corporate finance notes2.pdf

7/23/2019 Corporate Finance Notes2.pdf

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Lecturer: Ms. Nyathi


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Corporate Finance Notes - CFI 2201 A. Mashiri

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COURSE OBJECTIVES

To gain, understand and appreciation of the different sources of finance, their

management, their advantages and disadvantages and their effects on capital

structure. To comprehend the basics of security valuation, its applicability to other

areas of corporate finance, to gain appreciation of corporate activities and finally

restructuring.

COURSE OUTLINE

1. Sources of Finance4.1. Overview of Financial Markets

4.2. Evaluation of Main Sources of Finance

4.3. Equity Issues, Rights Issues, Retained Issues

4.4. Bond Issues and other debt instruments4.5. Venture Capital

2. Valuation of Securities2.1. Bond Valuation

2.2. Bond Yields

2.3. Risks Associated in Investing in Bonds

2.4. Equity Valuation

2.5. Option Valuation

3. Corporate Valuation and Corporate Structure3.1. The Total Cost of Capital

3.2. Theory of Capital Structure

3.3. Capital Structure Theory: Miller and Modigliani Model

3.4. The Trade Off Models

3.5. The Signaling Models

4. Dividends and Re-purchases

4.1. Dividend Policy4.2. Dividend Stability

4.3. Establishing a Dividend Payout Policy

4.4. Forms of Dividend Payments

4.5. Factors Affecting Dividend Policy

4.6. Theories of Dividend Policies


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4.7. Theoretical Issues that Could Affect Dividend Policy

4.8. Dividend Payment Procedures

4.9. Dividend Reinvestment Plans

4.10. Stock Dividends and Stock Splits

4.11. Stock Repurchase

5. Leasing f Financing5.1. Dividend Defined

5.2. Types of Leases

5.3. Forms of Lease Financing

5.4. Rational of Leasing

5.5. Accounting and Tax Treatment of Leasing

5.6. Evaluation of leases

5.7. Present value of Lease Contract

5.8. Valuation of Borrowing Alternative

5.9. Importance of the Tax Rate

5.10. Issues in Lease Analysis

5.11. Hire Purchase

6. Working Capital Management6.1. Cash Management

6.2. Inventory Management6.3. Short term financing i.e. accruals, accounts payable, bank loans, factoring.

7. Corporate Activity and Restructuring7.1. Mergers and Acquisitions

7.2. Demergers

7.3. Company divestitures and spin offs

7.4. Leverage Buyouts / Management buyouts

7.5. Holding Companies.

Suggested Reading

Brealey, Richard and Meyers, Stewart, Principles of Corporate Finance;4thed.

Brigham, Eugine F and Ehrhardt Michael C (202), Financial Management:

Theory and Practice, 10thedition.


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Pike, Richard and Neale, Bill, (2006) Corporate Finance and Investment:

Decision and Strategies, 5thEdition, Prentice Hall

Van Horne, James, Financial Management and Policy, 4thedition, Prentice

Hall International Editions.

Weston Fred J and Copeland, Thomas Managerial Finance, 9thedition,

Dryden Press International

Weighting of Assessment

Examination - 70%

Coursework - 30%

1. SOURCES OF FINANCE

1.1. Overview of Financial Markets

This topic identifies the sources of finance namely Debt and Equity capital.

Source of debt and equity is the financial market.

Financial Market is a place through which securities are created and traded.

There are several different types of financial markets:-

(a). Physical Asset Markets.

These are the tangible assets e.g. maize, cars, real estate, and

computers e.t.c.

(b). Financial Asset Markets

These deal with stocks, bonds, mortgages and other financial

instruments which are merely claims on real estate.

(c). Continuous Markets & Call Markets

Some markets operate on a continuous basis during opening hours

whilst some markets trade at specific times during opening hours e.g.

the Zimbabwe Stock Exchange open at 0900 and 1200 hours these

are the call markets.

(d). Spot Markets & Future Markets

These are terms that refer to whether the assets are being bought or

sold on the spot delivery or future delivery e.g. Zimbabwe Stock

Exchange you buy shares today and get them 7 days later.


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When an asset is bought or sold for future delivery at some date then it

is traded in future market.

(e). Primary & Secondary Markets

Primary markets are markets in which companies raise new capitaleither by a bond issue or issue of new stock.

Secondary marketsare markets already in existence in which securities

are traded amongst investor.

NOTE:The issuer of the security does not receive any proceeds from

the sale of the security in a secondary market.

(f). Private & Public Markets

In Private Markets transactions are negotiated directly between two

parties e.g. black market transactions.

Whereas in Public Markets standardised contracts are traded on

organised exchanges e.g. Zimbabwe Stock Exchange.

(g). Money & Capital Markets

Money markets deal with securities with maturities of 1 year or less.

Thats were we get treasury bills, call deposits, commercial paper,

bankers acceptance.

Capital markets are more concerned with instruments with maturity

greater than one year, e.g. bonds and equity.

NOTE:Capital Market is Stock Market

(h). Local & International Markets

Local Marketis when you trade within Zimbabwe

International Marketis when you trade beyond the borders of Zimbabwe

Secondary MarketsA secondary market is a market in which securities are traded. There are two

main markets to be considered: -

Organised Exchanges

Over the counter markets

Organised Exchanges


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- Stock markets are the most creative and most important secondary markets.

- Stock exchanges operate as auction markets as buyers and sellers are

matched.

- Examples of Stock Exchange

o Zimbabwe Stock Exchangeo New York Stock Exchange

o London Stock Exchange

o Botswana Stock Exchange

o Nairobi Stock Exchange

o Zambia Stock Exchange

NOTE:Stork Exchanges in developing countries are smaller compared to

developed countries.

Over the counter markets

- The over the counter market is an interchangeable organisation that is

used to describe any buying or selling activities in securities that does not

take place on stock exchange

- The over the counter is a dealer market in that business is conducted

across the country by brokers and dealers.

Importance of Secondary Markets

- They provide an indication of value of a company for example. The price of

an issuers shares in the secondary market will indicate the value of the

company.

- Secondary markets provide liquidity. They enable investors to sell their

shares i.e. buy shares in primary then sell in secondary market to enable

one to get in and out of market shares

- Without a healthy secondary market for shares there will only be a limited

market for new share issues.

- It provides a forum for exchange. A secondary market brings together

buyers and sellers of securities thus reducing search costs.

Listing of Stock Exchange

An exchange does not deal in securities of all companies. It has to select the

companies whose shares can be allowed to be bought and sold.


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The companies selected for those purpose as included in the official trading list.

Certain strict standards must be met and fees paid for initial and continued

listing.

Reasons for Listing

(a). Founder Diversification

The founders of the company have most of their wealth tied up in their

company; hence by selling some of their shares in a public offering they

can diversify their shareholding thereby reducing the risk in their

personal portfolios.

(b). It increases liquidity

- Shares in a privately owned company are in liquid as they do nothave a ready market.

- Search costs are incurred in trying to locate a willing buyer.

- Furthermore there are problems in valuing the stake in that market

- However by listing these problems are usually eliminated.

(c). It facilitates the raising of new cash

- It is difficult to raise new cash by selling new stock in a private

company, the reason being the existing owners might not have the

cash or they might reluctant to put in more money in the business.

- It is even more difficult to get outsiders to invest in a private company

as they will not have sufficient voting rights and might not get a return

in the form of dividends.

(d). To establish value of Company

You can easily establish value of a listed company.

(e). Prestige

- Companies seek listing for prestige reasons meaning you have met

requirements of listing such as fees e.t.c.

- Since the company will be known it becomes easy even to borrow

because you will be known.


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Disadvantages of Listing

(a). Cost of Reporting

- Listed companies are required to publish annual and semi-annualresults which are very costly.

- Accounts have to be audited and furthermore public has to be alerted

on any developments in that company that might affect the share

price.

(b). Disclosure Requirements

Disclosure of sensitive information in financial reports can give an urge to

competitors.

(c). Self Dealings

In privately owned companies there are opportunities for various types of

questionable but legal self dealings.

For example: - nepotism, payment of high salaries and perquisites (e.g.

company cars).

(d). Inactive Market or Low Price

If a company is small and shares are infrequently traded, this will result in

an under-valuation of shares.

(e). Control

Managers will not have control on the day to day running of the business

once the company is listed.

Dual Listing

- A dual listing is whereby a company is listed on more than one stock

exchange.


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- Generally such a companys primary listing is on a stock exchange in its

country of incorporation and its secondary listing is on an exchange in

another country.

Examples of Companies in Dual Listing

- Old Mutual has primary listing in London Stock Exchange, secondary

listing on the Johannesburg Stock Exchange and Zimbabwe Stock

Exchange

- Pretoria Portland Cement (PPC) - has primary listing on the

Johannesburg Stock Exchange and secondary listing on the Zimbabwe

Stock Exchange

- Hwange Colliery - has primary listing on the Zimbabwe Stock Exchange

and secondary listing on the Luxembourg Stock Exchange

Reasons for Dual Listing

- Improved accessibility to funds the Stock Exchange provides

companies with facility to raise capital.

- To gain access to a larger investor base.

- Improved visibility and profile

Disadvantages of Dual Listing

- The company in question has to comply with listing requirements ofboth markets.

- Cost of reporting i.e. reporting required in more than one company. It

may be necessary to produce two different sets of accounts under

different standards.

- Accessibility of Information ensure prices are same on both markets

and information availed on both markets.

De-ListingIt is the process of making a public company private.

De-listing can be volunteering or it can arise because a company has fallen

short of the listing regulations.

Reasons for de-listing


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(a). Under-valued Shares

Directors may believe that their shares are under-valued and may

decide to de-list their company.

(b). Financial Flexibility

If the company is now able to raise debt finance it makes sense forthem to de-list as there are no further advantages to being listed.

(c). Mergers and Acquisitions

Kingdom Financial Holdings was de-listed in 2007, its now part of

Kingdom Meikles African Limited.

Same applies to Tanganda Tea Company.

Capri was de-listed in 1998 through a reverse take-over by Inscor.

(d). Financial Problems of Entities / Viability Problems

Barbican Bank was de-listed due to liquidity problems as well as Trust

Bank, Zicco Holdings was de-listed is 1997.

(e). Control issue

The directors may wish to regain independence of action that they had

as executives of privately owned company. De-listing will then free them

from much regulations and public accountability.

(f). Fear of Take-over

Companies may be liable to hostile takeovers by larger and more

established companies.

1.2. Evaluation Of Main Sources Of Finance

Two main sources of finance:

- Debt Capital

- Equity Capital

Debt capital

- This can be long term e.g. bonds and debentures or can be short term

e.g. bank overdraft or commercial paper.


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- Long term debt is sourced from banks and other lenders of capital such

as life assurance companies or pension funds e.g. PTC Pension Fund.

- Where a company needs to fill in a short term funding gap it can use

short term debt, e.g. money market which has duration of less than a

year and is found under the current liabilities in Balance Sheet.

Advantages of using Debt Capital

- A creditor does not have voting rights does not participate in the

management of the entity.

- The use of debt is advantageous in that its interest expense is tax

deductable in calculating the taxable income.

Disadvantages of using Debt Capital

- The interest payments are contractual and principal repayment must be

made i.e. paying back interest and principal

- The lender may require security and in the event of a default the lender

has a right to repossess the asset.

- The cash drain is large since interest repayments have to be made on a

regular basis thus putting pressure on the company cash flows.

- High credits standards and a strong financial position are required for a

company to access debt capital.

1.3. Equity Issues, Rights Issues, Retained Issues

Equity Capital

- It is the most common source of financing for most companies and is

normally the first source of capital.

- Investors will inject cash or assets into a business in return for a

shareholding in that company.

- Equity is the permanent source of capital meaning you do not have to

repay it back as long as the company is in existence.

- It can be raised through rights issue or Private Placements.


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Rights Issue

It provides a way of raising new share capital by means of an offer to existing

shareholders inviting them to subscribe cash for new shares in proportion to

the existing holdings.

For example a right issue on a 1 for 4 basis, (1:4) at $2.80 per share would

mean that a company is inviting its existing shareholders to subscribe for one

new share for every 4 shares that they hold at a price of $2.80 per share.

Retained earnings

- These are profits that are not paid out as dividends but are retained in

the company.

- Retained profits are an attractive source of finance because investment

projects can be undertaken without involving the shareholders or any

outsiders.

- Use of retained earnings as opposed to new shares or debentures

avoids issuing costs.

Advantages of using Equity Capital

- Dividend payments are made at the discretion of the company. They

can choose whether to pay or not to pay the dividends.

- There is no obligation to pay the principal amount under Equity Capital.

Disadvantages of using Equity Capital

- On issuing shares voting rights are given to new shareholders leading

to the dilution of ownership and capital.

- The cost of under-writing and distributing equity is higher than that of

debt.

- Dividends are not deductable as an expense for calculating the

companys income, (because dividends are paid after tax on profit).

Financing Needs of Company and Product Life Cycle

Sources of financing that a company can utilise will ultimately differ

depending on its stage in the product life cycle.


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Launch Stage

- The pre-launch stage of a business a company will require seed capital.

- If the product still appears financially viable after these initial investments

the additional expenditure can be made for operating facilities e.g.

operating equipment then start up capital will then be required.

Start-up Business

Note: The start-up stage for a company represents highest level of business

(Which is risk associated with business itself e.g. high fixed costs, price

controls e.t.c.

- A start up business is likely to make accounting losses or very nominal

profits; for this reason start-up business should be financed by equity.

Moreover start-up companies have a large and growing demand for

cashflow, therefore taking on debts will put pressure on its cashflows.- In the launch stage the very high business risk implies that cost should be

kept variable and long term financial commitments should be avoided.

- Financing start-up business should come from:

o Business Angels

o Venture Capitalist

PRODUCT LIFE CYCLE

Launch

Start up Capital


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Business Angels

- These are individuals that have made money in their own enterprises and

are seeking the excitement in the financial reward of investing in another

business.

- The Angels usually receive stock / shares and a seat on the Board ofDirectors.

- As individuals are involved the deal is quicker to close and the

documentation much simpler.

- They have a very flexible approach and their analysis less vigorous.

- However they can only invest much lower amounts that Venture Capitalists.

Venture Capitalists

- These are normally professional investors who specialise in a particular

industry.

- They have a short term investment horizon.

- Their focus is to invest during the high risk start up phase of business

which if it is successful they can realise capital gains.

- They expect high rate of returns on their investment portfolio.

- As the total risk of a company declines over its transition from launch to

growth stage, the returns on new capital will fall, and hence venture

capitalists will no longer be interested in financing further operations. They

want to exit at this point and invest the proceeds in further high risk

investments

NB: Example of Venture Capitalists is Takura Ventures

Corporate Ventures:

- Corporate Venturing Companies invest in promising new ventures in order

to exploit their ideas to obtain the benefits of their new technology and gain

on urge on the market.

Growth Stage

- In the growth stage sales start to increase significantly as the product

attains market acceptance.


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- Although business risk is still high it has been reduced from that of the

launch stage.

- There may be additional funding requirements. A new equity has to be

identified to replace original venture capital and provide continued capital.

- Initial public offerings are common at this stage and provide an exit routefor venture capitalists.

- Attracting equity investors is not a problem at this stage as prospects for

future growth are high.

- The cash generated by the business is for re-investments and no dividend

is paid.

- Investors look to capital gains as a major source of capital.

Maturity Stage

- At this stage in the life cycle product demand and supply are now

synchronized.

- Replacement demand becomes major source of total sales.

- Cash flows are positive and there is a reduction in business risk.

- There is reduction in business risk which enables financial risk to be

introduced through borrowing.

- Because the cash flow are positive this enables the company to service

interest and principle repayment.

- The company can also afford to pay dividends.

Decline Stage

- At this stage demand for the product will eventually start to fall.

- Business risk is low at this stage and using more debt can increase the

financial risk.

- Re-investment into the business is no longer priority as the future growth

prospects are negative.

- Companies can now instigate a high dividend pay off policy.

1.4. Bond Issues and other debt instruments

Evaluation:


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- Evaluation is a process of arriving at the value for an asset expressed in

monetary terms.

- The value of an asset is the present value of expected future benefits

usually represented by cash flows discounted at a required rate of return.

- Bonds are the most basic type of fixed income security.- Fixed Income Security is a claim on a specified periodic stream of income.

Characteristics of Bonds:

1. Par Value / face value

- It is the stated face value of the bond. This is the amount paid to the

bond holder on the maturity of the bond.

- The par value represents the amount the issuer borrows and promises

to repay on the maturity date.

2. Coupon Rate

- It is the annual and semi-annual or quarterly interest payment paid to

investors.

- It may be fixed or floating. Some bonds do not pay coupons at all.

3. Yield

- It is the required rate of return on the bond. It is the rate of interest

required by investors in order to entice them to invest in a bond.

- They yield changes with changes in interest rates in the economy and

credit worthiness of the issuer.

4. Maturity

- Bonds have specific maturity dates on which the par value must be

repaid.

- The effective maturity of a bond declines each year after it has been

issued.

Bonds Classification

1. Coupon Payments


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(a). Straight Bonds / ballet Bonds / Vanilla Bonds

- It is the most common type of bond.

- The bond pays regular usually semi-annual fixed coupon over a fixed

period to maturity to return.

(b). Zero Coupon Bonds

- They do not make coupon payments.

- The investors receive the par value at maturity date but receive no

interest payments.

- They are issued at a discount and the investors return comes from the

different from the issue price and payment of the par value at issue

e.g. bond issued at $700 yet its par value is $1, 000, on maturity the

investor gets the $1, 000.

(c). Variable Rate / Floating Rate

- Floating rate bonds make payments that are tied to some measure of

current market rate.

- The payments can be linked to an index or from a current market rate

e.g. Treasury Bills rate or LOBOR.

(d). Income Bonds.

- They provide coupon payments that must be paid only if the earnings

of the firm are sufficient to meet the interest obligations. The principal

however must be paid when due.

2. Redemption Dates / Maturity Dates

(a). Double dated Bonds - Pricing.

- These are bonds that can have a range of possible redemption

dates.

- It eases flow of company cash flow.

(b). Callable Bonds.

- Callable bonds give the issuer the rights but not the obligation to

redeem the bond before maturity.


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- The issuer however must pay the bond holders a premium.

(c). Puttable Bonds.

These bonds give bond holders the right but not the obligations to

sell their bonds back to the issuer at predetermined price and date.

(d). Irredeemable Bonds / Perpetuals.

These are bonds which do not have redemption dates. So interest

on them will be paid indefinitely.

(e). Convertible Bonds

It is one that can be converted at the option of the holder into certain

number of shares in that company.

E.g. BAT issues bonds for $1000 to mature in December 2008. The

buyer will be given an option to convert the bond into shares worth

for example 20 shares and hence becomes a shareholder.

3. Issuer who is issuing them

(a). Treasury Bonds / Government Bonds.

These are issued by the Government

(b). Corporate Bonds / Debentures.

These are bonds issued by corporations / companies.

(c). Municipal Bonds.

These are issued by the municipality and local government

(d). Foreign Bonds.

These are issued by foreign government or foreign companies.

NOTE:- It is important to know the issuer so that one can asses the risk

involved under the bond being issued.

4. Priority

- The priority of the bond determines the probability that the issuer will

pay you back your money.

- The priority indicates your place in line should a company defaults in

payments.


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(b). Unsubordinated (senior) Security.

- It ranks above other loans or security with regards to claims on

assets or earnings.

- In the event a company defaults you will be 1stin line to receive

payments from liquidation of its assets.

(c). Unsubordinated (junior) Security.

In the event a company defaults you will get paid only after the

senior debt holders have received their shares

5. Currency

(a). Domestic Bonds.

These are bonds issued by the domestic borrower in their own

national markets denominated in the local currency that can be

purchased by anyone in possession of that currency.

(b). Foreign Bonds.

These are bonds issued by the national markets by foreign

companies or government in the currency of that country in which

the market is based.

The issues are subjected to regulations and supervision of thenational market.

Examples:

* Bonds issued pound sterling in London by foreigners are called

Bulldog Bonds

* Similarly bonds issued in US$ denominations in New York by a

foreigner are called Yankee Bonds

* Bonds issued in Japan by foreigners in Yen denominations arecalled Samurai Bonds

(c). Euro Bonds.

- These are bonds issued by government and companies outside

their own countries in currencies other than their own, e.g.

Swedish company issuing a bond in Zimbabwe in US$.


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- They can be bought by anyone or organisation having the

currency available.

- The bonds are not traded on any specific market.

Example:- A Eurobond denominated in Japanese Yen but

issued in the United States will be classified as a Euro yen

Bond.

(c) Price Yield Relationship

Bond

Price

Yield

- Interest rates are the primary determination of bond prices.

PRICE YIELD CURVE


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- However a change in the level of interest rates does not affect all

bonds in the same way.

- In order to determine how sensitive a bond price is to change in

interest rates one has to know the price yield relationship.

- The Price Yield Curve is a plot of the bonds required rate of return toits corresponding price.

- It is not a straight line, its a convex.

NOTE:- The price of a straight bondvaries inversely with changes in

interest rates:

- When interest rates increase bond prices fall.

- When interest rates decrease bond prices rise.

(a) Long Term Bonds- These are more price sensitive to a given

change in yields than the short term bonds.

(b) High Coupon Bonds- These are less price sensitive to a given

change in yields as compared to lower coupon bonds.

- The value of a bond in the market place is rarely constant over

life i.e. it fluctuates.

- When you calculate the price of a bond you are calculating themaximum price you would want to pay for the bond given the

bonds coupon rate in comparison to the average rate most

investors are currently receiving in the bond market.

- Bonds can be priced at: -

o Premium

o Discount

o Par

(c) Premium

If the bond price is higher than its par value the bond will sell at a

premium its coupon rate is higher than the required yield or

prevailing rates.

That is ieldrateCoupon


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(d) Discount

If the bond price is lower than its par value the bond will sell at a

discount the reason being coupon rate will be lower than the yield.

(e) Par

This means the interest rate of the bond equals the prevailing rate.

If the coupon rate on the bond equals the prevailing interest rates

the bonds trades at par.

That is ieldrateCoupon =

2. VALUATION OF SECURITIES

2.1. Bond Valuation

(a). Pricing of Redeemable Bonds

Bond Price =nn i

M

i

CC

i

C

)1()1(......

)1()1( 2 ++

++

++

+

=n

n

i

M

i

ixC

)1(

)1(

11

++

+

Where:-

C = Coupon Payment

i = required yield / interest rate

n = number of payments

M = maturity value / par value / face value


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For Interest payment paid more than once a year we effect the formulaebelow

Bond Price =fn

fn

f

i

M

f

i

f

i

xf

C

++

+

)1(

)1(11

Where:-

= frequency

If its semi-annually will be 2

If its quarterly will be 4

Example 1:

Calculate the price of a Bond with a par value of $1,000.00 to be paid in 10

years, a coupon rate of 10% and a required yield of 12%.

Assume that coupon payments are made semi-annual to bond holders and

that the next coupon payment is expected in 6 months.

Solution:

Bond Price =fn

fn

f

i

M

f

i

f

i

xf

C

+

+

+

)1(

)1(

11


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=212

210

212,01

1000

212,0

)2

12,01(

11

2

100

+

+

+

x

=[ ]

80472,31106,0

273195688,050 +x

= 80,31150,573 +

= 30,885

Example 2:

25 years ago ZESA issued an annual coupon payment bond with a 10%

coupon rate and a $1,000 par value.

The bond has now 10 years remaining until maturity.

Due to the change in the interest rates and market conditions the required

rate of return on the Bond is 8%.

What is the intrinsic value of the Bond?

Solution:

Intrinsic Value =n

n

i

M

i

iC

)1(

)1(

11

++

+


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=10

10

)08,01(

000,1

08,0

)08,01(

11

100+

+

+

=[ ]

193488,46308,0

463193488,01100 +

=[ ]

193488,46308,0

536806512,0100 +

= 193488,46301,671 +

= 20.134,1$

(b). Pricing of Zero Coupon Bonds

Bond Price =( )ni

M

+1

Where:-

M = maturity value / par value / face value


n = number of payments

Example:

Calculate maturity value of a zero coupon bond maturing in 5 years

that has a par value of $1, 000.00 and required yield of 6%.

Solution:


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Bond Price =( )ni

M

+1

=( )506,01

000,1

+

=( )506,1

000,1

= 26,747$

Bond Price =fn

f

i

M

+1

=25

2

06,01

000,1

+

=( )1003,1

000,1

= 09,744$

Example:

Calculate maturity value of a zero coupon bond that matures in 15

years from now if par value is $1, 000.00 and the required yield is

9.4%.

Solution:

Bond Price =( )ni

M

+1

=( )15094,01

000,1

+

=( )15094,1

000,1


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= 86.259$

(c). Pricing of Irredeemable Bonds

Bond Price =i

C

Where:-

C = Coupon Payment


Example:

In 1990 a company issued a number of $100 par value 0, 80 irredeemable

debentures.

Calculate the amount investors will be willing to pay for such a debenture in

2004 if the prevailing interest rate is 11%.

Solution:

Bond Price =i

C

=%100

%8100

=11,0

08,0

= 73,72$

2.2. Bond Yields

Bonds are traded on the basis of their prices but are compared in terms of

their yields.


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The three sources of return that may compromise a yield on a bond at:-

Periodic Coupon Interest.

Capital gains resulting from buying at a different price then the one

received when the security is sold / matures.

Re-investment Income from investing periodic cashflows.

1. Current Yield

Current yield is the most basic measure of the yield.

It is theBondofpriceCurrent

paymentCoupon

=priceMarket

Coupon

Example:

Suppose that a 15 year $1,000 par value 7% semi-annual coupon bond is

currently trading at $1, 1000.

What is the current yield on this bond?

Solution:

Current Yield =priceMarket

Coupon

= 100,1

000,1%7 of

=100,1

70


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= %36,6

Current yield is used to estimate the cost of profit from holding a bond.

Example: - if other short term interest rates are higher than the current

yields, the bond is said to carry a running cost or negative carry.

Disadvantages of Current Yield

(a). The current yield does not take into account potential gains or losses

resulting from the difference between the current market price of a

bond and its value upon maturity.

(b). It does not take into account time value for money.

2. Yield to Maturity (YTM)

Yield to Maturity is the measure of a total return that will be earned on

a bond if it is bought now and held to maturity.

It takes into account:-

- The pattern of coupon payments.

- The bonds term to maturity and

- The capital gains or losses arising over the remaining life of a

bond.

Formulae:

Bond Price =

nn YTM

M

YTM

C

YTM

C

YTM

C

)1()1(

......

)1()1( 21 +

+

+

+

+

+

+

Short Formulae:-

Year to maturity =

( )Bv

Bv

PP

n

PPC

+

+

2

1


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Where:-

C = Coupon

vP = Par Value

n = remaining years of maturity

BP = Price of the Bond

NB:Usually YTMis not given but bond price will be given.

The YTMis calculated by iteration. It is the discount rate that equates the

present value of all the bonds expected cashflows with the current market

price of a bond.

Example:

A bond is currently trading at a price of $96.50 with a coupon payment of

$8.75 paid semi-annually. I has exactly one year before maturity.

Calculate the YTM.

Solution:

Year to maturity =

( )Bv

Bv

PP

n

PPC

+

+

2

1

=

( )50.961002

11

50.9610075,8

+

+

= %47,12


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Advantages of Yield to Maturity

(a). It takes into account the potential gains or losses associated withholding the bond to maturity.

(b). It takes into account that coupon receipts can be re-invested and

hence further interest rates.

Disadvantages of Yield to Maturity

(a). It assumes that a bond is held to maturity. Typical investors do not

hold bonds to maturity.

They are much more interested in holding periodic returns which

depends on the bonds price when it is sold in relation to the purchase

price.

(b). The YTM is a promised yield in that it assumes a bond regardless of

its credit rating will pay off the promised cash flows. Hence the YTM

will only be realised if the issuer does not default.

(c). The YTM assumes a flat yield curve meaning that it assumes all

interest rates will stay the same through out the period and that

coupons are re-invested at that constant rate.

3. Yield to Call

Callable bonds might not reach maturity for the very reason that they

may be called before maturity.

Hence that yield to call was developed to measure the return on a bond

if it where to be called on a particular call date.

Formulae

Yield to Call =

( )CBCall

CBCall

PP

nc

PPC

+

+

2

1

Where:-


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CallP = Call price of the bond

CBP = Price of callable bond (Price at which bond is

trading currently)

cn = Number of periods until the call ends.

Example:

What is the YTC of a 6% coupon, 5 year bond priced at $98 that is

callable in 3 years at $105?

Solution:

Yield to Call =

( )CBCall

CBCall

PP

nc

PPC

+

+

2

1

=

( )981052

13

981056

+

+

=50,101

3

76+

= 21,8

Advantages of Call to Yield

It takes into consideration the coupon interest, capital gains and re-

imbursement of cash flow.

Disadvantages of Call to Yield

(a). It assumes that the interest will hold the bond until the next call date

and that the issuer will call thebond at that time.


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(b). It assumes that the interest received from the bond will be re-invested

at the yield to call rate.

3.2. Risk Associated With Investing In Bonds

1. Interest Rate Risk

This is the risk that an increase in interest rates will cause the price of

the bonds to fluctuate.

2. Call Risk

This is the risk that a bond will be paid off before its maturity date.

3. Re-investment Risk

This is the risk that cashflows or income generated might have to be re-

invested at lower yields if interest rate falls.

4. Default Risk

This is the risk that the issuer will fail to make interest for principal

payments when they fall due.

5. Down Grade Risk

This is the risk that the price of the bond might fall because the credit

rating agencies have reduced the credit rating of the bond issuer.

6. Liquidity Risk

This is the risk that the bond will not be sold so quickly because the

market is in liquid.

7. Re-structuring RiskThis is a risk that arises from the potential conflict of interest between

different claimants on firms assets when a company restructures.

8. Exchange rate Risk

If person is holding foreign bonds and currency of that bonds exchange

rate fluctuates it affects the value of the bond.


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9. Inflation Risk

When inflation increases value of the bonds decreases.

10. Event Risk

This is the risk that some unusual events will cause the price of bonds

to fall.

3.3. Equity Valuation

Ordinary Shares / Common Stock

- Common stock are equity securities that are issued by corporations

- An investor who purchases ordinary shares in a company becomes part

owner of that company

- The level of ownership will depend on the number of shares purchased

as compared to the total number of shares that has been issued by the

firm.

Characteristics of Ordinary Shares

(a). Control

- Ordinary Shareholders are the owners of the company and as such

they have control of the company

- This control is exercised through their voting powers on specific

issues at shareholders meetings

(b). Income

Ordinary Shareholders are entitled to a dividend but a company and its

directors are under no obligation to declare a dividend.

(c). Priority

In the event of a company being liquidated ordinary shareholders stand

last in the line to receive proceeds of liquidation as they are the residual

owners of the business. All other shareholders have to be paid before

they can receive their proceeds.

(d). Maturity


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Equity Capital is a permanent form of financing. It does not have a

maturity date and therefore the repayment of the initial amount is not

required.

(e). Tax Treatment

Dividends payments to common shareholders are not tax deductable,

i.e. they are taxed on dividends.

Valuation of Ordinary Shares

The value of an ordinary share is derived from the present value of all future

expected benefits it is expected to provide he expected future value comes in

two forms namely:-

- Expected Cash Dividends- Capital Gains or losses due to change in price.

Models of Valuing Ordinary Shares

1. Zero Growth Model

This is the simplest approach to shares valuation which assumes a

constant non-growing dividends dream

sK

DP 10 =

Where:

0P = The value of Ordinary Share

1D = Amount of annual dividend

sK = the required rate of return on common stock

Example

Edgars expects to pay a dividend of $3.60 at the end of each year

indefinitely into the future.


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If investors require 12% rate of return, what is the intrinsic value the

ordinary shares at Edgars.

Solution

sK

DP 10 =

=12,0

60,3

= 00.30$

2. Constant Growth Model

( )gK

gDP

s

++=

100

Where:

g = Growth Rate

0D = Dividends that has just been paid

sK = Required rate of return

Example

Kingdom Bank has just paid a $2 dividend. Analysts expect the firms

dividend to grow at a constant rate of 6% per annum.

If investors require a 14% return on investment, what is the intrinsic

value the Kingdom common stock?

Solution

( )gK

gDP

s

++=

100


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=( )

06,014,0

06,012

+

= 5,26

3. Variable Growth or Supernormal

The zero and constant growth model do not allow for any shift in the

expected growth rate. However in reality the growth rate might shift up

and down or cease due to change on company expectations.

The variable growth model incorporates for change in the dividend

growth rate.

( )

( ) ( )ns

n

ts

t

K

P

K

gDP

++

+

+=

11

1 10

Where:

0D = Dividends that has just been paid in period zero

1g = Supernormal Growth Rate

2g = Normal Growth Rate

1+nD = 1stDividend at the resumption of normal growth

nP = Terminal price of the stock

n =

t = Length of the supermodel growth period

( )

( )2

1

gK

nDP

s

n

+=

Example:

Analysts expect dividend of Econet wireless to grow at a rate of 20% for

the next 4 years and at a rate of 5% there after.


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The company has just paid a dividend of $2 per share. If investors

require a 12% rate of return, what is the value of Econets common

stock today?

Solution:

Step 1:

Find the present value of the dividend during the supernormal growth

period.

=( )

( )ts

t

K

gD

+

++

1

1 10

= ( )( )

( )( )

( )( )

( )( )4

4

3

3

2

2

1

1

12,01

20,012

12,01

20,012

12,01

20,012

12,01

20,012

+

+++

+++

+++

+

= 63565300,2459912536,2295918367,2142857143,2 +++

= 534,9

Step 2:

Find the present value of the terminal price at the end of the

supernormal growth period.

Note: 4PPn =

( )

( )2

1

gK

nDP

s

n

+=

( )( )2

41

gK

nDP

s

+=

=( )

05,012,0

05,0115,4

+

= 25,62


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=( )ns

n

K

P

+1

=

( )412,01

25,62

+

= 56,39

Step 3:

Sum the present value of both the dividend during the 4 year

supernormal growth period and the terminal price in year 4.

= 56,39534,9 +

= 09,49

Example:

Cealsys is experiencing a period of rapid growth. Earnings and dividends

are expected to grow at a rate of 15% during the next two years at 13% in

the 3rdyear and a constant growth rate of 6% there after.

The companys last dividend was $1.15 and the required rate of return on

stock is 12%.

Calculate the value of share today.

Solution:

( )

( ) ( )ns

n

ts

t

K

P

K

gDP

++

+

+=

11

1 10

Step 1:


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Find the present value of the dividend during the supernormal growth

period.

=( )

( )ts

t

K

gD

+

++

1

1 10

=( )

( )

( )

( )

( )

( )3

1

2

2

1

1

12,01

13,0152.1

12,01

15,0115.1

12,01

15,0115.1

+

++

+

++

+

+

=( )

( )

( )

( )

( )

( )3

1

2

2

1

1

12,01

13,152.1

12,01

15,115.1

12,01

15,115.1

++

++

+

= 2221,12124,11808,1 ++

= 615,3

Step 2:

Find the present value of the terminal price at the end of the supernormal

growth period.

Note: = ( )ns

n

K

P

+1

( )

( )2

1

gK

nDP

s

n

+=

=( )

05,012,0

06,017176,1

+

= 34.30

=( )ns

n

K

P

+1


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=( )312,01

34,30

+

= 59,21

Step 3:

Sum the present value of both the dividend during the 4 year supernormal

growth period and the terminal price in year 4.

= 62,359,21 +

= 21,25

Advantages of Dividend Discount Models

- Simplicity is use

Disadvantages of Dividend Discount Models

- Models are only applicable to dividends paying stocks

- Model requires that the cost of equity is greater than the growth rate

otherwise the model will give nonsensical answers. Sometimes stocks

experience periods of supernormal growth were the growth rate will

exceed the cost of equity

- The model assumes growth to be constant. However in reality growth

cannot be expected to continue indefinitely.

Preference Shares

- These are hybrid securities in that they have some characteristics of

debt & equity.

- Preference shares promise a fixed dividend and in this way they can

be likened to debt.

- However unlike debt preferred dividends are not deductable for tax

purposes. Hence it has a higher cost of capital than debt.

- Almost all preferred stocks have a cumulative feature providing for

unpaid dividends in any one year to be carried forward.


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- A company has to pay its accumulated arrears on preferred stock

before it can pay a dividend on its common stock.

- Preference shareholders are not given any voting rights in the

company because of their prior claim on assets and income.

Types of Preference Shares

(a). Participating Preference

These shares are entitled to the fixed dividends but in addition they

share in the remaining profits in some predetermined portion to the

ordinary shares.

(b). Redeemable Preference Shares

These are similar to normal preference shares except that the

company has the option to redeem them at a specified price on a

particular date or a given period of time.

(c). Convertible Preference Shares

These are similar to normal preference shares except that the holder

has right to exchange them for ordinary or other security according to

pre-arranged terms.

4. Valuation of Preferred Stock

p

pp

K

DV =

Where:-

pV = Valuation of Preferred Shares

p

D = Dividend

pK = Required Rate of Return

Example:


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Suppose Delta Corporation has a $100 par value preferred stock that

pays an annual dividend of $7. If investors require an 8% return on this

stock, what will be the intrinsic value?

Solution:

Value of Preferred Stock =p

p

K

D

=08,0

7

= 50,87

Example:

Assume the current market price of Schweppes preferred stock is $85 with

a dividend of $7.

What will be the expected rate of return if investors require rate of return of

8%. Should the investor consider buying the preferred stocks?

Solution:

Value of Preferred Stock =p

p

K

D

85 =x7

x =85

7


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= 0823,0

Rate of Return = %23,8

The investor can consider buying the shares as the Rate of Return is

higher than what they expect.

Advantages of Preferred Stock

- Flexibility

Dividends do not have to be paid in the year in which profits are

bad, while this is not the case on interest payments on long term

debt.

- It avoids dilution of ownership. This is because preference shares

do not carry any voting rights. Hence they avoid diluting control of

existing shareholders. Which is what happens when ordinary

shares are issued?

- Since preferred stock has no maturity this reduces cashflow drain

from repayments of principal that occurs with debt issues.

- Preferred shares will lower the companys gearing ratios.

- The issuing of preference shares does not restrict the companys

borrowing power.

Disadvantages of Financing Preferred Stock

- The after cost shares of preferred stock is higher than the after tax

cost of debt. Furthermore because of the possibility that dividendscan be passed preferred stock shareholder often require a higher

return.

- Fixed obligation of paying dividends. Although preferred dividends

can be passed the company is still under obligation to pay them in

subsequent years.


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3.4. Option Valuation

- Options are derivatives

- Derivatives are securities whose value is determined from the prices of

underline securities.- These assets are called contingent claims because their pay offs are

contingent on the prices of other securities.

Definition of Option

- It is the contract that gives the holder the right but not the obligation to

buy or sell an asset at a pre-determined price known as the strike price

or exercise priceon or before some expiration date.

- Most options areAmericanmeaning that they can be exercised at anytime before or on the expiry date.

- European Optionsallow only exercising on the expiry date.

- Example Puttable Bonds

(a). Call Option

- It gives its holder the right to buy an asset or security at a specified

date and at a specified price.

- Happens when one anticipate price is going to shoot and one willstill be able to buy them cheaper

- The holder of an option is not under any obligation to exercise it,

therefore call options are assets as the embody him the right to

buy and this right has value.

The Call Righter:

- Sells all call options at said the right calls.

- The righter of the call option receives the purchase price orpremium.

- The premium is payment against a possibility that a righter may

have to deliver the asset in return for an exercise price lower than

that of the market value of the asset.

(b). Put Option


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- If you think market will fall you buy put option.

- A put option gives the holder the right not the obligation to sell an

asset at a specified price at a specified date.

- The holder of a put option is not under any obligation to exercise it,

therefore the put option are assets as they embody him to sell andthis right has value

NOTE:These are used to limit ones risk / loss. The righter of the put

thinks the market will go down.

The Put Righter:

- The righter of the put option will receive a premium for righting the put.

(c). Trading of Options

- Options can be traded on the over the counter markets. This has

the advantage that the terms of the option contract can be tailor

made to meet the needs of the traders.

- However the cost of establishing the over the counter option

contract are very high

- Options Contract can also be traded on organised exchange e.g.

Chicago Board Options Exchange.

- They are highly standardised contract specifications trading in

specific quantities of securities for delivery in specific months.

Valuation of Option Contracts

A value of an option can be broken down into two parts.

Intrinsic Value

Time premium

(a). Intrinsic Value

It depends on the price of the asset underlying the option in relation to

the call option exercised price.

Formulae:

Call Option:


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KSC =

Put Option:

SKP =

Where:-

S = Current Stock Price

K = Exercised Price

As long as the difference is positive the option has value.

Otherwise ZeroP= or ZeroC= .

This is because the options can not have a negative value.

(b). Terms describing option

In the Money

Describes the option where exercise would be profitable.

Out of the Money

Describes the option where exercise would not be profitable.

At the MoneyDescribes the situation where the asset price and exercise price are

equal.

(c). Time premium

This is a function of the probability that the option could change in

value by the time it expires.

The time premium depends upon four variables:-

The amount of time before expiration

Volatility

Time Value of Money

Yield on the underlined asset

Example:


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In April 2004 maturity Call Option on a share of Motorola Stock was an

exercise price of $90 per share, sales on 16 December 2003 for $7.

The option is to expire on April 15 2004. Until the expiration day the

purchaser of the call is entitled to buy shares for Motorola for $90.

On December 16, 2003 the Motorola stock is trading / selling at $89, 25.

(a) Calculate the intrinsic value on 16 December 2003?

(b) Calculate the intrinsic value if Motorola trades for $100 on the

expiration date and the profits that will accumulate to the investor.

Solution for (a):

Call Option ( )C = KS

= 9025,89

= 75,0

Therefore ( )C = ( )0Zero

Note: An option can not be trade negatively therefore call option

equal to zero.

Solution for (b):

Call Option ( )C = KS

= 90100

= 10

Therefore Intrinsic Value = 10

Profit = ValueBuyingValueIntrinsic

= 710

= 3$


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Example:

In April 2004 maturity Put Option on Motorola with an exercise price of $90

per share, sales on 16 December 2003 for $7.

It entitles the owner to sell the shares of Motorola for $90 at any time until

15 April 2004.

If on December 16, 2003 the Motorola stock is trading / selling at $89, 25.

(a) Calculate the pay off to the put holder.

(b) Calculate the pay off on the expiration date if the Motorola Stock

trades at $80

Solution for (a):

Put Option ( )P = KS

= 25,8990

= 75,0

There is no profit in this situation its out of the money

Note: An option can not be trade negatively therefore call option

equal to zero.

Solution for (b):

Call Option P = KS

= 8090

= 10

Therefore Intrinsic Value = 10

Pay-off = ValueBuyingValueIntrinsic

= 50,710


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Profit = 75.2$

In this situation its in the money

3. CORPORATE VALUATION AND CORPORATE STRUCTURE

3.3. The Cost of Capital

Debt, Preferred Stock and Common Equity are the capital components of

the firm. If a company decides to increase its total assets then that increase

will be financed by an increase in one or more of these capital components.

The cost of each of these components is called Component Cost of

Capital.

1. Cost of Debt ( )dK


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Formulae:

Cost of debt ( )dK = )1( tKd

Where t= Marginal Cost of Debt (marginal firms tax rate

- It is the interest rate on the companys new debt.- This is the yield to maturity on existing debt,

- It is also called the before tax component cost of debt

- It is the current cost of debt or interest rate the firm would pay if it

issues debt today.

- The yield to maturity is the rate of return the existing bond holders

expect to receive and it is also a good estimate of the return that

new bond holders would require.

- The after tax cost of debt is used to calculate the weighted average

cost of interest

- It is the interest rate on the new debt less the tax savings due to the

deductibility of interest.

Example:

Edgars is planning to issue new debt at an interest rate of 8%. Edgars is in

the 40% marginal tax rate.

What is the companys cost of debt capital.

Solution:

Cost of debt ( )dK = )1( tKd

( )4,0108,0 =

6,008,0 =

%8.4=

2. Cost of Preferred Stock psK

3. Cost of Retained Earnings ( )sK


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(a). Capital Pricing Model ( )CPM

fmfs RRRK +=

Where:

fR = Risk Free Rate of Return

mR = Expected rate of return on the market

= Beta Stocks risk measure

fm RR = Risk Premium

(b). Bonds Yield + Risk Premium Approach ( )sK

approachpremiumriskyieldbondKs

+=

Example:

Suppose the Edgars interest rate on long term loan is 8% and the

risk premium is estimated to be 5%.

Calculate the companys estimated cost of the retained equity?

Solution:

approachpremiumriskyieldbondKs +=

%5%8 +=

%13=

(c). Dividend Yield + Growth Rate Approach ( )sK

Formulae:

gK

DP

so

= 1

Note that there is need to re-arrange the formulae and make sK

the subject of the formulae.

gP

DKs +=

0

1

Where:-


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0P = Value of the share

g = Growth Rate

Formulae to find growth rate:

( ) rateretentionROEequityonreturng +=

Example:

Suppose the Edgars Share sells for $21 and next year dividend is

expected to be $1.

Edgars has a return on equity (ROE) of 12% and they are

expected to pay out 40% of their earnings.

What is the cost of the retained equity?

Solution:

gK

DP

s

o = 1 or g

P

DKs +=

0

1

( ) rateretentionROEequityonreturng +=

6,012,0 =

072,0=

g

P

DKs +=

0

1

072,012

1+=

1196,0=


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%96,11=

(d). Cost of Newly Issued Equity ( )eK

Formulae:

( )g

fP

DKe +

=10

1

Where:-

eK = Cost of Newly Issued Equity


= Floatation Cost

0P = Value of the share

g = Growth Rate

Example:

Suppose the Edgars Share sells for $21 and next year dividend is

expected to be $1.

Edgars has a return on equity (ROE) of 12% and they are expected

to pay out 40% of their earnings.

Assuming the previous growth rate of 7, 2% and that Edgars has a

floatation cost of 10%.

Calculate the new cost of Equity.

Solution:

Formulae:

( )g

fP

DKe +

=10

1


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( )072,0

1,012

1+

=

1249,0=

%5,12=

(e). Weighted Average Cost of Capital ( )WACC

( ) pspsecedd KWKWtKWWACC ++= 1

Where:

dW = Weight of Debt

dK = Cost of Debt

( )tKd 1 = Cost of Debt (after tax)

ceW = Weight of Common Stock (equity)

eK = Cost of newly issued equity

psW = Weight of Preferred Stock

psK = Cost of Preferred Stock

- WACC is used primarily for making long term capital investment

decision.

- It reflects the firms average cost of long term financing.

- The weights are based on the firms target capital structure.

- The weights should be based on the market values of the firms

securities.

- If the firms book value figures reasonably approximate the market

values then you can use the book value weights.

Example:


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Suppose Edgars target Capital Structure comprises 45% debt, 50%

equity and 5% Preferred Stock.

Calculate the companys weighted Average Cost of Capital (WACC).

Solution:

From previous example the following has been established:

( )tKd 1 = 4, 8%

eK = 12, 5%

psK = 8, 42%

dW = 45%

dK = 50%

psW = 5%

Next step is to substitute these figures into the formulae below and the

weights are established from the given example.

( ) pspsecedd KWKWtKWWACC ++= 1

)0845,005,0()125,050,0()048,045,0( ++=

00421,00625,00216,0 ++=

08831,0=

%83,8=

Factors that affect Firms Cost of Capital

A. Factors that a Firm Cannot Control.

1. Level of Interest Rates

If interests rates in the economy rise the cost of debt increases

because firms will have to pay bond holders a higher interest rate in

order to obtain debt capital.

2. Market Risk Premium


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This is the perceived risk market in stocks along with the investors

inversion to risk. Individual firms have no control over this factor but

it affects the cost of equity.

3. Tax Rates

Companies have no control over tax rates or tax bands.

4. Dependent on the overall countrys economic conditions

When inflation rate is increasing, cost of doing business is more

expensive hence investors and lenders will demand a higher rate

of return which results in a higher cost of capital

When the economy is on its upbeat trend where demand forfunds increases and supply of funds are limited or not increasing

proportionately to demand then the lenders and financiers

increase their lending rate which will also increase a firms cost of

capital

B. Factors that a Firm Can Control.

1. Capital Structure PolicyThe weights used to calculate the WACC are based on the

companys target capital structure.

Therefore a change in the companys capital structure can affect

its cost of capital.

2. Dividend Policy

The higher the pay-up ratio of a firm then the more it will have toresort to expensive common stock financing similarly the more

a company retains the more it can rely on retained earnings.

Whatever Dividend Policy a firm will adopt this will have a

bearing on the cost of capital.


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3. Investment Policy

Dependent on the companys business risk

The higher a firms business risk, the higher the investorsrequired rate of return and the cost of capital will also

increased.

Dependent on the companys financial risk

Where a company is highly geared, the lending institutions will

consider the firms financial risk to be quite high hence would

require a higher rate of return from the firm hence increasing

the firms cost of capital

Dependent on the Size of Financing

Where the firms size namely its assets or sales turnover

cannot justify the size of financing needs, the lenders will be

more cautious and will impose a higher cost of fund which will

then increase the companys cost of capital

Example:

Hunyani has the following Capital Structure:-

Debt - 25%

Preferred Stock - 15%Common Stock - 60%

Hunyanis tax rate is 40% and investors expect earnings and dividends to

grow at a constant rate of 9% in the future.

Hunyani paid a dividend of $3.60 per share last year and its share price


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is currently $60. Treasury bonds yield 16%.

An average stock has a 14% expected rate of return. Company beta is

1.51.

The following terms apply to new security offerings:-

New preferred stock can be sold to the public at a price of $100 per share

with a dividend of $11.

Floatation cost of $5 will be incurred. Debt could be sold at an interest

rate of 12%.

Required:

Find the companys cost of debt, preferred stock and common stock.

Assume that Hunyani does not have to issue any additional shares of

common stock. What is the WACC?

3.5. Theory of Capital Structure

- Capital Structure relates to the mix of long-term finance.

- When a company expands it needs capital to finance the additional

assets.

- The capital can be derived from debt, equity or combination of both.

- This topic of capital structure serves to see how the capital structure of

a company will affect the companys risk and how companies should

finance their operations.


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1. Target Capital Structure.

- A firms target capital structure is a debt to equity ratio that a

company tries to maintain over a period of time.

- If the companys current debt ratio should fall below the target

level, issuing new debt will satisfy the new capital.

- If the firms current debt ratio increases above the target level, the

company will be required to raise new capital by retaining earnings

or issuing new equity.

2. Optimal Capital Structure.

- When a company is setting its target capital structure it has to

consider the trade-off between risk and return associated with the

use of debt.

- The use of debt increases risk to shareholders and the higher the

risk associated with the use of debt will depress share prices.

- The firms optimum capital structure is the one that balance the

influence of risk and return and maximises the firm share prices.

Cost

2K

WACC

Kd

Lowest level

of WACC


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Leverage

Value

Share prices highest

Share Price

Optimal Capital Leverage Debt Equity

- Cost of equity increases with increasing debt but more rapidly than

the cost of debt, the increase is to compensate for the risk taking.

- Cost of debt remains low due to the tax shield but slowly increases

as the company increases the gearing to compensate lenders for

the increasing risk

3.4. Factors that influence Firms Capital Structure Decision

(a) Business Risk

This is the risk that is inherent in the firms operations assuming zero

debt.

It is the risk that the company will not be able to cover its operating

costs.

The main features affecting business risk are:-

- Demand variability


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The more variable a firms sales are the higher the business risk.

- The sales price variability

Volatile market price will expose the firm more business risk than

that experienced by companies whose output prices are more

stable.

- The input price variability

Companies with uncertain input costs are exposed to high

business risk.

- Ability to adjust output pricesfor changes in input prices e.g. those

who sale controlled goods.

- Operating Leverage

The higher the % of the firms costs that are fixed then the greater

the business risk.

Tax Position

- The reason why companies use debt is because of the tax deductibility

of interest payments

- The deductibility of interest lowers the effective cost of using debt.- However if a company is already in a low tax bracket because its

income is sheltered fro taxes by depreciation, interest on current debt

or a tax loss may carry forward, then the use of additional debt will not

be advantageous.

Financial Flexibility

Reasons why you require the capital for will determine whether you get long

term or short term debts.

Conservatism of Aggressiveness of Management

- Aggressive Managers will tend to borrow more they do not hesitate to

take a risk.


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- Conservative managers are not risk takers, they would not want to

increase risk, and they would rather opt to borrow shareholders.

3.5. Theories of Capital Structure: Miller and Modigliani Theory

In the original paper of 1958 Franco Modigliani & Morton Miller (M & M)

assumed a world of no taxes and concluded that the value of the firm is not

affected by its capital structure.

They argued that in a world with no taxes companies can not benefit from

leverage or debt financing.

1. Assumption Made

(a) Perfect capital markets no taxes, all investors

(b) All companies are clustered or grouped into equivalent returnclasses meaning that all firms within a class have the same degreeof business risk.

(c) Business risk can be measured by EBITand firms within the samedegree of risk are said to be in a homogeneous risk class.

(d) All investors have homogeneous expectations about future earningsand the riskness of those earnings.

(e) There are no personal or corporate taxes.

(f) There are no bankruptcy costs.

(g) The debt of companies and investors is risk free and so the interestrate on all debt is the risk free rate of return.

(h) All cash flows are perpetuities meaning all companies have zerogrowth.

2. Proposition of M & M in World with Taxes

This proposition says the value of any firm is found by capitalising its

expected net operating income of EBITat a constant rate.

WACC

EBIT

K

EBITV

su

==

Where:-


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V = Value of a Company / Firm

suK = Required Rate of Return.

lu VV =

Where:

uV = Value of an ungeared / unlevered firm

lV = Value of a geared / levered firm

Example:

Two companies Unilever & Longman are identical in every respect

except that Unilever is unlevered whilst Longman has $15 million of

15% debt outstanding.

Assume that all the M & M assumptions hold, there is no corporate or

personal taxes. The EBIT is $12 million for each company.

What value will M & M estimate for each firm?

Solution:

suKEBITV =

3,0

12=

million40$=

Value of Leveraged company = Value of unleveraged company

ul VV =

- According to their proposition in the world of no taxes, the value of

a firm is independent of its leverage.

- According to their proposition WACC for the firm is completely

independent of its Capital Structure. The WACC of the firm


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regardless of the amount of debt it uses is equal to the cost of

equity it would have if it uses no debt.

- The market capitalizes the value of the firm as a whole. There is no

distinguision between debt and equity. The total value of the firm is

independent of its capital structure.

- The total market value of the firm is given by capitalising earnings

at a discount rate appropriate for its risk class.

3. Proposition of M & M in World with no Taxes

The cost of equity of a levered firm is equal to the cost of equity of a

unlevered firm in the same risk class plus a risk premium whose size

depends on both the differential between the unlevered firms cost of

equity and the amount of debt being used.

premiumRiskKK suSL +=

( )S

DKKK dsusu +=

Where:

SLK = Cost of equity for levered firm

suK = Cost of equity for unlevered firm

D = Market value of a firms debt

S = Market value of a firms equity (excluding debt)

dK = Cost of debt

Example:

Two companies Unilever & Longman are identical in every respectexcept that Unilever is unlevered whilst Longman has $15 million of





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Calculate cost of equity for Longman.

Solution:

Cost of equity for Longman ( )S

DKKK dsusu +=

( )( )1540

1515,030,030,0

+=

39,0=

%39=

NOTE:

According to this proposition Number 2 the inclusion of debt in the

Capital Structure will not increase the value of the firm because

benefit of using cheaper debt will be exactly offset by an increase in

the riskness of the cost of equity.

Cost of Debt:

The cost of debt has two parts: -

- It has the explicit cost thats represented by the interest rates.

- The implicit or hidden cost which is represented by an increase in

the cost of equity which increases when the proportion of debt to

equity increases.

Example:


except that Unilever is unlevered whilst Longman has $15 million of




Calculate the value of Longman taking into account that it had debt in

its capital.

Solution:

Calculating value of Longman equity:


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SLL

K

KdDEBITV

=

( )

39,0

1515,012 x=

million25$=

4. Arbitrage Support of a Proposition

- To support the above proposition M & M cited the presence of

arbitrage in the capital markets

- Arbitrage merely prevents perfect substitutes from selling atdifferent prices in the same market.

- In this instance, perfect substitutes are deemed to be two or more

similar firms operating in the same risk class but differ only in terms

of capital structure.

M & M argued that the total value of these firms has to be the same

otherwise arbitrage will enter the market and derives the values of these

two companies together.

Example:


except that Unilever is unlevered whilst Longman has $15 million of15% debt outstanding.




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Calculate the WACC of Longman since Unilever one is 30%

(Remember ul VV = )

Solution:

WACCEBITV =

WACC

1240 =

40

12=WACC

30,0=

%30= - Same as Unilever

5. Proposition of MM in World with Taxes

In 1963 M & M published a certain article which assumed the existence

of corporate taxes with the inclusion of taxes they argued that leverage

will increase the value of the firm.

This arises because interest is a tax deductable expense and therefore

in a leveraged company operating income flows through the investors.

(a) Proposition 1 of M & M

The value of a levered firm is equal to the value of the unlevered

firm in the same risk class plus the gains from using leverage whichis the value of the tax shield.

TDVV uL +=

Where: -

TD = Tax shield


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LV = Value of Levered Firm

uV = Value of Unlevered Firm

TD = Corporate Tax Rate x Amount of Debt

( )su

uK

TEBITV =

1

Example:

Suppose both companies are now subject to a 40% tax in their

earnings but all the facts in the previous section still apply.

What value would M & M now estimate for each firm?

Solution:

Value of unlevered firm:-

( )

suu

K

TEBITV

=

1

( )

30,0

40,0112,0 =

24,0=

%24=

Value of levered firm:-

TDVV uL +=

)154,0(24 m+=

624+=

%30=


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According to this proposition the value of the firm is maximised when

the company uses 100% debt financing.

(b) Proposition 2 of M & M

The cost of equity of a levered firm is equal to the cost of equity of

an unlevered firm in the same risk class plus the risk premium

between the cost of equity and the cost of debt and the amount of

debt used (financial leverage) and amount of corporate tax rates.

( ) ( )S

DtKdKKK SUSUSL += 1

Example:

(i) What is the cost of equity for Longman?

(ii) Calculate the WACC for Longman.

Solution to (i):

Note that S = (30 15 (being cost of debt)

( ) ( )S

DtKdKKK SUSUSL += 1

( ) ( )15

1540.0115,030,030,0 +=SLK

( ) ( )160,015,030,0 +=

39,0=

%39= - Cost of Equity.

Solution to (ii):

Calculating WACC for Longman

( ) ( )eked KWKdWWACC +=

( )30

1540,0115,0

30

1939,0 +

=

24,0=


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%24=

3.6. Trade-off Model

The trade off theory states that the company must trade off or balance thetax advantages of using debt against the cost financial distress.

The theory states that there is an optimum debt ration that maximises the

market value off-setting the benefits of a tax shield against the increasing

cost of financial distress.

1. Definition

Financial distress occurs when a firm has debts. The greater the debts

financing the larger the fixed interest charges and the higher will be the

probability that the company will experience a decline in earnings

leading to financial distress.

2. Direct and indirect Cost of Financial Distress

(a) Direct Cost

It relates namely to costs of bankruptcy.

Bankruptcy Costs

It occurs as value of business declines

The financial conditions of a business deteriorate to the point when

bills are not paid for the value of equity is zero.

The direct bankruptcy costs are primarily legal and administrative

these are payments made to lawyers, accountants and consultants.

(b) Indirect Costs.

Destruction of Value

Arguments between claimants can often delay the liquidation

process.

Bankruptcy can take many years to settle and during this time

machinery rust and buildings may collapse.

Disruption & Management


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The collapse of a company in financial distress will result in the loss

of jobs to managers and other key employees

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