CHAPTER 1

CHAPTER 1ObjectiveS of organisations

ObjectiveS of organisationsCHAPTER 1

CHAPTER 1

Objectives of organisations1What is meant by financial strategy

Remember the usual distinction between strategy, tactics and operational control.

StrategyXE "Strategy" is a course of action, including the specification of resources required, to achieve a specific objective.

TacticsXE "Tactics" are the most efficient deployment of resources in an agreed strategy.

Operational controlXE "Operational control" is the management of daily activities in accordance with strategic and tactical plans.

Senior management select the strategy

Middle managers decide the tactics

Line managers carry out the operational control.

2The importance of financial strategy to the organisation

Financial strategyXE "Financial strategy" is that area of a companys overall strategy within the scope of the financial managers, including:

From which sources should funds be raised?

Should proposed investments be undertaken?

How large a dividend should be paid?

How should working capital be controlled e.g. should discounts be offered to debtors for prompt payment?

Should hedging strategies be adopted to avoid currency or interest rate risk?

3Financial strategy and overall corporate strategy

A companys overall corporate strategyXE "Corporate strategy" will be a portfolio of different strategies designed to carry out a long-term plan of action to attain specified objectives. It is therefore of critical importance to consider the possible objectives of organisations.

4Aims and objectives of organisations

In most exam questions a companys primary objective will be assumed to be the maximisation of shareholders wealth.

But one may need to discuss alternative concepts.

MaximisingXE "Maximising" and satisficingXE "Satisficing" Maximising means seeking the best possible outcome.

Satisficing means seeking only an adequate outcome.

In practice often the shareholders wealth will be maximised subject to satisficing other objectives such as paying the workforce high wages, respecting health and safety issues and minimising environmental damage. Stakeholder views are assuming increased prominence.

5The goals of different interest groups

Whose returns are we maximising:

community?

employees?

management?

ordinary shareholders?

Last option is normally assumed, but often relaxed in the decision-making process.

Each of the interest groups is likely to have different objectives.

Community may want low pollution and high involvement in local issues e.g. supporting local charities.

Employees want high wages and continuity of their employment.

Management want high wages and may want the company to be as large as possible so that they can empire-build.

Ordinary shareholders want high dividends and growth in the share price.

Other interest groups which might be considered are trade suppliers, trade customers, debt providers, government, etc.

Focal point

The stakeholder approachXE "Stakeholder approach" to business is currently a fashionable idea in UK academic circles, with all the stakeholders working together as a team. Do not overemphasise the role of shareholders in your exam answers. If the other stakeholders are not happy, then there will be fewer profits generated for distribution to the shareholders.

6Calculation of rates of return on ordinary shares

Possible measures of returns on shares would be:

profits

earnings per share

dividends

dividends plus capital growth.

The best measure of returns to equity investors is generally agreed to be dividend yield plus capital growth.

Example

Over the last year the share price of X plc has increased from 120p to 150p, while a dividend of 18p has just been paid. What percentage return has been earned by the equity investors over the year? Ignore tax.

Solution%Dividend yield

15

Capital growth

25Total return407Risk and return

Indifference curvesXE "Indifference curves" show the relationship between return and risk for a particular investor.

Return is the anticipated dividend yield plus capital growth from the investment.

Risk is the probability that the actual return will be different from that forecast.

Most investors are risk averse, so demand higher returns to compensate for higher risks, thus their indifference curves tend to be of the shape above.8Problems with the assumed objective of maximisation of wealth Objectives of other parties (employees, management) may conflict with the assumed objective of maximising shareholder wealth in such areas as:

takeovers (management and employees may be keen for the company not to be taken over)

time horizon (management may concentrate on short-term profits)

risk (management may avoid risk since their job depends on the future of the company)

gearing (again, management may seek the low risk of low gearing).

The conflict between managers objectives and shareholders objectives may partially be overcome by designing a remuneration package which takes shareholder wealth into account e.g. share options.

9Changing share ownership patterns

Despite the former Conservative governments privatisation programme, individual direct shareholdings have fallen while institutional shareholdings have increased.

The reasons for this trend can be summarised as:

tax advantages of institutional investment

growth in occupational pension schemes

growth in unit trusts

individuals have concentrated their savings in their houses

stockbrokers have marketed to institutions rather than cultivating private investors.

ISAs (Individual Saving Accounts) have not reversed the trend described above: the percentage of shares held by institutions continues to grow, while the percentage of shares held directly by individuals continues to fall.

CHAPTER 2

Conflicts of interest

1Directors powers and behaviour

Shareholders entrust the day-to-day management of their company to directors. The directors will generally set their own agenda to run the business; shareholders are entitled to attend AGMs and challenge the directors but in practice this seldom occurs.

Directors may be remunerated by a bonus system based on the companys profitability. They will therefore be motivated to report high short-term profits, perhaps at the expense of long-term profitability. Similar arguments apply if their company is vulnerable to take-over. Reporting high short-term profits should drive up the value of the business and discourage predators.

However in the 1980s several managements took this process too far and flattered their reported profits by indulging in creative accounting e.g. the use of leased assets rather than purchased assets, or the use of quasi-subsidiaries. The continuing work of the ASB should discourage these practices e.g. the virtual abolition of extraordinary items in FRS 3 and the requirement to consolidate quasi-subsidiaries in FRS 5.

2Agency theoryXE "agency theory" and governance

The shareholders have appointed the directors as their agents to run the company. There is an agency relationship in law between the two parties. Agency theory examines this relationship and postulates that the company can be viewed as a set of contracts between each of the various interest groups. Although each member of each group might act in his own self-interest, the groups as a whole (i.e. the company) will not thrive unless all the groups comprising the company are performing well.

For example, managers must see it to be in their interests for the company to prosper in the long-term, so they should not just seek to boost short-term profits.

3Conflict between interest groups

This has already been examined in Chapter 1.

4Goal congruenceXE "goal congruence" Goal congruence exists where each of the units within a business (i.e. individual employees, managers, directors, departments, etc) is seeking to achieve personal objectives which are also in the best interests of the business as a whole.

To persuade managers that a companys long-term strength should be pursued, remuneration schemes may be based on growth in a companys share price.

For options granted under an approved scheme, there is no tax charge when the option is granted (at the current market value) and also no tax charge when the option is exercised, providing that options are exercised between three and ten years after they are granted, and not more frequently than once in three years.

Focal point

The remuneration of senior managers is a topical issue, with public disquiet centred on directors receiving large pay rises in newly privatised utilities for doing much the same job. As explained earlier, the Combined Code requires listed companies to include a report from the remuneration committee in the companys annual report, setting out the companys policy for remunerating its executive directors.

5Non-financial objectives

The influence of the various parties with interests in the firm results in firms adopting many non-financial objectives, such as:

growth

diversification

survival

contented workforce

quality service

environment issues.

Some of these objectives may be viewed as specific to individual parties, whereas others may be seen as straight surrogates for profit, and thus shareholder wealth (e.g. quality service). Finally areas such as respect for the environment may be societal constraints rather than objectives.

6Non-executive directors

The role of non-executive directors has been covered in the Cadbury Report. The organisation PRO NED exists to promote the role of non-executive directors in UK business. Historically non-executive directors have often been chosen by the chairman from amongst his golfing friends; this is no longer acceptable.

7Corporate objectives

For the purposes of studying financial strategy you are recommended to initially accept the theoretical objective of the maximisation of shareholder wealth. This can be relaxed when evaluating and criticising the theories.

Small firm objectives will be similar to those of listed companies above except:

agency problems are often avoided due to owner-managers

maximisation of owners wealth is more likely than that of shareholders wealth as the shares are not listed.

Objectives of public corporations will depend upon in whose interests they are run. Presumably such organisations are run in the interests of society as a whole and therefore many of the benefits they provide to society will be intangible.

CHAPTER 3

Corporate governance

1Introduction to corporate governance

The Committee on the Financial Aspects of Corporate Governance (the Cadbury committee) defines corporate governanceXE "Corporate governance" as the system by which companies are directed and controlled.

Development in corporate governance in the UK was slow until the establishment of the Cadbury committee in May 1991 and the publication of the Cadbury ReportXE "Cadbury Report" in December 1992 bounced the topic into the forefront of UK debate.

Main issues that have emerged in corporate governance:

trying to ensure a suitable balance of power on the board of directors

trying to ensure that directors are remunerated fairly

ensuring that the external auditors remain independent

making the board of directors responsible for monitoring and managing risk

other related issues include business ethics and corporate social responsibility.

UK practice in corporate governance can be compared to other systems internationally. Differences arise from the different traditions under which financial statements are prepared.

USA practice

SEC imposes quarterly reporting requirements.

all listed companies are required to have an audit committee.

German practice

large companies generally have a two-tier board system, with separate management board and supervisory board.

banks providing credit to a company will often hold a long-term equity stake in the company.

Japanese practice

traditionally companies wishing to do business with each other will buy shares in each other to symbolise their long-term relationship. Many companies were therefore sheltered from the attentions of external shareholders requiring dividends and interested in day-to-day matters. However the system of cross-holdings is now reducing.

2The debate on corporate governance in the UK

The Cadbury Report was published in December 1992, containing a Code of Best Practice.

The Greenbury ReportXE "Greenbury Report" was published in July 1995. It builds on the work of the Cadbury committee in setting out best practice in disclosing details of directors remuneration in a companys annual report.

The Hampel Report in 1998 brought together the previous recommendations of Cadbury and Greenbury, and submitted a proposed Code to the Stock Exchange which listed companies should comply with.

The Stock Exchange published its Principles of good governance and code of best practice (known as the Combined Code XE "Combined Code" ) in June 1998. All listed companies must now disclose in their annual report and accounts how they have applied the principles and complied with the Code.

The Combined Code is in two sections.

Section 1 is a code for listed companies and has four parts dealing with:

directors, including board meetings, roles and balance

directors' remuneration

the relations of the company with its shareholders

accountability and audit.

Section 2 is a code for institutional shareholders investing in listed company shares.

The Turnbull Report XE "Turnbull Report" was published in 1999 to publish guidelines to listed companied on how to apply the Principles of the Code.

The Higgs Report XE "Higgs Report" and the Smith Report XE "Smith Report" were published in 2003.

Focal point

The debate over corporate governance issues is of great importance to the future of the accounting profession. Keep up to date with this issue by reading articles on this topic in the professional press.

CHAPTER 4

strategy formulation

1The three levels of control

Strategic control ROCE, RI, gearing levels.

Tactical control pricing decisions, cash flow forecasts.

Operational control budgets, variance analysis.

Focal point

Note that the strategic level of control relates to the long term whilst operational control relates to the shorter term. Remember this when considering the information requirements for each level of control.

2Information requirements for financial control, forecasts, decision support and monitoring

definition of control.

budget variances.

sales variances.

variance analysis.

You will have met the control process in your earlier studies and will appreciate the three aspects of:

setting standards as performance guidelines

measuring actual performance

comparing the two and taking corrective action if required.

3Information needs of short-term financial planning

projected profit and loss account.

projected cash flow statement.

projected balance sheet.

statement of relevant assumptions.

statement of contingency plans.

financing implications.

methods of control.

A short-term plan would generally be prepared for the forthcoming one year period, broken down if required into months or quarters. The cash flow statement, in particular, would normally be prepared on a month-by-month basis.

4The financing of working capital

Within a business, funds are required to finance both fixed and current assets. The level of current assets fluctuates, although there tends to be an underlying current asset requirement.

The task of financial forecasting includes estimating the total permanent assets over time, and also the likely range of fluctuating assets.

5Meeting short- and medium-term financial objectives

The control of cash flows is of key interest to the financial manager, because the forecast financing requirement must be satisfied. The manager can take early steps to research potential sources of new finance before a crisis emerges.

6Business plans

Business plans set out how to achieve specific financial objectives. The plan covers a number of years (three to five typically, but could be longer) and is part of the companys overall strategic plan.

The plan is developed from forecasts:

environmental forecasts

industry forecasts

forecasts for the company itself.

7Analysing performance through ratios and other techniques

Ratios are of particular relevance when the performance of the profit centre and its constituent parts is measured by comparison with other organisations or parts of the profit centre.

Focal point

When analysing performance through the use of ratios it is important to use comparisons. A single ratio holds little information and is only of use when compared with other ratios, competitors, and over time.

Evaluation of the organisation as a whole ratios can be calculated from data produced by the accounting information system. Ratios can be used:

to compare results over a period of time

to measure performance against other organisations

to compare results with a target.

Key ratio used in practice is return on capital employed (ROCE):XE "Return on Capital Employed (ROCE)" ROCE may be termed return on investment (ROI).

Evaluation of parts of the organisation

If the accounting information system can break down parts of the organisation as investment centres all the ratios used for evaluation of the performance of the organisation can be computed and can be used in the same ways.

Other ratios are required for non-investment centres.

Structure of operating ratios the pyramid

Focal point

When answering exam questions it is important not to calculate ratios at random, nor to calculate too many ratios. Start at the top of the pyramid and then by using the comparisons mentioned previously, further analyse the problem areas.

ROCE = %

Fixed assets may be included in capital employed at various values.

Gross value (original cost):

comparison is facilitated

if net values are used, ROCE increases as an asset ages because of the reducing capital employed figure in the denominator

all assets are included, even those that have been fully depreciated.

Net value (net book value):

values after deduction of depreciation are shown in the balance sheet

profit is taken after deductions for depreciation. Therefore, net asset values should be used for consistency.

Gross profit percentageXE "Gross profit percentage" =

Should be constant. Variations due to:

selling prices

sales mix

items included in purchases (e.g. trade discounts, carriage)

items included in production cost

stock (obsolescence, shortages).

Affected by errors in stock valuation.

Stock turnoverXE "Stock turnover" =

Average stock holding period =

Where stock turnover is high:

indication of efficiency

danger of stockouts.

Low stock turnover indicates funds tied up unnecessarily

Changes in ratio due to:

improving/deteriorating efficiency

changes in management policy e.g. bulk purchases to get trade discounts.

Limitations:

inclusion of obsolete stock

different stock valuation policies

average calculation based on beginning and year-end stock may not represent actual average in year.

Debtor daysXE "Debtor days" =

Changes due to:

improving/worsening credit control

major new customer pays fast/slow

change in credit terms

early settlement discounts.

Norm = stated credit terms, e.g. 30 days.

Limitation are year-end debtors typical of level?

Creditor daysXE "Creditor days" =

High or increasing period:

may be good as credit from suppliers represents free credit

if excessive, suppliers will not extend credit

if excessive, may indicate insolvency.

Limitation are year-end creditors typical of level?

Current/working capital ratio

Norm 2:1 but industry variation.

Low ratio may indicate insolvency.

High ratio may indicate not maximising return on working capital.

Can be manipulated by window dressing.

Liquidity, acid test or quick ratio

Measures more immediate position (i.e. excludes stock).

Norm 1:1 but industry specific.

Can be manipulated by window dressing.

GearingXE "Gearing"

Denominator could be computed on the assets side of the balance sheet:

total assets less current liabilities

Market values or book values could be used.

Highly geared company

Substantial proportion of capital is preference shares, debentures or loan stock.

Share price often more volatile.

Must have stable profits and suitable assets for security e.g. property investment, hotel industry.

Limitations

Distorted by different accounting policies e.g. treatment of goodwill, revaluing assets.

Non-recording of assets e.g. operating leases.

8Controlling cash flows

Most cash control is carried out by drawing up traditional cash flow forecasts for future periods.

Forecast surpluses can then be invested until they are required.

Forecast deficits can be managed by changing the timing of receipts and payments:

offer prompt payment discounts to debtors

delay payments to creditors

defer discretionary purchases

raise new funds externally.

9Stock exchange ratios

Such ratios are significant to investors in reaching their decision of whether or not to increase or reduce their shareholding in a company:

dividend yield

earnings per share

price earnings ratio.

Dividend yields are generally calculated net of tax.10Comparing actual and expected performance

Horizontal analysis line by line analysis of current year with previous year(s). Extending the horizontal analysis over a number of years provides trends.

Example

20X320X4% change

mm

Turnover951.91,156.5+ 21.5

Cost of sales 617.1 739.0+ 19.8

Vertical analysis

Each balance sheet item is expressed as a percentage of the balance sheet total.

Each profit and loss account item is expressed as a percentage of sales (or earnings).

Example

Common size statements

20X320X420X320X4

mm%%

Fixed assets

Land and buildings156.9169.032.230.4

Plant and machinery202.8239.541.643.2

359.7408.573.873.6

Current assets

Stocks, debtors305.0344.062.562.0

Creditors

(due within 1 year)(163.5)(181.6)(33.5)(32.7)

Creditors (due over

1 year) (13.5) (16.0) (2.8) (2.9)

487.7 554.9100.0100.0

other techniques:

standard variance analysis

product life cycle analysis

learning curve analysis.

CHAPTER 5

Expansion and market maintenance strategies 1Short-term and long-term financial planning

Long-term financial planning depends on:

corporate philosophy and mission statement

meeting the shareholders required rate of return

what if analysis on spreadsheets

gap analysis.

Focal point

When answering an exam question it is important to consider the firms mission when analysing its performance. If required, clues as to the firms mission will be found in the question.

Gap analysis examines the difference between a companys estimated future performance and the managements desired position.

Ways of closing the gap:

improved internal efficiency

expansion within the present industry

diversificationXE "Diversification" into new fields.

The planning exercise continues via:

strategic plans

tactical plans

operational plans

monitoring deviations of actuals from operational plans.

Companies are often accused of favouring short-term profitability at the expense of long-term prosperity. Some of the reasons are:

reward systems

fear of disappointing the markets

fear of take-over

dominance of accountants (perhaps) in UK industry.

2Top down and bottom up planningXE "Bottom up planning" systems

Top downXE "Top down planning" senior management announce instructions which filter their way down through the organisation structure.

Bottom up information is gathered from lower levels, which is consolidated until a summary is produced for the board.

Long-term strategic decisions are ultimately the responsibility of senior management. They cannot shirk this role.

3Using budgets to influence the success of financial planning

long-term plans are implemented by developing them into a series of shorter term plans or budgets.

definition of budgetsXE "budgets": a plan expressed in money

You will have studied budgetary control in previous examinations.

4The relationship of investment decisions to long-term planning

Types of investment decision:

internal investments

external investments

divestments.

If the long-term planning objective is to maximise the wealth of shareholders, then conventional DCF analysis can be applied to investment decisions.

5Alternative strategies for long-term growth

conservative growth or high growth high growth is achieved by rapid diversification into similar markets as well as completely new markets.

Acquisition diversification.

horizontal diversification.

vertical diversification (backwards and forwards).

concentric diversification.

conglomerate diversification.

the search for synergy (2 + 2 = 5).

CHAPTER 6

The Valuation of Securities

1Models for the valuation of shares and bonds

All formulae use the fundamental relationship that the value of a security equals the present value of the expected cash inflows arising from owning the security.

Constant dividends

P0 =

Constant dividend growth

P0 = =

Estimating g

Extrapolation of past dividends i.e. dividend growth model e.g.

g =

Earnings growth model

g= br;b =

r =

Symbols

k=the shareholders cost of capital

P0=ex dividend market value of equity

d=total annual dividend payment

d0=total current dividend

d1=total dividend in one years time

g=dividend growth rate

b=retention rate

r=return on reinvested funds

EAIT=earnings after interest and tax

=EPS SYMBOL 180 \f "Symbol" number of shares

Notes

Remember that P0 is the ex div market value

Ex div MV = Cum div MV d0Focal point

Throughout the Strategic Financial Management paper the formulae relating to the valuation of securities and calculation of costs of capital are based on ex div security prices. This is because the equations are formed using discounting theory taking into account flows starting in one years time.

For determining g from past dividends, look out for the relevant period e.g. dividend growth over a four year period will give five dividend figures.

PE ratio =

Dividend cover =

Similar formulae apply for irredeemable bonds as they do for shares.

ExamplePodge plc has just paid a dividend of 14p per share. Two years previously the dividend was 12p per share. The companys shareholders have a cost of capital of 16%. Estimate the fair value of the share price.

Solution

12 (1 + g)2=14

g=8%

P0 =

= 189p

ExampleThe ordinary shares of Z plc are quoted at 3 ex div. The dividend just paid was 30p per share; four years ago the dividend was 25p per share. Estimate the cost of equity.

Solution

1 + g = = 1.0466 SYMBOL 92 \f "Symbol" g = 4.66%

ke= + g = + 0.0466 = 15.126%

2Limitations of such models

assumption of constant future growth rate could be wrong.

investors are assumed to be rational and risk-averse.

ignores asset values.

ignores earnings values.

ignores investors different tax positions.

Focal point

Although theoretically the correct value of a share is the NPV of its future income stream, be careful not to ignore other simpler methods of valuing shares such as calculating a net asset value or using a PE ratio (as explained below). Calculating the values of shares by different methods may give different valuations, but this extra information is a good thing, not a problem.

3Accounting information and share valuation

shares can be valued using

net assets basis

price per share = EPS SYMBOL 180 \f "Symbol" agreed PE ratio. XE "PE ratio" however, accounting information is based on the past, whereas in buying a share one is buying a series of future cash flows.

4Value-based measures

Economic Value Added (EVA) XE "Economic Value Added (EVA)" focuses on the concept of economic income.

Market Valued Added (MVA) XE "Market Valued Added (MVA)" is the value added to the business by management since it was formed.

Shareholder Value Added (SVA) XE "Shareholder Value Added (SVA)" represents the discounted future free cash flows less the value of the company's debt.

5Practical influences on share prices, including reasons why share prices differ from their theoretical values

good asset backing i.e. high net asset value per share.

level of earnings.

technical factors e.g. a larger number of sellers than buyers one day will tend to drive the price down.

changes in forecasts taking time to disseminate through the market.

distrust of particular management figures e.g. some fund managers always refused to own shares in companies involved with Robert Maxwell.

6The term structure of interest rates (yield curve)XE "Term structure of interest rates" The term structure of interest rates refers to the way in which the yield of a debt security varies according to the term of the security i.e. to the length of time before the borrowing will be repaid.

Normally, the longer the term of a security, the higher will be its gross redemption yieldXE "Gross redemption yield" (i.e. interest yield plus capital gain or loss to maturity).

Check that this is the case by looking at the UK Gilts Prices section of the Financial Times. The redemption yield on shorts will normally be less than the redemption yield of mediums and longs.

The yield curveXE "Yield curve" at any time shows the graph of gilts redemption yields plotted against the term of each gilt.

For example a gilt with five years before redemption could be expected to yield just over 5% pa until redemption, while a 20 year gilt would yield nearly 6%.

The normal form of yield curve is upwards sloping as shown in the graph. This can be explained by investors liquidity preference i.e. the fact that investors need to be compensated with a higher yield for being deprived of their cash for a longer period of time.

Unusually, the yield curve might become inverted i.e. downwards sloping. This arises when the expectations of investors generally are that interest rates are going to fall, so that short-term rates are higher than long-term rates.

A further factor affecting the shape of the yield curve is market segmentation theory. This suggests that different categories of investors are interested in different segments of the curve (e.g. building societies in the short end and pension funds in the long end). The two ends of the curve might therefore react differently to the same set of economic news.

Financial managers should inspect yield curves primarily to assess the markets expectations of future movements in interest rates.

7Models for the valuation of debt and other securities

The principles of valuing debt as the present value of the cash flows arising are exactly the same as for shares.

Irredeemable debt

P0 =

whereP0=ex int market value of debt

I=interest payments (net of tax if appropriate)

k=the required return (net or gross of tax)

Note: If I is net of tax, k must be net of tax.

Redeemable debt

P0 = present value of interest payments + present value of redemption amount

Convertible loan stock

If the option to convert into ordinary shares at tn is exercised, the cost is the IRR of the following cash flows

t0

(Ex interest market value of debt)

t1 SYMBOL 174 \f "Symbol" n

Interest SYMBOL 180 \f "Symbol" (1 SYMBOL 45 \f "Symbol" T)

tnMarket value of ordinary shares into which the debt is to be converted

Bank loans and overdrafts

Cost = interest rate SYMBOL 180 \f "Symbol" (1 SYMBOL 45 \f "Symbol" T)

Key to symbols above

kd=cost of debt

P0=ex interest market value of debt

I=total annual interest payment

T=rate of corporation tax

Notes

The cashflows for the determination of the cost of redeemable (and irredeemable) debt would need to be adapted if there were a lag in the tax relief.

Preference dividends are payable from post-tax profits and therefore should not be reduced by tax in the formula.

If no conversion ratio is given for convertible loan stock, it must be assumed that it will remain as debt.

Value convertible loan stock at the higher of entry value into equity and value as a straight loan stock.

Warrants

Value at the excess of entry value into equity over the current equity price.

Example Podge plc has irredeemable 10% debentures. Tax is payable at 33% and investors continue to require 16% (gross) on their investments. Estimate the fair value of a 100 debenture.

Fair value=

=

=62.50

ExampleThe 8% debentures of Y plc are quoted at 95 ex int and are redeemable at par in two years time. Corporation tax is paid at 33%. What is the net of tax cost of debt?

Solution

The cost of debt is the IRR of the following cash flows.

TimeCash flowDiscount factorPVDiscount factorPV

at 10%at 8%0(95)1(95)1(95)

18 SYMBOL 180 \f "Symbol" 0.67 = 5.360.9094.870.9264.96

2105.360.826 87.030.857 90.29

(3.10)

0.25The net of tax cost of debt to the company is slightly over 8%.

CHAPTER 7

Investment decisions1What is meant by adequate financial return?

in practice shareholders will have a satisficing objective i.e. they will seek a satisfactory return from an investment.

similarly companies will seek a satisfactory return from projects that they undertake.

There are several ways in which an adequate financial return could be measured:

profits

profits per share

ROCE

dividends

dividend + capital growth.

This last item is the accepted measure of shareholders wealth.

Since profits can be distorted by the selection of different accounting policies and by inflation, measures of return based on cash flows are preferred.

2The benefits of using net present value

The assumed primary corporate objective is generally the maximisation of shareholder wealth. Fundamental analysis implies that shareholder wealth equals the net present value of cash flows arising. NPV analysis can therefore unite shareholders and management in a common objective.

Focal point

The concept that shareholder wealth equals the net present value of cash flows arising provides the basis for the dividend valuation model. This concept is fundamental to financial strategy and the valuation of securities.

Other measures of project return are possible:

AdvantagesDisadvantages

PaybackXE "Payback"

Easy to understandIgnores the time value of money

The number of years it takes to recoup the initial investmentUses earlier cash flows which are more certain

Uses cash flows not profits

Useful measure if short of cashIgnores cash flows after payback period

Difficulty in finding a target period

Accounting rate of return

% return on investment in terms of accounting profitEasy to understand

Percentage result more acceptable to managementBusiness is judged by ROI by financial markets

Management often judged on ROI

Ignores the time value of money

Does not use cash flows

Ambiguity over definitions in formula

Difficulty in finding a target ARR

Net present value

Calculate using formula or tables

Accept only projects with positive NPV or rank mutually exclusive projects in order of NPVUses the time value of money

Unambiguous criteria for accept/reject decision

Direct link with assumed objective of investment appraisalNot easily understood by management

Requires cost of capital

3NPV analysis

NPV is based on cash flows, not profits.

exclude non-cash flow credits and charges e.g. depreciation.

ignore sunk costs.

relevant costs are opportunity costs and incremental cash flows.

deal with inflation by either discounting money flows at the money rate, or real flows at the real rate. Do not mix them up.

Focal point

If inflation is affecting different costs at different rates (as is normally the case), then it is much easier to deal with inflation in a DCF question by discounting money cashflows at money discount rates. This is the usual approach in exam questions.4The meaning of the time value of moneyXE "Time value of money" There is a time preference for receiving the same sum of money sooner rather than later.

5Reasons for time preference

Consumption preference SYMBOL 45 \f "Symbol" money received now can be spent on consumption.

Risk preference SYMBOL 45 \f "Symbol" risk disappears on receipt of money.

Investment preference SYMBOL 45 \f "Symbol" money received can be invested internally or externally.

6Simple and compound interest

Simple interestXE "Simple interest" SYMBOL 45 \f "Symbol" interest is paid when due and not added to the capital balance on which subsequent interest will be calculated.

Compound interestXE "Compound interest" SYMBOL 45 \f "Symbol" interest is added to the capital outstanding and it is on this revised balance that interest will be calculated.

Compounding formula:

S = P (1 + r)nwhereS=final amount

P=initial investment

r=interest rate for the time period (usually rate for a year)

n=number of time periods (usually number of years)

7The meaning of present valueXE "Present value" Definition: the present value of an amount S receivable in n years is that sum of money which, invested at the current annual rate of interest, r, will amount after compounding to S after the expiry of n years.

SYMBOL 92 \f "Symbol" P =

ExampleWhat is the present value of 500 in three years when r = 20%?

Solution

P=

=

=289

ACCA tables show values for for different values of r and n

r=column headings

n=row headings

Steps to use the tables:

select the appropriate r column

select the appropriate n row

read off the value of the intersection = the present value factor

multiply the factor by the cash flow = the present value.

ExampleUse the ACCA present value table to estimate the present value of 500 in three years at a discount rate of 20% p.a.

Solution

From tables, present value factor = 0.579 for r = 20%, n = 3

SYMBOL 92 \f "Symbol" Present value = 500 SYMBOL 180 \f "Symbol" 0.579 = 289 (as before)

8Estimation of IRR and NPV of a project and recommendation of project acceptance or rejection

Net present valueXE "Net present value": the net amount of all cash flows associated with the project discounted back to the beginning of the project.

Internal rate of returnXE "Internal Rate of Return" (IRR): that discount rate which gives a net present value of zero to a projects cashflows.

Investment decisions:

IRR if the IRR on the project is greater than the cost of capital accept

NPV if the present value of cash inflows less cash outflows is positive when discounted at the cost of capital accept.

ExampleA project requires an initial investment of 1,000 and generates cash inflows of 300, 400 and 500 respectively during Years 1, 2 and 3 of its life. The cost of capital is currently 10% p.a. Show whether the project should be accepted:

(i)by calculating the NPV of the project

(ii)by estimating the IRR of the project.

Solution

(i)TimeCash flowDiscount factorPresent value

at 10%

0(1,000)1(1,000)

13000.909273

24000.826330

35000.751 375

(22)

The project has a negative NPV so should be rejected.

(ii)10% is too high a discount rate. Try a smaller one, say 5%.

(iii)TimeCash flowDiscount factorPresent value

at 5%

0(1,000)1(1,000)

13000.952286

24000.907363

35000.864 432

81

Interpolating between the two,

IRR SYMBOL 187 \f "Symbol" 5% SYMBOL 43 \f "Symbol" = 8.9%

Since the IRR is less than the cost of capital, the project should be rejected.

9The meaning of an annuityXE "Annuity" Annuity: Definition a cash receipt, received each year, starting at Year 1, for a series of years.

Valued according to the ACCA cumulative present value tables.

PerpetuityXE "Perpetuity": Definition an annuity to be received indefinitely.

Present value of a perpetuity=

where a =annual amount receivable

r=discount rate

IRR of a perpetuity

=

where a=annual amount receivable

P=initial investment at time 0

ExampleA project requires an initial investment of 1,000 and generates an annual cash inflow of 150 for the ten years of its life. The cost of capital is currently 10% p.a.

(i)Recommend whether the project should be accepted by calculating its NPV.

(ii)If the project generated 150 p.a. in perpetuity rather than only for ten years, would this change your recommendation?

Solution

(i)NPV=SYMBOL 45 \f "Symbol" 1,000 SYMBOL 43 \f "Symbol" (150 SYMBOL 180 \f "Symbol" 6.145)

=SYMBOL 45 \f "Symbol" 78

Since the projects NPV is negative, it should be rejected.

(ii)Revised NPV = SYMBOL 45 \f "Symbol" 1,000 SYMBOL 43 \f "Symbol"

= 500

Since the projects NPV is now positive, it should be accepted.

10The efficient markets hypothesisXE "Efficient markets hypothesis" Weak form share prices reflect all the information contained in the record of past prices. As a result it is not possible to predict future share price movements by reference to past trends. Share prices follow a random walk.

Semi-strong form share prices also reflect all current publicly available information. Therefore prices will change only when new information is published. As a result it would only be possible to predict share price movements if unpublished information were known (insider dealing).

Strong form share prices reflect all information that is relevant to the company.

If this is the case then share price movements can never be predicted.

Gains through insider dealing are not possible because shares are priced absolutely fairly.

Focal point

It is generally believed that the UK stock market is at least semi-strongly efficient, although the sudden corrections of October 1987 and 1997 offered a serious challenge to this belief.

11The meaning of market efficiencyXE "Market efficiency"

Definition

An efficient market is one in which the market price of all securities traded on it reflects all the available information.

If this is correct, a companys real financial position, with respect to both current and future profitability, will be reflected in its share price.

Implications of EMH

Markets have no memory the pattern of past price changes contains no information about future changes.

Trust market prices in an efficient market they reflect all available information and are fairly valued.

There are no financial illusions investors are concerned only with the companys cash flows i.e. changes in accounting or dividend policies are irrelevant.

The do-it-yourself alternative mergers are often justified on the basis that they result in a more diversified and more stable firm, but investors can achieve their own diversification by holding different securities.

Seen one share, seen them all investors buy a share because it offers a fair return for its risk, not for any specific qualities. Therefore shares should be close to perfect substitutes for each other such that if the return on one is too low relative to its risk, nobody will want to hold that share, and vice versa if the return is too high.

Reading the entrails since market prices reflect all available information, a study of their detailed build up may be used to make predictions about the future.

Focal point

The efficient markets hypothesis should be thought of as a scale of market efficiency. Efficiency is measured in relation to the degree of relevant information reflected in the share price. As with many measurement scales, the extremes may not be observed in the real world.

CHAPTER 8

Portfolio TheoryXE "Portfolio Theory"1Introduction to portfolio theory

Portfolio diversification reduces risk. Investors are assumed to be risk averse, so diversification pleases investors by offering expected returns at lower risk than individual securities.

The better the negative correlation between the investments, the better the diversification (e.g. umbrellas and ice cream).

2RIsk and return of portfolios Two security portfolios:

return = weighted average of individual security returns

risk is not equal to weighted average of individual security standard deviations (unless perfectly positively correlated) (anything less than perfect positive correlation results in risk reduction).

Formulae

Variance, Var

=

Standard deviation,

=

Expected value,

=

Covariance, Covxy=

or

=

Correlation, Corxy

=

or

=

Return on a two asset portfolio,

Risk of a two asset portfolio,

wherexA is the proportion of investment A in the portfolio

1SYMBOL 45 \f "Symbol"xAis the proportion of investment B in the portfolio

is the expected return from the portfolio

is the expected return of investment A

is the expected return of investment B

is the standard deviation of the returns from the portfolio

is the standard deviation of the returns from the investment A

is the standard deviation of the returns from the investment B

CorABis the correlation between the returns of investments A and B

Example

Investment A has an expected return of 15% and variance of 13%, while investment B has an expected return of 12% and variance of 12%. Their covariance is 3.

Compute the return and risk of portfolios of investments A and B when the proportions of the total amount invested are as follows:

Investment:AB

(a)Proportion:0.20.8

(b)Proportion:0.70.3

Solution

(a)xA = 0.2

=(0.2 SYMBOL 180 \f "Symbol" 15%) + (0.8 SYMBOL 180 \f "Symbol" 12%)

=12.6%

Varp=(0.22 SYMBOL 180 \f "Symbol" 13) + (0.82 SYMBOL 180 \f "Symbol" 12) + (2 SYMBOL 180 \f "Symbol" 0.2 SYMBOL 180 \f "Symbol" 0.8 SYMBOL 180 \f "Symbol" 3)

=9.16

p=eq \r(9.16)

=3.03%

(b)xA = 0.7

=(0.7 SYMBOL 180 \f "Symbol" 15%) + (0.3 SYMBOL 180 \f "Symbol" 12%)

=14.1%

Varp=(0.72 SYMBOL 180 \f "Symbol" 13) + (0.32 SYMBOL 180 \f "Symbol" 12) + (2 SYMBOL 180 \f "Symbol" 0.7 SYMBOL 180 \f "Symbol" 0.3 SYMBOL 180 \f "Symbol" 3)

=8.71

p=eq \r(8.71)

=2.95%

Focal point

Note the following important results:

SYMBOL 183 \f "Symbol" \s 10 \hWhen CorAB = +1, the risk of the two asset portfolio becomes the weighted average of the risks of each asset.

SYMBOL 183 \f "Symbol" \s 10 \hWhen CorAB = 0, the final term in the p equation is eliminated.

SYMBOL 183 \f "Symbol" \s 10 \hCorAB affects the risk of the two asset portfolio and not the return.

As xA in the above example varies from 0 to 1, we can prepare a graph of the possible risk-return combinations available from holding a portfolio comprising proportions of A and B.

3Mean-variance efficiencyXE "mean-variance efficiency", efficient portfoliosXE "Efficient portfolios" and the efficient frontierXE "Efficient frontier"

A portfolio is mean-variance efficient if it offers the maximum return for a given level of risk, or the minimum risk for a given level of return.

All efficient portfolios lie on the efficient frontier.

4UtilityXE "utility" and its importance to portfolio selection

Investors are each assumed to be trying to maximise their own personal utility. Indifference curvesXE "Indifference curves" can be drawn for a particular investor showing combinations of risks and returns that offer that investor equal satisfaction i.e. equal utility. An investor will therefore choose the portfolio on the efficient frontier which cuts the highest indifference curve on the graph to maximise his utility.

5Portfolio selection when both risky and risk free assets are available

Combining a risk free asset with a single risky asset is a special case of the two asset portfolio considered earlier, where one of the assets has a certain return and zero standard deviation. The efficient frontier is then the straight line joining the risk free asset and the risky asset i.e. there is a straight-line trade-off between return and risk.

When a risk-free asset is combined with many risky assets, the conclusion emerges that there is only risky portfolio worth considering, comprising the whole market portfolio M. The portfolio selection therefore simplifies to selecting the optimal point along the capital market lineXE "Capital market line".

EMBED MSDraw \* mergeformat

Capital market line =

new efficient frontier =

market price of risk

Rf=risk free rate

Rm=return on

market portfolio

SYMBOL 115 \f "Symbol"m=SYMBOL 115 \f "Symbol" on market

portfolio

Approximations in practice

Rf could be estimated as the return available from Treasury Bills.

Rm could be estimated as the return available from a world index such as the FT/S&P World Index.

SYMBOL 115 \f "Symbol"m could be estimated as the standard deviation observed on a world index such as the FT/S&P World Index.

Equation of CML:

Rj= Rf +

Slope = The market price of risk and

Rj=required return for portfolio f which lies on the CML.Focal point

The introduction of risk free securities results in all portfolios inside the original opportunity set becoming relatively inefficient. Higher returns for each level of risk can be achieved by investing in a combination of risk free securities and the market portfolio and hence moving on to the CML.

Investors can choose a combination of risk free securities (e.g. government-backed Treasury Bills) and risky securities (the whole stock market). The straight line FM and beyond is their efficient frontier.

Example

An investor has 100 to invest. The following information is available:

Rm=15%(Return on portfolio m)

m=10%(Risk of portfolio m)

Rf=6%(Risk-free rate of return).

You are required to plot the capital market line and show that a lending portfolio (of 50 invested at the risk-free rate and 50 invested in portfolio m) and a borrowing portfolio (of 50 borrowed at risk-free rate and 150 invested in portfolio m) lie on this line.

Solution

To calculate portfolio returns we can treat the two investment opportunities as a two-asset portfolio, hence:

Lending portfolio

=0.5 SYMBOL 180 \f "Symbol" 15% + 0.5 SYMBOL 180 \f "Symbol" 6%

=10.5%

p=

=

=5%

Borrowing portfolio

Note: 150% of original stake is invested in M, 50% is borrowed.

=(1.5 SYMBOL 180 \f "Symbol" 15%)SYMBOL 45 \f "Symbol"(0.5 SYMBOL 180 \f "Symbol" 6%)

=19.5%

p=

=15%

(This shows that gearing up equity portfolios is a profitable but risky business.)

A graph can then be drawn showing that the returns and risks calculated for the portfolios above lie on the CML.

6The nature and significance of the Capital Market Line

The line joining the risk free rate (point F) to a portfolio of all quoted shares (point M) and beyond is called the Capital Market Line. It is the efficient frontier comprising efficient combinations of risk free and risky investments. Individual investors should select the point along this line at which their utility is maximised.

7Portfolio theory and practical financial management

Problems

need to assess the risk/return preferences of shareholders.

portfolio theory is only a single time period model.

forecasting returns and the correlations between returns is difficult.

However it is valuable for managers to appreciate the benefits of diversification, especially in unquoted companies where the shares might comprise a large proportion of the shareholders wealth. Larger companies should not be so keen on diversification, since their shareholders can become diversified by buying a selection of shares in different companies rather than relying on the companies themselves being diversified.

8limitations of portfolio theory

problems mentioned above.

measuring risk as the standard deviation of expected returns is not the whole story; there are other costs (e.g. the risk of bankruptcy) associated with high risk investment strategies.CHAPTER 9

The Capital Asset Pricing ModelXE "Capital Asset Pricing Model"1Systematic and unsystematic risk

systematic riskXE "systematic risk" depends on the market as a whole.

unsystematic riskXE "unsystematic risk" is unique to each companys shares.

Unsystematic risk can be eliminated by holding a diversified portfolio.

Focal point

This distinction between systematic and unsystematic risk is vital to the Capital Asset Pricing Model (CAPM). The assumption that return is only required to compensate for systematic risk is fundamental to the model. Contrast this with portfolio theory which considers only total risk.2The security market lineXE "Security Market Line" Only systematic risk commands returns in an efficient market. In CAPM systematic risk is measured by an index called SYMBOL 98 \f "Symbol". Risk-free assets have a SYMBOL 98 \f "Symbol" of zero. The market as a whole has a SYMBOL 98 \f "Symbol" of one. The systematic risk of all other securities is measured by reference to these values.

Equation of SML

Rj = Rf + SYMBOL 98 \f "Symbol" (Rm SYMBOL 45 \f "Symbol" Rf)

3Establishing beta factorsXE "Beta factors" for individual securities

We need to determine future factors for each individual company (in order to appraise future investments). In practical terms we will content ourselves with establishing past s and use these to appraise required returns on fresh investment projects.

The normal way of measuring s is to use regression analysis. The following diagram gives a graphical representation of this analysis.

The slope of the line gives the securitys SYMBOL 98 \f "Symbol" factor. Here the line is very steep and the SYMBOL 98 \f "Symbol" factor will be greater than 1.0.

If we performed similar analysis for another security we might obtain the following results.

In this case security z is of a low degree of systematic risk as it is far less volatile than the market portfolio. Its beta factor will be less than 1.0.

4AlphaXE "Alpha factors" factors and beta factors

Focal point

Note the differences between the axes of the security market line graph and the security characteristic lineXE "Security characteristic line" graph. This is a common cause of confusion.

By regressionSlope of line = SYMBOL 98 \f "Symbol"j =

=

=

SYMBOL 97 \f "Symbol" = the abnormal return i.e. the return observed greater than that forecast by CAPM. Sometimes also called the rate of price appreciation.

SYMBOL 98 \f "Symbol" = a measurement of the systematic risk.

5Problems of using historic data; stability of beta over time

Beta is calculated statistically from past observed returns.

the longer the period inspected, the better.

the more data inspected, the better, so perhaps use a sector average SYMBOL 98 \f "Symbol" rather than just one companys SYMBOL 98 \f "Symbol".

Beta will only be stable if the companys systematic risk remains stable i.e. the company carries on the same areas of business research indicates that betas are more or less constant over time.

6The assumptions of CAPM

total risk can be split between systematic risk and unsystematic risk.

unsystematic risk can be completely diversified away.

a risk free security exists.

beta values remain constant throughout time.

Focal point

Considerable research has been undertaken into the movement of company beta values over time. The assumption of constant beta values has been found to be fairly realistic as betas, although not absolutely constant, have been shown to move only slowly.

7The uses of the model in financial management CAPM enables a required discount rate to be calculated for capital investment projects on the basis of the projects systematic risk.

CAPM can be used to tailor make discount rates to the systematic risk of projects which differ from the current business risk of the firm.

Betas for project appraisal can be obtained by:

using SYMBOL 98 \f "Symbol"s of companies operating in similar areas to the proposed project.

forecasting project returns and market returns, and calculating a project SYMBOL 98 \f "Symbol" from first principles.

Warning when using betas from other firms, care must be exercised to ensure they are as similar as possible to the project. Watch out for differences in size, operating gearing and financial gearing.

Note that differences in financial gearing can be adjusted for by using M & M equations (see later).

CAPM enables a companys cost of equity to be estimated from the equation

ke = rf + SYMBOL 98 \f "Symbol"equity (rm rf)

where SYMBOL 98 \f "Symbol"equity is the observed beta of the shares in question.

CAPM enables the performance of fund managers to be assessed to see if their actual return exceeded the return expected from the model.

Example

Tussac plc is an all equity company with a cost of capital of 15% p.a.

It wishes to invest in a project with an estimated beta of 1.2. If rf = 10% and = 18%, what is the minimum required return of the project?

Solution

The firms cost of capital is probably irrelevant because the new project almost certainly has risk characteristics different from the firms existing operations.

Using the project beta, its minimum required return is 10% + (8% SYMBOL 180 \f "Symbol" 1.2) = 19.6%.

8The limitations of the CAPM model

views income and capital returns as equally attractive.

Focal point

The differences between the impact of taxation on income and capital returns have lessened in the UK. However, differences still remain and will affect the requirements of the investor.

ignores unsystematic risk, which may be of interest to investors who do not hold a diversified portfolio.

is a single period model.

what rate to choose for rf?

what SYMBOL 98 \f "Symbol" to choose?

in practice the basic CAPM appears not to work accurately for investments with very high or very low betas, overstating the required return for high beta securities and understating the required return for low beta securities. However this problem mostly disappears when the effects of taxation are introduced to develop the basic model.

similarly, CAPM does not seem to generate accurate forecasts for returns for companies with low PEs, and ignores seasonal effects. For example, May is usually a bad month for the stock market (sell in May and go away) while January is a good month. Such anomalies cannot be justified by CAPM.

9Alternatives to the capital asset pricing model

CAPM suffers from a number of problems, theoretical as well as practical, so researchers have sought other relations for the expected return on a share.

CAPM is a single index model

rs = rf + SYMBOL 98 \f "Symbol" (rm rf)

where a securitys expected return is a function of only one factor, the beta value.

Arbitrage pricing theory (APT)XE "Arbitrage pricing theory (APT)" is a multi-index model

rs = a + b1 f1 + b2 f2 + ...

a, b1, b2, ..are constants

f1, f2, ..are the various factors which influence share returns

For example f1 could be the return on the market (as in CAPM), f2 could be an industry index, f3 an interest rate index etc.

Arbitrage profits exist when profits can be made at no risk at all e.g. better returns are available from a different portfolio at the same level of risk.

APT states that when no further arbitrage profits are possible, the expected return from a security is given by:

rs = rf + SYMBOL 98 \f "Symbol"1 (r1 rf) + SYMBOL 98 \f "Symbol"2 (r2 rf) + ...

where rf=the risk free rate

SYMBOL 98 \f "Symbol"i=constants expressing the securitys sensitivity to each factor

ri=the expected return on a portfolio with unit sensitivity to factor i and zero sensitivity to any other factor

The model was proposed by Ross in 1976 but has not yet been developed into anything of practical use. Further work is continuing to identify:

the factors affecting security prices

methods of estimating rf and the SYMBOL 98 \f "Symbol"i.

CHAPTER 10

The Cost of Capital

1The cost of equity using the CAPM and dividend valuation models

The formulae use the same fundamental analysis as in the valuation of securities above.

Cost of equityXE "Cost of equity" Constant dividends

ke =

Constant dividend growth

ke = + g =

whereke=the cost of equity

P0=ex div market value of equity

d=total annual dividend payment

d0=total current dividend

d1=dividend in one years time

g=dividend annual growth rate, estimated either by extrapolating the previous observed growth rate, or by the earnings growth model g = rb.

Focal pointThe above equations are provided in the exam although the notation used may differ slightly. Note that d0 (1 + g) reflects the dividend to be paid in one years time and that therefore P0 is the ex div market value of equity.

Note also that it does not matter whether d and P0 are per share or total figures so long as you are matching like with like. Capital asset pricing model

ke =rf + SYMBOL 98 \f "Symbol"equity (rm rf)

whererf=risk free rate

rm=expected return on market portfolio

SYMBOL 98 \f "Symbol"equity=company (equity) SYMBOL 98 \f "Symbol"2The cost of redeemable and irredeemable debt

Irredeemable debt

kd =

whereI =annual interest

P0 = market value of debt (ex interest)

Redeemable debt

kd of loan stock redeemable at tn is the internal rate of return of the following cash flows (assuming tax relief is immediate)

t0(Ex Interest Market Price)

t1SYMBOL 174 \f "Symbol"nInterest SYMBOL 180 \f "Symbol" (1-T)

tnRedemption price

Focal point

Note that as with the formula for the cost of equity above the first return is received at t1. Therefore as for equity, the security price is ex interest.

Preference share capital

Fixed dividend (cf irredeemable debt)

Cost of preference share capital =

Convertible loan stock

If the option to convert into ordinary shares at tn is exercised, the cost is the IRR of the following cash flows

t0(Ex interest market value of debt)

t1SYMBOL 174 \f "Symbol"nInterest SYMBOL 180 \f "Symbol" (1 SYMBOL 45 \f "Symbol" T)

tnMarket value of ordinary shares into which the debt is to be converted.

Bank loans and overdrafts

Cost = interest rate SYMBOL 180 \f "Symbol" (1 SYMBOL 45 \f "Symbol" T)

Symbols

kd=cost of debt

P0 =ex interest market value of debt

I =total annual interest payment

T =rate of corporation tax

Notes

The cash flows for the determination of the cost of redeemable (and irredeemable) debt would need to be adapted if there were a lag in the tax relief.

Preference dividends are payable from post-tax profits and therefore should not be reduced by tax in the formula.

If no conversion ratio is given for convertible loan stock, it must be assumed that it will remain as debt.

3Weighted average cost of capitalXE "weighted average cost of capital" Formula for WACC

k = ke + kd

Notes

In this formula kd is the after-tax cost of debt. If kd were to represent the before-tax cost of debt, the WACC formula would be rewritten:

k = ke + kd (1 T)

The WACC formula may be expanded to incorporate other forms of financing, based on the respective market values.

Focal point

Note that in the WACC formula the costs of capital are weighted using their respective market values and not their nominal values. This is because, as can be seen from the formulae for each category of security, costs of capital are linked to market values.

ExampleX plc has 5m ordinary 1 shares quoted at 1.20, 2m preference shares quoted at 60p and 1m debenture stock quoted at 80. The cost of capital of each of these securities has been calculated as 20%, 10% and 8% respectively. Calculate the weighted average cost of capital, ignoring tax.

Solution

Total market value=(5m SYMBOL 180 \f "Symbol" 1.20) SYMBOL 43 \f "Symbol" (2m SYMBOL 180 \f "Symbol" 0.60) SYMBOL 43 \f "Symbol" (1m SYMBOL 180 \f "Symbol" 0.80)

=8m

SYMBOL 92 \f "Symbol" WACC=

=17.3%

When should WACC be used?

Companys funds can be viewed as a pool of resources.

New project is financed from this pool.

When not applicable?

Projects with different business risk to company.

Projects with different finance risk i.e. financed in a different way from the company.

Project specific finance e.g. government subsidy or grant.

Calculation difficulties are discussed below.

Calculating the cost of equity dividend valuation model

Validity of share price = discounted value of future dividends.

Current share price must be in equilibrium.

Validity of constant dividends or constant growth of dividends.

Determination of g.

Focal point

Note that g is either calculated using extrapolation of past dividend payments or the rb model. Both techniques are based on historic figures. The resultant growth rate is then used as an estimate for the future and therefore may be inaccurate.

Calculating the cost of equity capital asset pricing model

See CAPM section above.

Calculating the cost of debt

Validity of market value = discounted future cash flows.

Current market value must be in equilibrium.

Calculating the cost of convertible loan stock

Will it be converted into shares?

Determination of market value of shares at conversion date.

Calculating the cost of bank loans/overdrafts

Variable interest rates.

A general difficulty is the distinction between short-term and permanent finance e.g. overdraft if only for working capital, do not include in WACC.

4Theories of gearing

Operating gearing=

SYMBOL 222 \f "Symbol" higher fixed costs, higher operating gearing

ExampleA firm has fixed costs of 1m p.a. and variable costs equal to 80% of sales values. If sales increase from 10m to 11m, calculate the operating gearing.

SolutionSales of 10mSales of 11m

mm

Sales1011

Variable costs(8)(8.8)

Fixed costs(1) (1)EBIT 1 1.2SYMBOL 92 \f "Symbol" Operating gearing =

Financial gearing

Capital:

could also be based on book values

Income: (= Interest cover)

The traditional view of gearing

XE "Traditional view of gearing"Focal point

Note that the cost of debt will rise at very high levels of gearing. This is because although interest payments are contractual, and therefore certain, at high levels of borrowing the firms ability to meet its obligations becomes uncertain.

The traditional view of gearing states that there is an optimal gearing level at which the overall WACC is a minimum, and the overall market value of the firm is maximised.

Modigliani and Miller Proposition IXE "Modigliani and Miller Proposition I" (1958)

All companies with the same earnings in the same risk class have the same future income stream and should therefore have the same value, independent of capital structure.

This first proposition assumes zero taxation. Such an assumption is relaxed in the later propositions.

However, Proposition I leads to the following graph and formulae.

(i)

(ii)Proposition I

Without tax

Vg = Vu

keg=keu+(keu-kd)

WACCg=WACCu

whereV=Value of firm (Vg = value of geared firm, Vu = value of ungeared firm)

ke=Cost of equity (keg = cost of equity in geared firm, keu = cost of equity in ungeared firm)

kd=Cost of debt (must be gross of tax)

D=MV of debt

E=MV of equity

Assumptions

Investors are rational.

Investors have the same view of the future.

Personal and corporate gearing are perfect substitutes.

Focal point

Modigliani and Millers theory assumes that individuals are able to borrow funds at the same interest rate as that offered to companies. This can be observed in their arbitrage proof.

Information is freely available.

No transaction costs.

No tax.

Firms can be grouped into similar risk classes.

The arbitrage proof, which incorporates these assumptions, can be used to support the M&M Proposition I.

Modigliani and Miller Proposition IIXE "Modigliani and Miller Proposition II" (1963)

The values of companies with the same earnings in the same risk class are no longer independent. Companies with a higher gearing ratio have a greater net future income stream and therefore a higher value.

(i)

(ii)Proposition II With taxVg = Vu + Dt

keg= keu+(1-t)(keukd)

WACCg= WACCu(1)

Focal point

This final equation (for WACCg) is included in the formula sheet provided in the examination.

As gearing increases, the WACC steadily decreases.

Note that the without tax formulae are simply a special case of the with tax formulae with t = 0.

Focal point

Occasionally the horizontal axis of the Modigliani and Miller graphs use as a measure of gearing.

Although this alters the gradients of the lines it does not alter their theory.

Theory Arbitrage proof in a world with corporation taxes

Assume two companies, identical in every aspect except G is financed by 1,000 of 10% irredeemable debt. The M & M assumptions listed above still hold apart from corporation tax is now 35%.

The traditional view of the two companies could be:

UG

EBIT500500

Interest - (100)

500400

Tax (35%)(175)(140)

Dividends 325260Cost of equity ke20%26%

Value of equity (E)1,6251,000

Value of debt (D) - 1,000Value of firm (V)1,6252,000WACC20%16.25%

Suppose that an investor owns 10% of Gs equity (income 26). he should arbitrage i.e.

sell his stake in G for 100

adopt the same financial risk as G by borrowing a proportional amount at 10% = 1,000 SYMBOL 180 \f "Symbol" 10% SYMBOL 180 \f "Symbol" (10.35) = 65.

Focal point

Modigliani and Millers theories assume that investors are both rational and risk averse. Therefore once the investor has sold his original stake in the geared firm, he would wish to maintain the gearing risk by obtaining (or substituting) personal borrowing prior to investing in the ungeared firm.

Buy 10% of Us equity for 162.50 to give the same income as before i.e.

Dividends from U32.50

Interest on loan (6.50)

Income26.00But: investor has spare funds (100 + 65 162.50 = 2.50) which can be invested elsewhere to increase his income for the same level of risk

Result market pressure will quickly compete away this money machine. (Gs equity will fall in price, Us equity will rise.) Assuming (for convenience) all the price changes are concentrated on G this will give an equilibrium value of equity of 975 (162.50 65 = 97.5 for 10%) and a value of the firm of 1,975 for G.

5relevance of the cost of capital for unlisted companies and public sector organisations

Unlisted companies

no external share price exists, so no cost of capital can be directly calculated or beta estimated.

dividends are likely to be manipulated each year depending on shareholders personal tax positions.

best method to estimate the cost of capital is to take the cost of a similar listed company and add a risk premium.

Public sector organisations

the government sets a discount rate in real terms against which all large public sector projects are appraised.

however there are significant non-financial costs and benefits from most public sector projects which must also be taken into account. This is usually done as part of a formal cost benefit analysis exercise.

6practical problems in estimating an appropriate discount rate

The practical problems have been introduced above. The next chapter will develop the idea that a companys WACC can only be used directly to appraise new projects if:

the gearing ratio is unchanged by the project

the project is of the same risk class as the whole company.

Both of these assumptions are likely to be at least approximately valid in the majority of cases.

CHAPTER 11

Further Aspects of the Cost of Capital

1Capital structure and high gearing

Problems associated with high levels of gearing

The M&M proposition II suggests that companies should aim to maximise their gearing in order to maximise the value of the business. However in practice problems arise as gearing levels increase. Four new expected costs can be identified.

Vg = Vu + Dt- Bankruptcy costs(1)- Agency costs (2)- Tax exhaustion (3)- Personal taxes (4)

Focal point

The impact of these four costs at high levels of gearing serves to increase the weighted average cost of capital. This in some ways returns us to the traditional view of gearing.

Bankruptcy costs XE "Bankruptcy costs" the higher the level of gearing the greater the risk of bankruptcy with the associated costs of financial distress.

Vg = Vu + Dt Expected present value of the costs of financial distress

Agency costs XE "Agency costs" costs of restrictive covenants to protect the interests of debt holders at high levels of gearing.

Taxation exhaustion XE "Taxation exhaustion" the value of the company will be reduced if advantage cannot be taken of the tax relief associated with debt interest.

Personal taxes (Millers critique 1977) (see following).

Investors will be concerned with returns net of all taxes.

If a firms income is paid out as debt interest, corporation tax savings are made (see M&M 1963) but investors will have to pay income tax on debt interest.

If a firms income is paid out as equity return, corporation tax has to be paid but personal tax is saved (via the imputation system as dividends or by avoidance of capital gains tax by delaying sale or using exemptions).

In deciding its gearing level, a firm should consider its corporation tax position and the personal tax position of its investors if it wishes to maximise their wealth.

Firms should gear up until marginal investors face a personal tax cost of holding debt equal to the corporation tax saving. At this point there is no further advantage to gearing. Under current UK tax legislation this situation appears unlikely.

Practical constraints on level of gearing

Organisations perception of its debt capacity, based on its potential ability to repay such debt.

View of providers of capital as to acceptable level of gearing. (This can dramatically change.)

Quality of asset backing to the debt.

Expected cash flows and risk attached.

Tax position of organisation.

Size of organisation.

Countries in which funds are invested and borrowed.

Focal point

When answering exam questions it is important to consider practical aspects of gearing in addition to the theoretical aspects if so required.

2CAPM and the cost of capital

Betas are a way of measuring required rates of return and should respond to changes in gearing in the way predicted by M&M.

Focal point

Note that this formula is provided in the exam. The ungeared equity SYMBOL 98 \f "Symbol" (the asset SYMBOL 98 \f "Symbol") is lower than the geared equity SYMBOL 98 \f "Symbol" as it purely reflects the business risk associated with the equity. In many cases SYMBOL 98 \f "Symbol"d is assumed to be zero, so the second term of the equation will disappear.

As this approach is based on the theories of M&M, it is subject to the limitations of their theory.

3Pecking order theory XE "Pecking order theory" of capital structure

Pecking order theory suggests a reason for the observed inconsistency in practice between the static trade-off model and what companies actually appear to do.

Firms have a preferred hierarchy for financing decisions:

main preference to obtain finance from retained profits before raising funds externally

if funds raised externally, the preferred financing method is debt followed by convertible securities followed by preference shares followed by equity.

4Behavioural theory of capital structure XE "Behavioural theory of capital structure" Herd migration theory following what other firms were doing.

Follow my leader theory following the leading firm.

5Project-related discount rates and gearing

CAPM can be used to find a suitable discount rate for an individual investment/division, estimating the beta value of the investment by using the beta of a company in a similar area of business. However different companies can have different debt structures which affect their betas. M&M show how this problem can be solved by ungearing and then regearing the beta using the equation:

SYMBOL 98 \f "Symbol"a = SYMBOL 98 \f "Symbol"e + SYMBOL 98 \f "Symbol"d

whereSYMBOL 98 \f "Symbol"a=beta assetXE "Beta asset" = beta equity for the ungeared company

SYMBOL 98 \f "Symbol"e=beta equity for the geared company

SYMBOL 98 \f "Symbol"d=beta of debt

D=market value of debt

E=market value of equity

t=corporation tax rate

Focal point

Note that SYMBOL 98 \f "Symbol"e is the SYMBOL 98 \f "Symbol" that reflects the impact of gearing on equity and not on total capital. This is a common misconception.

If SYMBOL 98 \f "Symbol"d is assumed to be zero (a common assumption), then the equation simplifies to:

SYMBOL 98 \f "Symbol"a = SYMBOL 98 \f "Symbol"e

Example X plc manufactures TV sets. It is considering a more risky new project selling video games. X is currently ungeared and has an equity beta of 0.9. The average beta amongst video games sellers is 1.8, while their average gearing is 20% debt : 80% equity. Risk free investments yield 6%, the market return is 20% and corporation tax is 33%.

What required rate of return should X plc look for in its new project if it remains financed purely by equity?

Solution

We must first ungear the quoted beta for video games sellers. Assuming that debt is risk-free:

SYMBOL 98 \f "Symbol"a = 1.8 SYMBOL 180 \f "Symbol"

= 1.8 SYMBOL 180 \f "Symbol" = 1.54

This beta represents the pure systematic risk of the video games industry, excluding any financial risk arising from gearing.

Rs=Rf + SYMBOL 98 \f "Symbol" (Rm Rf)

=6 + 1.54 (20 6)

=27.6%

X plc requires a return of 27.6% from the new project.

Note that if X plc took on debt itself, a new geared beta for the company could be estimated from the geared beta equation used above.

Focal point

The necessity to first ungear the SYMBOL 98 \f "Symbol" remains. However if X plc takes on debt, the SYMBOL 98 \f "Symbol" can then be regeared to reflect this. Note that if an industry SYMBOL 98 \f "Symbol" is provided, it is already ungeared.

6The adjusted present valueXE "Adjusted present value" technique The procedure

Step 1Estimate the base case NPVXE "Base case NPV" assuming that the project is financed entirely by equity.

Step 2Estimate the financial effect of the actual method of financing (e.g. tax, issue costs, etc).

Step 3Add the values from steps 1 and 2 to give the APV.

If the APV is positive, accept the project.

The APV method has the advantage of breaking down a complex problem into its constituent parts rather than trying to encapsulate the whole problem into determining a single discount rate.

ExamplePam plc is considering a new project that would cost 20m. Half the necessary finance would be provided from retained profits, the other half coming from a five year subsidised development loan at 8% pa, compared to a normal market rate of 10%. A residual value of 10m is expected at the end of the 5 years.

The project would generate after tax (but before WDAs) net cash flows of 5m pa during the 5 year planning period. All capital expenditure attracts a 25% WDA on a reducing balance basis; tax is charged at a rate of 30% and is paid 12 months in arrears.

Companies in the new industry have an average gearing of 60% equity, 40% debt by market values, and a beta of 1.2. The return on the whole market is expected to be 16% pa.

Use the APV method to recommend whether this proposed investment should be undertaken.

Solution

First the base case NPV is calculated, assuming that the project is financed entirely by equity.

SYMBOL 98 \f "Symbol"asset=SYMBOL 98 \f "Symbol"e

=1.2 SYMBOL 180 \f "Symbol"

=0.82

SYMBOL 92 \f "Symbol" Base case discount rate =rf + SYMBOL 98 \f "Symbol" (rm rf)

=10 + 0.82 (16 SYMBOL 45 \f "Symbol" 10)

=15% approx.

Calculation of WDAs

m

m

m

Year 120.0 SYMBOL 180 \f "Symbol" 25%=5.0 SYMBOL 180 \f "Symbol" 30%=1.5

(5.0)

Year 215.0 SYMBOL 180 \f "Symbol" 25%=3.75 SYMBOL 180 \f "Symbol" 30%=1.13

(3.75)

Year 311.25 SYMBOL 180 \f "Symbol" 25% =2.81 SYMBOL 180 \f "Symbol" 30%=0.84

(2.81)

Year 48.44 SYMBOL 180 \f "Symbol" 25%= 2.11 SYMBOL 180 \f "Symbol" 30%=0.63

Year 510.0 SYMBOL 45 \f "Symbol"13.67 = (3.67) SYMBOL 180 \f "Symbol" 30% = (1.10)

Calculation of base case present value (m)

Time0123456

Outlay(20)

After-tax inflows

55555

Residual value

10

WDAs______1.51.130.840.63(1.10)

(20)56.56.135.8415.63(1.10)

Discount factor at 15%1.870.756.658.572.497.432

PV(20)4.354.914.033.347.77(0.48)

Base case NPV = 3.92m

Calculation of the PV of the financing side-effects

(i)Interest paid = 8% SYMBOL 180 \f "Symbol" 10m = 0.8m pa.

This attracts 30% SYMBOL 180 \f "Symbol" 0.8m = 0.24m tax relief p.a.

These payments are certain, so are discounted at 10%

PV=0.24m SYMBOL 180 \f "Symbol" 3.791 SYMBOL 180 \f "Symbol" 0.909

=0.83m

(ii)Interest saved on cheap loan = 2% SYMBOL 180 \f "Symbol" 10m = 0.2m p.a.

PV= 0.2m SYMBOL 180 \f "Symbol" 3.791 = 0.76m

(iii) Tax relief lost by having a cheap loan

PV=0.2m SYMBOL 180 \f "Symbol" 30% SYMBOL 180 \f "Symbol" 3.791 SYMBOL 180 \f "Symbol" 0.909

=0.21m

APV calculation

m

Base case NPV3.92

PV of tax shield on loan0.83

PV of cheap loan0.76

PV of tax relief lost on cheap loan(0.21)

5.30

Conclusion

The project has a positive APV and therefore should be undertaken.

7practical problems of using the APV technique

relies on the M&M Proposition II formulae to be valid so requires the M&M assumptions to hold true.

different discount rates should be applied to the different side effects, which can become complicated.

the danger of getting bogged down in the detail, and not being able to see the wood from the tree.

CHAPTER 12

Mergers and Acquisitions

1arguments for and against mergers XE "Mergers "and acquisitions

Types of merger:

horizontal mergers

vertical mergers (backwards or forwards)

conglomerate mergers.

A merger is rational if synergy XE "Synergy "is created.

An expansion policy based on merger or take-over can be justified on the basis of synergy i.e.

Value of A plc and B plc combined>Value of A plc operating independently+Value of B plc operating independently

(sometimes stated as 2 + 2 = 5)

Possible sources of synergy(=sensible argument

x=silly argument

Operating economies

(Economies of scale

(Economies of vertical integration

(Complementary resources

(Elimination of inefficiency

(Surplus managerial talent

(Surplus cash.

Market power

(The desire to earn monopoly profits (good for shareholders but not for public interest).

Financial effects

xDiversification reduces risk (it only reduces total risk not systematic risk for well diversified shareholders).

(Diversification reduces the variance of operating cash flows giving less bankruptcy risk and therefore cheaper borrowing.

xHigh PE ratio companies can impose their multiples on low PE ratio companies (bootstrapping).

Conclusion of synergy

Synergy is not automatic.

When bid premiums are considered, the only consistent winners in mergers and take-overs are victim company shareholders.

2Merger and acquisition activity internationally

Merger activity is much higher in the UK and USA than in Germany or Japan. This is principally because banks dominate the financial systems of Germany and Japan, and develop long-term relationships with the companies they serve, taking significant equity stakes. They would not sell these stakes to a predator.

In the UK and USA institutional shareholders are willing to sell if offered a significant premium.

The previous UK accounting standard SSAP 22 permitted goodwill to be offset directly against reserves, which was often stated as encouraging UK take-overs. However FRS 10 now requires UK companies to capitalise their purchased goodwill on the balance sheet and amortise it over its useful life. This brought UK practice in line with international practice and has ended the perceived advantage enjoyed by UK companies.

Focal point

Note that the regular reading of the financial sections of broadsheet newspapers is recommended for this section of the syllabus. Although it is unlikely that specific activities would be examined, an awareness of actual merger and acquisition activities can only enhance answers.

3Alternative strategies and tactics of mergers and acquisitions

Strategy