechanics for conversion would be provided by the bond issuer.
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FOREIGN AND INTERNATIONAL BONDS
It is worth noting, that bond issuance, may not necessarily be based in a domestic currency, but could be denominated in a foreign currency if this was considered to be an advantage.
International bonds, commonly known as Eurobonds, are those sold outside the fiscal control and jurisdiction of the countrys currency for which they are issued. So a Eurodollar bond issued in US dollars by investment banks in France for example would not be exposed to USA legislation & regulations. Of course Eurobonds could be therefore issued in any denominated currency (not in Euros !). If they were issued in Euros as Eurobonds, they also have to be issued outside the jurisdiction of the Euro. The decision of course will depend upon the requirements & locations for the debt capital being secured.
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SYNDICATED LOANS For every large amounts of debt capital required, conventional bonds or even just one bank alone may not be enough to raise the level of finance required. Syndicated loans are issued by a group of banks who firstly raise the capital and secondly share the risk in proportion to their respective contribution. Syndicated loans are common large projects, eg. civil engineering, infrastructure projects, large scale real estate.
PROJECT FINANCING
For large scale projects, it is not uncommon for an independent legal entity to be formed for the management of the project from end to end.
Project finance is then obtained through the new legal entity created, making it an independent operation to stand alone from the original owners and pioneers of the project. This business self containment has a number of advantages from a debt financing perspective in that it does not encumber the wider parent organisation(s) to risk.
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Loans are achieved on the merits of the project and extended to the newly created subsidiary. The risk to the lending institution(s) is high in relative terms, so therefore the cost of project finance will be well-above average commercial rates. Securing project finance will depend upon the credibility, track record and credit rating of the parent company(s) involved. Also the terms of contract relating to default will have a direct bearing on the rate of interest for the lending bank(s) to charge. The growth in project financing globally has grown significantly and has the distinct advantage of having the debt capital confined to a project per se rather than a corporation as a whole.
SALE AND LEASE BACK ARRANGEMENTS

One other attractive method of raising debt capital to finance business growth is to sell fixed assets owned and then lease them back. In this way capital is released for more effective deployment in the business.
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SECURITISATION AS A FINANCIAL INSTRUMENT The world of finance has created an extensive range of products from the principle of securitisation known as asset-backed securities. Securitisation is a process whereby a range of independent assets, which individually would be difficult to sell are bundled and repackaged into securities that can be sold in financial markets. Initially these were mortgage-backed securities, bundled from the first mortgages on residential property, the United States being the innovator and by far largest market player. Today through creativity and product innovation, a wide range of non-mortgage backed securities have been created.
From the perspective of raising debt capital such ingenuity has worked well, even in European markets.
It is important to understand and have confidence, as an investor, in the underlying asset. Securitisation is achieved by using an investment bank which sets up a trust to purchase and own the assets being securiterised from funds raised from the sale of asset-based securities to investors.
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Note the process was a major driver for the financial crisis in 2007 when unsound loans were securitised and sold into the financial community (known as the US sub-prime crisis).
Examples of Creative Securitisation include : 1. A global fast food chain selling franchise royalties as asset-based securities 2. World famous Pop stars offering bonds based upon future earnings from old album / song sales 3. World famous museum has securitised ticket and merchandise sales 4. US insurance company securitising the life of insurance policy premiums of US residents
5. Credit card securities based upon the volumes & levels of future repayments
6. Car loan securities based upon repayments as the underlying asset
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The motivation for securitisation is obvious

The creative selling of assets to raise debt capital To fund growth of core business Focus resources for the best return and where the best value is to be added Diverting risk away from that held in the returns from the selected underlying asset Asset based securities are easier to trade than their independent underlying assets
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DISCUSSION QUESTIONS 1. What is a bond and why have bonds become so prominent as financial instruments for the Corporate Finance Market ?
2.
Why are syndicated loans deemed to be essential for large scale debt financing ?
3.
Define a sale and lease back arrangement and explain the essence of this method of raising debt capital ?
4.
From your understanding of securitisation, explain the fundamental difference between mortgage backed and non-mortgaged backed securities. Explain potential risks arising from the product innovation in mortgage backed securities ?
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KEY TERMS ASSET-BASED SECURITIES BONDS CASHFLOW DISPARATIES CONVERTIBLE BONDS CORPORATE BONDS COUPONS CURRENT YIELD DEBENTURES DEBT TO EQUITY RATIO DEBT CAPITAL EUROBONDS EURODOLLAR FINANCIAL MARKET FINANCIAL PRODUCT MIX FIXED INTEREST SECURITIES INTERNATIONAL BONDS IOU
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MATURITY DATE (THE TERM) MORTGAGE BACKED SECURITIES NON-MORTGAGE BACKED SECURITIES PAR VALUE PROJECT FINANCING SALE & LEASE BACK SECURITISATION SYNDICATED LOANS RATINGS TRANSACTIONS UNDERLYING ASSET WORKING CAPITAL YIELD TO MATURITY
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SESSION 10
EQUITY FINANCING
INTRODUCTION TO EQUITY CAPITAL

ORDINARY SHARES, THE TECHNICAL TERMS LIMITED COMPANIES AND LISTED COMPANIES RAISING CAPITAL THROUGH A PUBLIC QUOTATION RIGHTS ISSUES PRIVATE PLACINGS
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SESSION 10
EQUITY FINANCING
BONUS ISSUES OR SCRIP ISSUES VENTURE CAPITALISTS DISCUSSION QUESTIONS KEY TERMS
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INTRODUCTION TO EQUITY CAPITAL

Equity capital is a term given to the Ordinary Shares of a business (known as common stock in the United States). Ordinary Shares are purchased by shareholders as an investment in the future prosperity of a company. Therefore shareholders are the owners of the companies equity capital. It is the shareholders who take the risk of investment in Ordinary Shares, and through the proportion of equity shareholding taken will represent the percentage ownership they will have in the company. In short, the shareholders are the business owners by virtue of their ordinary shareholding. Equity capital is also known as risk capital because there is absolutely no guarantee that the ordinary shareholders will get their investment back in the future or even a return on it. It is truly RISK CAPITAL.
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In the event of a company winding up as a result of liquidation, the ordinary shareholder is the last in the queue of creditors and probably will not receive back the funds they had invested. So the shareholder takes a gamble on the return on the investment made in ordinary shares.
WHAT ARE THE BENEFITS OF HOLDING ORDINARY SHARES ?
As a shareholder, the following benefits may be enjoyed : The opportunity to appoint company directors Be involved with the strategic direction of the business Obtain dividends paid on the basis of company performance as a return on their original investment
Receiving the annual report and accounts of the company

The right to sell their shareholding
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ORDINARY SHARES, THE TECHNICAL TERMS There are three important terms that should be understood ie. AUTHORISED SHARES ISSUED SHARES
PAR VALUE OF THE SHARES
Often there is a misunderstanding between authorised shares and issued shares because they are considered to be the same thing, which is not so. Authorised Shares is the limit to the number of shares that can be issued which was decided by the original owners of the company. Issued shares are those issued from the number of shares authorised, this means that to be technically connect a company may have
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Authorised and issued share capital Authorised but unissued share capital
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At the time of authorisation, future growth needs may have been estimated for which additional shares could be released to raise additional equity capital.
The par value of the shares is the nominal value originally set at the time the shares were offered for sale to investors, for example,
500,000 shares at a par value of 1
The price paid for the shares will fluctuate and could be above or below par value. The more important figure is the market price paid for the shares and that this represents a share premium in the difference between the market price and the par value.
For example if the stock market price today of Exodus Plc quoted on the London Stock Exchange is 13.65 per share and the original par value of the shares was 0.50 then the share premium is 13.15. On a point of interest when viewing the published accounts of a company the equity capital, expressed in ordinary issued shares is usually shown at par value, which maybe misleading because the market value of the shares is not shown.
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The share premium received is not a normal balance sheet entry convention, but there is usually a disclosure for the current share premium at the time the accounts were published. Of course for publicly quoted companies the share premium is dynamic and changes daily subject to a number of economic and financial market factors. Not all companies with equity shareholding are listed on the stock market and hence the daily fluctuation in share price will not be a phenomenon for the business to manage.
LIMITED COMPANIES AND LISTED COMPANIES There is a difference in terms of scale and strategic intent. A Limited Company is different from a Listed Company in the following ways :
A LIMITED COMPANY simply means that the limits of the company owner are only up to the amount of the money invested in share capital. This means that the shareholder as an individual (or other corporate company) is not liable for its trading debts or business beyond the amount already invested in the company shares. This is an important principle. As a part owner of a LIMITED company, it is the company which is liable for its debts, not the individual company owner.
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If you see, for example, Adrian Hall Ltd, it means the company is registered as a Limited Company and that the limits of liability to be accepted for the companys failings are only up to the value of shares in which investment has been made or pledged. This is why Limited Companies may have to offer collateral and or personal guarantees when borrowing or raising debt capital from financial institutions.
LISTED COMPANIES are called PLCs, hence Dewburys Plc could possibly be a Listed Company, listed on the stock exchange where their equity capital in the form of ordinary shares are traded. Such companies would normally have a limited minimum issued share capital to become publicly listed, apart from other criteria, It is to be mentioned that not all Plcs are listed companies, but are public companies by design and function who have not as yet decided to be listed. This is a small point of confusion so : All Listed Companies are PLCs Not All PLCs are Listed Companies
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Equity capital refers purely to the risk capital represented by ordinary shares. [ Students may be aware of the term Preference Shares, these do not form part of Equity Capital because they receive a pre-determined fixed return on investment, paid in the form of guaranteed, dividends annually.
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RAISING EQUITY CAPITAL THROUGH A PUBLIC FLOATATION
A public floatation exercise is needed in order to become a listed PLC, for which there are well-documented governance requirements and processes.
The main purpose is to raise significant amounts of equity capital to fund business development on a larger scale, but the responsibilities related to this are now to a wider group of equity shareholders, so there are both advantages and disadvantages attached to raising the corporate profile of the business on the public stage. Going Public involves the following outline stages, as shown in the Value Chain diagram (Figure 10.1) below : -
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Figure 10.1
IPO -- GOING PUBLIC
ALLOTPREPARATION APPOINTING A SPONSOR AND EXTERNAL ADVISOR UNDERWRITING THE SHARE ISSUE MENTS BY SELECTING OFFERS APPOINT ACCOUNTANTS APPOINT LAWYERS THE REGISTRAR PUBLICATIONS FOR THE PROSPECTUS THE SPONSOR BY BALLOT OR ALLOCATION
ADMISSION TO THE STOCK EXCHANGE FOR SHARE TRADING
AND
PUBLICITY
A
BROKER
AND
OFFER CLOSURE
This may take a considerable time to Get Ready to meet technical requirements and boast company visibility
The sponsor will project manage the floating
To determine the offer price and the guarantee of success through a commitment to purchase
This may also be the sponsor but maybe an independent broker to assess market takeup, w hen & how to place the offer and to secure
An independent accountant is ensure floatation criteria are met
Independent lawyers ensure and disclosure
For listing share ownerships and maintain the share register
A Soft Launch with a pathfinder prospectus to the financial media & large investors and the final prospectus stating the
Offers are recieved and the offer period closes for share allocations
Shares are then allocated based upon how the offer has been subscribed THE SHARES ARE OPEN FOR TRADING
appointed to compliance
investors
offer and
setting the offer price for shares
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RAISING EQUITY CAPITAL THROUGH RIGHTS ISSUES
Rights issues are new shares offered to existing shareholders. This is the easiest method and most common way to raise additional equity capital for existing companies. The normal way for a rights issue to be achieved is for shareholders to be offered new shares in the proportion to their existing shareholding so that they retain their current voting rights. This of course is a lower cost of share issuance and raising of equity capital than with a public listing.
To make a rights issue attractive, the new shares are usually offered at a discount from the estimated current market price. For a large scale rights issue, the issuing company will usually provide the issuing company will usually provide reassurance by having the rights issue underwritten.
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RAISING EQUITY CAPITAL THROUGH PRIVATE PLACINGS Private companies may depend upon a small number of individual external shareholders as the main source of equity capital. By simply widening the ownership base, without going to the open market, additional finance can be achieved through a private placing which is often organised through stock broking companies and their community of investors. This is time efficient and low cost to organise.
BONUS ISSUES OR SCRIP ISSUES FOR LISTED COMPANIES This mechanism in itself does not usually raise additional equity capital, it simply makes the companys shares more attractive, which in turn will increase the market price of the shares and the value of the listed company.
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A bonus issue on a one for one basis may mean that a shareholder with a 18 share gets two shares now worth 9 each. On the open stock market a 9 share may be much more saleable and hence demand for the shares is driven, and so is the price. This is simply using the elasticity of demand as a basis to improve share value.
SOURCES OF EQUITY CAPITAL FOR NON-LISTED COMPANIES VENTURE CAPITALISTS Companies in search of equity capital may refer to venture capitalists to come up with the finance in return for shareholding and some level of management participation. The venture capitalist takes the risk in the form of equity finance or debt finance or both. There are various forms of venture capitalist and different purposes served.
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A Business Angel is a wealthy individual who may often finance a business start up or for expansion, but these investments are of an order not usually exceeding 100,000. A more respectable title for these entrepreneurs is informal venture capitalist. Private Equity companies providing medium to longer term investment on the basis of high risk high returns for new or young companies or supporting management buy-outs and management buy-ins, the later where a new management team seeks to achieve equity in the business.
Private Equity companies may provide seed financing to support the development of the business concept and business model, to the start-up stage.
It is common for small to medium size enterprises (SMEs) to look to private equity companies to achieve business expansion domestically and geographically.
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DISCUSSION QUESTIONS 1. Explain the difference between Equity Capital and Debt Capital and outline the different sources of Equity Capital available to trading organisations of different sizes.
2.
Why would you seek to invest in Preference Shares in an organisation then an Equity Stake by investing in Ordinary Shares ?
3.
If you were to source for equity capital for a business start-up, where would you start and why ?
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KEY TERMS AUTHORISED SHARES BUSINESS ANGEL BONUS ISSUES / SCRIP ISSUES EQUITY CAPITAL GOING PUBLIC IPO INITIAL PUBLIC OFFERING ISSUED SHARES LIMITED AND LISTED COMPANIES LIQUIDATION ORDINARY SHARES PAR VALUE PLCS PRIVATE PLACING RIGHTS ISSUE RISK CAPITAL SHAREHOLDERS VENTURE CAPITALISTS
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SESSION 11

S 11 / 01 . 20
MANAGING CORPORATE FINANCIAL RISK
INTRODUCTION TO CORPORATE FINANCIAL RISK

KEY AREAS OF FINANCIAL RISK RISK FROM INTEREST RATES RISK FROM CURRENCY RATES LIQUIDITY RISK RISKS WITHIN THE FINANCIAL STRUCTURE DEBT TO EQUITY BALANCES AND FINANCIAL GEARING THE RISK OF FINANCIAL DISTRESS DISCUSSION QUESTIONS KEY TERMS
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INTRODUCTION Corporate Financial Risk occurs when conditions of uncertainty arise and the consequences of such risk have to be faced. Corporate Financial Risk Management is concerned with being proactive in this respect in order to minimise the impact of changing conditions upon the company and its financial position. To define risk, it is something undesirable that might happen. Financial risk management for companies should thus avoid exposure to irrational risk and also ensure that any exposure to risk is a calculated risk, which can be mitigated. Financial Risk Exposure for companies is derived from two environments The external business environment The internal corporate environment
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These environments are dynamic, some controllable, but are often beyond the boundaries of managerial ownership and control. Financial risk management systems are designed to monitor and track movements in the environment in order to be alert to the need for either a proactive set of actions or to react in time to minimise a financial threat. It is to remembered that financial risk incurred can lead to Reputation Risk and even entire Business Risk if not managed. It is smarter to avoid financial risk through careful insightful financial planning combined will sound corporate management and efficient market timing -or even to transfer the risk to third parties. The areas for financial risk exposure are many, but this session will consider the following :
S 11 / 03 . 20
Interest Rate Risks Currency Risk Liquidity Risk Risks from the financial structure Market value risks
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Risks from Credit Extension Risks from financial gearing and capital structure
Risks of financial distress
RISKS FROM INTEREST RATES Companies will borrow to finance business operations and to fund growth. Borrowing is normally undertaken to finance existing or future debt. Any form of debt capital will attract a prevailing rate of interest agreed between the bank as the lender and the company as the borrower. However, risk arises where future interest rates payable cannot be estimated with certainty. Often various forms of debt capital are agreed at a FLOATING RATE, this means it is a variable interest rate, subject to financial market conditions. Under these conditions, the cost of capital is vulnerable and financial risk can arise.
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For companies selecting a FIXED RATE of interest on loans taken, if these are large loans and long-term and then interest rates fall (as they have !), then the company faces a higher debt financing cost than otherwise would need to be. Again there is risk exposure. Therefore the vagories of interest rates and the choice of either FIXED or FLOATING RATE contracts may expose the corporate borrower to risk. One key role to be discharged by Financial Risk Management is that it must have mechanisms in place to protect the company from such exposure some of which will be explained in Session 12.
It is possible however for a floating interest rate contract to agree on upper limit and pay an additional interest rate insurance to protect the company, but all of this comes at extra cost !
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RISK FROM CURRENCY RATES An important decision to be made is to select the currency in which to borrow, especially for companies engaged in cross-currency border trading.
The Risk from any form of foreign currency barrier arises from exchange rate fluctuation and associated disparaties between currencies.
Financing large projects in a particular denominated currency may expose the company to losses, simply arising from exchange rate changes. For example the 1 to Singapore Dollar S$ has moved from 3 to 1 to less than 2 to 1 within a few years. If borrowing has been in 1 sterling repaid in Singapore Dollars to finance oversees debt in the UK, then the impact is substantial. The Malaysian Ringgit was 7 Malaysian Dollars to 1 sterling, it is now less than RM5. With the weaknesses of major currencies such as the US$ and the Sterling, the impact on world currency markets can be substantial.
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The risk is compounded if foreign currency has been borrowed at a floating rate without an interest rate cap !! Foreign Currency Risk can be most significant because risks arise from transactions, conversion rates and from the economics of the foreign exchange markets, so finding effective ways to minimise such risk exposure is vital (to be discussed in Session 12),.
LIQUIDITY RISK Liquidity risk arises when there is insufficient inflows of cash to meet the required outflows. This may be caused by business downturn, such as during times of recession, or maybe from difficulties in collecting outstanding monies from debtors. Cash flow planning, cash flow forecasting and cash management are all critical to be tracked, monitored and reviewed to ensure the companies working capital balances remain healthy.
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Credit extended to debtors actually is an opportunity cost incurred by the company extending such credit.
Delays in payment, not only frustrate inflows of cash, but also drive up the opportunity cost of capital. In addition bad debts that not recoverable impose pressure on company liquidity. Customers credit rating, customer management and care with extending terms for credit are important areas of financial prudence which are needed to avoid or offset financial risks from liquidity pressures.
RISKS WITHIN THE FINANCIAL STRUCTURE Risks arise from decisions taken which directly affect the financial structure of the company. Essential Typical Decisions Overdraft and for short-term borrowing
Longer-term borrowing
Debt to equity ratios and the associated implications for financial gearing
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Policy on sources to applications, whether to follow conventions of short term source to short term applications and long term application from long term sources
Currency within to borrow

Fixed or floating interest rates At the heat of the debate almost all financial risk that is within the capital structure arises when considering the relationship between debt and equity financing.
S 11 / 09 . 20
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DEBT TO EQUITY BALANCES & FINANCIAL GEARING Financial Gearing is determined by the relationship between debt capital and equity capital in their respective proportions to each other. If the proportion of debt to equity is high, a company is considered to be highly geared and the risk to ordinary shareholders increases arising from the needs to service the increasing costs of debt capital. Similarly if gearing is low, then there is low risk to the owners of the company because shareholders expected returns will probably be met. Financial Gearing usually concentrates upon the level to which the companies total capital is derived from long-term debt.
This can be measured in two ways.

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TOTAL LONG TERM DEBT EQUITY CAPITAL
TOTAL LONG TERM DEBT TOTAL CAPITAL ( ie. Long term Debt + Equity Capital )
But the Equity Capital in fact are the shareholder funds. Shareholder value will extend to what the company is worth to the shareholders (the net asset value or networth) so therefore another way of considering financial gearing is 3 TOTAL LONG TERM DEBT SHAREHOLDER FUNDS
TOTAL LONG TERM DEBT TOTAL LONG TERM DEBT + SHAREHOLDERS FUNDS
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Clearly a consistency in approach is needed so that comparison can be made apple to apple.
The fundamental question to be answered about financial gearing and the risks associated with it is : TO WHAT EXTENT CAN THE COMPANY PAY-OFF ITS LONG TERM DEBT FROM SHAREHOLDERS FUNDS For companies that have a significant level of short term borrowing, these capital gearing ratios are insufficient, so therefore a modification to this assessment of financial gearing could be : 5 ALL FORMS OF BORROWING
SHAREHOLDERS FUNDS
ALL FORMS OF BORROWING ALL FORMS OF BORROWING + SHAREHOLDERS FUNDS
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Clearly the ratios to be used must reflect the trading position of the company and the need to understand the ability to repay indebtedness. So far, in looking at Financial Gearing, we have considered only CAPITAL GEARING as related to capital structures and their respective values and proportions. One further and useful dimension is to consider INCOME GEARING where the relationships between profit and interest charges payable on existing levels of debt can be paid, this is the interest cover ratio. 7 NET PROFIT BEFORE TAX AND INTEREST INTEREST PAYABLE
This shows whether the volumes of income and the operating profit derived from trading is sufficient to cover the interest payable on outstanding debt.
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This clearly is a useful measure from which to assess the level of current risk. However because profit is variously defined from an accounting standpoint and corporate finance is more concerned with cash flow, a further refinement is to use cash flow or a basis to assess interest cover ie.
OPERATING CASH FLOW TOTAL INTEREST PAYABLE
One further aspect of gearing which is often overlooked, and yet is important to highlight to assess the risk of a business is to consider the level of fixed costs required for the business to perform and is referred to as OPERATIONAL GEARING ie. TOTAL FIXED COSTS
TOTAL FIXED AND VARIABLE COSTS
In companies with high fixed costs, the risk of breaking even may also be high, but the profit contribution after break-even will be high.
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In the aircraft industry, long haul international flights attract very high fixed costs producing a break-even point of 65% capacity (lets say), but the variable costs for each passenger are negligible, so on a long-haul flight operating at full capacity (lets say) there would be a high profit contribution. Operational Gearing may have to be considered when setting up a company or investing in one to determine the level of risk in achieving the break-even position.
Financial Risk in simple terms may also have to consider two key variables
THE RISK TO LIQUIDITY THE RISK TO SOLVENCY
And hence the probability and risks of financial distress.
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THE RISK OF FINANCIAL DISTRESS The risk to liquidity is of prime concern simply because if it cannot be averted, it can lead to insolvency where the total indebtedness of the company exceeds its net worth. In general terms as the level of indebtedness increases, then the propensity to repay the debt also increases and thereby so does the level of financial risk. Similarly, as the gearing ratio increases, so does the exposure to financial risk. In seeking to explore the potential risk for a company facing financial distress, the probability of occurrence owing to the following conditions can be helpful.
PROBABILITY LOW MEDIUM HIGH
To what extent is the companys sales performance linked to general market conditions
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PROBABILITY LOW MEDIUM HIGH
To what extent is the operational gearing such that fixed cost recovery may be threatened
To what extent can the companys fixed assets be converted to cash
To what extent can current non cash assets convert to cash
To what extent are sales revenues irregular or seasonal
S 11 / 17 . 20
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This simple analysis will help to support the rationale for investing (or not) in selected companies, or even for banks to advance loans in a form of debt capital and especially the security / collateral requirements for such finance. Managing Corporate Financial Risk is inevitably a balance between risk and return. To explore more financial strategies under the agenda of risk management and financial return we will now explore Derivatives Options, futures, forwards and swaps in Session 12 and Session 13.
S 11 / 18 . 20
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DISCUSSION QUESTIONS 1. Identify the key areas in which a company could become exposed to financial risk.
2.
Explain the term financial gearing and why it is a key factor in considering the risk appetite of a company.
3.
What is the difference between Financial Gearing, Operational Gearing and Income Gearing and how each exposes different types of financial risk.
S 11 / 19 . 20
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KEY TERMS FINANCIAL RISK REPUTATIONAL RISK BUSINESS RISK INTEREST RATE RISK CURRENCY RISK LIQUIDITY RISK FINANCIAL STRUCTURE RISK CREDIT EXTENSION RISK FINANCIAL GEARING CAPITAL STRUCTURES FINANCIAL DISTRESS FIXED AS FLOATING RATES OPERATIONAL GEARING INCOME GEARING SOLVENCY
S 11 / 20 . 20
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SESSION 12
FINANCIAL DERIVATIVES AND OPTIONS
DERIVATIVES DEFINED WHAT IS AN UNDERLYING ASSET RISK REDUCTION OR SPECULATION MAJOR CATEGORIES FORWARDS
OPTIONS OPTIONS
CALL OPTIONS PUT OPTIONS
S 12 / 01 . 19
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SESSION 12
FINANCIAL DERIVATIVES AND OPTIONS
DERIVATIVES AND HEDGING CORPORATE RISK
S 12 / 02 . 19
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DERIVATIVES DEFINED A derivative is a financial instrument where the product performance is derived from the value of an underlying asset, hence the term derivative. A derivative is in fact a form of a contract which gives the holder the right or obligation to either buy or sell volumes of the underlying asset. The potential financial advantage of holding derivatives as an investor is to benefit from the change in market value of the underlying asset, but of course losses can be incurred as well, some of which go down in history (eg. Barings Merchant Bank, losing almost 1 billion ; Societe Generale losing nearly 50 billion).
Derivatives must be viewed with caution, because the underlying asset may be volatile.
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SO WHAT IS AN UNDERLYING ASSET ? This term refers to any finance base which could be traded, eg. currencies, interest rates, future earnings, shares, share indexes and many many move, where today creativity in the underlying asset has led to substantial growth in this type of financial instrument.
DERIVATIVES FOR RISK REDUCTION OR SPECULATION ? The use of derivatives by companies was originally adopted to reduce risk, but now the opportunity for speculation from an investors perspective has led to a form of gambling mentality and for many substantial losses to be incurred too.
One good example of how derivatives have been used as a financial risk reduction/avoidance tool historically is in the commodity markets, for example cereals and other agricultural products. Here the producer (the farmer) is undercertain of the harvest and the price of the commodity when it is harvested and ready for the market. Equally the purchaser needs to know with certainty the commodity price because this affects the raw material cost into their manufacturing for the processed food markets. Both the farmer and the manufacturer need price certainty to meet their financial and business objectives and thereby limit their risk exposure.
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To manage these risks, the commodity producers sell their harvest forward by using a derivative instrument. The farmer and his customers then have confidence in their respective outcomes from the harvest and the investor in this derivative will take the gamble and financial risk. In this case the commodity owner is transferring their financial risk to derivative investors.
This market for derivatives was known as a commodities future markets.

From this beginning, there are now many derivative products which have been devised based upon the future value of the underlying asset, hence the term futures and futures markets.
The history in derivatives hence goes back to ancient times, but today the current global value of derivatives approaches US$700 trillion national value equivalent, and this is still growing.
The holder of a derivative has a financial asset which can be traded, the holder has the right to buy or sell up to the value held in the specified derivative.
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There are two markets for Derivatives : Over the counter market which has mushroomed in the past 20 years, where there is more flexibility and which is diverse, where derivatives can be customised to meet investors requirements in terms of size and expiry date. Exchange-traded derivatives for agreed product categories of underlying assets, which is long established.
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CATEGORIES OF DERIVATIVES Derivatives can be categorised into two basic groups : FORWARDS OPTIONS
FORWARDS are Forward contracts as explained in the commodity example stated earlier which sets a price (or value) on something to be delivered at a future time.
OPTIONS contracts where the option holder has the right to exercise or let lapse a right to buy or sell a derivative at a fixed price. There is no obligation, the option is simply held to trade or not to trade (or take advantage) in the underlying asset of the derivative on a specified date. If the option is taken up, it is said to be the exercised .
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The fixed price of the option is also known as the strike price of the option at the maturity time (or expiry date). The European approach to Options is they have only one date to be exercised, that is the expiry date whereas the American approach allows the option to be exercised up to and including the expiry date
For example, a share option, a term commonly used in the field of corporate finance, is a right (under contract) to purchase a specified number of shares at a fixed price at a specified future point in time. It can be taken up (or exercised) or be let to lapse. OR A company may pay an agricultural land owner a small sum to have the option to purchase freehold land held at an agreed price in the future, subject to planning permission for commercial or residential development being graded. If the planning permission is granted, the option will be exercised, otherwise it will be left to lapse. The option holder simply has the choice to exercise or not exercise the option at the due date of maturity.
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TYPES OF OPTIONS There are two main types of Options A CALL OPTION A PUT OPTION
A Call Option gives the purchaser of the option the right to exercise the option to buy an asset at a fixed price at a specified time.
An example commonly aired in international financial circuits are STOCK OPTIONS, a US term for share options.
If at the date of expiry of the option, say in 1 years time, the share price is at a premium over the Share Option price, then the option maybe called and the option to purchase be exercised.
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A Put Option, is quite different, it is in fact the opposite of a Call Option.
A Put Option gives the holder of the option the right to sell shares (or specified underlying asset) at a specified future period in time.
For example, if an option holder of a put has an exercise price for the right to sell 100,000 shares at 20 in 3 months time, and at that time the market price is 18, then if the right is exercised, the investor buys at 18 and sells the put option at 20, thereby making 200,000 profit, conversely if the current stock market price
is greater than 20 per share, then the put option would be let to lapse.
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The Share Option Market is a significant financial market for the student to be aware of
The Financial Times should be referenced under EQUITY OPTIONS for share option calls and Puts to get an idea of this important set of financial instruments.
The Share Option market trades (Buying or Selling) call and put options, where the option holder may sell on the option to another investor via LIFFE (London International Financial Futures and Options Exchange) and take profit prior to the expiry date(s). LIFFE is now also part of the New York Stock Exchange (NYSE). In fact LIFFE trades in over 2 trillion derivatives globally each day, by offering a broad range of derivative products using their e-trading platform,
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DERIVATIVES AND HEDGING CORPORATE FINANCIAL RISK
WHAT IS HEDGING ? Hedging is a term used for a range of methods a company may employ for offsetting the firms financial risk.
When a company uses derivatives to reduce risk, for example, it is said to be HEDGING.
Any form of corporate financial risk exposure should be minimised and this is why Hedging techniques are used universally.
One fundamental purpose for using derivatives and hence a core value proposition of them is that
DERIVATIVES SHOULD CHANGE THE FIRMS RISK EXPOSURE

because derivatives, well used, reduce layers of unneeded exposure to risk.
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(There is counter-argument of course if derivatives are used for speculation. ) Hedging, may not just be used tactically, it can also be a strategic corporate financial risk management strategy, because types of Hedging allow for both
SHORT TERM HEDGIING and

LONG TERM HEDGING
As we saw from the beginning of this session, Derivatives can be classified into two basic groups, FUTURES and OPTIONS, both of which have been outlined,
An example of short term hedging would be to sell a futures contract, where an example of long term hedging would be to buy a futures contract.
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Hedging is intended to reduce the downside risk to an investment. USING EQUITY OPTIONS TO REDUCE RISK OF EQUITY INVESTMENT. One simple example of how this principle works is as follows : 1. THE SANDREX CO LTD seeks to invest in NAVIVA Plc on the assumption that share prices will rise and a profit can be made.
2. 100,000 shares will be bought as one lot, currently priced at 2.95, an investment of 295,000.
3. A direct purchase could be made, or by hedging, a share call option could be purchased.
4. The downside risk is greater with a Direct purchase than with a Call Option.
5. With a call option, the downside risk is limited only to the share premium paid.
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6. Assume the price of 3month future call option for 100,000 shares is 320,000 (ie. 3.20 per share). 7. At the maturity time of the call option, the share price would need to be less than 3.20 in order for the share option to be exercised. Therefore the only risk is the share option premium of between 295,000 and 320,000 ie. 25,000.
In this way using an equity option will reduce the downside risk of equity investment.
Companies of a larger scale will be able to place options on whole share indexes eg. The FTSE, CAC and DAX and hedge their portfolio risk by taking call on put options according to how the market is expected to move and hedge their downside risk accordingly. The derivatives market has now grown to enormous proportions, most corporations will be using some form of derivative to manage risk on the one hand and even to speculate on the other.
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Commercial banks and investment banks are at the heart of derivatives trading.
The market is global 24/7 and it penetrates the fabric of most financial markets and their market players. THIS SESSION IS SUMMARISED IN FIGURE 12.1.
Session 13 will review some of the key mechanisms used for trading in derivatives.
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DERIVATIVES
Figure 12.1
SPECULATION
THE UNDERLYING ASSET
RISK REDUCTION
FINANCIAL RISK
OVER THE COUNTER
EXCHANGE TRADED
LIFFE
CALL OPTIONS
FORWARDS AND OPTIONS
PUT OPTIONS
HEDGING
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DISCUSSION QUESTIONS 1. Define and then explain what you understand by the group of financial instruments (products) called derivatives.
2.
What is an underlying asset, give examples.
3.
Outline the difference between a Put and a Call Option.
4.
Explain what is understood as Hedging and show how derivatives may be used to hedge Corporate Financial Risk.
S 12 / 18 . 19
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KEY TERMS A CALL OPTION A PUT OPTION CAC DAX DERIVATIVE DOWNSIDE RISK EQUITY OPTIONS EXCHANGE TRADED DERIVATIVES EXERCISING THE OPTION RIGHT FORWARDS FTSE FUTURES FUTURES MARKETS HEDGING LET LAPSE THE OPTION LIFFE NYSE OVER THE COUNTER MARKET OPTIONS RISK REDUCTION SPECULATION STRIKE PRICE UNDERLYING ASSET
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SESSION 13
FORWARDS, FUTURES AND SWAPS AS KEY MECHANISMS FOR DERIVATIVES TRADING

FORWARDS FIXED RATE FORWARD CONTRACTS FUTURE CONTRACTS SWAPS DISCUSSION QUESTIONS KEY TERMS
S 13 / 01 . 16
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INTRODUCTION From Session 12, you will recall that there are two main categories of derivative contracts normally OPTIONS Which Gives The Holder The Right To Exercise Or Not And FORWARDS Which Commit The Holder To A Clear Obligation To Exercise The Contract. Therefore OPTIONS do not tie down the Options Holder but FORWARD CONTRACTS do. FORWARDS To be clear, forwards are contracts in which the two parties (normally) involved are committed to complete a future deal. Forwards may sound special because of their technical nature, but almost everyone, at some time has been exposed to this type of arrangement.
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For example, consider yourself as an international brand conscious executive and need new cabin luggage from a world famous store, but the model number & design your requirements is out of stock. You agree to pay the price of 500, the store orders it for you and when it arrives at a future date, the sale is completed. You have in fact entered into a FORWARD CONTRACT ie. You have agreed to pay for the cabin luggage and collect when you are notified by the store. The store manager, acting on behalf of the store has sold you a forward contract. The contract is completed when delivery is made in exchange for payment. Note the price of 500 was set at the time of placing the order as well as the conditions of the sale. This is a common situation, so now the essence of a forward contract is grasped ! BUT PLEASE NOTE THIS FORWARD CONTRACT IS NOT AN OPTION, both buyer and seller are OBLIGATED. For the unaware, the world of futures seems complicated, remote, even bewildering, but clearly it is not so ! So to be clear, any FUTURES CONTRACT is a contractual agreement between two parties to undertake some form of exchange at an agreed price and future period of time.
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Forwards are hence over the counter products often customised to meet the buyers and sellers requirements.
Please note carefully that FORWARDS ARE NOT FUTURES !! Forwards are not traded as an exchange, but futures are standardised contracts which are traded on an exchange.
SO HOW ARE FORWARDS USED IN CORPORATE FINANCE ?
You may have heard of the term Buying Forward , this is a hedging tactic controlling future risk arising from interest rate or currency rate changes.
Buying forward involves entering into a Forward Rate Agreement.
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HOW DOES A FORWARD RATE AGREEMENT WORK ? Taking a simple example, let us assume that as a British company Oxley Ltd you have placed an order with an American company (Forester Inc.), which requires payment of US$1,500,00 in 3 months time. To hedge the risk of exchange rate rises of the sterling against the US$, you can fix the price today with the bank at which you will agree to pay and take delivery of the US$ in 3 months time. You have then taken out a FORWARD currency contract. The British company is committing Forward and is obliged to complete the deal. The way in which the company can use forward rate agreements is now explained yet further : Consider another British company, Delta Electrical Ltd, which to meet business development must borrow 5 million in 3 months time for a short term loan of a one-year period. The finance is required for a major capital equipment purchase. The following steps will explain how a Fixed Date Forward Contract can be set up.
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STEP ONE
The company will use 2 million from retained earnings, but needs to borrow 3 million, which it does from Barclays Bank Plc for a loan drawn down in 3 months.
STEP TWO
The agreed rate of interest with Barclays is 8% on a floating rate for a 12month period, secured by company assets and a personal guarantee by the directors of the company. Delta Electrical Ltd is now exposed to risk arising from potential increases in interest rates for the period of the loan. Delta Electrical decides to Hedge this risk exposure.
STEP THREE
STEP FOUR
STEP FIVE
Delta Electrical goes to another bank, HSBC to enter into a separate agreement to set up a FORWARD RATE AGREEMENT at 8% to commence in 3 months time for a one-year period. HSBC by entering into this forward contract has agreed to take the risk should interest rates rise above 8% and compensate Delta Electrical accordingly.
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STEP SIX
Delta Electrical has now hedged its risk and can proceed with their business plans having now in effect FIXED their rate of interest on the 3 million short-term loan.
STEP SEVEN
Its now time to consider the risk exposure under the agreements made with BARCLAYS and HSBC.
If Barclays rate increases to 9.0%, (the spot rate on the due day). Delta Electrical will owe them an additional 3,000,000 x 1% = 30,000.
This is compensated for by HSBC under the Forward Rate Agreement, so all is well and the cost of borrowing by Delta is protected and effectively hedged.
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STEP EIGHT
The Downside of the Forward Rate contract with HSBC has to be considered if interests rates drop, because a forward rate contract has been agreed at 8%. should spot rates on the due day be less than 8%, Delta Electrical will have to compensate HSBC for the difference, but because the loan with Barclays is on a floating rate, they are also compensated by the reduction in the cost of the loan.
STEP NINE
By hedging in this way by using a FORWARD RATE CONTRACT, the company has in fact FIXED ITS COST OF BORROWING, which of course is important.
This is a simple example to explain the basic principles. Banks will of course have to consider their position in relation to the time period of the forward contract in relation to interest rates market volatility.
One other way of reducing the exposure to risk is to agree an interest rate cap, beyond which the lending bank will cover the risk exposure.
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FUTURES CONTRACTS One special form of a Forward Contract is a Future Contract which are usually enabled on a regulated Financial Exchange whereby two parties agree to a contract to transact on an agreed item for a specified time and price. Both parties in a futures contract, which are usually standardised agreements, cannot back out (as is the case with an option). A futures contract is a position that has been taken !! Because a contract has been entered into these contracts, ie. future contracts are in fact a form of securing that are traded on futures exchanges. So therefore what is traded is the rights to the product / item or commodity (the underlying asset) being traded. When the right is exercised, then the underlying asset is delivered.
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To manage the arrangement between buyer and seller of futures contracts, a counter party is required to act as the go between. In Future Contracts trading this function is delivered by a clearing house, the intention thereby is to reduce the risk of non-compliance by both buyers and sellers. When a futures contract is entered into, a deposit (or for of security) is paid by the seller into a clearing house margin account to act as a buffer.
Should the buffer fall below a maintenance level, then a margin call will require the investor to top up. The right to the futures contract is normally governed by the requirement to make these deposits into the clearing house margin account because it is intended to protect the seller, in the event that market price fluctuations would disadvantage the seller. Future markets, are usually very stable because the price for each futures contract governed by the exchange is MARKED TO MARKET on a daily basis !! Both buyer and seller will be required to make daily adjustments (if so required) into the margin account held at the clearing house.
It is therefore easy to appreciate the risk exposure in using futures contracts, as both parties in a way are safeguarded.
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Futures trading takes place in a wide range of underlying assets which are categorised into commodity futures and financial futures over 35 futures exchanges worldwide.
This form of derivative has been remarkably successful with explosive growth taking place especially in financial futures contracts eg. for the Euro, Yen, Eurodollar deposits, US Treasury bonds etc. where interest rate futures dominate the market, even though exchange rate future contracts are the oldest of the financial futures category.
SWAPS A SWAP, a form of forward contract, is yet another way of Hedging corporate financial risk. Technically, a SWAP is an agreement between two investors (or counterparties) to exchange cash flows of one security for that of another, up until a due date when the SWAP matures.
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INTEREST RATE SWAPS A fixed-for-floating rate interest rate swap would exchange (or swap) fixed interest cash obligations for a floating rate (or vice versa) depending upon the financial risk positions of the investors and the conditions of the respective loans.
Interest rate swaps represent a very significant proportion of the SWAP market and moreover have grown to very substantial volumes.
An International Example Of A Fixed For Floating Interest Rate SWAP Two companies KATRINA PLC and CARLOS PLC have loan requirements of 50 million for 10 years to finance future business growth.
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Katrina Plc, based upon its current credit ratings can get 7.5% Fixed or LIBOR + 1.5% Floating Carlos Plc achieves bank finance offered at 9.0% Fixed or LIBOR + 1.0% If there is no SWAP market, Katrina Plc would select 7.5% Fixed and Carlos Plc would take LIBOR + 1.0% BUT under a SWAP Agreement, both companies can lower their interest rates whereby Carlos gets a 7.5% Fixed Interest Contract and Katrina gets LIBOR + 1.0%. Now finding a counter party with similar ambitions and volumes would be difficult. This is where the SWAP market has filled a market gap. Yes, there is a huge gap in the market AND a market in the gap, hence the success of interest rate swap markets, whereby banks have taken the market opportunities to become the counterparty in what has become a highly liquid swap market segment.
S 13 / 13 . 16
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CURRENCY SWAPS The purpose of a SWAP remains, but with currency SWAPS, interest payment streams would be exchanged across two denominated currencies at an agreed time (maturity date). For example if interest rates in the Eurozone are lower than those in the UK, a British corporation seeking Finance would borrow in Euro and SWAP into Sterling. This would be the first pragmatic step. This creates a position but the value of it would need to be monitored carefully to see what may occur to the exchange rate between the two currencies during the life of the swap, but usually, the principal amount of the loan would be swapped as well as the interest rate payable. Residential housing currency swaps is a significant business, whereby private owners will take an option to swap currencies during the life of the mortgage. The global market for currency swaps is currently around 5% of that for Interest Rate Swaps, to put things into perspective.
S 13 / 14 . 16
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211
DISCUSSION QUESTIONS 1. Give a brief description, in order to show the difference between the following : -
OPTIONS
FORWARDS FUTURES SWAPS
2.
What motivates engaging in the above derivatives from a corporate finance customer perspective.
S 13 / 15 . 16
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212
KEY TERMS A POSITION BUYING FORWARD CLEARING HOUSE COMMODITY FUTURESB CURRENCY SWAPS CUSTOMISED FINANCIAL FUTURES FIXED FOR FLOATING INTEREST RATE SWAPS FORWARD CONTRACTS FORWARD CURRENCY CONTRACT FORWARD RATE AGREEMENT FUTURES FUTURES CONTRACTS INTEREST RATE CAP INTEREST RATE SWAPS MARGIN ACCOUNT MARKED TO MARKET OBLIGATION OVER THE COUNTER SWAPS THE RIGHT TO EXERCISE
S 13 / 16 . 16
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SESSION 14
CONCLUDING WITH SHAREHOLDER VALUE
WHAT IS SHAREHOLDER VALUE

HOW CAN THE NEED FOR SHAREHOLDER VALUE BE MET SHAREHOLDER VALUE GAPS THE INVESTORS PERSPECTIVE ASSESSING VALUE CASH FLOW APPROACH ENTERPRISE APPROACH
S 14 / 01 . 21
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SESSION 14
CONCLUDING WITH SHAREHOLDER VALUE
OPERATIONAL SHAREHOLDER VALUE TOTAL SHAREHOLDER VALUE ECONOMIC PROFIT
KEY TERMS
S 14 / 02 . 21
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WHAT IS SHAREHOLDER VALUE ? Investors in equity capital in any business will expect a return on their investment and therefore every part of the business should be working towards this common accord to give shareholders a return. A satisfactory return for shareholders bind them to the company to sustain their investment, provided that their opportunity cost of capital is not compromised.
So shareholder value is the return shareholders receive from their investment through dividends together with the wealth created from the net asset value of the company should the company be sold.
The value created will also allow growth for the company to further develop the wealth potential from the original investments made by its shareholders. If a company has sustained growth and sound financial health, it follows that shareholder value will also grow. Therefore shareholder value is not just that value which has been generated for shareholders, it is also the value shareholders place upon their investment in the company.
S 14 / 03 . 21
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The implication of and priority for this notion of shareholder value inculcates a managerial mindset for shareholder value optimisation in which case a management culture is strongly influenced by shareholder return. This is not easily achieved because it means that managerial decisions taken to implement business strategy MUST answer questions such as : How much have shareholders invested in this business How much incremental return can be achieved for them Is this return significant, how does it compare with their original share price Are we considering the opportunity cost of their capital invested in the business
This is laudable and important, but how many managers have this in mind as part of their daily lives !
S 14 / 04 . 21
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If shareholder value is considered to be a strategic objective, then this requires the adoption of value-based management where business direction & purpose is focused on shareholder returns as a primary ambition. This implies that shareholder value, may become more than financial return for investors, but a way of life for company management even a philosophy for business. This is a huge contrast to taking shareholder value purely as a business objective, hoping that shareholders will be satisfied with their return from the managerial ethos and management competencies which accomplish the results achieved.
This is more often the case with many organisations, simply because there are a diverse range of objectives to be met in achieving the vision and mission of the business and the desired strategies.
S 14 / 05 . 21
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From a corporate finance perspective, the route to a shareholder value based business philosophy would be : A core client / customer base with realisable segment growth potential Sales growth from delivering customer value (getting more customers buying more)
Operational efficiency through cost efficient business processes

Superior product and brand value proportions to achieve competitive market leadership and superior customer service within a well-conceived budgetary control system
Substantial positive cash flow together with cost containment

Efficient treasury and cash management to ensure working capital efficiencies Reinvestment in the business from retained earnings A clear, well-defined, implemented business plan aligned closely to corporate financial management
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S 14 / 06 . 21
In summary, the delivery of sustainable incremental shareholder value must be achieved through a process of strategic management whereby the business ambitions and plans for the company are in absolute harmony with corporate financial management, for value based outcomes. There is a view that customer value drives shareholder value which in turn implies that the route to shareholder value from a management viewpoint is achieved through a marketing oriented approach to business, simply by winning customers, keeping them and ensuring that they come back more often.
S 14 / 07 . 21
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HOW CAN THE NEED FOR SHAREHOLDER VALUE BE MET If the above ideology for business is accepted then the question to be raised is : HOW DO WE GET THERE ?
A Strategic Approach has to be taken which will embrace the following : 1. A shareholder wealth based Mission Statement as the core purpose to be achieved. This is a mission to be achieved, not a corporate PR statement for stakeholders. 2. Shared values for shareholder value generation adopted across the company and cascaded through the multiple layers of management 3. Metrics for measuring shareholder value generation so that all staff understand their role and function in this respect by using shareholder value KPIs (or drivers) for performance assessment.
S 14 / 08 . 21
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4. Functional Business Plans driven by Shareholder value gaps.

5. Operations Management to embed these values and secure employee commitment to shareholder value as a prime objective with performance based management reward systems to reinforce this working culture.
SHAREHOLDER VALUE GAPS To introduce the concept and reality of shareholder value gaps into a business requires a shareholder value ethos which cascades down the organisation. These are then included within the framework of the divisional and departmental business plans by using the following core drivers of shareholder value namely : REVENUE GROWTH
S 14 / 09 . 21
OPERATING MARGIN
COST OF CAPITAL
Page 222
WORKING CAPITAL INVESTMENTS

INCREMENTAL CAPITAL EXPENDITURE TAX PAYABLE COMPETITIVE ADVANTAGE
At a basic level, Figure 14.1 outlines key functional elements required to drive shareholder value which comprise Drivers and Levers.
The core drivers are revenue growth and optimal pricing required to drive volume sales. These have to be matched with cost control and scale economies to preserve an operating margin. The Levers to enable those core functional drivers are therefore individual and operational efficiency, trade relationships and the ability to increase price.
S 14 / 10 . 21
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VALUE DRIVERS AND VALUE LEVERS

Figure 14.1
CORE DRIVERS FOR SHAREHOLDER VALUE
REVENUE GROWTH
OPERATING MARGIN
IMPROVE PRICING
INCREASE VOLUME
REDUCE COSTS
ECONOMIES OF SCALE
THE LEVERS
INCREASING PRICES
IMPROVE TRADE RELATIONS
INCREASE ORGANISATIONAL EFFICIENCY
INCREASE INDIVIDUAL EFFICIENCY
ACTIONS STATEMENTS, SCHEDULES AND RESOURCING THE CHANGE

S 14 / 11 . 21
Page 224
This approach to company management is important of course from a corporate financial perspective but it has not been accepted in all circles because there could be a conflict between shareholder value and stakeholder value, whereby the needs of customers, employees and society all need to be accommodated.
Shareholder value as a primary objective overlooks this and therefore as companies move towards requirements for corporate social responsibility, we should be advocating a sense of balance between shareholder vale and stakeholder value.
It is also through stakeholders that shareholders will derive value and return on investment.
S 14 / 12 . 21
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THE INVESTORS PERSPECTIVE The investors perspective will be more simplistic, even clinical ie.
HOW MUCH HAVE WE INVESTED ? WHAT RETURN HAS BEEN RECEIVED ? WHAT RETURN WAS REALLY EXPECTED ? IS THERE A GAP (THE SHAREHOLDER VALUE GAP) ? HOW HAS THE COMPANY PERFORMED TO-DATE ? HOW WILL IT PERFORM IN THE FUTURE ? SHOULD WE RETAIN (OR EXTEND) OUR INVESTMENT ? ARE THERE BETTER OPPORTUNITIES TO BE HAD ELSEWHERE ?
(This pragmatism is the mindset of non-involved, impartial, non-participating shareholders in the business !! )
S 14 / 13 . 21
Page 226
Where the ambition is to create more value and minimise value erosion from the actions taken by the company and its many interfaces of business. Companies may wish to define this pragmatism in terms of a SHAREHOLDER VALUE GAP and this then becomes the main driver for future strategic and operational planning.
ASSESSING VALUE From a corporate finance perspective, there are a number of ways in which value can be assessed.

S 14 / 14 . 21
USING CASH FLOWS VALUING THE COMPANY ENTERPRISE VALUE OPERATIONAL SHAREHOLDER VALUE TOTAL SHAREHOLDER VALUE ECONOMIC PROFIT
Page 227
THE CASHFLOW APPROACH From our earlier discussion of Net Present Value NPV and discounting is one way to assess value by using the DCF approach ie.
The Present Value Of Discounted Cash Flows For The Forecasted Time Period The Present Value Of Future Cash Flows Beyond The Forecasted Planning Period
THE ENTERPRISE APPROACH The enterprise approach to corporate value could be assessed by
The Present Value Of Net Free Operational Cash Flows
The Value Of Non-Operating Assets Held
S 14 / 15 . 21
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OPERATIONAL SHAREHOLDER VALUE By subtracting the debt from the total present value from business operations, operational shareholder value can be determined at the current period in time, ie.
Total Operational Net Free Cash Flows Debt And Contingent Liabilities Operational Shareholder Value
MINUS
TOTAL SHAREHOLDER VALUE
Should there be any non-operating assets held, such as investments then the total shareholder value should be adjusted for these, namely
Operational Shareholder Value
Non-Operating Asset Value
Total Shareholder Value
S 14 / 16 . 21
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229
Another way of explaining total shareholder value is : The Net Present value Of All Future Free Cash Flows The Current Value of Non-Operating Assets Debt and Contingent Liabilities
ECONOMIC PROFIT Economic Profit is different from accounting profit and from a management perspective probably more useful, especially if it is used as a metric for measuring performance. Students will be aware of the calculations for assessing profit the companies final accounts using the Profit and Loss account (or income statement) as the basis to determine various measures of profit.
Economic Profit is calculated by determining the amount earned after subtracting all operating expenses and a charge for the opportunity cost of capital employed.
S 14 / 17 . 21
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This means that economic profit is only achieved if at least the opportunity cost of capital is covered.
Moreover, it keeps managers very mindful of cost as well as any assets that are not really being used productively in the company, because this is cash tied up. Therefore Economic Profit using an entity approach, is calculated by
The Operating Profit Before Interest and After Tax
MINUS
A Charge for Capital To Absorb Return To Shareholders and Creditors (ie. Debt holders)
S 14 / 18 . 21
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231
Another way of explaining this is that

Operating Profit Before Interest and After Tax MINUS The Capital Invested to-date
the Weighted Average Cost of Capital
Economic Profit
Similarly the Economic Shareholder value is created when the weighted average cost of capital (WACC) is exceeded by the return on shareholders interest
If an equity approach is taken, then economic profit is calculated by taking the operating profit after interest and after tax is deducted. Strictly speaking this is the profit owing to equity shareholders as a result of employing their capital in the business.
S 14 / 19 . 21
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DISCUSSION QUESTIONS 1. Why is shareholder value important in Corporate Financial Management.
2.
Why do you feel that shareholder value should be appreciated from a number of perspectives ? Does this lead to more confusion than clarity.
3.
Can you explain in simple terms, how total shareholder value can be calculated.
4.
Why is economic profit a more useful concept for assessing value when compared to accounting profit.
S 14 / 20 . 21
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233
KEY TERMS CONTINGENT LIABILITIES ECONOMIC PROFIT ENTERPRISE VALUE NON-OPERATING ASSETS OPERATING SHAREHOLDER VALUE SHAREHOLDER VALUE SHAREHOLDER VALUE GAPS TOTAL SHAREHOLDER VALUE VALUE DRIVERS AND VALUE LEVERS
S 14 / 21 . 21
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ANNEX 1
SEMINARS
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235
6 SEMINARS IN TOTAL ARE PLANNED FOR THIS MODULE TO COVER POTENTIAL SYLLABUS DISCUSSION QUESTIONS PROPOSED AT THE END OF EACH SESSION. ASSESSMENT BASED SEMINARS SHOULD ALSO BE HELD FOR ASSIGNMENT PREPARATION, REVISION AND EXAMINATION BRIEFING.
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ASSESSMENT SEMINARS SEQUENCE

1. 2. 3. ASSIGNMENT PREPARATION ASSIGNMENT OUTLINES -- PRESENTATION ASSIGNMENT OUTLINES -- PRESENTATION
4.
REVISION OF SYLLABUS TOPICS FROM FRONT SHEETS OF EACH SESSION (TOPICS 1 TO 7)

REVISION OF SYLLABUS TOPICS FROM FRONT SHEETS OF EACH SESSION (TOPICS 8 TO 14) EXAMINATION BRIEFING
5.
6.
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237
SEMINAR 1 : ASSIGNMENT PREPARATION

EXPECTATIONS University Protocols Structure of a Good Assignment Content Expected Referencing to meet Academic Requirements Examples from previous courses Conclusion How to make this effective Using Appendices
Student Task
Students produce A Roadmap to address the assignment question of choice
Page
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SEMINAR 2 & 3 : ASSIGNMENT OUTLINE PRESENTATION
1. Students Are Required To Present The Plan For Their Corporate Finance Assignment 2. Students Will Be Selected For Presentation Depending Upon Class Size 3. Group Feedback From Peers Will Be Obtained 4. Critique Given By Tutor 5. Tutor Explains How The Assignment Is Marked And The Criteria Used For Assignment Evaluation
Page
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SEMINAR 4 : REVISION OF SYLLABUS
TOPICS 1 TO 7
Page
240
SEMINAR 5 : REVISION OF SYLLABUS
TOPICS 8 TO 14
Page
241
SEMINAR 6 : EXAMINATION BRIEFINGS

Protocols
Examination Techniques
Tutor Expectations The Content Of A Good Answer
Sample Questions & Answer Discussions

Criteria For Marking Examination Answers
Page
242
ANNEX 2
RECOMMENDED READING
Page
243
Arnold, G. (2010), Handbook of Corporate Finance, Financial Times, Prentice Hall Bender, R. and Ward K (2008), Corporate Financial Strategy, (3rd edition), ButterworthHeinemann Brealey, Myers and Marcus (2010), Fundamentals of Corporate Finance, (9th edition), McGraw-Hill Connolly, D. (2005), The UK Traders Bible, Harriman House of Publishing Ross, S., Westerfield R., Jaffe J. (2010), Corporate Finance, (9th edition), McGraw-Hill Vaitilingam, R. (2006), The Financial Times Guide to Using the Financial Pages, (5th edition), Prentice Hall McKenzie, W., The Financial Times Guide to Using and Interpreting Company Accounts, (4th edition), Financial Times Series
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USEFUL WEBSITES www.bloomberg.com www.money.cnn.com www.ft.com www.euronext.com www.reuters
www.wsj.com
www.investorschronicle.co.uk www.londonstockexchange.com
www.frc.org.uk/asb
Page 245
ANNEX 3
SAMPLE ASSIGNMENT QUESTIONS
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246
1.
Select any one area of the course on Corporate Finance and then propose an outline report for the following : 1.1 1.2 1.3 1.4 1.5 The definition of the Concept The value to the Corporate Finance functions of a Business A worked example The challenges to be faced in its implementation The insights gained through completing this assignment
2.
Using your understanding of the importance of cost of capital, state how a company could view this when making investment decisions of a strategic nature.
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247
3.
What do you understand by the term Shareholder Value ? Explain the ways in which value can be created and by using examples how companies can be valued.
4.
Risk is one of the main agenda items in all Corporate Finance Review Meetings. Using examples, show how risk can occur and how it can be controlled.
5.
Debt Financing is one of the major decisions for any company, especially to finance future growth. Identify and explain 5 sources of debt finance for a small to medium size enterprise and then identify, by contrast the additional sources open to larger organisations.
Page
248

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London School of Commerce

: Investment Project Appraisal (1)

Financial Derivatives and Options

: Sample Assignment Questions

AN INTRODUCTION TO CORPORATE FINANCE

The notion of cash flow is hence central to the subject of finance.

organisation will receive a CASH INFLOW.

INVESTMENT DECISIONS to decide where to place their surplus funds.

As can be seen the nature of Corporate Finance decisions is diverse.

THE INVESTMENT DECISION

all within emerging frameworks and regulations for CORPORATE GOVERNANCE.

2. Explain the terms : Debt Financing Equity Financing

Capital Preservation to minimise loss arising from unwise investment

5. The Investment Decision and Implementation

A Follow-up Investment Audit.

INVESTMENT SELECTION & DECISION TAKING

STRATEGIC INTENT INVESTMENT BUDGET

Types of Investment in line with Strategic Intent Capital Investment Budget

Opportunity Analysis Forming Proposals

NOTE : INVESTMENT APPRAISAL WILL BE EXPAND IN DETAIL IN SESSIONS 3 & 4.

The key issue is to determine how much more will be returned !

THE RISK FREE RETURN

1. Upon what basis would you decide to make a substantial investment.

INVESTMENT PROJECT APPRAISAL (1)

NET PRESENT VALUE

DISCUSSION QUESTIONS KEY TERMS

WITHOUT THE TIME VALUE OF MONEY

INVESTMENT PROJECT EXODUS CASH FLOWS ( 000s) NOTES

- 200 + 10 + 20 + 100 + 120

The initial outlay

Present Value Interest Rate Over The Number Of Years Defined

This can be stated as :

Number of years through which compounding of the interest

+ 65,750 + 68,616 ( 41, 816)

* See Appendix A Page 59 and Page 57

* See Appendix A Page 59 and Page 57

TOTAL PRESENT VALUE OF FUTURE CASH FLOW STREAMS

The IRR formula this may be expressed as : C F0 + C F1 1 + r Where CF =

Cash Flow at time zero

Cash Flow at Time one ( t i ) yearly for t i to t n

So by applying the above formula

18,348 18,348 + 181,800

18348 18348 + 181800

EXAMPLES OF COMPOUND INTEREST TABLES THE FUTURE VALUE OF 1

PRESENT VALUE FACTORS

INVESTMENT PROJECT APPRAISAL (2)

PROJECT JULIANNE -- PAYBACK ANALYSIS

(10) (5) (2) (1) 0 3

1.000 0.9091 0.8264 0.7513 0.6430 0.6209

(10,000) 4,545 2,479 751 683 1,863

(10,000) (5455) (2976) (2225) (1542) 321

ESTIMATING CASH FLOWS

CAPITAL EXPENDITURE RELATED TO THE PROJECT (CAPEX)

1. The simple payback method of investment project appraisal is nave. Discuss.

3. Why does the Accounting Rate of Return offer challenges of interpretation ?

THE COMPANYS COST OF CAPITAL

THE COST OF CAPITAL

THE COST OF CAPITAL

5. INTEREST RATE ON DEBT

WACC (After tax)

Interest Rate on Debt Interest Rate on Debt Paid in Dividends

WACC (After tax)

( 0.28 7% ) + 1.96% 11.32 % 195 695 +